Tuesday, March 23, 2010

Bernanke and Greenspan: Passing the buck. Part I.

“The buck stops here”
The sign on the desk of the President Harry Truman
“The buck starts here”
The sign on the desk of the Fed Chairman Alan Greenspan

Following Ben Bernanke's passionate defense(we have deconstructed the Chairman Bernanke's arguments here and here) of the Fed's monetary policy vis-a-vis the housing bubble, the Maestro himself weighed in on the matter. At first glance it seems that Mr. Greenspan has actually tried to learn from the crisis and that US monetary policy will be all the wiser for it. He acknowledges that :"In the growing state of high euphoria, risk managers, the Federal Reserve, and the other regulators failed to fully comprehend the underlying size,length, and impact of the negative tail of the distribution of risk outcome". Greenspan basically acknowledged that he was a victim of Disaster Myopia - a well known psychological phenomenon that stretches far beyond financial markets. Speaking of flood insurance Slovic, Fishhoff, and Lichtenstein (1980) quote Kates (1962) :"Recently experienced floods appear to set an upward bound to the size of loss with which managers believe they ought to be concerned(p.140)". They further say :"He (Kates) observed that individuals forecasting flood potential "are strongly conditioned by their immediate past and limit their extrapolation to simplified constructs, seeing the future as a mirror of that past" (p.88). Similarly, the purchase of earthquake insurance increases sharply after quake and then decreases steadily as memories fade (Steinbrugge, McClure, & Snow, 1969)." Memories of central bankers and many market participants seem to be purged even quicker than of those worried about floods. Even so, how Mr. Greenspan, who was heading the Fed during the near meltdown of 1998 and tech bubble crash of 2000, could be unaware of the left tail is somewhat of a mystery. Even this modest admission was partially rescinded when the Maestro added: "To this day it is hard to find fault with the conceptual framework of our [financial risk management] models as far as they go." The timing of this remark is particularly prescient for us because we are starting this blog with the explicit purpose of discussing extreme left tail events and the reasons for the inability of much of the present day risk modeling to deal with them.
A New Twist
We have written before about Ben Bernanke's fantastic claims that zero interest rates in early to mid 2000's did not affect the home prices. Mr. Greenspan unsurprisingly comes to the same conclusion but his reasoning is considerably different from that of his former subordinate. His reasoning goes as follows: "The global house price bubble was a consequence of lower interest rates, but it was long term interest rates that galvanized home asset prices, not the overnight rates of central banks, as has become the seeming conventional wisdom."
This argument would be understandable if a person making it had spent last 20 years on planet Mars and had no clue about any recent financial developments. Apparently, the Maestro does not understand that in the financial economy characterized by the high level of securitization the real lenders are those who are purchasers of the securitized loans. Many of the purchasers of Mortgage Backed-Securities (MBS) like hedge funds and banks' special investment vehicles (SIV) have employed ultra short term financing with mind boggling leverage thanks to the free short term money. A case in point are the two MBS Bear Sterns hedge funds that in 2007 needed to make heavy margin calls (only those that employ short-term financing need to meet margin calls, their leverage was 17:1) and thus were one of the first harbingers of disaster. The absurdity of this argument obscures an interesting question. Why did Mr. Greenspan not follow the defense of the Chairman Bernanke when he put the blame on the creative financing and ARMs in particular? Perhaps this quote made by Alan Greenspan in 2004 sheds some light on his reluctance: “Indeed, recent research within the Federal Reserve suggests that many homeowners might have saved tens of thousands of dollars had they held adjustable-rate mortgages rather than fixed-rate mortgages during the past decade, though this would not have been the case, of course, had interest rates trended sharply upward. …
American consumers might benefit if lenders provided greater mortgage product alternatives to the traditional fixed-rate mortgage. To the degree that households are driven by fears of payment shocks but are willing to manage their own interest rate risks, the traditional fixed-rate mortgage may be an expensive method of financing a home.“ This is like encouraging college students on a spring break to switch from jegermeister to vodka around midnight. We all know what followed.

Stat Gymnastics
"By way of complicated multiplication and division he showed the superiority of the Soviet rule over any other possible kind of rule"
Ilya Ilf and Evgeny Petrov in "The Golden Calf"

Mathematical statistics are an immensely useful tool, but they have to be used in good faith and by those who know its assumptions and limitations. Whether Mr. Greenspan falls into at least one of those categories we have no way of knowing. But his proof of the claim that the Fed funds rate delinked from the mortgage rate in 2002 has a distinct smell that is not Chanel. He argues: "But the 30-year mortgage rate had clearly delinked from the fed funds rate in the early part of this decade. The correlation between the funds rate and the 30-year mortgage rate fell to an insignificant .17 during the years 2002 to 2005, the period when the bubble was most intense, and as a consequence, the funds rate exhibited little, if any, influence on home prices."
What are we to make of this apparently rock solid statistical argument? We get our answer in the next paragraph when Maestro writes: "The funds rate was lowered from 6.5% in early 2001 to 1.75% in late 2001...". The correlation coefficient is the standardized measure of the common variation between two random variables. As real short term interest rates were reduced to effectively zero and were not raised for years, their variation became so low as to vurtually be non-existent. Where one variable has no variation measuring covariation or correlation is as useless as the work of Sisyphus of the Greek mythology. Thus, using the same argument as employed by the former Chairman above we could prove that zero nominal interest rates from 2008 onward had no effect on any of the financial markets, because the covariation of a constant zero with anything else is zero. The relationship between fed funds rate and long term rates is strong, but correlation can be a very bad tool to measure it. Indeed, p.38 of the paper states that :"The correlation coefficient in the US between the Fed funds rate and the 30-year mortgage rate from 1963 to 2002, for example, had been a tight 0.83." When there is significant variation, the relationship can be quite high over a reasonably long period.

Losing Forest Behind the Trees
The debates about housing, however, tend to obscure the real issue, sort of like losing forest behind trees. Between 2002 and 2006 the total indebtedness of the US economy increased by roughly 13.5 trillion dollars. Only about 4.4 TRLN can be attributed to the households, of which mortgages are a subset. 2 TRLN went to various governments and 7 TRLN to businesses. Of this 7 TRLN, a whopping 4.2 TRLN went to the financial sector, see Cassidy (2010). Thus, Mr. Greenspan presided over the biggest credit binge this little planet has ever seen.
We are writting all this not with the intention of focusing on the two of the Fed Chairmen personalities, but with a real practical purpose of improving the understanding of the extreme events and the potential for instability. In the next post we will discuss the implications of our discussion on the global financial volatility in the coming decade.

Next Posts:
"Greenspan and Bernanke: Passing the buck. Part 2 - The Future"
"Behavioral Finance and Extreme Event Risk: Information Cascades"
"Behavioral Finance and Extreme Event Risk: Disaster and Interrelatedness Myopia"

1. Slovic, P., Fischhoff, B. & Lichtenstein, S. (1980). Facts and fears: Understanding perceived risk. In R. Schwing and W. A. Albers, Jr. (Eds.), Societal risk assessment: How safe is safe enough? (pp. 181-214). New York: Plenum Press.
2. Kates, R.W. (1962). Hazard and Choice Perception in Flood Plain Management. Department of Geography Research Paper no. 78, University of Chicago Press.
3. Steinbrugge, Karl V.; Algermissen, Sylvester T. (1969). Studies in seismicity and earthquake damage statistics. Report Department of Commerce, Washington, DC. Appendix A, B, Summary & Recommendations
4. Cassidy J. (2010). How Markets Fail: The Logic of Economic Calamities. Farrar, Straus & Giroux.

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