RM: disasters and reactions

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From Ilya Somin at the Volokh Conspiracy:
http://volokh.com/archives/archive_2...tml#1253404230

Political Ignorance and the Case Against Paternalistic Regulation:

My colleague Josh Wright and co-blogger Todd Zywicki have an important essay criticizing the Obama Administration's proposed new Consumer Financial Protection Agency (CFPA). The premise behind the CFPA is that consumers' choices need to be limited by government regulators because otherwise consumers are likely to make mistakes caused by their own cognitive errors.

Josh and Todd outline several serious problems with the CFPA proposal and the economic theory underlying it. Here are two others based on my own work on political ignorance.

I. Voters are More Ignorant and Irrational than Consumers.

First, the CFPA and other paternalistic policies will have to be adopted through the democratic process. But voters tend to be rationally ignorant about politics, and commit serious cognitive errors in analyzing the little information about politics they do know. Political ignorance and irrationality is likely to be far more severe than the cognitive mistakes consumers make.

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II. Political Ignorance Increases the Risk of Regulatory "Capture."

Second, political ignorance opens the door to interest group "capture" of the CFPA or other agencies that will implement paternalistic regulations. Such regulations will necessarily be complex and difficult to understand. Rationally ignorant voters are unlikely to follow them closely enough to be able to tell the difference between effective regulations and harmful ones. As a result, it will be easy for interest groups and government officials to enact regulations that benefit politically influential businesses as the expense of the public under the guise of consumer protection.
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Expert advice is often useful in making difficult consumer decisions. On balance, however, it is better to trust experts chosen by consumers in a competitive market than to delegate coercive power to government-appointed experts who have neither the knowledge nor the incentives needed to genuinely improve consumer welfare.

The paper Somin links to:
http://www.finreg21.com/lombard-stre...gency-act-2009

The creation of a new Consumer Financial Protection Agency (“CFPA”) is a very bad idea and should be rejected. The proposal is not salvageable and cannot be improved in substance or in form. The proposal is premised on a fundamental misunderstanding of the causes of the financial crisis. The Obama Administration’s Financial Regulatory Reform White Paper, and the intellectual underpinnings of the new CFPA as articulated by law professors Elizabeth Warren of Harvard and Oren Bar-Gill of New York University, set forth the blueprints for a powerful regulatory agency designed to react to a perceived failure of consumers to understand innovative financial products. The foundational premise of the CFPA is that a failure of consumer protection, and specifically irrational consumer behavior in lending markets, was a meaningful cause of the financial crisis and that the CFPA would have or could have averted the crisis or lessened its effects.

Neither the White Paper nor Bar-Gill and Warren offer a scintilla of evidence to support these claims. Let us repeat that to make it clear—there is no evidence that consumer ignorance or irrationality was a substantial cause of the crisis or that the existence of a CFPA could have prevented the problems that occurred. In this article, we highlight three fundamentally problematic truths about the CFPA:

(1) The CFPA is premised on a flawed understanding of the financial crisis.

(2) The CFPA will have significant unintended consequences, including but not limited to reducing competition, consumer choice, and availability of credit to consumers for productive uses;

(3) The CFPA creates a powerful bureaucracy with undefined scope, risking expensive and wasteful regulatory overlap at both the federal and state levels without any evidence of its own expertise in the core areas it is designed to regulate.

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An interesting story combining credit ratings agencies and public pensions, from Canada:
http://pensionpulse.blogspot.com/200...ion-funds.html

Last week Tara Perkins of the Globe and Mail reported that rating agencies are at the crossroads:

Yesterday, the Investment Executive reported that according to DBRS, Canadian public pension funds hard hit by downturn are still solid:

Let's set aside the potential conflicts of interest of having DBRS rate Canadian public pension funds who bought ABCP paper based on their ratings (Caisse, PSP Investments, and Ontario Teachers).
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More importantly, how can DBRS or any rating agency rate these public pension funds without conducting a thorough performance audit? To do that, they need full transparency on the benchmarks governing internal and external investments. That information is not readily available, especially for private markets.
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It's not just rating agencies that are at the crossroads, but pension funds are at the crossroads too. We need a governance overhaul that introduces more transparency and a compensation system that rewards risk-adjusted returns. The status quo at rating agencies and pension funds is totally unacceptable.

This could've gone in the public pensions thread as well, but the story here is more of the whole credit rating problem. There are issues if the NAIC brings it under its aegis. There are issues continuing with business as usual. Many investors are not large institutions able to create their own internal ratings systems [and yes, there are issues there, too].

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From Canadian Underwriter [and thanks to the actuarial crew on twitter]
http://www.canadianunderwriter.ca/is...&pc=CU&ref=rss

As expectations of risk management functions grow in the current economic and regulatory climate, actuaries will have to move beyond their “familiar zone” and begin to consider the entire range of risks faced by an insurer, said Julie Dickson, the Superintendent of Financial Institutions.

Dickson delivered a speech to the Actuaries Club of Toronto on Sept. 23, 2009.
In it, she noted appointed actuaries have traditionally been considered as a separate “independent oversight function” with the authority to carry out their responsibilities and have direct access to an organization’s board as required under the Insurance Companies Act.

“The role has been about valuing an insurer’s insurance obligations and assessing its financial condition,” she said.

When considering insurance risks, such as segregated funds or longevity risks, OSFI expects the actuarial profession to develop appropriate views with respect to policy liabilities and related capital amounts, Dickson continued.

“As we move towards more comprehensive risk management, actuaries will be involved in the determination of each insurer’s own economic capital needs. To do this, actuaries will have to be more concerned about all the risks,” she said.

“While assessing liabilities has been a familiar 'zone' for actuaries, it will be necessary to move outside that comfort zone and consider the entire range of risks faced by an insurer.”

This seems to be more generically about ERM, and not necessarily related to the current economic situation.

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Maybe Securitization did not cause the crisis

http://www.tnr.com/blog/the-stash/ma...ions-not-blame

Soon forthcoming in the top-ranked Quarterly Journal of Economics is a very well- received paper by four economists with convincing evidence of what many believe was the primary cause of the subprime boom and bust: That securitization took away the incentive for lenders to properly vet borrowers.

But there's some new evidence questioning the paper's findings. To understand the how and why, we have to get into the nitty-gritty of the empirics.

If you plot FICO (i.e., credit) scores against the number of mortgages outstanding, you'll notice a peculiar pattern:
[graph at link]
Instead of a smooth curve, at certain FICO scores there are big jumps in the number of people with mortgages.

The reason? Rules of thumb observed by those in the mortgage industry for judging the chances a borrower will default. In the 1990's, Fannie and Freddie released research showing that about 50% of defaults are associated with borrowers who have FICO scores below 620. That happens to be where the biggest jump in the graph above takes place, suggesting that the industry looks far more kindly on a borrower with a score of 621 than a borrower with a nearly identical score of 619.

But who used this rule-of-thumb?

The economists -- Benjamin Keys, Tanmoy Mukherjee, Amit Seru, and Vikrant Vig -- assert that securitizers followed the rule in deciding whether to buy a loan from an originator. Problem is, that meant the originator then knew he didn't have to spend much time vetting someone with a FICO score above 620, since there was a good chance the loan would be securitized and off his books. For the opposite reason, the originator would be more likely to put in the proper due diligence when considering lending to a borrower with a score below 620.

What we should then see is borrowers with FICOs just above 620 defaulting more often than nearly identical borrowers with scores just below 620. And lo and behold, when the economists looked at the data, that's exactly what they found.

More at the link.

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This relates to pension funds, but does have to do with correlations going to 1 in rough economic times
http://seekingalpha.com/article/1636...le_lb_articles

[I added emphasis, and a link]

I appeared last Friday on a the PBS program WealthTrack, where the topic was asset allocation, in particular, as host Consuelo Mack put it, how to build an all weather portfolio. I was the skeptic of the group. I don’t think there is some magic asset allocation that protects you from the buffetings of financial storms without it also trimming your sails during fair weather. Here is an encapsulation of my views from the program.
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But the discussion of risk tolerance highlights that we can only go so far with asset allocation if we only look at assets. What matters is assets versus liabilities, because the liabilities determine our risk tolerance and, related to that, our demand for liquidity. It is impossible to formulate an ideal asset allocation strategy without knowing the liability stream those assets are intended to meet. There is no one-size-fits-all for asset allocation. This reminds me of an FAJ article I did back in the 1980s with pension actuary Jeremy Gold entitled “In Search of the Liability Asset”.


Diversification works well, except when it really matters
We all know the argument from Finance 101: If you hold 16 uncorrelated assets, your risk will drop by a factor of four. Well good luck with that.

During a crisis, when diversification really matters, correlations aren't near zero (as if they ever are). All that people care about is risk and liquidity. All assets that are highly risky drop, all assets that are less liquid drop. No one cares about the subtlety of earnings streams. It is like high energy physics. When the heat gets turned up high enough, matter is just matter, the distinctions between the elements is blurred away.

Nice analogy at the end there.

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Oh, Mandelbrot....
http://www.forbes.com/2009/09/28/man...rss_popstories

You Don't Know The Math
Michael Maiello, 09.29.09, 06:00 AM EDT
The complexities of the financial markets are beyond your broker's abilities.

Four years retired from Yale, Benoit Mandelbrot, the inventor of fractal geometry, is still trying to teach the essential lesson of his life's work--nature and markets defy easy description. Anyone who tells you otherwise is either trying to sell you something, doesn't know the math or both.
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You don't need to be a mathematician to get some benefit from the master's work. Just be wary, remember that the impossible can and will happen, and don't count on consistency. A student of fractals would have seen right through Bernie Madoff's claims.

Um, no.

Anyway, there's some stuff I excised you might want to read. This article does Mandelbrot no favors. Benoit, you do not need to have your name tied to Taleb, for one.

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Systemic risk and ratchet effect
http://hbswk.hbs.edu/item/6291.html

Executive Summary:

During periods of rising house prices, falling interest rates, and increasingly competitive and efficient refinancing markets, cash-out refinancing is like a ratchet, incrementally increasing homeowner debt as real-estate values appreciate without the ability to symmetrically decrease debt by increments as real-estate values decline. This paper suggests that systemic risk in the housing and mortgage markets can arise quite naturally from the confluence of these three apparently salutary economic trends. Using a numerical simulation of the U.S. mortgage market, the researchers show that the ratchet effect is capable of generating the magnitude of losses suffered by mortgage lenders during the financial crisis of 2007-2008. These observations have important implications for risk management practices and regulatory reform. Key concepts include:

* Consider the hypothetical scenario in which all homeowners decide to refinance and extract cash from any accumulated house equity so that their loan-to-value ratio is kept the same as the one for a new purchaser of that house. Suppose that the refinancing market is so competitive, i.e., refinancing costs are so low and capital is so plentiful, that homeowners can implement this refinancing each month. In this extreme case, during periods of rising home prices and falling interest rates, cash-out refinancing has the same risk effect "as if" all houses had been purchased and their mortgages originated at the peak of the housing market, thereby creating a large systemic risk exposure. Then, when home prices fall, the refinancing ratchet "locks,'' causing a systemic event with widespread correlated defaults and large losses for mortgage lenders.

* While excessive risk-taking, overly aggressive lending practices, pro-cyclical regulations, and political pressures surely contributed to the recent problems in the U.S. housing market, the simulations show that even if all homeowners, lenders, investors, insurers, rating agencies, regulators, and policymakers behaved rationally, ethically, and with the purest of motives, financial crises can still occur.

* The fact that the refinancing ratchet effect arises only when three market conditions are simultaneously satisfied demonstrates that the current financial crisis is subtle, and may not be attributable to a single cause.

* There may be no easy legislative or regulatory solutions: Lower interest rates, higher home prices, and easier access to mortgage loans have appeared separately in various political platforms and government policy objectives over the years. Their role in fostering economic growth makes it virtually impossible to address the refinancing ratchet effect within the current regulatory framework.

* We need an independent organization devoted solely to the study, measurement, and public notification of systemic risk, not unlike the role that the National Transportation Safety Board plays with respect to airplane crashes, train wrecks, and highway accidents.

* The subtle and multifaceted nature of the refinancing ratchet effect is just one example of the much broader challenge of defining, measuring, and managing systemic risk in the financial system.

Actual white paper:
http://www.hbs.edu/research/pdf/10-023.pdf

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I was going to put this post in the public pensions thread, but I think it really goes here:
On pension funds chasing riskier investments
http://pensionpulse.blogspot.com/200...omplexity.html

ith all due respect to Dr. Ros Altmann, smaller pension plans have no business investing in hedge funds, or other alternative investments like private equity. They should, for the most part, stick to a 60/40 stock/bond portfolio and look to allocate to quality managers.

If they are hell bent on hedge funds, then they should go to reputable funds of funds that will not rape them on fees and that offer managed accounts. But I am skeptical of most funds of funds and the reality is that smaller plans shouldn't be investing in strategies they do not understand.
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More risk? More complexity? What are investors and trustees to do? Let me share some comments with you. The financial engineers are working hard to "tame risk" but in my experience when everyone is rushing to play the same game, they all knowingly (or inadvertently) add to systemic risk.

A few years ago, everyone was peddling capital guaranteed structured notes in Canada and elsewhere. Go to any major investment bank and see how the sales of their structured products dropped off a cliff. It was the biggest scam I ever saw and yet so many retail (and few institutional investors) bought into these "capital guaranteed" notes, much to their demise.

I can tell you how it worked. Investors buy the product, the investment bank goes to buy a zero-coupon bond on margin and invests the cash proceeds into a fund of hedge funds. When the hedge funds were making money, this strategy worked well. But in 2008, the liquidity risk and leverage of these strategies were exposed as hedge funds suffered material losses and the structured products made nothing for investors. After fees, they ended up losing money.

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on rating mortgage-backed securities
http://www.lifeandhealthinsurancenew...ups-Jeers.aspx

The Center for Economic Justice and the Consumer Federation of America are opposing an effort to change the way residential mortgage-backed securities are graded.

The American Council of Life Insurers, Washington, has asked the National Association of Insurance Commissioners, Kansas City, Mo., to have an independent firm to create a quantitative “analytical measure” of RMBS safety, and replace reliance on current rating agency RMBS ratings with reliance on the analytical measure.

The CEJ, Austin, Texas, and the CFA, Washington, have filed a joint comment calling the proposal “yet another bald attempt by life insurers to change the rules – rules the life insurers once championed – to provide capital relief to insurers at the expense of consumer protection.”

The ACLI itself has asserted that keeping the current rules will require $11 billion in additional capital contributions, the CEJ and the CFA say.

“Insurers want alternative ratings of RMBS to reduce the amount of capital required under risk-based capital rules to support these poorly-performing securities,” the groups say.

“It is inconceivable that regulators would consider capital relief for these very risky securities given projections for continued high unemployment, mortgage defaults and mortgage foreclosures,” the CEJ and CFA say.

Insurers say the rating agencies have conflicts of interest, but the company that came up with the proposed RMBS grades also would face a conflict of interest, because it would face pressure to come up with results that would give the investors it served higher reported gains, the consumer groups say.

Even if the NAIC does change the rating methodology it uses, it should change the methodology for all types of asset-backed securities, not just RMBS, the consumer groups say.

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Tom Sowell with post-mortem, and mortgage lending standards
http://article.nationalreview.com/?q...E3NDlkNTJkNGE=

How did we get from home ownership to 15 million unemployed Americans? By ignoring the fact that there was a reason why only 64 percent of families owned their own home. More people would have liked to be homeowners, but did not qualify for loans under the mortgage-lending standards that had been in place for decades.

Politicians to the rescue: Federal regulatory agencies leaned on banks to lend to people they were not lending to before — or else. The “or else” included not having their business decisions approved by the regulators, which could cost them more money than making risky loans.

Mortgage-lending standards were lowered, in order to raise the magic number of home ownership. But, with lower lending standards, there were — surprise! — more mortgage-payment delinquencies, defaults, and foreclosures.

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Politicians may not know much — or care much — about economics, but they know politics and they care a lot about keeping their jobs. So a great distracting hue and cry has gone up that all this was due to the market not being regulated enough by the government. In reality, it was precisely the government regulators who forced the banks to lower their lending standards.

The other big lie is that this was a failure of economists and others to foresee that the housing boom would turn to bust and set off financial repercussions across the economy.

In reality, everybody and his brother saw it coming and said so — including yours truly in the Wall Street Journal of May 26, 2005. As far away as London, The Economist magazine warned about the danger. So did many American publications and individuals. The problem was that politicians refused to listen. They were fixated on the magic number of home ownership and oblivious to the economic interconnections that Russian economists saw long ago and from far away.