Defending Finance: Why Bankers and Economists Are Not to Blame for the Crisis

From the Economist, What’s wrong with finance

There’s nothing wrong with finance or economists, but there is often something wrong when leftists pontificate about finance and economics. In the same way the left dismisses IQ as being useless, the left also dismisses economics as merely being a superstition, akin to reading entrails, or the left criticizes economists for failing to predict the crisis. But what few realize is that economists don’t actually need to be able predict; they only need to have the tools and ability in place to stop crisis as soon as it arises so that the healthier portions of the economy can continue to function, a skill that policy makers are quite adept at as evidenced by the efficacy of TARP and other programs.

Note that these objections are not the same as the argument, familiar from the crisis, that individual banks are too big to fail (or TBTF). This approach is more akin to the idea of the “resource curse” that economies with an excessive exposure to a commodity, such as oil, may become imbalanced. Just as the easy money from drilling for oil may make an economy slow to develop alternative business sectors, the easy money from trading in assets, and lending against property, may distort a developed economy.

Too big to fail policy such as TARP has been a success though. Eight years later, and still not the slightest hint of trouble in the financial sector. In fact, with stricter lending standards, less leverage, and fatter balance sheets, thing are better than they have ever been.

And given that the US economy, especially since 2011, has done better than its peers both in terms of inflation adjusted economic growth, US dollar currency gains, stock market gains, consumer spending, profits & earnings, and so on – so I guess you can say Bernanke did a good job, and fed policy was a success. Now other foreign banks, such as the ECB, are copying Bernanke’s legacy of QE and low interest rates.

In defense of models, including the Homo economicus model that is the scourge of the left on the liberal presumption that humans are not as inherently self-interested as the Homo economicus model implies, these models do a pretty good job approximating and predicting real-life events. Economic models, despite their flaws, are better than having no models, and models can help us have a better understanding of the world. Working backwards, the empirical data agrees with the Homo economicus models, that humans act in their own self-interests. An economic model based on altruism would not agree with the data, making it useless.

It’s like how the left criticizes string theory for not being falsifiable, but string theory is logically consistent, obeying energy conservation laws and various symmetries – it’s just that we don’t yet have the technology to verify string theory. In the same way the Higgs Bosson, first conceived by Peter Hills in the 60’s through a mathematical model and then later verified experimentally, string theory will have to wait for its moment, but the inability to verify it empirically doesn’t mean we should automatically dismiss it. The left assumes that smart people lack common sense, but what does that say about average IQ people – are they going to be any better? Or as quoted by Scott Adams, “If there are no stupid questions, then what kind of questions do stupid people ask? Do they get smart just in time to ask questions?” The Black Scholes option pricing formula is only a heuristic. No one in finance uses it literally, but the left creates this straw man of quants who never deviate from a handful of models, as if the concept of tail risk is somehow a new or alien concept to people in finance that only the media knows about.

The best hope for progress is the school of behavioral economics, which understands that individuals cannot be the rational actors who fit neatly into academic models. More economists are accepting that finance is not a “zero sum game”, nor indeed a mere utility, but an important driver of economic cycles. Indeed, finance has become too dominant a driver.

Behavior finance is popular among those who in insist the market is rigged, and a bubble, and that investors are always irrational. In yet another straw man, no one actually believes the market is completely zero-sum. Due to fundamental drift, indexes such as the S&P 500 and fundamentals (profits & earnings) tend to be positively correlated such that someone who holds the S&P 500 into a long economic expansion will almost always make money. Eminent economist and mathematician Paul Samuelson posited that the market is in the short-run zero sum, but in the long-run less efficient.

A question that frequently arises is why no one went to jail for the crisis.

As for the Banksters, the fact that none of them did any hard time due to the policy of “too big to jail” is just another sign of the utter moral collapse of our country-to Hell with them all I say. I can only hope the sheeple will wake up long enough to realize the greedy banking bastards not only got away with gang-raping Amerika, they got paid handsomely for their lusty effort. A rope is too good for them.

Since 2008, people actually did go to jail for mortgage fraud, although you’ll never hear this from the media, who repeat the narrative that no one was arrested. According to wikipedia:

The number of FBI agents assigned to mortgage-related crimes increased by 50 percent between 2007 and 2008.[10] In June 2008, The FBI stated that its mortgage fraud caseload has doubled in the past three years to more than 1,400 pending cases.[11] Between March 1 and June 18, 2008, 406 people were arrested for mortgage fraud in an FBI sting across the country. People arrested include buyers, sellers and others across the wide-ranging mortgage industry.[10]

Two examples from the page: Delroy Davy Sentenced to 14 Years in Prison for Defrauding Failed Omni National Bank and Other Lenders and Former Bank Vice President Sentenced to 10 Years in Prison for Mortgage Fraud Scheme.

Understandably, being that these are stings the FBI is not going out of its way to make these arrests obvious, but behind the scenes there is justice.

Second, the bankers didn’t go to jail because being wrong is not a crime. Imagine, for example, a tour bus full of people is hit by a meteorite, killing everyone but the driver. Is the driver to blame for somehow not foreseeing meteorite risk? The models the bankers used could not have foreseen such as big collapse, so the problem is the models and not the bankers. Then there are the loser homeowners who thought buying a five-bedroom mansion on a $40,000 income was a good idea, or other homeowners who speculated in Miami or Las Vegas real estate, naively believing it would become the next Aspen or Manhattan. Or home flippers who thought they could flip to a bigger fool – until they became the fool, holding a highly-leveraged inventory of deprecating homes they couldn’t hope to sell at anywhere near a profit.

As people on Reddit understand, you can only go so far in protecting people from their stupidity.

The liberal media is also to blame for fanning the flames of crisis to get Obama elected, turning what could have been a localized subprime problem into something bigger.

“they sold the loans”

Another common argument is that bankers knowingly sold defective financial products to their clients.

With every investment comes a risk, as stated in the prospectus. The people who bought these investments were (presumably) seeking abnormally high returns. That’s what sometimes happens – when a unique investment strategy works for many years – almost too good to be true – and then things suddenly go bad, because there is seldom a free lunch. People go to jail for blatant impropriety – embezzlement, for example. Or going against the client’s wishes, such as by investing the client’s money in a riskier security that will generate a large commission for the broker, even though the client stipulated he wanted a safe investment. But even safe investments can fail, and like the bus driver, it’s not the fault of brokers for failing to foresee extreme tail risk. A fund that invests in foreign bonds could have a pristine 50-year track record, and then somehow five of the countries default in one month, causing a catastrophic decline to the bond fund. A typical example is a company that has millions of dollars of employee pensions under its control and it has to investment this money in a security that has the same ‘risk profile’ as a treasury bond, so this company goes to an investment bank like Goldman Sachs to mange the money. Goldman says they have a fund, such as the foreign bond fund, that has the same risk (according to mathematical models and historical data) as a 5-year treasury bond, but with a 2% added yearly return. Sounds like a great deal (more return for the same risk), and then things go bad. In the real world, outside of confines of mathematics, ’10-sigma’ events tend to defy statistical implausibility, and short of putting your capital in cold, hard greenbacks, there are few good solutions for dealing with ‘unknown unknowns’. You can have a mathematical model that works well 99.99% of the time, but that .001% will cause everyone to lose their money, and dealing with extreme tail risk is an ongoing area of research.

And contrary to the media’s attempt to frame Goldman Sachs as conspiring against the ‘little guy’, Goldman’s clients were other funds, not retail investors. Goldman took the other side of the trade not only because they thought it was a bad investment, but also to eliminate risk. Goldman cares about collecting fees but doesn’t want to lose large sums of money if the fund fails, so they took an opposite bet to protect themselves. Market makers do that all the time when they sell you stock or options. If someone is dumb enough to pay $100 million for my Monopoly Money fund, I’ll gladly take the opposite side of that bet. That’s probably what Goldman was thinking. Assuming fiduciary standards aren’t broken, there is no law that makes it illegal to sell someone an investment that in retrospect is a bad investment. Let’s assume there is a fund that involves homes, and I think the fund will fail, but my clients really want to invest in this fund. I have a duty to invest my client’s money in this fund even though I personally don’t think it’s a good investment, even going so far as to bet against the fund. It may seem like a conflict of interest, but it’s just doing business.

And then lastly, and probably most importantly, the government played a complicit role in inflating the housing market, forcing lenders to create risky loans to meet quotas.

“The National Homeownership Strategy: Partners in the American Dream”, was compiled in 1995 by Henry Cisneros, President Clinton’s HUD Secretary. This 100-page document represented the viewpoints of HUD, Fannie Mae, Freddie Mac, leaders of the housing industry, various banks, numerous activist organizations such as ACORN and La Raza, and representatives from several state and local governments.”

If anyone is to blame, it’s these people.