One of the consequences of the subprime meltdown and subsequent stock market decline this past week is certain: there will be a regulatory response. If past is prologue, there is also a good chance that regulatory responses will fail over the long term to the extent they are not based on a fundamental understanding of the underlying problems.
Over the next series of posts I offer a model that explains why markets crash. This model provides a way to sift through the various explanations offered as to what “caused” this most recent “crash,” including speculative excess (on the high end), irrational fear (on the low end), too little liquidity, too much complexity, rampant fraud, not enough disclosure, and the explosion in credit derivative products. I’ll show where each of these explanations falls short. Only with this work done is it possible to set out the relatively short and simple list of appropriate regulatory responses.
I start this series in the next post with a discussion of the stock market crash on October 19, 1987 (still the largest single day percentage drop on record). The dynamics that led to the crash in 1987 are surprisingly transparent, and understanding those dynamics provides a window into other crashes (including the Crash of 1929, and what happened in the equity markets this past week).
Two endnotes: First, I only deal with financial market crashes, so my analysis does not consider the interactions between financial markets and the underlying markets for goods and service. In other words, I am not making any claims about how to regulate monetary policy or other macroeconomic levers. I would note in this regard there is a fair degree of disagreement over the extent to which financial market are linked to real markets. As evidence, one need only look at the competing editorials in today’s New York Times by Casey Mulligan and Paul Krugman.
Second, the perspective I take focuses primarily on the nature of the demand curve for risky assets, which I think is largely a microeconomics perspective. So I hope to provide Gordon a third category of brave fools to disbelieve.
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1. Posted by fedgovernor on October 11, 2008 @ 8:40 | Permalink
Hey, please do a post on "The Big Scam!"
If you don't know what The Big Scam is ... let me lay it out for you. It's been all the rage in Southern California.
1) Buy a house. Any house will do, pay whatever the price is that the owner is asking (let's assume it's $100,000 in this example.) Get a 100% loan to do this. Don't use your own money for God's sake.
2) Next, bring in your appraiser. Pay him a $5,000 "fee" to appraise the house for what you think it's worth ($200,000).
3) Next, bring in your straw buyer, an illegal alien from Mexico. Sell the house to the straw buyer for the $200,000 appraisal. The straw buyer is going to get a $5,000 "rebate."
4) Next, bring in your brother-in-law Morty to originate the loan. Stick to Fannie Mae guidelines: You don't have to verify income, legal residency or employment (in fact, to do so would be "racist"). Originate a no-down-payment 100% LTV loan so your illegal alien is getting an "affordable loan." Pay Morty a $5,000 "closing cost" fee. Morty will sell the loan to Fannie Mae so he has no risk of default.
5) You now have $200,000 cash. Pay off your $100,000 loan and take a $100,000 profit.
6) Pay the "rebate" to the illegal alien. Have him skip town. He never actually moves into the house, because he just got fired from his job down at the Swift meatpacking plant and is in ICE custody. ICE will release him for "humanitarian reasons." Make sure you have a nice hotel room waiting for your straw buyer. You'll need him again shortly.
7) Fannie Mae now owns the house.
8) Pay a meth-head to strip all the copper wire Romex out of the house to sell for scrap. Hey, copper is worth a lot these days! Give the meth-head $5,000 to buy more meth.
9) Your total profit is $80,000
10) Go to the sheriff's auction. Buy the destroyed house from Fannie Mae for pennies on the dollar. Fix it up and flip it.
Lather.
Rinse.
Repeat.
2. Posted by fedgovernor on October 11, 2008 @ 8:42 | Permalink
And you eggheads wonder how we got into this mess?
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