Regulating Fannie and Freddie

[Papewaio]

Ah the sweet sweet smell of corporate welfare wafting through the economy from baked books and over leveraged assets. When will the fun stop?

Oh look the private sector does it so much better then government, why burden the private sector with rules and regulations. But if anything goes wrong to the private investments, lets bail it out with public sector money.

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I think the underlying structural issues need to be addressed. The US economy is looking suspicously too much like the 90's Japanese economy were the big banks and insurers weren't structured for the modern economy.

Has there been no learning from the likes of Arthur Anderson, the Energy Trading and WorldCom?

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At the end of the day transparency and accountability have to rise up. And if the private sector expects handouts, it should expect substantial strings attached. Not just to those who get it, but the entire sector so that the mistakes are not repeated.

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PS How is Warren Buffet and Co. doing? If it is a bear market, he must be in getting some bargins.

[Adrian II]

At the end of the day transparency and accountability have to rise up. And if the private sector expects handouts, it should expect substantial strings attached. Not just to those who get it, but the entire sector so that the mistakes are not repeated.

Alright, alright. But what sort of accountability? That's the issue I've been trying to raise.

Fannie and Freddie were accountable. So were Enron or WOL. It didn't work because

1. they got preferential treatment, and
2. the oversight was lax/incompetent/corrupt

It is obvious that markets do not sufficiently regulate themselves voluntarily and that the State is usually a bad supervisor. So, how do we make the State a better supervisor without killing the benefits of private business?

[Mangudai]

It is obvious that markets do not sufficiently regulate themselves voluntarily and that the State is usually a bad supervisor. So, how do we make the State a better supervisor without killing the benefits of private business?

Anti-trust laws should be enforced. There is no way companies like Fannie and Freddie should be permitted to hold 70% of US mortgages. Forcing overblown companies to split into many pieces is a viable solution.

[Mangudai]

I'm going to try to express a very big idea. I hope I can do it justice.

Nassim Taleb coined the term "ludic fallacy". Ludic is the latin word for games. Probability theory and game theory are sufficiently advanced to predict economic returns for gambling casinos. However, the economy as a whole is a different animal.

Probability theory and game theory are fashionable on Wal-Street. Quants (analysts) force their data to fit the Gaussian models, and express their uncertainty in standard deviations. Based on these models many people thought they understood how much risk they were taking. We all know outcome when they are wrong. The real world, and subsets like the financial markets, are not like games. The rules are not well defined, and rare events can turn the whole systems upside down.

We don't have any logically sound way of making decisions under uncertainty. Gaussian models are helpful most of the time, but sometimes they are woefully wrong. There are other mathematical models, but they are not logically sound either. We need to acknowledge deep uncertainty. In the words of Donald Rumsfeld, "there are unknown unknowns".




This idea also informs my view of regulation going forward. Many people are calling for the government to regulate the procedures used by credit rating agencies. This is a horrible idea because the regulators have no logically sound procedure. If the government did oversee credit rating procedures, this would lead to an even more dangerous level of misplaced trust in flawed models.

[Adrian II]

This idea also informs my view of regulation going forward. Many people are calling for the government to regulate the procedures used by credit rating agencies. This is a horrible idea because the regulators have no logically sound procedure. If the government did oversee credit rating procedures, this would lead to an even more dangerous level of misplaced trust in flawed models.

Besides Banquo's Ghost proposition that we abolish incorporation, this is another highly original contribution to the thread. It is an approach (or rather, an issue) which never even occurred to me.

Question for you. Gaussian prediction is mostly used when we don't know the mechanism underlying a distribution, right? If we would know the mechanism, we might take better samples and reach more sound conclusions with regard to markets. This points to inadequacies in economic theory rather than statistical analysis.

Or am I being blond here?

[Oleander Ardens]

Mangudai brought up what brought down "Long Term Investment" roughly 15 years ago, and now so many big names. When you roll the dice each new roll has the same probability. Rolling 66 times a 6 is very very improbable.

But in our real social world a session of 4 sixes in a row can highly increase the chance of a six in the next roll, because people may expect this exit. In our highly interconnected world, especially in the financial one everything influences everything with a varying degree. Some seemingly unconnected events can shape the peception and create in the mind of the majority a very strong correlation between events.

This in turn can morph into a self-fullfilling prophecy like the famous bear or bank run. Many think Lehmann will fail, many sell, more see this as a sign of Lehmann failing more sell. While usually there are enough different opinions to moderate a stocks movement in highly volatile and nervous markets a rumour can bring down a titan. Something which is quite unthinkable in pure statistical analysis. But something which happens now.

P.S: LT Investment thought they could only loose 5 millions a day at most, and they had two Nobels in their ranks and other highly esteemed mathematicians making this calculations. Then they lost it at a rate of over 50 millions a day.

[Mangudai]

Besides Banquo's Ghost proposition that we abolish incorporation, this is another highly original contribution to the thread. It is an approach (or rather, an issue) which never even occurred to me.

Question for you. Gaussian prediction is mostly used when we don't know the mechanism underlying a distribution, right? If we would know the mechanism, we might take better samples and reach more sound conclusions with regard to markets. This points to inadequacies in economic theory rather than statistical analysis.

Or am I being blond here?

Here are two quick examples one is Gaussian the other isn't.

Line up 100 people and measure their height. The distribution is Gaussian.
Line up 100 authors and measure how many books they sold, one of the people is JK Rowling author of Harry Potter. Her score is thousands of times greater than everybody else in the line put together. Not Gaussian.

Automobile insurance is well modeled by Gaussian methods.
Home owners insurance breaks the Gaussian model when there is a hurricane or tsunami. (Companies like All State barely remained solvent after Katrina.)
AIG wrote insurance on financial derivates. At the start of the crisis the CEO said "Our balance sheet is bullet-proof". He was relying on Gaussian models.


Economic theory is inadequate and may always be so. Oleander pointed toward one reason why. Perception and what we think other people are going to do is central in markets. Right now the best bull market are stable earners like packaged food, toothpaste, toilet paper, etc. I'm up 8% on that part of my portfolio in the past few weeks. The sector will probably go up another 8% as everybody rushes in hoping not to be last. Then when it appears that everybody is in who wants in, the stock prices will suddenly drop back to their normal levels.

Sales of toothpaste are Gaussian. Sales of the toy most requested this Christmas are not.

[Crazed Rabbit]

A opinion article on how Fannie and Freddie became so top heavy they toppled:
http://www.bloomberg.com/apps/news?p...d=aSKSoiNbnQY0

Back in 2005, Fannie and Freddie were, after years of dominating Washington, on the ropes. They were enmeshed in accounting scandals that led to turnover at the top. At one telling moment in late 2004, captured in an article by my American Enterprise Institute colleague Peter Wallison, the Securities and Exchange Comiission's chief accountant told disgraced Fannie Mae chief Franklin Raines that Fannie's position on the relevant accounting issue was not even ``on the page'' of allowable interpretations.

Then legislative momentum emerged for an attempt to create a ``world-class regulator'' that would oversee the pair more like banks, imposing strict requirements on their ability to take excessive risks. Politicians who previously had associated themselves proudly with the two accounting miscreants were less eager to be associated with them. The time was ripe.
...
What happened next was extraordinary. For the first time in history, a serious Fannie and Freddie reform bill was passed by the Senate Banking Committee. The bill gave a regulator power to crack down, and would have required the companies to eliminate their investments in risky assets.

Different World

If that bill had become law, then the world today would be different. In 2005, 2006 and 2007, a blizzard of terrible mortgage paper fluttered out of the Fannie and Freddie clouds, burying many of our oldest and most venerable institutions. Without their checkbooks keeping the market liquid and buying up excess supply, the market would likely have not existed.

But the bill didn't become law, for a simple reason: Democrats opposed it on a party-line vote in the committee, signaling that this would be a partisan issue. Republicans, tied in knots by the tight Democratic opposition, couldn't even get the Senate to vote on the matter.

That such a reckless political stand could have been taken by the Democrats was obscene even then. Wallison wrote at the time: ``It is a classic case of socializing the risk while privatizing the profit. The Democrats and the few Republicans who oppose portfolio limitations could not possibly do so if their constituents understood what they were doing.''

Democrats love regulations, except when it's on the government. Pape made a good analogy about the football team.

CR