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my thoughts on the financial crisis, second edition

A couple of days ago, I wrote a long post in which I tried to explain what had actually happened with the mortgage mess in the financial market. I took it down for a bunch of reasons, but mostly because I realized that, although I know more about how it worked than most of my friends, I didn't know enough.

Fortunately for me, the NPR show This American Life did an hour-long broadcast where they explain it in depth, and they did a pretty good job. Even more fortunately, there is now a transcript available, so you don't have to spend an hour listening. I think it was well done, and it does a very good job of showing the natural market motivations that arose to cause a lot of people to make a lot of bad decisions, without having to postulate any criminal conspiracies.

So, what to do about it? I find it hard to know what to advocate. The Paulson Plan looks at the moment like it is going to go through. I think it could work, if it is managed intelligently, and I think that Paulson has the skills to manage it intelligently, but a) he could make a mistake, and b) he could find his hands tied by the fact that he is working for the US government now, and not for the board of Goldman Sachs, and he must therefore show that he can be persuasive to a set of people that thinks along completely different lines. One major advantage that could come of the Paulson Plan is that, suddenly, the zillions of mortgages that have no clear owner will have a clear owner, and it will be possible to re-negotiate the terms of those mortgages. One downside to that, of course, is that you'd be hard-pressed to find an American who wants to be in debt to the government (and to their primary financial interface to the US taxpayer: the IRS.) And I haven't even begun to touch the ideological arguments over whether the government should be in the business of mortgage administration, or of buying commercial securities on the open (albeit distressed) market.

I find that I am not all that concerned with "punishing the guilty". There was clear fraud, at the very least on the part of the mortgage brokers who put down fictitious salary numbers on behalf of their clients. Those would not be hard to prosecute, if the clients who were sold the mortgages have held onto their documents. That would be far more satisfying to me than arbitrary caps on executive pay, which have no economic basis and, as far as I can tell, have only been proposed in order to make the "have-nots" feel like the "haves" are being punished at least a little.

What I do care about is the systemic problem. (Of course I do; I'm an engineer.) I'd love to get my hands on the design of a proper regulatory system for the US. Over the last twenty or thirty years, the financial markets have become an amazing ground for creative engineering. This has a lot of parallel with the computer technology world, and probably for a lot of the same reasons. The only way to devise appropriate regulation for such financial innovation is to innovate. The Fed needs a well-paid team of financial strategists to go over new products as they come out, and as they go to market; the job of these strategists is to look for things like asset bubbles—sudden inflations in house prices, or sudden explosions in the number of mortgages approved; that is, precisely the sort of thing that people were spotting four or five years ago—and dig around for the causes. You can't regulate effectively until you have seen the consequences, both expected and unexpected, of a new activity.

I still think Hank Paulson is a smart guy, and I still hope that his plan works. I wish I had some more effective way than "a blog with a small readership" to debate these ideas with policymakers though.


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Comments (5)

Grant Gould:

On the CEO pay issue, I actually think that the cap rises beyond the level of "unsatisfying" to the level of "kinda dumb." You're talking about taking the sort of organization that most needs a good executive team -- struggling businesses limping by on government bailouts -- and forcing them to basically paw through the remainder bin for cheap CEOs. That seems like an easy way to guarantee that the bailed-out firms are unlikely to be able to repay the investment.

I'm more sympathetic to other elements of the Dodd plan -- the government taking equity or warrants in the bailed-out companies, but the CEO pay bit seems like simple self-defeating spite.


I was more in favor of the Paulson plan before I saw him completely dodge the question of how either choice would affect people outside of high finance. I started out just sort of assuming that, well, duh, if big businesses like these fail, then it's going to be bad news for me. But... how exactly is it going to be bad news for me? He wouldn't say, in a manner that was clearly refusal and not misunderstanding; and so now I'm feeling a lot more skeptical. It's not that I want big businesses to fail, but... I'd like a little more candor, please, particularly given that Chicken Little is urging us to act so quickly.


I'd be interested in a transcript of his comments, if you know of one. From reading the Economist this evening, I suspect that the communication style that turns you off arises from the fact that he is really not a politician, and really not used to having to convince the public (rather than the guy on the other side of the table) of his views, and probably not used to having to convince a Congressman who has a well-developed sense of when one must state the obvious.


I don't know where a transcript would be. It looks from the House website like they only have archived hearings from previous Congresses, not from the current one.

The particular thing that turned me off was an exchange like this (paraphrased):

Congressperson: Secretary, I understand that this could be bad for the markets, but my constituent in Cleveland, OH has all these other worries, about his job, his daughter's college prospects, and he wants to know how this crisis will affect him, why he should care. Can you tell me that?

Secretary Paulson: Blah blah markets blah blah markets blah.

Congressperson: Secretary, I understand all that, and I agree with you -- but -- my guy in Cleveland just needs to hear that if this goes wrong he's going to lose his job and his daughter will never go to college.

Secretary Paulson: There, you said it, and I agree with you. (ed. note: this part is, as best I can recall, verbatim)

It came across very much not as him not knowing how to answer the question, but rather as not wanting to be held responsible for any statements he made in response to the question. I think he's a lot savvier than you take him for, in other words. I don't think you get to be a CEO without being a politician.


Oh I wasn't meaning to argue that he isn't savvy. I just think he's used to being savvy in a situation where he and all the people he's being savvy at have a shared context. And let's face it, Paulson has almost no shared context with the constituent in Cleveland.

I remember you posted that exchange elsewhere, and it struck me as a banking-CEO type thing to say, I guess. Kind of refusing to jump when the Congressman says "jump!" (These guys have egos miles high, and an elaborate ass-kissing pecking order. This is one of the "shared contexts" I'm talking about. I should tell you sometime about the time I had a demonstration of this.) I can't really make sense of it otherwise, because what on earth would he have to lose by being held responsible for a statement like that, by the time it would catch up with him? So why would he try to avoid it?

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Posted on September 25, 2008 9:21 PM.

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