Friday, June 13, 2008

Economic Lessons in History

I was revisiting another book last night. And while I already reviewed The Panic of 1907 back in May, I have to revisit one of the quotes.
"...research suggests that financial crises will occur where 'financial markets are opaque, when regulation and supervision are poor, and when lending is based on collateral rather than expected cash flow due to poor accounting standards. Countries that suffer from longer, costlier, and more systematically destabilizing crashes tend also to suffer from poor transparency, weak macroeconomic policies, and microstructural weakness in advance of the asset price bubble.'"
I was struck once again by how well this seemed to sum up what happened with the sub-prime sector of the mortgage market.

"financial markets are opaque" - Individuals and institutions buying the repackaged mortgages didn't really know what they were buying. Individuals entering into mortgage contracts frequently didn't understand the contract.

"regulation and supervision are poor" - Mortgage brokers were often unsupervised or unregulated by either federal or state agencies. Banks were regulated, but if they were not originating the loans...

"lending is based on collateral rather than expected cash flow due to poor accounting standards" - In many cases, homes were mortgaged based on anticipated appreciation in value and often not enough was done to verify buyer's income and ability to carry the debt. Once the mortgages were repackaged the value of the collateral (homes mortgaged) was hard to value.

The calls for more transparency and better macroeconomic policies speak for themselves. And microstructural weaknesses could cover a multitude of items from developing more advanced markets for the instruments involved, to better oversight of mortgage brokers and ratings.

After I read the quote, I followed the authors' footnotes and found the quote was from a work with three authors - two of whom I had the pleasure of meeting and knowing when I worked at the Federal Reserve Bank of Chicago, William Curt Hunter and George Kaufman. Sometimes it's a small world.

I look forward to your comments, especially if you've read the book.

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