The Cycle of the Storm

For the past several weeks, and often within the course of a given week, the tone of news about the economy has been like a roller coaster. One week housing starts or corporate earnings are unexpectedly up. The public likes it, and so does Wall Street.

Yet another week a surprising uptick in jobless claims hits. The public turns pessimistic again and the Dow takes a dip. Then Chairman Bernanke says there are strong indications that the economy has bottomed.

So we’ve entered a period of mixed signals and ambiguous indicators. Think back to the first quarter of this year, and it shouldn’t be hard to see the difference. After a brief period of collective optimism as the new administration came took over, the stark realities of an incredible tsunami of layoffs set in. The stories seemed increasingly grim as we stumbled our way through a tough and frightening first quarter.

In keeping with the season, the green chutes stories started showing up in the spring, and early in the summer some of the bolder pundits were among the earliest to pronounce the recession dead.

Against the backdrop of the beginning of 2009, the current mixed signals seem, in contrast, to be a good sign. Recovery doesn’t happen all at once, so it stands to reason that at the beginning of a recovery the signals would be mixed.

Just as there was a succession to the tumbling of the various sectors--starting, of course, with the banks and the big investment houses--there will be a sequence to the recovery. The crisis began with the banks, and the recovery seems to be starting with the banks. There’s really an elegant symmetry to the whole thing. A line from Yeats, “A terrible beauty is born,” comes to mind.

Remember, the signals were also mixed at the beginning of the downturn. Through 2007 and the first three quarters of 2008, the picture was cloudy and confusing. Unemployment began to rise well before the Bear Sterns and Lehman collapses. There were plenty of signs early on that something was amiss with the economy, but most people didn’t really have a clue what was coming.

There were recurring stories in the news about the subprime mortgage crisis, but people were too distracted by the noise of the energy-price crisis. But the true crisis, already well into its formation behind the scenes, wasn’t about energy at all.

Most people who were starting to feel the pinch of a nascent downturn thought it was all about the gas, until the collapse of the big financial firms in the fall of 2008 brought on a storm of a magnitude that no one was expecting. It was an economic equivalent of getting caught off-guard by hurricane Katrina. Few knew how serious the economic storm would actually be, so most of us were unprepared.

Indeed, one could say that the life cycle of a recession is like unto the life cycle of a hurricane. There is a period of gathering clouds, when no one is sure what course the storm will take and how much strength it will gather at sea before making landfall. This was 2007 and most of 2008. Especially given the behavior of the stock market, it would have been just as easy for the casual observer, entering 2008, to conclude that another boom could be in the making rather than a astronomical bust.

But then the storm struck in all of its wrathful, furious glory, leaving an immediate trail of astonishing devastation. This was the fall of 2008.

Then we went “into the eye,” a period of deceptive calm that gives few warnings of the fury that is still to come. This was the period from around just before the election through shortly after President Obama’s inauguration.

Once we were out of the eye, a second wave of fury ensued with the staggering tumult of job cuts as companies were forced to deal with decapitated credit lines, dreadful year-end results, and abysmal first-quarter forecasts.

In the spring the clouds showed some signs of breaking up and the storm signs of weakening. And through the summer bursts of sunlight have begun to show through gaps in the cloud cover. Is it time to send a bird out of the ark to see if it brings back a sprig of leaves?

Let’s just hope, to follow the metaphor through, that this is the end of the current hurricane season, and that there isn’t a Rita building strength in the tropics to unleash a second wave of fury after the economic Katrina. Sphere: Related Content

Economist Says We're Losing the Private Sector in the U.S.

During a broadcast of The Jerry Doyle Show Saturday evening, I heard Richard Ebling of the American Institute for Economic Research comment on the recently emerged allegations that Fed Chairman Benjamin Bernanke and former Treasury Secretary Henry Paulson strongarmed Bank of America CEO Kenneth Lewis into the acquisition of Merrill Lynch. Ebling said that this incident was a frightening indication that we have lost the private sector in the U.S.

Clearly the full story here has not yet been revealed, so in my judgement conclusions are premature. But, in the meantime, let's play devil's advocate for a moment and flip the argument around.

Given the widely held view that the crisis that made the acquisition of Merrill Lynch necessary in the first place was the result of extreme deregulation that allowed the financial sector to run amok, perhaps the correct view is that, since the Reagan administration, it has been the government rather than the private sector that, in effect, ceased to exist -- in terms of imposing any reasonable level of control over the parameters in which the financial sector could operate.

In other words, due to the extensive influence of business and financial interests over government policies (or non policies) during the past 25 years, government had become, in effect, an extension of the private sector, an instrument to further the interests of those with the resources to influence policy through lobbying, campaign contributions, and so forth.

So one could argue that the incident was one of government taking a measure, however drastic, to compensate for the effects of having surrendered regulatory authority that should never have been relinquished in the first place.

Whether this drastic measure may have constituted any wrongdoing on the part of the government remains to be seen as the facts continue to emerge, and perhaps this story gives further weight to the calls for an independent panel, with subpoena power, to investigate the origins of the financial crisis and the government's initial attempts to manage it. Sphere: Related Content

Has Declining Mathematical Literacy in the U.S. Contributed to the Economic Crisis?

The idea that students in the U.S. are behind other major nations in math and science has been discussed widely, and it’s backed up with hard data. For example, a study by the Program for International Student Assessment (PISA), administered by the Organization for Economic Cooperation and Development (OECD), found that 15-year-olds in the U.S. ranked 24th among other countries in math literacy and 26th in problem solving.

It’s telling that the math and science performance of students in the U.S. seems to decline as they progress through school and as the expected skill-set advances with age group. Elementary students test about on par with international peers, but in middle school they fall behind, culminating in the troubling results for the 15-year-olds in the PISA study.

Talk of problems with math and science education in the U.S. is nothing new, having emerged as a topic of attention in the media at least as far back as the 1970s. As a long-term issue, it raises the question of what has happened as students with inadequate mathematical literacy and problem solving skills have advanced into college and on to professional life.

I don’t currently have data to back this up, but it would seem that the students who do come out of high school with a strong grounding in math would gravitate toward the more math-intensive subjects like science, engineering, and biomedicine. For the rest, that leaves the less mathematically rigorous majors like business and liberal arts, in which students can struggle through the most basic required college math courses and then move on to advanced coursework in their chosen majors.

By extension, this would mean that some graduates less skilled in mathematics may have moved on to careers in fields like financial services, which, in turn, is problematic when you consider the increasingly complex nature of the financial instruments that have emerged over the past 20-30 years.

One such instrument is the securitized pool of subprime mortgages, which, now infamously, investors were allowed to purchase at 30-to-1 leverage. What does this mean, mathematically, and what level of math does it take to understand it?

As one of my math professors was fond of saying, the best way to understand something is to take “the simplest example,” so that’s what we’ll do. Let’s say I have $10 to invest, and I am allowed to invest it at “30-to-1 leverage.” Leverage is really a euphemism for debt. If I can invest my $10 at 30-to-1 leverage, it means essentially that I can use my $10 as collateral to borrow $300.

So let’s say I do that, and I use the borrowed $300 to buy a security consisting of 300 $1 loans (as I said, this is a simple example). For each year it’s outstanding, simple interest of 5 percent is payable on each $1 loan. Thus, for the first year, I can expect a profit of $0.05 on each of the loans, or $15 -- a handsome return, made possible by 30-to-1 leverage, of 150 percent on the 10 dollars of my own cash that I put up as collateral. My budget for the year is based on that expected return, including payments on the $300 I borrowed to buy the security, along with any other expenses -- after which, hopefully, I will retain a decent profit margin.

However, let’s assume everything doesn’t go quite as planned. I receive my interest payments on 285 of those loans, for a return of $14.25. But 15 of the borrowers, or about 5 percent, default. Here are the consequences:

• I’ve incurred a shortfall of $0.75, or 5 percent, on my budgeted revenue for the year, from which my expenses and profit margin were to have been derived.
• I’m now on the hook for the $15.00 in bad debt. If I can’t collect, the first $14.25 of that loss eats up the interest revenue I received, and the other 75 cents adds to the loss on my original $10.00 cash -- now 7.5 percent -- and that’s before paying my expenses, including the payments on the $300 I borrowed to buy the security.
• I would now do my best to mitigate this devastating loss, laying off staff and cutting other expenses, and filing claims with any company that may have insured me against losses. And so the cycle of crisis begins, with losses passed through the system from one stakeholder to the next.

This is a very simple model of what happened in the subprime mortgage crisis, and it illustrates how leverage has as much power to magnify losses when things go wrong as it does to magnify profits when things go right.

For the current discussion, it’s noteworthy that the math I used here is very simple -- using ratios and percentages to calculate expected interest, returns, etc. No advanced math is required -- no algebra, certainly no calculus. It’s elementary-school or at most middle-school stuff. It’s the sort of math that the cohort of fifteen-year-olds in the PISA study should have mastered well.

So how could this crisis have been allowed to happen? Did too many people in the financial community -- not to mention the grass-roots consumers who were taking out mortgages, negotiating home prices, and investing in the stock of banks that were issuing risky mortgages -- lack the math skills to comprehend the possible consequences? Or were they blinded to the magnitude of danger by the lure of potential profit?

While only simple math is required to see the inherently questionable risk in such a highly leveraged investment, there are other factors to consider when evaluating an investment, such as:

• How accurate are the valuations of the assets underlying the security -- the accuracy and stability of home prices, in this case
• How accurate are the assessments of the ability of the borrowers to repay, and of their default probability

These two considerations require somewhat more complicated math. Analyzing valuation accuracy, risk of loss, and default probabilities enters the realm of actuarial science and is highly vulnerable to any flawed assumptions or inaccuracies in the input data (garbage in, garbage out). Among such data flaws could be widespread misrepresentation of borrowers about their incomes, or prices that have been distorted by a speculative bubble. The results of an actuarial analysis should price the level of risk into the cost of the security and measure the risk, in terms of factors like expected default rates, against the expected return. But any inaccuracies in the original data or assumptions can lead to a misinformed decision.

If we look in this context at how the subprime mortgage crisis could have been allowed to occur, we see only a couple of explanations: (1) not enough people understood the math well enough to see what could go wrong, and/or (2) those who saw the potential for disaster (and, yes--there were a few lonely, expert voices crying in the wilderness) didn’t speak up loudly enough or act decisively enough.

Or, perhaps more plausibly, the explanation could lie in some combination of the two factors. If so, the level of math literacy throughout society is even more important. If enough everyday homeowners, mortgage underwriters, investment bankers, and others throughout the population of stakeholders understand the math, they are more likely to make better decisions that would counteract the impact of those who may be capable of understanding the danger but, out of whatever motivation, are at best in denial or at worst deliberately ignoring it.

This is why it’s good to see that math and science education are among the priorities of the Obama administration. Combined with the greater public attention the crisis is generating to finance and economics, an increased level of mathematical sophistication throughout the country could lead to a future of better financial decisions by all stakeholders, from the boardrooms of the financial sector to grass roots consumers on Main street. This would make future crises of this magnitude far less likely. Sphere: Related Content