Reader Richard Kline is providing a mini-series that was prompted by an anonymous reader who had observed that a complex systems theory view might raise doubts about regulatory policy. Financial overseers believe that liquidity is always and ever good, but that view may be naive:
Perhaps a lesson to be learned here is that liquidity acts as an efficient conductor of risk. It doesn’t make risk go away, but moves it more quickly from one investment sector to another.
From a complex systems theory standpoint, this is exactly what you would do if you wanted to take a stable system and destabilize it.
One of the things that helps to enable non-linear behavior in a complex system is promiscuity of information (i.e., feedback loops but in a more generalized sense) across a wide scope of the system.
Richard, in a guest post last week, posed a question he wanted to take further:
To what extent have nonlinear processes promoted the Securitization Bubble, precipitated its collapse, or prolonged the resulting instabilities in the financial system?
After a background discussion, he presented five issues:
Does innovation require untrammeled information flow across social/ economic event spaces?
Is the crisis in securitized debt the result of a ‘black swan’ event?
Was the creation of the Securitization Bubble the result of nonlinear processes in the financial markets?
Is a financial event-space optimized for propagation desirable?
If not, what structure or process parameters might improve process outcomes?
That post presented his response to the innovation question and prompted quite a few comments. Hopefully, this offering, on black swans, will elicit more reader discussion. Your comments very much appreciated.
From Richard Kline:
A black swan event, loosely described, is an occurrence that: 1) is structurally possible within a system, 2) is of very low probability within that system, but which 3) should it take place has a disproportionate impact upon the systemic order. An older name for such a systemic event is a ‘blue sky catastrophe’ (catastrophe is a technical term in dynamics), itself a specific form of bifurcation catastrophe where a system sharply and disproportionately changes its internal order following precipitating shift(s) in internal variables or order which can be quite small. Does the present financial crisis as a whole represent a low-probability nonlinear transformation of the US or the global financial system, or of major markets therein? In my view, no—or at least, not yet.
Yves here. I do have a wee definitional dispute. Taleb considered black swan events not merely to be low probability, but unimaginable. They blindside the incumbents, just as the collapse of the World Trade Center towers did. But this distinction does not affect the thrust of his argument.
Back to Kline:
It is important to consider this question closely despite the quick negative conclusion since many in and near to the financial community profess loudly that “No one could have known” that such massive losses from collateralized debt obligations were possible, or that credit spreads could widen and stay widened for months on end. The financial community does not use the black swan terminology, but the claim is the same: “Our crisis was not foreseeable.” “The system is liquid, it’s just in a stubborn panic.” “We are the victims of fraud and a lack of transparency; wider remedies would be unhelpful.”
From the other side of the financial industry’s mouth with more brass than consistency, we also hear, “Financial innovations are sound, and they did not contribute to unanticipated market instabilities.” We have ‘an accident’ where no one at the scene claims to be or know the driver. Bear in mind that the bubble in financial assets, particularly residential real estate in the US and some markets in Europe, and the collapse of that bubble should best be viewed as discrete processes with potentially distinct drivers. Both those processes embody some contributory if not primary nonlinear transformations. Even more, strictly linear and low dimensional occurrences can in combination easily produce sharply nonlinear and even chaotic outcomes. Nonetheless, on present examination neither the bubble nor its crash fit the black swan hypothesis. Many if not most of the component processes of both were linear, highly probable, and fully visible.
To consider just some contributors to the Securitization Bubble: In the period of negative real interest rates after 2001, mortgages increasingly came to be originated to borrowers at the bottom of the financial system whose capacity to pay depended upon the continuation for decades of historically very low interest rates. Similarly, hundreds of billions of dollars were lent for securitized junk bond debt speculation at the top of the financial system where the viability of that debt also depended upon the continuation of historically low interest rates. Both debt streams were extensively securitized. Concurrently with these entirely observable trajectories, bank-like speculative vehicles proliferated which borrowed, lent, and underwrote the quasi-insurance of credit default swaps to very large sums, again facilitated by historically low interest rates and by borrowing at the extreme short term via commercial paper offerings to capture the best rate spreads. No commercial bank was then permitted to operate with the severe leverage, lack of hard reserves, and term mismatches of these ‘wildcat banks,’ to resort to an historical term, since these practices, severally and jointly, have a strong association with financial failure. Wildcat quasi-banks speculated in securitized debt in very large volume; in many cases, their operating models depended upon the availability of such instruments. If, when, and as rates rose, large portions of these debts would turn sour. If these debts went sour, the value of the securitized loans as collateral would decline. If the value of the collateral declined, the terms for short term loan refinancing would shift higher in rates and requirements even if liquidity remained constant. These were linear relationships of high probability.
Judging in real time the onset of the turnaround for such trajectories is hard; however, the rise in the Fed Funds rate from 2006 marked a fair closing bell, and indeed many large financial buyers such as pension funds by then stood well back from purchasing such (in)securities. If markets were self-correcting, instability dampening systems, origination of low equity mortgages and high leverage buyout bonds would have tapered off from that point. Instead, the reverse happened. With rising interest rates, loan criteria _loosened_ and volume if anything rose.
At the same time, securitized debt underwriters shifted to ever shorter term commercial paper funding themselves for their pass-through conduits to maintain favorable interest rate spreads and thus stay level with their quasi-bank competitors, exposing themselves also to term mismatch potentials severe by historical norms. In the course of this bubble expansion, correlated asset price rises were ongoing in residential real estate, equities, commodities, and bonded debt, a highly negative indicator for the sustainability of price increases. Again, all of these trajectories were observable; all of them had high probability negative outcomes which would drive trend reversals; all of them had repeated historical validation for such outcomes; all of them were publicized as such by knowledgeable participants and observers.
By the autumn of 06, both residential real estate prices and residential mortgage failures had diverged so extremely from long-term trends that if these shifts were sustained the changes themselves would have represented a nonlinear systemic transformation. Instead, the observable linear relationships held: mortgage delinquencies rose and home prices flattened as interest rates rose, maintaining their historical correlations if at extreme values: not New and Different but More of the Same only more so.
Considered separately, the ongoing crisis in the financial system began in June 07 with the most mundane of events: a margin call on a smallish short-term debtor as their securitized collateral declined. That debtor failed to cover and publicly collapsed; a few smallish hedge funds similarly got squeezed out. When bids for their securitized collateral came in solidly below face, holders of securitized collateral lost face generally with their creditors: if “housing prices always rise,” the debt on them was now declining. The worst managed volume purchasers of this debt in Europe promptly went insolvent, indicating both the risk and the illiquidity of mortgage backed securities. Commercial paper quotes for securitized debt holders came in a levels they could not pay, while over the counter offers for their securities came in below the outstanding debt against them. Banks and bank-like holders of large securitized debt positions massively sold liquid collateral to cover their short-term positions, precipitating extensive swings in multiple markets, provoking a full-blown liquidity squeeze. The transformation of the commercial paper market does denote a nonlinear transformation, and will be discussed next in this series. However, none of the inputs to that change were themselves nonlinear. Furthermore, even if short term debt availability had declined in a linear fashion, it would certainly have declined, coming to the same position over a few months so long as the market price of securitized debt continued to decline.
By November 07, new reporting requirements made the existing market price decline of debt securities more difficult to hide, forcing more of these assets onto the books of major financial firms. Concurrently, home price declines and unsold inventories both accelerated. None of these changes were markedly nonlinear; instead, they extended decline trends already locked in. By January, large commercial banks and primary dealers began pulling back from lending or guarantees wherever they could while frantically raising capital themselves, severely exacerbating financial system liquidity constraints. The primary driver of those choices, though, appears to be their own functional insolvency due to unstated losses in securitized debt holdings, perhaps exacerbated by mismatch losses in credit default swaps. A drop of 300 basis points in interest rates did not reinflate the mortgage, junk bond, or commercial paper markets since accelerating housing price declines at the bottom of the financial system and major unrealized losses at the top of the financial system served as ironbound negative indicators for loan risk. If the exact circumstances for the implosion of Bear Stearns in March remain opaque, it is clear that they faced a major run of customers, cascade of margin calls, and withdrawal of dealer counterparties: a very large if old-fashioned bank run performed by financiers rather than retail depositors. There has yet to be any mention of a precipitating major loss for BSC from a nonlinear event. All of these events, and likely more to come, are directly driven by linear price declines in massive quantities of securitized debt, trajectories which were largely locked in from the date of issuance for these instruments.
The surge and purge of the Securitization Bubble has not been a black swan event; it has been a cooked goose event. In that respect as in prior historical examples, the faces change but the fools remain the same. A salient hypothesis from this summary, to which I’ll return, is that to the extent that nonlinear processes figured in these trajectories, they were in the making of the bubble more than in the baking of it. The ‘black swan’ metaphor fails 2), its low probability condition. In fact, we have not even seen 3), a real shift in systemic order in the financial system—yet.
Despite well-publicized failures of some exposed small and mid-size operators, there has been no default cascade to this point, either of short-term obligations of securitized debt holders or swap counterparties. Few banks or bank-like entities have failed outright, though only due to massive public lending. Over the counter securitized debt transactions can and do take place, though they have become rare. Liquidity is in the system for mundane commercial loans, though money is far more expensive. Mortgages are still issued, though far fewer and none at all for higher valuations; the volume declines are linear expressions, however. Local government revenues are declining, but service collapse, bond defaults, and bankruptcies are not widespread. Yet; not yet. And so long as price declines for securitized assets are not realized faster than asset holders acquire offsetting capital, such outright market failures may not happen at all. Those asset price decline trends?: they appear to be accelerating, and have a long way to run; a long way in relation to historical prices; a long way in relation to inventories; a long way in relation to solvency. We haven’t seen truly non-linear changes in the financial system—yet, i.e. (sustained) turbulence, catastrophic order transformation (say of market volume, market participants, or currency), or chaos.
In my view, there has been a black swan event in the US financial system within the last ten years: the budget surplus for the Federal government in the few years through 2000, and I don’t mean this facetiously. Sovereign pubic debt in the US is not intended to be retired overall but rolled over, since this debt, as the best quality available, highly liquid, and copious, is the fulcrum for all large-volume private financing. With the budget surplus, however, the potential for the contraction of outstanding Federal debt was real—even while it was an event that ‘could not happen’ in the financial system in the US functioned ‘as designed.’ Moreover and concurrently, external demand for US Treasury debt, especially from China if often indirectly, began rapid and large increases due to trade flows and their related policy responses. This external demand has proven to be somewhat insensitive to price, effectively making China the winning high bidder for Treasuries whenever it chooses to be, although this factor was not as evident eight years ago and more.
Thus an unheard of budget surplus together with major new Treasury buyers indicated that the asset basis for large-volume transactions in the US was going to contract sharply, putting pressure on top tier banks and bank-like entities to find the next best alternative, and fast. These were . . . securitized GSE instruments. Which as slightly less favorable assets carried slightly more charming rates. It was this experience which in many ways set the feet of large US financials on the slippery slope of asset backed security speculation. Thus an event structurally possible within the US financial system, but of very low probability (hadn’t happened since your grandfather was younger than your children are now, and wasn’t intended to happen at all), refocused major capital flows at the top of the system. With disastrous near term results as we now see. That the budget surplus appears to have been largely generated by capital gains thrown off by the dot.com equities bubble, and so not sustainable not to say illusory, is secondary since the effect of the surplus on the system as a whole was real at the time.
Did anyone at the time worry regarding ‘a destabilization of the financial system’ in consequence of the ephemeral budget surplus? People scratched their heads, and then applauded; no one saw ‘an event that cannot happen’ as indicative of a systemic problem—which it was beyond the summary above. This is what really happens when people see a black swan: nothing, as they have no context. This is another reason why markets heavily dependent upon the competence and reactivity of participants cannot reliably make stable adjustments to low probability events.
Further reading:
Christopher Zeeman. 1989. A new concept of stability. In B. Goodwin and P. Saunders, ed. Theoretical Biology.
Hyman Minsky. 1986. Stabilizing an Unstable Economy.
[Zeeman greatly developed the catastrophe concept, of which this paper is a fine distillation in a theoretical text itself splendidly rich. Minsky is a voice worth hearing.]
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“The transformation of the commercial paper market does denote a nonlinear transformation, and will be discussed next in this series. However, none of the inputs to that change were themselves nonlinear.”
???
This is a potentially interesting article that unfortunately is unreadable, due to promiscuous repeated insertion of the word “non-linear”. This seems to be a crutch posing as an argument.
Non-linear relationships are commonplace in finance. It’s a matter of mathematical definition and distinction. Stuff accelerates and decelerates. What else is new?
I’m not familiar with “non-linear systems”. To me this is a black box concept imported from another discipline, intended to convey exotic comprehension. I see absolutely nothing that requires particular emphasis on non-linear relationships in order to understand the credit and securitization crisis ex post.
You bet Minsky is a voice worth hearing. He is very easy to understand. His is a logical and intuitive framework that is very easy to understand, and is completely independent of any reliance on the idea of non-linearity, as it should be. Non-linearity is a common place feature, not an explanation.
Taleb’s black swan was a convenient conceptual construct on his part. The primary purpose of the construct was to inoculate the core idiocy of the value-at-risk cult. Taleb writes far more about the disease than the cure in his own reviews of the application of his ideas. The black swan imagery is for the purpose of correcting a failure of imagination in the risk management industry.
Stuff doesn’t just accelerate and decelerate: it changes dimension, and changes state. The language of ‘acceleration and deceleration’ regresses dimension to trend. Such delta changes are of course tremendously important for finance but from my perspective are more interesting for what if anything they imply regarding larger changes to systems. I recommend that you extend your reading to nonlinear systems, as the risks and potentials of changes in financial variables are more interesting offtrend than on from the perspective of the systems within which said trends are embedded. Space constraints for this post require condensation and limit wider terminology, so yes I do agree that I use the term ‘nonlinear’ here as a placeholder more than I would like. More specific ideas will be raised in later posts.
As Yves noted, my use of the black swan concept is broad, more a way to discuss the presence or absence of catastrophic state changes in markets and the financial system.
I disagree with the idea that the current crisis is a “black swan event”, and I do not think that including Minsky here strengthens your argument. Minsky developed an integrated theory of the business cycle and financial crises. It’s kind of difficult to describe patterns of events that have occurred roughly every 5-10 years throughout much of capitalism’s history as “black swan events”.
So RueTheDay, we agree more than you suggest: the bulk of the post is devoted to discussing how and why the present crisis _is not_ a black swan event, a catastrophic nonlinear state change per se.
Near and long term cycles are something regarding which I have spent decades studying and approaching theoretically. I will post very little regarding cycles in this series however. The specific organizational changes to financial systems which interest me here are not primarily driven by cyclial inputs but seem to me more intra-variable relationships. Propagation and connectivity issues, and how perspectives on them might shape better financial regulation are the focus of this series.
“Stuff doesn’t just accelerate and decelerate: it changes dimension, and changes state.”
It would be helpful (to me anyway) if you could weave this distinction and these ideas into some specific examples in your posts to follow. I don’t relate naturally if at all to the idea of financial stuff changing dimension and changing state. And it shouldnt’ be necessary for a person with mathematics and finance training to read a book to see a clear example of this.
“how perspectives on them might shape better financial regulation are the focus of this series.”
Government regulations were the cause and will not be the cure. This will happen again just as it always has threw out history. Regulations threw intender consequences or lack of enforcement will just insure that it happens on a more frequent basis. Government is the problem not the solution.
Ruetheday:
I agree, no black swan event here. The current disaster was predictable. I did. I sold my Los Angeles condo in 2006 for 3.91X what I paid for it in 1998. When I sold the condo could have rented for 210 months rent. This is like a great article by Jeremy Siegel at his website. The article appeared in the WSJ, I believe 14 March 2000, near the top of the high-tech bubble. Was that too a black swan event? What idiots were paying 189X earnings for Cisco? I remember the 1971-73 “Nifty- Fifty” washout.
This stuff really is foreseeable.
To Anon of 8:56, you will find my next post interesting in that I raise several instances of nonlinear state changes in recent financial markets and extend this discussion to definitions. A critical issue is to see events as trajectories in a state-space of defined parameters.
As one example of spaces which differ in state consider banking asset Tier 1, Tier 2, and Tier 3 capital. An asset can pass back and forth between the tiers; the transition denotes a change in state. In the process, several variable dimensions may shift, but obviously the most important is the marketability, i.e. ‘liquidity,’ of the asset.
A separate example of a change which is certainly a change in state but which from the perspective of its immediate market-system may be a change in dimension also occurs with a futures contract for a grain commodity which was purchased for normal supply-demand delivery changes hands to others who use it strictly as a speculative instrument driven by price and liquidity. The qualitative way the future contract moves changes; if enough contracts move, the exchange-space is modulated by the shape of the trend function so that the state-spaces attractors, hard limits, velocity, and other parameters shift. This kind of mutual modulation of trends and their state-spaces is essential to following the impact that issues like mortgage securitization pose for capital markets and the financial system as a whole; I do not see how perspective can be gained here without concepts from organizational dynamics. Instead, one comes away with fragmentary, trend-specific references and analyses, just what we largely see in the financial press now.
All of the questions I raise here should properly be discussed in _monograph-length_ texts. I cannot begin to cover all of the issues involved. Clarity is at a premium; by the same token, my time to compose these posts is constrained. I am pursuing these more to raise ideas than to adequately summarize all of the concepts involved. This post deals primarily with a single question regarding the nature of the Securitization Bubble, hence the _lack_ of development here of market-state space concepts.
Bedtime for now . . . .
“Yves here. I do have a wee definitional dispute. Taleb considered black swan events not merely to be low probability, but unimaginable. They blindside the incumbents, just as the collapse of the World Trade Center towers did. But this distinction does not affect the thrust of his argument.”
I can’t believe Taleb means “unimaginable to an individual,” he must mean “unimaginable to the consensus.”
I think that later is consistent with his books, and certainly he would agree that with 6 billion human brains out there, someone, somewhere is pretty much imagining everything.
It becomes (another Taleb/Popper theme) a question of luck versus accuracy.
odograph – Taleb is getting at the distinction between what Keynes termed risk and uncertainly. The former implies that a discrete set of outcomes can be defined and a probability assigned to each; the latter implies that the full set of outcomes are not known a priori. IOW, we don’t know what we don’t know.
Sure, I get that Rue. There are related discussions here. I really wanted to talk about what “unimaginable” really means on a planet of billions. I think that bit is important, especially given sub-cultures (peak oil, pandemic watchers) who have firm (they would argue known) risks in their minds.
Yes, by the definitions that (I think) you and I subscribe, risk is a calculable factor … but one actually rare in the real world. Uncertainty is fuzzier, and incalculable.
An unpopular Defense Secretary got poop for trying to explain “unknown unknowns,” but they are real.
Richard,
As I understand it, long-term credit experienced a “state change” during the bubble, effectively transforming into liquid “money”. That was the magic of securitization.
So, has it shifted back into “non-money”? I would answer yes. Clearly the marketability of these instruments has changed enough to qualify as changing in nature. This is a “grey swan” even in Taleb terms, since a minority of participants saw it coming. Nonetheless, it is a state change with non-linear effects amplified by leverage. These effects have been temporarily suspended by the application of the Fed’s balance sheet. I say “temporarily” because its quite likely that the instruments will remain long-term illiquid for the vast majority of holders.
Imagine a climber pulling a sack of bricks behind him on a short rope. His climbing rope experiences a “phase change” and weakens enough for the weight of the bricks to snap it. Magically, 500ft of rope are inserted into the rope holding the bricks. For a second, it seems the climber will stay aloft. Until the slack is taken up, that is, and the climbing rope snaps. The Fed’s balance sheet is like $500b of rope — it does not change the “nature” of the climbing rope” above — and we are working our way through that slack.
“Independent” … I passed on upgrading because I thought SoCal prices were bubbled … but one question I had hanging in my mind is that for 20 years I’ve been hearing people claim that.
When something is a (permanent?) risk held by a sub-group, but rejected by the mainstream, is it really rejected (semantically?) as a “swan?”
I think there has to be some sort of fuzzy bar here. It’s not reasonable to survey the world and make sure that no one nowhere expected a thing before calling it a swan. I expect there is always someone.
And as Taleb describes in his scenarios, it isn’t really about (small) minority disbelievers. It is about the majority who drive markets (or politics, or life) and what they accept as imaginable.
“Taleb is getting at the distinction between what Keynes termed risk and uncertainly”
Knight, not Keynes
Doh! Yes, Knight.
“The Madness of Crowds” says it all. Tulip Mania; South Sea Bubble… et al. Probably needs to be updated for the dot-com bubble, and now for sub-prime mania.
These kids know nothing! Is it “Oil Price Mania” next?
Check out contrairian theory and don’t follow the bellwether sheep, because you will be lost in the herd.
Also check out value investing, as practiced by Warren Buffet.
Geez, you set up a compensation system that rewards people for not foreseeing the easily foreseeable, and then when they fail to predict the easily predictable, you scratch your head and wonder why?
I don’t see why it takes a rocket scientist to figure that one out.
well i have a phd in numerical analysis from yale and know something about nonlinear systems and you do NOT need this gobbledygook to explain this stuff simply.
ill-conditioned is a much better term for the same thing.
it is not helpful to use terminology that adds nothing to the meaning.
an ill-conditioned system is one where, either right away or outside a local neighborhood, small changes in inputs create huge changes in outputs.
does it matter if you show off by using terms like hessian and jacobian and all that stuff to sound like you can do the math when you’re trying to write about policy?
i read that stuff and i can do the math in my sleep and the article can be rewritten much more simply and the more simple the more will agree.
“the amount (whether frequency, magnitude, etc) by which some things shifted was more than the amount of shift many people, who bothered to think at all, thought likely, and when shifts of that amount occurred, the resulting changes were far more drastic than would have been predicted by a simple model that assumed ‘if you double this, you get double that,’ sometimes, if you double this you get a hundred times that, and no one thought about that.”
same thing, but it doesnt show off.
the use of nonlinear in that article is neither necessary nor sufficient.
I think I am agreeing with Mr. Kline when I say that neither the housing bubble and its close cousin the credit bubble where black swan. They are reruns seen many times before.
However, I think it is fair to say that some of the permutations that the crises took have been fairly unpredictable. The odd behavior of LIBOR (including the cheating issues) is one of many examples. Another would be the structured finance issues. Some of these vehicles were mathematically bullet proof: until the market for their components completely shut down. The odd happenings in the municipal funding area are yet another.
It is not clear if these odd permutations add up to enough of an effect to be called a black swan sized impact. It is even arguable that some of these issues may have alerted some parties earlier to the danger then might otherwise have happened. To the extent that preventable actions are possible that would be helpful.
I am grateful for the points of the article, which I read as:
The current financial system stress did not result from an “out of the blue sky” or “black swan” event. Instead the stress was easily forseen, and was predicted by many observers. In the article, predictable is also named “linear”.
The current financial system stress appears to be caused by greed and stupidity, the usual suspects.
The actual “out of the blue” event was the US budget surplus occuring near the year 2000. The surplus reduced the supply of US bonds, increasing the price. The “not price sensitive” national entities did not reduce their purchases in the case of higher prices.
I would suggest some other unexpected events:
The collapse of the USSR, the former world threatening evil empire, occurring near the year 1991.
This collapse was preceded by phenomonal computer technology evolution. This technology was developed almost exclusively in the US. The technology evolved so quickly that it could not be predicted. This also provided dramatic computer aided progress in every other field, including weaponry.
I have trouble perceiving the “dot com” incident as any other than the same old predictable greed and stupidity.
I would also suggest that another unexpected event has occured. The US has ceased developing technology. Development is work, costs money, and has risk. This chore has been outsourced. Seemingly in replacement has been the development of financial instruments.
From a complex systems theory standpoint, this is exactly what you would do if you wanted to take a stable system and destabilize it.
Is this a bad thing? I guess it depends on what value you apply to a stable system. Living organisms are unstable systems; in such cases achieving stability is generally not a desired outcome.
The effects on the financial system from the change of both the previously Soviet economies, and the change in China to a more capitalistic style of system I think are a good point.
I listened to a Chicago-NPR radio show that was posted at CR. They point that they made was not that the US surplus was a problem, but that Greenspan’s keeping the US interest rate so low and for so long was the mechanism that made the “Big Pot of Money” go looking for new vehicles for investment.
The two arguments are not mutually exclusive, and I suspect at some point after it all shakes out, you will be pretty well able to tell where the money came from.
As for some peoples complaints about Mr. Kline’s verbiage. At times they do come across as some what like an adjective ridden Lovecraft tale. But the complainers simplified explanations strike me as neither all that synonymous, nor all that simple. It is not easy writing to a mixed audience-particularly when half of it is anonymous by name, and almost all of it is anonymous in fact. I think a little friendlier discussion methods are warranted.
Get over the anonymous thing already. It is as old as publication. Whenever this comes up, for instance, I invoke Benjamin Franklin who was both at turns anonymous and pseudonymous.
Lear some frikin’ history.
To Dave Pearson at 10:56 AM, sorry to be so long replying, my schedule is awkward for the post cycle here.
The change in liquidity which came with mortgage securitization does indeed strike me as a state change—in the financial system if not necessarily in the underlying assets. For example, the mortgages in and of themselves don’t look that much different; the volume of certain classes changed near the end—more ARMs—so that the dimension and state of certain regional markets likely changed in consequence. S Florida where folks were buying to flip had state and dimension changes as a regional market by that definition. Price rises shifted the centrality of the national mortgage market enough higher that volume of things like jumbos exceed the system parameters too, pointing toward a systemic change away from the ‘variable basins’ defined by the GSEs for example, but the ‘mortgage space’ is returning more toward historical parameters now that distortions from financial market capital demand have, at the present, declined, pulling prices back toward norms. However, most markets looked the same, and in principle can still be made and traded individually.
The price and volume change in mortgage issuance from, say 2000 through 2007 was considerable, but not of an order of magnitude that I would say it was a nonlinear rise, or a systemically unprecedented rise; these are reasons why I resist black swan definitions. Also, actual price declines _for the underlying houses_ are backing down in a comparatively ordered fashion comparable to past regional downtrends. They will trough in 2010 or so barring a depression, in which case they will drift down for another three to five years. The rate changes and overall shape of the trend don’t look nonlinear, and if jumbos continue to be issued by the markets in some fashion then the dimensions of the trend don’t look that different, either. If actual housing prices had changed all at once, regionally or nationally—say a 35% change in three months—that transition would be more nearly nonlinear, but this isn’t really what we have seen. Prices have been either downshifting or downtrending in various markets since Autumn 06. As Accountant commented above, he sold the deflection of the trend, and made out like a bandit. A lot of other folks got ‘sold the dummy’ in Border-speak. To the extent to which housing prices are delayed in their realignment, the eventual shifts will either become sudden nonlinear changes or the pressure of financial loss will be shifted elsewhere in financial-system-space.
It’s essential to distinguish what space one is interpreting at a given time, even though state spaces are linked. The massive changes in liquidity which came from accessing the huge residential mortgage market shifted the parameters of the financial system in multiple ways. These shifts were nonlinear state transitions, and highly destabilizing for capital markets in the mid-term. Liquidity inflows from housing mortgages ceased suddenly, withdrawing a dimension and provoking wider state changes for the top of the capital markets. Even now, if ABSs are marked down heavily for risk and embedded loss, they would trade, as liquid participants do still exist at the upper echelon. The issues of systemic liquidity changes as connectivity functions, and correlation risks will come up in later posts in this series, so I’m going to defer any real discussion of them for now.
‘Most mortgages looked the same’ (2nd Paragraph)
To Russell1200, yes, the collapse in the short term muni auctions was nonlinear state change. Most short term markets had already locked up, but the solid guarantees of the financial auctioneers maintained liquidity there—until those top tier financial dealers withdrew their guarantee and refused to ‘make the market.’ That collapsed a critical dimension, exposing the auctions to prevailing market constraints on short term debt, which in turn totally destabilized that local market space: the market catastrophically dissolved. Nonlinear events are bad for financial markets on the whole.
To Russell1200, the incipientl decrease in US Treasury debt and St. Alan’s New Low Rates were separate changes, principally of dimension and state respectively, though they certainly became highly correlated in an expansionary fashion in the financial state-space subsequently.
Regarding these posts, if I were taking a month or two to compose this series, I could and would make the verbiage more fluent with more embedded examples. Since I’m putting them out in near-real time (for me) with other research on hold, their dimensions are not as optimized for this state space as I or others might prefer. As it were. . . . You should hear how these issues sound in _my_ head before I compress them for distribution. : ) Time to change trajectory on a squash ball for awhile; I’ll look in late for any comments to come.
Sy Krass said…
Richard…
Aren’t these reoccurring bubbles (dot com, subprime, securitization, and now maybe commodities) due to the powers that be trying to stave off the cyclical Kondratieff cycle, which is inevitable?
I’m surprised and disappointed in the hostility of some of the comments. Richard’s first post in this series was very similar in style to this one and elicited useful discussion of the substance. But that one had a geeky title,”Is the Securitization Crisis Driven by Nonlinear Systemic Processes?” I’m left wondering whether the title succeeded in screening out those not familiar with the subject area.
To Sy Krass, I am certain from my own research that their are long-term cyclical functions equivalent to the Kondratiev model, though I construct them somewhat differently. In particular, the cyclical function is exogenous (external) to economic activity rather than endogenous to it. Consider it as a channel which oscillates such that activity within it including economic activity is modulated variously in a cyclical fashion. The oscillations are ‘inevitable’ but they are quasiperiodic and not precisely predictable in timing or effect. Bubbles _may_ cluster at some portions of a cycle more than others, but can occur in any portion of a cycle; I say that from historical comparison. It is my view accordingly that bubbles, as opposed to economic expansion per se are context dependent economic instabilities; there is nothing in cyclicality or in economic behavior that _mandates_ their appearance. A review of the summary I give in this post of some drivers to the Securitization Bubble emphasizes the _situational_ nature of this specific process: we did not ‘have to have’ a bubble, at this time or at all. Hence, consideration of _how_ we got a bubble may inform interventions so that we do not repeat the experience.
As an example of more fundamentally cyclically driven behavior, innovation cycles map well with long-term cyclical processes. The text by Nakicenovic and Grubler I mentioned in the first post directly studies this effect. Or for another example, the ‘improved productivity’ in the US economy considered to have occurred throughout the 1990s compared to the 1970-90 period and the 2000- period is derivative of a long term cyclical function, in this case specific to the US, and structurally predictable accordingly. Attempts to ‘suppress the business cycle’ are doomed to not only failure but disaster in my view. That, however, is a long and separate discussion. I’m going to refrain from commenting extensively on cyclical processes in this series of posts because it will only complicate the issue, regrettably. Your question was a fair one, though, and I did not want to leave it unanswered.
Regarding the tenor of some commentators to this particular post, requests for greater clarity and specific examples are always in line. I took the comments as an opportunity to expand the discussion in that way.
Sorry to be oversimple, but do over-accumulation of capital and the falling rate of profit ring any bells? At least that is the optic which has long since been “clear” to me. The interesting questions, in real economy terms, concern what led to the huge excess of credit-liquidity prior to the current cycle? Both the increase in global labor supply and the IT revolution are pieces of the puzzle, but neither counts as a self-sufficient explanatory factor.
“I’m left wondering whether the title succeeded in screening out those not familiar with the subject area.”
Didn’t realize “familiarity” with the subject was the price of admission for reading the post series. It might be helpful if you or Richard could summarize your interpretation of a non-linear system process (there are many), as well as why its particularly relevent to this crisis. If you can’t do that in a general way, I’d be interested in how your interpretation differs from Soros’ theory of relexivity, for example. It would be helpful to know your starting point for those of us who are “unfamiliar” with the subject. Those who are “familiar” with it should be able to summarize it in their own way.
Richard, I think that I’m using “non-linear” differently than you are.
In my simple math, a call option has a nonlinear payoff. Zero if the security is worth less than the strike, S-X if above.
Non-linear, in this sense, applies to a drop in housing prices of 30%, even if it occurs in an orderly and predictable fashion. After all, at some drop in housing prices, the equity is wiped out, and debt starts to take losses. A change in state, if I understand you correctly.
So even if the underlying process is orderly and predictable, the results are highly unpredictable. So while I’d agree that the current crisis isn’t a black swan event (love that term, by the way), isn’t it still non-linear?
“Richard, I think that I’m using “non-linear” differently than you are.”
Very good point. The entire subject matter is poorly and illogically categorized. Which is why its scope and meaning requires better definition and context, even if presumed by those familiar with the subject.
Anonymous 5.50 am, please leave me out of your little war. I’m trying to be polite and civil here.
“please leave me out of your little war”
Fair enough.
Still a good point, though.