Understanding the GFC

For anyone wanting a brief rundown on why the Global Financial Crisis happened, I can highly recommend this speech to the Sydney Institute by David Gruen, head of the macro division of the Australian Treasury. David has 13 causes of the GFC, which is hardly a nutshell, but about as concise as one can reasonably get.

And there are some gems in the footnotes. For example:

…financial instruments became so complex that eventually literally no-one understood fully the nature of the instruments they were buying and selling.5

5. Andy Haldane (April 2009) analyses the problem as follows: “Consider an investor conducting due diligence on a set of financial claims: RMBS, ABS CDOs and CDO². How many pages of documentation would a diligent investor need to read to understand these products? … For simpler products, this is just about feasible – for example, around 200 pages, on average, for an RMBS investor. But an investor in a CDO² would need to read in excess of 1 billion pages to understand fully the ingredients [‘billion’ is not a misprint]”. As he puts it dryly: “With a PhD in mathematics under one arm and a Diploma in speed-reading under the other, this task would have tried the patience of even the most diligent investor. With no time to read the small-print, the instruments were instead devoured whole. Food poisoning and a lengthy loss of appetite have been the predictable consequences.”

6. As Alan Blinder (Wall Street Journal, May 2009) put it: “Take a typical trader at a bank [or] investment bank …. Darwinian selection ensures us that these folks are generally smart young people with more than the usual appetite for both money and risk-taking. Unfortunately, their compensation schemes exacerbate these natural tendencies by offering them the following sort of go-for-broke incentives when they place financial bets: Heads, you become richer than Croesus; tails, you get no bonus, receive instead about four times the national average salary, and may (or may not) have to look for a new job. These bright young people are no dummies. Faced with such skewed incentives, they place lots of big bets. If tails come up, OPM [other people’s money] will absorb almost all of the losses anyway. Whoever dreamed up this crazy compensation system? That’s a good question, and the answer leads straight to the doors of the top executives of the companies. So let’s consider the incentives facing the CEO and other top executives of a large bank or investment bank … . For them, it’s often: Heads, you become richer than Croesus ever imagined; tails, you receive a golden parachute that still leaves you richer than Croesus. So they want to flip those big coins, too. From the point of view of the companies’ shareholders—the people who provide the OPM – this is madness. To them, the gamble looks like: Heads, we get a share of the winning; tails, we absorb almost all of the losses. The conclusion is clear: Traders and managers both want to flip more coins—and at higher stakes—than the shareholders would if they had any control, which they don’t.”

14. Or, as Paul Krugman put it in answer to a question after his first Lionel Robbins lecture on 8 June, 2009: “In macroeconomics … [over recent years, US] graduate schools were divided between those that devoted most of their time to teaching models in which this sort of thing [the global financial crisis] could not happen and Departments that devoted all of their time to teaching models in which this sort of thing could not happen.”

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5 Responses to Understanding the GFC

  1. Joesph Clark says:

    “But an investor in a CDO² would need to read in excess of 1 billion pages to understand fully the ingredients”

    Nonsense. Most CDOs are very easy to understand and CDO^s are just CDOs derived from a bunch of CDOs. Economists who repeat nonsense like this are just too lazy to do basic research.

  2. Joseph Clark says:

    “Economists who repeat nonsense like this are just too lazy to do basic research.”

    I don’t mean you Andrew.

  3. Pingback: Andrew Leigh summarises some short explanations of the financial crisis « Smooth

  4. a student says:

    I know people who manage CDO’s, and even they have trouble figuring out what is going on. What happens if someone pre-pays? What is the agreement on how that money is re-invested? How do you treat interest and principle pre-payments in that case? It soon gets very complicated.

    The concept of a CDO is easy to understand, but the details are extremely messy.

  5. Patrick says:

    Yes, the sheer number of agreements involved means that you really do need rigorous standardisation.

    But I don’t really think they are unworkable for as much, nor necessarily in need of more regulation. No 6 is the bigger problem, that maybe does need regulation.

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