Analyzing Last Fall

At this, the beginning of a new semester, Derek recently described for me his spring schedule, senior year. AP Chem, pre-engineering, and AP Government/Econ. And, his day ends at about 12:30, ideal for golf season. He was also eager to tell me that in the 4th quarter, when the transition to the Econ portion of his third period class begins, they traditionally stage a stock market contest. He said that last semester, the winning team finished down 30%. Let's hope he does better, for all of our sakes.

About last fall. How in the world did it happen? How did all that shareholder value just vanish? (And what timing!)I think most of the culprits are well known, but the mystery to me is how they conspired together to work such a precipitous collapse. Obviously, this is going to be studied, and written about, for decades. And I haven't yet seen anyone offering a comprehensive explanation.

In Monday's WSJ, however, L. Gordon Crovitz devoted his weekly column to a discussion of a factor I'd not before encountered. "Value at Risk" ("VaR") models have been used on the Street to measure various types of financial risk, using historical data. Thing is, any model using "historical data" must include the "low but real risk that some new element could make the historical data a poor measure of the future." Once upon a time, these risks, outlying on the "tails" of the Bell Curve, were openly acknowledged in the form of high incomes earned by traders capable of managing the risk that lives many standard deviations from the mean. Here's the upshot from Mr. Crovitz:

It's now clear that the data that banks used were distorted by years of government initiatives to promote homeownership. Government-mandated loans led house prices ever higher and house-price volatility ever lower. When the VaR models looked back, they wrongly modeled a low risk of default. Wall Street shouldn't make the mistake again of ignoring the impact of politics on economics - and politicians should find ways to achieve social goals without undermining the integrity of markets.

This dovetails interestingly with today's "Fan and Fred's Lunch Tab" in the WSJ:

"...politicians like Mr. Frank have been telling us for years that Fannie and Freddie's federal subsidy was a free lunch. We are now slowly, and painfully, learning the price of Mr. Frank's famous desire to 'roll the dice' with Fan and Fred."

What is the price? The WSJ notes that the narrow measure (the price of bailing out Fan and Fred) has gone from $25B six months ago (with a 50% probability that nothing would have to be paid), to a minimum of $238B - greater than the entire federal budget deficit of fiscal 2007.

Even this estimate may be far too low. As for the "macro" cost of Chris and Barney's excellent adventure into housing market manipulation, let's just say a trader who could have figured out how to trade this risk would have become the world's richest man. After all, Mr. Frank pronounced Fan and Fred safe not long before their collapse, and doubled-down on that pronouncement by threatening the race card whenever anyone questioned the viability of the Fan/Fred "affirmative action in housing" model. It would have been hard to bet against them.

In sum, I sure don't know how all the pieces fit together, and I have yet (surprisingly) to find anyone claiming to. But it's a certainty, notwithstanding Mr. Frank's claim that he and his pet mortgage bankers had nothing to do with it, that our affirmative action in housing program is going to bleed this economy hard for years, if not decades.