Tim Hamlett: Bankers may not have paid enough attention to “random events” that mattered

I come from a small business background so these matters of high finance often bewilder me. But let us see if I can get it right.

Somewhere in distant White Pigeon, Nebraska, a person who is renting a house notices that the banks are offering such spectacular discounts in the first few years of a mortgage that it would actually be cheaper to pretend to buy a house, and simply leave when the bargain years expire.

So this person contacts the bank mortgage salesman, who collects a commission for providing a mortgage that offers heavy discounts in the first few years and very little chance of lasting beyond that time.

In years gone by this would have bothered the bank. A second-hand, and probably not very well cared for, house is unlikely to be a goldmine comparable to a proper mortgage running for the next ten or 20 years. But we have fixed all that. The bank wraps the right to receive the repayments up in a financial instrument, which it sells to another bank.

This bank, a world-famous institution with offices in New York, reshuffles its collection of mortgage rights and hires a rating agency to certify the health of the resulting instruments. The rating agency, possibly because its fee gets in its eye, fails to spot the looming right to repossess an unpromising property in White Pigeon and certifies that the instruments are wonderful.

They may then depart in a variety of directions. They may be exported to Hong Kong and sold to unwary investors as a secure and lucrative investment. They may be sold to another bank, which will use them to meet its capital reserve requirement, possibly enhancing their attractions for this purpose by insuring against default.
For this purpose the bank will contact a specialised insurance agency, which also has poor eyesight when it comes to the property prospects in White Pigeon. This is a dangerous game for the insurance company because unlike death, house fires, road accidents or other insurable risks, defaults on financial instruments are likely to come not in a predictable trickle but in one devastating avalanche.

But so far everyone is happy. The salesman has his commission, the first bank has a profit, the second bank has more profit, the rating agency has its fee, the bank with the reserve requirement has cheaply met regulatory urges and the insurance company has its premium. As long as the resident in White Pigeon keep up his mortgage repayments the whole beautiful structure looks solid. Some time in the last few months, though, he stopped.

We may now note a few other peculiarities in what is turning into an international disaster. Firstly, everyone concerned is extremely well paid. Most of them, in fact, are bankers, who enjoy a very well-cushioned existence, with the option of a prestigious stint in government service at the end of their careers to add fame to their already considerable wealth. Another thing we may note is that everyone concerned has been either very greedy, very stupid, or both.

After all there has been a well-established critique of the financial industry's habits since at least 2004 (which is when "Fooled by Randomness" came out) based on the observation that bankers, abetted by economic academics, grossly underestimate the incidence of unusual catastrophes. They ignore the fact that the same system which produces steady profits in most years also produces collapses in a few.

This has happened before. It has happened often before. They never learn.

Another odd feature of the situation is that the remedy is apparently to throw large sums of money at the people who caused it.

It is not for me to quarrel with the high priests of American financial officialdom. Perhaps buying US$700 billion worth of financial junk and repossessed houses is the only way to save the world. I am glad that I am not an American taxpayer who is required to contribute to this exercise.

It may be that this is a rather critical view of the situation. I occasionally have to apologise to my academic colleagues for the sceptical view of the world which one tends to pick up as a journalist. For some of us, all idols have clay feet, all prophets are false and all emperors have no clothes, at least until the contrary is convincingly demonstrated.
But having said that I think it is time to take a second look at banks. They work very hard at looking wonderful: the architecture, the dress, the manners, the prose style, all exude sobriety, solidity and prudence. Beneath the surface they seem to be no better behaved than the rest of us, though their mischief has worse consequences.

Can you think of an enterprise in Hong Kong which the government would spend large sums of money to preserve from bankruptcy... which is not a bank. The DAB* doesn't count.

That doesn't, of course, mean that Hong Kong practices capitalism red in tooth and claw. No doubt this is the reason why we have not, or not yet, been engulfed in the ongoing catastrophe. Hong Kong big business is a cozy little world in which the most lucrative enterprise is coddling the government.

People who work directly or indirectly for Hong Kong's largest employer (the government) can go home on the train (monopoly) or bus (franchise) switch on the electric (duopoly) light, cook their (price-controlled) rice from a (duopoly) supermarket on a gas (monopoly) flame and tune into their favourite radio station (a government department) to hear that some dimwits in Canada have announced that Hong Kong has the freest economy in the world.

Makes you wonder what the other places are like.

* Democratic Alliance for the Betterment and Progress of Hong Kong