Saturday, December 19, 2009
Systemic Risk Creation
"As Congress lumbers toward creating a systemic-risk regulator, it's worth a look back--to 2002, when an economist named Stiglitz and a duo named Orzag wrote a paper with the droll title, 'Implcations of the New Fannie Mae and Freddie Mac Risk-Based Capital Standard.' We won't keep you in suspense. The paper, written the year after Joseph Stiglitz won the Nobel Prize for economics, concludes that on the basis of historical experience, the risk to the government from a potential default on GSE debt is effectively zero.' Their analysis has recently been making the rounds on the Web to a chorus of chortles. ... The paper is notable because it represents the almost universally held view of the two mortgage giants at the time and for years afterward. These pages began writing about the systemic risk posed by Fannie and Freddie at around the same time, but until the very end we were in the distinct minority. Fan and Fred's own regulator assured the world that they were well-capitalized almost until they wre put into conservatorship in September 2008. ... The assumptions in the test were said to be 'severe.' Even so, the probability of a default was 'so small that it is difficult to detect.' Some $111 billion in taxpayer-funded bailouts later, with perhaps hundreds of billions to go, the risks have been detected. ... In reality, it took barely a year of financial distress for Fan and Fred to burn through their capital and wind up in taxpayer laps. Professor Stiglitz says of his paper today, 'I'd like to think that if we'd done the same stress test in 2007, ... we would have said, "You ought to be worried."' Taxpayers would like to think so too. ... Both Orzags and Mr. Stiglitz were officials in the Clinton Administration and saw the debates about Fan and Fred that the Clinton Treasury began in the late 1990s, only to get clobbered by the companies' lobbying machine. ... Why should anyone think that regulators--or economists--will predict the next systemic debacle any better? ... And when large, systemically important companies are threatened with curbs on their business, they will pay Nobel laureates to write studies that explain away the dangers, and hire lobbyists to block any reform. A future Treasury secretary may also dismiss critics of a future Fannie Mae, or Goldman Sachs, as 'ideologues,' as Hank Paulson did in 2007-2008. ... Look no further than the eminent Mr. Stiglitz or the brilliant Orzag brothers for how hard it is to detect systemic risk, much less do anything about it", my emphasis, WSJ Editorial, 1 December 2009: http://online.wsj.com/article/SB10001424052748704204304574543503520372002.html.
I remember this paper, concluding at the time it was a rationalization for then current Freddie and Fannie (F&F) lending policies. I saw F&F as insolvent years ago. Is it a 25-sigma event as the Vampire Squid said in 2007? What would CPA Fred of Illinois have said if asked about this paper? Do I detect some WSJ sarcasm here? I think Stiglitz is smart. He knew he was providing the rationale F&F wanted. The WSJ may be right about the Orzags. I have not been favorably impressed with either's intellect.