Friday, March 27, 2009

Krugman Jumps the Shark

It pains me to say that, as Paul Krugman has been my favorite commentator for about 15 years. But, sadly, it's true. In his latest column, Krugman takes aim at securitization:

But the wizards were frauds, whether they knew it or not, and their magic turned out to be no more than a collection of cheap stage tricks. Above all, the key promise of securitization — that it would make the financial system more robust by spreading risk more widely — turned out to be a lie. Banks used securitization to increase their risk, not reduce it, and in the process they made the economy more, not less, vulnerable to financial disruption. ... I don’t think the Obama administration can bring securitization back to life, and I don’t believe it should try.
There are so many problems with this nonsensical argument, it's hard to know where to start. First of all, the "key promise of securitization" has never been to "spread[] risk more widely." The key promise of securitization is that it allows commercial banks and other lenders to make new loans. More importantly, if securitization is so awful, then why has Krugman defended it so many times in the past?
  1. Just 8 months ago, he penned a strong defense of Fannie Mae and Freddie Mac, which were literally created to securitize home mortgages. He even argued that "the Fannie-Freddie experience shows that regulation works." So which is it: do Fannie and Freddie show that well-regulated securitization works, or is securitization "a collection of cheap stage tricks"?
  2. When Geithner originally outlined the administration's bank rescue plan, Krugman wrote:
    What is in it, in reverse order: 1. Super-TALF: a big expansion of the Fed’s quantitative easing, with Treasury backing. I’m OK with that. [Emphasis added]
    The TALF, of course, is a Fed program that's specifically designed to restart the securitization markets for assets backed by small business loans, student loans, credit card receivables, auto loans, and the like.
  3. Krugman has also praised the Resolution Trust Corporation (RTC) on several occasions, referring to it recently as "a good role model." After Bear Stearns failed, he wrote:
    Looking ahead, we probably need something similar to the Resolution Trust Corporation, which took over bankrupt savings and loan institutions and sold off their assets to reimburse taxpayers. And we need it quickly.
    How did the RTC sell off a substantial portion of those assets? Through—you guessed it—securitization! In fact, the RTC practically invented the market for securitized commercial mortgages (CMBS).
It's disappointing to see Krugman making such comically absurd arguments about banking/financial policy—a subject which, as a theoretical economist, he knows virtually nothing about. It's sad that people take his views on the bank rescue seriously.


Fergus O'Rourke said...

Why is Krugman's inconsistency more important than the fact that he is wrong about securitisation ?

Anonymous said...

We know that financial history has seen a myriad of "banking crises" (intended as a crisis involving or caused by a severe and generalised mis-assessment of credit risk on originated loans, having the result of impairing bank balance sheets at a domestic scale) in all sorts of different financial systems. These systems had different regulatory and institutional characteristics (just a few crises of the past 20 years: Japan , Sweden, the Asian Crisis, South America). The reflection on this simple fact in my opinion should lead to healthy scepticism in concluding that the securitisation model is mainly responsible a priori generating the bad lending practices that we saw during the subprime crisis.

Anarchus said...

Oddly enough, Herr Krugman was half (or maybe 1/3) right: at least part of the promise of securitization was that it allowed for wider diversification of risks across institutions and regions of the country. Obviously, as you point out, securitization also freed up bank capital to be used and re-used in making fresh loans, packaging them up and selling them off and then doing it all over again. But the professor wasn't all wrong, he just misplaced his emphasis, maybe.

But then he goes on to blame securitization as the cause of the lack of diversification when it's not - if anything, it was the inability to sell the less attractive tranches of securitized assets that caused the troubles.

Searching for root causes, I'd place at least a lot of the blame on the CDS market, where smart wheeler dealers like Goldman Sachs were able to keep their junk-creation machine going by laying off the risk time-and-again to AIG and a few others by buying CDS's against their residual garbage.

Anonymous said...

(1) Need securitization be so complex? What's the purpose of complexity other than to hide risk?

(2) Was the use of derivatives to protect each other from risk judicious? Wasn't it an illusion that these derivatives hedged and hedged again will somehow protect the entire system, when the sum of all the risk was too high for the system to swallow?

(3) Does the Finance industry for the sake of finance make sense?

Anonymous said...

This is not about the time-honored tool of securitization into one bundle, but about the recent invention of slice&dice securitization.

Underlying the glamorous new world of finance was the process of securitization. Loans no longer stayed with the lender. Instead, they were sold on to others, who sliced, diced and puréed individual debts to synthesize new assets. Subprime mortgages, credit card debts, car loans — all went into the financial system’s juicer. Out the other end, supposedly, came sweet-tasting AAA investments.

This is from the previous paragraph of Dr K's column. In context he is clearly talking not about all securitization but "baloney" securitization. Yes, the paragraph you quoted does not make this distinction, but still, the context is clear.

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