Tuesday, October 07, 2008

Gary Becker Speaks Out

Professor Gary Becker of Chicago has an excellent column in the WSJ today.

Here is one particularly good section:

"The main problem with the modern financial system based on widespread use of derivatives and securitization is that while financial specialists understand how individual assets function, even they have limited understanding of the aggregate risks created by the system. That is, insufficient appreciation of how the whole incredibly complex financial system operates when exposed to various types of stress. In light of such limitations, it is difficult to propose long-term reforms. Still, a few reforms seem reasonably likely to reduce the probability of future financial crises."

I think this does hit one nail on the head -- that participants did not know how the system as a whole would behave when under stress.

The best analogy is that of soldiers marching over a bridge. The longstanding rule is to break cadence, or there is a risk that the frequency of the march will hit the natural frequency of the bridge and cause a positively reinforcing, amplifying force that can cause the bridge to collapse. In differential equations courses, this film of the Tacoma Narrows collapse is often used to illustrate the concept.

In the mortgage backed securities markets, participants were in some sense walking in step and did not realize it. One place where I really see this is in the complexity of all the MBS, which given the point we are in now, really exacerbates the problems of valuation. A little less tranching and fewer bells, whistles and triggers on these securities would be really nice right about now.

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