mathbabe

This is a guest post by Mekon:

When you come in to work nowadays, you have to read the blogs. The other day, two blogs I like to read both had pieces about Freddie Mac and whether it had inappropriately bet against people refinancing their homes. I’ll spare you the details, which live in the highly technical world of mortgage securitization, but the issue is that Freddie Mac had a large position in “inverse floaters,” which are worth more when people don’t refinance.

The first piece says this is fishy, because Freddie Mac also makes rules on who gets to refinance and who doesn’t. So they have lots of incentive to make the rules more stringent, block people from refinancing, and profit by doing so.

But the second piece says there’s nothing fishy here at all: Freddie Mac is probably holding the inverse floaters to hedge interest rate risk. That is, they might need them just to be neutral to interest rates (people prepay when interest rates go down), because the rest of their book is exposed the other way.

How do you tell who’s right?

The first thing to realize is that they’re actually disagreeing on facts. This isn’t like the usual economic disagreements, where people argue over principles (whether the Fed should worry about unemployment as well as inflation) or things you can’t prove (how bad the economy would have gotten without the stimulus). It should be easy to settle this one: take Freddie’s book and see how it goes up and down when interest rates go down/stay the same/go up and people prepay more or less.

I imagine we haven’t done this because we don’t have the book.

Some opacity in finance may be unavoidable, but sometimes it’s completely unnecessary and self-inflicted. These are government enterprises! Why don’t we make their books transparent? If we can’t do it right away, what about with some kind of time lag? We’re talking about their positions from 2010, for heaven’s sake!

The second thing – forgive me if I’m off base here, I’m a fan of both blogs – is that it doesn’t seem like either one of them has fully done their homework (to be fair, without being able to see into Freddie’s book, it’s not clear how they could have). Both sites followed up with more detail, but nothing that seems definitive – put another way, I still can’t tell who’s right.

I’d like to see people be more sure about the facts before publishing conclusions. I thought maybe this was just me, but then I ran across a paper by Andrew Lo which makes much the same point (see the last section). Andrew looks at 21 different books about the financial crisis and compares the range of conclusions they draw to Rashomon. And, like the Freddie example, he finds no agreement on the underlying facts. I hear his frustration when he urges: “By working with a common set of facts, we have a much better chance of responding more effectively and preparing more successfully for future crises.” Amen.

Finally, if you’ll indulge me, a little sociology. If you’ve been around finance for a while, I think you’ll agree with me that people being on loose ground with their arguments and a bit quick on the draw with their conclusions is more the norm than the exception. Put another way, there’s an awful lot of noise in finance. Why is this?

This blog has focused a lot on how finance today is both complicated and opaque. One thing I’d add is that finance isoverpopulated. I don’t just mean that we’d be better off if smart people thought more about curing cancer and avoiding famine and less about executing trades a millisecond faster or securitizing and sell some kind of risk that’s never been traded before. (But duh.)

What I mean is that finance today is so complicated and opaque that it requires extremely specialized skills to understand what’s going on. At the same time, the field employs way more people than could ever have those specialized skills. End result: many people working in finance don’t really understand it. Which makes noise an accepted part of the culture. Which in turn makes it even harder to understand what the hell is going on.

I don’t know how to fix this, but wouldn’t you feel a lot better about our financial system if we could (1) make it simpler, and (2) cut the number of people needed to operate it in half?