How did we get into this mess?

1. Housing price steadily went up since 2001.
2. Buyers of all sorts sensed opportunity and started buying.
3. Lenders loosened lending standard because they saw low risk in the short term, due to rising price of housing; long term they had planed to sell the loan to Wall Street for repackaging and resell
4. Wall Street used financial models to create complex securities based on mortgages and then sold them to investors, especially from China and Oil countries
5. China and Oil countries accumulated savings and need to invest. Treasury was yielding low so they invested in these mortgage backed security thinking they have good collateral behind it.
6. Credit rating agencies didn’t understand the new instruments, such as CDO square, and went to Wall Street for help. They use the same financial models to assess the risk of these new financial instruments, and gave AAA rating to a lot of the product that turned out to be CCC.
7. China and Oil exporting countries see the AAA rating and bought those securities in bulk. This creates a credit boom as liquidity is everywhere.
8. But when housing market reversed its upward trend and started to go down, everything turned.
9. Buyers stop buying, foreclosures are rising, lenders stop lending, Wall Street can’t sell the securities they repackaged, foreigners stop buying those security, and rating agencies quickly down graded previous AAA to CCC, consumers are reeling, corporations cut back and layoff, and quickly we are in a financial crisis plus recession.
10. Deleveraging process needs to run its course. We will see down turn extend beyond 2010. When everything is purged, the economy will grow again.

System integration

System interaction causes system failure: when you look at individual pieces they work as expected, but when you integrate the pieces into a system the system will fail in certain situation. Example: Our financial system. Which piece causes the broke down? Is it Wall Street financial engineers who created the securities that pool risks, slice and tranche these risks and sell to different investors? Is it rating agencies who rate the CDOs as triple A? Is it the investor who bought these securities without knowing the risk, and relied solely on rating agencies? Is it the borrower over extended their leverage based on the belief that credit will always be available?

Financial engineering creates easy credit. Rating agencies rate and investors buy financial products they don't understand. Risk and credit assessment failed. The ensuing credit boom inflated housing price. The booming housing market created a booming economy and high share price. Everything is linked so when one piece breaks the entire system breaks down.

We can have a segmented, inefficient system that is reliable and low risk within its limits. Or we can have an integrated system that resources can be shared and flow to the most efficient use, but when one piece breaks down the entire system breaks down. There are costs to integration but these costs are not seriously considered. Experts believe the risk is low until the entire system failed.

Specialization is the source of efficiency. But who is going to look at system integration - making sure that every specialized component works smoothly with each other and won't cause a breakdown?

Deregulation and Bailout

There are people out there who hold “free market” as an ideology rather than a practical approach to increase the welfare of the society. They advocate minimum government, deregulation, and freedom, to the degree that regulation is seen as bureaucratic and evil.

However, in time of crisis they go out to ask for government help in astronomical sum of money. This is inconsistent. One who wants no adult supervision should take full responsibility of one’s action and expect no rescue. If you want unlimited speed highway you should not ask for ambulance when you have an accident. That is the spirit of freedom. Insisting deregulation in good times and a bailout in bad ones is irresponsible and hypocritical.

Now regulation is in vogue again. However, in ten years you will start to hear vocal opinions on deregulation and the merit of freedom again. Be aware of such voice. A lot of them are only irresponsible folks.

To what extend new products should be regulated?

Mortgage securitization was considered a good idea a few years ago due to its ability to spread out risk. It is today considered as the cause of the financial crisis – making renegotiating mortgage terms impossible. This is a testimony that product ideas that are tried in the marketplace for only a few years are not proven solutions. It takes time for a bomb to explode.

Because of competition there is immense pressure to get the product to market fast. This is true with pharmaceutical as well as financial products. Without a government agency as a gate keeper, society will be the lab mouse of innovative products. Some products are safe to use the public as lab mouse – remember the days when Windows crash daily? But others will have severe consequences, such as death or global financial crisis. To what extend new products should be regulated? What’s the right balance between safety and efficiency?

What caused the failure of Mortgage Back Security?

Mortgage back security (MBS) and Collateralized Debt Obligation (CDO) were invented with the same concept of life insurance. The goal was risk sharing. In life insurance, there is an important assumption that people don't die at the same time. From historical data life insurance companies know that, in a group of 1000 people age 40, they can reliably expect 3 deaths a year. So they go out to collect $3 from each participant in the beginning of the year, and then distribute $1000 to the family of each deceased member at the end of the year. This is called risk pooling and risk sharing.

MBS is expected to work the same way. Because the pool of mortgage from across the country, and from borrowers who work for different industries, it is assumed that default won't happen en mass. In statistical jargon, default would be independent event.

This independent event assumption works under normal condition. But under certain circumstances, the assumption can be completely wrong. In the life insurance case, when a deadly flu virus sweeps through a country, or a major war breaks out, or a large scale natural disaster strikes, people can suddenly all die at the same time. The events are no longer independent, because one underlying cause links all of them.

The current financial crisis starts from mortgage suddenly default en mass. The underlying factor is low interest rate for an extended period of time. Low interest rate causes housing price to go up nationally, because the same monthly payment can buy more expensive houses under a low rate environment. When housing price shots up too high, it can no longer be supported by income. Naturally it would have to come down a bit. When it comes down people with weaker credit and lower income start to be late on their payment. Market re-priced their risk and their interest rates went up. Now they can no longer affort the monthly payment, their bank foreclosed their houses. Foreclosure depresses housing price, causing even tighter credit. More delinquency ensue followed by more foreclosure. A downward spiral accelerates.

En mass default of mortgages means risk sharing no longer work. Banks understand that the MBS and CDO they hold as assets worth less. But how much less? It is difficult to value. The complexity of these financial instruments blocks transparency. The lack of transparency results in a confidence crisis on counter party default. Credit suddenly freezs, LIBOR and commercial paper rate shot up. Consumer credit deteriorates, and bank solvency becomes an issue.

Wall Street Meritocracy is based on wrong accounting

From 2001 to 2006, national housing price rises more than 60%, according to Federal Reserve. In that kind of environment, sub-prime borrowers don't go bust. If they can not pay the mortgage, they will sell the house at a higher price and repay the loan in full. Mortgage lender and Wall Street firms are hugely profitable because they can lend at a high interest rate to sub-prime borrowers and yet enjoy a low default rate similar to that of investment grade. And the executives enjoy compensation linked to these huge profits. That is until the housing price starts to fall. Mortgage losses pile up and the assets based on these mortgage worth only a fraction of that in the good times. Write offs amount to hundreds of billions of dollars and investor's worth plunged.

Business will always have cycles. In good times the profit is overstated. Inflated housing price is sure to fall at some point. But Wall Street compensation never factors in this fact. If they are rewarded for the good times, it is only fair that they suffer at the bad times. When investors see huge losses in their pension portfolio, Wall Street executive don't get negative number of compensation.

My conclusion: Wall Street executives are not compensated according to performance. They are having a call option on business cycles: hugely rewarded at good times and immune from bad times. Is this meritocracy? Is this pay for performance? Or is it just ripping benefits of economic growth while avoiding the unavoidable slumps? At a minimum we should not call such lopsided compensation meritocracy. It is based on incorrect accounting.

Taiwan Independence

If Taiwanese have a choice between becoming a state of United States or a province of China, the former will win with a super majority. Why? The US constitution will guarantee Taiwan a high degree of autonomy, continued democracy, and a rule of law.

Although the Chinese economy is growing briskly, China remains an autocratic regime. Government power is arbitrary and sustained by gun and nationalism. Tibetan protests are suppressed with ruthless military action. Human right advocates receive jail time rather than Congressional medal-of-honor. Internet is censored so people of grievance lost their voice. It is scary under Chinese rule.

Because of this nature of Chinese government, difference in regional interest will be resolved by gun rather than in court. Taiwan has no chance of winning any difference.

Taiwan’s president Ma is improving the relationship with China. But he would be foolish to surrender Taiwan’s sovereignty. It is Taiwanese sovereignty that guaranteed the freedom of its people, including the rights to sue their own government and replace a bad government by election. This is the only reason that an $11 billion worth of weapon purchase from the US can be justified. It is the price we paid to have political freedom.

Chavez of Venezuela 2

Chavez of Venezuela is a big disappointment. He turns out to be a power grabber rather than a disadvantaged people's advocate. After being defeated in the 2007 referendum, he uses Congressional recess to centralize agriculture and tourism and expand presidential power. He is becoming a communist dictator rather than a social democratic reformer. His financial support of the Columbian rebel army showed how dangerous this guy really is. Although he come to power by election, does he ever believe in democracy?

The question of suffering

This book is very good:
God's Problem: How the Bible Fails to Answer Our Most Important Question--Why We Suffer (Hardcover)by Bart D. Ehrman (Author)

1. God is omnipotent - all powerful.
2. God is a loving god.
3. Why are there mudslid and tsunami that causes so much suffering?

Is suffering God's intention? How can that be loving?
Is God not capable of stopping it? How can that be all powerful?
Why would God murder all ten of Job's children just to test his faith? Is that love?

Author was an evangelical Christain and at one point a priest. After 20 years of searching for an answer he becomes an agnostic.

working hard or making smart transactions

What can really make you rich is not your technical skills. It is the beneficial transactions you make. I have personally experienced this. I worked hard to pass exams while working as an actuarial assistant full time and made $40,000 a year. And then I made a bad transaction buying a small condo that I have to sell at a $40,000 loss (26.7%) when I relocate for a new job in the midst of a tough market. (Full disclosure: the condo is still not sold.) All of my hard work goes to the seller who sold it to me and the buyer who buy it from me. I have no ground to complain about any grievance. I deserve it by being stupid and not market savvy with real estate. Market is always efficient. The problem is when you are not savvy, the information asymmetry problem is working against you. You won't call it fair when you suffer such a loss. But I have only myself to blame. This is the miracle of market economy and capitalism. I learned it the hard way. Hope this personal painful story help you to avoid the same mistake I made. But you probably are much smarter than I was. So let's just see this as my personal follies, and laugh it away.