Tuesday, April 7, 2009

Modeling the Meltdown; Part 3b: Sketching the Model—Other Factors

As we create our model, we need to ensure we are covering the contributing factors referred to in Part 1. Let’s look at each of these:
  • Cheap Money: For each element of a model, we need to decide whether we are going to model it, or provide it as an input to the model (also known as an “external factor” or “externality” in economic jargon). If we were to model the generation of interest rates, we would need to implement the rules by which the Fed sets these rates. The Fed’s logic borders on inscrutable, so we are better off defining interest rates as an external factor. This is also a good idea because as we run the model forward, we’ll want to test it under conditions of different interest rates.

  • Lowered savings and increased borrowing: We would hope to see this as an emergent behavior by consumers. The specific rules that would generate this behavior have yet to be defined.

  • Loose loaning standards: These standards are a set of regulatory requirements (or lack thereof) that are asserted by a governing body on the mortgage industry. We can lump all governing bodies together in the “government” actor in this model. The mortgage lending regulations can then be seen as parameters on the government object: minimum down payment required, proof of income required, etc. These parameters should be implemented as external factors. When there are no requirements set by the government, then the choice of how risky to be in granting loans falls on the “bank” actors. The choices the banks make result from an internal calculation based on some set of logical rules (just as consumers’ decisions how much to borrow and save), yet to be defined.

  • Financial engineering:

    • MBS: There is a specific way that MBSs are constructed. We can think of the financial businesses that build them as factories that take in mortgages as a raw material. The MBS are then sold as products to other financial businesses (possibly even banks that originate mortgages), as well as investments that consumers make (stocks and mutual funds). There again need to be some logic rules about how the characteristics of mortgages translate into MBS products. The characteristics of the MBS products will also depend on which risk tranche the specific product is derived from.

    • CDS: These are different than MBSs, because a CDS is not a product but a contract (a legally binding agreement). A contract has two parties, on of which pays the other some amount based on some condition occurring. For CDS contracts, the “seller” of the contract agrees to pay the “buyer” a specific amount if an MBS named in that specific contract has too many defaults on its underlying mortgages. It may be possible to resell a CDS to a third party, but we will avoid this complexity in this model. (Sidebar: Selling a CDS would be akin to buying a life insurance policy on yourself, and then selling it to someone else so that you could spend some of the money now before you die. You can see that this can generate a conflict of interest when someone else benefits from your death. Similarly, a purchaser of a CDS that does not own the MBS which that specific CDS insures would benefit if the MBS went bad. One perverse causal chain would be for a bank issuing sub-prime mortgages to ultimately buy a CDS insuring those mortgages, after already having sold those mortgages. Then the worse the mortgages were, the more likely the bank would be to profit. I have not heard of this occurring… yet).

  • Leverage: Recall that leverage was being applied in many areas—foremost in amplifying the popping of the real estate bubble into global financial crisis.

    • Recall that homeowners leverage by placing a small down payment relative to the price of a house. We have this covered above under “loose loaning standards.”

    • Banks can leverage when making loans to a level specified by the government, called the “capital requirement”. While complex in its details, it can be expressed as a single number (currently about 6%). This, like interest rates, is set by the Federal Reserve. (Sidebar: In fact, the capital requirement is a strong tool at the Fed’s disposal. The lower it is, the more money banks can lend without taking on more deposits, which increases the money available in the economy. It's like printing money, but more easily undone when the money supply must be decreased again).

    • Non-bank financial businesses generally can apply as much leverage as they see fit. When there are public shareholders, there are consequences (e.g. the CEO “Perp Walk”) if those businesses don't act in the best interests of shareholders, and accounting standards to enforce prudent behavior. But for private financial businesses, like hedge funds, the only limit to leverage is how much they can get away with (see the story of Long Term Capital Management, aka LTCM, for a lesson on the consequences of this behavior). In our model we’ll likely provide a range of leverage levels across these private financial businesses based on real-world data. We might add an external factor capping leverage rates in the future, as this is a regulation the government is contemplating.
So, through a combination of internal logic and external factors, we are beginning to fully capture what we need to model. The modeler’s creed, credited to Einstein, is to “make everything as simple as possible, but no simpler.” That’s more of an art than a science, and the next step in building our model.

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