Adam Smith® Says

Adam Smith lives in Princeton, NJ, next-door to Paul Krugman, Princeton professor, New York Times Op-Ed columnist and oh, by-the-way, winner of the 2009 Nobel Prize in Economics.

I wonder how he invested that money?

On July 8th Smith and Krugman put on a little show for fewer than 100 folks at a meeting in Princeton of New Jersey Common Cause. Someone was there to take bad video of the event which I have here and intend to share with you over three posts today and tomorrow.

Krugman is a very smart economist working at the top of his game and explains things pretty well.  In these clips (there are 17 in all) he presents what could easily be the contents of a dozen or more columns.  And what I like is it is presented colloquially with us getting a much better sense of the man than from his very polished work in the Times.

I am not saying Krugman is right about everything, but I think these clips are very worth watching for a sense of our time and current thinking about it.  And it is odd how little it has to do, really, with economics and how much with government and just the way things do and don’t get done in our culture.

I look forward to reading your comments.

Take a look at the chart to the left, which comes courtesy of the Federal Reserve.  It makes the point that private label mortgages, which are mortgages securitized by Wall Street firms, mainly investment banks, are responsible for most of the mortgage mess we are in as a nation.  These are the white sections in these two related graphs.  There is a lot to understand here and it is particularly damning if examined closely because it shows Wall Street to be at best incompetent and at worst criminal.

All of the organizations and organization types mentioned in this table do the same thing — they buy or fund mortgages then package thousands of those mortgages together into securities they sell on the open market.  If the quality of every security was the same then the percentage of bad mortgages would exactly match the percentage market share for each player.  Yet that is far from the case.

Let’s do some numbers:

Organization        Mortgages (millions)          Troubled (100,000)              % Troubled

Banks/Thrifts              8                                            397                            4.9

Fannie Mae                18                                            444                            2.4

Freddie Mac               13                                            232                            1.7

Ginnie Mae                   6                                            378                           6.3

Private Label                8                                           1734                         21.6

All of these organizations perform similar functions, all employ the same staff functions, all buy, for the most part, from the same pool of available mortgages, except of course there are varying requirements for each organization like the maximum loan, minimum credit score, etc.  Yet the variation from best to worst is as high as 10-to-1.  How can that be?

From a strictly statistical standpoint it CAN’T be.  In theory the population of mortgages, like the population of homeowners, should be represented by a normal (bell shaped) curve, with the bad mortgages taking up a small section on the left side of that curve.  It should be a small section because, since these mortgage pools are designed by statisticians, in order to be statistically acceptable the risk must generally be within two standard deviation from the norm.

Here’s how it SHOULD look:

About 2.15 percent of mortgages are expected to go bad, represented by the white space on the left of the curve.  Some of the government-backed and bank/thrift mortgages were a little better and some were a little worse, but they are all clustered not too far from that 2.15 percent number, which is as it should be.  And remember this is during an unprecedented world financial melt-down.

Then there are the private-label numbers, which are precisely TEN TIMES worse than expected.  Statistically that’s crazy, but NOT crazy if the population of mortgage holders isn’t normal.  That would be the case, for example, if the population included a large number of people who had no intention to actually make their mortgage payments, which seems to be the case here.

Remember that these private label numbers include those from all Wall Street firms, including — presumably — some firms that weren’t intending to be crooks.  So the bad numbers within these numbers are actually even worse — far worse.

What’s particularly damning about these data is that the non-private label numbers are so good, yet some of those government programs DON’T EVEN TAKE CREDIT SCORES INTO ACCOUNT.

This is Wall Street rocket sciecne run amok.

One particular irony here is the notion that the Clinton Administration, forcing an end to blue-lining and encouraging lenders to make more lower-income mortgages, exacerbated the mortgage crisis.  Some people claim this policy change is the entire basis of the current problem.  Then why isn’t it reflected in the bank/thrift and various Federal program numbers?  They should be.

What these data say about the private label (Wall Street) mortgage securities is that there was systemic fraud.  Wall Street would like to pin that fraud on homeowners, but it is so pervasive that it really has to be more properly pinned in the statisticians who allowed it to happen and on their bosses who ORDERED it to happen.  These aren’t just bad decisions, they are statitically impossible with a normal population.  These are CRIMINAL acts costing billions of dollars and damaging the nation as a whole.  Yet who is going to jail for it?

Nobody so far.