Kevin Drum - February 2009

The Gaussian Copula

| Wed Feb. 25, 2009 2:33 AM EST
I've been reading about Wall Street's fabulous Gaussian copula function for some time, but aside from a vague notion that it was a rocket science method of measuring risk, I've never had the slightest idea what it was actually all about.  In this month's Wired, Felix Salmon explains.  Basically, it's a clever way of figuring out whether the odds of two different bonds defaulting are correlated.  If they are, then bundling them together into a single security is risky since there's a good chance they'll both go into the toilet at the same time. If they aren't, bundling them together is fairly safe since even if one of them defaults, at least the other one is still safe.  Its inventor was a math guru named David X. Li:

In 2000, while working at JPMorgan Chase, Li published a paper in The Journal of Fixed Income titled "On Default Correlation: A Copula Function Approach." (In statistics, a copula is used to couple the behavior of two or more variables.) Using some relatively simple math — by Wall Street standards, anyway — Li came up with an ingenious way to model default correlation without even looking at historical default data. Instead, he used market data about the prices of instruments known as credit default swaps.


Hmmm.  The implication here is that the fundamental problem with the Gaussian copula — which was the mathematical basis behind the proliferation of CDOs, CLOs, and all the other shiny new investment vehicles that imploded so spectacularly last year — is that it was based on the relatively brief historical record of credit default swaps.  I don't have any doubt that that's true, but a few paragraphs later the real villain turns out to be a familiar one:

"Everyone was pinning their hopes on house prices continuing to rise," says Kai Gilkes of the credit research firm CreditSights, who spent 10 years working at ratings agencies. "When they stopped rising, pretty much everyone was caught on the wrong side, because the sensitivity to house prices was huge. And there was just no getting around it. Why didn't rating agencies build in some cushion for this sensitivity to a house-price-depreciation scenario? Because if they had, they would have never rated a single mortgage-backed CDO."

There's just no getting around it: there might have been technical problems with the Gaussian copula function, but even if it had worked the way people thought it did it wouldn't have mattered.  The rating agencies and the sell-side BSDs were just using it as an excuse to pretend that house prices would rise forever anyway.  That was a far more fundamental problem than the statistical shortcomings of the formulae they used.

Still, it's an intriguing piece that's worth reading.  You can put it alongside Joe Nocera's piece last month on Value at Risk, yet another quant model developed at JPMorgan whose wide misuse contributed mightily to our current economic meltdown.  When common sense takes a holiday, it turns out, all the math in the world can't save you.

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Obama's Speech

| Wed Feb. 25, 2009 12:15 AM EST
I don't know how meaningful this is, but listening to Barack Obama's speech tonight it struck me that there were only two places where he specifically asked Congress to send him legislation.  The first was a cap-and-trade plan to address global warming, and the second was the Hatch-Kennedy national service bill. On healthcare, by contrast, he merely said he would be bringing stakeholders together "to begin work on this issue next week."

Maybe that's significant, maybe it's not.  But I was at least a little surprised that his healthcare pitch wasn't a bit punchier.

A few miscellaneous observations.  Overall, it was a good, adult speech.  The beginning was like a punch in the gut to Republican fecklessness over the past eight years, but later on Obama somehow got plenty of bipartisan standing Os anyway, even in a few places where I wouldn't have expected it.  There was some fine populist demagoguery aimed at Wall Street ("This time, CEOs won't be able to use taxpayer money to pad their paychecks or buy fancy drapes or disappear on a private jet"), but it was mainly just a cover for an admission that he planned to keep shoveling money into banks.  And he made it pretty clear that he would announce a withdrawal plan from Iraq within a few days.

That's all for now.  Consider this an open speech thread.

Obama's Mortgage Plan

| Tue Feb. 24, 2009 6:38 PM EST
Is Barack Obama's plan to help out distressed homeowners unpopular?  Rasmussen asked the following question to find out:

Some people say that having the government subsidize mortgage payments for financially troubled homeowners puts the government in the position of rewarding bad behavior. Is the government rewarding bad behavior when it provides subsidies to those who are most at risk of losing their homes?

55% said yes and only 32% said no.  But it's a leading question!  When the Washington Post and New York Times asked a more straightforward version of the question (Post: "Would you support or oppose the federal government using 75 billion dollars to provide refinancing assistance to homeowners to help them avoid foreclosure on their mortgages?") the results were reversed.  Over 60% supported the plan.  Matt Yglesias converted these results into handy chart form, which I've stolen and displayed over on the right.

The basic meme in the leftosphere is that Rasmussen deliberately chose conservative wording here and the results aren't to be trusted.  But I want to push back on that a bit.  There are two points to make here.

First, these poll results aren't necessarily contradictory.  It could well be that some people think Obama's plan is likely to reward bad behavior in some cases but they support the plan anyway.

Second, there's something to be learned here if we don't dismiss Rasmussen's results out of hand.  Here's the problem: liberals often suffer from poll literalism, a disease in which we look at simple poll questions and think they show that everyone supports us.  60% support national healthcare! 70% support more spending on education!  Hooray!

But those numbers are largely meaningless. The real question is, How many people still support national healthcare after conservatives have spent months scaring everyone into thinking it means they'll never be allowed to see their old family doctor again?  Probably not as many.  Likewise, how many people will support Obama's mortgage plan after they've heard all the conservative talking points against it?  Probably less than the Post and the Times say.

Now, my guess is that once everyone's had their say, Obama's plan will still garner considerable support.  But it might not, and understanding how Republican talking points affect public opinion is valuable.  That's what Rasmussen has told us here, and it's worth paying attention to.

Habeas at Bagram

| Tue Feb. 24, 2009 4:42 PM EST
Should prisoners held at Bagram Air Base in Afghanistan have the right to file habeas corpus suits challenging their imprisonment?  Both the Bush and Obama administrations say no.  Hilzoy has a good post exploring the issues:

On the one hand, had anyone asked me in, say, 1991 whether Iraqi prisoners whom we were holding in Kuwait were entitled to file habeas petitions in US court, I would have said: of course not. They are entitled to lots of things, many of them detailed in the Geneva Conventions. But it would have seemed bizarre to me to suggest that they were entitled to habeas rights.

I still feel this way about those detainees at Bagram who were captured on or near an actual battlefield. To say that I do not think they are entitled to habeas rights is not to say that I do not think they are entitled to anything. Afghanistan is a signatory to the Geneva Conventions. Its soldiers are entitled to the rights of prisoners of war. Any civilians we capture are likewise entitled to those rights until "a competent tribunal" determines that they are not prisoners of war.

The problem is that not all the prisoners at Bagram were captured on a battlefield.  Some, like Amin Al Bakri, were abducted in Thailand and then flown to Bagram, and this makes it impossible to simply assume that everyone there is a POW:

It was neither me nor the federal courts that muddied the distinction between the jurisdictions of the federal and military courts, thereby making it impossible for the federal courts to simply defer to the military in these matters. It was the Bush administration. They were the ones who sent CIA agents all over the world kidnapping people, flew those people from places like Thailand into a war zone, and then turned around and said: heavens, you cannot scrutinize what we did — you'd be interfering with the conduct of the military in wartime!

Read the whole thing for a pretty good, nuanced discussion of the issues at hand.  This is a tough one to unwind.

The Mandate Returns

| Tue Feb. 24, 2009 3:52 PM EST
During the primary campaign, one of the big disagreements between Barack Obama and Hillary Clinton was about healthcare mandates.  Should a national healthcare plan require that everyone be covered one way or another, or should coverage be optional?  Clinton favored a mandate and Obama didn't, but Ezra Klein has been talking to some of the Obama folks involved in formulating the upcoming budget and says that things have changed:

The budget — and I was cautioned that the wording "is changing hourly" — will direct Congress to "aim for universality." That is a bolder goal than simple affordability, which can be achieved, at least in theory, through subsidies. Universality means everyone has coverage, not just the ability to access it. And that requires a mechanism to ensure that they have it.

Administration officials have been very clear on what the inclusion of "universality" is meant to communicate to Congress. As one senior member of the health team said to me, "it will cover everybody. And I don't see how you cover everybody without an individual mandate." That language almost precisely echoes what Senate Finance Chairman Max Baucus told me in an interview last summer. "I don’t see how you can get meaningful universal coverage without a mandate," he said. That judgment was further emphasized last fall, when he released the first draft of his health care plan and built in an individual mandate.

This strikes me as a concession to reality on Obama's part — both political reality and policy reality.  It's also good news.  Regardless of the details, I think it's important to commit to the principle of universality in a concrete way, and an individual mandate is one way to do that.  It's not the way I'd do it, but at least once the principle is in place it makes it a lot easier to argue productively over the details.  So two cheers for the mandate.  It's a pragmatic and welcome shift.

Cui Bono?

| Tue Feb. 24, 2009 3:24 PM EST
Bond king Bill Gross thinks it would be a bad idea to nationalize banks and force bond owners to take a haircut.  This would "create an instability policymakers should not want to risk," he says, and might undermine other financial sectors such as insurance companies and credit unions.  Megan McArdle is unimpressed:



....I am concerned about the sudden consensus about nationalization — I haven't yet seen a good reason to believe that a tiny bank in a tiny nation like Sweden presents a good model for tackling the problems of the largest financial services company in the world.  But the fact that Bill Gross is worried about bondholders taking a loss makes me more inclined to favor the notion.  It's perverse, I know.

Nationalization should be a last resort.  And there's no question that nationalizing a multinational giant like Citigroup is a far more complex undertaking than nationalizing Nordbanken.  On the other hand, there's just no way that taxpayers can be expected to continue shoveling capital into big banks in return for tiny minority shares.  In the case of Citigroup, for example, the government has so far handed over $45 billion to a company that could be purchased lock, stock and barrel for only $10 billion.  There's just no way that taxpayers are going to keep putting up with that, and they shouldn't.

In any case, it's also possible to overstate the difficulty of nationalizing a big money center bank, I think.  It's not as if we'd fire the entire staff, after all.  What would happen in reality is that the board of directors would be dissolved, some of the senior staff would be replaced, shareholders and bondholders would take a hit, and the bank would continue running as normal except with a stronger capital base and government guarantees behind it.  Then, in a few years, it would be refloated and put back in private hands.

It would be nice if it doesn't come to that.  But there's a pretty good chance that it will.  Not because anyone wants it to, but because, eventually, it will probably be the least bad option left for the weakest of the banks.

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Take It Or Leave It

| Tue Feb. 24, 2009 2:59 PM EST
Chuck Schumer says that grandstanding governors who hope to score political points by turning down some minuscule proportion of the stimulus money earmarked for their state have another thing coming:


Take that, Bobby Jindal!  Or, rather, thanks, Chuck Schumer!  After all, if Schumer is right, it means that guys like Jindal are off the hook.  "I tried to be fiscally responsible, folks, I really did, but the Democrats didn't give me any choice."  Long sigh.  "So I guess I'll have to take all their money after all."  Even longer sigh.

But I guess that's OK.  A bit of Republican theatrics won't hurt us, and at least this means that Louisianans will get the unemployment benefits that Jindal tried to deny them.  Which is not only good for them, but good for the economy too, as even commie pinko Fed chairman Ben Bernanke recognizes:

BERNANKE: If unemployment benefits are not distributed to the unemployed, then they won't spend them and it won't have that particular element of stimulus.

SEN. JACK REED (D-RI): So if this was done on a wide basis, it would be counterproductive, not productive?

BERNANKE: It would reduce the stimulus effect of the package, yes.

If you have some principled objection to the idea that fiscal stimulus works, then fine.  But if you don't, there's no reason to object to extended unemployment benefits.  In terms of bang for the buck, it's probably one of the best uses of stimulus funds in the entire package.

Growing Your Own

| Tue Feb. 24, 2009 2:32 PM EST
Mark Kleiman repeats his longtime favorite proposal for decriminalizing pot:

Substantively, I'm not a big fan of legalization on the alcohol model; a legal pot industry, like the legal booze and gambling industries, would depend for the bulk of its sales on excessive use, which would provide a strong incentive for the marketing effort to aim at creating and maintaining addiction....So I continue to favor a "grow your own" policy, under which it would be legal to grow, possess, and use cannabis and to give it away, but illegal to sell it. Of course there would be sales, and law enforcement agencies would properly mostly ignore those sales. But there wouldn't be billboards.

I get his point: decriminalizing marijuana is one thing, but do we really want the Philip Morris marketing machine working overtime to produce endless PR campaigns allegedly aimed at adults but in reality doing nothing of the kind?  Probably not.

But I wonder if there's some middle ground here?  I'm always dubious of proposals that rely on law enforcement to "mostly ignore" technical violations of a law, since that's an open invitation for them to abuse their discretion.  So I'd prefer to legalize commercial operations. But practically speaking, is there some way to open up commercial cannabis sales but limit their operations to a fairly small size?  It seems like there ought to be, and it would certainly be a boon to those of us without green thumbs.  Ideas?

UPDATE: Another objection here.

The Home Mortgage Deduction

| Tue Feb. 24, 2009 1:59 PM EST
The home mortgage deduction is regressive, pushes up housing prices, motivates people to buy bigger houses, and doesn't increase homeownership rates anyway.  So Ed Glaeser says we should get rid of it:

Now, I do understand that drastically reducing the cap on the mortgage interest rate now, in the midst of a housing crash, would be kicking the markets when they are down. Yet this crisis provides us with an opportunity to act that will be lost if we wait until housing prices rise again.

So here is my utterly quixotic proposal. Enact legislation now that will gradually decrease the cap on the mortgage principal for which homeowners can deduct interest payments by $100,000 a year over the next seven years until it hits $300,000.

Sure, fine by me.  The home mortgage deducation is a perfect example of a policy that might have made social sense at one time, but outlived its usefulness years ago and now continues a zombie-like existence as one of the third rails of American tax policy.  But why bother decreasing the cap?  Why not just decrease the amount of interest you can deduct from 100% to 95% to 90% and eventually to zero over 20 years, starting, say, in 2011?  And replace it each year with a proportionate increase in the standard deduction.  (Or maybe something else.  Ideas welcome.)

Or replace it with nothing at all, in the name of fiscal responsibility.  Not many votes in Congress for that, though, are there?

The Dow

| Tue Feb. 24, 2009 1:40 PM EST
Matt Yglesias is annoyed at the undue attention paid to the Dow Jones Industrial Average:

Not only is it obviously stupid for political commentators to be assessing the quality of economic policy by tracking the ups-and-downs of the stock market but the fact that the commentators who want to do this keep wanting to specifically use the Dow Jones Industrial Average just highlights their ignorance....Why not use the S&P 500? Or the Wilshire 5000?



In CNBC's defense, it's worth noting that they're just giving the people what they want.  Lots and lots of fairly ordinary people have money invested in the stock market, but virtually nobody has a bunch of money invested in derivatives based on, say, the TED spread, even though right now it might be more important than the DJIA.  What's more, it's sort of interesting just how good a proxy for the economy the Dow Jones is.  Take a look at a historical chart and you'll see that its ups and downs correlate pretty well to the overall state of the economy.  If you're looking for a sexy, fast-moving, gut-wrenching indicator of the economy's animal spirits, you can do a lot worse than the DJIA.

And why the DJIA instead of the S&P 500?  It's the power of the first mover.  The S&P didn't get started until 1923, and even then was published only once a week.  Boring!  By the time they finally got around to doing things daily, the DJIA was the king of quotes, and it's stayed that way ever since.  And since the two indexes follow each other so closely anyway, I guess there's never been any really compelling reason to switch loyalties.  Plus it helps when the guys who own the average also happen to own the country's biggest financial newspaper.  That kind of synergy is hard to beat.