What Happened To The U.S. Financial System?

The situation in the U.S. financial system grew even more dire this week with the failure of yet another bank (Washington Mutual), and predictions of imminent disaster without a mammoth $700B government bailout. Only time will tell whether this bailout actually solves anything, and whether this is the end of the big surprises; somehow I doubt it. But to me, the more interesting question is, “how did the mighty American economy, which represents 25% of the world’s GDP and 50% of the world’s wealth, get itself into such a horrible mess?” The simple answer is: massive disregard for financial prudence, caused by greed and incompetence…

Tech Bubble

A good place to start the story is with the tech bubble of the late 1990s. Bubbles are created when the value of something becomes disconnected from its true intrinsic value, and value starts rising on momentum alone. Usually this is caused by exuberance and herd-mentality; common sense goes out the window. In the case of the tech bubble, marginal tech companies with marginal business models got bid up beyond any semblance of realistic or historical valuations. To keep the bubble going required bigger and bigger suckers to buy at inflated prices. But eventually, as with all bubbles, reality set in. Once there were no more suckers left the price stopped rising and the smart money started getting out. Slowly prices started to drop, and more and more people started to sell. This drove prices down faster and faster and the bubble popped. In the end, prices reverted to their mean, the mediocre companies went out of business, and things returned to normal.

But, as a result of the tech crash and all the associated doom and gloom, the U.S. Federal Reserve thought it prudent to lower interest rates to historic lows (1%) in late 2001 to help cushion the effect on the economy and avoid an economic depression, or so they said. Well, it worked. People and businesses borrowed lots of money, and the economy recovered. The problem was, the Fed was avoiding a relatively small problem and encouraging a much bigger one…

Housing Bubble

Through the first half on this decade, U.S. housing prices grew, on average, at an extraordinary rate of 15%+ per year, which is way above the long-term average of 2-3% per year. This created yet another bubble, this time in housing.

So historically low interest rates certainly helped create the bubble, but as with all bubbles, it was hype and exuberance that really drove it. For example, speculators who couldn’t invest in tech stocks anymore switched to real estate. Housing was the new “hot” investment. The signs were undeniable. Everywhere you looked, there were seminars, books, and TV shows about flipping houses and how to make millions in real estate. In 2005, 28% of houses were bought for “investment” purposes. Builders cranked out new houses, there were bidding wars by buyers, and the whole industry got caught up in the mania.

But people’s incomes weren’t increasing at 15% per year, so how could they afford these rapidly increasing prices? This is where the banks and lending institutions magnified the problem because they too got caught up in the mania. The mortgages being offered by some of these institutions were ridiculous:

• Variable rate interest-only for the first 2 years
• Variable rate with interest rates as low as 1% in the first year
• Variable rate with payments less than interest for the first 5 years, meaning that the principle outstanding was growing
• Piggyback loans that allowed the downpayment to be borrowed against home equity
• No downpayment
• Cashback home equity loans beyond the equity in the house

There are estimates that 43% of first-time homebuyers in 2005 made no downpayment. The goal was for everyone to buy a house, whether they could realistically afford it or not…

Well, it worked. Millions of people bought houses they had no business buying. But why people would assume interest rates would stay historically low is beyond me…

Inflation

The next wrinkle was rising inflation. Since 2000, energy prices have increased significantly. For example, crude oil has gone from $30 a barrel to $120 a barrel. Why? Because we’ve run out of cheap oil, and emerging economies like China and India are using a lot more energy than they once did. So, as you’d expect, rising energy prices caused everything to be more expensive to produce, thus driving up inflation.

The Federal Reserve, wanting to control inflation (since that’s its job!), quickly raised interest rates from 1% to 5% to cool the economy. The problem was that all those people with variable-rate mortgages they already couldn’t afford had their mortgage payments double or triple. And it wasn’t only the dubious borrowers, with the so-called subprime mortgages, that got into trouble, but many borrowers with prime mortgages as well. Too many people got overextended. Default rates grew, and housing prices crashed, or more precisely, reverted to normal. But as you can see from house price graph above, they may still need to fall even further to get back to normal.

The net result was that by August 2008 approximately 9% of all mortgages were either delinquent or in foreclosure. Oops…

What isn’t clear yet is how this caused the financial armageddon we now see. So what if 5-10% of your customers are defaulting on their loans? The other 90% are still paying.

Derivatives

The problem is these lending institutions don’t have sufficient assets to cover their debts; they’re using leverage. Leverage is a great way to make lots of money, but it’s also a great way to lose lots of money. But these lending institutions aren’t just leveraged, they’re highly leveraged, some 20 to 1, others more than 30 to 1. So now if 3% of their loans default, that represents a loss of 60% of their assets if they’re leveraged 20 to 1, or a loss of 90% of their assets if they’re leveraged 30 to 1. Oops…

So that explains why all the lending institutions are in trouble – they were under-capitalized based on their risk exposure. Fine, so what about insurance companies like AIG? The insurance companies provided insurance to these lending institutions in the form of credit swaps and other financial derivatives. So when lending institutions wanted to collect on these insurance policies, the insurance company had huge problems because they too were highly leveraged. What do you do if you don’t have enough cash to cover your redemptions? You borrow more money. The problem is no one has any money to lend (except apparently the American taxpayer). All the financial institutions went to hide in their holes to wait for the carnage to end. So if you can’t pay your debts, and you can’t borrow any short-term money to tide you over, what happens? You go bankrupt, plain and simple.

Worst of all, all these financial institutions are so co-dependent through all of these credit swaps and other derivatives they’ve sold to each other that it’s like a big game of dominos. Knock one over and bunch more fall. Throw in a little market manipulation to bring down a few companies (à la Bear Stearns), and there you have it. One massive financial mess…

Lessons?

So what can we learn from this fiasco? Greed is extremely dangerous. The desire to make lots of money, regardless of the cost, is pervasive throughout the U.S. financial sector. All of these problems we now face were foreseeable. But the government did nothing to stop it. The Federal Reserve did nothing to stop it. The financial institutions did nothing stop it. Not that I think they could have. They always seem to be 8 steps behind. They move too slowly…

There were some experts that sounded the alarm bells years ago, but they were largely ignored. We’ll eventually get through this mess, but this isn’t going to be the last bubble. Where there’s greed, there’ll be speculators. The speculators will be always be looking for something new; there’s way too much money sloshing around to do otherwise. The next bubble may be agriculture, or energy, or alternative energy, or tulip bulbs, who knows…

The question is, what are you going to do next time? Are you going to become complacent like everyone else until it’s too late, or have you learned your lesson? Did your financial advisor help you avoid this mess? Probably not. Mine didn’t. Why not? That’s an interesting question…

[Content © 2008 SorryToConfuseYou.com, All Rights Reserved.]

Representative Democracy?

It’s an election year once again on both sides of the border in North America, and the spectacle that is our democracy is on parade again. As I get older (and apparently more crotchety), our electoral process disgusts me more and more every time I have to sit through it…

My main complaint is that our democratic / electoral / legislative processes seem horribly inefficient and wasteful given the quality of the results we receive. The problem, I think, is we’re focusing on the wrong things, like style over substance for example. Given we’re in the 21st century now, you’d think we could improve upon a process that’s been essentially unchanged for more than 100 years…

Representatives

Let’s start from the beginning. The intent of democratic government is essentially:

• “Government of the people, for the people, by the people”

In North America we implement democracy using representative government, meaning we select a local representative to run government on our behalf. Originally each representative represented 10,000+ people; it’s now 100,000+ people. How can these representatives know what their constituents want? They can’t. So a key characteristic of democratic representatives is:

• “While representatives are elected by the people to act in their interest, they retain the freedom to exercise their own judgement as how best to do so.”

In other words, I can’t possibly figure out what my constituents want, so I’ll simply explain my views, and if they elect me, then my views must be most representative of their views. In the 1800s, in the world of the horse and buggy, and no telephones, this process made sense. What other alternatives were there at the time?

But what about now? Do our representatives still need to be completely autonomous? Or could they instead be more of a conduit for our interests? Hmm…

Parties

So we’ve successfully elected representatives to represent us. But having a bunch of random people with a bunch of different views attempting to govern would be very difficult, nothing would ever get done. So long ago, candidates got together with other like-minded candidates and formed political parties to present a more unified set of views.

But slowly, over time, the importance of the individual representatives diminished and the importance of the parties increased to the point where the local representatives are now largely irrelevant, at least in Canada. For example, many people will vote for the same party every election regardless of who the local candidate is. I bet in many ridings you could elect a monkey – I know I’d vote for a monkey if it got the party I wanted elected…

Our local representatives could remain relevant if they sometimes voted against the party line, but they don’t. In Canada, voting against the party line will usually get you kicked out of the party. Constituents and conscience be damned – tow the party line or else…

So, during the election, we’re no longer voting for a representative individual, we’re voting for a representative party. Fine. This isn’t horrible. Our regional interests may not be well represented, but the federal government should, in theory, be dealing mostly with national issues anyway, right?

But at least the majority of voters will be represented by the governing party, right? Wrong. Because we have more than two major parties in Canada, and we don’t have proportional representation (which I’m not necessarily convinced is the answer to anything), the party that forms the government rarely gets more than 50% of the votes (it’s usually about 40% – 45%), even though they hold the majority of the seats. Oops…

But my main complaint about our party system is the governing party completely controls the agenda, which means the policies of the other elected parties are irrelevant. What if I like some policies from each party?

Campaigning

On to my least favorite part – the elections.

The amount of money and the number of people it takes to organize, run, and report on all the candidates’ campaigns is enormous. For example, the cost to the taxpayers for the last Canadian federal election was something like 300 million dollars. Which means it cost a million dollars per person elected. I don’t know about you, but to me, that seems like a lot of money to be spending every election. And I don’t think I want to know how much the U.S. spends…

But the worst part of the election is, it’s not about debating policy, it’s about appealing to the superficial desires and the basic instincts of the voter.  If you listen to politicians or their strategists in interviews, it’s all spin and rhetoric; same thing during the political debates. There’s no real debate, no discussion, no give and take, no listening, everything is about “talking points”.

Elections are popularity contests. It’s not about doing the “right thing”, it’s about winning. No one is ever going to admit they were wrong, or give their opponents credit because there’s no incentive to do so. The goal is to undermine your opponent as much as possible.

So in the end, the politicians treat the voters like children – and we let them! For example, if one parent offers broccoli and the other offers ice cream, what do you think the child is going to pick? The child doesn’t care what’s good for them, they want the instant gratification. So if one party offers new social programs, and the other offers to cut social programs, who do you think is going to elected? It’s not about intelligent, well thought out policy. It’s about manipulating votes – which leads to more and more targeted spending or micro tax break for very specific groups.

Governing

All the dirty campaigning and rhetoric leads to a thoroughly adversarial environment during the election. This adversarial environment carries over into legislative process, because there’s always another election eventually. The opposition will attack everything the government does, just because it was someone else’s idea. There’s very little civility or cooperation left in politics.

But if you think about a corporate boardroom or a project team, would this type of atmosphere be productive? Not likely… In fact, this type of poisonous environment would likely be extremely detrimental. Healthy debate is good, but the ability to compromise and cooperate is essential to make a team work effectively. The term “office politics” is used to describe negative, subversive behavior in the office. Yet this is what governing is about every day. Hmm…

So where does all this get us? Does it get us the best possible government? I don’t think so…

A Better Way?

Right now, there is no incentive for politicians to cooperate or be civil. Quite the opposite. They have every incentive to destroy their opponents. But all the energy spent on the rhetoric, posturing, and political theater is energy not spent on actually governing the country. So how do we take the “politics” out of politics?

I think the root of the problem is that in politics, personality and ego are attached to everything. But what if we broke this link? What if politicians didn’t pass laws? What if they simply wrote them? For example, what if we had the following system:

• Any elected representative (not just one from the governing party), or large group of citizens could propose an initiative
• All the representatives would then debate and frame the wording of the initiative, and come up with a reasonable set of choices for the voter
• The initiative couldn’t be put to voters until the all the representatives agreed on the wording and choices (with some remedy for dealing with obstructionists)
• The voters would vote, say once a quarter, through the Internet or mail, on finished initiatives, and the politician would be bound by the outcome
• Voters could reject an initiative if they weren’t happy with the list of choices provided
• Voters could recall representatives if they wanted

Since all representatives would need to approve the finished initiative, it would ensure that all points of view would be covered, and it would also require that politicians compromise in order to get their initiatives finished. Regardless of all its potential flaws, I think, at the very least, a system like this would put the emphasis back where it belongs, on policies rather than the politicians, and promote healthy debate rather than bickering.

Obviously there would be many criticisms of such a system. The most obvious ones would be:

• People aren’t interested in day-to-day goings on of government
• Laws are much too complicated for the average person to understand

But I don’t buy that people aren’t interested. The amount of media coverage of elections and government legislation is fairly high. If people didn’t care, they wouldn’t watch, and the media wouldn’t spend so much time on it. I think a substantial percentage of the population would like more input into the functioning of their government. As for the complexity of laws, I think forcing legislators to simplify our legislation would be a net benefit anyway. Our laws and our tax system, and government in general, is way too complicated already.

But would it really be possible to simplify all government legislation into bite-sized pieces? I think so. Start with the simpler social policy questions like the propositions that many U.S. states vote on already and work your way up.

Bottom line, I think our current representative democracy in Canada is seriously flawed, and could benefit from incorporating more elements of direct democracy. In some ways, the U.S. has much more input into their government than we do. For example, they have (and actually use):

• Citizen’s initiatives
• Referendums (ballot questions)
• Recall

But in the end, the problem, of course, is any changes require our elected representatives to make them, and they don’t really have much incentive to change the status quo, do they?

[Content © 2008 SorryToConfuseYou.com, All Rights Reserved.]

Drowning In Risk Factors…

As I discussed previously, we don’t have a clear idea of the causes of many of the degenerative diseases we face today, like heart disease and cancer; all we have are risk factors. In some cases, we have a lot of risk factors. For example did you know there are now over a thousand known risk factors for heart disease? But which of these thousand risk factors actually cause heart disease? All of them? None of them? Why don’t we know what the causes of these diseases are yet?

Unfortunately, these diseases are extremely difficult to study because their causes are non-trivial. The biggest difficulty in studying them is they don’t develop overnight. Some scientists believe that diseases like heart disease and cancer can take 20+ years to develop. So how can we possibly know which combination of factors during all that time caused or contributed to the disease? Hmm…

Observational Studies

The field of epidemiology has been around for hundreds of years. Originally, it was used to study outbreaks of infectious diseases (i.e. epidemics). Today it’s a staple of scientific research, and there are thousands of studies published every year. Unfortunately, as Dr. George Davey Smith and Dr. Shah Ebrahim discuss in their editorial “Epidemiology — Is It Time to Call It a Day?“, the track-record for observational studies correctly identifying the causes of degenerative diseases is less than stellar. In fact, not only do they often find spurious associations, but sometimes they find the opposite of the correct answer. For example, as detailed in the New York Times article “Do We Really Know What Makes Us Healthy?“, doctors for many years prescribed hormone replacement therapy to older women to reduce their risk of heart disease, only to find out recently that it actually increases their risk.

The problem is observational studies are inherently limited. Observational studies involve monitoring a large group of people for some period of time, asking them questions or giving them medical exams at regular intervals, and recording mortality and disease rates. But how often do they monitor the people in these long-term studies? Certainly not every week. In the famous on-going Nurse’s Health Study, for example, they send out questionnaires every two years. Even if you’re monitoring something simple like birth control usage, how do you boil all the variations or permutations of potential usage down into a multiple choice question?

And after the researchers have collected their data, they plug it all into a computer and hope to find correlations. The better studies (prospective studies) as least decide what they’re testing before running the study so they can attempt to minimize confounding factors in the design of their study. The more dubious ones (retrospective studies) go looking for associations in data from studies designed for completely different purposes. Sandy Szwarc from the Junkfood Science blog has a long list of examples of this type of weak “data-dredge” study.

By definition, observational studies are largely uncontrolled (i.e no intervention and no randomization) and thus will have many confounding factors. This is where the judgement and biases of the researchers come in. It’s possible to get different results depending on how the researchers manipulate or “interpret” the data. If the associations being studied are small, the adjustments made to the data can easily skew the data to reveal associations where there are none.

And even if the studies find compelling associations, they’re still just associations. We don’t know why the association exists. They may be causative or could simply be correlated.

In the end, observational studies are like excavators. If you’re looking for big obvious things, like rocks, you’ll find them. But if you’re looking small subtle things, like fossils, you’re going to miss them. It’s the wrong tool for the job.

Clinical Trials

So if observational studies aren’t good at discovering the causes of diseases, what about clinical trials? Clinical trials avoid a number of the limitations of observational studies by design. The best clinical studies are double-blind so neither the doctor nor the patient know whether they’re in the study group or the control group. Clinical studies also are typically short and small in order to control for as many confounding factors as possible.

But if it can take 20+ years to develop these diseases, how much is it going to cost to run clinical studies for that length of time? This, of course, ignores the problem that people won’t like strict controls on how they live their lives for long periods of time either. In the old days, they experimented on patients in mental hospitals since they were a captive audience and not likely to object; but we can’t do that anymore…

Also, some things, like diet, aren’t suitable for double-blind studies because people know whether they’re eating low-fat or low-carb foods, for example, which introduces an additional set of confounding factors.

Clinical trials are useful for testing new drugs because they can use placebos to make the study double-blind, and the experimenters can focus on one specific variable. But for monitoring lifestyle or other human behaviors, clinical studies don’t seem particularly suited…

Biological Research

Our best hope for really understanding these degenerative diseases is to understand them at the molecular level – by understanding the biological mechanisms at work in our bodies. Observational studies and clinical trials can help to at least point us in the right direction since biological research is very expensive and time-consuming. I’ll explore some of the findings of current biological research in future posts.

But what can we do in the meantime? Who should we believe? That’s the hard part…

[Content © 2008 SorryToConfuseYou.com, All Rights Reserved.]

Causality Versus Correlation

We hear regularly about the “causes” and “preventions” for various diseases from the media. For example, high-fat diets cause this, and high cholesterol causes that, or as I discussed last week, coffee helps “prevent” heart disease. But do we actually know whether these things cause or prevent these diseases? If you read any of the major health sites you might think so. But if you read them again more carefully, you’ll notice they don’t actually talk about causes, they talk about risk factors. Take the American Heart Association web site for example:

Disease	Causes	Major Risk Factors
Heart Disease	?	Smoking, high cholesterol, high blood pressure, lack of exercise, obesity, poor diet
Type 2 Diabetes	?	Smoking, high cholesterol, high blood pressure, lack of exercise, obesity, poor diet
Stroke	?	Smoking, high cholesterol, high blood pressure, lack of exercise, obesity, poor diet

So what’s the difference between a “cause” and a “risk factor”? Risk factors sound like risks, which are bad, right?

Let’s look at an example. What’s the leading cause of car accident mortality?

• Reckless driving? Nope.
• Speeding? Nope.
• Getting distracted? Nope.
• Bad weather? Nope.

None of these things actually cause death. Car accident mortality is usually caused by bodily harm incurred when we’re introduced to Newton’s First Law of Motion, i.e. “A body in motion will remain in motion unless acted upon by an outside force”, like a tree or another car!

Now you might argue that this is splitting hairs, but my point is that we need to be careful when talking about cause and effect. In order for something to be causative, we need to be able to link the series of events together with a clear relationship between them. For example:

• Serious bodily harm usually causes death because we lose too much blood and our internal organs fail, or our internal organs become too damaged to function

Straightforward, right? So back to our secondary factors:

• Speeding can increase the probability of an accident, and thus death, because you and the other drivers have less time to react to avoid a collision
• Bad weather can increase the probability of accident, and thus death, because reduced visibility / traction can prevent you from avoiding a collision

Still straightforward, right? If we analyze car accident rates, we’d expect that drivers who speed or drive recklessly would have higher mortality rates. We start with a plausible cause, and we can verify effect. If necessary, we can test our hypothesis in a controlled environment.

But say we notice that drivers with red cars also have higher mortality rates. Now what? We have effect, but what’s the cause? Working backwards is dangerous – just because something is correlated, doesn’t make it causative. For example, what happens if we ban red cars? Will we have fewer car accidents? Not likely. In this case, red cars may be correlated to personality types that are more likely to drive recklessly, rather than being causative in any way. Some people are going to drive recklessly regardless of car color. So red cars may not cause increased mortality, but they are a risk factor for increased mortality.

All of this is intuitive for car accidents, but what about diseases? If we look back at the American Heart Association web site information from above, how many causative factors are listed? None. How many correlated factors are listed? All of them. Oops…

Digging around a little, I couldn’t find any major health sites that said XXX causes YYY, besides smoking causing lung cancer. But some certainly imply causation:

“Extensive clinical and statistical studies have identified several factors that increase the risk of coronary heart disease and heart attack.”

Risk factors increase the risk of heart disease? I don’t think so… What they should have said is “they’ve identified several risk factors that are associated with an increased risk of heart disease”. It’s a subtle but important difference.

“People with diabetes are two to four times more likely to develop cardiovascular disease due to a variety of risk factors”

“Due to” implies “because of” – which certainly implies cause and effect. Hmm…

The definition of a risk factor is:

“A risk factor is a variable associated with an increased risk of disease or infection. Risk factors are correlational and not necessarily causal, because correlation does not imply causation“

So by definition, risk factors don’t cause anything. If diet and obesity were causative, they’d say so – but they don’t. So why are they trying so hard to get us to control risk factors that may or may not be causes? That’s a topic for a future post…

Risk factor != cause

Also, don’t assume that major risk factors are more likely causative than minor risk factors. “Major” simply means that they’re more strongly correlated. For example, yellow teeth are a major risk factor for lung cancer. So yellow teeth cause lung cancer?

[Content © 2008 SorryToConfuseYou.com, All Rights Reserved.]