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More personal information

Further to my last piece, on the unsurprising facts that people with access to others’ personal information use that access for any reason, including ordinary curiosity, a topical example has cropped up:

Helen Jones-Kelley, director of the Ohio Department of Job and Family Services, disclosed today that computer inquiries on Samuel Joseph Wurzelbacher were not restricted to a child-support system.

The agency also checked Wurzelbacher in its computer systems to determine whether he was receiving welfare assistance or owed unemployment compensation taxes, she wrote.

(Wurzelbacher, aka “Joe the Plumber” is currently enjoying 15 minutes of fame for asking Obama awkward questions in public)

While the searching of government databases on Joe is less surprising than that it was found out, its ordinariness makes it more significant. You can get away with a lot these days, provided you keep your head down. But stick your head over the parapet, by becoming an activist, or falling out with a government official of some kind, and you know that you will suddenly be subject to a degree of scrutiny that would otherwise be easily avoidable. I think that is a key reason why we do not have the democratic ideal of the “politically involved layman” – the risks involved in politics are too great to be taken on lightly; they’re only worth it if you are prepared to devote yourself to activism in a major way. It’s a soft barrier, but its one more barrier between the political class and the rest of us.

Personal Data

Schneier is shocked to find that people whose jobs are to handle other people’s personal data, actually take an interest in what they are doing.

Faulk says he and others in his section of the NSA facility at Fort Gordon routinely shared salacious or tantalizing phone calls that had been intercepted, alerting office mates to certain time codes of “cuts” that were available on each operator’s computer.

“Hey, check this out,” Faulk says he would be told, “there’s good phone sex or there’s some pillow talk, pull up this call, it’s really funny, go check it out. It would be some colonel making pillow talk and we would say, ‘Wow, this was crazy’,” Faulk told ABC News.

I’m sure anyone who’s worked for a telephone company, or an ISP, or a retail bank, finds that familiar. The information available is generally less interesting than actually hearing people’s phone conversations, but occasionally you get something worth mentioning – look at all the the sex-line calls on this bill, is this Fred Bloggs the Fred Bloggs that was on the telly, and so on.

If the personal information is more obviously sensitive, then there should be rules to limit how it is casually accessed. Of course, those rules will be broken from time to time – tax people are not supposed to investigate celebrities out of curiosity, here is a story from Britain, and one from the US. But in many cases it’s very much a grey area. A fraud investigator, say, or a programmer trying to track down a bug, would have more freedom to legitimately poke about where she wanted to than a call centre operator who would have little excuse to look up any information except on the calls received (although accidents can happen).

There will always be people whose access bypasses the checks – it is rare to have an in-house IT system that can work without the support staff being able to access the production system to fix it. The major regulatory/compliance effort within banks over the last five years or so has been restricting access to production data to fewer people, for the sake of Sarbanes-Oxley compliance, but it’s really hard to deny access to the people who write the software.

Now, the NSA ought to have very strong controls on access and use of information, with monitoring and spot checks and so on, but if the telephone interceptions are being carried on by the NSA in defiance of the law, it is hardly to be expected that appropriate rules will be applied to the staff.

Housing Policy

Mr Mouse claims in a comment that widespread home ownership is undesirable. I would not go quite so far; there are benefits to home ownership – primarily the removal of the costly landlord-tenant relationship. Having said that, we are in agreement that the situation where the typical person’s investment portfolio consists solely of a highly leveraged bet on his local housing market is undesirable to the point of insanity. The point has been made widely, e.g. by Shiller.

But even if we accept a public policy aim of increasing home ownership, making it easier for people to borrow money is not the obvious way of going about it. If we want more people to own, say, smoke alarms, the way we do it is to make smoke alarms cheaper. Similarly, if a government decided, rightly or wrongly, that it would be better for more people to own houses, the obvious approach would be to make houses cheaper.

Headline of today’s London Evening Standard: “Worst House Prices Fall for 18 years“. I don’t remember reading recently about the “worst oil price fall” or “Worst computer price fall”. How is this?

The answer is obvious: once you have started down the road of encouraging home ownership by increasing borrowing, rather than by reducing prices, there is no turning back.

If I buy a computer, I don’t care what happens to its market value after I bought it. I will use it for 5-10 years then throw it in the bin. It is a physical asset, not a financial asset. If I borrow money to buy something, however, it is not just a physical asset. It is collateral. If I have been encouraged to get into this position, then undermined by a deliberate policy of devaluing the collateral, I will feel betrayed.

And so the process is continued. Interest rates are held down. The private sector’s lending standards are attacked. The supply of housing is deliberately restricted. After a while, it becomes obvious to everyone that a crash must come sooner or later. But even that is not enough to stop it. By that point, not only the government but also a large proportion of the population and a significant proportion of the financial industry is dependent on the bubble continuing – not for ever, as that is obviously impossible, but for long enough for “something to turn up” to save any individual participant. To someone looking to profit from the inevitable, the question is the usual one: “will the market stay irrational for longer than I can stay solvent?”, but with a coalition of politicians, swing voters, rich bankers and the construction industry devoted to keeping the market irrational, the question is even more pointed than usual.

Risk Aversion

In general, the higher the risk of an investment, the higher the expected return demanded by an investor. Readers familiar with the capital asset pricing model will know that there are two types of risk in the economy: systematic and nonsystematic. Nonsystematic risk should not be important to an investor. It can be almost completely eliminated by holding a well-diversified portfolio. An investor should not therefore require an higher expected return for bearing nonsystematic risk. Systematic risk, by contrast, cannot be diversified away. It arises from a correlation between returns from the investment and returns from the stock market as a whole. An investor generally requires a higher expected return than the risk-free interest rate for bearing positive amounts of systematic risk.

John C. Hull, Options, Futures and Other Derivatives, fifth edition, p.61

One quibble I have with a lot of the discussion of mortgage investments (such as this one, which I think is otherwise very good), is that it seems to offer a choice between two possibilities:

1) The current market prices of the securities correctly reflect their expected return

2) The securities are currently undervalued due to panic or other irrationality

I am fairly confident that neither of these positions is correct. Risk aversion is not irrational. If an investor loses more than he can afford to lose on one investment, that loss will itself cause secondary losses — if the investor is an institution, it might lose its credit rating, or go insolvent, causing some of its human and institutional capital to be impaired. Therefore, the expected utility of an risky investment is lower than its expected return.

As alluded to by Hull, in many cases much or all of the risk of an investment can be diversified away, leaving the extra risk premium small or zero. This is clearly not the case for mortgages. There is a possibility of a loss of somewhere on the order of a trillion dollars. No investor can absorb or hedge that. Many large investors — sovereign wealth funds, private equity, etc. -— have taken on stakes. Some are probably still looking for better prices than they’ve so far been offered. All will be looking for very substantial discounts against the expected return, because they know there are more sellers than buyers.

That is why I believe claims that this is a profit opportunity for the government.

That’s not the same as saying the government should be buying up mortgages at above current market value — there are other good arguments against it. But it holds up one piece of the argument, provided we assume that government is in fact better able to absorb the potential losses than private investors, which seems reasonable to me, though I can’t quite put my finger on a non-handwavy reason why.

Mortgages and scale

Arnold Kling, who knows what he’s talking about, says that the idea that mortgages will turn out to have a better return than their current market prices indicate is rubbish. In his view, the market prices are likely to accurately reflect the true value.

As far as I can see, that is unlikely. In a simplistic model, underpriced mortgages will be bought by investors who can make profits by holding them. But surely any such model assumes capital is plentiful relative to the assets under discussion. The crucial fact here is that, because of the past hideous underestimate of risk, the size of the mortgages held by institutions who shouldn’t be holding them is, apparently, in the high hundreds of billions of dollars. Many other investors have felt they are a good long-term bet. But most of those investors have already bought as much as they can afford, or else are holding on for better bargains, knowing that there is no competition to bid the prices back up in the short term.

On that argument, a buy-up by the US government is indeed a profitable opportunity for it. I think it could be defended on those terms. If I were drawing it up, however, I would want it explicitly to aim at making a profit. I would set a fund of fixed size to buy assets, planned to ensure that some of them are left over, and then spend it over a shortish period buying whatever seemed to be most competitively priced. The aim would be to make profits, and hopefully do some general good in the process; not to save overexposed financial institutions at any cost.

Is this counter to my principles? Yes. I do not consider myself a “naive libertarian”, in that I recognise that state intervention can be beneficial in some cases. However, I think that forgoing such benefits, by separation of economy and state, would be a better general policy than allowing fallible politicians to identify allegedly beneficial interventions. This intervention, even if beneficial, sets a horrific precedent, and will terribly undermine all free-market arguments for years to come. It could usher in an era of big government. That’s why it should be opposed.

Indeed look at the converse. If it doesn’t happen now, and the system survives with less damage than the proponents are claiming, what a valuable example it will be of how markets are able to adjust to the most severe problems.

Washington Mutual

Since Washington Mutual, like Northern Rock, has now gone bust without owning securitized mortgage derivatives, can we please lose the idea that securitization was the problem. Mortgages were the problem.

Without securitization, the financial system would have been much more exposed, but it would have just been the retail banks, not brokerages like Bear and Lehman.

Also, if securitization has been done properly, and the brokerages had actually sold the securities they created, there would have been much less of a problem. All the loss would be carried by investors who were not leveraged and were risking funds they could afford to lose. I know I said that before, but now Tyler Cowen is saying it too (or at least approvingly quoting others who are).

Now it can be argued that, had the risk not been spread out by securitization, the problems of bad loans would have come to a head much sooner, and the total impact would therefore have been smaller. That might be true. It is totally equivalent to saying that if there was no regulation of financial institutions, the problems might have got obvious sooner and therefore have been smaller. True or not, it’s a strange way of looking at things. Since nobody is using the John Adams seat-belt argument that regulation is the problem, then blaming securitization should be out of court as well.

What was the problem?

Since I have claimed that the derivatives involved in the financial system problems were not too complicated, what was the real problem?

There are many candidates, too many to cover right now. The use of irrelevant statistics to justify risky holdings, as I mentioned before, was a large part of the problem. The government pressure to make more and cheaper loans to less creditworthy borrowers has been widely commented on, and may have contributed significantly, but can’t excuse the banks’ errors.

The actual error made by the banks was very simple – embarrassingly simple, really. They bought mortgages to securitize them. They split the securities into high-risk, medium-risk, and low-risk bits. They valued the bits and found that they were more valuable than the original mortgages, which meant the process was profitable to them. They sold the high-risk bits to speculators and the medium-risk bits to long-term investors. But they kept the low-risk bits. Thats it! That’s the error!

Presumably, after they valued the low-risk bits, they found that nobody actually wanted to buy them at that valuation. What they should have done was price them down until people did want them, then re-evaluate the whole business on the basis of the actual market prices that they got for them. I have no idea whether that would have meant that securitization would have carried on or not. But either way, it would not have left the financial system dangerously exposed to the housing crash. At worst, it would have ended up as the “normal” sort of Wall St scandal – clever investment bankers sell a whole load of toxic crap to investors (see auction-rate, internet IPOs, etc. etc. etc.)

Why did the banks hang onto these investments, rather than sell them? I guess that they believed they were “really worth” pretty close to par value, and that buyers didn’t want to buy them at that price just because they were uninformed. Also, because they were rated as so safe, the regulators were happy to consider them non-risky for the purposes of capital requirements. That was the regulators’ biggest error. Because of course these two justifications contradict each other. If the securities can’t be sold at their alleged “real value”, then they are tying up the banks’ capital, and should be counted as such.

(I’m surprised we haven’t heard more about the mezzanine tranches that were sold to fund managers, pensions, insurance, etc. They were never seen as safe, so the bodies holding them could afford to take losses on them.)

It almost seems a shame that this whole crisis is caused by one such straightforward error. It ought to be something like “derivatives are too complex” or “regulators were subverted” or “government forced banks to make bad loans”. It’s a let-down that it was just “banks held one particular type of investment that it was never their business to hold, just as a by-product of one business line”.

Financial Complexity

I want just to grab one factoid out of the swirl of information and misinformation relevant to the current financial situation – the idea that the problems were caused by fiendishly complicated derivatives (see, e.g., here)

Horribly complex derivatives do exist: a “snowball”, for example, “is a structured swap with a funding leg and a coupon stream whereby the coupon paid on a given date is given by the sum of a fraction of the coupon paid in the previous period plus an amount determined by the realization of the rate process in the coupon period itself”

However, while estimating the value of a snowball requires so much computer power that researchers are designing custom hardware and offloading computation onto graphics chips, the difficulty of valuing a derivative does not depend on the derivative itself being complex. The mortgage backed securities which are the most obvious cause of the current problem are actually quite straightforward. That doesn’t make them easy to value.

The point of the complexity is in fact to make them easier to value. After all, no amount of differential calculus will tell you whether Mr Bloggs at number 11 will default on his mortgage, if you don’t know whether he has a job, and what his credit card balance is, and whether house prices on his street are going up or down. If you have good statistics, however, you might have a decent stab at how much a thousand mortgages are worth, or how much the best 400 out of a thousand are worth.

That was the theory. It failed, not because of the complexity of the derivatives, or because of errors in the mathematics, but because the statistics were crap. Statistics collected over ten years during which house prices only ever went up were not of much use when prices started to fall. Statistics collected on mortgages originated by lenders with their own money cannot be used to accurately model mortgages originated by lenders working only for commission. Et cetera.

The other bugbear instruments in some commentary are the “weapons of financial mass destruction”, credit default swaps. These are simpler still; just a guarantee by one party of a debt owed by another. The main problem with them is their very simplicity – rather than selling them on like securities, someone holding one would just create a new one to cancel it out. That’s what makes it so difficult to sort things out when a participant like Lehman defaults – its net position is manageable, but that net consists of astronomical credits and debits that almost, but not quite, cancel each other out. If the CDSs were more sophisticated (with central clearing), the problems would be smaller.

I think that this New York Times piece is very good, except for the one point, that the difficulty of valuing a mortgage derivative is not due to its inherent complexity, but mostly just because it’s made out of mortgages.

What are police?

The orthodox view these days is that police are the arm of the state responsible for fulfilling the state’s function of preventing crime (to the extent possible).

I think that is a catastrophic error. Preventing crime, as I’ve written before, is not a separate activity, but is an aspect of almost everything we do – something so inherent in the human condition that we aren’t really aware of the extent that it drives our behaviour.

What this means is that there’s no way to draw a line around “preventing crime” and thereby delimit the scope of the police. Every issue becomes a police issue. I think that is the real meaning of a “police state” – not one where the state uses the police, but one where the police take control of the state.

If the police are not agents of the state, what are they? I think it is healthier to see them as state-funded helpers of private citizens. We all work to prevent crime, but there are some jobs that come up which we are not able to do because they take to much time or special expertise. Detection of crime is the most obvious of these.

If we take this approach, what really changes is the difference between police and public. The police do not have a separate role, they just have greater capabilities owing to their skills and available time. The most significant implication is that they do not need special legal powers. The only things they should be doing are things that members of the public could do, but don’t have time for.

Another way of saying that is that police should be held to the exact same standard as anyone else. Which means that, in a case like this one, if the press reports are accurate, the issue is not about whether Mr Carter gets an apology or compensation, or about administration of police disciplinary procedures, but about why the PC in question is not facing criminal charges. The idea that it might be an internal police matter is quite incompatible with the police being assistants rather than masters of the population.

But the concept goes further. If the police are assisting the public, then whatever they are doing, it should be because someone has asked them to. Management should be a matter of which requests to prioritise, not setting an agenda independent of the public. Valid reasons for not doing something might be that it is too costly for the benefit, but might also be that people are already achieving what can be done without the police.

This is not meant to be an anti-police rant. I think we do need full-time, trained police, and I think there is a better case for them to be state-funded than there is for most branches of the state. I think many of them do a good job and I have sympathy with their difficulties. But I think it would be easier for them, and better for us, if we accepted the principles above.

And what really matters here is what people believe. I have said before that the police usurpation of the right of self defense, has, in the popular mind, actually outrun what the law really says. The police were founded on the principles I have stated, and while bad laws have been passed in the last few decades, they have generally not been controversial, because they are following rather than leading the change in attitudes – for the worse – about the role of the police.

The bad attitudes go beyond this. I was going to use as an example bin men – another arm of the state notable for actually having an important function. Bin men are not The Agents with The Responsibility for disposing of rubbish, which is something the rest of us should not need to think about. On the contrary, they take everybody’s refuse to the processing centre in one go because it’s a lot more efficient than having everybody chuck black bags into the boots of their cars.

I was going to say that, but even in that state function, the same error is appearing. I remembered this piece from 2004 which mentioned a man getting into trouble for collecting litter and taking it to a dump without a license. This is the real problem – not the idea that some things should be done by the state, but the idea that some things should only be done by the state.

The Georgian Side

The Georgian side of the Ossetian question is now coming out. Saakashvili is claiming that Georgia didn’t move against S. Ossetia until after Russian forces entered it. The cold war warrior element is making the point that S. Ossetia’s status for the last fifteen years has rested on Russian support.

I have no confidence in being able to get to the truth of the conflicting views. I dwell on the question because, as unclear as the facts of the matter are, the principles that should guide us are just as unclear too.

We can’t really talk about the reasons why South Ossetia might “deserve” to have independence from Georgia, without talking about why Georgia “deserved” to get its independence in 1991. I don’t recall any such principles being argued, but of course Croatia and Slovenia were getting all the attention at the time.

The argument for having clear and explicit rules is the formalist one that if you know in advance what position the most powerful actors are going to take, violent conflict is unlikely.

That is a weaker argument if the rules, clear-cut as they are, depend on facts which are unclear. But even so, I think it would help. One reason the facts are so unclear is that, at the end of the day, the outcome won’t depend on the facts. If it did there would be a more concerted attempt to determine what they actually are.

Retreating to what I can say in the absence of clear rules or reliable facts, I was interested that in his interview linked above, Saakashvili did not argue on the basis of Georgian claims to South Ossetia. Instead he emphasised the attacks by Russia on targets outside of Ossetia, and claimed that Ossetia was just a pretext for a Russian attack on the rest of Georgia.

Here, at last, we really do have the Kosovo precedents coming into relevance. If TV stations in Belgrade were legitimate targets in the protection of Kosovan rebels, then what gives the oil pipeline at Poti its immunity?

Another point is the effect of time. If outsiders now want to argue that Ossetia should rightly be controlled by Tbilisi, it’s too late. They’ve been successfully calling for ceasefires for over a decade, and the outcome of any genuine negotiation is never likely to be that one side totally gives in. A ceasfire is always tempting, but sometimes it can mean giving up without noticing. Sometimes the best route to peace is to fight it out. I’m not saying that was or is the case in Georgia – that depends on those pesky facts again.

Just in case you’re wondering, the sort of things I would be interested in, if there were any way of reliably establishing them, would be:

Why are the South Ossetians more friendly to Russia than to Georgia?
Would there be a reasonable way to establish borders for South Ossetia?
Are there internal conflicts within Ossetia?
What problems does independent South Ossetia cause for the Georgia? Smuggling, organised crime, control of resources?
What is the economic situation in Ossetia?
What provoked the recent Georgian offensive against S.O.?
How does the situation affect other issues in the region?
What are Russia’s other interests in the region? – I believe there were claims that Chechen terrorists were using parts of Georgia as refuges..
All the same questions again with respect to Abkhazia.