Value of politicians

Here’s a little factoid that I think is relevant to my politics as entertainment theme:

Three employees of our government, and their approximate salaries:

Gordon Brown, Prime Minister: £200,000

Mark Thomson, Director-General of the BBC: £816,000

Jonathan Ross, Entertainer: £6,000,000

Where is the power really in our system of government? Jonathan Ross’s earning power is the result of a “tournament” effect of the star system in entertainment, so maybe we should leave that out. But what does it mean that the manager of the BBC is worth four times as much as the PM?

Possibly he is better qualified? Wikipedia suggests not. (Brown has a PhD in history from the university of Edinburgh). Hmm, Gordon Brown took a doctorate in history and I never knew. Is there some significance in the lack of public attention given (by me, at least) to that? Isn’t it really quite important? Does the fact that the thesis was on a bit of the history of the Labour party make it less important?

Back to the pay, can we explain it away by saying that the mechanics of the different roles means that the director of the BBC needs to have special expertise, whereas the PM doesn’t, instead having (highly paid) civil servants to supply the technical expertise?

OK, perhaps this isn’t a big deal. Being Prime Minister certainly has perks beyond the salary. But the fact that taxpayers pay 30 times as much for Jonathan Ross than we do for a Prime Minister at least takes some of the ridicule away from my theory that politics provides more value as entertainment than as government.

Legislation – the details

I was planning, in relation to the previous post’s subject, to mention the government’s classification of an Icelandic bank as a terrorist organisation in order to freeze its assets.

As is so often the case, as I researched to fill in the details of exactly what happened, I found it wasn’t what I thought. As is occasionally the case, the truth is more interesting than the falsehood.

The order freezing the assets of Landsbanki, and section 4 of the Anti-terrorism, Crime and Security Act 2001 under which the said order was made, make no reference to terrorism, except in that the section is part of that act.

The government is not “misusing” anti-terrorism law to grab the money, they are doing precisely what they were empowered to do in 2001.

4. Power to make order

(1) The Treasury may make a freezing order if the following two conditions are satisfied.

(2) The first condition is that the Treasury reasonably believe that—

(a) action to the detriment of the United Kingdom’s economy (or part of it) has been or is likely to be taken by a person or persons, or

(b) action constituting a threat to the life or property of one or more nationals of the United Kingdom or residents of the United Kingdom has been or is likely to be taken by a person or persons.

(3) If one person is believed to have taken or to be likely to take the action the second condition is that the person is—

(a) the government of a country or territory outside the United Kingdom, or

(b) a resident of a country or territory outside the United Kingdom.

4.(2)(b) is not relevant since the order cited 4.(2)(a) instead, so no allegation of terrorism of any kind needed to be made. The government has the clear legal power to seize the assets of any foreigner who it believes is likely to take action detrimental to the economy of the United Kingdom.

Holy shit.

How did it get that? Well, the clue is in the act. This was the act that was passed in December of 2001, against the votes of many Labour MPs who objected to the detention-without-trial provisions. The “seizing the assets of foreigners for any economic reason” bit escaped any public debate.

This is the lesson that we have to take from the Landsbanki saga. The anti-liberty measures that get argued about on the 9 o’clock news are the tip of an iceberg of literally unbelievable powers being accumulated by the government, that will be unveiled in a few years when the fuss has died down, and used against people who you would least expect to be the target.

Authoritarian MPs

There are a couple of schemes in progress responding to the breakneck progress of the all-knowing, all-powerful state in Britain.

One is the sending of copies of 1984 to every MP, and another is the stroll that some bloggers have in mind for Wednesday.

Alarmed as I am by the situation, I think these protests are fundamentally misdirected.

I do not believe that the Labour Party is pushing in this direction (ID cards, national childrens databases, national ID databases, detention without charge, ID required for buying mobile telephones, etc. etc. etc.) because the MPs are a bunch of authoritarian bastards, despite appearances. It is not their aim to see all these powers gathered and used. I suspect they actually aren’t bothered about it one way or another, and, given the chance to offer their honest opinion, would probably say most of it isn’t worth doing.

They are pushing it all because they think it is a vote-winner, and for no other reason.

That being the case, demonstrating that there is a small group of people who are very strongly opposed serves no purpose. They know that, but we only have one vote each, and they don’t believe there are enough of us to matter.

The only way to win this is to gain the attention of the ordinary voter, and bring home to them the problems of having the all-powerful state monitoring their every move. The biggest publicity victory we have had so far was the news that local councils were using anti-terror surveillance powers to monitor people putting non-recyclables in recycling bins. That beats the by-election victory of David Davis and the Lords’ defeat of 42-day detention.

Even politics doesn’t help. It is true that, in the boxing match of electoral politics, the Conservatives have taken very good positions on most of these issues, and therefore, if they win, there should be some relief in the short term. But in the longer term, the fundamentals will reassert themselves. The Tories will find their pro-liberty positions a liability, and, in due course abandon them. Liberty simply isn’t what the MPs went into politics to fight for, and if push comes to shove, it will be sacrificed to improve electoral chances and therefore whatever it is that they are aiming for.

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”.