This piece suggests that the evolution of the global financial crisis is an exemplar of chaos theory. It begins with a brief outline of chaos theory, which is excerpted from Wikipedia‘s Chaos Theory.
The discoverer of chaos was Henri Poincaré in 1890, but Edward Lorenz is widely recognized for his pioneering work on chaos in weather prediction in 1961. Chaos theory describes the behaviour of certain dynamic systems – that is, systems whose states evolve with time – that may exhibit dynamics that are highly sensitive to initial conditions, popularly referred to as the 'butterfly effect'. As a result of this sensitivity, which manifests itself as an exponential growth of perturbations (disturbances) in the initial conditions, the behaviour of chaotic systems appears to be random. [more]
The phrase ‘butterfly effect’ refers to the idea that a butterfly's wings flapping in Tokyo might create tiny changes in the atmosphere that may ultimately alter the path of a tornado in the Caribbean. The flapping wing represents a small change in the initial condition of the system, which causes a chain of events leading to large-scale alterations of events. Had the butterfly not flapped its wings, the trajectory of the system might have been vastly different. While the butterfly does not cause the tornado, the flap of its wings is an essential part of the initial conditions resulting in the tornado.
This happens even though these systems are deterministic, meaning that their future dynamics are fully defined by their initial conditions, with no random elements involved. This behaviour is known as deterministic chaos, or simply chaos. However, even though they are deterministic, chaotic systems show strong unpredictability not shown by other deterministic systems.
Chaotic behaviour is observed in natural systems, such as the weather and climate, in the laboratory in a variety of systems, in the dynamics of satellites in the solar system, population growth in ecology, the dynamics of the action potentials in neurons, and molecular vibrations, but there is some controversy over the existence of chaotic dynamics in economics.
So let’s see if a parallel can be drawn between the global financial crisis and chaos theory. Most of what follows has been derived from Niall Ferguson’s highly informative book The Ascent of Money – A Financial History of the World published in 2008 by Allen Lane, an imprint of Penguin Books.
It’s accepted that the origins of the GFC are in the housing crisis that began in the US. As far back as the 1930s the American dream was home ownership, This was made easier by the US Federal Housing Association which provided federally backed insurance for mortgage lenders to encourage large (up to 80% of purchase price), long (twenty year), fully amortized and low interest loans. The market was energised when in 1938 a new Federal National Mortgage Association (nicknamed Fannie Mae) was authorized to issue bonds and buy mortgages from the hundreds of existing Savings and Loan associations, which were at the time restricted to making loans only to those living within 50 miles. The conditions for borrowing made home ownership more viable than ever before.
Skip to 1968 when Fannie Mae was split in two: Government Mortgage Association (Ginnie Mae) which was to cater for poor borrowers like military veterans, and a rechartered Fannie Mae, now a privately owned government-sponsored enterprise permitted to buy conventional as well as government backed mortgages. Two years later, to provide competition in the secondary market, the Federal Home Loan Mortgage Corporation (Freddie Mac) was formed. With the housing market now underwritten by Fannie, Ginnie and Freddie, the political winds strongly favoured a home-owning democracy.
Jump to the 1980s when the Savings and Loan associations, the foundation on which this home-owning democracy was built, were permitted to invest in whatever they liked – commercial property, stocks, even junk bonds. Recklessness, and in some cases fraud followed, which led to the collapse into insolvency of hundreds of S&Ls, a hugely expensive outcome of ill-considered deregulation.
Skip now to Detroit in the early 2000s with its decaying motor industry and rising unemployment. With home ownership strongly encouraged by both the Clinton and Bush administrations, the city was flooded with advertisements for attractive 100% loan deals, so-called NINJA loans (to someone with No Income, No Job or Assets), and so subprime mortgages were born. These seemed to work well so long as interest rates stayed low and people kept their jobs, and as long as real estate prices continued to rise. In a city like Detroit those conditions were unlikely to continue. But that did not worry the subprime lenders. Unencumbered by regulatory constraints, these lenders, who knew best the flakiness of subprime loans, instead of putting their own money at risk resold their loans in bulk to Wall Street banks, pocketing big commissions on the way. The banks bundled the loans into high yielding residential mortgage-backed securities and sold them to investors around the world, eager to make a few hundredths of a percentage point more return on their capital. Repackaged as collateralized debt obligations (CDOs), these subprime securities could be transformed from risky loans to flaky borrowers into investment-grade securities triple-A rated by the rating agencies Moody’s or Standard & Poor’s. Contrary to the usual closeness of lender and borrower, this device put thousands of kilometres between the borrowers in Detroit and those receiving interest payments, so that the latter had no idea of the origin or nature of their purchase; they just collected their interest payments, no questions asked, no due diligence done.
Then came a pivotal move by the Federal Reserve. It raised short-time interest rates from 1% to 5.25%. This had a modest but significant impact on average mortgage rates, which went up by about a quarter from 5.34% to 6.66%. But the effect on the subprime market of this seemingly small change turned out to be devastating. More of this later.
The other trap in the subprime mortgage saga was the use of ‘teaser’ interest rates to attract borrowers, but when they were reset after a year or two the repayments moved beyond what a lot of borrowers could afford. In one scheme in Detroit the teaser rate was 9.75% for two years but then jumped to 9.125% above the short-term rate at which banks lent money to a other
By late 2005 house prices in Detroit began to decline, mortgagees were beginning to default, by March 2007 one in three were in default, and foreclosures were rising steeply. Detroit was a foretaste of things to come. Memphis (the bankruptcy capital of the US), followed as did many other cities, and predictions were made that foreclosures could reach 2.4 million. Housing prices continued to fall as people, unable to sustain mortgage payments, abandoned their mortgages and houses, put their house keys in the letter box and walked away, and thousands of houses that no one wanted to buy flooded onto the market.
By mid 2007 the subprime mortgage market began to turn really sour and shockwaves began to spread through the world’s credit markets, wiping out many hedge funds and costing banks and financial institutions billions of dollars in bad debts. The main problem was overpriced CDOs of which there were over half a trillion dollars value sold by 2006. Some banks went down: Bear Stearns in the US and Northern Rock in the UK. Lehmann Bros collapsed. Losses in excess of one trillion dollars were anticipated. As Niall Ferguson put it in his book “The subprime butterfly had flapped its wings and triggered a global hurricane.”
The rest is recent history. It emerged that not only banks, hedge funds and other financial institutions had become heavily involved in the subprime market, but so also had public utilities and local councils all around the world. So the losses were gross and extensive. An outcome was the drying up of credit markets as credit became scarce and expensive. Even large banks were reluctant to lend to each other. In turn this severely affected business operations that today are usually highly leveraged. Unable to borrow to sustain normal business, inventories were run down, production curtailed and workers sacked. In some instance firms went to the wall.
The GDP of major economies and economic growth began to shrink, and countries around the world moved into recession. In Australia the mining boom began to collapse, and as a consequence Australian Government revenues diminished sharply, budget deficits became a reality, and national debt began to accumulate, a debt that will take many years and a return to a buoyant economy to reverse, especially as the Government took steps to stimulate the economy with cash injections and infrastructure spending.
So how did we get to this place?
The proposition this piece advances is that although this awful financial and human calamity resulted from many factors in the dynamic system that is the global financial system, there seems to be at least one, perhaps two ‘butterfly’ events that precipitated the crisis that now afflicts the world. Niall Ferguson identifies the ‘subprime butterfly’, but that was a pretty substantial butterfly. I wonder if it was the smaller butterfly, the modest rise in average mortgage rates that went from 5.34% to 6.66% when the Federal Reserve raised short-time interest rates from 1% to 5.25% that was the tipping point. There’s no way of being certain, but the seeming smallness of this event and the chaotic financial state that followed it, points to it as the butterfly that flapped its wings.
What do you think?
Niall Ferguson’s book, despite its dry title The Ascent of Money – A Financial History of the World, was a most informative read. It traces the origins of money from the days of silver coins, through the introduction to Europe in the 1200s of the decimal system and the calculation of interest by Fibonacci (of number sequence fame), the origins of bonds to finance wars the city-states of Tuscany: Florence, Pisa and Siena, waged against each other, to the origins of shares (in the Dutch East India Company) and the advent of the first stock exchange in Amsterdam with its accompanying central bank. The book explains the evolution of financial instruments over time up until the present, and explains in detail the evolution of the current global financial crisis. Ferguson describes the skulduggery and fraud that has characterized the financial markets over the centuries; mildly reassuring us that today’s chaos, while having its unique characteristics, is nothing new.