Review: The Trillion Dollar Meltdown

A question I have regarding the current financial/economic woes being attributed to the “credit crunch”, is this: Why did the money lenders give out loans on easy terms to people who were likely to default on them? The prime example of this is the so-called ninja loan.

Providing an answer to this question (in terms of the decision making of those managing the loans) is perhaps the most useful aspect of “The Trillion Dollar Meltdown”, by Charles R. Morris, a US centric examination of the credit crunch. By explaining complex financial instruments such as collateralized debt obligations (CDOs) and credit default swaps, Morris illustrates how several factors drove the accumulation of toxic debt:

  • The originators of loans would simply end up selling them on, thus weakening their dependence on the ability of the borrowers to pay the loans back.
  • The subsequent handling of the loans was then split up amongst many different parties, aggravating what Morris describes as the “Agency problem”, the problem of ensuring that an employee, contractor or other party performing a service for you does not act against your interests.
  • There was increasing reliance on complex, mathematical constructs to guide investment decisions. The models the constructs were based on only imperfectly modeled the real world and break down in times of economic stress.

On this basis, it seems to me that the use of difficult to understand models to package loans up into complex financial instruments along with the diffusion of responsibility for managing the loans amongst those trading such instruments may have enabled high levels of risky debt to accumulate.

The originators of loans were incentivised simply to sell as many loans as they could, since they were no longer dependent on the loans being paid off. They’d simply be paid for arranging the loans in the first place.

The people who were subsequently managing the loans, and thus had an interest in ensuring they didn’t buy too much risky debt, were those trading in the financial instruments. The complexity of the instruments (combined with optimistic ratings by the credit rating agencies) obscured the real risks from those people.

This is by no means the full story, since one also has to consider the legal/institutional framework within which this was taking place. For example, there is the role of financial regulators and other forms of government intervention in the financial system to consider as well. There is also the behaviour of the borrowers to consider too.

Morris does address the role of the financial regulators in the US. He blames Alan Greenspan for keeping interest rates low thus enabling a sustained period of cheap credit to develop, and he also blames “free market” ideology and financial deregulation. However here I find him less convincing. My main point is that in many significant respects, the financial system is not a “free market”. For example, the very fact that the Federal Reserve has a monopoly on printing money and sets interest rates shows we’re not talking about a “free market”.

Moreover, Morris himself argues that the financial services sector in the US enjoys “inordinate privileges”, pointing out for example that in a free market, a sector that takes high risks, like the financial sector does, would occasionally endure periods of big losses, as well as enjoying periods of high profits. But while the industry certainly enjoyed the high profits, its losses are often offset by government bailouts (NB: Morris was writing before the recent bailout programmes announced by Western governments).

Morris cites an example where Countrywide was paid $22 billion by the Atlanta Federal Home Loan Bank when they incurred losses that were likely to lead to insolvency. Providing bailouts to loss making companies is most definitely not a “free market” approach. Nor is it a “free market” when a privately run student loan organisation gets subsidies from the state (to take another example Morris criticised). The privileges enjoyed by Freddie Mac and Fannie Mae (the two big mortgage providers in the US) are also incongruous with a “free market” approach, and the role of these privileges in the credit crunch is not examined by Morris.

My point here is not to argue for the “free market” but to suggest that blaming “free market” ideology for failures in a system that enjoys considerable state intervention that goes beyond merely setting the rules of the game is perverse, especially when you simultaneously argue that some of the interventions directly contributed to the failures concerned!

Overall, the book may well prove useful to people wishing to understand the behaviour of the lenders in the credit crunch, but Morris’s attempt to blame it all on “deregulation” and the “free market” going too far is not convincing.

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Happy 2008!

2008 looks as if it could be a crucial year in British politics. The current government’s poll ratings have dropped substantially and seems to be beset by problem after problem. If they cannot turn things around they’ll be on course to lose the next general election.

Also, in the wake of story after story depicting loss of personal data through incompetence, it looks people are finally waking up to the dangers of the national identity scheme and the other huge surveillance/database schemes the British government has been pursuing over the last decade or so. This development has yet to kill off the national identity scheme however, but if it does so, it will mark a major blow for civil liberties and privacy. Such a development would suggest that the tide is turning against the onslaught on civil liberties and privacy we’ve been seeing from this government. It’s been a long time coming.

2008 is also a crucial year for the US and thus the world, with George W Bush’s presidency into its final year and presidential elections being held. Given the US’s role as the most powerful country in the world, a change of direction from its government will have an impact on everything from middle east politics to efforts to deal with climate change.

I expect 2008 to be an interesting year.

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Big brother proposals from EU and US

The Sunday Times reports that the EU and US authorities are planning to fit satellite trackers to all cars to monitor speed, location/routes taken and the wearing of seatbelts:

BLACK box recorders could be installed in all new cars under a European Union ruling.

The aircraft-style equipment would also act as a tracker, using global positioning satellites to record the location and route of a vehicle and to tell how fast a driver is going and whether seatbelts are being worn.

Data recovered from the boxes could give investigators important clues on how accidents are caused.

However, British motoring groups fear the technology could be used by government to introduce a national congestion charge or to keep tabs on people’s movements.

The European commission has asked the police forces of member states to look at whether the technology could improve road safety. Every year about 50,000 people are killed on European roads and another 3.5m are injured.

If, as expected, the police give their backing, manufacturers would be required to install black boxes in all new cars by 2009.

The National Transportation Safety Board in America also wants to make them mandatory by the same date. Already 15% of vehicles in the US are fitted with the palm-sized devices. Most new cars there have them fitted as standard. (Emphasis added)

Oddly enough, a couple of years back, the UK government was proposing similar stuff as a means of performing nation-wide congestion charging/road tolling.

The day when you’re activities are continuously tracked 24/7 is not long off.

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Electronic voting: A threat to democracy?

With low turnouts in many elections in Britain, some people have suggested that electronic voting could be allowed in order to make things easier and hopefully raise voter turnouts, e.g. see this BBC report about e-voting trials in Swindon in recent local elections.

In America there has been a big push towards introducing electronic voting systems after the Florida vote counts in the 2000 presidential election where the voting machines’ performance may have influenced the end result in a tight election.

However the move towards electronic voting is by no means straightforward. With a paper ballot, with the vote manually registered by the voter as occurs in British elections at the moment, you have a high degree of checkability. People know what they write on the ballot before it’s put in the box. Vote counting can be done under the eyes of the candidates, their representatives and independent observers. We can therefore create reliable voting procedures and vote counting procedures quite easily.

With electronic voting, things are not so straightforward. Without knowing what code is running on the computer recording your vote, you cannot be sure whether the vote is correctly registered by the computer. The vote counting is done by the computer essentially out of sight. The possibility of incorrect counting due to software bugs, the software being hacked or plain skullduggery on the part of the software writers has to be taken into account.

America’s recent experiences with voting machines provided by a company called Diebold provide worrying reading:

Under the Help America Vote Act (HAVA), the Election Assistance Commission is charged with establishing voluntary standards for voting machine software and creating an independent testing process for the software. However, this process is far behind schedule. Under HAVA, the Election Assistance Commission members should have been nominated by the President in February 2003. Unfortunately, these nominees have only recently been sent to the Senate for confirmation.

Without this federal review and testing of software, deeply flawed software has been marketed by companies and bought by states. An Analysis of an Electronic Voting System was recently authored by Tadayoshi Kohno, Adam Stubblefield, Aviel Rubin, and Dan Wallach. This voting software, produced by Diebold, has already been purchased by two states. According to this study, some of the most serious of numerous flaws permit a person to:

-vote multiple times,
-view ballots already cast on a machine,
-modify party affiliation on ballots,
-cause votes to be miscounted,
-create, delete and modify votes on voting machine, and
-tamper with audit logs and election results.

States Purchase Insecure Software
As a result of this study, Maryland put on hold its purchase of Diebold voting machines. Later, an independent review confirmed the previous findings. It counted 328 security weaknesses, and concluded that: “The system, as implemented in policy, procedure and technology, is at high risk of compromise” (pg. 17).

Diebold had threatened legal action against students and ISPs who publicised the flaws found in their voting machines, though they have now backed down.

A comprehensive account of both the problems with the machines and the legal actions Diebold attempted in order to try and stop various internal emails detailing flaws in the machines being distributed around the web can be found here. Diebold’s response to the problems has been far from reassuring as the threatened legal action illustrates. But it gets worse, since according to the above article:

The state of Maryland, however, commissioned an investigation of the Diebold machines by SIAC. SIAC found 328 security weaknesses; of those, 26 were designated critical . Among the problems: Diebold doesn’t encrypt vote totals before they are transferred to the Board of Elections over the Internet. Diebold’s response is far from reassuring, as the Washington Post reported:

“Further, as a result of the review, Diebold has rewritten its software to include better encryption coding and harder-to-crack passwords. The encryption and password upgrades will be made only for the machines destined for Maryland , [Diebold executive Mark] Radke said, and would not be available for the 33,000 touch-screen machines already in use elsewhere.”

So there you have it: the squeaky wheel gets the grease. Diebold will fix Maryland’s machines, but everyone else in America will continue to suffer from hundreds of security holes, 26 of them critical. Feel better?

Of course, anyone that really cares about security knows that a system has to be built with security in mind from the get-go. You can’t just bolt security on top of a system after the fact and assume that the any problems will be fixed. But that’s exactly what Diebold proposes to do. They told us to trust them before, and now they’re asking us to trust them again. How trusting are you?

The above articles paint a very worrying picture about the way electronic voting is shaping up in America and suggest other countries should be very careful and cautious about e-voting. It seems to me that the any moves towards e-voting should involve the following requirements (based on the list in the security focus article):

* the use of open source software that is open to scrutiny by anyone

* the voting machines must pass thorough testing to ensure security and reliability

* the voting machines must produce paper copies of the votes, verified as accurate by the voter, to be used for auditing purposes.

* voting machines must be usable by the disabled.

* Surprise recounts must be held in a proportion of randomly selected constituencies in each election.

* voting machines must only communicate with other systems in order to report vote totals. Incoming communication from other systems should be forbidden.

At any rate, until trials have shown that electronic systems can be used reliably without opening up scope for manipulation of the voting process, we should stick to paper ballots.

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