Lehman Bros. and Consensus

My interest in climate change derived in part from experience in the stock market where “consensus” is not infrequently established in favor of opinions that are completely incorrect. And, in many cases, the people promoting the views are competent and serious people. How are such things possible? I read about the Bre-X and Enron failures, trying to distinguish between the “shame on you” and the “shame on me” components – i.e. yes, the original misconduct and deceit was deplorable; but at what point should proper independent due diligence have been able to detect misconduct? At what point were regulatory agencies negligent? Obviously we’re going to see a new spate of such inquiries in the wake of the recent collapses.

I was particularly intrigued in the cases of Bre-X and Enron failures by the tremendous acolades meted out to the promoters right up to the eve of their collapses.

As evidence of this ongoing interest, a reflection on Bre-X was one of the very first Climate Audit posts (Feb 6, 2005). I observed that Felderhof and de Guzman were lionized at the 1997 PDA convention (March 10-16, 1997) and walked around like royalty only a few days before the fraud was revealed. de Guzman literally disappeared a few days later, supposedly either jumping or being pushed from a plane over the Indonesian jungle. Others speculate that he may have assumed a new identity in a Third World barrio somewhere. The “consensus” disappeared quickly. Take a look at the post.

In another early post, I observed the “consensus” that Enron was not only a well-managed company, but the most outstandingly managed company in the U.S., citing a couple of quotes from Kurt Eichenwald’s Conspiracy of Fools:

The next morning just after ten, Skilling stood beside Lay as a photographer snapped their pictures for an article in Fortune. They were more than happy to participate; already that year, in its annual rankings, Fortune had hailed Enron as America’s best-managed company, knocking General Electric from the number-one perch. (p.227)

After months of effort, Karen Denne from Enron’s public relations office landed the big fish: CFO magazine had selected Fastow as one of the year’s best chief financial officers. (p. 260)”

Lay opened his briefcase and pulled out the latest issue of CFO magazine, glacing at the cover. The Finest in Finance. Lay smiled to himself. He found the table of contents, looking for Fastow’s name. Beneath it were the words: How Enron financed its amazing transformation from pipelines to piping hot. Lay turned to the article, “When Andrew S Fastow, the 37-year old CFO of Enron Corp. boasts that “our story is one of a kind’ he’s not kidding" it began”. Fastow was obviously as creative and sharp as Lay and Enron’s board of directors had come to believe” (p. 267)

Turning now to Lehman Bros. I looked quickly at their website this morning, which reports that in the last two years, Lehman Bros has been ranked #1 by both Barron’s and Fortune:

2006 – Ranks #1 in the Barron’s 500 annual survey of corporate performance for the largest companies in the U.S. and Canada.

2007 – Lehman Brothers ranks #1 “Most Admired Securities Firm” by Fortune.

One more example of “consensus”.

I don’t want readers to start piling on with accusations or making uninformed comparisons of climate change to these corporate failures. For once, I want to be able to be nuanced statements without provoking a lot of piling on. I personally am unimpressed by “consensus”, especially when there is no independent due diligence. That doesn’t mean that I’m impressed by “skeptic” proposals either (BTW).

One of the curious aspects to Enron’s rise to prominence is that nobody understood how they actually made money. That’s one of the reasons why I’m so adamant about wanting clear A-to-B explanations of how doubled CO2 leads to 3 or more deg C and why excuses for not providing such explanations are so disappointing. I believe that forcing oneself to provide such an explanation would be very healthy for the AGW community.

In passing, recall that Enron had an early interest in climate change policy. I was prudent enough to save a pdf of their policy position, which I reported on a couple of years ago.

Lehman Bros also seem to have been actively interested in climate change, producing a couple of reports, most recently here dated Sept 2007. In their acknowledgements, they thank James Hansen for clearing up some “questions that had been niggling us”:

On the scientific side, we are grateful to Dr. James Hansen, Director of the NASA Goddard Institute for Space Studies, who, at the end of a particularly informative dinner hosted by Ben Cotton of the Man Group, gave generously of his time to clear up a number of scientific questions that had been niggling us. Dr. Peter Collins and Richard Heap of the Royal Society provided valuable input and brought us up to date on the more controversial areas of scientific developments in the domain of global climate change.

In the summer and September of 2007, we also spent a lot of time trying to understand “questions that had been niggling us” – like what data set was used in GISTEMP, why Hansen changed the provenance of GISTEMP data sets, how GISTEMP adjustments were done and why. Hansen was notably uncooperative, even saying that he refused to “joust with jesters”. Maybe we went about it the wrong way. Maybe we should have asked Lehman Bros to find out for us.


  1. DeWitt Payne
    Posted Sep 17, 2008 at 9:08 AM | Permalink

    CO2 cap and trade would have been a gold mine for Enron if it had been implemented in time. Of course they would eventually have gone belly up anyway by being too greedy. There’s a basic pattern with bubbles. Part of that pattern is the statement that this time it’s different.

    Steve: I doubt that it would have had any bearing on the collapse. My take is that the collapse was primarily due to absymal investments. Also that the frauds themselves did not “matter” in terms of the collapse; where they “mattered” was only in delaying the recognition of the failures. The goofy off-balance sheet limited partnerships were small beer in the scheme of things but they enabled Enron to show slight profits, rather than losses (and any loss would have caused the Ponzi scheme to collapse earlier.) The fact that the modern-MWP differentials are so slight makes me very wary of the accounting schemes in the Team studies.

    • Not sure
      Posted Sep 17, 2008 at 11:34 AM | Permalink

      Re: DeWitt Payne (#1),

      …Part of that pattern is the statement that this time it’s different…

      Who else remembers all the talk about the “new economy” during the dot com bubble? It was used to explain away the very fact that no one could figure out exactly how the dot bombs were going to make money. It was clearly nonsense, but people believed it because they wanted to believe it. I see some of that too, in the most fanatical AGW proponents. snip

  2. Gerald Machnee
    Posted Sep 17, 2008 at 9:24 AM | Permalink

    Enron is what I call a “paper” company – going up in value on paper, but no real assets. It was probably one of the worst cases in recent memory. We had a smaller case in Manitoba run by one young man which collapsed a few years ago. He had also been highly written up before that. Somewhat similar to stocks and the current overpriced vale of housing in many parts of Canada. My wife lost RRSP’s in the 1980’s collapse in Alberta and British Columbia.
    I look at many of the proxies and “evidence” of climate change as “paper”. It may have been altered, or it may not have good documentation. A graphical comparison of rising temperatures and GHG is “paper” or circumstantial, that is, without good documentation. I keep a copy of my two favorite questions on hand: 1) Steve’s question about a detailed accounting of the temperature change with a doubling of CO2 and 2) Where do I find a MEASUREMENT of the temperature increase caused by the increased CO2 in the atmosphere?
    So today we have a consensus on global warming among academics, media, and much of the public, and maybe politicians(sort of in public). This as a result of “paper”. When will someone at thr top do an audit? Maybe after a long cold spell or “collapse of the warm market”?

  3. Jeff Alberts
    Posted Sep 17, 2008 at 9:47 AM | Permalink

    Maybe we went about it the wrong way. Maybe we should have asked Lehman Bros to find out for us.

    You should have invited him to an expensive dinner, and slipped him a Mickey Finn, THEN asked the questions.

  4. Posted Sep 17, 2008 at 9:48 AM | Permalink

    I believe a consensus in the stock market is call a herd. Herd mentality leads to bubbles that have to burst. A scientific consensus seems to lead to a political mentality. Instead of responding as scientists to reasonable questions on the subject, they respond with political double speak.

  5. Gerry Morrow
    Posted Sep 17, 2008 at 9:56 AM | Permalink

    It seems to me the problem with “consensus” is that where it occurs it stifles the ability of people to move forward. This is so particularly in the sciences where it is clear that each new discovery hailed by the scientific community has proved over time to be “nearly right” as people have looked further into the topic. “Consensus” in the AGW debate seems to me to be a deliberate policy of trying to close down the debate. “All the scientists tell us there is global warming and it is anthropogenic,” is a common phrase used by politicians in the UK. Quite why they (the Hockey Team)would want to close down the debate is a mystery to me because they seem to have won the political battles anyway and it will take years, in the absence of a definitive moment in climate change, like the earth cooling, or the CO2 disappearing out of the atmosphere for the good ship “Consenus” to be turned around. Interestingly, there is consensus that something should be done to reduce carbon emissions – even sceptics should endorse it as being a sensible thing to do, hence Kyoto. However there doesn’t appear to be any consensus on how to do it, hence nobody is carrying out the Kyoto agreement. I’ve said all along in this debate that if things are as bad as the adherents to AGW say they are it is not possible for us to move to solutions on an industrial scale quickly enoughh to reduce the CO2 emissions an avert the forecast disaster.

  6. mpaul
    Posted Sep 17, 2008 at 10:11 AM | Permalink

    Steve writes:

    “consensus” is not infrequently established in favor of opinions that are completely incorrect.

    This is a really powerful idea and I’d love to see you develop it a bit.

    Nassim Nicholas Taleb wrote a book called the Black Swan and argues that most significant events in history come from the unexpected — random events that combine to produce highly improbable results. We like to think that we are masters of our own universe, that we can create models of systems to accurately explain their behavior. But for complex, multivariate systems, our modeling tools are no where near the level of sophistication needed to produce meaningful predictions. Wall Street does a lot of modeling of risk. But if someone could accurately model Wall Street, they would be the richest person on earth. Time and time again, the models have proven to be inadequate.

    Consensus in our context is a form of hubris.

  7. DaveM
    Posted Sep 17, 2008 at 10:24 AM | Permalink

    And another corporation of some “consensus” of merit was Arthur Anderson Consultants… Now “broadly” known as another great; Accenture.

  8. jae
    Posted Sep 17, 2008 at 10:28 AM | Permalink

    Looks like Lehman Bros. was very deep in the climate-science consensus, too.

    Steve: This article may over-state things: Hansen is said to be a “scientific adviser” to Lehman Bros. Going to a dinner does not make him a “scientific adviser”. This sort of going a bridge too far always backfires.

  9. Gary
    Posted Sep 17, 2008 at 10:36 AM | Permalink

    These sociological changes mimic the paleontologist’s punctuated equilibria rather than gradualism. To put it another way, it a takes a while for the water to fill up behind the dam (the consensus), but it only takes a sharp earthquake to empty the lake (the bursting bubble). We see it everywhere because of social inertia, desire to be part of the group, and the personal expense of being a contrarian. It would be useful to have a sociologist comment on the phenomenon and point out cases where the consensus was altered before the disaster happened. The key for guiding policy is to know how much of the consensus is valid and how much is wishful thinking. Auditing fulfills much of that role, but unless the auditors are competent and their work accepted, it’s useless. Peer review should do this, but we’ve seen how it’s lost sight of its charge. The only solution I can see is a vigorous competitor to the consensus that challenges it in the marketplace. Otherwise we seem doomed to high amplitude boom and bust cycles in whatever area we look at.

  10. Dodgy Geezer
    Posted Sep 17, 2008 at 10:42 AM | Permalink

    ‘Consensus’ is built into all social animals at a very basic level – it’s the thing which makes a whole herd of deer run when one sees a lion, or fish to swim in a shoal. It’s likely to have considerable survival benefit, so it’s probably well down in the brain circuitry.

    One problem in the financial sector with trying to stop and think is that it’s proveably non-optimal (I suspect – I don’t have the maths to do so!). But if a bubble is forming, you make more money by joining it than by turning away. The trick, as always, is to get out at the right time. I remember being in a merchant bank in 2001 when the analysts showed that US investments were overpriced. So we got out, and lost a lot of money because everyone else stayed in. The reason the US was up was that there was nowhere else to put money – so it went up regardless of justification.

    What is changing, of course, is the risk. Investment at one level has a low risk – as the bubble rises the risk increases. A lot of regulatory rules specify that risk assessments, and a formal statement of risk appetite are made, so that internal compliance can police these rules. But it’s one thing measuring a risk, and quite another to ignore financial gain. Everyone knew that the markets were getting risky – while Lehman Bros stayed on top it was correct to praise them as #1. It’s just that, as #1, they were in the riskiest spot.

    So I’ll put my tongue firmly in my cheek here, and say that perhaps a ‘wrong consensus’ is not necessarily a ‘bad’ thing – it’s just how humans behave. On balance it may be beneficial in a society. It has a bad effect on leading edge science, where by definition someone is discovering something which no one else knows. So whatever consensus there may be is always against it. See Clarke’s First and Second Laws. But in finance, or art, or literature, or in many other human occupations, consensus may just be the way humans interact. It’s just fashion that demanded that women wear mini-skirts during the 60s-70s cold spell. Was that wrong…..?

  11. Craig Loehle
    Posted Sep 17, 2008 at 10:55 AM | Permalink

    One aspect of the current consensus revolves around models, both GCMs and fancy statistical models like Mann uses. In both cases the fancy-ness inhibits auditing. It is like the level of sophistication itself is taken as proof of correctness. My preference is for simplicity. When I was being audited here Julien in particular sneered at my work as simplistic, as if complex stat methods are necessarily better, but at least my methods had the virtue of transparency.

    • bender
      Posted Sep 17, 2008 at 11:53 AM | Permalink

      Re: Craig Loehle (#12),

      fancy-ness inhibits auditing

      This is a huge problem. Gavin Schmidt should be making best friends with the auditors, because his toys are inherently suspicious due to their complexity. Instead …

  12. Norm
    Posted Sep 17, 2008 at 11:23 AM | Permalink

    Is the consensus that Enron was guilty of fraud of the same ilk?

    Some of what Enron did was done by other companies but was seen as smart accounting. PeopleSoft moved all of its developers to a shell company then they contracted with the company to develop software. This allowed PeopleSoft to capitalize development costs that would otherwise be expenses. When Enron collapsed, PeopleSoft quickly unwound the arrangement. It is my understanding that Enron’s “frauds” were of a similar nature.

    Similarly, it was the consensus among many in Silicon Valley that allowing people to back-date stock options was legally acceptable. I questioned a corporate counsel and an auditor at a company I worked for and was assured “everybody does it”.

    Consensuses should always to be questioned, but they rarely are.

  13. bender
    Posted Sep 17, 2008 at 11:49 AM | Permalink

    What is the topology of a “consensus”? It is a ring. You have an individual who thinks the other individuals have a solid factual basis underlying their beliefs. Each thinks the other is an authority, and around it goes. No one is overtly irrational, yet faith blossoms like a ring of roses round a wreath. John A touched on this in the Jolliffe thread. It is not a conspiracy. It is a spatially distributed belief network. No one is to blame when the consesnus is proven wrong through a critical “divergence”. Yet it’s everyone’s fault.

    Does climate science participate in a belief ring? Is AGW a “house of cards”?

    It all depends on whether or not the GCMs are parameterized correctly. Audit the GCMS! It is the one thing in which so many must invest so much faith. There are very, very few who understand these GCMs. And that is a problem. THAT is what the corporate world has to teach us.

    Given that fragile topology – that critical dependency on hte GCMs – you would think the GCMers would be pounding the pavement to educate us. Bending over backward. But what do you get at RC when you tug at that card? Maximum derision. That is what fuels my skepticism.

    • Pat Keating
      Posted Sep 17, 2008 at 12:30 PM | Permalink

      Re: bender (#15),
      I agree with you that auditing the GCMs is an important task (they are very opaque, though), but it will still come down to Steve’s famous question re climate sensitivity. We know what the ‘bare’ value is (without feedback), but the AGW proponents magnify it by ‘dressing’ it with positive feedback.

      Until we know the sign and magnitude of the true feedback, the modelers are free to use whatever climate sensitivity they want — and that is just what they do, of course.

  14. stan
    Posted Sep 17, 2008 at 12:14 PM | Permalink


    The first step on the path toward wisdom is the recognition of all that isn’t known. The fool is entranced by the aura of certainty. The wise man is always mindful of his ignorance.

  15. Barney Frank
    Posted Sep 17, 2008 at 12:45 PM | Permalink

    Re: bender in #15,

    What is the topology of a “consensus”? It is a ring.

    In the case of Lehman, Enron, the dot coms, etal it is more like a staircase which leads to a cliff with a ‘greater fool’ standing at each higher step.

  16. mzed
    Posted Sep 17, 2008 at 1:15 PM | Permalink

    I do not mean to pile on, and you are right to be skeptical about “consensus” in general, but you *are* making a somewhat faulty comparison, however, as scientific “consensus” happens within a different (though admittedly not completely dissimilar) context. I’m sure you’re as familiar with the details about scientific behavior as I am, so I won’t bore you with them. Suffice it to say that the kind of quantitative measurements being made in the financial world are often *very* different than those being made in the scientific world.

    Now, sure, there are similarities–particularly in the natural sciences involving large systems where careful control of experiments is impossible. But the point is, it isn’t good enough to doubt “consensus”–you have to look at the particular science involved, and the details about its structure–its social structure, its experimental structure, the mathematics it uses, the quality of its journals, the quality of its practitioners, its pedigree, etc. Then you can get a good picture of how trustworthy it is in general, and hence how trustworthy its consensuses are. In almost every regard I can think of, climate science comes out as more trustworthy than the financial world (where, really, there are *no* scientists whatsoever).

    However, I’m sure you’re aware of all this, so I won’t say more.

    • Kenneth Fritsch
      Posted Sep 17, 2008 at 3:08 PM | Permalink

      Re: mzed (#21),

      But the point is, it isn’t good enough to doubt “consensus”–you have to look at the particular science involved, and the details about its structure–its social structure, its experimental structure, the mathematics it uses, the quality of its journals, the quality of its practitioners, its pedigree, etc. Then you can get a good picture of how trustworthy it is in general, and hence how trustworthy its consensuses are. In almost every regard I can think of, climate science comes out as more trustworthy than the financial world (where, really, there are *no* scientists whatsoever).

      When you used the phrase “particular science involved” in the above excerpt I thought you intended to comment on the science as in a hypothetical or even conjecture about the science involved – and in this case climate science. Instead you talk about the scientists and vaguely about the tools they may chose to use. I doubt the differential in the intellect and trustworthiness of the individuals involved, as you seem to be pointing, would make any difference in how a consensus was formed in any field. Looking at the good character of the people making a consensus you choose to accept instead of the science/profitability at hand goes very much to the heart of the making of a bubble. Investors in any given enterprise might even be convinced that what others see as a consensus is a bubble and they are betting on others temporary irrationalities. What counts is the science/profitability and not the consensus about it or the people making the consensus.

      • mzed
        Posted Sep 22, 2008 at 10:26 AM | Permalink

        Re: Kenneth Fritsch (#36),

        Sorry I’m only just now getting to this (also sorry I wasn’t using the reply-and-paste feature–I’m still getting used to the “new” site). I didn’t mean to imply that gauging the moral trustworthiness of scientists was an important part of the scientific process (though I suppose it might be); I meant whether their practices and data were trustworthy. That is, do they tend to produce results that are replicable, or, at the least, able to be falsified, or that follow standard practices? In other words, good science will eventually produce something resembling consensus, so being skeptical about “consensus” is not enough. That’s all.

        • Kenneth Fritsch
          Posted Sep 22, 2008 at 2:16 PM | Permalink

          Re: mzed (#154),

          That is, do they tend to produce results that are replicable, or, at the least, able to be falsified, or that follow standard practices? In other words, good science will eventually produce something resembling consensus, so being skeptical about “consensus” is not enough. That’s all.

          If you have been reading at CA you will find that the answer to your first question would be “no” in any number of papers and methodolgies analyzed here.

          I would agree with your second sentence if changed to read: “In other words, good science will eventually produce something resembling a correct consensus, so being skeptical about “consensus” is not enough as one needs detailed analyses to determine whether the consensus is correct and particularly so when there is evidence that new methods have been invented in attempts to substantiate the consensus and that the weaknesses and invalid aspects of these methods have been discovered outside the bounds of the consensus.

  17. Tom C
    Posted Sep 17, 2008 at 1:16 PM | Permalink

    If I remember correctly, the Enron problem was first diagnosed by a day-trader who noticed that Enron always seemed to just barely meet its earnings projections. He did a statistical analysis and showed the improbablilty of such business success. Apparently, good practical statisticians are more important for uncovering this sort of thing than whistleblowers.

  18. Keith Herbert
    Posted Sep 17, 2008 at 1:21 PM | Permalink

    Speaking of consensus
    Skeptics who reject the consensus view in the climate debate are often referred to as “flat Earthers”. Unfortunately there are two problems with this comparison:
    1. Those flinging the flat Earth comment are referring to a consensus opinion that Columbus had to battle flat Earth fears in selling his voyage to the new world. Except at that time it was a consensus the world was round but the size of the globe was disputed. Columbus was wrong about the size but luckily there was another continent in the way.
    2. When people actually did believe the world was flat, it was a consensus belief and was…well wrong.
    So in arguing skeptics are silly to reject the consensus viewpoint, they give two examples where consensus opinion is and was wrong.

  19. mzed
    Posted Sep 17, 2008 at 1:24 PM | Permalink

    I will add that bender and Pat are correct: independent testing of the GCMs would be a good path towards clearing them of any suspicion. But, again, as I have said before to others: you can make your own GCM! There is no law against it. Make one and publish the results. Do the work that others have done; put your own reputation on the table. If it’s so easy to make a GCM that shows global *cooling*, for example, why hasn’t anyone made one? There are lots of GCMs–some of them are better than others. But if no one can make a GCM that truly contradicts the results of any others…isn’t that at least a small reason to give the concept itself a certain amount of trust?

    • bender
      Posted Sep 17, 2008 at 1:36 PM | Permalink

      Re: mzed (#24),
      We don’t need new GCMs or new paleoclimate studies. We need a robust method for scrutinizing scientific conjectures before (and as) they are being promoted to the level of global policy. Literature peer review has proven to be too weak.

  20. Steve McIntyre
    Posted Sep 17, 2008 at 1:49 PM | Permalink

    #22. Your recollection is pretty much correct (according to Eichenwald’s book.) There’s an enormous difference in perception between a company having a slight profit and a slight loss. There shouldn’t be – because the difference can be simply deferring a few expenses, but that is often enough to appease analysts that want to believe.

    That’s exactly why I’m so suspicious of the Team MWP reconstructions. They agree on very little except that the MWP was a fraction cooler than the modern warm period i.e. a slight profit. How many accounting decisions went into the reconstruction? I’ve shown that trivial variations lead to a warmer MWP than modern period.

    Briffa’s substitution of Yamal for the Polar Urals update – without a full reconciliation and explanation of the differences. Imagine that being done in a corporate environment. It’s jaw-dropping. Mann et al using invented Sheep Mt data instead of the Ababneh update. Mindboggling.

    We’re going to hear about oversight failures of Lehmann Bros. Well, I’d like to hear something about oversight failures at NSF, who have abandoned their regulatory obligations to ensure data archiving by rock stars like Lonnie Thompson. Well, Lehman Bros were rock stars in their field. IF it’s bankrupt now, then it was bankrupt 12 months ago. The market, like science, is “self-correcting”, but I’d be pretty mad if I bought Lehman Bros stock this year and there turns out to be negligent oversight.

  21. anna v
    Posted Sep 17, 2008 at 1:56 PM | Permalink

    September 17th, 2008 at 1:24 pm

    I will add that bender and Pat are correct: independent testing of the GCMs would be a good path towards clearing them of any suspicion. But, again, as I have said before to others: you can make your own GCM! There is no law against it. Make one and publish the results. Do the work that others have done; put your own reputation on the table. If it’s so easy to make a GCM that shows global *cooling*, for example, why hasn’t anyone made one? There are lots of GCMs–some of them are better than others. But if no one can make a GCM that truly contradicts the results of any others…isn’t that at least a small reason to give the concept itself a certain amount of trust?


    It is very simple to make any of these GCMs to predict cooling instead of warming. Change the albedo, change the sensitivity, change any of the tens if not hundreds of parameters.

    It is very hard to get it published since all the peer posts are hogged by the AGW crowd.

    Trust what? The old boy network?

  22. Stan Palmer
    Posted Sep 17, 2008 at 2:12 PM | Permalink

    Some have mentioned the consensus in the Internet bubble. Nortel Networks made a big bet and moved the company from telecom and into fibre optic networking. At its peak, it valuation amounted to about 37% of all corporate valuation on the Toronto stock exchange. It traded as high as $124.50 Canadian. Today’s posting about consensus is suited to Nortel since it made a coporate announcment this morning about selling what remains of its fibre optic division to raise cash. As a result the stock declined by about 50% today.

    As before, Nortel traded as high as $124.50 because of the consensus about it and its market. Today, it is trading at an the equivalent of 30 cents (taking into account a 10 to 1 consolidation).

    The consensus was that fire optic networking was going to be the market of the future. A company that once dominated the Canadian stock market is now worth around 1 billion dollars.

  23. Ed
    Posted Sep 17, 2008 at 2:13 PM | Permalink

    There is a theory of “informational cascades” (from economics) that addresses consensus building behavior. The theory is that subsequent decision makers often follow the decisions they see made in front of them, without necessarily evaluating all the information used to make that decision. The classic example is “Do I go left or right at the next turn?” Since the two people ahead of me went left, I take that into consideration. Soon we have a “herd instinct”-like behavior of nearly everyone turning left.

    “Informational cascades” explain how small numbers of decision makers up front (who may be wrong) can strongly influence subsequent followers, quickly leading to “consensus” (which may be wrong but it is a consensus).

    The authors of an important paper on the subject created a web site with many links to additional references on the topic at

    See also “A Theory of Fads, Fashion, Custom, and Cultural Change as Informational Cascades”, Sushi Bikhchandani, David Hirshleifer, Ivo Welch, The Journal of Political Economy, Vol 100, No 5 (Oct 1992), 992-1026.

    I found a copy online here

  24. Posted Sep 17, 2008 at 2:14 PM | Permalink

    I don’t believe a government audit system will work. The IPCC, would cease to exist without widespread man made climate change. When is the last time any of us in our various countries saw even one of the thousands of government institutions recommend its own disbandment or even its own reduction. Can you imagine the US department of education saying ‘we have too much money’ cut our funding we need to reduce staff. If the science shows there is no global warming, reduction or disbandment is the exact position the IPCC would find itself in.

    The IPCC/UN/US cannot run the audit systems either for the same reason. If the possibly “false science” dies the industry dies. Since the auditors will only specialize in climate science, they loose their jobs too. I strongly believe that for these reasons, the most aggressive audit system will simply slow the inevitable acceptance of man made global warming whether the science agrees or not.

    Besides if the audits corrected all the science, what would Steve McIntyre have to blog about?

  25. bender
    Posted Sep 17, 2008 at 2:24 PM | Permalink

    Putting #30 and #31 together:
    It is only under unusual circumstances that herds disband themselves. Overcoming the positive feedbacks that generate cohesion requires either external forcing or internal subversion.

  26. Ross McKitrick
    Posted Sep 17, 2008 at 2:28 PM | Permalink

    Mzed (21): I would argue the exact opposite. The market is ruthless at annihilating false consensuses (consensi?). It just happened today. Academia is not, and can construct marvelous defensive mechanisms to allow a false consensus to live on decade after decade. In the financial market people have to invest their money based on the information being presented. The next day (or month or year) you get to see if the info was right or not. Either the stock price goes up or it doesn’t, the firm pays a dividend or it doesn’t, the venture makes a profit or it doesn’t. If you invested based on faulty information you lose money. It sharpens the incentives to get good information. Now it often happens that firms try to cover up losses, e.g. by booking costs later than they should, or paying a dividend they can’t really afford to, but those games have to come to an end when the line of credit gets maxed out and the bills are due. The examples in the US illustrate this. Financial experts have been publicly warning since early this year that a handful of big investment houses like Lehman’s are insolvent, but gov’t officials and Lehman execs circled the wagons and declared everything was OK. Look how long it took for the market to unravel that nonsense.

    Browse the world of financial weblogs, or professional financial advisors, and you’ll find most have either a bearish or a bullish bias. If someone is dumb enough to take the advice of a bear or a bull at face value without considering the counterarguments then he or she will end up losing money. When you’ve got money on the line, it makes you sit loose to the reputation of the person giving you advice and think it through from scratch for yourself. Having thousands of people thinking for themselves is fatal for creating consensus. And having the objective test that at the end of the day a number is going to flash on the screen that signals unambiguous gain or loss keeps the individual traders and investors on their toes. You just have to stay objective or you’ll lose. Your wishes count for nothing in the market. That’s why you learn to be objective or you lose.

    But in the world of climate change, there are no objective tests, at least none that warmers like to get pinned down on. The results being published in journals seem to bear an awfully suspicious resemblance to the results the authors want to be true, especially when it comes to GCM runs. Warmers get around the lack of warming in the tropical troposphere by running so many model parameterizations that they can encompass any conceivable outcome. They ignore evidence of problems in the surface data by arguments that come down to defending arbitrary adjustments by appeal to the fact that they make arbitrary adjustments. Anecdotes of any sort, from anywhere in the world, get invoked as evidence in support of the hypothesis. Anomalous warming on Tuesday proves AGW, and cooling on Thursday does too. This can go on decade after decade because there is no objective test for the underlying hypothesis. And in saying that I do not count as a test the cute business of GISS and CRU modelers publishing black box averages that are then used to validate the outputs of GISS and CRU models.

  27. Steve McIntyre
    Posted Sep 17, 2008 at 2:51 PM | Permalink

    I missed an obvious remark in my post. In climate science terms, Lehman Bros is simply a “divergence problem” – a divergence between revenue and costs. Briffa has an answer: assume that there is no divergence. Problem solved. There, that was easy. Why didn’t the Fed think of it?

    • mugwump
      Posted Sep 17, 2008 at 2:56 PM | Permalink

      Re: Steve McIntyre (#35),

      The Fed is using infilling to solve AIG’s divergence problem. I guess Lehman’s divergence problem just wasn’t big enough to worry about.

  28. JamesG
    Posted Sep 17, 2008 at 2:59 PM | Permalink

    Going a wee bit farther back, I have a vivid memory of a CNN interview with Lord Simpson of Marconi, where he was explaining how he had managed to glean enormous success off the dot com boom by clearing out old technologies and embracing all that was techie, and he was giving advice on how we could all follow suit. Only a year later Marconi was worth zero and Simpson was fired in disgrace. That CNN spot had been sponsored by Arthur Anderson. I also remember an article (in Time I believe) where traditional US businessmen were complaining that all the funding went to dot com companies where investors seemed to behave just like Alice through the looking glass – leaving reality behind as they entered. Will the herd ever learn to look more closely next time, or will they forever continue to believe exactly what they want to believe?

    • mugwump
      Posted Sep 17, 2008 at 3:19 PM | Permalink

      Re: JamesG (#37),

      Will the herd ever learn to look more closely next time, or will they forever continue to believe exactly what they want to believe?

      I once heard a hypothesis (forget where, sorry) that the time between major financial crises is about the same length of time it takes to turn over a generation of money managers. The point: every generation has to screw up big at least once before they learn. Makes sense to me. I know I did.

  29. Kenneth Fritsch
    Posted Sep 17, 2008 at 3:25 PM | Permalink

    . Re: Ross McKitrick (#33),

    I was going to add a comment to my post above pointing to the correction process that is more readily available to the markets than to academia and climate science – honest I was- before reading Ross McKitrick’s post. McKitrick says it much better than I could have. I look at what is happening to these companies, as part of the home mortgage fallout, as reason to celebrate. My only misgivings are with extent to which the “natural” fallout and timely corrections are being inhibited.

    • Not sure
      Posted Sep 17, 2008 at 5:46 PM | Permalink

      Re: Kenneth Fritsch (#40), I’m actually worried that companies with very little to do with the current fiasco will be unnecessarily punished by the market. As Steve mentions, this happened to mining companies after the Bre-X fraud.

      This also happened after the dot com bubble burst. I managed to find a job at a large software company during that time. They had tens of millions of dollars in revenue and large and serious customers. They had a real product which had very little to do with the Internet at all, and which was used every day by hundreds (thousands?) of people. But the market punished them anyway. The same herd mentality that created the bubble over-punished all technology companies once it burst.

      A new consensus had formed around the idea that all technology companies were flaky money-losing operations. Having just worked for a dot com, I knew this company was nothing of the sort, so I invested some of my few remaining reserves in it. The stock immediately went down and I lost my nerve. If only I had been more courageous… I sold it a few years later for five times what I paid for it at the nadir of the bust.

  30. James Erlandson
    Posted Sep 17, 2008 at 3:30 PM | Permalink

    Warren Buffett, in his 2004 letter to Berkshire Hathaway stockholders said:

    General Re’s derivative contracts have always been required to be marked to market, and I believe the company’s management conscientiously tried to make realistic “marks.” The market prices of derivatives, however, can be very fuzzy in a world where settlement of a transaction is sometimes decades away and often involves multiple variables as well. In the interim the marks influence the managerial and trading bonuses that are paid annually. It’s small wonder that phantom profits are often recorded.
    Investors should understand that in all types of financial institutions, rapid growth sometimes masks major underlying problems (and occasionally fraud). The real test of the earning power of a derivatives operation is what it achieves after operating for an extended period in a no-growth mode. You only learn who has been swimming naked when the tide goes out.

    GCMs involve multiple variables and their predictions won’t be tested for decades. And by the time the tide goes out on AGW all the players will have moved on.

  31. SteveSadlov
    Posted Sep 17, 2008 at 3:41 PM | Permalink

    I am very worried about this. The carbon trading market in the US is a mere fraction of London’s market. If this particular Ponzi scheme fully collapses, the collateral damage will be huge.

  32. mzed
    Posted Sep 17, 2008 at 4:02 PM | Permalink

    #25–this is a policy question. However, I will agree that the criteria for good policy is different from that of good science. I would further claim that peer-review is not merely the process of publication, but extends beyond it into the citation history of a paper, but that would be a somewhat extended discussion. Suffice it to say that I agree mere publication is probably not a sufficient basis to base policy on.

    #27–sure, it’s simple–if you plug in unreasonable values! At any rate, again, if it is so easy to produce empirically verifiable results, then there should be someone willing to make a journal that will publish them–science is a competitive process, after all, and it’s simply not true that there is a world-wide conspiracy involving the editors of every scientific journal to produce bogus results. Of course there are smaller groups that have their own interests, but “it’s a global conspiracy” is just a bad claim. However, this is all I will say about it, as we probably shouldn’t bog these comments down on the subject.

    #28–yes, I’m aware of Stainsford. If you read their methods and their Supplementary Information, you will find the following statement on cooling-models before averaging:

    “Finally, runs that show a drift in T g greater than 0.02 K yr-1 in the last eight years of the control are judged to be unstable and are also removed from this analysis.”

    And, later, on six remaining cooling-models:

    “This runaway effect is an unphysical consequence of using a mixed layer ocean; it could happen at any point in the control or double CO2 phases.”

    These seem like fair comments to me. They leave the door open for anyone to produce a *realistic* GCM that shows cooling, and to publish their results. In saying this, I myself in no way affirm the results of currently-published GCMs. I simply note that no one has created and published a reasonable model that shows a cooling climate in the presence of a doubling of CO2. How can it be that this is a meaningless result? Resorting to conspiracy theories (see above) is not an adequate (or rational) response.

    If Richard Lindzen himself has published a value of 1.2C warming for a doubling of CO2, on what reasonable basis should I assume that a model which showed cooling would be trustworthy?

    Finally, you yourself say that we’re seeing the “physically reasonable” GCMs–well, heaven forbid! If only someone would publish a physically *unreasonable* GCM–then science could finally progress! What are you saying here?

    #33–thank you for your very nice reply, Mr. McIntyre. I agree that there are market tests–I did say they weren’t completely dissimilar. And yes, the problem of pseudoscience is a famous one. However, I would argue that any science has its own similar test–the long-term ability of articles to get cited by other articles. To doubt this is to doubt the integrity of the entire scientific enterprise–certain scientists or grouops of scientists may err, of course, even for their entire lives, but if we can’t trust scientists to do their own housecleaning over time, why should we trust *any* science? Certain theories will be trendy for periods; but ultimately, the truer ones will succeed, because there will always be new scientists to come around and look carefully at the results. As for anecdotes, these are obviously not science and lie outside the peer-review process.

    Finally, what is wrong with adjusting parameters to reflect real-world results? If some GCMs can accurately model real-world tropical tropospheric behavior (which does show a weak warming), why shouldn’t this be viewed as at least some sort of progress? The models which don’t reflect this can be dispensed with (as they should be).

  33. Robinson
    Posted Sep 17, 2008 at 4:08 PM | Permalink

    I read Patrick Michael’s book (“Meltdown”) and with respect to consensus would like to quote him here:

    The nature of modern science predisposes it to groupthink, simply because large programmatic areas, such as global warming, compete with other large groups for finite taxpayer support….

    This, it seems to me, is an obvious side effect of state funding. With respect to oversight, how can the state effectively oversee the same scientific projects it relies on to determine policy? In the end it has to write pay cheques to both sides.

    Contrast this with the situation in the private sector, where both sides have an interest in economic success, but the state also has an interest in economic stability (it seems to me that investing thrives on instability, at least for those taking short positions). Yes, the current financial crisis is a massive failure of oversight, but I think that is only because most of those involved (particularly politicians and central bankers) did not understand the complexities of the kinds of financial instruments they were either trading or overseeing (Warren Buffett seems to have been one of the few shrewd financiers out there with sense however, describing derivatives as “financial weapons of mass destruction” back in 2003).

  34. bender
    Posted Sep 17, 2008 at 4:09 PM | Permalink

    And where is their sensitivity analysis of the impact of this decision?

  35. Don B
    Posted Sep 17, 2008 at 6:39 PM | Permalink

    A couple of years after the end of the unwinding of the high tech stock market bubble, an academic research paper evaluated the performance of hedge funds. Hedge fund activities are not completly secret-they must file quarterly reports with the federal government in certain conditions. Hedge fund managers, among the smartest of investors, did not avoid the bubble but cynically traded. One interesting fact from the study was that the high tech stocks the funds traded did not all peak at the same time, and in the quarter following those peaks the hedge funds dumped those stocks and purchased others, only to dump them sequentially.

    One of the huge fund failures did not occur after the bubble popped, but before that. Julian Robertson’s Tiger fund must have recognized the folly in the bubble, avoided the bubble, underperformed the market and his competitors, and his investors dumped that fund to look for greener pastures.

    It is not possible that most climate scientists are dumb, while only sceptics see the truth. Perhaps many climate scientists, like the nimble hedge fund managers, are aware that it is not in their self-interest to fight the consensus, while preserving their reputation to fight another day, waiting for the ultimate unwinding of the bubble.

  36. Michael Strong
    Posted Sep 17, 2008 at 6:40 PM | Permalink

    I emphatically agree with Ross above, that markets are far more effective at discovering false consensi than is academia. See “Put Your Money Where Your Theory Is,”


    for several examples of decades-long speculative bubbles in academia and the proposal that we replace academic “consensus” with prediction markets (futures markets in ideas). See also Robin Hanson’s brilliant article, “Could Gambling Save Science,”


    There are various implementation issues, but at least real world outcomes provide objective criteria for success, whereas academic consensus, outside those fields of study in which critical experiments are more or less possible, is meaningless.

  37. matt
    Posted Sep 17, 2008 at 6:45 PM | Permalink



    agree with you that auditing the GCMs is an important task (they are very opaque, though), but it will still come down to Steve’s famous question re climate sensitivity. We know what the ‘bare’ value is (without feedback), but the AGW proponents magnify it by ‘dressing’ it with positive feedback.

    See http://danhughes.auditblogs.com/category/gcms/giss-modele-coding/ for some comments from a software developer on a few looks that he has taken on ModelE. Gavin joins the discussion, and then departs when the questions keep coming and getting harder.

    Agree that the GCM code that I’ve seen is an absolute train wreck. We’ve seen breathalyzer code that was reasonable get taken apart in court. The GCM would would fare much, much worse.

    Most interesting would be to unleash the more recent static analysis software tools that have really evolved over the last 10 years. Unfortunately, when the model is written in fortran…

  38. JP
    Posted Sep 17, 2008 at 7:35 PM | Permalink

    Perhaps the analogy of Enron and consensus should go a step further and include Authur Andersen. Anderson was tasked not only to audit Enron’s books but also to “consult” for Enron and its investment oppurtunities. Financial consulting was actually as lucrative as the actual management accoutning. Of course there was a huge conflict of interest. In the pre-Sarbanes Oxley days the same firm could keep the books and “consult”. In order for Andersen to keep its lucrative consulting business with Enron it had to look the other way in how Enron declared revenue. Way before the Justice Department took action, the markets punished Andersen visciously. In 3 days time Andersen was finished. The only thing that remains is this old webpage<. Anderson at one time was one of the top 5 accounting firms in the North America, went under in less than a week. I remember reading newspaper accounts of its employees coming into work one morning. A mass voicemail to all of its employees told them that they were no longer employed and to “have a nice day”. Andersen lost everyone of its accounts in less than a week.

    This incestuous behavior also exists in the climate science world. A conflict of interest exists between the people who fund “research” (usually the Federal Goverment) and those who do the research. Like Andersen, the scientists realize who funds thier paychecks. Scientists are no different than other people. They have mortgages, families to provide for, etc… At some point in time even the most maverick scientist realizes it isn’t worth fighting city hall. There is no Schumpeterian “creative destruction” in the world of Climate Science. Unlike the Wall Street financial advisors and brokers who will soon be unemployed by the tens of thousands, Climate Scientists will always find employment

  39. Nicholas
    Posted Sep 17, 2008 at 8:53 PM | Permalink

    Perhaps one reason that these people are so praised before the massive failure is that those who take big risks, and win, seem impressive. After all, the bigger the risk, the bigger the reward – until your luck runs out.

    I’m not sure how that relates to climate issues but it might help explain this potential paradox.

    • bender
      Posted Sep 17, 2008 at 8:57 PM | Permalink

      Re: Nicholas (#52), Regression to the mean is how it relates to climatology. What goes up tends to come down.

  40. jeez
    Posted Sep 18, 2008 at 3:21 AM | Permalink

    30 and 31, Jeff ID and Bender.

    You are touching on a subject I hypothesized about 30 years ago. I used to call it the law of bureaucracy. A bureaucracy is just another business entity, but one which cannot make profit in the marketplace, a cost center, so no salary, staff, or other budget increases without being given more money from its patron government. This leads to interesting behavior compared to regular businesses which try to maximize their profit with a minimum of resources.

    The only way a bureaucracy can increase its budget is with a funding increase, but a bureaucracy that does a good job of dealing with the problems assigned to it will not get a budget increase, because there is no need for further funds as the problem they solve is determined to be adequately addressed.

    Therefore all bureaucracies have a tremendous incentive to do an inadequate job in fulfilling their mission. It is the only way they can justify a budget increase and achieve staff and salary increases.

    There are many ways this can be expressed subtlety, such as “expanding the mission”, but when the layers are peeled back, a bureaucracy that admirably works within its budget to achieve its stated goals is punished, while one which takes a dive just before the finish line can whine about the need for more resources to do better next time…

  41. JamesG
    Posted Sep 18, 2008 at 4:17 AM | Permalink

    Decent 3rd party review is obviously lacking in both academia and the financial markets. I don’t agree with Ross that markets are intrinsically better because it’s the human element, not the system, that consistently fails us. Only a proper regulatory framework can prevent the worst excesses. Self-regulation clearly doesn’t work. The overheating and subsequent bust was easily preventable if the Fed had been prudent rather than being a cheerleader for credit-based bubbles. All they had to do was read some history and use some commonsense. But then the Fed is a private entity with it’s own short-term profit motive, when it should really be looking at the long-term.

  42. James Erlandson
    Posted Sep 18, 2008 at 6:26 AM | Permalink

    From today’s Wall Street Journal:

    One reason that AIG had floated beneath the radar screen of the business media (relative to Wall Street investment firms) is that its business model is so complex and opaque that it is impossible to describe simply … Among its many products, AIG offered insurance on derivatives built on other derivatives built on mortgages. It priced those according to computer models that no one person could have generated, not even the quantitative magicians who programmed them.

    Sound familiar?

  43. Shawn Whelan
    Posted Sep 18, 2008 at 7:16 AM | Permalink

    And the consensus among financial experts seems to be ride it out it always gets better. But the economy is going to continue on this train wreck until the real estate market which caused the whole thing corrects itself. And this financial meltdown is totally a result of the government through low interest rates and the use of Fannie and Freddie and the CRA to build the resulting housing bubble.

    Sound familiar?

  44. Steve McIntyre
    Posted Sep 18, 2008 at 7:33 AM | Permalink

    #55. I’ve been looking for a clear explanation of why these businesses failed. The reference is interesting though I don’t think that it’s got the thing exactly. When I was in my 20s, Noranda had a very active copper business in which it bought copper concentrate to be priced on the London Metal Exchange in certain months and sold refined copper in other months. It had a very active copper trading program which was “hedging” in the traditional sense of the word i.e. it used the futures market to remove speculative risk from price swings so that it made its income in this part of the business on smelting and refining, rather than price speculation. They’d have a small speculative book but that was kept quite separate and controlled. Options were used in the commodity trading business long before they became prominent in the financial businesses.

    The use of the term “hedge fund” to describe speculation on prices always annoyed me as a type of misrepresentation.

    I haven’t followed the affairs of the big Wall Street “investment banks” until recently. I presume from their collapse that the core of their businesses had ceased to be brokerage or other “routine” steady businesses like that and that they had developed huge speculative books in which mismatches developed between their obligations and liabilities. All very well when the market runs your way, but speculation nonetheless.

    While everyone is screeching for more regulation, the question is what to regulate? Until people understand what the business was and why it failed, then it will be hard to know what to do. As a start, I’d definitely begin with looking at the form of disclosure. The idea that no one can understand the business is absurd. Of course, it can be understood. It may take a little time, but it can be understood. I’m quite sure, for example, if I had access to the books and records, I could understand the business and why it failed. Then you’d know what to try to avoid.

    My guess is that the speculative aspect of the business was under-disclosed and speculative profits were made to look like operating profits.

  45. Steve McIntyre
    Posted Sep 18, 2008 at 7:40 AM | Permalink

    #56. Sometimes things do get better. There was a very bad bear market in Oct 1987, which hurt for a while, but it got better.

  46. Buddenbrook
    Posted Sep 18, 2008 at 7:58 AM | Permalink

    Why are those of the consensus not open to debate the key scientific issues? Why are they withholding data? Why were many difficult questions left unanswered in the IPCC review process? Why do realclimate.org often censor difficult questions (as reported by numerous individuals)? Why are doubt and inquiry met with derision and objection? Why is the parameterization of GCMs not discussed openly? The same for surface temperature record and UHI. Paleoclimatic studies. etc. There is an impenetrable wall of certainty, and those daring to ask the wrong questions are villified inside the climate science community.

    It is not an attitude that you’d expect from those who are confident the facts are on their side. And it is not a scientific attitude. And that should be enough to make every thinking person skeptical.

    Then what motivates the consensus to function the way it does? There definitely exists a strong peer pressure to keep individual researchers in line. But it goes deeper than just that and the nature of bureaucracy (that has been discussed above).
    If you have invested 20-30 years of hard work, feelings of purpose, feelings of self-worth into something, like Hansen has done for an example, it’s near impossible psychologically to entertain the possibility that it has very much been for a false cause.

  47. Steve McIntyre
    Posted Sep 18, 2008 at 8:08 AM | Permalink

    #59. Just because people act like jerks doesn’t mean that they are wrong. And you can’t deduce one from the other.

    • bender
      Posted Sep 18, 2008 at 8:15 AM | Permalink

      Re: Steve McIntyre (#60), Is it true that jerkism is uncorrelated with incompetence and dishonesty? Should check the pysch lit on that one.

      Of course, what is true for a population may not be true for an individual sample. But if the correlation is high, the probability geos up.

    • Craig Loehle
      Posted Sep 18, 2008 at 9:42 AM | Permalink

      Re: Steve McIntyre (#60), While jerkism does not necessarily prove someone is wrong, it does prove that they would not ADMIT they are wrong. It is a characteristic of the heads of companies like Enron that imploded that admitting mistakes was not something they did. A characteristic of Lehman Bros was getting heavily into speculative trades so complicated that no one knew what they were worth or how risky, likewise no one could assess the true risk of the mortgages they held which had been bundled and securitized, and similarly AIG was insuring not merely consumers but risky securities and instruments. In all of these cases, it was too complicated to know what you were really doing, $ wise, and no one would admit it. Similarly no one will admit that this climate stuff is simply extraordinarily complex. The unwillingness to admit what you don’t know or that you can’t be 100% certain due to this complexity is in fact jerkiness in my view, and ties the financial failures directly to the climate wars, psychologically. Steve M, by the way, does a very nice job of admitting mistakes and fixing them and clearly stating what he thinks he knows or does not know.

  48. Steve McIntyre
    Posted Sep 18, 2008 at 8:15 AM | Permalink

    I noticed that we were also talking about bear markets in Sept 2007, except in that case, we were talking about the bear market in NASA temperatures:
    The September 2007 Bear Market in NASA Temperature “Pasts”

  49. Dodgy Geezer
    Posted Sep 18, 2008 at 8:33 AM | Permalink

    “Therefore all bureaucracies have a tremendous incentive to do an inadequate job in fulfilling their mission. It is the only way they can justify a budget increase and achieve staff and salary increases.”

    Alas, your Law has already been noted by C Northcote Parkinson…

    : Noted, but enough OT moralizing about bureaucracies.

  50. Steve McIntyre
    Posted Sep 18, 2008 at 10:17 AM | Permalink

    #64. In the AIG case, I do not agree that everything was too complicated to understand, any more than I believe that GCMs are too complicated to understand. I firmly believe that whatever AIG was doing can be broken into understandable bites and, underneath it all, there were some speculations taking place that are quantifiable.

    I can assure you that I know precisely what it feels like to have an option go to 0. Been there, done that. It sounds like AIG was underwriting options, which can be profitable if they all end up out of the money, but every so often, the market snaps back at you and the underwriter loses 10 times what he expected to make. It’s harder to understand why AIG was in this business. It seems from what little I know that they had a large garden-variety business, and that they tried to goose profits with a go-go business which has imploded everything. A lot the same as Enron (which started with a boring pipeline business, which ended up being their only asset of any value.)

    • Stan Palmer
      Posted Sep 18, 2008 at 2:50 PM | Permalink

      Re: Steve McIntyre (#65),

      On the mystery of the AIG failure. Apparently, it is actually quite simple. From Wikipedia:

      IG’s share prices fell over 95% to just $1.25 on September 16, 2008, a stark contrast from the 52-week high of $70.13. The company reported over $13.2 billion in losses in the first six months of that year.[8][9] As Lehman Brothers suffered a major decline in value and share price, potential investors began to compare the types of securities held by AIG to those held by Lehman, and found that AIG had valued their Alt-A and sub-prime mortgage-backed securities at rates 1.7 to 2.0 times those Lehman had used for what Lehman officials called similar securities.[8

    • Jonathan Schafer
      Posted Sep 19, 2008 at 11:34 AM | Permalink

      Re: Steve McIntyre (#65),


      AIG’s problems are a conglomeration of everything else happening in the financial world.

      After Enron, new accounting rules were put in place that required the re-evaluation of investment portfolios each quarter as if the company were being sold.

      For a number of years, due to artificially low interest rates provided by the Fed, and prodded by congress to make affordable housing loans to just about everyone (bad cred, no doc, no verification loans), Fannie Mae and Freddie Mac moved their business model to providing the majority of funding for home mortgages. All the mortgage brokers were out pushing these low-interest no doc loans because the Fannie/Freddie money came with an implicit guarantee of backing from the federal government. Fannie/Freddie then packaged these loans into CDO’s and sold them off. The CDO’s were all rated as investment grade even though they contained a huge chunk of no doc/no verification loans mixed in with the good loans.

      The companies that bought these SIV’s, either as straight up CDO’s or mixed with other investments also bought insurance, hedging their bets on the value of the investment. That’s were AIG comes in, as they were the primary provider of this type of insurance. Highly profitable when times are good.

      Well, as you can imagine, when the housing bubble burst, and default rates began to soar, as people couldn’t afford the increased payments on the interest only loans, or super low ARMS, the value of the SIV’s started to go down. As the big investment houses, who owned many of these SIV’s began to re-evaluate them each quarter, they found their debt/capital ratio going the wrong way. They had to start cannibalizing other investments to keep both their liquidity and their debt ratio from going too high. Unfortunately, they haven’t been able to do that. And so companies that a year ago had high stock prices and good earnings are today going bankrupt as they struggle through a capital crunch due to the downgrade of their SIV investment holdings.

      And now that many of these institutions are making claims to AIG, they are faced with a cash crunch to pay off these enormous claims due to excessive write-offs of the investments.

      In this case, all of this pain can be traced back to bad governmental policies. Congress pushing the Community Reinvestment Act re-auth during Clinton’s presidency, the fed maintaining artificially low interest rates, accounting rule changes, and bad business practices. It really had little to do with an audit failure because business conditions could/would simply change too much in a quarter that there was simply no way to audit this danger.

      Congress was pushed for reforms to Fannie/Freddie in 2005 but refused, instead more interested in the millions of dollars of lobbying money the two companies gave. Fannie/Freddie never had to provide outside auditing, even though they were “public” companies, instead reporting directly to the government whom they were plying with cash contributions, and AIG got caught up in a bad business decision to provide all this insurance without spreading the risk amongst the reinsurance companies.

      The government’s intervention in these businesses has directly caused most of this mess, along with a moral failure by the businesses involved to conduct themselves within not just the rules but the spirit of the market. By packaging these good and bad investments together as investment grade SIV’s, they made tons of money. Now, the chickens have come home to roost.

      Failures in the free market is designed to tell you you are doing the wrong thing. Success is designed to tell you you are doing the right thing. But with the government intervention, questionable morals, living by the lawyer, and just plain bad business come together, you end up with the mess we have today. And the more the govenment intervenes, and ponies up taxpayer cash to prop up these invalid business models and bad characters, the longer it’s going to take to unwind this mess.

      My 401k has taken a huge hit and I don’t even have investments in these types of companies, but the repercussions are hitting everywhere. On the plus side, once this is over with, assuming we can keep government out of where they shouldn’t be, things will improve and values will start to go up again.

      • James Erlandson
        Posted Sep 19, 2008 at 12:26 PM | Permalink

        Re: Jonathan Schafer (#103),
        Fannie/Freddie never had to provide outside auditing, even though they were “public” companies, instead reporting directly to the government …

        From page F-2 of Fannie Mae’s 2007 annual report:

        In our opinion, such consolidated financial statements present fairly, in all material respects, the financial position of Fannie Mae and consolidated entities as of December 31, 2007 and 2006, and the results of their operations and their cash flows for each of the three years in the period ended December 31, 2007, in conformity with accounting principles generally accepted in the United States of America.

        /s/ Deloitte & Touche LLP

        Page 113 of Freddie’s 2007 annual report bears a similar statement signed by PriceWaterhouseCoopers LLC.

        • Jonathan Schafer
          Posted Sep 19, 2008 at 2:06 PM | Permalink

          Re: James Erlandson (#104),

          Yep, you are correct, I must have misread that somewhere. They are exempt from certain SEC disclosure rules according to their K-8 statement (2007 at least), and of course don’t pay state or federal taxes, but they do appear to have outside audit.

          The efficacy of that audit appears in question, or the rules were so ambiguous as to be unable to properly categorize them because despite being fined 400MM by the federal government for accounting violations and also the subject of shareholder lawsuits over restating earnings for 2001 – 2005, nothing seems to have occured at the auditor level.

          KPMG was their previous auditor and was sued along with Fannie Mae by shareholders. Fannie Mae turned around and sued KPMG for not catching the accounting errors. I use the term errors as they used them, when in fact, they were blatant violations intended for upper management to increase their bonuses based on financial results.

        • James Erlandson
          Posted Sep 19, 2008 at 2:32 PM | Permalink

          Re: Jonathan Schafer (#108),
          … and of course don’t pay state or federal taxes …

          Page F-58 of Fannie’s 2007 Annual Report — they paid federal taxes.

          Freddie’s 2007 Annual Report includes Note 13: Income Taxes. “We are exempt from state and local income taxes. Table 13.1 presents the components of our provision for [federal] income taxes
          for 2007, 2006, and 2005”

          Both benefitted from Low Income Housing Tax Credits (LIHTC).

        • Jonathan Schafer
          Posted Sep 19, 2008 at 4:09 PM | Permalink

          Re: James Erlandson (#109),

          Sorry, should have been state and local, not federal and state.

  51. TerryBixler
    Posted Sep 18, 2008 at 10:31 AM | Permalink

    Th cost of energy directly and immediately puts the fundamental unit of mortgage industry in jeopardy. The mortgage payer is faced with the mortgage, energy costs and food costs. The mortgage is first to go. The instruments are complex because of the many layers of wrapping and various defense
    packages but it is the base unit paid by the property owner that is the problem. With the low qualification requirements the walk away happens more quickly.

  52. bender
    Posted Sep 18, 2008 at 10:56 AM | Permalink

    On the correlation between competence and self-importance:
    Unskilled and Unaware of It: How Difficulties in Recognizing One’s Own Incompetence Lead to Inflated Self-Assessments

    • DeWitt Payne
      Posted Sep 18, 2008 at 11:36 AM | Permalink

      Re: bender (#67),

      That’s one of my favorite papers. But it turns out that the converse is also true. For a task that is known to be very difficult, most people will under rate their own performance and think that they are less skilled than average.

  53. Stefan
    Posted Sep 18, 2008 at 11:10 AM | Permalink

    #59 “Why are those of the consensus not open to debate the key scientific issues?”

    With AGW there is plenty of motivation to believe for those who are against consumerism, against multinationals, feel that technology equals pollution, and so on. It’s a whole cultural movement, going back over 50 years, but to study it is the domain of psychologists and sociologists, etc. There have been several critiques written based on serious academic study over the years, but all of that is OT here, and quite so. It is also further complicated by how various psychologists and sociologists are themselves part of that anti-consumerist movement.

    To me as a layman, this blog is valuable for its focus on the specific rational scientific issues.

    Supporters of AGW say to me that the science can be trusted because it is naturally self-correcting. But while I used to accept the media’s presentations on AGW, nowadays I’m skeptical because, as is obvious here, that self-correction appears to be a very very slow process.

  54. Posted Sep 18, 2008 at 12:33 PM | Permalink


    Buddenbrook (#59) hits the nail squarely on the head: “If you have invested 20-30 years of hard work, feelings of purpose, feelings of self-worth into something, like Hansen has done for an example, it’s near impossible psychologically to entertain the possibility that it has very much been for a false cause.”

  55. jeez
    Posted Sep 18, 2008 at 1:25 PM | Permalink

    I think you’ll find this explains it all Steve M.

    And Dodgy Geezer 63, that’s totally cool. I never claimed any precedence.

    • bender
      Posted Sep 21, 2008 at 12:48 PM | Permalink

      Re: jeez (#71),
      jeez, you need more tempting bait. I missed it the first time as well.

  56. Steve McIntyre
    Posted Sep 18, 2008 at 3:01 PM | Permalink

    I understand that similar problems are affecting the various firms, but I’m still trying to understand how the wheels fell off the wagon in the first place. It sounds like the firms had turned into massive speculations – called “investment banking” , but actually neither “investments” in a traditional sense, not “banking” in a traditional sense.

    If that’s the case, then it makes sense to save the core old-fashioned businesses, but not the “investment banking” parts. Maybe some of the unemployed Wall St modelers can use their skills on GCMs.

    • James Erlandson
      Posted Sep 18, 2008 at 3:34 PM | Permalink

      Re: Steve McIntyre (#72), These two sources have the best explanation I’ve seen so far.
      A Freakonomics piece by two professors from Universtiy of Chicago Graduate School of Business.
      CNN/Fortune article that gives some detail on the role that Credit Default Swaps play in all this.

      Because there were so few defaults over the past few years, mutual funds, investment banks and insurers like AIG wrote lots of swap contracts as an easy way to make money. It was like writing auto insurance policies in a world with no car accidents.

    • Stan Palmer
      Posted Sep 18, 2008 at 4:32 PM | Permalink

      Re: Steve McIntyre (#72),

      What caused the wheels to fall of was the increase on defaults on sub-prime mortgages. These mortgages were being written with interest rates that were not commensurate with the risk unassociated with them.

      However this is not the entire story. It had to do with executive compensation that was based on the quantity and not the quality of sales. Executives could earn large bonuses for large amounts of business written but these bonuses could not be rescinded if the anticipated profit failed to materialize. This is true in the financial market bubble just as it was true for Internet stocks when the last bubble broke

  57. Sam Urbinto
    Posted Sep 18, 2008 at 3:23 PM | Permalink

    One prevailing opinion on how the wheels fell off the wagon is a mix of unreasonable optimism, greed and legislation implemented in the early 1990s and 2000s to encourage mortgage loans to people that couldn’t afford them.

    Not so mucht he wheels fell off, as a spoke stress fractures here, a cotter pin falls out there, a bolt loosens another place and over time there’s a point where it just all falls apart. Or the wagon goes over the cliff because you’re watching the spokes breaking on one wheel, you’re going downhill, the brakes don’t work, and the horses have become detached and run off.

    Sometimes you just have to jump….

  58. mpaul
    Posted Sep 18, 2008 at 5:07 PM | Permalink

    Steve #65, I have a different take. The financial firms are all now using proprietary models that are decedents of the original Black-Scholes models. The theory is that you can completely neutralize risk through hedges consisting of complex derivatives. Few people truly understand these models — but among those who do there’s consensus (or at least there was) that the models are reliable. If you believe that you can neutralize risk, then it is perfectly prudent to execute a strategy to the limit of your ability to raise capital.

    But this is where hubris comes in. Too many people began to believe that the models were perfectly reliable. But in the end, once again, reality turns out to be much more complex than the master of the universe thought. Oh well.

    Look, I believe in the merits of computer modeling. Its a great way to gain insight into how systems might behave. But problems develop when people begin to confuse reality with models. Lets not fool ourselves into thinking that models can predict all possible outcomes resulting from a nearly infinite set of potential perturbations.

  59. Harry Eagar
    Posted Sep 18, 2008 at 10:08 PM | Permalink

    Sometimes consensus is just silly. For example, there was a market consensus for a while that the real estate under Tokyo was worth more than the real estate in North America.

    You could take it to the bank — literally.

    It’s possible that the factors that raise a man (rarely a woman) to the top of the financial system do not include broad intelligence. I tnink of them as idiots savants, nimble with a spreadsheet but otherwise incapable of crossing a busy street unaided.

    However, it is also true that perception of a consensus and an actual consensus are not always the same. I don’t know what the count is today, but for a long time there were more freudian analysts in Manhattan than in Europe. What was the consensus then?

  60. bender
    Posted Sep 18, 2008 at 10:36 PM | Permalink

    Interesting. Widespread fear of risk leading to a perceived need for hedging and a subsequent dependence on an unreliable, poorly understood model … all under the philosophy of a “precautionary principle”.

    Interesting times.

  61. Posted Sep 18, 2008 at 10:43 PM | Permalink

    Massive expansion in leverage and debt. Won’t stop till debt levels get back to historic levels (more write-offs).

  62. Steve McIntyre
    Posted Sep 18, 2008 at 10:58 PM | Permalink

    One of my friends who’s in real estate said that the American real estate bubble was fed by banks lending 100% of purchase to unqualified buyers with no equity, exacerbated by interest rates that started low and increased by half a point or so per annum. They purchasers had no equity and started walking away. The buyers had no assets or could declare bankruptcy so there were no pockets. Sun Belt states seem to be particularly prone to this.

    I guess that the Wall St “investment banks” ended up taking the risk without having any idea who the customers were. MAybe they used GCMs.

    • Posted Sep 19, 2008 at 12:32 AM | Permalink

      Re: Steve McIntyre (#81), It was worse than that. Many banks were offering home equity loans for 125% of the home value. Pure insanity.

      Pat Frank, While deregulation played a role, the housing bubble/credit crisis was mainly caused by the tech crash and 9/11 market plunge. Real Estate was the flight to quality. Now gold is the flight to quality. What bubble do you think will burst next for the thundering herd?

  63. Steve McIntyre
    Posted Sep 18, 2008 at 11:02 PM | Permalink

    Warren Buffett on derivatives in 2002.

  64. Pat Frank
    Posted Sep 18, 2008 at 11:28 PM | Permalink

    The bank crisis came to the US because the Republican government deregulated the home mortgage market, and banks had to enter it because they knew their rivals would do so. The market is relentless. Either enter it or get consumed by those who do. Remember the Savings and Loan scandal of 20 years ago? The then Republican government (under Reagan) deregulated the S&L’s and they all had to go pell-mell into that market. Deregulation has been an unmitigated disaster since Carter deregulated the airlines. But that hasn’t kept them from trying it again and again. More of the same always works, doesn’t it?

  65. Andrey Levin
    Posted Sep 18, 2008 at 11:54 PM | Permalink

    Computer and internet technology allowed too much players into stock market, too fast world-wide movement of huge capital, instant assess to highly leveraged credit, too easy (and delusional) hedging of risk, etc.

    Take a look at this graph, and note that D&J fever, and especially amount of shares traded (solid blue bars at the bottom) perfectly co-incide with computerization of stock and financial markets:


    Climate modelers should teach our financial gurus how to impose higher “viscosity coefficient” into financial system.

  66. Andrey Levin
    Posted Sep 19, 2008 at 3:48 AM | Permalink

    This is priceless:

    the events of the past year are not a mere accident, but are the results of a conscious and willful SEC decision to allow these firms to legally violate existing net capital rules that, in the past 30 years, had limited broker dealers debt-to-net capital ratio to 12-to-1.
    Instead, the 2004 exemption — given only to 5 firms — allowed them to lever up 30 and even 40 to 1.
    Who were the five that received this special exemption? You won’t be surprised to learn that they were Goldman, and Morgan Stanley.


    Under an alternative approach adopted by the SEC in 2004, broker-dealers with, in practice, at least $5 billion of capital (such as Bear Stearns) were permitted to avoid the haircuts on securities positions and the limitations on indebtedness contained in the basic net capital rule. Instead, the alternative net capital program relies heavily on a risk management control system, mathematical models to price positions, value-at-risk models, and close SEC oversight.

  67. Andrey Levin
    Posted Sep 19, 2008 at 3:52 AM | Permalink

    M-m-m: “The five firms allowed to rump-up leverage to 30-40:1 were Goldman, Merrill, Lehman, Bear Sterns, and Morgan Stanley.”

  68. James Erlandson
    Posted Sep 19, 2008 at 4:16 AM | Permalink

    Last week, C-SPAN Q&A interviewed Peter Wallison of the American Enterprise Institute about Fannie and Freddie. Remarkably he was in complete agreement with Ralph Nader:

    The mentality of see no evil, hear no evil and speak no evil that pervades official Washington’s approach to the GSEs is a product of an influence machine that is oiled by revolving doors, the care and feeding of key politicians across the nation, a quick strike, taking no prisoners, public relations operation and targeted contributions to advocacy organizations – activities financed by slush funds created by generous forms of corporate welfare.

    Wallison ticked off the problems and abuses surrounding GSEs the same way Steve McIntyre would tell the story of the Hockey Stick.

    But the Congress is part of the problem here. They are implicated in creating Fannie and Freddie, keeping it alive, protecting those two companies against attack from any side within the political process and in the private sector, and they get benefits from Fannie and Freddie.

    they [GSEs] hire the staff of these people, they hire the lobbyists who are the friends of congressmen and senators, they give out money to community groups who then in turn support those congressmen and senators who are their friends.

    it is a way for Congress, without actually appropriating any money, to direct money to their friends …

  69. jim edwards
    Posted Sep 19, 2008 at 4:45 AM | Permalink

    #81, Steve M.

    Poverty on the part of the borrower is not necessary to rob banks of their investment. In California, which has seen the bubble grow and pop as badly as anywhere, we have anti-deficiency legislation for purchase-money mortgages that secure owner-occupied homes.

    If a homebuyer borrows $400k to buy a house, and the house drops in value to $260k, the lender can foreclose upon non-payment but can’t seek a nickel more than the auction price. [i.e. – no personal liability in Calif for the $140k+ loss, even if the buyer has $10 million in the bank.]

    Of course, it can be argued that lenders know this going in and price their loans accordingly. By the time banks are taking possession of these homes, however, some of the pissed off homeowners have been stripping them of copper tubing and fixtures. When transaction costs et Al are added in, I’d be surprised if many of these lenders are recovering 45 cents on the dollar – IF the home can be sold.

    • Kenneth Fritsch
      Posted Sep 19, 2008 at 9:14 AM | Permalink

      Re: jim edwards (#89),

      Re: jim edwards (#90),

      While I agree with what you recommend here, Jim Edwards, more important and in line with what I find valuable at this blog is that analyzing each issue in some detail, as you have done in these posts, brings a better understanding of these issues, be they economic or climate related, than general arm waving and/or finger pointing.

  70. jim edwards
    Posted Sep 19, 2008 at 5:34 AM | Permalink

    #83, Pat Frank:

    Re: Deregulation.

    It’s never existed, so you can’t blame the free market for this mess. From time to time, government removes SOME regulations from an overegulated activity and calls it deregulation; the same government continues to meddle in the activity with arbitrary mandates and unwarranted subsidies, invariably resulting in bad investment choices and failure.

    A great example in California was the energy crisis several years ago. The state “deregulated” the energy market, but made it essentially illegal to build new power plants. Federal population policy was to bring about 1 million people per year into California. Computers and big TVs became affordable and widespread. President Clinton and Gov. Grey Davis took personal credit for the economic boom centered in Silicon Valley. Electricity consumption in California soared until peak demand was equal to, or even slightly above, peak supply.

    This is where government enabled the fraud by Enron, etc. The “deregulated” spot market run by the State’s Independent System Operator had rules [AKA regulations] that assigned the highest price per MegaWatt sold to ALL of the MegaWatts sold in that time period. If 99% of the energy went for $42 / unit, and the last 1% went for $1100 / unit [because nobody wants to be the guy without electricity…], then ALL of the electricity was billed out at $1100 under the State’s “deregulated” regulations. The Enron guys were only too happy to think up ways to bid up the last unit of energy. It was vastly more profitable to game the system than to produce and deliver energy.

    Of course, the prior Republican Gov., Pete Wilson, and the evils of deregulation were blamed for the energy crisis, even though Wilson had pushed for more power plants and was rebuffed.

    The same thing has gone on with the current meltdown. The mortgage industry is “deregulated”, and yet the Congress has created two vehicles to make sure more mortgages are written [Freddie and Fannie], The Federal Reserve has been practically showering financial institutions with “free” money, and Congress has further pushed financial institutions to lend to buyers who did not qualify under traditional rules.
    How is this “deregulation ?” We need laissez faire.

    • Michael Smith
      Posted Sep 19, 2008 at 1:04 PM | Permalink

      Re: jim edwards (#90),

      We need laissez faire.

      Amen to that.

      It is not the free market that encourages bankers and mortgage lenders to make loans to people that cannot repay them. To the contrary, in a free market such behavior leads to losses, not to profits, and eventually results in bankruptcy if the practice continues long enough.

      Remember that the rationale for creating Freddie and Fannie and passing legislation like The Community Reinvestment Act was to encourage lenders to make MORE RISKY loans than they were otherwise willing to make. It was justified as a means to put an end to discrimination in mortgage lending. Well, that’s precisely what they got: a great deal of indiscriminate lending, with completely predictable results.

      Now, if this economic mess were the result of a lack of government regulation, then even worse problems should exist in the less regulated market for, say, automobile financing. Well, do we see huge numbers of car loans being made in excess of the market value of the car? No. Do we see massive numbers of vehicle repossessions brought on by borrowers who can’t make their car payments? No. Do we see the price of cars crashing because of an oversupply situation created by an artificial, unsustainable stimulation of demand resulting from the sudden availability of new loans to unqualified borrowers? No.

      But unfortunately, as Ludwig von Mises pointed out, the free market always takes the blame for the problems created by government intervention and regulation. So when this mess has been socialized, i.e. when the burden of the problem has been shifted to the taxpayers, you can expect a new dose or regulations and interventions.

  71. Geoff Sherrington
    Posted Sep 19, 2008 at 7:00 AM | Permalink

    Just for interest, some readers might like to find and read some of the Chicago Law School papers on Property Rights that gained the 1991 Nobel Prize in economics for Ronald Coase. I had the delight of long discussions with one of his compatriots, Richard Epstein. Property Rights is a type of way of life, a philosophy for viewing transactions, that I find particularly clear, logical and helpful. It’s a bit like the Scientific Method for economists except not so widely known or used.

  72. Steve McIntyre
    Posted Sep 19, 2008 at 9:22 AM | Permalink

    #89. In Canada (or most parts of the world), mortgages are security for loans and the banks obviously have recourse against whatever assets they can find. As a result, people have to be at least a bit prudent in how much they spend for a house and how much debt they take on.

    California legislation that prohibited banks from taking recourse would have to be considered a type of regulation – in the sense that it was a legislated alteration to common law practices. It’s not hard to see why this sort of action might backfire.

  73. Steve McIntyre
    Posted Sep 19, 2008 at 9:26 AM | Permalink

    #87. That’s an interesting list. Given their business “plans”, it seems like a pretty fundamental misrepresentation to call these things “investment banks”, when they were neither “banks” nor “investments”. They appear to have turned into charnel houses of speculation on paper of lower quality than junk bonds.

  74. Luis Dias
    Posted Sep 19, 2008 at 9:45 AM | Permalink

    MAybe they used GCMs.

    That’s the most cynical comment I’ve heard from McIntyre for a while hehe. Easy there, mister! You still haven’t audited the GCM’s to be able to puke on them like that, or have you? Until now, we only have Koutsoyannis…

  75. Andrey Levin
    Posted Sep 19, 2008 at 10:04 AM | Permalink

    Re#93,94, Steve

    In Canada banks refused to lower mortgage landing standards, couple of years ago. Hence no financial crisis, except for CIBC who was careless enough to meddle with US mortgage backed securities.

    Housing markets are going boom and bust quite regularly around the world, but without terrible shakeout of whole financial system we currently see. In US, the case of social engineering to push “American dream” – ownership of home – was practically mandated by federal government, beginning with Community Reinvestment Act of Carter vintage. See, for example, here:


    This, plus crazy leverage for derivatives of 30-40:1, plus stupid idea that it is possible to buy insurance against any risk (life insurance does not mean that you are immortal) – and we have “super” bubble instead of regular one, like dotcom or commodities runs.

  76. Barney Frank
    Posted Sep 19, 2008 at 10:09 AM | Permalink

    Re # 83.
    Our current mess was started primarily by the Federal reserve. Right after creating an asset bubble in the late nineties with excessive and prolonged easy money it went about doing the same thing after 9/11. In 2004, in the midst of a very strong economy, the Fed funds rate was still at 1%. After the bubble was created it then popped it with 14 or fifteen consecutive interest rate hikes.
    Piled on top of this in the nineties were regulations which incentivized actually making risky loans to otherwise unqualified buyers, especially as backed up by Fannie and Freddie, which had the implicit (now explicit) guarantee of the Federal government behind them.
    Are regulations necessary? Yes. Is this mess the result primarily of deregulation? No.
    It is primarily the result of the Fed blowing up a balloon, coupled with bad regulations, not no regulations.

  77. Sam Urbinto
    Posted Sep 19, 2008 at 10:15 AM | Permalink

    Stan: Yes, rather than my “unreasonable optimism, greed, and legislation to encourage mortgates to people that couldn’t afford them”, interest rates too low to cover the associated risks. I knew the end of this opera before it started.

    mpaul: Or rather than just my Sure, models that are reliable (or seem so at the time) over-relied upon and then using that to think you can neutralize risk through hedging things with complex derivatives.

    bender: Yep.

    Steve: That’s it, sub-prime, no real finanical or emotional ties to this free candy. Then the interest starts going up, and buckets of people can’t afford it any more. Like letting the repo man take your Mercedes back.

    Pat: If I remember correctly, the legislation that started this out began under Clinton in the early 90s during the tech bubble rampup. Deregulation of certain things just doesn’t work too well long term. Just proof that politicians by and large don’t understand economics.

    captdallas2: Yep, paradigm shifts and naive edge-skirters.

    Andrey: Reminds me of the days of the stock market with 10% margins and how that turned out.

    jim: Yep. Consensus! The herd mentality and the voices of those that do understand economics being drowned out by it.

    Kenneth: Look at every boom/bust cycle. I don’t know if there’s any analyzing any of this in detail. It’s rather a typical expected pattern. I trace it back to the fact that if it sounds good, folks go along with it, then complain when it goes kablooy. But it’s the fault of everyone at once.


    I know that gold is being pitched pretty heavily right now. A perfect time to stay out of it.

    For those wondering, adjusted for inflation compared to 2006, if you bought gold at $420 in 1910, you’ve done a little better than doubled your money in 2008 at $980 Not so great over 88 years. 🙂 Compare that to the DJIA in 1910 at 60 and 2008 at 11,870

    So if gold in 2008 is a 2006 adjusted $980, what are some other years?

    1970 $195 (good rise to now!)
    1980 $1567 (ouch you lost a lot of money!)

    Silver is perhaps more interesting; if you got it in 1930 it was $4. If you sold it in 1980, it was $38. That’s about 6X gold and 9.5X silver over the same period.

    Meaningless but interesting, just as corn in 1974 cost $3.50, adjusted for inflation to 2008 that’s almost $16. In fact on that basis, it was above the current $7 from 1974-1984

    You can also see oil is rather in a unique spot. In 1979 it was an April 2008 dollars $106 (from 1973-1985 it was $40 or above). In 2006 it was aabout $70. Now (May 2008) it’s $118. Quite a far cry from the usual price from about 1946-2002, hovering usually around $20

  78. Sam Urbinto
    Posted Sep 19, 2008 at 10:22 AM | Permalink

    Andrey: The specific legislation that more or less rather led to this now was itself from in the early 90s. Of course, the roots behind it both general and specific have many offshoots to many parties over many years in many areas.

  79. DeWitt Payne
    Posted Sep 19, 2008 at 10:37 AM | Permalink

    The Fed has a basic problem caused by th Humphrey-Hawkins Full Employment Act. Instead of just being responsible for maintaining the value of the dollar, they are also legally responsible for maintaining “full employment”. Those two tasks can be mutually exclusive.

  80. jim edwards
    Posted Sep 19, 2008 at 10:54 AM | Permalink

    #93, Steve:

    As a Canadian, you may not be privy to how our loan market has been operating down here.

    As an example, I applied for a refinance a few years ago. There was heavy telemarketing by mortgage brokers asking if owners wanted to refinance. These middlemen would ask how much you wanted to get out in ready funds, and what your current balance was – then they’d tell you what your home appraisal would have to come in at in order to qualify. I could pick my own appraiser or use theirs. The mortgage brokers always seemed to know somebody who could make the appraisal come in where it was needed. These appraisers are a key element of the meltdown. Independent appraisers get paid $300-400 per job, and those who cooperate with high appraisals are very popular with the mortgage brokers.

    I was a student at the time, so I had no substantial income, but my wife was very well paid as a public school teacher. When I told the mortgage broker what her income was, he was very surprised, but stated, ” We don’t need to put that down.” I asked why. He responded that he had paid a C.P.A. he knew to write a letter stating he had been doing my taxes for several years, and that he had put down on my loan documents that I was earning “$9000 per month as a consultant.” Lying on these mortgage documents is a federal crime.

    I fired him and went to Wells Fargo, a major consumer bank. Unlike the mortgage broker, Wells Fargo lends their own money out. Wells Fargo didn’t ask me to lie and didn’t give me a choice in appraisers. Wells Fargo has had some losses in this market, but they’re in very good shape.

    So, the two guys who had an auditing function for the securitized loans [the appraiser and the accountant] were apparently willing to turn a blind eye or even engage in fraud. Many American borrowers participated in these conspiracies to defraud and now claim they’ve been victimized by “predatory lending practices.”

  81. Sam Urbinto
    Posted Sep 19, 2008 at 11:15 AM | Permalink

    Rightous indignation?

    I would say that 90% of the time, those that complain about getting burnt are simply using a scapegoat to excuse something they themselves did.

  82. Steve McIntyre
    Posted Sep 19, 2008 at 1:53 PM | Permalink

    #105. “Laissez faire” and poor legislation are not the only two alternatives in the world. Ordinary people can’t determine whether Lehman Bros or AIG is solvent. If they want to speculate, then they should be entitled to do so, but the speculation should be clearly disclosed with warning labels all over it. As an individual investor, I expect “banks” to be “banks” and not derivatives speculators. If I want to invest in derivates speculations, then the fund should be entitled the “Lehman Bros Derivatives Speculation Limited PArtnership” or whatever, so that you know what you have. If Lehman or Bear had two hats, an ordinary brokerage business and a derivatives speculation business, then they should not be allowed to put the cash balances of ordinary investors at risk to fuel their speculations.

    I have much the same attitude to this as to climate – disclosure, disclosure, disclosure; due diligence, due diligence, due diligence.

    • bender
      Posted Sep 19, 2008 at 1:58 PM | Permalink

      Re: Steve McIntyre (#106),

      As an individual investor, I expect “banks” to be “banks” and not derivatives speculators.

      Spot the canuck. Sounds like the guy on the ING commercials.

    • jim edwards
      Posted Sep 19, 2008 at 3:06 PM | Permalink

      Re: Steve McIntyre (#106),

      If Lehman or Bear had two hats, an ordinary brokerage business and a derivatives speculation business, then they should not be allowed to put the cash balances of ordinary investors at risk to fuel their speculations.

      Agreed, but in a laissez faire system, you still have post facto law. What you’re describing is embezzlement and / or fraud against clients. It can happen as easily in a regulated industry as it can in a laissez faire system. One difference between the two is in a regulated system, people stop looking out for themselves because they assume the government is doing it for them [See Hurricane Katrina].

      We shouldn’t assume that consumers won’t be protected if regulators disappear, and businesses are no longer forced to uphold arbitrary a priori conditions. Even where consumers lack adequate information, many companies do well certifying measurement standards, and ISO or organic compliance of third party companies. Who should pay the cost of that certification ? Joe Taxpayer or the party who directly benefits from the information ? The SEC requires a baseline of financial disclosure, but if the SEC didn’t exist corporations would have to disclose their financials if they wanted to command a premium price for their shares. Many exchanges would likely demand it. Where money is at stake, market standards would likely evolve so certifying bodies would carry bonds or malpractice insurance in case of misleading appraisals.

      I don’t expect that I will sway you or anybody else that laissez faire is best, but rather that there’s no reason to believe it means less protection. That’s propaganda.

      Viva disclosure and due diligence.

  83. Michael Smith
    Posted Sep 19, 2008 at 2:50 PM | Permalink

    “Laissez faire” does not mean a license to mislead, mislabel, inadequately disclose or otherwise defraud — all of which should be illegal.

  84. steven mosher
    Posted Sep 20, 2008 at 2:01 AM | Permalink

    Well, time for some armchair philosophy. Steve’s question is really about consensus and how it goes awry, or rather how sometimes it fools smart people, or leads us astray. Let’s begin by understanding that we learn in two ways. We “learn” indirectly from others, and we learn from direct personal experience. We are social animals; we evolved as social animals. it has adaptive value.
    Monkey see; monkey do. One fellow learns to make fire; others watch him or are taught. They all dont have to reinvent the wheel. So in some way we are programmed to watch others, trust others, and do as they do. It has great survival value. The other day I stood on my friends 10th floor balcony.
    he said it was time to go, he was going to take the elevator down, but I suggest a faster route would just be to jump. “you’ll die moshpit” , “says who”, “says the laws of physics” “where did you learn that?” “in school” “from a teacher? in a book. thats an appeal to authority” “no its been tested” “not in this particular circumstance, with moshpit, I’m special” .we took the elevator.
    I decided against “questioning authority” Funny aside, one day a kid came into my class with a “question authority” tshirt. I asked him if he stopped at stop signs. a quizzical look came over his face. Learning from others, forming consensus, and conforming to their will has other values as well. It takes away uncertainty. Not in a statistical sense, but in an emotional sense. Few people have a high tolerance for living in a state of uncertainty. They want an answer even if it is a bad one. They
    also dont want to stand out from the crowd and be thrown out of the tribe. So for the most part we are bred to be somewhat compliant to the will and beliefs of others. Life outside the tribe, is nasty, short and brutal. But we also know that consensus is imperfect, like all adaptive strategies. The ghost dance, financial bubbles, incorrect scientific theories; history is littered with examples of the consensus being imperfect: sometimes with deadly consequences; othertimes not so deadly. Proper auditing can help us identify some cases where the consensus is suspect; the scientific method ( itself rather ill defined) can help us weed out other cases where the consensus is suspect, but in the end there is no canonical method for finding all the cases where the consensus is wrong. We’re fallible. So apply any method you like, there will always be cases that are undecidable. And since most loath uncertainty, they follow their genes and the herd.

    Now, I don’t believe in anything I haven’t personally witnessed or tested. so with the exception of SteveMC, Anthony watts, and jeez, none of you exist.

    man its late.

    • Kenneth Fritsch
      Posted Sep 20, 2008 at 2:29 AM | Permalink

      Re: steven mosher (#115),

      but in the end there is no canonical method for finding all the cases where the consensus is wrong. We’re fallible. So apply any method you like, there will always be cases that are undecidable. And since most loath uncertainty, they follow their genes and the herd.

      Sounds great. I think we need to take a vote on this in the morning – or at least a vote on voting on it.

  85. Andrey Levin
    Posted Sep 20, 2008 at 3:29 AM | Permalink


    In two words: the best insurance for unpredictable future is to live full life today.

  86. Steve McIntyre
    Posted Sep 20, 2008 at 6:43 AM | Permalink

    I’ve deleted a couple of comments moralizing about laissez faire for editorial reasons. I realize that this thread raises issues beyond climate, but IMHO this blog does better editorially when people stick to narrow issues, rather than using narrow issues to expound general philosophies. I’m interested in things like where specific regulations of the US mortgage market went awry or did not go awry, but I’m not interested editorially in general philosophisizing about the pros and cons of regulation.

    • Jonathan Schafer
      Posted Sep 20, 2008 at 8:11 AM | Permalink

      Re: Steve McIntyre (#117),

      Sorry Steve, it’s easy to get carried away.

      Specifically, the roots of this begin back in the Clinton administration, when the Community Reinvestment Act came up for renewal. The Clinton administration pushed to expand the scope dramatically, and they essentially began a shakedown of the major banks to provide housing loans to people who traditionally would have been renting rather than owning.

      Here’s a good article about it. This was essentially the beginning of the sub-prime market and the securitization of sub-prime mortgages as cdo’s.

      The following is from another article, not the one mentioned above.

      The Clinton Administration’s regulatory revisions [1] with an effective starting date of January 31, 1995 were credited with substantially increasing the number and aggregate amount of loans to small businesses and to low- and moderate-income borrowers for home loans. Part of the increase in home loans was due to increased efficiency and the genesis of lenders, like Countrywide, that do not mitigate loan risk with savings deposits as do traditional banks using the new subprime authorization. This is known as the secondary market for mortgage loans. The revisions allowed the securitization of CRA loans containing subprime mortgages. The first public securitization of CRA loans started in 1997 by Bear Stearns. [2] The number of CRA mortgage loans increased by 39 percent between 1993 and 1998, while other loans increased by only 17 percent. [3] [4] In short, the federal government began forcing banks to make subprime loans to people who couldn’t afford them.

      Fanny and Freddie also underwent a change in philosphy which had no basis in rules/regulations changes

      Fannie and Freddie dominate the mortgage market, but they don’t originate home loans. Instead, they make their money in two major ways. One is conservative: They get a fee for guaranteeing the payments on mortgages they buy, which they then resell to investors, usually in the form of mortgage-backed securities. The more aggressive way is to hold on to the mortgages, assume all the inherent risk, and make money on the spread between their low cost of capital and the higher yield of the mortgage portfolio. (Alan Greenspan would later call this “the big, fat gap.”) The more mortgages the GSEs buy, the faster their profits can grow. Since 1995, Fannie and Freddie’s holdings of residential debt have grown an average of 20% a year, and together they now carry $1.5 trillion in home loans and mortgage securities on their books–more than the top ten commercial banks combined. Thanks in large part to this growth, Fannie has had double-digit profit gains for the last 17 years–and an average return on equity of 25%. But the GSEs’ size has people increasingly worried about what might happen if anything went wrong–and not just to Fannie and Freddie but to the entire financial system.

      Their original revenue stream was solely on the spread between what they sold the CDO’s for and what they got the money from the treasury at. But when they started holding onto mortgages themselves to keep the spread, that was a turning point for the financial industry. In the 90’s, they also opened the floodgates of their political efforts, plying politicians and other organizations with over $500 million in contributions, and hiring a lot of political insiders into their “partnership offices”. See store here.

      Beyond this, it is clear that hedge funds and other investment banks wanted in on the game and used a variety of investment vehicles, derivatives, and cheap, short term-debt in hopes that interest rates stay low. They provided money where Fannie nad Freddy couldn’t…The adjustable rate market. There has been a lot of “innovation” in the mortgage industry, including interest only loans and super-low “teaser” ARMs. With the fed holding down interest rates, people began using the cheap money to buy more house than they could afford, thinking that with housing prices skyrocketing, they would be able to sell after only paying interest for a year or two, and make a lot of money. But all those loans were packaged with much higher rated loans and sold as investment grade cdo’s. And as interest rates started to rise, and the teaser rates on the arms gave way to reality, foreclosures started to increase, dropping the value of the cdo’s.

      As I posted yesterday, in come the credit default swaps as a hedge against the cdo investments, which started a capital drain as issues of cds’ had to start paying out. A lot of the big investment banks had a lot of money tied up in cds’, as well as cdo’s. I don’t know that there were any rules/regulations broken in this area. I think these businesses just bet the wrong way. And in some cases, it cost them everything, or the taxpayers at least.

  87. Steve McIntyre
    Posted Sep 20, 2008 at 9:30 AM | Permalink


  88. steven mosher
    Posted Sep 20, 2008 at 9:46 AM | Permalink

    re 115. No even voting gets it wrong. My observation is that no method will eliminate all the cases of a wrong consensus. there will alway be undecidables. In those cases most people “vote” or follow the herd. Me, I dont mind living in uncertainty. See 116

    • Kenneth Fritsch
      Posted Sep 20, 2008 at 12:29 PM | Permalink

      Re: steven mosher (#120),

      I am surprised that you, of all people, seemingly did not get my point – which is the same as you give in the post linked above.

      How about a show of hands by experts in lieu of an objective means to determine the level of uncertainty in a projection/prediction? And who were the experts in the home mortgage meltdown and how were they showing their hands? Who should they have been and how would we identify them?

  89. steven mosher
    Posted Sep 20, 2008 at 9:58 AM | Permalink

    re 116 Yes. Today is last day of your life. You won’t get a second chance at today. So if I died today, they would write, he died posting to climate audit. It’s what he lived for. Is it any different for the war hero, who dies in battle. It’s what he lived for. Not an original thought of mine, but one expressed very well by my old Mentor William A Earle.


  90. Steve McIntyre
    Posted Sep 20, 2008 at 12:37 PM | Permalink

    Warren Buffett seems to have got it right. He counts as an expert for me.

    • Kenneth Fritsch
      Posted Sep 20, 2008 at 6:40 PM | Permalink

      Re: Steve McIntyre (#123),

      Warren Buffett seems to have got it right. He counts as an expert for me.

      While Buffett seems to get it right on investments and running businesses almost all of the time and I would also select him as an uber-expert in those areas, there are other areas that I would not value his judgment.

      Unfortunately when it came to a show of hands in his area of expertise he has only one hand to raise (he has been shown to be too honest to raise both) so how would we handle the consensus tally? Would we give his judgment a weighting equal to the dollars, or perhaps in the Euros that he so wisely purchased many months ago, that he has earned for his shareholders and himself? If we find the proper method for weighting Buffett’s judgment in those areas how would we apply an anologous weighting to climate scientists when it comes time for them to provide a show of hands for a consensus?

  91. stan
    Posted Sep 20, 2008 at 1:32 PM | Permalink

    30-1 leverage on assets whose riskiness was badly underestimated. http://www.redstate.com/diaries/redstate/2008/sep/20/the-root-causes-of-the-financial-crisis/

    I would love to know the name of the really, really “smart” Wall Street type who came up with the brilliant idea years ago that lending to third world countries was risk free because countries can’t go broke. [No, but they can default.] I’d love to know the name of the really, really “smart” Wall Streeter who came up with the idea that subprime junk could be magically turned into investment grade paper by repacking, slicing and dicing it. I’d love to know the name of the “genius” who used models to predict that so many of the trading days in August of 2007 were each nearly impossible (one in ten million) events.

    I’ll bet each one was a high IQ individual with an Ivy League education and multiple graduate degrees whose hubris led him to be far more certain in his analysis than he should have been. I know that lots of the other Wall Street types who listened to them were.

    I think the hockey team would be very comfortable working with the computer geeks whose modeling magic sliced and diced subprime junk into investment grade paper.

    Hubris, hubris, hubris.

  92. M. Jeff
    Posted Sep 20, 2008 at 2:36 PM | Permalink

    The WSJ may have been prescient. Opinion from February 20, 2002:
    Fannie Mae Enron?

  93. stan
    Posted Sep 20, 2008 at 5:37 PM | Permalink

    (114) Steven Mosher,

    The connection b/w Wall Street “consensus” problems and science “consensus” on e.g. AGW, is that in every case, the consensus was a revolutionary new one which quickly overturned traditional conventional wisdom. And turned out to be wrong. Originally, everyone knew subprime debt was not investment grade. Someone comes up with a fancy computer model and an “innovative” new legal structure and in short order the consensus changed radically. Oops. Same thing for lending to third world countries or program trading which assumed that severe market drops couldn’t happen. Oops, new consensus very wrong, should have stayed with the old one.

    Same thing for the hockey stick. Everyone knew that the MWP was historical fact. Enter the hockey stick and climate scientists, with a breathtaking lack of curiosity, adopted a drastic new consensus. The interesting question is what common parallels can be found in these situations where people are so willing to abandon traditional wisdom for a revolutionary new assertion. A couple of obvious ones to start:

    1) Hubris. Far too much certainty in someone’s number-crunching and the believers’ intellect. The problem of being too clever by half. Aren’t we really, really smart?!

    2) Self-interest. Adopting the new idea paid big bucks for the believers.

  94. Harry Eagar
    Posted Sep 20, 2008 at 8:51 PM | Permalink

    ‘ If Lehman or Bear had two hats, an ordinary brokerage business and a derivatives speculation business, then they should not be allowed to put the cash balances of ordinary investors at risk to fuel their speculations.’

    That, or something very like it, was the inspiration for the Glass-Steagall Act.

    There’s a reason there wasn’t a crash between 1936 and now.

    The Ludwig von Mises crowd can moan all they want, but the people going down the tubes now begged for the right to go down it. Very modest New Deal regulation actually worked, was dismantled by people who had an ideological, not logical, objection to it, and we see the result.

    The idea that the CRA is behind the crash — i.e., that the poor people in the United States secretly transferred trillions of dollars of wealth from the rich people — is so silly that it is hard to believe otherwise smart people fall for it.

    • jim edwards
      Posted Sep 21, 2008 at 11:32 AM | Permalink

      Re: Harry Eagar (#128), and 133:

      Just because capitalism was able to sustain extraordinary economic growth IN SPITE OF unnecessary economic regulation does not mean market stability is a RESULT OF New Deal-style regulation.

      If there’s one place I’d expect people to think about the difference between correlation and causation, it’s Climate Audit.

      CO2 has increased; so have some temperature records. Does that mean that our entire economy needs to be retooled according to the plans of Al Gore and Jim Hansen ? Maybe so, maybe not – but not on the basis of that evidence, alone. Things like climate and the economy are a little more complex than our various party leaders would have us believe.

      The U.S. has a long history of occasional economic downturns since 1800. Many of these have been after a long war, and virtually ALL of them have been caused by bad monetary policy on the part of the federal government. [This includes the Great Depression.] Capitalism hasn’t caused any of them.

      I, for one, have more faith in 300 million people making day-to-day decisions tailored to their informed interests than I do in a few commissars in Washington D.C. deciding what they believe is in the majority’s [not everybody’s] interests and what actions people should be allowed to take.

  95. Steve McIntyre
    Posted Sep 20, 2008 at 8:55 PM | Permalink

    Sitting across the border, it seems like an unholy alliance of dergulating things that ought to be regulated e.g. liquidity ratios and poor regulations e.g. legislated no recourse debt.

    In penny stocks, promoter’s stock is escrowed usually up to 5 years. Looks to me like Fuld’s bonuses should have been escrowed.

  96. jeez
    Posted Sep 20, 2008 at 9:29 PM | Permalink

    Some of the regulations that were in place should have helped to stem the tide but were circumvented. Fannie Mae and Freddie Mac were only supposed to cover conforming loans, ie loans with a least 20% down with a total value originally capped at, I believe, 380K for most of the period, although it was raised after that. It is now currently 417K for a single family loan.

    Borrowers who put down 20% are far far far far far less likely to default than no money downers, and this would have stabilized the system, at least somewhat.

    Mortgage brokers somehow became credit issuers and would arrange for an addition loan to use as the down payment, often at credit card rates. Then somehow this mortgage was sold upstream as a conforming loan. In my opinion, this was major fraud being committed. This is where people should be going to jail, many of them.

    If these no money down loans had no one upstream to offload to, the practice would have quickly ended and helped prevent the poor quality assets from getting packages into CDOs and CMOs.

    The Alt A nightmare has yet to really hit. In this case, after the loan limits got raised, upper middle and upper class buyers would put their money down, and have conforming loans which could be sold upstream, then they took out the entire equity of the down payment or more as an equity loan (we don’t call them second mortgages anymore), and bought their Lexuses, boats, and second homes. Of course as with subprime, most with ARM, exploding mortgages.

    The bailout will be interesting, according to my sources we are about one-third of the way through the write-downs, and the Fed is already talking about a 700 billion dollar bailout. Wait till that balloons to 2 trillion.

    Which leads us to this new mantra:

    Socialized medicine=BAD, Socialized finance=GOOD?

  97. steven mosher
    Posted Sep 20, 2008 at 10:42 PM | Permalink

    RE 122. When it comes to money matters I dont watch the experts. I watch for STUPID money.
    When I saw stupid people buying houses, I knew it was gunna be bad. same with the stock market, back in the days at the top of the bubble I had one particular stupid guy call me and say he was
    taking out a second line on his house to invest in the market. I cashed out and put it into real estate. and then cashed out of that, when stupid money came in.

    So, I watch for STUPID money. Simply put, in my experience stupid money coming in is a clear sell signal.

    • Posted Sep 21, 2008 at 5:29 AM | Permalink

      Re: steven mosher (#131), I have noted the stupidity index myself. If only Moody and the other raters included the percent stupidity when they evaluate companies.

  98. Andrey Levin
    Posted Sep 20, 2008 at 11:35 PM | Permalink

    Jeez, you forget that subprime mortgages represent only fraction of mortgage-backed securities, and only fraction of subprime mortgages will foreclose, and only fraction of foreclosed home’s value will be destroyed.

    If unwinded in properly manner, in couple of years owners of CDO and CMO (US government?) will return 90 cents from dollar. The damage will be not in trillions.

    • jeez
      Posted Sep 21, 2008 at 2:13 AM | Permalink

      Re: Andrey Levin (#132),

      At leverages of 30 to 1 or more, a 10% loss in underlying value is not a 10% loss. We are 1/3 of the way through the write downs.

  99. Harry Eagar
    Posted Sep 21, 2008 at 12:11 AM | Permalink

    That’s assuming there is no crash. A shaky assumption.

    In the Great Depression, many solvent businesses failed for lack of access to money. The New Deal put government in as a backstop in a liquidity crisis.

    Worked great for 70 years. It is not obvious that it will work in 2008.

    If the dollar deflates, it will take a loooong time to come back.

    I realize this sounds like the kind of tipping point argument that, eg, Al Gore makes. So it is. It is just better backgrounded historically than his tipping point scenario.

  100. Andrey Levin
    Posted Sep 21, 2008 at 2:40 AM | Permalink

    Re: Geez

    It is paper losses: some loose, some gain, and for US capital market as a whole losses and gains mostly cancel each other. Plus some losses are outsourced for foreign holders.

    Real losses are from rotting empty homes, slowdown economy from lack of capital and low consumer confidence, and investments idling in unused houses and factories, will be in hundreds of billions, not trillions.

    The real danger, as rightfully pointed out by Harry Eagar, is snowball economy crash due to disruption of financial system. That’s why extraordinary efforts of federal government to keep capital flowing and insurance (AIG) valid are justified.

  101. jeez
    Posted Sep 21, 2008 at 3:31 AM | Permalink

    I agree, except for the magnitude in the financial markets.

    We have had 350 billion in write downs–700 billion bailout proposed.

    There’s another 600 billion in write downs to come–bailout number? 1 trillion? 2?

    The collapse of the capital markets is already seizing up business activity like you cannot imagine. Banks have no money to lend. I reluctantly agree that bailouts are necessary to keep business functioning. I just wish some (many) people were going to jail or having every asset down to their tooth brush confiscated instead of living a life of luxury.

    • Michael Smith
      Posted Sep 21, 2008 at 11:07 AM | Permalink

      Re: jeez (#136),

      We have had 350 billion in write downs–700 billion bailout proposed.

      There’s another 600 billion in write downs to come–bailout number? 1 trillion? 2?

      But bear in mind that these “losses” and “write-downs” don’t mean that 600 billion dollars has disappeared from the economy, as if it were placed in one large pile and burned. In fact, if every one of these firms were allowed to go bankrupt, not a single dollar would disappear from the economy. Total spending in the economy wouldn’t change a bit — it would just be spent by different people and perhaps for different things.

      For instance, right now money is being transferred into AIG by its shareholders (whenever initial or new shares are issued), by its creditors (whenever loans are made or credit extended) and by its customers (in the form of insurance premiums) and is being spent by AIG management on salaries for employees, claims from customers, supplies, etc. Now, the current spending by managment apparently exceeds the current rate of transfers in — which cannot continue indefinitely and is why they need to go bankrupt.

      So what happens when the firm goes bankrupt? The transfers in are stopped and managment can no longer spend the money. But no dollar bills are burned up. Instead, those who were previously transferring money into the company — the shareholders, creditors and customers — will now spend that money on something else. Total dollars in existence doesn’t change, and neither does total spending.

      Except for the very tiny amount of money that gets hoarded — you know, actually put under someone’s mattress — all money gets spent. Even money sitting in a passbook savings account is spent by the bank — generally, its invested in something, so it does get spent. So whenever money ceases to be spent by one individual — such as the poor fellow who loses his job when AIG goes under — you can always find that money being spent somewhere else — in the case of AIG, it will be spent by those who use to give it to AIG.

      This is why all the “ripple effect” and “melt down” scenarios are generally bogus. They focus on the loss of “employee spending power” that results, for example, from laying off thousands of employees. This loss — so the claim goes — means that all the businesses where the employees used to spend their money will be forced to layoff people, resulting in still more loss of “spending power”, etc, until we have a “melt down”.

      But what they ignore is that every dollar lost in “employee spending power” from a bankruptcy means a dollar increase in the “spending power” of those who were previously transferring money into the bankrupt company. So any “loss in demand” in one area is balanced out by a corresponding “increase in demand” in whatever area the new spenders of the money choose to spend it. And loss in employment in one area is balanced by an increase in employment in another area.

      So, yes, there can be dislocations as demand shifts from one area to another — but the notion that there is an inevitable, negative “ripple effect” is false.

      No, these large dollar figures simply mean that due to bad decisions, a great deal of money was transferred to people who will never pay it back. (Or, in AIG’s case, as I understand it, they underestimated the risks and issued more insurance than they can now provide.) And to replace that money, the firms that made these bad decisions want to see the government enact another transfer — from your pocket to theirs.

      Of course, to make the transfer difficult to see, it won’t be done directly. It will be done by having the Federal Reserve create new paper money — which will, over time, devalue your money proportionally. So you will pay — in the form of higher prices for all manner of goods — and the firms that made the bad decisions will get away with doing so, so that they can make more bad decisions in the future.

      Those who are buying into the “too big to fail” and “melt-down” scenarios if these guys are allowed to go under really should read, “Economics in One Lesson” by Henry Hazlitt. It’s a very easy read, with little math or statistics — just a lot of common sense and logic anyone can follow.

  102. Andrey Levin
    Posted Sep 21, 2008 at 4:34 AM | Permalink


    There is one clear indicator of damage caused by housing and financial crisis: GDP growth. It is down to about 0.5% instead of natural 2.5% for last half year. It is about 150B losses to real economy. It will probably last another three quarters, and then about 1/3 of losses will rebound as delayed consumption. Total losses to economy – less than 300B.

    I know, it is very optimistic scenario…

  103. Phillip Bratby
    Posted Sep 21, 2008 at 7:06 AM | Permalink

    Christopher Booker comments as follows in his article in the Sunday Telegraph. It can be read at http://www.telegraph.co.uk/opinion/main.jhtml?xml=/opinion/2008/09/21/do2105.xml

    Financial crisis: Lehman misses out on carbon credit scam

    What is the connection between the bankrupt Lehman Brothers and the likelihood that in four years’ time our electricity bills will jump another 25 per cent (on top of the rises likely from soaring coal and gas prices)?

    The answer is that, before its collapse, Lehman was pitching to become the leader in the vast trade created by the new worldwide regulatory system to “fight climate change” by curbing emissions of carbon dioxide.

    The biggest money-spinners will be the schemes whereby industry will pay for permits to emit CO2 at so much a ton, either directly to governments or by buying them on an international market.

    This market, soon to be worth trillions of pounds, was where Lehman hoped to be “the prime brokerage for emissions permits”, as it set out in two hefty reports on “The Business of Climate Change”.

    Advised by some of the world’s leading global warming activists, such as Dr James Hansen and Al Gore (a close friend of the firm’s erstwhile managing director Theodore Roosevelt IV), Lehman bought their message wholesale. GIM, the company set up by Gore to sell “carbon offsets” in return for planting trees, was a prized Lehman client.

    The particular market that Lehman hoped to dominate is centred on the buying and selling of carbon permits, through the EU’s Emissions Trading Scheme (ETS) set up in 2005, the UN’s Clean Development Mechanism (CDM) and the “cap and trade” system proposed for the US by both McCain and Obama.

    This may still seem abstract but it will affect all our lives, because ultimately we will all be paying for it, through the colossal costs it will impose on industry, not least electricity.

    The EU scheme already adds more than a billion pounds a year to our electricity bills. In four years’ time it will become much more obvious when, under phase two of the ETS, permits will be auctioned, at a projected initial figure of £35 per ton of CO2.

    On the basis of current wholesale prices, the annual cost of electricity used in the UK alone is around £32 billion. Adding £35 for every ton of CO2 emitted in producing it will mean that our electricity supply companies will have to pay £8 billion for their permits, adding 25 per cent to the total cost. Under EU rules, this must be passed on to all of us in our bills.

    The idea is that, to reduce carbon emissions by an eventual 60 per cent, the number of permits auctioned will reduce year by year, leaving an ever larger shortfall which firms will have to account for either by reducing emissions or by buying additional permits – not least from the developing world under the UN’s CDM.

    Everything about this grandiose scheme betokens the economics of the madhouse.

    The new costs it will impose are so colossal that whole industries, including aluminium, steel and Germany’s chemical companies, threaten to move their operations outside the EU unless they are given free allocations. It has not even been agreed who – whether national governments or the EU itself – will run the auctions or keep the hundreds of billions of euros a year the scheme will raise.

    China, by virtue of having built giant dams to produce electricity, will be a net “carbon creditor”, able to sell permits to the EU worth billions more, despite continuing to build a new coal-fired power station every four days.

    So will Russia, thanks to it having closed down so much of its polluting industry after the fall of Communism. There is not the slightest indication that the scheme itself will result in any lowering of global CO2 emissions.

    What is certain is that it will pile astronomic costs onto everyone in the EU, inevitably impacting most severely on poorer householders that will face bills they cannot afford. The only other certainty – perhaps a consolation – is that those sharing in this bonanza will not include Lehman Brothers, now excluded from cashing in on what threatens to become the maddest scam the world has ever seen.

    • Reference
      Posted Sep 28, 2008 at 5:20 AM | Permalink

      Re: Phillip Bratby (#139),

      At the bottom of this week’s column titled “Carbon capture is not yet here” Christopher Booker writes the following correction:-

      I have been asked by Generation Investment Management, the company set up by Al Gore, to correct a statement in last week’s column. Although Mr Gore is a friend of the erstwhile managing director of Lehman Brothers, GIM has never (as was reported elsewhere) been a “client of Lehman Brothers and has no direct links with the bank at all”.

  104. PhilH
    Posted Sep 21, 2008 at 8:03 AM | Permalink

    Here’s an explanation of the sub-prime market and what happened to it. http://www.nyrealestatelawblog.com/2008/02/a_subprime_cartoon_strip.html
    It takes a minute to load but it’s worth it.

  105. Steve McIntyre
    Posted Sep 21, 2008 at 8:27 AM | Permalink

    #140. It’s sort of like Team proxy studies – with the multiproxy guys in the role of the investment banks and the NSF being like the Accounting regulators.

    • jeez
      Posted Sep 21, 2008 at 12:13 PM | Permalink

      Re: Steve McIntyre (#141),

      Steve if you do an audit of all the comments above, you will find in comment 71, the original jester who linked to the subprime primer.

      Sigh, nobody takes me seriously. ~ a rather beaten down and despondent jeez.

      PS. I know moshpit is the funny one, but looks aren’t everything.

      • PhilH
        Posted Sep 22, 2008 at 12:46 PM | Permalink

        Re: jeez (#148), Jeez, jeez, I’m sorry. Didn’t mean to step on you.

  106. M. Jeff
    Posted Sep 21, 2008 at 9:06 AM | Permalink

    The Alt A nightmare has yet to really hit.

    Are you sure? Can it get any worse than this?

    WSJ, September 20, 2008
    As Times Turn Tough, New York’s Wealthy Economize
    Plastic Surgeons, Jewelers, Yacht Builders Brace for Leaner Times; Saying No to Caviar

    … a New York retail manager, planned to treat herself to a facelift by cashing in $15,000 in stocks. But … …she realized their stock portfolio had taken such a hit that it was out of the question. … …Her consolation: a $1,200 Botox treatment she had this week instead. …

  107. jim edwards
    Posted Sep 21, 2008 at 11:06 AM | Permalink

    Real estate appraisal / valuation techniques could use a good statistical going-over. This entire meltdown would have been avoided if we had a better process for assigning value to real estate. Consider that various commissions and closing costs add up to ~10% of the price of a house; many of the worst loans would probably never have proceeded if there hadn’t been an unrealistic expectation that homes would undergo extraordinary increases in value. That unrealistic expectation is built on our crazy method of assigning value to real estate.

    Imagine a town has 1000 homes each with a value of $200k. If one sells for $220k, our current system assigns a value of roughly $220k to all of them. Put another way, an extra $2-4k of upfront money, plus an extra $16-18k in borrowed money, leverages an increase in market valuation of $20 million.

    We allow very small samples to drive extraordinary volatility. At least in the stock market, people are accustomed to looking at the fraction of completely fungible shares that are driving price swings.

    Combine this with Steven Mosher’s “STUPID money” [#131] and there is a recipe for disaster. A few STUPID buyers can dramatically affect the market valuation of a community.

    Unfortunately, a number of entrenched interests love the current system.

    Politicians and tax assessors have traditionally loved this system, as it allows them to increase taxes on long-time residents. This is why Proposition 13 passed in California 30+ years ago. People who bought houses for $20k were being asked to pay taxes as if they had bought their house for $80k – because a single STUPID buyer was willing to pay $80k for a house a kilometer away. [Today, Prop 13 is under attack in Calif. because “it’s unfair” that people who choose to pay more for their homes pay more tax than their neighbors who elected to buy when the price was lower.]

    Real estate agents, whether working for the buyer or seller, make higher commissions if a higher sales price can be justified.

    Mortgage brokers, who don’t have to live with the consequences of an overvaluation, make more money on bigger loans. It costs less to make a loan for $100k than it does to make two loans for $50k, each.

    Appraisers, of course, make their living off of it.

  108. Steve McIntyre
    Posted Sep 21, 2008 at 12:05 PM | Permalink

    #145. I have my own views on what caused the severity of the Great Depression, which I might discuss some day.

  109. stan
    Posted Sep 21, 2008 at 12:11 PM | Permalink

    As Amity Schlaes (sp?) showed in “The Forgotten Man”, the New Deal deepened and extended the Depression. FDR made it far worse than it needed to be (e.g. destroying food while people were hungry in a bizarre effort to prop up food prices). The idea that the New Deal made things better is just contrary to the facts. It wasn’t until FDR shifted to advisors who rejected the socialist ideology of his New Dealers that things belatedly started getting better.

  110. Steve McIntyre
    Posted Sep 21, 2008 at 12:30 PM | Permalink

    #148. My apologies. I read the thread a little later in the day. I thought that the attitude of the Czar of subprime accounting was pretty much the same as that of Team climate science.

  111. steven mosher
    Posted Sep 21, 2008 at 1:36 PM | Permalink

    re150, I’ve worn my self out trying to teach him how to set up a joke

  112. jeez
    Posted Sep 21, 2008 at 1:42 PM | Permalink


  113. Sam Urbinto
    Posted Sep 22, 2008 at 10:00 AM | Permalink

    A lot of folks are talking about the huge gains in gold recently. This means to me, it’s time to not buy gold. Things run on emotion, or perhaps it’s better to say optimism and pessimism. Kinda like what mosh said about stupidmoney. If you’re spending $100 a month on stock in a healthy company at $2 a share and the price falls it $1, it’s time to start putting more into the company to buy more shares. 🙂

    For those curious, inflation adjusted gold (to 2007 prices). It has been at about $250-500 an ounce since 1913. If you bought some in 1977 and sold it in 1980, you did very well — $250 to $2145. Don’t forgot opportunity costs.

    If you bought it at the peak of the frenzy in 1980, you’ve gone from that $2145 to $733 (sep 2007)….

    Sometimes if you run with the herd, you end up going over the cliff into the ocean.

  114. Posted Sep 22, 2008 at 3:08 PM | Permalink

    we are grateful to Dr. James Hansen, Director of the NASA Goddard Institute for Space Studies, who, at the end of a particularly informative dinner hosted by Ben Cotton of the Man Group, gave generously of his time to clear up a number of scientific questions that had been niggling us.

    Was Hansen’s generosity repaid with a generous speaker’s honorarium?

    I knew Lehman was toxic, but not so far. I tried the Report link, it froze my PC.

    Did it mention Carbon Derivatives? It is one of the markets Lehman wanted to play with.

  115. Posted Sep 23, 2008 at 12:22 AM | Permalink

    This thread is about sociological things, a bit. So I recommend you an excellent 35-page text by Richard Lindzen about the disturbing state of sociology of climate science:


  116. James Erlandson
    Posted Sep 24, 2008 at 5:20 PM | Permalink

    From the WSJ Crisis on Wall Street blog:
    Schumer: Senate Has ‘Consensus’ on Need for Bailout Bill

    Sen. Charles Schumer (D., N.Y.) said Wednesday a consensus exists in the Senate “that we have to do something” by passing a financial-rescue package, even though most members don’t like the Treasury Department’s proposal and want it changed.

    Consensus got us into this mess and consensus will get us out.

  117. Posted Sep 27, 2008 at 7:27 PM | Permalink

    Hey Steve Mosher!

    This is an article I wrote on the Stupidity Index. Steve Mac you snip at will just let Mosh see it to give me a review. Actually, You might enjoy the hockey stick graph link in the article.

  118. Posted Sep 9, 2009 at 9:41 AM | Permalink

    “I think that the failures of Enron and WorldCom and other companies are partially failures of investors to recognize companies that are selling for a thousand times nothing, but chances are they may be worth only that.”

7 Trackbacks

  1. By Interessante « BLASFÉMIAS on Sep 17, 2008 at 9:43 AM

    […] por JoaoMiranda em 17 Setembro, 2008 Lehman Bros. and Consensus por Steve […]

  2. […] However, today this interesting post from Steve McIntyre of Climate Audit.org caught my attention, combining to two main political themes of the day,  ‘Climate Change’ and the present economic problems, showing that nothing is unconnected in money and politics. Enjoy. It is also worth visiting the site to read the insightful comments. […]

  3. […] Bros. and Consensus by Steve McIntyre Climate Audit 17 September, […]

  4. […] not quite accurate but it has some true core, see the fast comments. More details at IceCap.US and ClimateAudit.ORG. Post Feed: Lehman Brothers (1850-2008) – Lubos Motl Read […]

  5. By Say My Name « Climate Audit on Feb 6, 2010 at 4:01 PM

    […] James Hansen, presumably exhausted from answering “niggling questions” at a gala Lehman Bros dinner tells the film-maker: I’m not going to use McIntyre’s […]

  6. By Get Yer IOP Porkies here! « The Policy Lass on Mar 2, 2010 at 11:29 PM

    […] a post from CA: My interest in climate change derived in part from experience in the stock market where […]

  7. […] https://climateaudit.org/2008/09/17/lehman-bros-and-consensus/ […]

%d bloggers like this: