Center for Business and Economic Research - Ball State University


CBER Data Center
Projects and PublicationsEconomic IndicatorsWeekly CommentaryCommunity Asset InventoryManufacturing Scorecard

About

Commentaries are published weekly and distributed through the Indianapolis Business Journal and many other print and online publications. Disclaimer

RSS Feed

Disclaimer

The views expressed in these commentaries do not reflect those of Ball State University or the Center for Business and Economic Research.

Recent

Trump’s Tariff Recession Is HereMy new forecast, completed in late April, predicts a national recession began as early as March in reaction to Trump’s tarriffs.

Two Key Economic Lessons in One BillHoosiers face trade-offs and opportunity costs in the wake of SEA1.

Time to Fix Economic Development PolicyAllocating tax dollars to land development won’t cause economic growth.

The Unanticipated Effects of SB1Businesses, governments and households may all feel the effects.

View archives

Top Tags

jobs and employment 261
economics 201
state and local government 188
education 186
indiana 171
economic development 171
budget and spending 145
taxes 144
law and public policy 142
workforce and human capital 139
Browse all tags
Reporter / Admin Login

September 22, 2008

Bad Loans Soured Lehman Brothers' Soup

The collapse of Lehman Brothers and the widespread stock sell-off it engendered is a bit scary. It shows those of us on Main Street that more than a year after the sub-prime mess became daily news, significant and sophisticated financiers still grapple with the effect on their firms. They are now far less significant and sophisticated than they once believed. 

I am still uncertain as to how this will end. The US and world economy will emerge stronger, more vibrant and empowered with better risk assessment tools than it is today. Sadly, it is very possible that the road to this ending will include a significantly slowing economy. This will depend upon how many more firms will follow Lehman into financial history.

It is easy, and more than a bit tempting to attribute this crisis to greed. That won’t do. Ignorance is a far better explanation. It requires less coordination between actors and there is far more empirical support for ignorance. Occam’s razor still works. Here’s how we got here.

When the sub-prime mess began I envisioned a smart young mathematician working in a financial engineering department of a Wall Street firm. He’d been engaged in risk analysis using historical data on a variety of loans. These included mortgages (always safe) small business loans and a host of others with straightforward and nearly constant default rates. Imagine that this young mathematician spent hours each day feeding these data into his models, applying statistical tests to the output and carefully ensuring that he could observe the regularity of Brownian motion. (Kinda makes you want to study finance doesn’t it?).

From this data on loan history he carefully blends each to match risk and return. The soup created from this exercise is then sold to other banks to provide a ready stream of income for their investment banking needs.

Then he arises from his labors, heads to the company canteen and chats with his co-workers about the 80/20 mortgage he just got on a nice house in Brooklyn. Oblivious is he to the possibility that his loan style might have a different default rate than the historical mortgage data he uses to manage risk. This isn’t greed, it is ignorance. I won’t be the first to argue that Wall Street will be looking for more polymaths rather than just mathematicians in years to come.

Fast forward to today. From our mathematician’s soup of risk, dozens of ingredients soured. This has caused untold numbers of analysts to carefully pick bad loans from the soup– though most of the soup was tossed, becoming valueless as an exchangeable asset. Lehman Brothers owned much of these. Yet over the past year claimed it didn’t require additional assets. It is just like a restaurant, which has thrown away its soup insisting it would still have a lunch for its patrons.

My biggest fear remains knee-jerk Federal regulation. We cannot control ignorance (or greed) with regulation. Only knowledge born of the pain that Wall Street now feels will fix the soup.

Link to this commentary: https://commentaries.cberdata.org/95/bad-loans-soured-lehman-brothers-soup

Tags: finance


About the Author

Michael Hicks cberdirector@bsu.edu

Michael J. Hicks, PhD, is the director of the Center for Business and Economic Research and the George and Frances Ball distinguished professor of economics in the Miller College of Business at Ball State University. Note: The views expressed here are solely those of the author, and do not represent those of funders, associations, any entity of Ball State University, or its governing body.

© Center for Business and Economic Research, Ball State University

About Ball State CBER Data Center

Ball State CBER Data Center is one-stop shop for economic data including demographics, education, health, and social capital. Our easy-to-use, visual web tools offer data collection and analysis for grant writers, economic developers, policy makers, and the general public.

Ball State CBER Data Center (cberdata.org) is a product of the Center for Business and Economic Research at Ball State University. CBER's mission is to conduct relevant and timely public policy research on a wide range of economic issues affecting the state and nation. Learn more.

Terms of Service

Center for Business and Economic Research

Ball State University • Whitinger Business Building, room 149
2000 W. University Ave.
Muncie, IN 47306-0360
Phone:
765-285-5926
Email:
cber@bsu.edu
Website:
www.bsu.edu/cber
Facebook:
www.facebook.com/BallStateCBER
Twitter:
www.twitter.com/BallStateCBER
Close