TAVAKOLI vs. JORION. The Subprime Crisis: an orchestrated or spontaneous Ponzi Process?

September 6th, 2011 by Paul Jorion | Print TAVAKOLI vs. JORION. The Subprime Crisis: an orchestrated or spontaneous Ponzi Process?

A translation by Bénédicte of my post of September 3rd: TAVAKOLI vs. JORION. LA CRISE DES SUBPRIMES : PYRAMIDE ORCHESTRÉE OU SPONTANÉE ?

You will find in my “La crise du capitalisme américain” (The Crisis of American Capitalism) (La Découverte 2007; Le Croquant 2009), written between November 2004 and October 2005, a chapter describing the dynamics of the crisis which was then underway. This chapter is entitled: “The price of shares and houses: financial bubbles” (pages 195 to 220) and it contains a section entitled: “The financial bubble as a ‘naturally occurring Ponzi process’”. The phrase was not mine: it was borrowed by me, as I explain it there, from Robert J. Shiller, who introduced it in his book Irrational Exuberance (New York 2000).

The subprime crisis I was anticipating and of which I was describing the future course was essentially to me a spontaneous process. I will explain the word “essentially” later on.

In “L’implosion” (The implosion) (Fayard, 2008), which came out in May 2008 – I mention this to emphasize that I had finished writing this book more than six months prior to the fall of Lehman Brothers – I use the events that took place in 2007 and early 2008 to illustrate the dynamics of the bubble and its ultimate bursting which I had forecast in The Crisis of American Capitalism. To a large extent, I was then simply filling in the blanks of the description I had made three years earlier (See also here my April 18th, 2008 blog: A population dynamics approach to the subprime crisis).

Why bother reminding this? Because of an e-mail I received today (September the 3rd) from my friend Janet Tavakoli, containing a statement she made on December 8, 2010 before the Federal Housing Finance Agency, the regulator of the Government-sponsored Entities Fannie Mae and Freddie Mac, as well as a powerpoint presentation summarizing her testimony.

In these presentations, Janet Tavakoli describes the subprime crisis as a “pyramid” or a “Ponzi scheme”, not as a “spontaneous” one but an orchestrated one. In other words, while I describe the subprime crisis as essentially displaying a dynamics of let’s say a “physical type”, she describes it as primarily resulting from intentional fraud.

It would never cross my mind to claim that fraud played no role in the subprime crisis. There was fraud but it did not play, in my opinion, a more important role in the subprime crisis than anywhere else in finance – and in the business world generally speaking where it is endemic. Here is what I wrote in that respect in an article which was first published on the present blog, and then in the N° 161 issue of the Le Débat review that came out in September 2010:

Decision-makers define the criterion for their club membership as expertise. My own [financial] experience of eighteen years convinced me that this criterion is actually of a different nature: a personal leniency towards fraud.

… in what terms do decision-makers refer to this leniency towards fraud? As “team spirit.” “The person in question fails to display team spirit” is the coded language used in the world of financial institutions for finger pointing those who show integrity and disapprove of fraud.

Deliberate efforts to feed the spontaneous dynamics of the financial bubble came to be added to it, orchestrated by the Mortgage Bankers Association, the trade association of banks granting mortgages in the United States. I’m discussing this in the pages devoted to “predatory lending” in The Crisis of American Capitalism (pages 148 to 151) as well as in the chapter entitled “The anti- “predatory lending” Act of North Carolina (1999)” in The implosion (pages 264 to 268). I describe the deliberate efforts made to feed the bubble. We’re talking here though of greed, not of fraud.

Between the interpretation of the dynamics of the crisis offered by Janet Tavakoli’s and mine, a choice needs to be made. I fear that if we focus only on fraud, we will end up one day throwing out the baby with the bathtub water. I fear that if we use the idiom of a police force and judges failing to do their job, we will one day claim that problems have been solved because half a dozen bankers are now behind bars. We will then have forgotten about financial bubbles as “spontaneous Ponzi processes” whose dynamics is beyond the capacity of individuals – be they bank executives – to prevent and control them. We might neglect then as well the current inability of economists to detect the occurrence of such bubbles, and their lack of knowledge about how to control them when they occur. We would forget about the need for bodies whose aim is to detect the appearance of bubbles and, should they occur, to nip them in the bud. We would forget about the need to create a genuine science of economics understanding the dynamics of bubbles instead of the propaganda doctrine which is currently being sold under that label.

Finally, and to further support the validity of my own approach, I will simply state the following: I would have been unable to forecast the subprime crisis back in 2005 by detailing its dynamics and then “fill in the blanks” of that description with the evidences that the crisis provided in 2007, if the dynamics of the crisis had not been essentially what Shiller called as “a spontaneous Ponzi process”. Massive fraud depends on too many individual decisions, on too many imponderables, the overall effect of which is unpredictable to allow a precise forecast of a crisis caused by fraud.

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