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INTERVIEW THE UNDERCOVER ECONOMIST


TIM HARFORD IS AN AUTHOR AND COLOMNIST FOR THE FINANCIAL TIMES. HE IS MOST KNOWN FOR HIS BEST-SELLING BOOK THE UNDERCOVER ECONOMIST AND HIS BBC SERIES TRUST ME I’M AN ECONOMIST. HARFORD’S DOWN TO EARTH EXPLANATIONS OF FINANCIAL ISSUES MAKES HIM THE PERFECT PERSON TO ASSIST CANDIDE IN MAKING SENSE OF THE RECENT ECONOMIC CRISIS.


Q: You point to the continuous repackaging of subprime* mortgages as being the single biggest factor behind the financial crisis. Can you give a summary of this explanation to our readers now? A: One explanation, when looking at the financial crisis, is to view what happened as essentially a technical problem with the banking system. For whatever reason, people got careless, they got stupid and greedy. They made mistakes. Subprime mortgages were being constantly repackaged with the idea of splitting the risk into carefully defined sub-sections, so you knew exactly how risky your slice of the pie was going to be. The problem was, if you made even a small mistake in evaluating how likely it was that somebody wouldn’t pay their mortgage, or if the person not paying their mortgage correlated with a second person not paying their mortgage, then the repackaging process magnified the mistake. So, say you thought there was only a five percent chance that a mortgage wouldn’t get paid back and actually it’s a 10 percent chance, after repackaging the chance of a mortgage default might have gone up 50 times, 100 times, 500 times, 50,000 times. What doesn’t look like a big mistake turns out to have massive consequences and this was a key technical failing at the heart of the crisis.


* Sub prime lending means making loans to people who may have difficulty maintaining the repayment schedule. These loans are characterized by higher interest rates and less favorable terms in order to compensate for higher credit risk.


Q: Did banks not consider that people might struggle to make repayments on mortgages they


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could barely afford? A: One of the problems was that different departments of the bank were very isolated from each other. You might get one person estimating the chance of a default, another


then it’s very easy to look at a number on a spread sheet and think that you’ve basically understood the truth through all the assumptions. This was a big part of what went wrong. So, while it was an accident,


Reserve, admitted he was wrong in trusting that the banks would never risk bankrupting themselves. Is regulation the key to preventing another financial crisis? A: Yes and no. It’s definitely the key to preventing another financial crisis, but just to tell you that doesn’t really say anything. We had lots of regulations, just the wrong kinds of regulation. The U.S. had two big semi-government institutions, Fannie Mae and Freddie Mac, who were actively encouraged by regulators to go out and make very risky loans. That was supposed to be about getting mortgages to poorer people, helping them to obtain access to houses. These organizations were therefore offering credit to people who couldn’t get it from the banks, which started out as a very noble thing, but after a while just got corrupted when they started making very risky loans - on the basis that the tax payer would look after them if anything went wrong. So, that’s an example of a very regulated sector, very deeply bound up with the government, making big mistakes because there weren’t the right regulations.


Q: So regulation is a Photograph: Fran Monks


person trying to work out how clustered mortgage defaults are, and a third person in charge of restructuring and repackaging these mortgages. If those people aren’t talking to each other all of the time,


it came about because people were careless and stupid and they cut corners - but it wasn’t a deliberate conspiracy.


Q: Alan Greenspan, former Chairman of the Federal


complicated issue; is anything else being done to prevent another financial crisis? A: Efforts are being made in the U.S. and the UK to try to make the banks more modular, so if a bank goes down it doesn’t necessarily bring anything else down with it. It sounds like a really good idea and it is, but it’s also very hard to do. It’s always going to be the case that banks do deals together. For instance, Northern Rock had a lot of mortgage customers, but not


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