The Econophysics Blog

This blog is dedicated to exploring the application of quantiative tools from mathematics, physics, and other natural sciences to issues in finance, economics, and the social sciences. The focus of this blog will be on tools, methodology, and logic. This blog will also occasionally delve into philosophical issues surrounding quantitative finance and quantitative social science.

Monday, December 03, 2007

The O.C. of the Arctic (or The Global Reach of the Credit Crunch)

If anyone had any doubts -- or wishful thoughts (forlorn hopes) -- about how far the (mostly) American credit crises can reach, here is an article that should dispell any lingering doubts about how inter-connected financial markets are.

The New York Times has an article -- U.S. Credit Crisis Adds to Gloom in Norway (December 2, 2007) -- describing how Narvik -- a remote Norwegian town north of the Artic Circle -- has been harmed by investments in "complex securities investments" (i.e., credit derivatives). Here is a brief excerpt from the article:
Norway’s unlucky towns are the latest victims — and perhaps the least likely ones so far — of the credit crisis that began last summer in the American subprime mortgage market and has spread to the farthest reaches of the world, causing untold losses and sowing fears about the global economy.

Where all the bad debt ended up remains something of a mystery, but to those hit by the collateral damage, it hardly matters.

Tiny specks on the map, these Norwegian towns are links in a chain of misery that stretches from insolvent homeowners in California to the state treasury of Maine, and from regional banks in Germany to the mightiest names on Wall Street. Citigroup, among the hardest hit, created the investments bought by the towns through a Norwegian broker.

For Ms. Kuvaas, being in such company is no comfort. People here are angry and scared, fearing that the losses will hurt local services like kindergartens, nursing homes and cultural institutions. With Christmas only weeks away, Narvik has already missed a payroll for municipal workers.

Above all, the residents want to know how their close-knit community of 18,000 could have mortgaged its future — built on the revenue from a hydroelectric plant on a nearby fjord — by dabbling in what many view as the black arts of investment bankers in distant places.

“The people in City Hall were naïve and they were manipulated,” said Paal Droenen, who was buying fish at a market across the street from the mayor’s office. “The fund guys were telling them tales, like, ‘This could happen to you.’ It’s a catastrophe for a small town like this.”

Now, the towns are considering legal action against the Norwegian brokerage company, Terra Securities, that sold them the investments. They allege that they were duped by Terra’s brokers, who did not warn them that these types of securities were risky and subject to being cashed out, at a loss, if their market price fell below a certain level.
All of the familiar themes are there: relatively unsophisticated investors getting sold complex derivatives -- where these naivetes were the ones who were, in effect, 'writing' the derivatives ... i.e., they receive higher yields but expose themselves to tremendous losses (or as Nassim Nicholas Taleb so eloquently puts it, stepping in front of steamrollers to grab pennies), angry citizens that range from old age pensioners to kindergarteners, and threats of lawsuits. It happened with Orange County, California. While no one will mistake Narvik (in the winter) for 'the O.C.', the underlying problems are the same: unscrupulous derivatives salesmen and gullible, unsophisticated investors that get lured by higher yields without realizing that they are exposing themselves to Black Swan type risk.

Here is a bet I'm willing to make ... I'll bet that this sort of thing will happen again and again. Maybe next time it won't be credit derivatives or derivatives linked to municipal debt ... it'll probably be some other 'fancy' financial instrument ... but the same thing will happen again and again. The names and faces (and models) may change, but some things are constant: human greed, hubris, and gullibility.

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