Spero Consulting

Posts Tagged ‘alternative to TARP’

We very much like the ancient Greek story of Cas­san­dra, and one could well imag­ine that for almost ten years, Harry Markopo­los felt like a modern-​day Cassandra.

We don’t know enough about Mr. Markopolos to know whether he wrote let­ters to the SEC about hun­dreds of other fund man­agers claim­ing that they also ran Ponzi schemes or were part of the con­spir­acy to assas­si­nate Pres­i­dent Kennedy, were adducted by UFOs, or pro­vided FDR with advanced knowl­edge of the bomb­ing of Pearl Har­bor or some com­bi­na­tion of the four. If so, then it is quite pos­si­ble that Mr. Markopo­los is a lucky crank, but we doubt it.

Instead, it seems that Mr. Markopo­los is quite knowl­edge­able and was quite spe­cific in his crit­i­cism of Bernard Mad­off. Moreover, it seems that he was quite will­ing to stake his rep­u­ta­tion and devote his time, energy, and con­sid­er­a­tion to doing the right thing – only to be ignored by an indif­fer­ent bureau­cracy. Now that is a sur­prise, isn’t it.¹

We sym­pa­thize with Mr. Markopo­los. Since late September, we’ve writ­ten to a num­ber of folks in the press and gov­ern­ment about our pro­posed solu­tion to the mort­gage cri­sis only to receive no seri­ous feed­back. We did received one demean­ing form e-​mail mes­sage from our Con­gress­man Jason Alt­mire.²

As The Wall Street Jour­nal reports in Chas­ing Bernard Mad­off, which appears on-​line as Mad­off Mis­led SEC in ’06, Got Off, it seems that Mr. Mad­off may have avoided some scrutiny due to fam­ily and polit­i­cal connections. 

Whether any­one acted overtly to stymie a seri­ous inves­ti­ga­tion into Mr. Madoff’s prac­tices in unclear. The much more com­mon and insid­i­ous prac­tice would be to dis­miss the alle­ga­tions with a know­ing chuckle and pos­si­bly a wink and per­haps a few rhetor­i­cal questions: “Bernard Mad­off? The for­mer chair­man of NASDAQ? Yeah, right.” Or pos­si­bly: “No, we inves­ti­gated that com­plaint. We didn’t find any­thing. I don’t know what that guy’s prob­lem is. What his name Markopolo­po­gos or what? He doesn’t think we take our jobs seri­ously. Who is he to crit­i­cize us? That …off. He should get a life.”

We sus­pect the bureaucracy’s iner­tia was moti­vated in ways sim­i­lar to those that we wrote about last month in Good Luck with that: Get­ting Bank Exam­in­ers to Act. We’d guess that if any SEC employ­ees had an inkling of the truth, they – like Mr. Mad­off – hoped that the prob­lem could be solved with a nice bull mar­ket. (One of the most damn­ing pieces of evi­dence against the SEC deals with the facts that to imple­ment Mr. Madoff’s stated strat­egy, the sizes of cer­tain equity options mar­kets – stated in terms of the num­ber of open posi­tions – would have to be about five times larger than they were/​are.)

Given that col­lec­tive behav­ior, we think that Ronald A. Cass states it best in his WSJ opin­ion col­umn, Mad­off Exploited the Jews: “The vio­la­tion of trust at the heart of that story … It illus­trates the lim­its of law, not the need for more of it.”

Note: We’ll likely expand and edit this post in the morn­ing, but wanted to cir­cu­late the idea before bedtime.

We’re rather dili­gent – but not obsessed– about keep­ing up with finan­cial new.¹ We’ve heard many finan­cial firms announce lay-​offs and have read how at a few, like Gold­man, senior man­agers have decided to forgo bonuses.

As we recall, most banks have announced with­drawals from sub­prime mort­gage orig­i­na­tion and loans, which seems like a wise move, but given the mag­ni­tude of their errors and mis­takes, we’re very sur­prised that we haven’t read more about banks tak­ing dra­matic and dras­tic actions to limit risks and exposures.

We don’t mean hoard­ing cash and the knee-​jerk reac­tions not to lend. We’re think­ing more about their invest­ing, trad­ing, and struc­tur­ing operations.

Maybe the banks are elim­i­nat­ing desks and floors, but they just aren’t talk­ing about it, or maybe they have men­tioned it, but we’ve missed it.

We’d cer­tainly encour­age finan­cial firms to change their ways. In fact, while we’re close to Lib­er­tar­ian on many eco­nomic issues, we wrote on Octo­ber 11, to Elim­i­nate Pro­pri­etary Trad­ing at Insured Insti­tu­tions as a way to mit­i­gate moral haz­ard and pro­tect tax-​payer interests. (Once they’re insured, it is no longer a free mar­ket, and there should be quid pro quo, not just subsidization.)

On Sep­tem­ber 24, in our post Could a “Bailout” Pro­long the Finan­cial Cri­sis?, we wrote:

So, if the government’s pur­chase of these thin­gies is approved, we would expect to see a con­tin­u­a­tion of the pan­icky behav­ior until the secu­ri­ties are actu­ally trans­ferred to the gov­ern­ment because it is unlikely that any­one will know who has the worse ones so (means that) all remain sus­pect. (Also note that the most pan­icky firms might be ones who are pro­ject­ing their port­fo­lios onto oth­ers, and so might be the ones that other firms would like to avoid.)

Now that the TA is out of TARP, it seems that this week’s equity mar­ket per­for­mance, par­tic­u­larly among finan­cial firms, sup­ports our Sep­tem­ber 24^th pre­dic­tion above, i.e., the con­tin­u­a­tion of pan­icky behav­ior until actual trans­fers occur. We dis­cussed related issues on Octo­ber 7, in Even A Per­fect Bailout Will Fail.

Or maybe they’re just tak­ing a wait-​and-​see approach. That’s what we pre­dicted in early Octo­ber when we described the very high prob­a­bil­ity of fail­ure of TARP.

Today’s Wall Street Jour­nal reports that Citi Weighs Its Options, Includ­ing Firm’s Sale, and we won­der if it will sur­vive the weekend.

As we argued in Big­ger Is Not Nec­es­sar­ily Bet­ter way back in Sep­tem­ber, we see no rea­son to encour­age mega-​mergers and we based that argu­ment on both moral haz­ard and sys­tem­ati­za­tion of idio­syn­cratic risk considerations.

So, as we argued in around Octo­ber 10, we believe that It’s Time! to nation­al­ize the worst offend­ers leav­ing no share­hold­ers, except non-​executive employ­ees, with any own­er­ship inter­ests. We reit­er­ated much of the same argu­ment in a very long post from Wednes­day: OMG, Mr. Paul­son Agreed with Us Twice in One Week! (Yeah, we have a teenager.)

It seems that given its size of around $2,000,000,000,000, we tax­pay­ers will be on the hook for Citi, any­ways, so why not elim­i­nate the mid­dle­man and pro­vide any upside ben­e­fit to the true resid­ual claimants?

In two recent posts, The Fail­ure of Boards to Direct and When the Going Gets Tough…Quit, we’ve crit­i­cized the com­po­si­tion of Citigroup’s board because of their gen­eral lack of finan­cial indus­try expe­ri­ence. (We’re sorry, but that seems uncon­scionable to us.)

We won’t repeat all of our argu­ments for nation­al­iza­tion, but the expro­pri­a­tion of Cit­i­group would cer­tainly moti­vate other banks to act quickly and largely to mit­i­gate risks and sta­bi­lize cash flows. (It would likely stop insur­ance com­pa­nies and oth­ers from buy­ing small banks or S&Ls in their beg­garly attempts to become bank hold­ing companies.)

By the way, for new read­ers, we’re not just for the nation­al­iza­tion of a few banks, we actu­ally have a pri­vate solu­tion for the mort­gage cri­sis that involves pro­vid­ing the right tax incen­tives – like invest­ment tax cred­its – to indi­vid­u­als, firms, and fund man­agers. (Read about it here: A Bet­ter Solu­tion (than a gov­ern­ment takeover).)

That solu­tion to the mort­gage cri­sis stills leaves the larger liq­uid­ity or con­fi­dence cri­sis for banks. That has arisen because the mort­gage cri­sis has informed us (and oth­ers) that despite their pseudo-​sophistication and the veneer of objec­tiv­ity and sci­ence (almost), there is a very good chance that they don’t under­stand their envi­ron­ment or have reli­able ways to value many of their prod­ucts – despite their mas­sive invest­ments and activ­i­ties for those pur­poses. In terms of an adverse selec­tion prob­lem, they’ve reveal them­selves to be low types. (See last week’s Global Warm­ing and the Mort­gage Cri­sis for a dis­cus­sion on that topic.)

So, as a nation, we should want (and attempt to moti­vate) the banks to act quickly and deci­sively (and with their pri­vate infor­ma­tion) to get their accounts in order.

The ben­e­fits of TARP don’t seem to have pro­vided the cor­rect moti­va­tion to the bank­ing firms to act to main­tain their own liq­uid­ity and cap­i­tal posi­tions. We’d argue that this is an incen­tive prob­lem and that if the ben­e­fit of the TARP “car­rots” have been insuf­fi­cient moti­vate socially-​optimal behavior. So, per­haps a “stick,” like the threat of expro­pri­a­tion, induce clean-​up. More­over, it is seems that Citi will be ours any­way, so, why not give it a try on tax­pay­ers’ terms rather than tax­pay­ers’ backs?

Update (01−20−09): now that Mr. Paulson’s term as Trea­sury Sec­re­tary has ended, we must admit that the small bit of opti­mism we exhib­ited in this post was sadly and unfor­tu­nately mis­placed. It was out-​of-​character for us, but we’re a hope­ful pes­imist. He quickly reverted to his behav­ior of Sep­tem­ber and Octo­ber, and for that, the mar­kets, the nation, and the world have and will con­tinue to suffer.

We hope that his ear­lier actions haven’t caused irrepara­ble dam­age, but we’re doubtful.

This is a longish post that cov­ers sev­eral aspects of the ongo­ing finan­cial cri­sis and, for the con­ve­nience of new vis­i­tors, con­tains plenty of ref­er­ence links to ear­lier posts.

In our mind, until last week, the cur­rent Trea­sury Sec­re­tary had an incred­i­bly long and unbro­ken string of wrong deci­sions and actions. Start­ing in March if not ear­lier, and through early Novem­ber, in almost every impor­tant deci­sion, when Mr. Paul­son zigged we would have zagged, and vice versa.

Well, actu­ally, we wouldn’t have zagged or zigged as that requires effort. Instead, we hope our rhetor­i­cal flour­ish illus­trates our oppo­si­tion to many of Mr. Paulson’s deci­sions. We would have done what we have advised all along, and what Mr. Paul­son finally, finally seems to be doing: nothing.

As we advised in Sep­tem­ber, par­tic­u­larly in the posts Over­re­ac­tion and Moral Haz­ard: Now That Will Be a Cri­sis and Pub­lic Bailout? Why Rush or Do It at All? among others, we rec­om­mend Mr. Paul­son to vig­or­ously do noth­ing, and advice Mr. Obama and the next Trea­sury Sec­re­tary do the same: noth­ing or more pre­cisely, noth­ing much. 

We ital­i­cize the “much” because we con­tinue to (1) offer our pri­vate, non-​governmental solu­tion to the mort­gage cri­sis, which the gov­ern­ment has yet to address since TARP become law, and (2) offer advice on the best way to mit­i­gate the big­ger and more wor­ri­some liq­uid­ity cri­sis, and that will require a bit of aggres­sive gov­ern­ment action to moti­vate remain­ing bank man­agers to act or sell. See, we don’t think that the gov­ern­ment should act (much), but we do think that banks and share­hold­ers should.

In gen­eral, we’re strongly in favor of an eco­nomic ver­sion of the Hip­po­cratic Oath: do no harm. Thus, we advise: do very lit­tle for which there will be few unin­tended con­se­quences. (Although we do have two spe­cific rec­om­men­da­tions in mind that we’ll men­tion later.)

So lit­tle time, so many mis­takes: what’s the point?

The Treasury’s ear­lier insid­i­ous approach of get­ting the government’s many, spindly, lit­tle fin­gers on all of its Vishnu-​like arms into hun­dreds of firms will likely have no end, ever. (Our pre­dic­tion: they’ll rene­go­ti­ate rates when tax­pay­ers are sup­posed to reap the ben­e­fit of rate increases.) It was so very dis­ap­point­ing – not sur­pris­ing, but so very dis­ap­point­ing – to see our fed­eral offi­cials act in such rushed and expe­di­ent manners. 

Until last week there didn’t seem to be any thought – even an after­thought – of the havoc they were wreaking. Given shal­low­ness their depth of thought, we would have been con­vinced that Mssrs Paul­son and Bush were teenagers with Prog­e­ria had text-​messaged their inter­views and press releases.

What’s the point: when we taught decision-​making to MBAs we heav­ily empha­sized (1) know­ing the deci­sion cri­te­rion – the objec­tive func­tion – and (2) iden­ti­fy­ing rel­e­vant or incre­men­tal costs and ben­e­fits across alter­na­tive courses of action.

We saw no indi­ca­tion that our government’s lead­ers oper­ated under such a frame­work, par­tic­u­larly in Sep­tem­ber and Octo­ber of this year.

In other words, it should be very clear how to account for the fed­eral government’s deci­sions and actions. One would hope that offi­cials would have some met­ric by which they mea­sure the effect of their actions, but that seems to have been beyond them.

What were Mssrs. Bush, Paul­son, and Bernanke try­ing to accom­plish? What were (or are) the costs and ben­e­fits of their fea­si­ble alter­na­tives? Which cat­e­gories of costs and ben­e­fits seemed to have the most reli­able and firm esti­mates? What deci­sions were most sen­si­tive to under­ly­ing vari­ables and assump­tions? Which deci­sions seemed the most robust across poten­tial changes in the eco­nomic environment?

Dur­ing the both the orig­i­nal mort­gage cri­sis and the larger, ensu­ing and ongo­ing liq­uid­ity cri­sis, has the reader heard any gov­ern­ment offi­cial speak in those terms? Or, until last week, when Mr. Paul­son said, “Nyet,” were their state­ments more like: “Eek! We’ve got to do some­thing! We don’t have time to think?” Yeah, it was a rhetor­i­cal question.

As reg­u­lar read­ers know, we have very seri­ous doubts about the effec­tive­ness of var­i­ous aspects of the government’s plan – although “plan” seems to be too thought­ful and orga­nized a term to describe the government’s response to the cri­sis of 2008. Like­wise, we have even greater doubts about its effi­ciency, or the ratio of ben­e­fits to costs. (Is it not approach­ing zero?) We mean that there are at least two issues to con­sider: (1) will the government’s response ulti­mately be suc­cess­ful? Will it be effec­tive? And (2) If achieved, what will that “suc­cess” cost? Will it be efficient?

Unfor­tu­nately, so far, we’ve not heard a def­i­n­i­tion of success.

However, seven weeks after the approval of TARP, the results don’t look good. In fact, unless “suc­cess” has been defined down­ward, the results look more like fail­ure. The NASDAQ Index sits at roughly half of its twelve-​month high, and has lost as much value since the pas­sage of TARP – about 700 points – as it did in the period from its high last Decem­ber to the end of Sep­tem­ber. Like­wise, the S&P 500 has gone from about 1,524 last Decem­ber to 806 today, with 366 points of that 718 point drop occur­ing since Sep­tem­ber 30. Ditto for the DJIA: down from 13,991 last Decem­ber to today’s close three points below 8,000. It stood at 10,831 on Sep­tem­ber 30. Tril­lions and tril­lions of dol­lars of value destruc­tion – both before and after TARP.

Thus, “suc­cess” how­ever defined, seems doubt­ful. More­over, any claim of suc­cess must be tem­pered by the very heavy cost bourne by tax­pay­ers and investors. So, given those results, we’re very encour­aged by Mr. Paulson’s new­found hes­ti­tancy to act. But is the too lit­tle arriv­ing too late?

Don’t just do something. Stand there.

Given its sim­i­lar­ity to our position, we very much enjoyed the recent opin­ion essay by our for­mer Wash­ing­ton Uni­vesity col­league, Rus­sell Roberts in The Wall Street Jour­nal. It was enti­tled, “Don’t Just Do Something. Stand There.” A month after our post, Out of Their Ele­ments, and weeks after related posts like Well, This Is a Fine Mess You’ve Got­ten Us into…., Mr. Roberts makes sim­i­lar points, and he draws sim­i­lar, dis­cour­ag­ing, and almost depress­ing con­clu­sions about the future. Unfor­tu­nately, that doesn’t give us even a quan­tum of solace.

For­tu­nately, how­ever, it does seem that Mr. Paul­son may have read Mr. Roberts’ col­umn dur­ing the sec­ond week­end of November, internalized it, and vowed swift inac­tion in the tur­bu­lent finan­cial markets.

Finally: doing noth­ing! But why did it take so long?

We write that because last Tues­day, Novem­ber 11, Mr. Paul­son rebuked the automak­ers and their advo­cates seek­ing TARP funds, and news reports both last week and this week note that the Trea­sury have no plans to buy trou­bled assets or imple­ment new schemes. (Last Wednes­day, in response to the news, we wrote Tak­ing the TA out of TARP, and ungra­ciously gloated over the fact that we had cor­rectly pre­dicted the law’s inef­fec­tive­ness and poten­tial harm nearly six weeks earlier.)

Last Mon­day, the day before Mr. Paul­son denied TARP funds to the auto indus­try, we wrote Patience Please! They Just Need More Time!, which noted that the car man­u­fac­tur­ers had 35 years – that’s THIRTY-​FIVE YEARS – since the first oil cri­sis to change their ways. It seems that through the entire time – almost the life expetancy of a Russ­ian male – man­age­ment, the unions, and the deal­er­ships have been locked in an inter­minable game of “chicken” with each wait­ing for the other swerve to avoid col­li­sion and death to reap the pride­ful spoils of victory. 

While in some ways, Chicken seems like an apt metaphor, it ignores the fact that over the past 35 years, with each myopic deci­sion the spoils have become smaller and smaller – and are now almost noth­ing. In that sense, the auto indus­try seems more like a black hole where a mas­sive expanse (of warm sun­shine and fren­zied activity) has shrunken to a cold, shriv­eled, and nearly non-​existent state. Yet, its mass – or more pre­cisely, the mass of its lia­bil­i­ties – seems to warp and dis­tort nearby space as it smoth­ers and destroys every­thing within reach.

Unfor­tu­nately, the self-​destruction of a once-​vital and proud indus­try is not a game or a black­hole mil­lions of ligh years away. It col­lapse is tragic and close and the col­lat­eral dam­age of the col­lec­tive, short-​sighted self­ish­ness – mea­sured in the hun­dreds of bil­lions if not tril­lions of dol­lars and in terms of lives ruined – has been all too real. More­over, the siu­ta­tion is not interminable, but it finite, and the end is near.[1. We admit to being a bit overly harsh as it seems the ill-​advised CAFE stan­dards wouldn’t per­mit the Big Three to lever their com­pete­tive advan­tages with large cars and trucks. At one time, they did make the best large cars in the world (and we still love our Suburban.)]

So, in our mind, ignor­ing GM, Ford, and Chrysler seems to be both the effi­cient and just thing do, and we admire Mr. Paul­son for admit­ting – even if only implic­itly – that his ear­lier actions were mis­takes. Clearly, we wish that he could have been a faster learner. It might have saved all of us hun­dreds of bil­lions of dol­lars of cash and tril­lions of dol­lars of equity value.

It’s our view that The Gov­ern­ment Will Save Us! Not!. Instead, we’d pre­fer that it get out of the way and pro­vide incen­tives to pri­vate enter­prise to act autonomously. In that spirit, we still pro­pose A Bet­ter Solu­tion (than a gov­ern­ment takeover), which involves tax incen­tives for buy­ers of trou­bled assets. Those incen­tives could be imple­mented as invest­ment tax cred­its or as extremely accel­er­ated depre­ci­a­tion, and would pro­vide large (30%-40%) and imme­di­ate tax sav­ings that would cush­ion the down­side risk of uncer­tain val­u­a­tions. (The things are hard to value.)

Make an example: nationalize the worst one(s).

We’re gen­er­ally almost lib­er­tar­ian in our free mar­ket approach to eco­nom­ics, but don’t get us wrong, we con­tinue to urge the gov­ern­ment to nation­al­ize the worst cap­i­tal­ized banks: the very few, not the many. We’d much pre­fer the out­right expro­pri­a­tion of the worst offend­ers both out of a sense of jus­tice and as a warn­ing to other firms to act quickly to save them­selves rather than to wait for gov­ern­ment handouts. 

Just as importantly, with com­plete own­er­ship of a few firms, it is much more likely that there would be many calls from many par­ties, espe­cially com­peti­tors and poten­tial investors, to re-​privatize the nation­al­ized insti­tu­tions ASAP. That polit­i­cal pres­sure would prove to be very ben­e­fi­cial to reduc­ing the government’s influ­ence in finan­cial intermediation.

Imag­ine if the gov­ern­ment would have nation­al­ized AIG, would the out­come have been any worse than what we’ve seen in the past two month? Would it have been any more expen­sive than it has already been? We’d argue – and have argued – that issues with col­lat­eral, includ­ing those related to AIG’s dimin­ished credit rat­ing, would have been mit­i­gated through gov­ern­ment own­er­ship and creditworthiness.

More­over, other than non-​executive employ­ees hold­ing shares, we’d argue that none – not 10% nor 20% – of the old own­er­ship struc­ture should remain. That might induce share­hold­ers in other firms to become a bit more activist and demand stronger and more knowl­edge­able rep­re­sen­ta­tion on their boards of direc­tors. (See our recent: The Fail­ure of Boards to Direct.)

We’d pre­fer the fren­zied, moti­vated efforts of bankers seek­ing cre­ative solu­tions to their most vex­ing prob­lem over the cur­rent sce­nario where hoard­ing of funds and wait­ing seem to be the pre­ferred tac­tics. In that sense we as an econ­omy, a nation, and a soci­ety are in no bet­ter posi­tion today than we were six or seven weeks ago.

We wrote about what has and con­tin­ues to occur in Even A Per­fect Bailout Will Fail and Finan­cial Pro­jec­tion in a Cri­sis among other posts.

Unfor­tu­nately, the biggest dif­fer­ence between now and the end of Sep­tem­ber is that our col­lec­tive equity hold­ings have lost about one third of their value, and new asset classes like CMBS are likely to depre­ci­ate like MBS already has. How­ever, on the upside, it seems that Mr. Paul­son is mov­ing (or more accu­rately not mov­ing) in the right direction.

In all seri­ous­ness, we do pray that our senior gov­ern­ment offi­cials take the right, rea­soned, and thought­ful actions. We hope you’ll join us. Per­haps it’s working.

(This a long post; so, there are prob­a­bly a num­ber of typos, which we’ll cor­rect dur­ing the com­ing days.)

Reg­u­lar read­ers will know that we often crit­i­cize the stu­pid appli­ca­tion of math­e­mat­i­cal mod­els, espe­cially ones related to finance and eco­nom­ics; ergo, our firm’s motto, “Thought Before Calculation.”

In that light, we note that in last Friday’s The Wall Street Jour­nal (Novem­ber 7) the edi­tors excerpted a speech that Michael Crich­ton gave at Cal Tech in 2003, entitled ‘Aliens Cause Global Warm­ing.’ (For those who don’t know, Mr. Crich­ton passed away early last week.)

In the speech, Mr. Crich­ton dis­cussed the Drake equa­tion which attempts to illus­trate the winnowing-​down process of all the plan­ets in the uni­verse to ones that could sup­port life and could send intel­li­gent sig­nals (to us). There are seven vari­ables in the equa­tion, which was the impe­tus of the SETI project and one of the jus­ti­fi­ca­tions for spend­ing funds on it. For SETI, think Jody Fos­ter in the screen ver­sion of the late Carl Sagan’s Con­tact.

Mr. Crich­ton made the excel­lent points that the Drake Equa­tion is a serious-​looking equa­tion and that its seri­ous appear­ance pro­vided poten­tial inves­ti­ga­tors with a veneer of serious, scientific inquiry. This is despite the fact that NONE of the seven vari­ables can ever be known or esti­mated. Thus, the inves­ti­ga­tion was not sci­ence and was/​is not that dif­fer­ent than count­ing the num­ber of angels on the head of a pin. 

Mr. Crich­ton con­cluded that SETI et. al. “is unques­tion­ably a reli­gion.” (Below we argue it is a bad reli­gion – mean­ing a poorly-​considered one.)

More­over, he con­tin­ued his argu­ment by not­ing that with­out legit­i­mate sci­en­tific inquiry and pro­ce­dure, “soon enough garbage began to squeeze through the cracks…” (By this point, the reg­u­lar reader and the astute reader can see where we are headed by this post’s title.)

He went fur­ther to note that the achiev­ing con­sen­sus around a “model” is not sci­ence, and vice versa.

We go fur­ther to argue that such con­sen­sus is not sci­ence, nor even part of science’s broader super-set, reason. 

Yes, we view sci­ence as a sub­set of rea­son – the empir­i­cal part of rea­son. And so, we’d argue that such con­sen­sus is in fact a sub­sti­tute for rea­son. In fact, it fills the entropic chaos of unknow­ing that is the absence of reason. 

Thus, we con­trast such sci­en­tism with more fully-​developed reli­gions like, say, Christianity, which via numer­ous pas­sages, includ­ing the first chap­ter of the Gospel of St. John, defines God as rea­son (logos) and com­mands man to use that same rea­son to be bet­ter than instinc­tual, impul­sive ani­mals amidst the chaos.¹

At first glance, it might seem that the val­u­a­tion (and sub­se­quent real­iza­tion) of mortgage-​backed secu­ri­ties (MBS) and other finan­cial assets has lit­tle in com­mon with the esti­ma­tion of the cur­rent num­ber of intel­li­gi­ble planets.

However, both method­olo­gies require giant leaps of faith when mov­ing from real­ity to a model as both suf­fer from the absence of rel­e­vant data. Other galax­ies and solar sys­tems (and plan­ets) are just too far away to con­sider care­fully, and there are only (rel­a­tively) short his­to­ries of mort­gage prod­ucts and repay­ments avail­able from which one HOPES to extrap­o­late the future, and this is where and why the con­sen­sus arises. 

There are no good mod­els; so, indi­vid­u­als agree to use mod­els already in use (as a val­i­da­tion for their choice). Often, such mod­els first appeared in text­books for entirely dif­fer­ent pur­poses but were used out of convenience.

Mort­gage port­fo­lio, MBS, and CDOs suf­fer a few addi­tional bur­dens not shared by ET’s would-​be friends, including: (1) depen­den­cies and inter­ac­tions between or among bor­row­ers that would seem to be absent with plan­ets; (2) non-stationarities through time with respect to these (and other rel­e­vant) rela­tion­ships; and (3) the inter­ac­tions are endoge­nous as they involve people’s cog­nizant responses through time to eco­nomic con­di­tions and per­sonal cir­cum­stances. (In that sense, it is truly a daunt­ing task.)

Please see our ear­lier post for a descrip­tion of the mort­gage pool or port­fo­lio prob­lem. In it, we illus­trate how recent calls for more trans­parency are non sequiturs and sim­plis­tic, but do show a lack of under­stand­ing about the nature of the problem.

It seems that the soci­olo­gies of both plan­e­tary and mort­gage mod­el­ing envi­ron­ments do seem to place a pre­mium on con­sen­sus. While every indi­vid­ual trader or struc­turer may have their own idio­syn­cratic tweaks, most solve val­u­a­tion prob­lems in sim­i­lar man­ners because there just aren’t that many tractable ways to per­form the cal­cu­la­tions. But, as many for­mer traders and struc­tur­ers have dis­cov­ered, choos­ing a method­ol­ogy for its tractabil­ity is very dif­fer­ent than choos­ing one for its applic­a­bil­ity, par­tic­u­larly when the envi­ron­ment changes rapidly or drastically.

In fact, we’d argue that the recent lack of exchange or illiq­uid­ity in these mar­kets results from the real­iza­tion and inter­nal­iza­tion that these mod­els have failed, and no suit­able replace­ment yet has been found; ergo, the paralysis. 

As fur­ther evi­dence of paralysis, today Mr. Paul­son announced the Trea­sury Depart­ment wouldn’t pur­chase any trou­bled assets as part of their TARP efforts. (Recall that the “TA” in TARP stands for “Trou­bled Asset.”) It seems that the gov­ern­ment doesn’t know how to value them, either. We’d have been sur­prised by the announce­ment had we not pre­dicted it six weeks ago.

As always when we dis­cuss these top­ics, we point read­ers to our essay Uncer­tainty Man­age­ment, which presents a broader view of the nature of unknow­ing – far broader than the nar­row empha­sis on risk or mea­sur­able uncer­tainty one typ­i­cally sees.

Finally, as usual, we also note that we have pro­posed a pri­vate solu­tion to the mort­gage cri­sis that uses tax incen­tives – via the equiv­a­lent of accel­er­ated depre­ci­a­tion or invest­ment tax credit – to induce pri­vate pur­chases of the trou­bled assets. We sug­gest Mr. Paul­son con­sider that alternative.

Exclud­ing fools – which we admit pro­vides a non-​trivial exclu­sion – we doubt that finan­cial mod­el­ers or ana­lysts will regain the (mis­placed) self-​confidence they exhib­ited in the calm-​market era prior to mid-​2007. 

In our view, such well-​earned and well-​deserved humil­ity will be ben­e­fi­cial for soci­ety as a whole. Such feel­ings may spur inno­va­tion and increase the level of thought­ful of analy­ses per­formed (rather than rote, pro­ce­dural tasks). Perhaps it may change the struc­ture of contracts.

Per­haps the recent fail­ures will allow senior man­agers to gain effi­cien­cies through the real­iza­tion that irrel­e­vant details are not infor­ma­tion and so many rou­tine tasks and algo­rithms are indeed worth­less – despite the claims of reg­u­la­tors and audi­tors. (Oh, who are we try­ing to kid. The skep­tic in us sug­gests that we’re show­ing our naiveté.)

Recently, we’ve seen many op-​ed essays call­ing for more trans­parency in finan­cial state­ments, par­tic­u­larly with respect to mortgage-​related secu­ri­ties. Many of these essays have been writ­ten by famous and esteemed indi­vid­u­als or their staffs.

In our own idio­syn­cratic, round-​about way, we’ll explain the empty silli­ness of such argu­ments, and we begin by crit­i­ciz­ing the notion that “more is always better.”

Too Much Infor­ma­tion: Unfor­tu­nately, we’ve not read a sin­gle essay that con­tained an intel­li­gent, con­crete argu­ment for why more trans­parency is bet­ter than less – as if trans­parency, in and of itself, is a good (or is inher­ently good).

More pre­cisely, in all of these arti­cles, the value of trans­parency is assumed, and the assump­tion seems to be implicit and sub­con­scious (uncon­scious?) rather than some­thing arrived at via seri­ous delib­er­a­tion. (Hint: we can’t recall any of these essays that bother to define trans­parency. Pre­sum­ably, it is like pornog­ra­phy: you know it when you see it.)

In that half-​assed way, these recent prompts for more trans­parency have much in com­mon with the slightly older admo­ni­tions to elim­i­nate mark-​to-​market account­ing.¹

In their the­o­ries, many econ­o­mists – includ­ing, yours truly – have shown that more trans­parency, which often means more pre­cise infor­ma­tion, is not always bet­ter than less; in fact, it can make things strictly worse. Such seem­ingly patho­log­i­cal results are actu­ally rather com­mon in a vari­ety of social set­tings, includ­ing some markets, and arise for a num­ber of reasons, including risk-​sharing and incen­tives, where more infor­ma­tion can affect an agent’s behav­ior and actions or efforts thereby reduc­ing social wel­fare and/​or exac­er­bat­ing incen­tive problems.

For exam­ple (and this is a gross gen­er­al­iza­tion of the results with­out spec­i­fy­ing any of the nec­es­sary assumptions) in Kan­odia, Singh and Spero (JAR, 2005), we show that it is bet­ter to keep two unknown vari­ables as unknowns rather than know only one with per­fect pre­ci­sion. Think of it in the fol­low­ing way: sup­pose there are two ran­dom vari­ables – one that is some­what in the person’s con­trol and the other, which is not.

If the one under his influ­ence is known per­fectly, he’ll overem­pha­size it. If the other one is known per­fectly, then he’ll right­fully con­clude that the noisy sig­nal of his effort will be over­looked in favor of the other vari­able so he’ll do lit­tle. The for­mer cre­ates over-​exertion and the lat­ter cre­ates under-​exertion and both are socially dam­ag­ing; thus, one can find a happy medium in less extreme cases where nei­ther vari­able is known with total pre­ci­sion. (It should remind one of Goldilocks.)

Now, let’s be very clear that one need not be an econ­o­mist to know that more infor­ma­tion or trans­parency is not always bet­ter. For exam­ple, how does the reader answer ques­tions from a spouse, rel­a­tive, or friend when asked some­thing like, “Do you like my new hair­cut?” or “Does this dress make me look fat?”

In addi­tion, there are other cases where another party reveals per­sonal details with too much pre­ci­sion. In fact, we as a soci­ety have the col­lo­qui­al­ism, “Too much infor­ma­tion!” for just such cases where you’ll never again look at the revealer in the same man­ner and sub­se­quently rue­fully won­der, “why did they have to tell me that?”

Details Are Not Infor­ma­tion: this is a par­tic­u­larly apt time to repeat our admo­ni­tion that details are not infor­ma­tion. Back in April, we posted a long essay on the dif­fer­ence between details and infor­ma­tion or use­ful facts. (Use­ful facts are ones that might cause a deci­sion to change as the fact is real­ized.) Our point in that essay was to dis­tin­guish between keep­ing track of a lot of nec­es­sary data – as in data pro­cess­ing – and the quite dif­fer­ent task of pro­vid­ing use­ful infor­ma­tion to decision-makers. If one leaves sys­tems design to sys­tems peo­ple, one will likely get the for­mer and not much of the lat­ter. More­over, if the decision-​maker can’t design the sys­tem – not the pro­gram­ming – then his or her com­pe­tence at decision-​making should be jus­ti­fi­ably questioned.

The same dis­tinc­tion between details and infor­ma­tion holds true with finan­cial assets, too. More trans­parency can mean an inun­da­tion of book-​keeping and account details, which may pro­vide no infor­ma­tion or which may require expert judg­ment to (sift through to) become infor­ma­tion. In either case, the recip­i­ent of the data dump may not “see the for­est for the trees.“² So, one may have all the facts, but no abil­ity to orga­nize them – much like a child writ­ing a term paper.

And, that, of course, illus­trates the silli­ness of call­ing for more trans­parency for mortgage-​related secu­ri­ties. The big­ger prob­lem is that with every datum about every mort­gage in a pool, there is still no easy way to value them.

The issue isn’t the details, it is how to com­bine cur­rent and past details to deter­mine value and risk in the future, and it is very likely a per­fect method is unknow­able. So…

Value Matters, BUT There’s No Trans­par­ent Way to Find It: let’s illus­trate the notion in to a fairly high level of detail (for a blog post). We’ll ignore the “water­fall” aspect of real mortgage-​backed secu­ri­ties and CDOs where dif­fer­ent classes of secu­rity hold­ers have dif­fer­ent pri­or­ity claims on the cash flows because those claims are not the con­found­ing fac­tors – the intere­la­tion­ships of the mort­gages are.

So, imag­ine a pool of T thou­sand mort­gages going down the first col­umn of a spread­sheet. Fur­ther, sup­pose that the next 360 columns rep­re­sent months, m, so, the row t and col­umn m inter­sec­tion is the amount of cash received from bor­rower t in month m. Now that cell will actu­ally be a func­tion of any num­ber of fac­tors, includ­ing inter­est rates which affect whether the mort­gage is repaid early; the person’s wealth and income which deter­mine whether the bor­rower declares bank­ruptcy, the rela­tion­ship between the value of the col­lat­eral and the loan bal­ance, etc. We could go on and on, but the point is that each cell could take any num­ber of val­ues depend­ing upon many dif­fer­ent factors.

One page of the spread­sheet would then rep­re­sent one entire sce­nario of how cash is received from all T thou­sand mort­gages over the next thirty years.

At issue for val­u­a­tion (and risk mod­el­ing) is how to com­bine out­comes across all mort­gages. The cells are clearly related within a row, i.e., a borrower’s sta­tus in one month will affect cash flows in later months.

But, cash flows are also related within columns – phe­nom­ena, like a hur­ri­cane, may con­tem­po­ra­ne­ously affect more than one bor­rower – and across columns, too. For exam­ple, someone’s default in month m may make another’s default in month m + n more likely. So, the big­ger issue is: how does one relate bor­row­ers across time and space to arrive at a dis­tri­b­u­tion of cash flows. (Note: we mean “space” lit­er­ally because com­mu­nity and regional effects mat­ter – the inter-​row action, sometimes.)

One could gen­er­ate any num­ber of sce­nar­ios or pages, but, of course, the issue for val­u­a­tion (and risk) are which com­bi­na­tions in the numer­ous T x 360 grid are more (or less) likely (and how wide is the range of pos­si­ble outcomes)?

In other words, the prob­lem lays with deter­min­ing the joint dis­tri­b­u­tions across bor­row­ers and time. As we see it, there is no cor­rect method, but there is an infin­ity of incor­rect meth­ods, espe­cially ones that rely only on his­tor­i­cal rela­tion­ships, par­tic­u­larly very short histories.

Those incor­rect meth­ods include many that were imple­mented in recent years. As we see it, many of those meth­ods were imple­mented because they were solv­able, not because they were accu­rate. Unfor­tu­nately, those weak­nesses (inac­cu­ra­cies) were obscured by the rel­a­tive calm­ness of the mar­kets, includ­ing the near-​Ponzi-​like schemes of dif­fer­ent banks buy­ing the secu­ri­ties to re-​securitize them yet another time.

So, we ask those writ­ers urg­ing more trans­parency: exactly how would it help us find a price in the above exam­ple? Our illus­tra­tion high­lights the rea­son why there is a lack of buy­ers. There are data aplenty. What is lack­ing is a quan­tifi­able notion of the future.

That, dear reader, is why we devel­oped and wrote about an alter­na­tive solu­tion to TARP. One that involved the use of invest­ment tax cred­its or cash-​basis account­ing (to per­mit the imme­di­ate expense of the pur­chase price) to sub­si­dize and cush­ion the risk of pur­chas­ing these con­glom­er­a­tions of cash flows. It would pro­vide pri­vate buy­ers with an imme­di­ate ben­e­fit of 30% — 40% of the pur­chase price, which seems large enough to per­mit room for error.

As always, we encour­age vis­i­tors to read our essay, Uncer­tainty Man­age­ment, which dis­cusses the notions of mea­sur­a­bil­ity (quan­tifi­a­bil­ity) and immea­sur­a­bil­ity by dis­tin­guish­ing between the broader idea of uncer­tainty and the nar­rower idea of risk. In that regard, the num­ber and cost of mis-​specification errors related to our ongo­ing cri­sis may be the great­est in any period in history.

We’ll prob­a­bly edit this again in the near future.

Foot­notes: