Spero Consulting

Posts Tagged ‘failure of TARP’

Given the past two days’ front page head­lines in the The Wall Street Jour­nal, it seems that banks are doing a lot of brac­ing. Monday’s head­line announced that Banks Brace for Bonus Fury, and today’s head­line announces that Banks Brace for Bailout Fee.

The first arti­cle notes of com­plaints by the pub­lic and gov­ern­ment offi­cials about bonuses paid for 2009 ‘results.’ The sec­ond arti­cle describes a likely attempt by fed­eral offi­cials to, in some sense, mon­e­tize those com­plaints by levy­ing new fees onto banks. (Soon, we’ll soon pub­lish a related post regard­ing the inef­fi­ciency of many of the bonus plans.)

There is some­thing dis­turb­ing about large bonuses at sev­eral, if not all, of the firms that are fre­quently men­tioned in the press. That’s because firms like B of A (and its sub­sidiary Mer­rill Lynch) and many oth­ers did not gen­er­ate last year’s gains and prof­its on their own. They could not have gen­er­ated those prof­its on their own. So, regard­less of their repay­ment of the TARP funds, it doesn’t seem that all those prof­its should be theirs to use or dis­trib­ute in what­ever man­ner that they choose.

Thus, the pub­lic has a right to com­plain about the pay­ment of the sub­si­dized bonuses, but don’t blame the employ­ees at the firms; instead, blame the gov­ern­ment for not hav­ing thought through the impli­ca­tions of its guar­an­tees and promises when it made the invest­ments. It was another case of very short-​term think­ing by our elected and appointed officials.

To be sure, it is highly likely that many dili­gent and earnest work­ers per­formed well and earned their bonuses, but for many others, profits were rec­og­nized only because the fed­eral government’s guar­an­tee kept many of their firm viable and/​or credit-​worthy.

It wasn’t the pre­ferred stock invest­ment that kept the firms alive when their counter-​parties and oth­ers had lost faith nor the sub­se­quent increase of some silly cap­i­tal ratio. You seen cap­i­tals ratio et. al., are non sequiturs dur­ing a liq­uid­ity cri­sis. If the firm doesn’t have cash and can’t raise it because no one will buy its hold­ings or invest in it, its can’t sell the cap­i­tal ratio or use it for collateral.

It was the government’s guar­an­tee to each firm that was deemed “too big to fail” that saved it one of them and allowed their trad­ing part­ners to prosper.

Those guar­an­tees made the gov­ern­ment the de facto resid­ual claimant despite its small, for­mal own­er­ship stake (in pre­ferred stock for the most part).¹

The prob­lem is that the gov­ern­ment didn’t do a very good job of nego­ti­at­ing the terms of those guarantees.

At the time of the TARP invest­ments and promises, our pub­lic ser­vants pan­icked. They didn’t take the time to demand covenants and restric­tions on the future use of funds nor did they charge an ade­quate fee for sav­ing the insti­tu­tions.² As we wrote at the time, we thought the fees should include many rolling heads and the elim­i­na­tion of much com­mon equity.

Given that, it’s a lit­tle bit ironic and quite a bit silly for gov­ern­ment offi­cials to com­plain about cur­rent com­pen­sa­tion lev­els and 2009 bonuses. If the gov­ern­ment wanted to do some­thing about bonuses it should have restricted them when it injected the cash and guar­an­teed the firms’ sur­vival.³ It shouldn’t whine now or attempt to apply retroac­tive fees although charg­ing sub­stan­tial fees for the con­tin­ued sub­si­diza­tion is okay with us.

A long aside: at first glance, reg­u­lar read­ers may regard our opin­ion as incon­sis­tent with our sup­port last sum­mer for Andrew Hall in his dis­pute with Citigroup, but it’s not. See Prop Trad­ing and Pay at Banks.

Our points then were:

1. The gov­ern­ment and reg­u­la­tors had no author­ity to abro­gate con­tracts, includ­ing pay con­tracts. So, Citi should give him his due.
2. Bank­ruptcy does pro­vide the oppor­tu­nity to rene­go­ti­ate con­tracts, but the gov­ern­ment wouldn’t let events run their course. Arbi­trar­ily abro­gat­ing (or dishonoring) contracts is uncon­sti­tu­tional. More impor­tantly, main­tain­ing the dis­ci­pline to uphold seem­ingly unpop­u­lar con­tracts is cen­tral to main­tain­ing the Rule of Law. It dis­tin­guishes the U.S. from many other nations, and that col­lec­tive self-​restraint makes this a great (and gen­er­ally pre­dictable) nation.
3. Mr. Hall and all other pro­pri­etary traders should find new, unreg­u­lated places of employ­ment, where they can reap the rewards of their com­bined clev­er­ness and efforts but also bear the risks of fail­ure. (It seems to have worked-​out well for him, and we sus­pect would work out bet­ter for most traders.) See our post Elim­i­nate Pro­pri­etary Trad­ing at Insured Insti­tu­tions.

We pre­sume that Mr. Hall and Phi­bro would have made those gains with or with­out Citi; so, the gov­ern­ment sav­ing Cit­i­group had lit­tle effect on his trad­ing strate­gies. (Who knows? His gains may have been larger with­out Citi and with more capital.)

Why do we whine about about our pub­lic ser­vants whin­ing and try­ing to impose fees? Well for two rea­sons: (1) it’s annoy­ing to her them com­plain about com­pletely pre­dictable behav­ior that they induced and (2) the cur­rent sit­u­a­tion is no dif­fer­ent than the sit­u­a­tions that the gov­ern­ment cre­ated at Fan­nie and Fred­die when those two thin­gies were pay­ing large bonuses for “per­for­mance” that was wholly-​subsidized by the gov­ern­ment. That cre­ated and/​or exac­er­bated moral haz­ard prob­lems then and will now, too.

In con­clu­sion, note that we’re not resent­ful or envi­ous of any­one get­ting a large bonus, and we hope that folks enjoy them, but we do blame the bureau­crats at the Trea­sury and the Fed for not con­sid­er­ing this out­come in the fall of 2008 and early 2009. Fur­ther­more, we don’t see the pro­posed appli­ca­tion of an arbi­trary, ex post tax as any­thing other than vin­dic­tive­ness or the appease­ment of the pop­ulist mob. Either motive should be beneath our fed­eral officials.

Finally, note that we’ve com­plained about sim­i­lar gov­ern­ment actions in the past. For exam­ple, see The Chil­dren who Have Eaten their Cake… and Con­fis­ca­tory, Abu­sive Tax­a­tion: It’s Ali­men­tary and Dan­ger­ous.

Respond­ing to our request for com­ments in yesterday’s post, Happy Anniver­sary to…Us!, a reader from Aus­tralia pointed us to an excel­lent and quite com­pre­hen­sive arti­cle in May’s edi­tion of The Atlantic Monthly. (Thanks Steven.)

The arti­cle is enti­tled “The Quiet Coup,” and was writ­ten by Simon John­son, an econ prof at MIT and the for­mer Chief Econ­o­mist at the Inter­na­tional Mon­e­tary Fund (IMF). For­tu­nately, as you can tell by the link, the arti­cle is freely avail­able from The Atlantic’s web site.¹

Mr. John­son seems to be a very smart man with vast and use­ful expe­ri­ence and knowl­edge, and he uses his back­ground and skills to frame the cur­rent eco­nomic cri­sis in a very inter­est­ing way.

In much of the arti­cle, he treats the US as a poten­tial IMF client, and ana­lyzes the sit­u­a­tion the same way he would (or has) viewed emerg­ing mar­ket coun­tries faced by sim­i­lar crises, par­tic­u­larly with respect to the inter­ac­tions of the country’s oli­garchy and the gov­ern­ment. How­ever, he does rec­og­nize that the US is different.

“Of course, the U.S. is unique. And just as we have the world’s most advanced econ­omy, mil­i­tary, and tech­nol­ogy, we also have its most advanced oligarchy.”

We’ve talked about crony cap­i­tal­ism on sev­eral occa­sions, and Mr. John­son brings sev­eral insights to light. (We define oth­ers’ insights as things we haven’t thought, yet, or things that took us a long time to fig­ure out.)

Need­less to say, if you like our analy­ses of and pre­scrip­tions for the mort­gage débâ­cle and liq­uid­ity cri­sis, then you’ll like his, too. (If your new to our site, sam­ple our cat­e­gories and archives for related con­tent. There are vast quan­ti­ties of it.) For exam­ple, he writes:

“…This is what Ben Bernanke, the man who suc­ceeded him, said in 2006: “The man­age­ment of mar­ket risk and credit risk has become increas­ingly sophis­ti­cated. … Bank­ing orga­ni­za­tions of all sizes have made sub­stan­tial strides over the past two decades in their abil­ity to mea­sure and man­age risks.”

Of course, this was mostly an illu­sion. Reg­u­la­tors, leg­is­la­tors, and aca­d­e­mics almost all assumed that the man­agers of these banks knew what they were doing. In ret­ro­spect, they didn’t…”

and,

“To break this cycle, the gov­ern­ment must force the banks to acknowl­edge the scale of their prob­lems. As the IMF under­stands (and as the U.S. gov­ern­ment itself has insisted to mul­ti­ple emerging-​market coun­tries in the past), the most direct way to do this is nationalization…”

The entire arti­cle is well worth read­ing, and view­ing the cri­sis through the prism of an IMF econ­o­mist pro­vides fresh insights that few can offer.

For the umpteenth time since Sep­tem­ber, The Wall Street Jour­nal has pub­lished an opin­ion col­umn that rec­om­mends the gov­ern­ment pur­chase of “toxic” banks assets. Today’s (Feb­ru­ary 3’s) ver­sion is by Robert C. Pozen: How to Value Toxic Bank Assets. (We really do hate the use of that adjec­tive “toxic” because depend­ing upon the appli­ca­tion, many tox­ins have redeem­ing value. We’re not sure about these mort­gage thingies.)

Of course, the title of the essay is com­pletely mis­lead­ing as there is noth­ing in the text that dis­cusses val­u­a­tion – only the 20% hair­cut in the pur­chase price for what­ever the val­u­a­tion would be. See, that’s the prob­lem with all of these plans; there is no sin­gle best way to value the secu­ri­ties. We dis­cuss­the basics of these val­u­a­tion meth­ods in Gos­samery Argu­ments for Trans­parency and Our Reply among other posts.

Please note that in the five months since TARP became law, the gov­ern­ment hasn’t been able to value any of assets, and to the best of our rec­ol­lec­tion has not bought a sin­gle dollar’s worth of them.

Mr. Pozen writes that “The plan should also help banks sell new stock to insti­tu­tional investors, instead of rely­ing entirely on cap­i­tal infu­sions from the Trea­sury. Insti­tu­tional investors will not buy a bank’s stock if they are wor­ried that it will later announce large write-​downs of its toxic assets. Now Trea­sury would effec­tively be set­ting a floor on the price of the asset equal to 80% of its esti­mated value.”

That is silly since Mr. Pozen has no idea of 100% of the esti­mated value of these assets; so, there would be no 80% “floor.”

Given the mag­ni­tude of the prob­lem, our other com­plaint is of sec­ondary impor­tance: once again, by pub­lish­ing a col­umn that rec­om­mends one buyer-​the State – of dis­tressed assets, the Jour­nal aban­dons its free mar­ket prin­ci­ples in this time of con­tin­u­ing finan­cial panic.

As reg­u­lar read­ers of our site know, we rec­om­mend tax incen­tives for the pri­vate pur­chase of mortgage-​related assets. Either per­mit cash-​basis account­ing, which is the equiv­a­lent of imme­di­ate amor­ti­za­tion of the pur­chase price, or mort­gage invest­ment tax cred­its, which off­set the firm’s or individual’s tax liability. 

The imme­di­ate amor­ti­za­tion would be recouped when cash flows were real­ized (in the future); so, the ini­tial tax sav­ings would later be recouped.

More impor­tantly, the gov­ern­ment would pro­vide a 30% — 40% against over-​valuation, which should moti­vate pri­vate buy­ers – whether they be firms, funds, or indi­vid­u­als – back into the market.

We think that such tax incen­tives would moti­vate buy­ers, and of course, our call to nation­al­ize the worst large banks is done to moti­vate the better-​performing banks to has­ten their actions to purge their bal­ance sheets, rather than wait­ing for the gov­ern­ment to save them. (The worst ones are hope­less, and as we wrote a few weeks back, remind us of the movie Week­end at Bernie’s. Their main value now should be as exam­ples of account­abil­ity and consequence.)

Obvi­ously, we just don’t under­stand the fas­ci­na­tion with “gov­ern­ment” solu­tions. Why not moti­vate the pri­vate sec­tor to act? At this time, it is still larger and more dis­cern­ing than the Trea­sury Depart­ment and the rest of the government.

Wouldn’t it be bet­ter to stim­u­late exchange among mul­ti­ple, semi-​informed, self-​interested buy­ers trad­ing on their own bits of pri­vate infor­ma­tion with their own resources, each of whom would have a sub­stan­tial mar­gin of error (30 – 40%), rather than the Fed­eral bureau­crats spend­ing other people’s money if they could ever come up with a sin­gle val­u­a­tion method?

We don’t think the “free mar­ket” cre­ated the prob­lem, but can’t we at least pro­vide incen­tives to let (rel­a­tively) free-​market poli­cies try to solve it.

If you missed it on Mon­day (Jan­u­ary 26), L. Gor­don Crovitz had an inter­est­ing arti­cle in The Wall Street Jour­nal enti­tled Bad News Is Bet­ter Than No News. In our zeal to com­plete a project, we missed it when it was pub­lished, but now men­tion to the reader that it is worth their time.

We like it because it is con­sis­tent with much that we’ve writ­ten on these pages since the blog’s incep­tion, and espe­cially since last Sep­tem­ber. For exam­ple: no one knows what the mort­gage thin­gies are worth, the banks can’t lend because they don’t know how unsound THEY are, and the government’s actions have exac­er­bated the prob­lem by not pro­vid­ing any res­o­lu­tion to the uncer­tainty. Our solu­tions: nation­al­ize the worst banks and pro­vide gen­er­ous tax incen­tives to buy­ers of the thin­gies to resolve the uncertainty.

Mr. Crovitz men­tions: “Bankers now recall the fine print of VaR analy­sis, which is that it always includes low but real risk that some new ele­ment could make the his­tor­i­cal data a poor mea­sure of the future.”

This, of course, is the Prob­lem of Induc­tion, but unlike Mr. Crovitz, we don’t think that there is nec­es­sar­ily a low risk that past is not pre­dic­tive of the future. (We could pro­vide many cita­tions to our old posts, but point new read­ers to our essay, Uncer­tainty Management, Or, Ignoramus et ignorabimus, Or How Trad­ing is Like Play­ing in a Cul­vert on a Hot, Sunny, Summer Day. You can still drown from a flash flood on a sunny day. Actu­ally, you could do it even with­out a flood.)

Feel free to search other posts for com­plaints about boards and senior man­agers, but here’s a brief recap of what we think hap­pened: many expe­ri­enced traders left the big banks for more lucra­tive options, and they were replaced dur­ing times of unusual placid­ity by junior traders with­out much of a his­tor­i­cal per­spec­tive. Through lax con­trol, e.g., greed com­bined with poorly-​designed incen­tives, and because the folks who gen­er­ate (short-​term) rev­enue tend to win inter­nal argu­ments with risk man­agers – if those argu­ments even occur – the orga­ni­za­tions were over-​confident and unpre­pared for adversity.

More­over, the over-​reliance on math­e­mat­i­cal mod­els, which were per­fectly fine when noth­ing was hap­pen­ing, allowed the banks to avoid the con­sid­er­a­tion of tail-​events. Those event are so unpleas­ant to comtem­plate, any­way, so why bother?

To even hypoth­e­size that really bad things could hap­pen could be taken as a sign of weak­ness or incom­pe­tence by undis­ci­plined man­age­ments, and prob­a­bly were. (We think that is a silly per­spec­tive in the finan­cial mar­kets and in life in gen­eral, and it is one of the rea­sons that although we don’t hunt, we’re a huge pro­po­nent of sec­ond amend­ment rights. As we men­tioned pre­vi­ous posts, we view guns as the equiv­a­lent of deep, out-​of-​the-​money puts: they’re gen­er­ally an incon­ve­nience, but they do help man­age tail risk.)

Back to our story: bad stuff starts to hap­pen, and no one admits they’re wrong – prices will bounce back, right – or knows how to react (until every­one pan­ics at the same time). 

Mr. Crovitz quotes a late J.P. Mor­gan exec­u­tive as say­ing that traders should earn their big money for man­ag­ing the tail-​risk, not the typ­i­cal, daily volatil­ity, but that advice seemed to have been ignored in hopes of prof­its and con­tin­ued stability.

We think that another water anal­ogy is appro­pri­ate. Placid times are like slow mov­ing streams: it’s easy to wade out into the deep parts with­out too much con­cern. That’s despite the fact that algae thrives in such envi­ron­ments (and makes the bot­tom quite slip­pery). It doesn’t take much of a change in cur­rent – or even a mis­step – to turn that con­fi­dence into panic. More­over, it doesn’t even have to be your mis­step when there are other folks nearby grasp­ing at any­thing when they start to fall – espe­cially ones who over­es­ti­mated their own abil­ity or the stream’s con­stancy and over­stepped the bound.

We chuck­led when we saw this head­line in The Wall Street Jour­nal today, Jan­u­ary 15: Fed Offi­cials Say Ail­ing Banks Require More U.S. Funds.

That’s not really news, and – by the way – it’s tau­to­log­i­cal or true by def­i­n­i­tion. (Uh, oth­er­wise, they wouldn’t be ail­ing now would they, precious.)

Any­way, our point is always the same – we’re con­sis­tent that way. Just because they need the money, doesn’t mean that they deserve the money nor does it mean that they’ll spend it wisely.

In that way, they’re not much dif­fer­ent the the home­less alco­holics who beg for drink­ing money on the Roberto Clemente bridge in the city of Pitts­burgh, and pre­sum­ably – this is just a wild hunch – in other cities around the coun­try, too.

Now, we know that some drug addicts get monthly Social Secu­rity checks from the fed­eral gov­ern­ment because their drug addic­tion tech­ni­cally – or, at least, bureau­crat­i­cally – dis­ables them, but we don’t think that usage is wise gov­ern­men­tal pol­icy, either. Maybe it’s just our nar­row way of think­ing, but such poli­cies not only sub­si­dize but also seem to con­done such unde­sir­able, anti-​social behav­ior, and we, as a soci­ety, end-​up with more of the dys­nfunc­tion­al­ity that we should be try­ing to eliminate.

The only com­pel­ing argu­ment that we’ve ever heard for such sub­si­diza­tion was pre­sented by the aptly named, Alfie Doolit­tle, Eliza’s father, in My Fair Lady. His was a strictly util­i­tar­ian argu­ment. Mr. Doolit­tle didn’t really deserve the £5 he was ask­ing for (her). In his own words, he was unde­serv­ing and planned to con­tinue to be unde­serv­ing, but he’d cer­tainly enjoy spend­ing it on a spree for he and his mis­sus; so, in that sense, the pay­ment would be used to max­i­mize soci­etal wel­fare and cre­ate jobs for those serv­ing him.

We don’t see the valid­ity of that argu­ment in the government’s response to the cur­rent finan­cial cri­sis, and it seems that many other mem­bers of the middle-​class feel the same way.

By the way, in an arti­cle yes­ter­day, U.S. Seeks Rest of Bailout Cash, the reporters Deb­o­rah Solomon and Damian Paletta wrote: “Con­gress rejected Trea­sury Sec­re­tary Henry Paulson’s ini­tial request, send­ing mar­kets tum­bling. A sec­ond ver­sion of the law passed sev­eral days later, allow­ing Trea­sury imme­di­ate access to $350 billion.”

Per­haps those two slept through the wealth destruc­tion that fol­lowed pas­sage of TARP, as they make no men­tion of that drop in equity val­ues. The DJIA was at 10,831 on Sep­tem­ber 30; so, talk about rewrit­ing his­tory! More pre­cisely, talk about an extremely weak argu­ment to waste more of our money!

Per­haps if the ail­ing banks and their reg­u­la­tors were a bit more straight­for­ward and bit more like Alfie Doolit­tle, we’d per­son­ally be a bit more sym­pa­thetic. Until then, we’ll point read­ers to our other posts, includ­ing the last few (What Is Cit­i­group Worth? and When Is Enough Enough?) and our entry from three months ago when we first called for the nation­al­iza­tion of the weak­est banks as a les­son to the remain­ing healthy ones: It’s Time!

So, we con­clude by ask­ing rhetor­i­cally: why sub­si­dize irre­spon­si­ble, anti-​social behav­ior, regard­less of the recip­i­ents’ hygiene, con­nec­tions, or cronies, espe­cially when – unlike Alfie – it and they are not the least bit amusing?

The Wall Street Jour­nal reports today that Obama Keeps His Dis­tance From Trea­sury on TARP. It seems the Mr. Obama and his rep­re­sen­ta­tives are not pro­vid­ing the Bush admin­is­tra­tion offi­cials with specifics about their mort­gage and liq­uid­ity crises-​related plans.

We say: what’s wrong with that? 

Whether Mr. Obama and his staff are seri­ously delib­er­at­ing and con­tem­plat­ing spe­cific plans or actions or whether they are just pre­tend­ing to do so, either is fine with us. Both are a vast improve­ment over the panic-​speech of Mr. Paul­son and Mr. Bernanke in the last half of September.

It’s our opin­ion that if those two had kept their mouths shut, took deep breaths and attempted to think, then the finan­cial mar­kets, the world’s economies, and the wel­fare of most the cit­i­zens of the United States would be much bet­ter today – not good, but better.

Fre­quently over the past few months, we’ve posted are own pre­scrip­tions for the two crises and they involve tax incen­tives to mit­i­gate the mort­gage cri­sis, and force­ful expropriation/​nationalization of the very worse large banks to mit­i­gate the con­fi­dence and liq­uid­ity cri­sis that con­tin­ues to loom over the nation and the world. Nation­al­ize not because the gov­ern­ment will oper­ate the finan­cial insti­tu­tion more effi­ciently, but do it because the gov­ern­ment and the peo­ple it rep­re­sents are already the resid­ual claimants. Nation­al­ize to penal­ized the failed boards and man­age­ments of the worst offend­ers, and set exam­ples to moti­vate health­ier firms to act. (Inter­ested par­ties can search our archives for many, many related posts.)

Any­way, had the Bush admin­is­tra­tion and appointees been more delib­er­ate there would still be a mort­gage prob­lem and a liq­uid­ity cri­sis, but the extent and effects of the liq­uid­ity cri­sis would have been muted. Many of their plans would still have been counter-​productive, but those mis­takes would not have been ampli­fied by the panic-​speech and vice versa, and we doubt that we would have seen the stock declines and record volatil­ity that we’ve observed.

So, we cheer for Mr. Obama’s laconic style and hope that his aides con­tinue to emu­late that aspect of his per­son­al­ity dur­ing the tran­si­tion and while in office. That almost seems conservative.

Some­times, less is more, and silence is golden; so, we’ll end here.

If you haven’t read it, For the Vix, 40 Looks Like It’s the New 20 in today’s The Wall Street Jour­nal please know that is a decent column.

We par­tic­u­larly like the paragraph:

“Volatil­ity may not return to its highs, but it isn’t clear when it will get back to nor­mal, either. Volatil­ity breeds fear, which breeds more volatil­ity. There is still too much uncer­tainty about the losses lurk­ing on bank bal­ance sheets and about the depth and breadth of the cur­rent reces­sion to inspire much calm.”

Now, the first sen­tence is true but says absolutely noth­ing. We’re not try­ing to ridicule Mark Gon­gloff the writer of the Ahead of the Tape column; instead, we empathize with the dif­fi­culty he faces writ­ing about mar­kets and uncertainty.

The notion of uncer­tainty about uncer­tainty–and the inabil­ity to mea­sure it in a sim­ple man­ner – tends to make state­ments about the topic either sound overly-​complex and overly-​qualified (by all of the nec­es­sary descrip­tive qual­i­fi­ca­tions to the state­ment) or makes them sound trite. Some­times that’s the writer’s fault, but often it is the reader’s fault, too, espe­cially when the reader incor­rectly pos­sess no uncer­tainty about their own “knowledge.”)

Now, we espe­cially like Mr. Gongloff’s fol­low­ing sen­tences because that’s almost exactly what we’ve writ­ten dur­ing the past sev­eral months – almost three months now.

The mort­gage cri­sis that cre­ated the con­fi­dence and liq­uid­ity cri­sis and the result­ing equity mar­ket volatil­ity all con­tin­ued unabated. Last Wednes­day, in The Mort­gage Cri­sis: Why Not Incen­tivize the Pri­vate Sec­tor? we wrote: “By the way, folks who think this Thanks­giv­ing week’s mini-​rally sig­ni­fies that the worst is over are likely to be sadly mis­taken. We do hope that we’re wrong, but doubt it.” 

While we try not to make much of one-​day changes, even when they are as large as today’s drop of 680 points in the DJIA and the nearly 9% decreases in the S&P 500 and NASDAQ indices, we do believe both the con­tin­u­ing volatil­ity and losses pro­vide evi­dence that the government’s actions to date have not helped instill con­fi­dence. In all like­li­hood have hin­dered econ­omy and finan­cial activ­i­ties by not allow­ing any res­o­lu­tion of the uncer­tainty of the value and via­bil­ity of large finan­cial intermediaries.

We wrote about that in Could a “Bailout” Pro­long the Finan­cial Cri­sis? and The Uncer­tain Value of Mort­gage Secu­ri­ties (among other posts) in late Sep­tem­ber. How­ever, the government’s exe­cu­tion and lack of plan­ning has been even worse than we could have imag­ined, and we had extremely low expec­ta­tions to begin with. 

As we have been men­tion­ing since that time, we wish fed­eral gov­ern­ment would pro­vide tax incen­tives – say, mort­gage invest­ment tax cred­its – to moti­vate pri­vate pur­chases of trou­bled assets. 

We also wish the gov­ern­ment would expro­pri­ate the worst offend­ers – the most poorly cap­i­tal­ized large banks. We know that the Trea­sury can’t run banks any bet­ter than the exist­ing man­age­ments, but that’s not one of our reasons. A main rea­son is to moti­vate other health­ier insti­tu­tions to act. Hav­ing ready buy­ers – moti­vated by such tax cred­its – would cer­tainly help those banks exchange assets for cash, and that lack of trade keeps the analy­ses of each bank’s finan­cial con­di­tional need­lessly opaque, and that’s (by def­i­n­i­tion) no way to resolve uncertainty.

We’re not sure when dur­ing the day, Mr. Paul­son spoke of new pro­grams (Paul­son Says Trea­sury Actively Mulling New Res­cue Pro­grams), but we doubt if that stemmed the (ebbing) tide of sharply decreas­ing equity val­ues. Unfor­tu­nately, there is no rea­son to expect any pos­i­tive news any time soon.

The Wall Street Jour­nal today, Novem­ber 28, reports Res­cue Plan Strained by Lack of Staff.

We’ve crit­i­cized the government’s response to both the domes­tic mort­gage cri­sis and the larger global con­fi­dence cri­sis since it – that which became TARP – was first pro­posed. (We use the sin­gu­lar “it” because we’ve not heard any gov­ern­ment offi­cial decou­ple the prob­lems either in their ini­tial panic or in the inter­ven­ing months.)

Since mid-​September, other than times when we were too busy to write, our crit­i­cism as been con­sis­tent, harsh, and steady: (1) ini­tially the gov­ern­ment offi­cials, led by Trea­sury Sec­re­tary Henry Paul­son, over­re­acted. That hys­te­ria – or maybe it was (indistinguishable) hyperbole – exac­er­bated the sit­u­a­tion and cre­ated real panic and extremely high volatil­ity, which remains. (2) Their solu­tion – which, as Trea­sury offi­cials now implic­itly admit did not meet the def­i­n­i­tion of a plan – was poorly con­structed and des­tined to fail. And (3) as we wrote nearly two months ago, in Even A Per­fect Bailout Will Fail, “What Hope of Suc­cess with Typ­i­cal Bureau­cratic Efficiency?”

The arti­cle cited above pro­vides evi­dence of that “Bureau­cratic Effi­ciency,” by which of course we meant inef­fi­ciency. (We should have included “inef­fec­tive­ness,” too, but it seemed like overkill at the time.) The key line in today’s arti­cle: “The cur­rent Trea­sury has so far strug­gled to keep up with the task of hir­ing enough peo­ple to han­dle the $700 bil­lion finan­cial res­cue package…”

Would any rea­son­able per­son expect any more (or less) from a mas­sive, cen­tral­ized bureau­cracy? In that regard, is the fed­eral government’s response to this dis­as­ter or cat­a­stro­phe any dif­fer­ent than its response to Hur­ri­canes Kat­rina and Ike? (Ike has escaped national atten­tion due to the more destruc­tive finan­cial cri­sis and the recent Pres­i­den­tial election.) 

Thus, our gov­ern­ment seems to be unable to deal with either large-​scale nat­ural or man-​made dis­as­ters. How­ever, while Michael Brown, the Direc­tor of FEMA at the time of Kat­rina, could never be blamed for caus­ing Kat­rina, can the same be said of Mr. Bush’s finan­cial appointees in the cur­rent crisis?

In today’s (Novem­ber 26) edi­tion of The Wall Street Jour­nal, there is a Deal Jour­nal arti­cle enti­tled, “Paul­son Plan: ‘Truly Idiotic.’”

Although we’ve not gone that far in describ­ing TARP et al, we’ve been harshly crit­i­cal of Mr. Paul­son. In fact, we’ve men­tioned that his series of actions don’t seem to con­sti­tute an actual plan, because the word “plan” implies a cer­tain degree of, well, plan­ning or fore­sight and forethought, and those pre­req­ui­sites seemed absent in his Panic of ’08.

The quoted accuser in the Deal Jour­nal arti­cle is Charles Calomiris, a prof at Colum­bia, and he make sev­eral good points, includ­ing “we’re using half-​measures designed in an inap­pro­pri­ate way,” and “The prob­lem is the com­pletely opaque dis­tri­b­u­tion of losses because no one knows how to value these mort­gage losses.”

We’ve made sim­i­lar remarks any num­ber of times, and it is exactly those opaque joint dis­tri­b­u­tions of cash flows (and there­fore losses) that cause all the trou­ble and makes the pools impos­si­ble to value with any degree of precision.

While we do agree with his crit­i­cism, we don’t agree with his rec­om­men­da­tions. Pri­mar­ily his sug­ges­tion that “the gov­ern­ment offer to buy any mort­gage for 40 cents on the dollar.”

It is unclear how the 40% solu­tion is derived, and think­ing in terms of Akerlof’s Lemons Model, you can be sure that only one type of mort­gage would be offered: one with a value between zero and 40% of face value.¹ Thus, if the gov­ern­ment com­mits to pur­chase any mort­gage, it would cer­tain over-​pay, and thus sub­si­dize the worst cases, and if the gov­ern­ment does not com­mit, then it is likely the mech­a­nism would fail with few or any trans­ac­tions. (The dif­fi­culty of valu­ing the mort­gages does com­pli­cate mat­ters as does their cur­rent book value.)

Why not try a pri­vate solu­tion? Why not offer mort­gage invest­ment tax cred­its or per­mit imme­di­ate and accel­er­ated amor­ti­za­tion (depre­ci­a­tion) of the pur­chase price of those mort­gages and mortgage-​related secu­ri­ties for prospec­tive buy­ers? Then set low tax rates for prospec­tive real­ized cash flows.

We’re sure that many buy­ers have some val­u­a­tion model, but likely (and jus­ti­fi­ably) do not trust it. Giv­ing a 30% — 40% tax break should pro­vide them with an ample cush­ion to take a chance. How could such a plan be any worse than a government-​administered plan, or a government-​regulated, fixed-​price one? (Remem­ber the government’s suc­cess at other attempts at price con­trols: both sup­ports and ceilings.)

By the way, folks who think this Thanks­giv­ing week’s mini-​rally sig­ni­fies that the worst is over are likely to be sadly mis­taken. We do hope that we’re wrong, but doubt it.

Noth­ing has solved the over­whelm­ing prob­lem that the mar­kets do not trust the large finan­cial inter­me­di­aries, and those banks do not trust each other. The mort­gage cri­sis informed about the banks’ short­com­ings; so, solv­ing that mort­gage cri­sis won’t cause any­one to believe that the bank’s judg­ment has improved – at least for quite some time. In that respect, Mr. Calomiris is quite right. Mr. Paul­son has done noth­ing to help.

Thank god we live in a coun­try that can with­stand such epic mis­man­age­ment. What was the total $7.5 trillion?

(New read­ers can search the archives from the past sev­eral months to find many related articles.)

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.)

Jeez, our post from two weeks ago, which noted the sim­i­lar­i­ties between TARP and GARP, makes us seem almost prescient.

Like T.S. Garp, it seems that Mr. Paul­son is jet­ti­son­ing let­ters as he con­tin­ues lonely and aim­less pur­suit. In fact, we’d pre­fer that he take up Mr. Garp’s hobby as it is less dam­ag­ing to the econ­omy and our well-​being than many of Mr. Paulson’s extant actions.

We base our state­ments on today’s announce­ment that the Trea­sury Depart­ment will not pur­chase any Trou­bled Assets: Trea­sury Not Plan­ning to Buy Bad Loans, Assets.

This is one case where we hate to be cor­rect, but it is exactly what we wrote about in Sep­tem­ber and early Octo­ber, when we wrote exhaus­tively that the government’s government-​run “bailout” could not be imple­mented quickly and would fail. (Search, bailout, for exam­ple, for our many posts on the topic.)

We’d also note that it is not too late to attempt a pri­vate solu­tion to the prob­lem. As we men­tioned repeat­edly – includ­ing in ear­lier posts today–the prob­lem is that no one has con­fi­dence in their own val­u­a­tion meth­ods, and that lack of con­fi­dence is jus­ti­fied thus the mort­gage mar­ket is par­a­lyzed. (The broader credit cri­sis also involves a paral­y­sis, but that lack of move­ment relates to dis­trust­ing each other rather than one’s self. Although there is a self-​referential aspect to it that we wrote about in Finan­cial Pro­jec­tion in a Cri­sis.)

How­ever, as we pro­posed in Sep­tem­ber in A Bet­ter Solu­tion (than a gov­ern­ment takeover), pri­vate buy­ers could be induced to pur­chase the trou­bled assets with the proper (and sim­ple) tax incentives. 

Either per­mit buy­ers to imme­di­ately expense their pur­chase price (and then pay low rates on future sales or cash flow realizations) or pro­vide an equiv­a­lent mortgage, investment tax credit.

Such tax incen­tives would pro­vide a cush­ion or mar­gin of error of 30% — 40% of the pur­chase price and would likely be large enough to stim­u­late a sub­stan­tial demand for the mort­gages and the mortgage-​related prod­ucts thereby pro­vid­ing liq­uid­ity with­out the heavy hand of Uncle Sam splash­ing around. (We sus­pect that many traders, struc­tur­ers, and mod­el­ers know that they were/​are wrong, but doubt that it is by an addi­tional, say, 35%.)

Now that our offi­cials seem less in the full-​panic mode than six weeks ago, per­haps they’ll take the time to pon­der or think or con­sider about rea­son­able, sim­ple, and rel­a­tively cheap alter­na­tives to their now dis­carded scheme. We know it is a stretch for many of them, but what else can they do? Garp. Garp. (Or is it rp, rp.)

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: