Spero Consulting

Posts Tagged ‘Treasury Department’

The Government’s Response to the Finan­cial Cri­sis of 2008

A con­flu­ence of events dur­ing the past few days reminded us of how the fed­eral gov­ern­ment failed the nation dur­ing the finan­cial cri­sis of 2008. At the time, we men­tioned that our pub­lic ser­vants pan­icked, but now we think that we can offer a bet­ter expla­na­tion of why that occurred. Bank reg­u­la­tors, includ­ing the Fed, the lender of last resort, were utterly unpre­pared for it.

The news the past two days shows how utterly unpre­pared the nation of Haiti was to face any type of large scale dis­as­ter. After this week’s earth­quake, noth­ing on its half of His­pan­iola seems to be work­ing, and inter­na­tional res­cue and human­i­tar­ian are sti­fled by the lack of access. For exam­ple, the main (prob­a­bly the only) port is destroyed, and there is only one air­port with one run­way with no lights and no fuel sup­ply (for return flights). While the injured and hun­gry suf­fer, planes cir­cle or wait on tar­macs in the U.S. and the Caribbean. (May God bless those unfor­tu­nate souls and all of the inter­na­tional efforts and vol­un­teers who are attempt­ing to help.)

Now, Haiti was a dis­as­ter before the earth­quake; so, it is under­stand­able that the nation did not have the resources to develop and fund con­tin­gency plans.

In some ways, and despite the after­math of Hur­ri­cane Kat­rina, it seems that our great nation is much better-​prepared to han­dle emer­gen­cies and dis­as­ters. Many fed­eral, state, and local agen­cies have indi­vid­ual and coör­di­nated con­tin­gency plans and train­ing exer­cises to pre­pare for a vari­ety of man-​made and nat­ural disasters.

It is also true that many fed­eral and state agen­cies and reg­u­la­tors require busi­nesses and orga­ni­za­tions in a vari­ety of indus­tries to per­form stress tests and sce­nario analy­ses and develop con­tin­gency plans to deal with extremely bad hypo­thet­i­cal events. Arguably, the most famous of these exer­cises was last spring’s Super­vi­sory Cap­i­tal Assess­ment Pro­gram (SCAP), which we wrote about (and crit­i­cized) a few times.

As many of our read­ers will recall, via SCAP, fed­eral bank reg­u­la­tors required the nation’s 19 largest banks to per­form a series of stress tests and sce­nario analy­ses to deter­mine weak­nesses and iden­tify cap­i­tal inad­e­qua­cies. Other than requir­ing cer­tain insti­tu­tions to raise cap­i­tal, we’re not sure if that pro­gram required the banks to iden­tify and main­tain con­tin­gency plans.

Note that except for the coör­di­nated nature of the pro­gram – requir­ing all the banks to per­form their analy­ses simul­ta­ne­ously – and the impli­ca­tions of the analy­ses – the fact the some firms were required to raise cap­i­tal – there was not much new about the process.

For sev­eral years, large banks have been required to per­form mar­ket and credit-​related stress tests and sce­nario analy­ses as well as develop con­tin­gency plans for liq­uid­ity prob­lems and crises, and those analy­ses were reviewed by the appro­pri­ate reg­u­la­tors. Those analy­ses weren’t stan­dard­ized, and – given the lack of uni­for­mity in assump­tions, method­olo­gies, and sce­nar­ios – the results could not be con­sol­i­dated in any mean­ing­ful way. So, it would have been very dif­fi­cult to iden­tify any sys­temic risks from the results of such exercises.

Given that fact, one would hope that reg­u­la­tors, includ­ing the lender of a last resort, would have per­formed their own stress tests and sce­nario analy­ses to deter­mine poten­tial threats to the finan­cial sys­tem. How­ever, we do not recall read­ing or see­ing any report that men­tioned that the Fed or the Trea­sury Depart­ment had per­formed any such analy­ses. (We’re too lazy to do a thor­ough web search today.)

Thus, one can explain the government’s and Fed’s near com­plete panic as result­ing from a total lack of pre­pared­ness as the cri­sis unfolded. (Since Sep­tem­ber 2008, it has been our con­tention that their behav­ior and rhetoric – to jus­tify pas­sage of the TARP bill – exac­er­bated the crisis.)

So, with­out any evi­dence to refute our spec­u­la­tion, we con­clude that our pub­lic ser­vants and reg­u­la­tors had no idea what to do when things went bad because they had never con­sid­ered the pos­si­bil­ity of that things could go bad in such a way and to such an extent. (We mean the nearly com­plete dis­so­lu­tion of con­fi­dence in the nation’s largest banks as a result of their ter­ri­ble mort­gage invest­ments.) We sus­pect that lack of con­sid­er­a­tion was true prior to when Bear Stearns failed in the spring of 2008 and that noth­ing changed in the inter­ven­ing six months.

Now, we have only two things to say about that: (1) com­pare their behav­ior in the fall of 2008 to the brave first-​responders on 9 – 11 or at any num­ber of other dis­as­ters and tragedies, and (2) these are the same folks who now want to “reg­u­late sys­temic risk.”

*We don’t mean the human suf­fer­ing. We mean the government’s incom­pe­tent response.

Or, Is It the Naïve Government’s Stress Test­ing Exercise?

More Lack of Plan­ning and Insight from Our Reg­u­la­tors and Gov­ern­ment Officials

About one month ago – on April 7, to be pre­cise – we asked, Where Will the Bank Stress Test­ing Exer­cise Lead?

In that post, we wrote that the tests could be designed one of three ways: (1) with a pos­i­tive bias to ensure that all or almost all of the banks could pass the tests, (2) with no bias to get a hon­est — though not nec­es­sar­ily accu­rate — assess­ment of each bank’s finan­cial con­di­tion (with accu­racy con­strained by the implicit and explicit assump­tions built into the exer­cise), or (3) with a neg­a­tive bias to ensure that most or all banks fail the test.

Given the var­i­ous news reports that four­teen of the 19 banks may have “failed” the tests and that the four­teen have since been nego­ti­ated down to ten that may “require cap­i­tal,” it doesn’t seem that the tests were designed or biased to gen­er­ate pos­i­tive results. In ret­ro­spect, it doesn’t seem that the eco­nomic assump­tions were par­tic­u­larly neg­a­tive – see We Can’t Sub­si­dize the Banks For­ever in today’s edi­tion of The Wall Street Jour­nal for evi­dence that first quar­ter eco­nomic activ­ity and sta­tis­tics were worse than pro­jected in the exer­cise. Note, how­ever, that if they were designed with a pos­i­tive or opti­mistic bias, then the reg­u­la­tors who designed the Super­vi­sory Cap­i­tal Assess­ment Pro­gram (SCAP) wre/​are hor­ren­dously clue­less and incom­pe­tent, and that’s not out­side the realm of possibility.

As we wrote last month, we can’t imag­ine any­one design­ing a neg­a­tive bias into the tests; so, that means that, most likely, the gov­ern­ment sought an “hon­est” though not nec­es­sar­ily accu­rate assess­ment of each bank’s abil­ity to absorb addi­tional losses.

That was and is prob­lem­atic given the amount of pub­lic­ity gen­er­ated about the pro­gram. It would have been much bet­ter to per­form the tests in total secrecy – in what appeared to be a dis­jointed, dis­or­ga­nized, ad hoc, and unsys­tem­atic man­ner to belie any sense that a thor­ough inves­ti­ga­tion or com­pre­hen­sive and national approach was being under­taken. (They should have been stan­dard­ized but secret tests with no pub­lic­ity or acknowl­edge­ments of their existence.)

The three-​day delay in announc­ing their find­ings shows that the reg­u­la­tors – the Fed, the OCC, etc – were unpre­pared for the results. As we wrote back then, there was no sce­nario analy­ses of the stress test out­comes. For exam­ples, what will we do if four­teen banks require more cap­i­tal, all nine­teen, what about two giant ones, etc?

It’s another exam­ple of gov­ern­ment offi­cials being too rash and not thought­ful enough for their own – and the economy’s – sake. That’s why the road to hell is paved with good intentions.

When we find the time, we’ll expand this post later today or tomor­row, but the events of this week show that the government’s response to the Liq­uid­ity Cri­sis, which is, in fact, a cri­sis in con­fi­dence in finan­cial inter­me­di­aries, is no more thought­ful than its reac­tion to the Mort­gage Débâ­cle, and that pan­icked and over-​publicized response cre­ated the Liq­uid­ity Cri­sis in the first place.

Please, folks, first “do no harm,” which means that you have to think before act­ing or cal­cu­lat­ing. Now where have you seen that before?

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?

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.)

We must admit, this is our first post that is truly in bad taste, but it seems so appro­pri­ate that we just could not help our­selves. TARP. TARP.

We’re try­ing to write seri­ously about the government’s – the Trea­sury Department’s – lat­est expe­di­en­cies and tac­tics to … well, we’re not sure of the objec­tive… pre­sum­ably, to make it all go away so that Mr. Bush and his appointees can enjoy their last Autumn and Christ­mas in D.C. (Why would any­one want to ruin Mr. Bush’s last Christ­mas in the White House by caus­ing the pos­si­ble finan­cial ruin of much of the world. Peo­ple can be so mean and self­ish some­times! Can’t we just use the tax­pay­ers’ money to pay them to go away!)

So here is our per­sonal prob­lem. Every time we think of TARP we are reminded of Garp as in John Irving’s The World Accord­ing to Garp. It has been a long time since we’ve read it; so, the details are slightly hazy, but we think we’ve remem­bered enough to draw the cor­rect analogy.

We’re not actu­ally reminded of Garp him­self, so much, but more of his father T.S. Garp, the critically-​wounded, WWII sol­dier, who spends his last days bedrid­den and sense­less in a state­side army hos­pi­tal. As we recall, he had been a ball-​turret gun­ner on per­haps the under­side of a B17 or B24, who took shrap­nel to the head dur­ing a bomb­ing raid over Germany.

“T.S.” were not his first two ini­tials, but rep­re­sented his rank, Tech­ni­cal Sergeant, which is about all of the back­ground his mother, an attend­ing hos­pi­tal nurse in the same ward, knew of his father.

As we recall, despite his dimin­ished state, T.S. Garp had one com­pul­sion, which he seemed to be able to do uncon­sciously and def­i­nitely not self-​consciously. Dur­ing these com­pul­sive episodes, he would repeat his name, “Garp, Garp.…” As his con­di­tion wors­ened, his mantra changed to “Arp, Arp…” and finally, just before his death to “Ar, Ar…”

In our mind, many of the Treasury’s recent tac­tics don’t seem that dif­fer­ent than T.S. Garp’s last efforts. How­ever, within a shorter period of time – less than two weeks – they seemed to have gone from “TARP, TARP…” to “RP, RP.…”

The injec­tion of cap­i­tal to “save the banks” seems to be noth­ing more than a Relief Pro­gram. Cor­po­rate wel­fare and crony­ism at its self-​indulgent best.

So did yesterday’s tough talk go like this? “We’re forc­ing you to take this money, which no one else will lend to you, and you won’t lend to each other. Fur­ther­more, to show you we mean busi­ness, we’re going to guar­an­tee your debt for a frac­tion of the true, underlying, insurance pre­mium, and finally, before you say any­thing, know that we’re going to insure your deposits, too. That should teach you to get into a mess like this, again.” Maybe Mr. Paul­son should read John Rose­mond, rather than con­tact­ing his for­mer employ­ees and his friends for advice on how to save themselves.

Once again, shame on them.

As they spend our money–all of our money–the cru­elty of those two near-​homonyms, sense and cents – all 70 tril­lion of the lat­ter – becomes bru­tally clear.