Things I Wish I Said
An idea for the 'toxic waste' problem
But these assets have a kind of information asymmetry problem. The bank says, "How about $1 million for this asset." The buyer says, "I'll give you $50,000." The bank says, "Why so little?!" The buyer says, "I don't believe you that it's worth $1 million!" The bank says, "Well, we paid this gentleman in a suit over here to put an AAA price tag on it! Of course it's worth $1 million!" And the buyer says, "Yeah right" and walks away. The idea is that the bank knows more than the buyer about these assets, so the mere fact that it is trying to sell them is a signal that you shouldn't buy them at all. This is kind of like the lemon car problem: if you don't trust the used car salesman, the fact that he is selling the car at all is a red flag.
But what if the banks had to do the following thing. They parcel out all their mortgage-related securities into bundles. At that point, some public and some private parties (or perhaps partnerships somewhat similar to those envisioned by the Geithner plan) say how much they'll pay per bundle. The trick is that only some bundles can be sold, but they all have to be sold for the same price, and furthermore, the order of choosing is the following: first the government picks its bundles, then the private investors pick theirs, and then the bank keeps the rest.
This would create an immensely powerful incentive for the banks to create bundles of precisely equal value: since they go last in picking the bundles, they had better make them all identically valued. This is like splitting cake between two kids: you have the first kid cut the cake, then the other kid choose the first piece. This makes the first kid very, very careful to cut equal pieces.
So if the bank made unequal bundles, then the private parties and public parties would underbid, take the most valuable ones, and leave the trash for the bank. The government's leverage works like this: it relies on the private participants to set price, but it goes first in picking. Perhaps it simply picks at random. Then the private party is incentivized to bid an accurate price -- if it bids too much (on the theory it'll just grab the sweet bundle), the sweet bundle may simply disappear. (Competition is intended to make the bids not be too small.) The leverage is that the government buys 10 bundles for every 1 bundle private parties buy.
In terms of cake, this works like this: the bank has the cake, we want to give them a fair price for the cake to reduce the uncertainty in their balance sheet. The problem is, no-one will buy a piece of cake because they're worried that some pieces have no filling, and the bank knows how to cut slices with no filling, and will just sell you those. So the market for cake freezes. Furthermore, the cake is simply too big for anyone to buy up the whole thing, which would ensure that they don't get cheated. The government could buy the whole cake, but has no idea what it should pay. So what we do is make the bank cut 16 slices of cake, then ask private parties to bid for the right to get two or three slices. The government then buys 10 slices at the market price. The government picks 10 slices at random. The private parties get their pick of another two or three, and the bank selling cake gets the remaining couple.
As a side benefit, now that there's an agreed-upon price for these slices, a) the bank can write down whatever losses it took on the cake, b) it just got a fat roll of cash, c) it can now sell it's own slices on the market as bundles, or re-bundle the remaining assets and repeat the trick.
This would undoubtedly leave some banks bankrupt. (It is analogous to the 'stress test' that's been proposed by the Treasury.) Those can be taken over and basically nationalized and dealt with. Those who survived to tell the tale would have accurate balance sheets that counterparties could trust, and credit in theory would be available.
The bottom line? Taxpayers are exposed to the same risks and getting the same performance from their portfolio as the hedge funds and private equity that bought the bundles from the banks. Even if bank employees who have inside information quit and join the hedge funds to cheat, the fact that the government picks first and at random, and that the banks go last, leaves very powerful incentives for the banks to make the bundles as even as they know how. ¶ 11:11 PM 0 Comments
Tuesday, March 24, 2009
So there's a problem with our banks. They have assets that are troubling them. They're troubling because they are illiquid, resulting in a lock-up of credit and a general mistrust in each other's ability to pay. If you think the other bank has a 1% chance of failing tomorrow, letting them hold your money is crazy.
But these assets have a kind of information asymmetry problem. The bank says, "How about $1 million for this asset." The buyer says, "I'll give you $50,000." The bank says, "Why so little?!" The buyer says, "I don't believe you that it's worth $1 million!" The bank says, "Well, we paid this gentleman in a suit over here to put an AAA price tag on it! Of course it's worth $1 million!" And the buyer says, "Yeah right" and walks away. The idea is that the bank knows more than the buyer about these assets, so the mere fact that it is trying to sell them is a signal that you shouldn't buy them at all. This is kind of like the lemon car problem: if you don't trust the used car salesman, the fact that he is selling the car at all is a red flag.
But what if the banks had to do the following thing. They parcel out all their mortgage-related securities into bundles. At that point, some public and some private parties (or perhaps partnerships somewhat similar to those envisioned by the Geithner plan) say how much they'll pay per bundle. The trick is that only some bundles can be sold, but they all have to be sold for the same price, and furthermore, the order of choosing is the following: first the government picks its bundles, then the private investors pick theirs, and then the bank keeps the rest.
This would create an immensely powerful incentive for the banks to create bundles of precisely equal value: since they go last in picking the bundles, they had better make them all identically valued. This is like splitting cake between two kids: you have the first kid cut the cake, then the other kid choose the first piece. This makes the first kid very, very careful to cut equal pieces.
So if the bank made unequal bundles, then the private parties and public parties would underbid, take the most valuable ones, and leave the trash for the bank. The government's leverage works like this: it relies on the private participants to set price, but it goes first in picking. Perhaps it simply picks at random. Then the private party is incentivized to bid an accurate price -- if it bids too much (on the theory it'll just grab the sweet bundle), the sweet bundle may simply disappear. (Competition is intended to make the bids not be too small.) The leverage is that the government buys 10 bundles for every 1 bundle private parties buy.
In terms of cake, this works like this: the bank has the cake, we want to give them a fair price for the cake to reduce the uncertainty in their balance sheet. The problem is, no-one will buy a piece of cake because they're worried that some pieces have no filling, and the bank knows how to cut slices with no filling, and will just sell you those. So the market for cake freezes. Furthermore, the cake is simply too big for anyone to buy up the whole thing, which would ensure that they don't get cheated. The government could buy the whole cake, but has no idea what it should pay. So what we do is make the bank cut 16 slices of cake, then ask private parties to bid for the right to get two or three slices. The government then buys 10 slices at the market price. The government picks 10 slices at random. The private parties get their pick of another two or three, and the bank selling cake gets the remaining couple.
As a side benefit, now that there's an agreed-upon price for these slices, a) the bank can write down whatever losses it took on the cake, b) it just got a fat roll of cash, c) it can now sell it's own slices on the market as bundles, or re-bundle the remaining assets and repeat the trick.
This would undoubtedly leave some banks bankrupt. (It is analogous to the 'stress test' that's been proposed by the Treasury.) Those can be taken over and basically nationalized and dealt with. Those who survived to tell the tale would have accurate balance sheets that counterparties could trust, and credit in theory would be available.
The bottom line? Taxpayers are exposed to the same risks and getting the same performance from their portfolio as the hedge funds and private equity that bought the bundles from the banks. Even if bank employees who have inside information quit and join the hedge funds to cheat, the fact that the government picks first and at random, and that the banks go last, leaves very powerful incentives for the banks to make the bundles as even as they know how. ¶ 11:11 PM 0 Comments
Who makes the laws around here?!
I think we should go further, though. Congress should pass a law saying that any CDS contracts held by or owed to American companies are non-binding. If the parties want to continue to pay them, fine. If they don't want to, fine. It is as if they simply never happened.
This would have much the same effect as the bad bank strategy that's been floated, but even the threat of that legislation should be enough to force the value of these instruments to plummet to zero, where they belong, wiping out the miscreants who got us into this mess in the first place. Good riddance.
It'd probably also be more efficient, as the banks would then, on their own time, trade these worthless assets away in some kind of gigantic orgy of write-offs. When the dust settles, the people who were defrauded by people selling them junk bonds hidden inside AAA rated firms, like AIG or whoever, should be allowed to file personal civil liability lawsuits. Then they can all exhaust themselves suing each other, keeping vast armies of paralegals fully employed until the sun goes nova. ¶ 9:57 PM 0 Comments
Friday, March 6, 2009
I liked this post about the high-finance shenanigans and what we should do about them.
I think we should go further, though. Congress should pass a law saying that any CDS contracts held by or owed to American companies are non-binding. If the parties want to continue to pay them, fine. If they don't want to, fine. It is as if they simply never happened.
This would have much the same effect as the bad bank strategy that's been floated, but even the threat of that legislation should be enough to force the value of these instruments to plummet to zero, where they belong, wiping out the miscreants who got us into this mess in the first place. Good riddance.
It'd probably also be more efficient, as the banks would then, on their own time, trade these worthless assets away in some kind of gigantic orgy of write-offs. When the dust settles, the people who were defrauded by people selling them junk bonds hidden inside AAA rated firms, like AIG or whoever, should be allowed to file personal civil liability lawsuits. Then they can all exhaust themselves suing each other, keeping vast armies of paralegals fully employed until the sun goes nova. ¶ 9:57 PM 0 Comments
Social capital and the trust deficit
Some examples. The main obstacle to creating a new manufacturing company in the 1900s was capital. You needed a lot of money to buy the machines. The main obstacle to creating a new information company in the 2000s is people and social connections and finding a place in the psychological environment. Think about a classic social enterprise like news (or, ta da!, banking). The value of a newspaper has always relied on its reputation and its occupying a particular niche in the psychology of a region. But whereas it used to be that sufficient cash could buy the presses and distribution systems, and those were the main obstacles, today those obstacles to creating a news organization are much smaller. There are still the barriers of building a good reputation, which are high ones, but the point is, the decrease in capital barriers for information economy businesses means that the social aspects are relatively much more important.
Even a classic manufacturing thing like making shoes looks far different. Nike is mainly a branding/marketing company, which outsources the apparent content of its entire business. The value Nike is adding is around patents, licenses, knowledge, connections, marketing and branding. In similar ways, the outsourcing of manufacturing has impacted other industries as well, rendering their social dimension more important than their capital-dependent dimension.
A standard way of talking about this is the "U of value" -- the observation that in modern American product companies, most of the value (in terms of where the profits go) come at the beginning of the development cycle -- in product design and building the connections for manufacturing -- and at the end, where the marketing and branding are. That is, the economy in the 2000s is much more dependent on the ability to coalesce brilliant teams of design experts, build networks of supply and distribution, and field marketing campaigns than it is about TQM on the assembly line.
Fair enough. But what this means all around is that the economy is much more dependent on something which policy-makers have a harder time getting a handle on -- social capital. When capital is the main bottleneck to economic activity, then financial operations with the money supply are a great lever. When the main economic activity bottlenecks are people talking at parties, building trust, making connections, traveling to visit their counterparts and bonding with them, gelling with teammates, and such, it is much harder to get a handle on that economic engine through monetary means.
The banking system is a good example. Banks have always relied on their reputations for a big part of the value they provide. That's not news. But as with anything else, falling capital barriers means that actors which might not be big, but with a lot of social capital, can have tons of influence. The bubbles we've seen could be described as ills of socially-organized economies. People follow each other. They rationalize actions relative to what they see others doing. They choose who to trust. (Or, perhaps more accurately, they shop around for someone to tell them what they want to hear and then trust that source.)
The point isn't to say that people weren't important to the economy in the 1900s, but to point to the banking industry as a key initiator of the current problems as evidence that these kinds of more social and psychological issues of trust, risk tolerance, and personal connections are now not just peripheral features of the most esoteric parts of the economy, but are a lot more deeply embedded in the economy than they used to be.
The primary mode of transmission of this crisis -- credit -- is an indication that psychological factors are key. Credit is basically the financial representation of trust. If there's a trust shortage, there'll be a credit crunch.
Which means that when this economy is sick, the ways we learned to cope with a sick economy whose principal engine was capital may not work as well. We need new schemes. More psychological schemes. Schemes tailored more towards trying to make sure that trust can be safely bestowed. ¶ 9:07 PM 0 Comments
Tuesday, March 3, 2009
I think part of the story of the 2008-2009 financial problems are the ills of the rising importance of the social aspects of the organization of the economy. There have obviously long been important social aspects to the economy and how business is organized, but it seems to me that our economy in the past few decades has come to rely more and more on the social or psychological dimensions of value than it has in the past.
Some examples. The main obstacle to creating a new manufacturing company in the 1900s was capital. You needed a lot of money to buy the machines. The main obstacle to creating a new information company in the 2000s is people and social connections and finding a place in the psychological environment. Think about a classic social enterprise like news (or, ta da!, banking). The value of a newspaper has always relied on its reputation and its occupying a particular niche in the psychology of a region. But whereas it used to be that sufficient cash could buy the presses and distribution systems, and those were the main obstacles, today those obstacles to creating a news organization are much smaller. There are still the barriers of building a good reputation, which are high ones, but the point is, the decrease in capital barriers for information economy businesses means that the social aspects are relatively much more important.
Even a classic manufacturing thing like making shoes looks far different. Nike is mainly a branding/marketing company, which outsources the apparent content of its entire business. The value Nike is adding is around patents, licenses, knowledge, connections, marketing and branding. In similar ways, the outsourcing of manufacturing has impacted other industries as well, rendering their social dimension more important than their capital-dependent dimension.
A standard way of talking about this is the "U of value" -- the observation that in modern American product companies, most of the value (in terms of where the profits go) come at the beginning of the development cycle -- in product design and building the connections for manufacturing -- and at the end, where the marketing and branding are. That is, the economy in the 2000s is much more dependent on the ability to coalesce brilliant teams of design experts, build networks of supply and distribution, and field marketing campaigns than it is about TQM on the assembly line.
Fair enough. But what this means all around is that the economy is much more dependent on something which policy-makers have a harder time getting a handle on -- social capital. When capital is the main bottleneck to economic activity, then financial operations with the money supply are a great lever. When the main economic activity bottlenecks are people talking at parties, building trust, making connections, traveling to visit their counterparts and bonding with them, gelling with teammates, and such, it is much harder to get a handle on that economic engine through monetary means.
The banking system is a good example. Banks have always relied on their reputations for a big part of the value they provide. That's not news. But as with anything else, falling capital barriers means that actors which might not be big, but with a lot of social capital, can have tons of influence. The bubbles we've seen could be described as ills of socially-organized economies. People follow each other. They rationalize actions relative to what they see others doing. They choose who to trust. (Or, perhaps more accurately, they shop around for someone to tell them what they want to hear and then trust that source.)
The point isn't to say that people weren't important to the economy in the 1900s, but to point to the banking industry as a key initiator of the current problems as evidence that these kinds of more social and psychological issues of trust, risk tolerance, and personal connections are now not just peripheral features of the most esoteric parts of the economy, but are a lot more deeply embedded in the economy than they used to be.
The primary mode of transmission of this crisis -- credit -- is an indication that psychological factors are key. Credit is basically the financial representation of trust. If there's a trust shortage, there'll be a credit crunch.
Which means that when this economy is sick, the ways we learned to cope with a sick economy whose principal engine was capital may not work as well. We need new schemes. More psychological schemes. Schemes tailored more towards trying to make sure that trust can be safely bestowed. ¶ 9:07 PM 0 Comments
