Capital, Not Toasters, Dr. Krugman

It wasn’t Dr. Krugman’s hate-mail treatment of securitization that made my brain go tilt.

(I say this even though we concur with Barry Ritholz’s reasoning in his blog article, “Paul Krugman is Wrong About Securitization.” )

What really got to me was the reference to toaster giveaways. Toasters! Sylvain paid $5 for ours — used — twenty years ago, and it works just fine, thank you very much. A new toaster would not motivate any of my friends or family members to open a bank account. Nor anyone in my daily life: postman, hairdresser, restaurant manager, butcher, bus driver. I do not think any of the octogenarians who called us last year to ask if their pension plans were in imminent danger of going bust would take solace in a toaster, either.

(What a sad commentary on the general state of trust in American institutions that is — that people looking for truthful answers would turn to strangers quoted in a newspaper!)

The depositor has gone the way of the toaster. After expenses, interest and taxes, few Americans in their earning years have any income left over to put in a savings account, and retirees can’t live on deposit interest either. But something else is going on, too. Trying to make ends meet in our service economy has turned most of us into unwitting entrepreneurs. The average working American knows the meaning of the phrase “ownership society,” because an increasing share of the operating and financial risks in our economy have been foisted on us by commercial entities seeking infinite returns through endless expense management, not genuine growth. As we reach the limit of self-reliance in an economy that is stacked against us, working Americans are coming dangerously close to realizing that we are the real capitalists; that it is our energy, optimism and ideas that feed the growth of the economy.

And capitalists do not need toasters. We need capital.

Working Americans need access to funding at a fair cost of capital — meaning at rates that reflect the value of what we produce and the reliability with which we repay our financial backers. Small business owners, freelancers and entrepreneurs need access to finance, no different than corporate CFOs. We need to be able to respond to business opportunities and, at the same time, plan for the provision of care and education for our children, who are the future intangible wealth of the economy. Yet we have far fewer resources at our command than CFOs, and we are the first to be taxed by the government or be saddled with hidden taxes by the banks.

Let’s not kid ourselves. A 70s-style banking system cannot serve the American small business owner any better today than it did in the 1970s. Nor can a 70s-style education system, which failed us in math and science, enable us to thrive in an information-based economy. By now it is abundantly clear that our economy cannot be pumped up by consumption. We have consumed ourselves and our environment to death, literally.

Economic revival requires that the tables be turned: ordinary Americans need to be treated with respect as the capable producers we are, or can be, not the mindless consumers that we are expected to be. For this inversion to take place, the economy must be re-engineered to listen, think, judge, respond, take responsibility and above all adapt, through the use of informational feedback. In an economy that rewards responsible resource allocation and renewability, informational capital is uniquely important because its value increases – rather than being depleted — through utilization.

All of which brings me back to securitization: the only form of credit extension that can realign the incentive structure so as to reward value creation by transforming data into informational capital and using it as a partial substitute for monetary capital.

That is what securitization was before the banks set out to sabotage it. Sylvain and I watched the abuses begin in earnest after 1998 and the failure of Long-Term Capital. It took about a decade to completely dismantle the securitization market by subverting its rules, which were not well known outside the circle of practitioners. Because ignorance kept the easy money machine well-lubricated, everyone had a hand in its destruction, including the people whose best interest it was not to destroy it: investors, regulators, finance professors, journalists and ordinary Americans who were allegedly too dumb to understand it.

Supposedly, the economic crisis is going to teach the American consumers a lesson or two about their spendthrift ways: more second-hand toasters, and fewer plasma TVs funded by the “home ATM.” But what about the people who got off scot-free with our equity? What have they learned?

And more importantly, when can we expect the return of a real economy?

We are used to being taxed. We accept the necessity of sacrifice. Yes, there is pride and honor and a sense of due accountability in the label “taxpayer.” At the same time, we have a right to expect that the economy we help finance has incentives in place for our children to live secure, wholesome, meaningful lives. Because we live in a commercial society that regulates itself through information, raising the incentives means raising the standards on informational disclosure, which will have the effect of lowering the barriers to entry for anyone who demonstrates the ability to generate that which others value.

As a good faith gesture towards the re-establishment of the economy on a fairer footing, we ask the government to acknowledge that we are being made the lenders of last return in the attempt to restart a baking system that, as yet, we have no reason to trust. We deserve to know precisely how big our transfers of wealth are going to be. And then, we’d like reasons to believe we will never be asked again.


Originally published at the R&R Consulting website and reproduced here with the author’s permission.

67 Responses to "Capital, Not Toasters, Dr. Krugman"

  1. Guest   April 13, 2009 at 9:38 pm

    What does this mean? Securitization: “the only form of credit extension that can realign the incentive structure so as to reward value creation by transforming data into informational capital and using it as a partial substitute for monetary capital.”

    • AR   April 14, 2009 at 6:00 am

      Thank you very much for asking.Securitization (NB, I don’t mean CDOs, CDS, or CDOs of CDS, all money games) uses historical receivables performance data as an arm’s-length measure of company credit quality.Carried out under proper supervision, securitization allows companies to finance themselves at a cost of capital closer to their true economic profile than the market rate of return, which is based on accounting “information” which favors mature companies or structural models whose self-referential nature is inherently unstable.Securitization starts by valuing asset pool performance using non-public historical data to construct cumulative risk measures, then builds a capital structure around the pool to match the asset cash flows and give every class of investor a fair risk premium based on the payment uncertainty of their tranche.But, risk measurement at origination is not enough. Security performance needs to be revisited over time (the “feedback loop”) and there needs to be surveillance in place to ensure that the company is not subsidizing the cash flows with its own P&L. (This is wrong, Enron-style banking. Securitization is non-recourse finance after all.) Then, based on observed performance over the life of a transaction, the cost of capital can be raised or lowered or the structure adjusted the next time the company floats an ABS or RMBS.Recycling information from last deal when structuring the next, is what I mean by “partial substitute for monetary capital.” Re-calibrating the cost of funds based on recent credit performance (rather than “brand” or “share of the wallet” or other non-economic objectives) is what I mean by “realign the incentive structure so as to reward value creation.” If transaction structure is faithfully updated in light of unfolding information, the pricing can be said to be truly in equilibrium.Anyone today with a banking license – and now, the US government – can run a legitimate Ponzi scheme called an ABCP conduit. All you need is enough SPEs and a big enough repayment window to launder money from one vehicle to the next. Value creation is different from this. It is what defines capital and distinguishes it from mere money. If our financial system leaders do not understand or acknowledge the indivisible relationship between the health of the real economy and credit discipline, the harm to our economy will be irreparable in our lifetime.Our research indicates that economic recourse from unreimbursed servicer advancing was rampant after 2002. Intensive monitoring would have stopped the advancing and enabled the market to self-correct against the issuance of under-collateralized transactions.When Amna Nawaz interviewed me last month for the Today show, she asked, perceptively:”Are you saying that if all the deals had been re-rated, none of this would have happened?”The answer is yes.But an almost equally important effect of re-rating would have been the gauntlet to arranging banks, to structure to more transparent standards. This would have served the needs of ordinary American capitalists and would have served as a well-modulated stimulus to economic growth, innovation, alternative energy, education, information, the arts–just about any kind of human activity where people act out of love and commitment rather than the modern perversion of self-hatred called the pure profit motive.In short, contrary to the growing consensus among pundits or academics who didn’t even utter the word two years ago, securitization is not the problem. It has been around for thirty mostly stable years. Nor is the problem with human nature, which is perennial. It is a knowledge and an enforcement gap.

  2. Anonymous   April 14, 2009 at 8:30 am

    Throwing sand in the eyes?Paul Krugman is right about securitization. The citizens should have never been exposed to its risk and should never be again.The destruction of their wealth is there for everyone to see.To be against the professor in this case is suspect.

  3. AR   April 14, 2009 at 8:50 pm

    Fortunately, RGE Monitor is a place where ideas can be genuinely debated and the idolatry of the classroom can be shed.Dr. Krugman and, apparently, you mistake securitization for structured finance. I have already defined this difference above so there is no need to reiterate.The SEC highlighted the possibility that “the citizens would be exposed to this risk” again, after the Investment Holding Company scams of the 1920s, as early as 1994. And still they decided to exempt structured transactions from the 1940 Act. See page 77 of ICRG 92-50.We’ve been around for a decade, enduring our share of censorship, mockery and disdain by the biggest abusers in the system for trying to reform the system with better information. Where were you?

  4. Guest   April 19, 2009 at 7:35 pm

    Great article! The only insight I guess I can offer would be to realign this with an international scope, where this was not only a conduit of the U.S. But rather the last 9 years, gave evidence of this pandemic globally, especially with international agreements, money was just cycled through, repeating several times over.Essentially pseudo-economic growth that was based on favoritism, Even though these Masterminds can convince the public and buyers of these investments, economics can not be played with, the fundamentals will yield or they wont. Richard Gilpin in “International Political Economy” notes that money (billions) where internationally funneled through favoritism in chapter 1. <- Excellent book.This article I guess argues that economic multipliers of investment should be transparent and when it is not it effects all of society. The tidbits even point to capitalism as the instigator or its role in fraud and what will be left of society (capitalism) when consumerism slows because the lack of transparency in investments that are squeezing out the ability of citizens to become entrepreneurs. Yeah Marx argues this, so does the EU. There are many books and journal articles that insist on a war on the middle class, maybe that is the direction this article is going?But essentially capitalism depends on the middle class more than the other two, they bring price to equilibrium. The top can only by so much of one product, and the bottom have to save to afford one product, so essentially consumerism depends on the middle class. That is the key that makes America an “ideal consumer market” (our vibrant middle class). So, when the SEC states that “citizens would be exposed to risk.” they are essentially stating the middle class. And I think this is the main point of your article that the middle class are finding it more difficult to be consumers considering their savings and investments (Roth IRA’S, IRA’s ect) have dwindle thus they are not spending, and since they cant get credit to become entrepreneurs they cant expand their consumer viability. But then the article turns to blame capitalism for creating money hungry individuals that abuse their influence without controls. True those exist, and essentially they are favored. Yet rather is that a capitalism defect? Are you really arguing that capitalism dynamics are flawed? Sorry honey, but to really argue this you must give an alternative to capitalism. Besides it is not capitalism that gives this problem. For instance in your example you gave music and art as one of your points. In music and art, wouldn’t it make sense that in a capitalist notion that the best art and the best music would flourish? But it does not, (we have garbage). It is not capitalism that controls this notion. It is favoritism, favoritism is placated in every type of economic system, the bad apple that seems to have a sweeter taste that gets passed around the most.In addition mathematics, economics, and capitalism dont like favoritism, but people do. So it is a problem with society, note economic models.

    • AR   April 20, 2009 at 2:23 am

      Capitalism is the enemy of favoritism, and I’m all in favor of it!But then, I believe if Marx were around today, he would understand that class warfare is waged on the battleground of risk, not profit; that securitization is a price discovery mechanism for bundles of capital (think: the parts market for capital) lacking brand or a liquid trading marketplace; that its essence (if not the execution) is people’s capitalism.Plus I think the reincarnation of securitization will support better art and music, by using 21C data gathering and communication infrastructure to find the people who appreciate and pay for it. Ditto alternative everything else.

  5. Guest   April 19, 2009 at 8:09 pm

    In your title, you state toasters are not wanted? So, your saying how to get the affluent to reinvest? and not the individual assets of the middle class, its the assets of the affluent that the bankers want. The affluent are tivy to economic information, they will invest when they know it is worth a dime. So your pinpointing to the cycle, middle class wont consume till they have money, the affluent wont invest till the middle class becomes productive and consume. Chicken Egg problem? In addition this theory points to trickle- down-economics. (trickle-down-economics, Greenspans baby)I would take into consideration that side-liner money that Wall Street keeps talking about, couple trillion taken out of the market, minus losses. The essence is that that side-line money, where did it go? Banks? did they transfer it to other currencies? The dollar is essentially strong because of it (and other reasons). This side-line money is held by investment minded people, so it must of went somewhere and have potential use. (the only negative culprit would be that a percentage of that taken out from Wall Street was not a hard asset, but leveraged, thus they couldn’t have a risk appetite) but even if this percentage represents more than half of what was taken out from world markets it would still leave at least a trillion side-liner money.

  6. AR   April 20, 2009 at 2:49 am

    I fear that an awful lot of the side-liner money will not be coming back into circulation anytime soon.Richard Fisher, from one of the Fed banks, just came out to HK (where I am teaching this month) to drum up support for the dollar. Some colleagues of mine who went to hear him found it a distinctly odd experience. Meanwhile, my “Hongky” friends have been switching out of dollars into RMB for years.Mainly the point of my blog was that a return to the old fashioned banking model Dr. Krugman advocates sounds better than it is. Banks used to systematically overcharge their borrowers while underpaying their lenders—by giving them (in Krugman’s words) toasters instead of a better spread. A today revival would be even more unfair because we don’t have the same social safety net to lean into. We’ve lost that, and we’ve been driven into self-employment, where we are at the mercy of every other organized institution.Unfair borrowing costs and the risk shifting over the past thirty years – these two things combined – represent a much bigger burden to the middle class than the drop in asset values due to the crises. Unfortunately, these developments are almost invisible to those with steady employment and a pension.I am most worried about the people who don’t have pensions or much savings to lose. Their primary assets are their homes, their children and their non-commercial accomplishments, where they may excel beyond what many professionals can achieve. I believe there are a lot of Americans who fit this description.