On How We Got Here

Every morning I wake up and look at Yahoo Finance and then open the front door and pick up the NY Times and the Wall Street Journal. And then sometimes I get mildly indignant at the news.The more I try to look at what’s happened the past two years, the more I realize that everyone has their own version of history. And, belatedly, I realize how difficult the writing of history must be, trying to figure out how society progressed from an earlier time to a later time, or from then to now. History is only a plausible story that everyone comes to accept as the more or less canonical version. I’m not a relativist, but with regard to cause and effect in human affairs, there is no provably “correct” explanation and there is no proof. Every path to the present has many possible trajectories that got there, maybe even parallel ones, as in the path integral formulation of quantum mechanics.

It seems to me that one plausible version of what happened recently is as follows.

In the excitement and/or greed of the last twenty years, and following the repeated attempts to avert any market downturns, money was easy to borrow and a class of assets, call them class A (think of houses as an example, but I want to be more generic) became vastly overvalued by any reasonable standard. (Fair value is very hard to figure out because it obeys the Hole-In-The-Bucket Law1.)

Derivatives on class A were therefore vastly overvalued too and, being derivatives, much more sensitive to changes in fair value (think subprime mortgages and their tranches). When people began to come to their senses, they realized these assets weren’t worth what they’d paid for them. As a result, the firms that owned them or held too many of them on their books became insolvent.

There were other complex securities in the world, belonging to classes B, C, and D, etc., and as people became scared of complexity, they shied away from these securities too. These securities weren’t overvalued in quite the same way. Whereas class A securities became “genuinely” worth much less, classes B, C and D became illiquid and so seemed to be worth much less too, but more for psychological reasons than for “physical” reasons. The companies that owned them got into difficulty too.

As everyone fled the insolvent and illiquid securities they lost confidence in the economic future and stock prices fell, and people felt poorer and spent less and companies projected less future profits and fired people who then spent less money and so they drove other companies that depended on them to do badly and so on and so on.

The administration is trying to cure insolvency and illiquidity with stimulus, but stimulus is mostly a cure for illiquidity. They are using a medicine for living people to revive the dead2. The best thing would be to ring fence and restructure only the insolvencies and to stimulate the illiquidities. The desperate effort to treat insolvency with stimulus and the Chicken-Little warnings about the consequences of not doing so detracts from the confidence necessary to restore liquidity.

Much of the sense of unfairness and indignation about the current bailout and bonuses comes from the fact that large insolvencies are being treated as illiquidities in the hope that time and volatility will save them, but small insolvencies don’t get the same kindness. This is a kind of appeasement of large firms and people whose risk-taking should instead merit an honest declaration of insolvency, which is why I still think we need just one Churchill, not many Chamberlains.

– 1: The Hole-In-The-Bucket Law: Fair value depends on future cash flows; future cash flows depend on the state of the future economy; the state of the future economy depends on how people use their money now; how people use their money now depends on their perception of their net worth; their net worth depends on fair value. See http://en.wikipedia.org/wiki/There’s_a_hole_in_the_bucket, Belafonte, H. & Odetta. See also Soros, G (1987) The Alchemy of Finance.)

2. A little old Jewish lady at a funeral shouted: “Give that man some chicken soup.”

“Are you out of your mind? Can’t you see he’s dead?” someone said. “Chicken soup won’t help.”

“Well it can’t do any harm,” said the little old lady. Not true here.


Originally published at Wilmott.com and reproduced here with the author’s permission.

2 Responses to "On How We Got Here"

  1. Anonymous   April 11, 2009 at 11:12 am

    I agree. If there is really a liquidity issue, let’s make a web site and model the ‘fair value’ of a real, actual tranche that some bank wants to effectively flip to the govt — which is all this latest public-private fund smoke-and-mirrors is about. I bet the issue is at base the expected rate of default, as that is the real killer, beyond correlations or recovery assumptions. Banks are modeling for fewer defaults than others might think wise, and likely twiddle their internal default models relative to their own holding’s attachment points, right above what is now a binary trigger for many tranches, given the wipeouts of the lower attached buffering tranches. Banks can then claim they’re 90% moneygood rather than 0% nogood. Let’s spell it all out and then have a public debate about each deal the banks want out of.

  2. Anonymous   April 12, 2009 at 1:06 am

    I can’t see how the government can help with insolvency of individual banks. Right now government seems to ignore the issue by using forbearance and forcing modification of “mark to market” accounting practices. Government appears to believe this is a blip in mortgage financing that will go away if they can just stabilize housing prices. If indeed 4 trillion dollars has vaporized and much of it is held by large money center banks there is no way to solve that problem without wiping the insolvent banks out. Most of the losses are in mortgages will not to worth their face value for years, if ever. In California there are over 600,000 homes that have been foreclosed that banks haven’t offered for sale (at reduced prices) because they don’t want to write them down. They apparently can now carry them at full market value unless they are sold at which time the loss has to be taken? The banks apparently can’t afford to do that without additional government help.The government is making matters worse by allowing banks to hide their loses thru the techniques mentioned above. What that has simply done is make an average investor unable to tell healthy banks from insolvent banks. Wells Fargo’s recent upbeat earnings are already being challenged as not showing its loan loses accurately. I believe the government, in an effort to stabilize the credit markets may in fact make things worse. We need transparency and honesty in banking and this just makes financial issues just more opaque. Finally, I fear inflation is a serious concern with all the stimulation. As a retiree, I can not withstand hyper inflation should it occur. I know government says it isn’t a problem and if it becomes one they can handle it, but this is the same government that told me for months we only had a subprime mortgage problem!