I’ve got my hands on a copy of Xavier Vives‘ new book, “Information and Learning in Markets.” It’s a graduate-level textbook on mechanisms for information aggregation and I have to admit - my inner nerd is pretty excited at the prospect of not understanding most of it.
Archive for the 'Finance' Category
Information and Learning in Markets
Steve Waldman has done up a brilliant explanation of the credit crisis:
Alice, Bob, and Sue have ten marbles between them. Whenever one kid wants another kid to take over a chore, she promises a marble in exchange. Alice doesn’t like setting the table, so she promises Bob a marble if he will do it for her. Bob hates mowing the lawn, but Sue will do it for a marble. Sue doesn’t like broccoli, but if she says pretty please and promises a marble, Bob will eat it off her plate when Mom isn’t looking.
One day, the kids get together to brag about all the marbles they soon will have. It turns out that, between them, they are promised 40 marbles! Now that is pretty exciting. They’ve each promised to give away some marbles too, but they don’t think about that, they can keep their promises later, after they’ve had time to play with what’s coming. For now, each is eager to hold all the marbles they’ve been promised in their own hands, and to show off their collections to friends.
But then Alice, who is smart and foolish all at the same time, points out a curious fact. There are only 10 marbles! Sue says, “That cannot be. I have earned 20 marbles, and I have only promised to give away three! There must be 17 just for me.”
But there are still only 10 marbles.
Suddenly, when Bob doesn’t want to mow the lawn, no one will do it for him, even if he promises two marbles for the job. No one will eat Sue’s broccoli for her, even though everyone knows she is promised the most marbles of anyone, because no one believes she will ever see those 17 marbles she is always going on about.
…
Almost whatever happens, the trading of chores, so crucial to the family’s tidy lawns and pleasant dinners, will be curtailed for some time. Perhaps some trading will occur via exchange of actual marbles, but this will not be common, as even kids see the folly of giving rare glass to people known to welch [sic] on their promises. It makes more sense to horde.
A credit crisis arises when many more promises are made than can possibly be kept, and disputes emerge about how and to whom promises will be broken. It’s less a matter of SIVs than ABCs.
Steve later gives an example of the three balance sheets that count produce the situation he described:
| Assets | Liabilities |
| Physical marbles: 4 | |
| Marbles promised from Bob: 0 | Marbles owed to Bob: 7 |
| Marbles promised from Sue: 2 | Marbles owed to Sue: 18 |
| Total Assets: 6 | Total Liabilities: 25 |
Bob (equity: 12)
| Assets | Liabilities |
| Physical marbles: 6 | |
| Marbles promised from Alice: 7 | Marbles owed to Alice: 0 |
| Marbles promised from Sue: 1 | Marbles owed to Sue: 2 |
| Total Assets: 14 | Total Liabilities: 2 |
Sue (equity: 17)
| Assets | Liabilities |
| Physical marbles: 0 | |
| Marbles promised from Alice: 18 | Marbles owed to Alice: 2 |
| Marbles promised from Bob: 2 | Marbles owed to Bob: 1 |
| Total Assets: 20 | Total Liabilities: |
I really enjoy this sort of analogy, because I think that a lot of policy decisions can be enlightened by considering the actors to be individual people rather than the organisations (or entire countries) that they are. So what should Mum and Dad do? Steve also observes the three main possibilities:
Perhaps Mom and Dad will decide that the best thing to do is just buy some more marbles, so that all the children can make good on their promises. But that would mean giving Alice 19 marbles, because she was laziest and made the most promises she couldn’t keep, and that hardly seems like a good lesson. Plus, marbles are expensive, and everyone in the family would have to skip lunch for a week to settle Alice’s debt.
Perhaps the children could get together and decide that an unmet promise should be worth only a quarter of a marble, so that everyone is able to keep their promises after all. But then Sue, the hardest working, would feel really ripped off, as she ends up with a much more modest collection of marbles than she had expected. Perhaps Bob, the strongest, will simply take all the marbles from Alice and Sue, and make it clear than none will be given in return, and that will be that.
Or, perhaps Alice and Bob could do Sue’s chores for a while in addition to their own, extinguishing one promise per chore. But that’s an awful lot of work, what if they just don’t want to, who’s gonna force them? What if they’d have to be in servitude to Sue for years?
The ultimate answer is a combination of all three: Buy some extra marbles (but not all 30), declare each promise to be worth less than a full marble (but not as little as a quarter) and force Alice, and to a lesser extent Bob, to do some chores for Sue (but not full replacement).
The real question is this: Whose fault is it that Alice was able to continue running up debts she couldn’t pay? Should mum and dad been watching all along to make sure that everybody played nicely? Or should Bob and Sue have had more sense when Alice promised to pay them?
As might be expected, there’s a fair amount of questioning about the finance system as a whole going on.
The claim is that the market is best able to distribute this cash to the most worthy of projects, but at what point is their judgement questioned? How are these bastards allowed to be indispensable?
It’s true that the purpose of the finance industry is to, as efficiently as possible, allocate capital (i.e. savings), risk and returns; or, as the Economist puts it, to write, to “write, manage and trade claims on future cashflows for the rest of the economy.” In that regard, the industry as a whole plays a vital role in the economy. But that on its own doesn’t necessitate the indispensability of individual banks. That comes from a variety of inter-related factors:
- There are banks and there are banks. Ceteris paribus, nobody cares if a Small-Town Bank (STB) goes bust because it is provincial: nobody other than its direct debtors and creditors are affected. Investment banks are (effectively, sort of) where the STB goes to borrow money, though. If they go down, so do all the little commercial banks that depend on them. To use a cheap analogy from The Wheel of Time series of fantasy novels, one might think of the central bank as the True Source, the investment banks as Rand al’Thor using one of those artefacts and all the little banks as power-wielders that are vastly powerful compared to civilians but insects next to Rand. Rand channels the hundreds of little power-wielders and adds his own enormous ability to suck down the juice in order to draw massively on the true source. If somebody were to kick Rand in his privates while he’s doing his thing, half the planet gets ripped asunder. Therefore, the protection of Rand while he’s doing his thing is paramount. He is genuinely indispensable. This analogy neatly explains why you don’t actually want a single investment bank, btw. Having a single, semi-god-like character that’s able to channel the über-load of the True Source is great in a novel, but bloody stupid in real life. Redundancy is key. You want several investment banks that are competing with each other so that if one goes belly-up, the others can take over.
- Real innovation is rare, so when somebody has an idea, all the banks leap on it at once. That’s nominally fine in itself, but it unfortunately means that the actions of the (investment) banks are highly correlated, which makes for fantastic profits when it all works and a world of pain when it doesn’t. In essence, even though they’re are several investment banks competing with each other, since they all offer the same services at the same prices using the same strategies, they’re acting as though they’re a single investment bank.
- The latest round of innovations has served to tie a lot of financial institutions together from the perspective of policy makers. This point really comes in two parts:
- Securitisation and the splitting of those securities into tranches of risk exposure, in principle, allow financial institutions to spread and share individual risk between themselves so that if a Bad Event happens, they all lose a little rather than just one of them losing a lot.
- There has been a general move away from transparency, with most of these securities being held off balance sheets and being traded in private sales instead of on open markets.
The securitisation and tranching may have gone too far over the last few years, but that on its own isn’t the problem. The problem is that it was combined with a lack of transparency, meaning that it has become enormously difficult to pick apart the pieces when somebody falls. To quote the Economist again, “Bear Stearns may not have been too big to fail, but it was too entangled.” While they could have let Bear Stearns fall rather than be swallowed by JP Morgan, doing so would have required the careful unpicking of all of Bear Stearn’s positions, which would have taken months. That would then have fed into the final point …
- People are nervous lemmings. Even if the investment banks were properly competitive and transparent and each employed different strategies so that if one fell, there wasn’t so much risk of the others falling, a major bank collapse is still a problem because we’re all idiots. We panic. Then we see each other panicking, which helps us justify our own panicking and makes us wonder if maybe we’re not panicking enough. The panic can then develop a momentum of its own, causing other banks to collapse when they otherwise didn’t need to.
So … that’s why they’re indispensable. But that doesn’t mean that we should be paying them the way we do. Judgement of bankers’ performance is really only measurable after we pay them, which is stupid. I’ve written briefly on bankers’ pay before here. It is worth noting, though, that calls for bankers’ pay to be made in the form of stock have to face up to the fact that many employees of Bear Stearns had a huge share of their savings invested in Bear Stearns stock.
One of my favourite topics - indeed, in a way, the basis of my current research - is looking at how we tend to accept the declarations of other people as true without bothering to think on the issue for ourselves. This is often a perfectly rational thing to do, as thinking carefully about things is both difficult and time consuming, often resulting in several possible answers that serve to increase our confusion, not lessen it. If we can find somebody we trust to do the thinking for us and then tell us their conclusions, that can leave us free to put our time to work in other areas.
The trick is in that “trust” component. To my mind, we not only tend to accept the views of people widely accepted to be experts, but also of anybody that we believe knows more than us on the topic. This is one of the key reasons why I am not convinced by the “wisdom of crowds” theory and it’s big brother in financial markets, the efficient market hypothesis. I’m happy to accept that they might work when individual opinions are independent of each other, but they rarely are.
Via Greg Mankiw, I’ve just discovered a fantastic example of a person who is not an expert on a topic, but definitely more knowledgeable than most people, who nevertheless got something entirely wrong. The person is Mark Hulbert, who is no slouch in the commentary department. Here is his article over at MarketWatch:
I had argued in previous columns that inflation might not be heating up, despite evidence to the contrary from lots of different sources …
I had based my argument on the narrowing yield spread between regular Treasury bonds and the special type of Treasuries known as TIPS. The only apparent difference between these two kinds of Treasury securities is that TIPS’ interest rates are protected against changes in the inflation rate. So I had assumed that we can deduce the bond market’s expectations of future inflation by comparing their yields.
… My argument appeared to make perfect sense, and I certainly was not the only one that was making it. But I now believe that I was wrong. Interpreted correctly, the message of the bond market actually is that inflation is indeed going up.
… My education came courtesy of Stephen Cecchetti, a former director of research at the New York Fed and currently professor of global finance at Brandeis University. In an interview, Cecchetti pointed out that other factors must be introduced into the equation when deducing the market’s inflationary expectations from the spread between the yields on TIPS and regular Treasuries.
The most important of these other factors right now is the relative size of the markets for TIPS and regular Treasury securities. Whereas the market for the latter is huge — larger, in fact, than the equity market — the TIPS market is several orders of magnitude smaller. This means that, relative to regular Treasuries, TIPS yields must be higher to compensate investors for this relative illiquidity.
And that, in turn, means that the spread between the yields on regular Treasuries and TIPS will understate the bond market’s expectations of future inflation.
Complicating factors even more is that this so-called illiquidity premium is not constant. So economists have had to devise elaborate econometric models to adjust for it and other factors. And those models are showing inflationary expectations to have dramatically worsened in recent months.
I have never met Mr. Hulbert, nor read any of his other articles. I cannot claim that I wouldn’t have made the same mistake and I have to tip my hat to him for being willing to face up to it. There are remarkably few people who would do that.
The “orderly liquidation” of Bear Stearns is certainly dramatic, but I think that it will be the only US investment bank to fall from the current mess. The reason can be found in this press release from the Federal Reserve:
Release Date: March 16, 2008
For immediate release
The Federal Reserve on Sunday announced two initiatives designed to bolster market liquidity and promote orderly market functioning. Liquid, well-functioning markets are essential for the promotion of economic growth.
First, the Federal Reserve Board voted unanimously to authorize the Federal Reserve Bank of New York to create a lending facility to improve the ability of primary dealers to provide financing to participants in securitization markets. This facility will be available for business on Monday, March 17. It will be in place for at least six months and may be extended as conditions warrant. Credit extended to primary dealers under this facility may be collateralized by a broad range of investment-grade debt securities. The interest rate charged on such credit will be the same as the primary credit rate, or discount rate, at the Federal Reserve Bank of New York.
Second, the Federal Reserve Board unanimously approved a request by the Federal Reserve Bank of New York to decrease the primary credit rate from 3-1/2 percent to 3-1/4 percent, effective immediately. This step lowers the spread of the primary credit rate over the Federal Open Market Committee’s target federal funds rate to 1/4 percentage point. The Board also approved an increase in the maximum maturity of primary credit loans to 90 days from 30 days.
The Board also approved the financing arrangement announced by JPMorgan Chase & Co. and The Bear Stearns Companies Inc.
You might argue that this should have been in place a while ago, but now that it’s in place, I doubt that any more US investment banks will fall. You can safely assume a 50bp drop in the base rate in the next week, I think. As with the previous drops, I think that we will see little, if any drop in longer-term paper. That increased gradient in the yield curve, combined with the effectively-intentional inflation (their liabilities are largely nominal and a fair fraction of their assets are real), should be enough to recapitalise the banks over time. The new lending facility from the New York Fed seems designed explicitly to give them that time.
See also this comment from Deutsche Bank’s Mike Mayo (HT to Calculated Risk):
Lehman is Not Bear. 1) It has more liquidity, 2) It has support among its major counterparties, evidenced by an extension on Friday of a $2B working capital line with 40 banks (one issue w/Bear Stearns [BSC] seems to be that counterparties pulled in lines). 3) Its franchise is more diversified given almost half outside the US and an asset management business that is more than twice as large relative to its size (BSC was more plain vanilla). 4) It has a seasoned and experienced CEO (Bear’s CEO was new). We maintain our Buy rating given a belief that LEH will weather this storm and our estimate of a price to adj. book value ratio of 83%.
The industry issue seems more liquidity than solvency, and LEH protected itself more fully after it’s problems similar to BSC in 1998. At year-end, it had $35B of excess liquidity combined with $63B of free collateral, implying $98B available for liquidity, or $70B more than needed for $28B of unsecured short-term debt (which includes the current portion of long-term debt). While it also has $180B of repo lines, we take comfort that 40 banks extended credit on Friday and believe that some of the repos are likely to be termed at least to some degree.
Just after the loans to Bear Stearns from J.P. Morgan with the unlimited backing of the US Fed were announced, but before it became public that it was actually a buyout, my brother sent me a quick email:
This is [bad word removed]. Surely if the Fed bails out a large bank/ financial company they should receive some equity in return for their cash. Otherwise you just ensure the rich stay rich no matter what. Please respond with a thoughtful rightwing diatribe.
Fed moves to bail out major US bank: http://www.abc.net.au/news/stories/2008/03/15/2190458.htm
I responded with:
*) Yes, it’s [bad word removed]. It should be allowed to collapse on its own. If the government does get involved, it should be to nationalise the thing outright, close its operations and then immediately sell the various arms off to the highest bidders on the market. The government should not attempt to keep it running as a going concern (as the UK is with Northern Rock).
——
*) No, it’s not [bad word removed]. It is commonly said (including by me) that central banks have two tasks: control inflation and minimise unemployment. The US Fed, unlike most central banks, (a) does not have real independence from the executive or legislature; and (b) is forced to consider unemployment at the same time as inflation. For the BoE, RBA and ECB, fighting inflation comes first and ONLY THEN, when it’s under control, do they look at unemployment.
This isn’t quite true, though. The US Fed actually has three roles:
a) As an independent institution, to control inflation, but not — as yet — with an explicit target like the BoE, RBA and ECB have;
b) As a semi-independent institution, to minimise unemployment; and
c) As simply one of a collection of government agencies working together, to ensure the ongoing stability of the financial system.That third point, for the US, takes absolute priority over everything else. To be honest, it does in Britain, Australia and Europe as well. It’s important because if the entire financial system melts down, you end up with 3rd-world-style catastrophes and we know that those aren’t fun.
It was clearly on that third point that the US Fed offered its recent US$200 billion facility to the market at large and also on that third point that they declared Bear Stearns too big to fail. They are clearly worried that that the market is a long way from rational right now and that the collapse of even one investment bank would have domino effects that really would threaten the entire system.
——
Personally, I think the US$200 billion facility was reasonable but I think the Bear Stearns bail-out was not. I appreciate the domino risk, but so long as the Fed is acting to ensure that there is market liquidity, I don’t think there is too much cause for concern. To the extent that they prop Bear Stearns up at all, it should be under the explicit understanding that a) it is short term; b) Bear Stearns open their books to the world; c) Bear Stearns negotiate for someone else to buy them out; and d) if they fail to sell themselves within a month, they get nationalised and the Fed then sells it off in chunks.
Some people are likening the Fed’s reactions to those of the Bank of Japan in the 1990s: propping up banks and ought-to-be-bankrupt borrowers so their financial system never had to recognise the dodgy loans on their books. As far as I can tell, the two main differences are that a) the BoJ initially had much lower interest rates, so they had less room to manoeuvre in keeping the real economy out of recession; and b) the US banks are notionally required to “mark to market” when doing their accounts rather than their preferred “mark to model”, which means that so long as the market for sub-prime-mortgage-backed assets is illiquid, they’re obliged to mark those assets as having a value of zero. That is, they’re forced to recognise the bad loans upfront rather than hanging on to them for a decade or so.
And this morning I wake up to this:
In a shocking deal reached on Sunday to save Bear Stearns, JPMorgan Chase agreed to pay a mere $2 a share to buy all of Bear - less than one-tenth the firm’s market price on Friday.
Well, waddayaknow …
I’ve been meaning to read this piece by Martin Wolf (chief economics commentator for the Financial Times) for the last week. As it happens, it’s a “me too” response and a minor expansion to this brilliant piece by Raghuram Rajan (professor of finance at the Graduate School of Business at the University of Chicago and former chief economist at the IMF). I recommend reading both of them in full. Here are some cut-down snippets from Rajan’s efforts:
The typical manager of financial assets generates returns based on the systematic risk he takes - the so-called beta risk - and the value his abilities contribute to the investment process - his so-called alpha.
…
[T]here are only a few sources of alpha for investment managers. One of them comes from having truly special abilities in identifying undervalued financial assets. [e.g. Warren Buffet]
…
A second source of alpha is from … using financial resources to create, or obtain control over, real assets and to use that control to change the payout obtained on the financial investment. [e.g. a venture capitalist]
…
A third source of alpha is financial entrepreneurship or engineering - creating securities or cash flow streams that appeal to particular investors or tastes. As long as the investment manager does not create securities that exploit investor weaknesses or ignorance (and there is unfortunately too much of that), this sort of alpha is also beneficial, but it requires constant innovation.
…
How do untalented investment managers justify their pay? Unfortunately, all too often it is by creating fake alpha - appearing to create excess returns but in fact taking on hidden tail risks, which produce a steady positive return most of the time as compensation for a rare, very negative, return.
…
True alpha can be measured only in the long run and with the benefit of hindsight - in the same way as the acumen of someone writing earthquake insurance can be measured only over a period long enough for earthquakes to have occurred. Compensation structures that reward managers annually for profits, but do not claw these rewards back when losses materialise, encourage the creation of fake alpha. Significant portions of compensation should be held in escrow to be paid only long after the activities that generated that compensation occur.
Martin Wolf’s addition comes in like this:
By paying huge bonuses on the basis of short-term performance in a system in which negative bonuses are impossible, banks create gigantic incentives to disguise risk-taking as value-creation.
We would be better off with Jupiter’s 12-year “year”, since it takes about that long to know how profitable strategies have been. The point is that a year is an astronomical, not an economic, phenomenon (as it once was, when harvests were decisive). So we must ensure that a substantial part of pay is better aligned to the realities of the business: that is, is made in restricted stock redeemable over a run of years (ideally, as many as 10).
Yet individual institutions cannot change their systems of remuneration on their own, without losing talented staff to the competition. So regulators may have to step in. The idea of such official intervention is horrible, but the alternative of endlessly repeated crises is even worse.
Dani Rodrik has been noting for a while that Martin Wolf seems to be coming ’round to his point of view in economic development. I’ve seen the same thing and it’s great to see.
Via Paul Krugman, make sure you check this out. It’s a fantastic graphical representation of how Collateralised Debt Obligations work and what happens when people start defaulting on their mortgages.
Greg Mankiw has a brief note (I’ll include it verbatim):
This is the VIX index, which uses options prices to measure expected stock market volatility over the next 30 days. The latest run-up is striking. It suggests that the recent bumpy ride in financial markets is likely to continue for a while.
I had never heard of the VIX Index before (yet another thing to add to the shamefully-ignorant-about pile), but I do notice that while the 2-year graph Prof. Mankiw includes makes the current turmoil look unprecedented, it’s actually nothing of the sort. Here’s the same graph over the maximum possible period:
Looking at this, the recent brouhaha is certainly serious, but is also certainly no worse (yet) than we’ve had before. The LTCM (1998) and 9/11 (2001) events are clearly discernible. Other than those two, I have no idea why volatility was so high between 1997 and 2003, or why it spiked in 1990 (something to do with the then-upcoming recession?).
A friend pointed me to this conspiracy theory video. I’ve not watched more than 30 seconds of this particular video, but according to discussion on the RANDI forums, I understand that it splices footage directly from a number of other conspiracy theory films into one, with all the greatest hits of the anti-establishment anarchist left being given a run (christians and/or jews are evil and secretly rule the world, 9/11 was a government inside job, the entire global banking system is a sham and run by bad people, etc).
Of more interest to me is this question, put to me by my friend:
Why are more and more of these conspiracy theories coming out in video format only, with no transcriptions?
Perhaps it’s to appeal to a wider audience (i.e. more people are willing to watch a movie than read the equivalent text). Perhaps it’s because a movie can more readily achieve an intense, even emotional, impact than abstract text. Perhaps it’s just another example of market demand and supply …
The real (as in true) explanations for what goes on tend to be considerably more complex and almost infinitely more tedious than those offered by conspiracy theorists. People seem to want answers, but aren’t willing to accept that they might be anything other than simple and exciting. Maybe that’s a result of today’s media culture of soundbite-driven news and action movies, but maybe it’s just an unfortunate consequence of otherwise rational ignorance. You can’t be an expert in everything (strictly speaking, it’s too costly), so you don’t waste your time trying and instead trust the summaries given by people you take to be experts.
As an example of the demand for simplified summaries, consider the recent turmoil on the world’s credit- and stock-markets. I have spoken to several people about the happenings and most of them aren’t the least bit interested in understanding the details of what’s going on. Instead, they only want to know if (a) the world is going to end (i.e. they’re going to lose their job or their pension savings are going to collapse) or (b) if it’s all been caused by evil, money-grubbing people deliberately destabilising the world for their private profit.
By my thinking, to really understand the current turmoil (I still refuse to call it a crisis), you need to understand the basics of:
- How bonds work
- The difference between long-term and short-term bonds
- The difference between government and commercial securities
- The fact that central banks announce a target interest rate rather than fixing it by fiat
- Reserve requirements
- Overnight inter-bank lending
- How banks view loans to consumers (i.e. as assets)
- Structured finance in general
- CDOs in particular
- Derivatives
- Hedging and hedge funds
- The difference between credit markets, stock markets and foreign exchange markets and how movements in each might affect the others
- The carry trade
And that’s before you start considering the psychology of the people involved and all the resulting work in behavioural finance. Unless you’re seriously (and usually, professionally) interested in investment, finance or economics, why would you care about all of those details? You wouldn’t … you just want to know if the world is going to end and if there’s somebody to blame.
On the supply side of these nuggets of information, you have … well, you’re looking at one. Commentators, both professional (in the mainstream media) and self-appointed (in your local pub and all over the internet) are competing to convince you that they are experts in the topic at hand and having managed that, to provide you with their summarised opinions.
Suppose, however, that for some reason you can’t properly identify who is a real expert or you have some reason to distrust the experts you can identify. In that case, you’re left taking in the simplified views of non-expert subject-matter aficionados, of which a small but statistically-significant fraction are going to be conspiracy theorists. Insofar as they want to expand their customer base, conspiracy theorists (who, to be frank, are often less troubled by the truth than they are with attracting an audience) will experiment with their provision of service to best meet the demand for simple and exciting explanations. Thus, we have movies with no (tedious) transcripts.
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