Possible Insight

Financial Crisis Act III: The Flailing Response

with 8 comments

As we saw in Act I and Act II, the current financial crisis was enabled by government interference in the housing and mortgage markets, then initiated by Wall Street’s willful blindness to systematic risk in the MBS market. Now we are observing the government’s flailing response.

First they bail out Bear Stearns.  Then they let Lehman go bankrupt.  But AIG gets a lifeline. On to a $700B bailout intended to purchase toxic MBSs. And most recently forcing several probably healthy banks to absorb $250B in government investment. Along the way, there were a bunch of changes to FDIC regulations and a see-sawing stock market.

You might be asking yourself, what the heck is going on here? The reason for all the flailing is that the government is attempting to implement a command and control solution to an extremely distributed problem.

It all comes down to “liquidity”.  Liquidity is a measure of the fungibility of an asset: how quickly you can turn it into something else.  Cash is very liquid.  Credit cards and checks are almost as good as cash.  Investments in machinery, startups, and education are very illiquid.

Most people think liquidity is good.  But it’s also bad.  Illiquid assets tend to be the most productive.  Cash just sits there.  But a machine can make stuff.  A startup can develop innovative products.  A scientist can discover new things. So from this perspective, we actually want to allocate assets as much as possible to high productivity/low liquidity items.

If Company A keeps a lot of cash around while Company B invests in high productivity machinery, Company B will tend to out-compete Company A (at least over the short run where no negative Black Swans occur). Firms therefore demand the financial tools they need to be Company B. So the modern economy has evolved to support what we might call “just-in-time liquidity”. There’s no need for small firms to hoard cash because they tap a credit line. There’s no need for their local banks to keep as much cash as would be necessary to cover all these credit lines, because they can borrow from bigger banks.  And so on for every cash supply line you can think of. But just-in-time liquidity relies on trust. Everyone has to believe that they can get cash when they need it.There must be enough total liquidity in the system to meet these needs.

The problem we have now is that some large financial institutions were holding a bunch MBSs that they thought were fairly liquid and worth X.  Unfortunately, it turns out MBSs are no longer that liquid and are worth a fraction of X. A double liquidity whammy! So the banks that held them needed to sell more liquid assets so they could provide the total amount of liquidity their customers needed.  But when almost everybody is selling, almost nobody is buying so these other assets became less liquid, which requires selling still more assets.

Meanwhile, the rest of the economy is quickly trying to adjust by conserving cash because they don’t believe they can get liquidity from financial institutions. Households are cutting down on purchases to. Small businesses are cutting staff. Manufacturers are slowing production. Raw material suppliers are reducing investments.

Taking toxic MBSs off the books and restoring liquidity at the top won’t solve the problem now.  Everyone downstream is already adjusting and it will take time for people to begin trusting just-in-time liquidity again. It’s like removing a tumor after its metastasized. Sure it helps, but you’ve got to address all the low-level knock-on effects too. Unfortunately, the government is mostly set up to affect events top-down not bottom-up. They can buy assets in markets and strong arm big companies. But they can’t make everyone feel safe.

Add to the liquidity problem the need for real economic adjustments. At the end of the day, a bunch of people purchased homes they couldn’t really afford. A bunch of developers built homes for which there was actually no demand. Banks took risks that turned out badly for them. Other people made decisions assuming their homes were worth a certain amount and their homes are no longer worth that amount. No amount of wishful thinking or financial engineering will change these painful facts.

That’s why the government is flailing.  First, they don’t really have the tools necessary to influence the distributed decisions of everyone in the economy.  Second, with an election coming up, they would prefer that people not have to swallow all of the real economic pain now. But the system has gone chaotic and it’s hard to believe that the government can exercise any fine tuned control. I believe the system can heal itself and the government is almost as likely to make things worse as better.  Best to just let things sort themselves out. However, I’m not terribly confident of these beliefs and am really glad I’m not the one in charge.  The pressure to do something must be enormous.


Written by Kevin

October 15, 2008 at 11:19 pm

8 Responses

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  1. I agree that there has been some denial in taking our (collective) lumps. But I also believe that runs on banks (and other self-fulfilling prophecies) can be triggered by events like the current ones. It is possible that a depression ensues that could otherwise have been avoided had someone (i.e. Uncle Sam) plugged the leak with a big enough wad of cash until confidence is restored and the economy is once again auto-catalytic. Whether this is such an occasion is anyone’s guess, but as you say cash is useless unless deployed, so I say deploy away. The real question is how to get the most bang for the buck.

    I will point out that there are some big players with cash on the sidelines that are licking their chops and saying that there this is a once in a lifetime opportunity for investors in undervalued equities. So in some sense I agree that the problem may be self-correcting. The lower the market goes, the more investment there will be, not only in liquid public markets, but also private companies as well.

    One thing I think could be a big mistake is halting short selling. While it seems distasteful to the media and “Main Street” for some ruthless Gordon Gekko-type to profit from someone else’s loss, this is irrational thinking. Short selling a company that ends up going bankrupt concentrates cash into the hands of the short sellers where at least it has a chance of being deployed meaningfully very quickly into equities and other value drivers. Without short selling, that value gets dissipated and does nobody any real good. We’ve heard recently of David Einhorn making a fortune on the short side, and we can be pretty sure that that money will be back in action at least partially on the long side very soon.

    As an aside, naked short selling is bad because it’s a credit shell game (back to what got us into trouble). The uptick rule may be a good thing because it prevents unnecessary volatility and self-fulfilling panics.


    October 16, 2008 at 8:01 pm

  2. I agree that we have to avoid runs on banks. We already have expanded FDIC insurance which should prevent that. If it doesn’t, I agree the government must step in.

    But it shouldn’t bail out people who took risks that simply didn’t pan out. It’s not a crisp line, though. What to do about Money Market Funds? On the one hand, account holders should deserve to bear some loss because they had the benefit of higher interest rates. On the other hand, you don’t want everyone pulling out of their Money Market Funds at once. Perhaps a floor of .90 on the dollar before FDIC insurance kicks in?

    Your absolutely right about short selling and naked short selling. We need the former to provide discipline but the latter is not actually a good faith bet.


    October 16, 2008 at 8:13 pm

  3. I’ve struggled with the economic and philosophic implications of the bailout, while concluding that Paulson is correct that it is a completely necessary, and maybe even obvious, next step. And I’m not prone to taking the Fed or the cabinet at it’s word.

    From your write-up, you recognize the “seizing engine” nature of the crisis. If intra-institutional liquidity is the oil in the engine, then when that oil has gone a’missin, there isn’t much that regular market forces can do to get the crank turning again.

    I’m not sure if it’s a good analogy, but for better or worse, here’s how I think of Paulson’s proposoal to allow the government to be a clearinghouse for the worst of the toxic waste on balance sheets:

    Have you heard the blue-eye-green-eye-psychopaths on an
    island riddle? In it and similar puzzles, an outsider comes in and makes a declaration. Usually it’s declaration of a fact that the other participants are already aware of (e.g. — “people on this island have blue eyes”), but by dint of the observation coming from an independent actor at a fixed moment in time, it carries extra information. Now everybody knows that everybody knows the declared fact.

    Paulson is effectively serving that function. He’s saying, “nobody is willing to trade because they don’t know if their counterparty is on the verge of bankrupcy or highly solvent. Well, I’m here to tell you that their assets are worth X.” Now all participants can act because not only has the value of the mystery assets been declared, but said
    value is being backed by a fairly reliable source and the downside is now somewhat knowable.

    It’s hard to say whether free market mechanisms alone could converge on some kind of valuation for those assets in time to get the engine turning over again. If they take too long, the stasis will have secondary consequences that are long lasting.


    October 20, 2008 at 4:19 pm

  4. Bruce, I love the blue-eye inductive proof puzzle analogy. It’s formally the same problem, but I’d never thought of it quite like that.

    For those who don’t know what he’s talking about, here’s the example.

    The connection between this puzzle and the markets is discussed in John Allen Paulos’ A Mathematician Plays the Stock Market

    Relatedly, we should question the media’s role in fueling the crisis, see my post on dangerous ideas


    October 21, 2008 at 9:56 pm

  5. My junior seminar in economics was actually on common knowledge and the blue-eyed people puzzle was day 1. As I recall, I was able to figure out the answer for myself.

    But the bailout plan is not equivalent because, as I mentioned in the original post, MBSs are no longer the issue. The cancer has spread. A cascade has already occurred. Institutions already had to sell other assets to cover their MBS losses using mark-to-market accounting for capital requirements.

    This puts their total position in doubt, not just their MBS position. That’s what the forced investments in leading banks was all about–to convince people that at least these select institutions were solvent.

    But I think the cost is far worse than the gain. The whole crisis was created by the quasi government status of Fannie and Freddie combined with political pressure. Now a good chunk of our entire banking system will be subject to the same pressure.

    If the government was concerned about making capital available to Main Street, they should have expanded lending to Main Street directly through the SBA. Then once those loans were paid off, the government involvement would be over.

    But now we’ve got a semi-permanent government finger in the pie of private institutions.


    October 22, 2008 at 5:51 am

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