Gautam Mukunda
[EMAIL PROTECTED]
"Freedom is not free"
http://www.mukunda.blogspot.com
----- Original Message ----
From: John Williams <[EMAIL PROTECTED]>
To: Killer Bs (David Brin et al) Discussion <brin-l@mccmedia.com>
Sent: Tuesday, September 23, 2008 6:52:33 PM
Subject: Re: Meltdown
Dan M <[EMAIL PROTECTED]>
> That's
> what the interest rate measures...the willingness of folks to buy GE notes.
Gee, really? It couldn't possibly be just a little more complicated than that?
Me:
Well then, what do you think it measures? For a first approximation analysis,
that's a pretty good assessment of what it measures. There are more factors,
but in the short-term money market, not that many, really. These are usually
very short-term unsecured notes (1 day, I believe, in this case). The only way
to lose money is if the company defaults _tomorrow_. Most companies, btw, rely
on this sort of very short-term financing, and every company relies on it
indirectly, because even if you don't (and the odds are really, really high
that your company does) your customers surely do.
> A rational
> market wouldn't change GE's interest rate that quickly
Again, really? Either you are stating a tautology, or you have no way of
knowing whether the change was reasonable.
Me:
Well, he can't state it to a certainty, but I think you need to provide an
alternative explanation here. We had enormous market events followed
immediately by a pretty-much unprecedented increase in money market interest
rates, paired (presumably not coincidentally) by a massive flight of investors
from the money markets - massive defined as hundreds of billions of dollars.
This flight was particularly odd given that _no person_ lost money in such
investments. Fidelity, which would up its fund, covered its responsibilities
and made up the money the fund had lost out of internal funds (and good for
them too!). While such a massive movement of capital might be rational, it's
stretching the Efficient Markets hypothesis _way_ past its breaking point to
argue that this is so, and in particular ignores everything we know about
behavioral finance. It also ignores everything any practitioner could tell you.
> BTW, in saying this, I'm arguing that there is a problem that is not
> inherently related to the government, but originated with market players who
> build bubbles and panic,
How profound. Maybe you should write it up as a paper and submit it to
an economics journal. Surely you are the first to realize this!
Me:
OK, this is just rude. Are you a professional economist?
> In a sense, the problem is not that there is a housing bubble in some areas
> of the country. It's the timing of the market response, and the irrational
> extension of it.
Sure, the government was largely responsible for creating a huge home price
bubble and encouraging a bunch of bad loans to con-artists and people who
had no business getting the loans, but that is not the problem. The problem
is that the market finally began adjusting the price towards fundamental
values. Right. Good point.
Me:
I would say this is an opinion without a lot of evidentiary support. The
government was not "largely responsible" for the run-up in home prices. It
certainly didn't help - it was at least partly responsible. But there are many
other actors involved. A conservative should understand the limits of the
power of the government! Even if this were the case, the actions of the
government were known and transparent. They do not - and cannot - explain the
decision by AIG to take on $42BB in unhedged risk on credit-default swaps
structured based on subprime mortgages. That's a purely private failure. The
government made many mistakes in this case, but it's simply impossible to argue
that it is solely, or even primarily, responsible for the decision by major
financial institutions to (functionally) go massively long on sub-prime
mortgages. The obvious support for that argument, btw, is that at least two
major players in the financial markets -
JPMorganChase (run by Jamie Dimon) and Goldman Sachs (run by Lloyd Blankfein)
didn't. If the government were responsible, you'd have to explain why they
were immune to pressure. Instead they - brilliantly - handled this potential
crisis exactly right. And thank goodness, too, if Dimon hadn't called this one
I think we'd be completely screwed. There's a difference between the position
"markets are usually the best way to allocate capital" and "markets are always
right." I can't think of any economist who would agree with the latter
statement.
> This is a personal example of the irrationality of the market that I'm
> talking about.
Right, blame "the market" for adjusting values to where they should be, not
the government for being largely responsible for putting values out of whack.
That's the ticket.
Me:
The government certainly did some things that were very foolish. But I'm
curious as to what, exactly, you think it did that caused AIG or Lehman to make
the decisions they did.
I'm also kind of curious if you've ever worked in finance. I'm virtually
certain the answer is no. I'm not saying that to be insulting, and I hope you
won't take it that way. My own experience with finance is largely secondhand.
I find the topic fascinating, and some ideas from the corporate finance
literature underlie my dissertation, but it's not something I've had enormous
amounts of formal training in. Some. And a lot of interest, particular in the
history of finance. But that can be quite illuminating, and I found it to be
so in this case. For example, we had a series of events occurring. We saw the
mark-to-market value of financial instruments constructed based on subprime
mortgages drop to near zero. Functionally that explains the collapse of Lehman
and AIG. Although the value of these instruments is presumably substantially
lower than their purchasers thought they were, a true value of zero is
implausible at best (absent strange
leverage constructions _unviersal across the instruments_ this would imply a
default rate on subprime mortgages of nearly 100%, which is clearly not going
to happen). This collapse forced Lehman to declare bankruptcy while it was
technically still solvent - an unprecedented event, so far as I know. Now, as
part of this, Lehman then defaulted on its short-term loans. This caused
several money market funds - Fidelity among them - to go below $1.00 in share
price value, also a nearly unprecedented event. Following that we saw a rush
of hundreds of billions of dollars out of the money markets (again, even though
no client had actually lost any money). And we saw a great deal of fear that
another bank - MorganStanley or Goldman, presumably - might be next. Now, note
that both MS and GS appear to have been _short_ sub-prime mortgages, so there
doesn't seem to be a real reason they'd go under. But, because of how
investment banks are structured, if
people demand higher interest rates for short term loans from them, they would
be forced to go under immediately. Note the problem here: No increase in
interest rates, no bankruptcy. Increase in interest rates caused by fear of a
bankruptcy, however, can _cause_ the bankruptcy. Any individual investor,
knowing the bankruptcy would not occur, would happily lend the money. But
because that certainty does not exist, the money might not be lent.
Now, you have these fund managers. All of them are worried. They've just seen
several things happen that they've never seen before. They know that there are
still securities on a lot of balance sheets that have probably not yet been
marked down fully. But they don't know where they are. Furthermore, these
financial instruments are so technically complex that _no one_, not the people
who owned them, not the people who originated them, can properly value them
under current market conditions. Thus not only do they not know the financial
status of companies in which they might invest, those companies themselves
probably no longer know what their financial status is.
So the point of all of that was to give a sense of the atmospherics of what was
going on. Now the thing to remember is that investment decisions are not made
by an amorphous market, they're made by individual fund managers. And right
now those fund managers have seen things happen that they have never seen in
their entire careers, and that their considerable technical training tells them
_cannot happen_. Perfectly rational computers might continue to say, look, GE
isn't a default risk, let's keep making money. Human beings, though, might
pull back on the reins pretty hard. For each individual person who does so,
that's fine. It's not a big deal. If _everyone_ does it, though, a lot of
companies are suddenly in a lot of trouble - including companies that are
otherwise perfectly solvent, or have even made all their decisions correctly.
And if a bunch of companies that are otherwise fine suddenly go under, they are
likely to drag lots of other
companies with them through things like counterparty risk or that they were
customers to those other companies and so on. If you've worked in or near (and
I was, at least, near) finance, it's easier to remember that the decisions are
made by people, and sometimes those people can act in ways that arent' strictly
rational due to a combination of risk-aversion and ambiguity.
The point of all of this being - it's absolutely true that markets are, all
things being equal, the best way to distribute most non-public goods. But it's
not true that markets - particularly financial markets, which for a variety of
reasons are more susceptible to bubbles than other types of markets - are
_always right_. Panics happen. There's a wonderful book by Kindelberger, a
classic in the field, called _Manias, Panics, and Crashes_ that I recommend to
everyone. Financial markets can collapse in the presence of unanticipated
ambiguity - in this case, the ambiguity of instruments that no one can properly
value, which has the potential to destroy companies that have not really made
any mistakes. In the face of such events, government intervention is an
entirely reasonable - indeed, necessary, thing to do. It's really no different
than the FDIC, in a sense. The money markets are not that different from a
bank, and what we saw was a massive bank
run. In this case, it's absolutely true that the government did many things
to make the situation worse and is inextricably linked with the roots of the
problem. It's simply not the case that this is entirely, or primarily, a fault
of the government. The financial institutions screwed this one up by the
numbers (if you're really curious as to the technical reasons behind it, Nassim
Taleb's two books are absolutely irreplaceable and also two books that can
really change everything about how you look at the world if you take them
seriously. I did). That doesn't make them criminal - as far as I can tell no
serious violations of the law have so far been revealed. It makes them
_wrong_. Wrong happens. If people on the right need to give up the belief
that markets are perfect, people on the left should probably also understand
that mistakes and crimes are not the same thing. The problem with being wrong
on this scale, though, is the consequences can
hit all of us. Thursday was the scariest day I've seen since 9/11. It was
_terrifying_. We're not out of the woods yet, even if the immediate threat
seems to have been beaten back a bit.
Best,
Gautam
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