Same Economy, Different Bubble

from the and-it's-going-to-pop dept

Last year, The Onion (which has a knack for predicting the future in really scary ways) had an amusing article: Recession-Plagued Nation Demands New Bubble To Invest In. In the immortal words of Homer Simpson: "It's funny 'cause it's true." And, indeed, one of the big fears we've had since the beginning of the government's response to the financial crisis is that it hasn't been doing anything to solve the real problem of a lack of transparency. Pumping more money into the system without fixing that simply meant that we'd repeat the cycle, with the money eventually finding some bubble again.

At this point, it's worth taking a step back, and understanding why these sorts of bubbles occur. Sometimes, investment bubbles can actually be quite beneficial. In markets of true innovation, where a clear success story or business model hasn't yet been worked out, a bubble allows a lot of money to be thrown at the problem at once. From that, you get a lot of ideas tested in the marketplace very rapidly. Many of them fail once the bubble collapses, and many investors lose money, but the ideas that do work and do stick around tend to takes us forward in leaps and bounds. Bubbles in innovative technologies function as a form of speeding up the innovation process and getting lots of infrastructure built and ideas tested rapidly. It's no fun if you're caught on the wrong side of the investment, but for society, it can be a net gain.

However, that's not what happened in the last economic crash. That was built on a different sort of bubble, based not on funding innovation, but on a series of arbitrage plays where bankers actively worked to obfuscate risk, so that it could be passed on to the latest sucker. Basically, they kept taking riskier and riskier assets, and packaged them in a way that they looked less risky. Then, by making it so no one could really look at (or understand) the true risk, they could sell these super risky investments off to suckers at prices as if they were safe. And, since such a house of cards takes a while to collapse, it doesn't take long for everyone to pile in, feeling like they have to match those returns.

So, the answer to this is to increase transparency. If you could really get the information out there, such that people could look at the underlying details and properly calculate the risk, not based on random clueless rating agency employees, but in a true market, then it would be that much more difficult to pass off and misprice super risky vehicles as safe.

But that's not what's happening. Without any efforts at increasing transparency, combined with pumping a ton of new cash into the market, we're getting another bubble. The bankers are still operating the same way they did in the past -- which is looking for ways to obfuscate the risk and find new suckers to take the risk off their hands without really understanding how to price that risk. It may be securitizing life insurance or it may be in the carry trade. It doesn't really matter. The money is looking for a new bubble and a focus on short term profits over long term sustainability -- and that's enabled by allowing banks to play "hide the risk."

This is really quite worrisome. It's been over a year since the financial crisis went into panic mode (even if the actual recession and problems significantly predated that). And while the "worst case scenario" did not occur, there's been little evidence of real fixes to the economy or any attempt to really fix the factors that resulted in the original problem. Instead of creating transparency and a long term strategic focus, we're just pumping cash into the economy to try to help suckers find the next bubble.

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Did Not Understanding The Leverage Cycle Kill The Economy?

from the something-worth-exploring dept

David Warsh's latest economics column delves into the renewed interest being given to economist John Geanakoplos' paper explaining how the real issue that brought down the economy was a misunderstanding of "the leverage cycle." Basically, the argument is that everyone (mainly, the Fed) gets so focused on the interest rates, that they stop focusing on the leverage/collateral involved. It's sort of the central banker equivalent of when the mortgage broker tries to get you to ignore all the real terms in your mortgage and just gets you to focus on how much you'll be paying each month. The argument, then, is that the government could have done much more to prevent the crisis if it had simply paid more attention to the leverage situation, which had obviously grown totally out-of-hand. Basically, the argument says that in a competitive market for credit, leverage will always rise, as some parties take bigger and bigger risks, forcing others to do the same. But then everyone's way overleveraged, and when the music stops, basically everyone's left without a seat. It's an interesting theory -- one that sounds good, though on a first read I'm not entirely convinced. While the issue of how much leverage was out there is obviously a part of the problem, I'm not entirely sure that the government would realistically be able to totally control the issue. While it could put in place certain regulations, it seems like there would always be loopholes that allowed leverage to occur elsewhere. Either way, I'm going to do some more reading on the subject, but wanted to pass it along here to see what others thought of it in the meantime.

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Making The Tough Choices To Save The Economy?

from the stop-giving-the-banks-everything-they-want dept

With the latest plan laid out last week on how to "save Wall Street" ("the Geithner plan"), there's a lot of back and forth over whether or not this is a good plan or not -- and while Planet Money had a decent "is it good or bad?" show, the folks there didn't get too deep into it (and even claimed that no one really thought the plan was all that dangerous (just that it could slow down the recovery). However, the more I read up on it, the worse and worse it seems. Simon Johnson has a long, but worthwhile writeup at The Atlantic, where he delves into how Wall Street has effectively taken over Washington DC, such that it helped both create the mess, and then set things up so that the "recovery plan" only benefits those who caused the problems in the first place. This echoes a piece by Andy Kessler last week, where he pointed out that we're effectively handing money to those who brought the collapse upon us -- and suggests that the better response is to simply stymie the plans of the hedge funds -- flooding the markets where they're looking to buy, rather than subsidizing them.

Then, there's Umair Haque, who basically makes the same points, but suggests that this is an outright looting of taxpayer money by putting most of the risk on taxpayers, and encouraging the hedge funds to make increasingly risky loans (you know, like the ones that got us into this mess in the first place). The root of all of these stories is that the government seems to think that the only way to fix the problem is to reinflate the bubble, rather than letting the bubble deflate and moving forward from there. The problem with reinflating the bubble isn't just that it puts off the inevitable (though, it does), but that the inevitable is that much worse when it comes.

It's what we've done for the past couple decades -- effectively building an even shakier house of cards, and every time the cards start to fall... we just reinforce it with another layer of shaky cards to prop it up. At some point, the cards do have to fall, and propping it up with more leverage isn't going to help that.

Even if, as Richard Posner suggests, the current plan is about the most politically feasible, it's still problematic. The politics of the situation is troubling. On one side, you have populist anger, making it difficult to do certain necessary things. On the other, you do still have the influence of the bankers, who view the world as being one where we need to keep propping up that house of cards.

Why is it that no one is talking about carefully taking down the house of cards while building a sturdy house next door?

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Why Do We Assume No One Is Fixing The Financial Crisis?

from the things-are-happening... dept

While some keep insisting that the government needs to step in, in a big way, to fix the financial crisis, Paul Kedrosky posits an interesting and worthwhile theory, as well: lots of folks within the industry are scrambling to fix things every day, and if we just gave them a chance they might get stuff done. He's not saying this is definitely happening, but he uses the Y2K crisis as an analogy. Many people were totally freaked out about it, insisting that there was no possible way all the problems could get fixed in time. But they did. They did because a lot of people worked really hard to get things done and solve most of the problems. And he's wondering if the same sort of thing is happening today with the financial markets:

I hear too many naive projections, too many scenarios constructed via extrapolating early failures forward and assuming the same thing can happen in the same way, so systemic collapse is ahead. While that is possible, and this time is different (tm), it's at least worth wondering what if the Y2K lesson matters more than we might have thought. Government aside, independent and fiercely survival-minded actors are doing what they can throughout the economy and the financial system to mitigate the risks they face from the current depression. Credit default swaps are being netted and torn up; banks are trying to unwind swaps and other derivatives. Some financial institutions are accidentally healing, at least a little, under the flood of savings pouring into them from petrified and security-seeking citizens. There are myriad other examples, but the point is that the bell has been rung, people are acting, and communication networks are afire -- and history says these are circumstances in which people can, by protecting themselves, surprise us all with the outcome.

It's definitely a point worth thinking about. We've been told over and over again that only the government can help us out of this mess, but people seem to think that the rest of the financial world is sitting around picking their noses as the world collapses -- and there's little reason to believe that's actually true. In fact, if you listen to this week's This American Life "Act 2" (starting about 45 minutes in) covers a couple of entrepreneurial guys who are doing their part: buying up "toxic" mortgages on their own and restructuring them -- and they're making decent money doing so. While even they're a bit skeptical about that on a larger scale, as Kedrosky noted, the same was true of the individuals working on solving the Y2K crisis as well.

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Garbage In... Radical Transparency Out?

from the one-hopes... dept

The latest edition of Wired Magazine has two articles that pick up on stuff we discussed last year. First up, was the question of how the various quants on Wall Street got so suckered into believing their risk models that didn't take into account the idea that mortgage defaults weren't necessarily independent events. The end result was garbage in, financial crisis out. However, Felix Salmon has a detailed look at the "garbage in" part of the equation. Apparently, much of it was based on widespread reliance on a formula by one financial engineer, who thought that you could price risk by finding correlations. While in retrospect this may look silly -- it should have looked silly at the time as well. It made a huge incorrect assumption: that correlations were static instead of variable. But... once it went into the "black box" people simply accepted the output as gospel. This is an issue that comes up all too often. Even if people know that a computer model is "just a model," it leads to situations where they just rely on the computer because the computer said so -- not taking into account it's obvious faults.

However, the good news is that, as a result of this mess, there may actually be some movement towards the solution a few of us have been suggesting for a while: radical transparency. Back in November, we suggested that public companies should be allowed to do away with quarterly reports in favor of real-time data dumps in standardized formats, that would allow anyone to build tools on top of the data to analyze it themselves. Rather than obscuring the real situation within companies, as is the case today, this would expose everything, and let anyone build tools to analyze the real underpinning fundamentals. It would also serve to get rid of the extremely damaging focus on "quarterly" returns at the expense of long-term thinking. And, finally, it would help combat the problem described above where everyone's relying on a black box to pop out risk metrics. Yes, many might adopt the same formulas, but by exposing all of the underlying data in a real-time format with a full API, anyone could structure their own system for reading the data and analyzing it. Then we wouldn't have silly situations where everyone believes that bundles of toxic mortgages have a AAA rating.

Of course, almost every discussion I've had with anyone about the subject had people saying the concept was so insane no one was actually thinking about it. Turns out that might not be entirely true. Daniel Roth discusses an almost identical plan in Wired, suggesting that the idea isn't so far-fetched after all. That doesn't mean anyone is going to implement such an idea any time soon, but at least the idea is out there and permeating and getting some attention. It may take a while, but eventually people will begin to realize that it makes much more sense than anything else going on these days. We're not going to fix a broken Wall Street by throwing extra money at the problem, but we might be able to fix it by opening up, adopting radical transparency, and then letting the market more accurately value things based on real data.

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Is Piracy Really More Important Than The Financial Crisis And Climate Change?

from the priorities,-people dept

Reader Virginia notes that in an announcement concerning European Commission President Jose Manuel Barroso and Chinese Prime Minister Wen Jiabao meeting to talk about various issues, it seems odd that "piracy" was apparently a priority over both the financial crisis and climate change. You would think that the other issues would be much more important, but the old legacy content industry still has been able to convince politicians that piracy is some huge political problem, rather than a business model issue they could take on, if only they bothered to try.

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Blaming Failure On The System Actually Does Have Some Benefits...

from the before-we-trash-everything-here... dept

A bunch of folks have sent in Daniel Gross' excellent review of the World Economic Forum in Davos last week, where he bemoans the fact that no one is willing to step up and take the blame (or even find people who should shoulder the blame) for the economic collapse we're all living through. He has a great line near the beginning:

Success is the work of Great Men and Great Women, while failure can be pinned on the system.

Indeed, in reading the article, I definitely agreed, and sometimes I find it troubling that we credit success stories to individuals who were often much more lucky than anyone cares to imagine, and when failure occurs, no one's willing to admit that they had any part in it. However, in thinking about it some more, I'm less and less sure that this is a bad thing. In many ways, it's actually an important part of creating future success stories.

If we went around blaming individuals for every failure, it creates tremendous incentives not to take on the necessary risk to create those next breakthroughs. The difference between success and failure is often such a fine line it's difficult to see. In almost every success story you hear of one or two minor things that could have brought the whole thing crashing down if things had gone differently. But in celebrating the "heroes" associated with success, we create incentives for others to experiment and take necessary risks. In not punishing the individuals behind the failures too harshly by calling them out for "blame" we don't create incentives to avoid those necessary risks. That's a good thing.

That isn't to say that we shouldn't look at what happened and why it went wrong, but it's right to look at the systems that went wrong and how to fix them, rather than calling out people to tar and feather. That's counter-productive and only makes it that much more difficult to encourage the next generation of entrepreneurs to take the necessary risks to create economic growth.

Of course, there is one additional point that needs to be made here. Despite what I said above, there is a significant problem when we interpret that initial sentence to mean we should then socialize the loss -- and pin the effects of it on taxpayers, which seems to be exactly what this country has done all too often.

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Building Good Banks Instead Of Bad Banks

from the revisiting-the-idea dept

Last year, we had an interesting discussion about using the government's bank bailout money not to bail out banks, but to build an entirely new set of banks that weren't encumbered by the problems of the legacy banks. It seems like that idea is worth revisiting, as there's been plenty of talk about having the existing banks dump a bunch of their "toxic assets" into a so-called "bad bank." The idea is gaining a lot of steam, but definitely worries a lot of people. Willem Buiter, however, has a different suggestion that harkens back to our older discussion: rather than creating a "bad bank" with all the toxic assets, why not create "good banks" instead and turn all of the legacy providers into "bad banks."

This would solve the biggest problem of the bad bank solution: which is that the government would effectively be paying for a ton of assets that no one has any idea how to value -- meaning there's a half decent chance that we (the taxpayers) will overspend on those assets. Instead, the "good bank" idea would be that those banks would then buy up the good assets from legacy banks -- which are good because they can actually be valued. The legacy banks then automatically become "bad banks," but the taxpayers are left with the good assets, rather than the toxic ones. Buiter then suggests that those legacy banks have their banking licenses taken away so that they can't do any new business -- but can only look to wind down or sell whatever remaining assets they have. Effectively, this system would also avoid rewarding the shareholders of those legacy banks (though, they could still receive something from whatever's left over after the sale of the various assets).

In actuality, this is a suggestion for rebuilding the entire banking system, and throwing off the old banks. It's still pretty risky, however, and plenty of folks in the US would be horrified (of course) at the idea of the government effectively owning the entire "good" banking sector. Still, if you could set it up in a way that allows the system to quickly, but safely, transfer over to private ownership, the idea does seem significantly better than the bad bank solution. That said... you have to wonder why the government is needed to fund the banks under this scenario at all. Why aren't private investors putting up the money to buy up the "good" assets of the legacy banks? Are they still just too afraid to spend? Too afraid that "good assets" are really toxic? Or are the banks too afraid to sell any of the good assets?

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Putting The Financial Crisis In Perspective: It's Tough To Keep Economic Growth Down

from the 140-year-view dept

If you're at all interested in economics in general, you should read David Warsh's Economic Principals column, which is always interesting (and you should absolutely read his fantastic book Knowlege and the Wealth of Nations, which is highly relevant to many of the discussions we have around here). Anyway, his latest column shows a nice little chart of per capita GDP in the US over the past 140 years or so, which effectively shows a pretty consistent upward trajectory, where even recessions and the Great Depression -- which is noticeable -- are hard pressed to stop the eventual economic growth. The message is pretty clear: it's hard to keep economic growth down. In the midst of a great contraction and massive deleveraging, that message seems to get lost pretty quickly -- but it's worth remembering.

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Transparency On The Bailout? Banks: No Thanks!

from the who-needs-transparency? dept

The Associated Press is being a bit unfair with its set of "gotcha questions" it asked a bunch of banks that have received bailout money, suddenly demanding that they all explain how the money is being used and how much is being used, but it is an important issue. In handing over all of this money to banks for a stake in those banks, one would think that we, the taxpayers, deserve at least some transparency into how the money is being spent. Considering the sums handed over, this is hardly an out-of-line question. Yet, we've already seen that the promised transparency surrounding the bailout has hardly been forthcoming. And, the worst part of it is that the thing we need more than anything else right now is significantly more transparency to rebuild the trust in the financial system.

Of course, it's not the banks' fault that they're not detailing what they're doing. There's no reason for them to do so right now. However, we should be asking why the government, which rushed to hand over so much money while promising transparency, didn't require more openness as a part of the deal and hasn't done much to add any transparency to the process since handing over the cash. Sure, everyone's been pretty busy, but transparency shouldn't be an afterthought here, it should be a central piece of any economic recovery package. The fact that the government hasn't done much to increase transparency should be seen as a troubling sign.

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Internet Company Valuations Now Below Their Lows From Last Bubble Burst

from the in-case-you-didn't-realize-how-big-the-financial-crisis-has-been dept

I doubt there's anyone out there who would claim that the dot com bubble bursting was a bigger deal than the current global financial restructuring that's been going on. However, plenty of people (myself included) have suggested that internet companies are more isolated from the root causes of the mess this time around -- and that's almost undeniably true. Last time, a lot of the trouble came directly from overvalued internet companies. This time, it's had little, if anything, to do with internet companies. However, apparently some are noticing that the valuations of 50 or so top internet companies have dipped below their lowest point from when the dot com bubble popped. Of course, in the aggregate, that's rather meaningless. Each of the companies looked at have different circumstances. Besides, the current global financial mess means that no one's really sure how to value anything, meaning that current valuations of pretty much any stock should probably be taken with a huge grain of salt.

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Treasury Bill Rates Go Negative; Loaning Money At A Guaranteed Loss

from the wow dept

It caught some attention yesterday when the rate on four-week US treasury bills went to zero yesterday, but an even more astounding data point occurred when the yield on three month US treasuries briefly went negative. Yes, this meant that companies were willing to lend the government money for three months, knowing they wouldn't make back all their money.

If you want to know just how bad things are out in the market right now, this means that companies feel more comfortable losing some money to the government than investing in anything.

As for the obvious question of why would anyone invest in a bond that's guaranteed not to earn them a return, it simply comes down to alternatives. In theory, you could keep all that money in cash, and not lose any of it -- but that's not practical. If you literally kept it in cash in a giant vault somewhere, you'd pay so much to protect it, effectively you'd be "losing" more of it anyway -- not to mention the very real risk that some of that cash would be stolen. But why not leave it in a bank? Well, again, this comes down to how much of the money in a bank account is actually federally insured to be there. Insurance only covers so much, and since there's a small, but very real, risk that certain banks might just up and disappear, many companies recognize that treasuries at a loss are the best investment. In other words, they feel that no matter what they do with their money, they're going to lose money. So the strategy of investing in a negative t-bill is to lose as little as possible.

Of course, some might point out that going negative doesn't really mean that much. After all, if the return on the t-bill was less than inflation you were losing money in real purchasing terms anyway already. However, from a psychological perspective, it's still rather stunning that on a purely nominal basis, the return is negative. As a basic indicator of just how scared companies are to invest money right now, it's pretty powerful.

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Creative Destruction: Time To Make Companies Small Enough To Fail

from the channeling-schumpeter dept

The news is filled with stories of the latest bailout: this time of the US auto industry, and for some reason it has me thinking about Joseph Schumpeter. Schumpeter, as (hopefully) many of you know, was an economist in the first half of the 20th century, who today is probably most well-known for two things: his championship of the concept of "entrepreneurs" and ongoing innovation as the process of economic growth, and the creation of profits, as well as the idea of "creative destruction" brought about by those entrepreneurs, taking down old industries with new ideas, new products and new processes. There is much that Schumpeter got wrong in his analysis (in general, I'm not a huge fan of much of Schumpeter's work), but throughout it all, there were some very important ideas that have been proven time and time again.

It's important to revisit his work, as we're seeing a sudden influx of economic philosophy "battles" between different schools of economists over how to deal with the financial crisis. The new Keynesians still believe that through government tweaking, we can guide the economy to some sort of "soft landing." The more free market-focused economists fear the end result of such tweaking. The split in schools of thinking has become significantly less pronounced than in the past, and ideas seem to permeate back and forth among these and other economic philosophies, but some core beliefs are common across most economists, and they've been shown to be correct time and time again.

Competition and Innovation

Innovation, driven by competition, is the core of economic growth. Competition drives companies to keep innovating, creating better and better products (often for less and less money). Companies that rest on their laurels get beaten in the marketplace, and that's good for everyone (except, temporarily, employees and shareholders of those companies). It gives the public better products, made more efficiently, and it keeps companies from becoming burdens.

Encouraging competition should be a key goal of government, but in most cases that means staying out of the way. Unfortunately, things don't always work out that way, and the government has often been much more involved than necessary, later causing problems. This is often seen in a rush to send antitrust lawyers after a company for being successful, but not when it's doing any actual harm on the market, or preventing any real competition from happening.

We also see it as a problem in the government's intellectual property policies, which often do little to encourage innovation, and plenty to hinder it by creating defacto monopolies.

If the government should be involved at all, it should be to enable (not create) the infrastructure that's necessary for further innovations. It should be enabling the next generation of entrepreneurs to be creating the next great businesses.

Too Big To Fail

But, rather than doing that, we see the government looking to prop up non-competitive, non-innovative behemoths that are being called "too big to fail." These are companies that, often with the help of government regulations and subsidies, have become so intertwined in the economy, that a failure on their part really would cause significant ripples throughout the rest of the economy. While there are some who suggest they should be allowed to simply fail anyway, the economic risk in doing so is quite large -- in part, as a result of bad gov't policies for many years, abused and exploited by these companies.

Simply giving these companies more money and new regulations isn't going to make a difference. It only puts off the inevitable, and potentially will make things even worse when the problems resurface. The regulations and "oversight" will seem like a good deal at first, but over time the companies will twist the regulations to their advantage. They'll create new and larger loopholes, and the regulations won't do what they're intended to do, but will instead have created massive new problems. It's what almost always happens.

Creative Destruction

So perhaps it's time to go back to Schumpeter, with a big twist. If we grant the premise that some of these companies are too big to fail, and they absolutely need gov't bailouts to make them work, then why not set the terms of the bailout as being that they need to use the money to become small enough to fail? That is, they can get the money, one time only, and then need to look at breaking themselves up into separate pieces (even competitive pieces) that, by themselves, are no longer too big to fail.

The end result is that you aren't left with the same terrible situation, while also creating a new generation of "spinoffs" that can innovate and compete against both older firms in the space, and new upstarts that can more readily enter the market, rather than face a few giants. That way we're enabling more competition and innovation, leading to economic growth, while dismantling the structure of "too big to fail."

It's not quite that simple, of course. But, on the whole, it makes absolutely no sense to be "bailing out" companies that are too big to fail while leaving them as too big to fail. The end result is just going to keep sucking in more bailout money and wasting it, rather than encouraging innovation and competition.

A Cold Douche

This, obviously, is not the "creative destruction" that Schumpeter was talking about at all. In fact, at times he toyed with the idea that companies too big too fail were where the market would eventually end up. But, he also recognized the power of destroying old industries and setting the path for new innovations -- and he knew that the process was often messy, tied to business downturns.

In economist Robert Heilbroner's excellent The Worldly Philosophers, Heilbroner recalls sitting in Schumpeter's class at Harvard during the Great Depression:

When he lectured on the economy at Harvard in the midst of the depression, Joseph Schumpeter would stride into the lecture hall, and divesting himself of his European cloak, announce to the startled class in his Viennese accent, "Chentlemen, you are vorried about the depression. You should not be. For capitalism, a depression is a good cold douche." Having been one of those startled listeners, I can testify that the great majority of us did not know that a douche was a shower, but we did grasp that this was a very strange and certainly un-Keynesian message.

And, indeed, this economic restructuring is a good cold shower (though, some may prefer douche), but we don't get that sort of restructuring when the government is propping up exactly what needs to be restructured.

So, let's repurpose creative destruction with a clear plan: if you accept government bail out money because you're too big to fail, then that money needs to be used to make you small enough to fail.

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It's Not Liquidity Or Solvency That's The Problem: It's Transparency

from the a-lack-of-information dept

Last month, in writing about the financial crisis, I tried walking through the root causes of how the financial crisis happened and how to prevent it from happening again -- and the point I kept coming back to was the lack of transparency. It wasn't (as some people want to claim) "greed" or a "lack of regulation" that caused the problem, but bad information (though, some might blame that on greed and a lack of regulation). Aaron deOliveira points out that some folks are noticing the same thing, suggesting that the real problem these days isn't a lack of liquidity in the markets, but a significant lack in reliable information. People just don't know how much things are worth, and that's a huge problem.

Last week, on the always excellent Planet Money podcast, there was a discussion about what money really is. Many people think that it's a hard representation of value, but it's not. As the podcast noted, money is a relationship. Take a listen to fully understand what this means, but it's exactly right. Money is merely a relationship of trust between certain parties that enables trade. If I trust this piece of paper is worth a certain amount, I can do business with you. If I don't trust that the paper or trinket you hand me is actually worth anything, then I will not do business with you, and your "money" is not money at all.

The problem that we're experiencing today is that, due to a lack of clear and trustworthy information out there, no one is quite sure what anything is worth, and that makes any sort of trade difficult. Money only works when there's a trusting relationship, and you only get that sort of trusting relationship when there is a reasonable flow of information to the parties involved, such that they're confident that what they have (or what they're trading for) has value. The problem over the last few months (or, for some, years) is this realization that the information they had was bad, and they could not trust it, and thus, the "relationship" that made thing valuable disappeared. Without this trust, plenty of things that do have value are being severely undervalued, because there's no (or very little) credible information, and that's leading to panic, because no one is sure what anything might actually be worth.

So, once again, we're back to the situation where we were before: the answer should be more information, more widely distributed in a much more open fashion. We should all be demanding significantly more transparency both from corporations on any sort of investment they put forth as well as from the government who is shoveling dollars -- but not information -- into the market to try to deal with the problem. But, until it gets more information into the market, then the trust will not be regained, and the dollars they throw into the market will merely decrease in value, because there are not enough relationships built on trustworthy information.

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Are Venture Investors Not Meeting Their Capital Calls?

from the or-just-threatening dept

Last month, we talked about how the financial crisis might impact the venture capital community, noting that many more limited partners (LPs, or the folks who put money into venture capital funds) were looking to sell their stakes in the aftermarket. Bloomberg is now taking a look at the issue, noting that more than double the amount of stakes is up for sale compared to a year ago, basically confirming that a number of LPs are looking to get out of their commitments. One interesting tidbit is that, in many cases, this has nothing to do with losses from venture capital, but due to the rules that the LPs (pension funds or institutional investors) have on allocation. As we mentioned in the original post, most of these investors set aside a certain small percentage of their money for such high-risk alternative investments. The problem is that with the rest of the market collapsing, these investors overall portfolio has shrunk, driving the venture investments over the self-imposed limits -- forcing them to sell off to rebalance. Partly, this shows the silliness of forced rebalancing under such principles. It's forcing firms to get out of investments that might be okay, just to keep percentages intact.

However, the bigger issue is hidden at the very bottom of the Bloomberg article. It's the question of whether or not any of these LPs are defaulting on their commitments to VCs. That's been the big fear. Since LPs merely commit to venture capital funds, and then wait for "capital calls" before actually handing over the money, the worry is that LPs would default. However, the article notes that there's no evidence that this has actually happened yet. It may still just be early, as the real market collapse is only a few months old, and there probably haven't been many (if any) capital calls in the last few months. But, does anyone know of any LP that has actually failed to meet a capital call? It would be interesting to hear if it's actually happened, or if it's just a concern at this point.

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Suckers And Transparency: Preventing Another Financial Crisis

from the can-we-outlaw-suckers? dept

In continuing to try to understand the root causes of the financial crisis, we find that the whole story just keeps getting more interesting. While lots of folks are trying to blame one single thing (free markets, regulations, greed, poor people, rich people, bankers, mortgage lenders, hedge funds, short sellers, the President, Congress, etc.), the truth is that almost all of those explanations aren't just wrong, they're highly misleading. The problems involve a whole bunch of different things that combined to create the incentives that resulted in this situation -- and preventing it from happening again is hardly an easy proposition.

Finding the last sucker

Earlier this year, in talking about a highly questionable investment firm that was investing in startups, we wrote about how the venture capital game has always been about finding the last sucker to invest. It used to be the public markets, but when that dried up, apparently some VCs moved on to basically skirting public offerings by getting firms like the one described in the post to effectively trick unsophisticated investors out of their money and put it into a "fund" that then went to startups. It was the same process -- but actually less regulated than the public markets, and much more open to fraud.

The more I read about and understand different aspects of the current financial crisis, the more it becomes clear that basically the same thing happened here, but just on a much, much larger scale. It was a giant game of hot potato, where folks were passing along toxic assets looking for the last sucker to take them -- except the process of finding that last sucker became so valuable, that many of the firms in the business of finding new bigger suckers... found themselves. In many cases, the suckers were, in fact, unsophisticated investors like the school districts we described recently, but the various banks got so tied up in the process that they started betting on these things themselves.

Becoming the last sucker

While we've been trying to avoid the blame game, the more details come out, the more it looks like an awful lot of the trouble actually comes from the ratings agencies, such as S&P and Moody's. As we discussed in the story about the school districts, the ratings agencies screwed up pretty massively, by taking collections of poorly rated loans, and effectively claiming that all together, they suddenly became low risk assets. At some level you can see where they were coming from. If they were basing their decisions on the idea that default rates were independent, then bundling a bunch of questionable assets is a potential diversification strategy. You're assuming that only a small percentage will default, and you can look at historical numbers to figure out the risk. But, the problem is that these aren't independent, and as defaults start happening it leads to more defaults -- and the ratings agencies were simply fooled by their own models.

That's the generous interpretation, at least. The other is that there was outright fraud going on at the ratings agencies, and there's some evidence there was a fair amount of fraud. My guess is there was a little of both. The ratings agencies were pushed to rate these financial products highly, and so they created models that would support a high rating. Basically, rather than creating models that actually judged the risk, they created models that told them what they wanted them to say, because, in part, their business model depended on it. It was, as noted, garbage in, financial crisis out.

A lot of this becomes clear in Michael Lewis' excellent (as usual) discussion with a hedge fund guy who recognized this early (and made quite a bit of money doing so). What's fascinating is how much work even he had to do before he realized how fragile the whole setup was. When the financial crisis first went into full swing, many folks pointed the blame finger at hedge funds that were shorting bank stocks, like this guy. However, as the Lewis profile makes clear, he wasn't to blame. He was accurately telling everyone that the financial system itself had been built on a myth -- and the mythmakers were believing their own myth.

The end result is that the race to find that last sucker resulted in plenty of suckers being taken -- but when there weren't enough of those, the banks basically made themselves the next sucker in line, and convinced themselves that they weren't suckers. While there was almost certainly some amount of fraud involved in all of this, part of the problem was that everyone started believing their own bogus models in order to convince themselves that there would always be a later sucker (or, even worse, that they didn't need a later sucker).

So how do you prevent suckers?

And that leads us to the crux of the problem. How do you prevent suckers? At some point, you can just say, well it should be "buyer beware," and to some extent I agree with that sentiment. But, when all of the other incentives are as screwed up as they were in this situation, then even the "aware" buyer finds that almost every single datapoint he or she is using is wrong. That's what was happening here. You could look pretty deep at many of these assets and everything was saying they were solid, when the reality was they were not. In cases of outright fraud by ratings agencies, you can pull out the blame finger, but in many cases it wasn't so much fraud as it was the "experts" deluding themselves. How do you stop defrauding suckers, when it's the suckers defrauding themselves... and then earnestly convincing everyone else in the process?

Radical transparency

The one thing I keep coming back to as a solution is to put in place some aspect of radical transparency on pretty much all aspects of financial instruments, both on the debt side and the equity side. On the equity side, I'm surprised that more folks haven't picked up on Umair Haque's point that quarterly reports are obsolete and not nearly transparent enough. What if public companies provided ongoing reports that revealed a lot more than they do today. And, similarly, any debt instrument provided much more detail concerning what was actually making up the investment.

The reason school districts got stuck with worthless CDOs was because the information they got wasn't transparent at all. Sure, the prospectus was a book three inches thick, but all that information was actually used to obscure what the product was. Hell, the districts thought they were buying actual bonds, not making a side bet on how those bonds would do (what the CDO actually represented). But if there were real transparency within these instruments, and everyone buying into them could easily understand what was actually at stake, then they wouldn't be so reliant on ratings agencies and their crappy models. They'd be able to build their own models -- or openly share and discuss models with others.

While there will always be some "last sucker" out there, we can limit the risk of such things by limiting the suckers as much as possible -- and the way to do that is to become much more transparent and open with information.

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Instead Of Bailing Out Broken Banks, Why Not Build New Banks?

from the thinking-out-of-the-box dept

Plenty of people are pretty angry about the financial bailout, where it often looks like taxpayers are effectively handing over money to banks who screwed up big time by betting excessively on high risk investments, and borrowing a ton of money in the process. However, the argument from the other side (which does make sense) is that the "alternative" could be the collapse of the global financial system, and that would have such far reaching impacts that it's not at all desirable. But, that assumes the only options are to either bailout the banks or to let them fail entirely. Some are trying to come up with other options. Salman Khan and David Leinweber have come out with a suggestion that instead of bailing out banks, the government should take the $700 billion and use it to fund an entirely new financial sector. Then, as the screwed up banks fail, these new banks can take over their discarded assets.

This certainly has some appeal. The idea is that you wouldn't be rewarding shareholders in the original banks and also wouldn't be allowing the entire capital engine to seize -- and, on the flip side, you also might be rewarding the shareholders of the new banks (the American taxpayer). However, there's also tremendous risk in doing this. In effect, it's something like building a new airplane from within a troubled airplane that's flying at 40,000 feet, getting it to fly from the air, and then moving people from the troubled airplane to the new one. There's an awful lot that can go wrong. Also, in doing this in such a rapid fashion, when it's still not entirely clear what all the root causes of this crisis are, you run the risk of simply transferring the core problems to these new banks (basically taking the problems from the first airplane to the second, if we continue the analogy). Then you end up spending $700 billion to basically create a new set of troubled banks that are even more confusing, because they were put together in a rush. So, while it's an interesting idea, it seems like it would present some significant problems as well.

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Online Psychics: A Growth Business In Down Times

from the contrarian-opportunities dept

I'm definitely a big believer in the idea that there are some businesses that thrive especially in economic down times, and that any business should be looking to take advantages of those opportunities -- but I'm not exactly sure that online psychics were what I was thinking of at the time. Apparently, the online psychic business is booming these days, as people with more money than sense figure the best thing to do is ask a psychic what's coming down the road in their financial future. I don't necessarily mean to cast aspersions on the psychic profession, but my own view into the crystal ball suggests that if you want to have more money than otherwise in the future, you shouldn't spend what money you do have on psychic readings.

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Bloomberg Sues The Fed For More Transparency Over $2 Trillion In Emergency Loans

from the that-would-be-useful-info dept

While plenty of people are focused on the $700 billion TARP bailout/rescue plan that Congress gave the Treasury Department, that's not the only cash the government has at its disposal. In fact, the Federal Reserve has apparently handed out $2 trillion in emergency loans, with almost no transparency over who received the loans and what the collateral is or how it's valued. Bloomberg (the company, not the mayor) is now suing to have the Fed reveal that info. The government has been talking up a storm about how all of these bailout efforts would be very transparent with respect to taxpayer money -- but the reality hasn't lived up to the rhetoric.

The article linked above is from Bloomberg (the party suing the gov't), so perhaps it's biased, but it does seem noteworthy how pretty much everyone tried to dodge questions concerning the $2 trillion in loans. The only person who seemed to be willing to say anything was Rep. Barney Frank, who is the House Financial Services Committee Chairman. Yet, his explanation for the secrecy is hardly compelling:

"I talk to [New York Fed CEO Timothy] Geithner and he was pretty sure that they're OK. If the risk is that the Fed takes a little bit of a haircut, well that's regrettable.''

Pretty sure they're OK? That's hardly a ringing endorsement for keeping the details of such loans a secret.

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What Obama Should Do To Get The Entrepreneurial Viewpoint

from the we're-about-to-find-out dept

Two contrasting articles crossed my desktop this weekend, both about how President-Elect Barack Obama is likely to govern. The first, by Mark Cuban, criticizes Obama for the list of economic advisers that Obama chose to consult concerning his plans to take on the economic downturn. Cuban, correctly, worries about who is missing from that list:

Notice anything missing?

Not a single entrepreneur. Yes Warren Buffett started a business, but he will be the first to tell you that he "doesn't do start ups". Which means there isn't a single person advising PE Obama that we know of that knows that its like to start and run a business in this or any economic climate. That's a huge problem.

I absolutely agree. It is the entrepreneurial spirit that is needed right now. But, at the same time, it makes you wonder just how Obama would have accomplished this. Any one or two entrepreneurs are unlikely to do a really good job representing all entrepreneurs. Entrepreneurs, for the most part, don't all view things the same way, and there's no real organization of entrepreneurs. The reason entrepreneurs become entrepreneurs is often that they see their own way of doing things and don't want to be locked up by convention. So, while it is worrisome that there aren't any entrepreneur-types on the list, I'm not sure I'd be that much more comfortable with a few entrepreneurs representing the interests of all entrepreneurs either.

That brings us to the second article. It's by David Carr in the NY Times, and looks at how Obama's campaign ran like an entrepreneurial startup itself, leveraging the internet and new technologies to do a complete end-run around much bigger and more well-known "corporate brands" in the political space. And it wonders if Obama will continue to use those tools to govern as well.

So, at the very least, one could argue that Obama, himself, is something of an entrepreneur, but more importantly, one would hope that Obama does, in fact, continue to leverage the internet to hear from folks -- and is actually willing to listen and take suggestions seriously. Why not create an economic roundtable of sorts online that lets more people weigh in? Let ideas in the mix bubble up to the top using ratings systems (and maybe some White House moderators) and contribute them to the mix. If someone has a particularly good suggestion, why not invite them to a meeting with those "big shot" economic advisers as well? It doesn't mean that every hare-brained scheme needs to be listened to, but if there's a good way to allow the best ideas to bubble up and get recognition, it could be quite a powerful new way to govern. To some extent, there's already some indication that this is where things are headed with the transition website Change.gov, but it remains to be seen if that's just a Presidential suggestion box... or something a lot more powerful.

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