Friday, September 26, 2008
The crash is inevitable, necessary, and not to be feared
In examining the various plans to deal with the financial crisis, there seems to be a common element: a desire to avoid at all cost the collapse of an interlocked collection of derivative securities which could be called the House of CarDS (credit default swaps). The fear is that the massively tangled web of credit default swaps and other derivative securities will explode like a powderkeg that will destroy the economy if things go sour; because of this fear, the collapse must be prevented at all costs.
That attitude is fundamentally wrong and dangerous. First of all, it allows Americans to be held hostage to any demands financial institutions might make. Fail to do as they say, and they'll drop a match. Secondly, the costs of keeping the House of CarDS from collapsing are going to increase exponentially until it does collapse. Since the collapse is inevitable, it would be foolish to spend trillions of dollars postponing it. Thirdly, a collapse of the House of CarDS would not cause a major loss of value in the assets therein; since the loss has already occurred and has simply not been realized, the collapse would simply represent the acknowledgment of the already-existing loss. Fourthly, the biggest factor in today's credit lockup is that nobody knows what any of the paper assets are worth. If the paper assets in one's account are only worth $0.05 on the dollar, it's better to liquidate them and have $0.05 on the dollar of real assets, than to keep pretending the assets are worth face value when everyone knows they're probably worth less but nobody knows how much.
The first point should be self-explanatory. The second point is not so self-explanatory, but it is both observable empirically and explainable theoretically. I'll return to it later. As for the third third point, consider the following analogy: Joe Banker opens up a bank. Individual account holders are limited to depositing $100,000. The first $10,000,000 that people deposit in are shown on display. Any money that's put in after that goes to the vault in the back. What Joe doesn't tell anyone is that he actually pockets 80% of deposits and send them to secret offshore accounts in Fredonia. Each individual account holders can see that the bank has over $10,000,000 in assets, which is clearly enough to pay him off. What the account holders don't see is that the same assets are being used to back many times their worth in deposits, so even though people have deposited a total of $1,000,000,000 in the bank, there are only about $210,000,000 worth of assets backing them up.
Would a run on the bank cause the people to lose money? Not really. A run on the bank would cause the later depositors to lose everything, but the major loss came when Joe pocketed 80% of the deposits and sent them off to Fredonia. While a bank run would arbitrarily redistribute the losses (so those who withdraw early pass their losses off to latecomers), depositors on average will have lost $0.79 on the dollar before the run even started. The only effect of the run will be a fight over the last $0.21.
Returning to the original second point (exponential cost to prop things up), assume that Joe's Bank hasn't crashed yet, but the reserves are getting low (people who deposit money sometimes have the audacity to withdraw it). So Joe decides he needs to get more depositors. Easy solution: offer higher interest rates. In response to the higher rates, more people deposit the money, and Joe keeps getting more and more money to put in his pocket. Each dollar that Joe takes in and then pays out must be replaced by more than $1. Even if Joe weren't pocketing anything, the payment of interest would require an increase in the rate of deposits. If Joe starts pocketing money for himself as well, that will cause things to escalate rapidly.
On to point number four. Suppose that Acme Plastics has recently borrowed a lot of money to purchase another company which, as it happens, had lots of assets of dubious worth. If those assets are worth $0.10 on the dollar, Acme Plastics is solvent. If they're worth less, it's not. Acme Plastics has an assembly line all set up to produce Tickle Me Paulson dolls, and stores are waiting to receive them. All Mr. Acme has to do is get $100,000 of raw plastic on credit and he'll soon have $1,000,000 worth of merchandise. Unfortunately, since potential creditors have no way of knowing whether Acme Plastics is solvent, they have little desire to lend money and risk having to fight other creditors for its return.
If the crash of the House of CarDS revealed the real value of Mr. Acme's dubious assets to be $0.15 on the dollar, the crash would help Acme Plastics get credit, since he could show that his business was solvent. Even if it showed the value of those dubious assets to be only $0.01 on the dollar, though, it could still be a good thing for the Acme Factory. Markets love gains, but they tolerate losses. What they don't like is question marks. If the assets are shown to be worth $0.01 on the dollar, and that is insufficient to meet obligations to existing creditors, there are many ways to keep the factory open. Creditors may accept a debt-for-equity exchange. Or the business could be liquidated with the factory, intact, bought out by someone who could then supply the raw plastics needed to begin production. Even if none of those desirable things happened and Acme Plastics was disbanded, that wouldn't be much worse than having the company go broke because it couldn't get the credit needed to produce products.
So what do all these points mean? The fundamental danger in today's marketplace is not that there will be a crash, but rather people will act irrationally in an effort to avoid one. Nobody is going to want to see his portfolio drop by $0.50 on the dollar overnight, but throwing in good money after bad in an effort to deny reality is no solution. A lot of the money put into the markets by investors is gone. No amount of hope or optimism will change that. The only way to restore confidence in the markets is to find how much money is gone and how much remains, and then move forward.
That attitude is fundamentally wrong and dangerous. First of all, it allows Americans to be held hostage to any demands financial institutions might make. Fail to do as they say, and they'll drop a match. Secondly, the costs of keeping the House of CarDS from collapsing are going to increase exponentially until it does collapse. Since the collapse is inevitable, it would be foolish to spend trillions of dollars postponing it. Thirdly, a collapse of the House of CarDS would not cause a major loss of value in the assets therein; since the loss has already occurred and has simply not been realized, the collapse would simply represent the acknowledgment of the already-existing loss. Fourthly, the biggest factor in today's credit lockup is that nobody knows what any of the paper assets are worth. If the paper assets in one's account are only worth $0.05 on the dollar, it's better to liquidate them and have $0.05 on the dollar of real assets, than to keep pretending the assets are worth face value when everyone knows they're probably worth less but nobody knows how much.
The first point should be self-explanatory. The second point is not so self-explanatory, but it is both observable empirically and explainable theoretically. I'll return to it later. As for the third third point, consider the following analogy: Joe Banker opens up a bank. Individual account holders are limited to depositing $100,000. The first $10,000,000 that people deposit in are shown on display. Any money that's put in after that goes to the vault in the back. What Joe doesn't tell anyone is that he actually pockets 80% of deposits and send them to secret offshore accounts in Fredonia. Each individual account holders can see that the bank has over $10,000,000 in assets, which is clearly enough to pay him off. What the account holders don't see is that the same assets are being used to back many times their worth in deposits, so even though people have deposited a total of $1,000,000,000 in the bank, there are only about $210,000,000 worth of assets backing them up.
Would a run on the bank cause the people to lose money? Not really. A run on the bank would cause the later depositors to lose everything, but the major loss came when Joe pocketed 80% of the deposits and sent them off to Fredonia. While a bank run would arbitrarily redistribute the losses (so those who withdraw early pass their losses off to latecomers), depositors on average will have lost $0.79 on the dollar before the run even started. The only effect of the run will be a fight over the last $0.21.
Returning to the original second point (exponential cost to prop things up), assume that Joe's Bank hasn't crashed yet, but the reserves are getting low (people who deposit money sometimes have the audacity to withdraw it). So Joe decides he needs to get more depositors. Easy solution: offer higher interest rates. In response to the higher rates, more people deposit the money, and Joe keeps getting more and more money to put in his pocket. Each dollar that Joe takes in and then pays out must be replaced by more than $1. Even if Joe weren't pocketing anything, the payment of interest would require an increase in the rate of deposits. If Joe starts pocketing money for himself as well, that will cause things to escalate rapidly.
On to point number four. Suppose that Acme Plastics has recently borrowed a lot of money to purchase another company which, as it happens, had lots of assets of dubious worth. If those assets are worth $0.10 on the dollar, Acme Plastics is solvent. If they're worth less, it's not. Acme Plastics has an assembly line all set up to produce Tickle Me Paulson dolls, and stores are waiting to receive them. All Mr. Acme has to do is get $100,000 of raw plastic on credit and he'll soon have $1,000,000 worth of merchandise. Unfortunately, since potential creditors have no way of knowing whether Acme Plastics is solvent, they have little desire to lend money and risk having to fight other creditors for its return.
If the crash of the House of CarDS revealed the real value of Mr. Acme's dubious assets to be $0.15 on the dollar, the crash would help Acme Plastics get credit, since he could show that his business was solvent. Even if it showed the value of those dubious assets to be only $0.01 on the dollar, though, it could still be a good thing for the Acme Factory. Markets love gains, but they tolerate losses. What they don't like is question marks. If the assets are shown to be worth $0.01 on the dollar, and that is insufficient to meet obligations to existing creditors, there are many ways to keep the factory open. Creditors may accept a debt-for-equity exchange. Or the business could be liquidated with the factory, intact, bought out by someone who could then supply the raw plastics needed to begin production. Even if none of those desirable things happened and Acme Plastics was disbanded, that wouldn't be much worse than having the company go broke because it couldn't get the credit needed to produce products.
So what do all these points mean? The fundamental danger in today's marketplace is not that there will be a crash, but rather people will act irrationally in an effort to avoid one. Nobody is going to want to see his portfolio drop by $0.50 on the dollar overnight, but throwing in good money after bad in an effort to deny reality is no solution. A lot of the money put into the markets by investors is gone. No amount of hope or optimism will change that. The only way to restore confidence in the markets is to find how much money is gone and how much remains, and then move forward.
