Streetwise Professor

September 27, 2008

Brief Thoughts on the Bailout

Filed under: Derivatives,Economics,Politics — The Professor @ 11:42 pm

A couple of quick, semi-random thoughts.

First. Many of the difficult to value assets in bank portfolios are tranched claims on payments from mortgages. The securitizers took pools of mortgages, and created securities that had different priority claims on the cash flows. The more senior tranches have first priority on cash flows, and lowest exposure to a default by the borrowers; the less senior tranches have lower priority, and the highest exposure to borrower default.

These complicated structures have option-like characteristics, and complicated relations between default rates and timing on the one hand and security cash flows on the other. This makes each piece more difficult to value than the underlying pool of the loans. Put differently, even if you have a good idea on the default risk of the underlying pool of loans, it is more difficult to determine how this default behavior will affect the cash flows on the different tranches. Therefore, it is harder to value the individual tranches than the pool of loans underlying them.

One way to facilitate the valuation of these securities, and hence the liquidity of the market, would be to reverse the tranching process and create vanilla MBSs. Equivalently, if the bailout plan proceeds, and the government starts bidding for assets, it could solicit offers only for bundles of the tranches collateralized by a given pool of loans, where each bundle would be equivalent to a vanilla MBS on the underlying pool.

Operationally this might be a challenge because, by design different tranches were typically marketed to different clienteles. But it is worth considering as part of the strategy, as pools of whole loans should be easier to value than the sliced and diced CDO tranches created from them.

Second, the WaMu bailout seems to be preferable to the buy assets approach of the Paulson plan. It is targeted at an institution that needs help, and utilizes the existing powers of the government. Indeed, other than the monoline insurers and the investment banks (notably Goldman and Morgan Stanley), most of the financial institutions that warrant concern are banks subject to FDIC regulation, and therefore standard FDIC approaches can be relied upon rather than taking a wholly new approach that doesn’t necessarily address the problems of the institutions posing systemic risk.

Third (I guess this is a bonus, as I set out promising only “a couple” of comments). The essential intellectual underpinning of the Paulson plan to buy assets is that the auction process–or whatever process that the government will use to buy assets–will improve market transparency. That is, the prices “discovered” in the auctions/market purchases will reflect private information about the value of the assets, and other market participants can use this information to mitigate asymmetric information problems that seriously impair market liquidity for problem assets. Even though sellers will receive an information rent (i.e., the government will overpay due to its information disadvantage), the creation of information is a public good that improves efficiency that is an offsetting benefit.

Perhaps. I am skeptical that the auction prices will be all that informative, given the heterogeneity of the underlying assets and the (related) lack of competition that is likely to characterize the auctions. Discovery of a noisy price in a not-very-competitive auction for a particular CDO is unlikely to improve the precision in the valuation of another CDO that is not bought in the auction.

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3 Comments »

  1. Professor:

    Sounds as if you’ve read the recent Soros article in the Financial Times and agree with his assessment. See below for link to article:

    http://www.ft.com/cms/s/0/9973c5b0-8a6d-11dd-a76a-0000779fd18c.html?nclick_check=1

    While as I am sure you can imagine I don’t agree with Soros’ views on Russia, I do respect his model for viewing the financial markets. In particular, Soros would argue that one of the primary reasons the CDO tranches, in question, are so hard to value is that the neo-liberal economists’ equilibrium pricing models are flawed. As has been shown with Black-Scholes and LTCM the methodology used by much of Wall Street is based on a false assumption; namely, that markets are self-correcting and efficient.

    What are your thoughts and has the current crisis forced you to reevaluate your assumptions on regulation and markets?

    Comment by Timothy Post — September 27, 2008 @ 1:10 pm

  2. Hi, Timothy–

    Believe it or not, came up with what I wrote all by my lonesome, without any help from George;-) Hadn’t read his FT piece, so thanks for sending it.

    The stuff about asymmetric information is basic finance. One of the things that disturbs me about the various bailout plans is that they seem to avoid coming to grips with basic finance.

    I teach a PhD course in options valuation, and one of the things I hammer into the students is don’t fall in love with your models. It’s easy to do. They are often beautiful. More beautiful than reality, with all its non-linearities, singularities, regime shifts, and other aesthetically jarring features. The LTCM guys in particular suffered from model Narcissism, more content to gaze at the beautiful reflection of their models than to question how they related to reality.

    That said, models can be a valuable tool, as long as you recognize their limitations and are constantly on the lookout as to where they seem to be doing badly. LTCM and other big players also fall into the trap of failing to recognize that the models assume that prices processes are exogenous, and do what they do regardless of what you do. When you become big, like LTCM did, and some other big players recently, you move the markets, and usually against you.

    In the end, though, models are the worst way to try to understand markets, except for all other alternatives that have been tried.

    Re assumptions on regulation . . . as some of my earlier posts say, I have yet to hear a cogent suggestion of a specific regulation or regulations that would have had a dramatic impact on the way things played out. Moreover, two of the main culprits have a government address–the Fed, which conducted a monetary policy that facilitated the formation of a real estate bubble, and Fannie/Freddie, which were instrumental in supporting, subsidizing, and encouraging the development of the subprime market and deficiencies therein.

    I try to keep an open mind on these things, and recognize that regulation can improve outcomes in some cases. I also recognize, however, that regulation can create problems and/or exacerbate them. The restrictions on short selling that I’ve written about are a case in point. Again, I caution against using regulation as a mantra, without coming to grips with the specifics.

    The ProfessorComment by The Professor — September 27, 2008 @ 3:16 pm

  3. professor, you wrote:

    “LTCM and other big players also fall into the trap of failing to recognize that the models assume that prices processes are exogenous, and do what they do regardless of what you do.”

    BINGO! Well put. This is the essence of Soros’ Thoery of Reflexivity. I would prefer that Soros use the term “feedback loop” because at their most basic, financial markets are feedback loops where the price of a security is also one of the inputs used to value the security. I would love to see folks like yourself push economists to admit that economics is not a discipline like natural sciences but much more of a social science.

    Additionally, I have felt for some time, August 1998, that economics could benefit greatly by using models which have traditionally been used to model closed disequilibrium systems (e.g. hurricanes).

    Regarding regulation I like to keep it simple Sam. Basically, regulators should look to make a basic distinction between investing and speculating. The difference between to the two in my mind is that investments earn their rate of return through capital gains and through paying cash dividends, some later than others. Speculation, on the other hand, earns its rate of return solely through capital gains (e.g. currency speculation).

    Neither, investment nor speculation, is inherently right or wrong. Rather, there needs to be regulations which limit speculation from impacting the real economy. I have no problem with gambling, either in a casino or through derivatives vehicles. However, firms which want to speculate should be distinct from those that want to take Joe Sixpack’s paycheck deposit. This is what Glass-Steagall was all about and why I was against its repeal.

    The biggest problem facing us right now with this bailout plan is the fact that the speculative vehicles, such a CDOs squared, have the potential to impact the real economy if left to blow-up on their own. I am all in favor of letting these institutions fail, and thereby maintaining a healthy moral hazard, but, unfortunately, the commingling of investments and speculations over the past 10 years makes it tough to let the knuckleheads fail without screwing the “Jacksonian mobs” (i.e. the rest of us).

    So, is Paulson’s plan simply going to buy Credit Default Swaps from institutions? Why not freeze all derivative contracts? Can you explain to me which general types of derivatives are necessary to help the real economy grow? Obviously, the credit Default Swaps were supposed to reduce risk but since they can’t even begin to assess the risk profile of many of these instruments when the markets are under stress why should we try to save them?

    Comment by Timothy Post — September 28, 2008 @ 8:08 am

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