Streetwise Professor

It is painfully evident that the financial engineering profession–of which I am a member, at least of the academic branch–created models that were painfully inadequate for the purpose of valuing, and appraising the risks of, highly credit sensitive mortgage derivatives.   The real products were too complicated, too non-linear, too dependent on unknown and arguably unknowable parameters to value accurately.

Thinking about that sparked thoughts of a topic that I blogged about extensively some time back–climate science and climate models–but which I have largely ignored since.   Financial engineering and climate modeling have a lot in common.   Both attempt to characterize sometimes highly non-linear things by solving numerically partial differential equations.   The results generated by both types of models are highly dependent on the values of certain parameters that are not directly observable, and often times very difficult to estimate even approximately given the limited data available; hence, parameter inputs for both types of models are often guesstimates, at best.

The pronounced deficiencies of financial engineering models, especially for credit sensitive mortgage products may hold a lesson for climate science, and for policymakers who base (directly or indirectly) decisions affecting literally trillions of dollars of wealth on the predictions of these models.   That lesson is a simple one: be very skeptical about the predictions of these models.   The one-eyed man is king in the land of the blind, and having a model is arguably better than not having one, in the sense that one’s predictions are more precise with a model than without one–but that does not mean that the precision is high in any absolute sense.   Indeed, the very elegance and deceptive precision of the models–they produce, after all, numbers to machine precision–can make them extremely alluring.   The models are so much more elegant, neater, ordered, and logical than messy reality.   Thus, modelers too often tend to fall in love with what they have created.   The financial crisis makes manifest the dangers inherent in this attraction.

If anything, climate and climate models are more complicated than CDOs and the models to value them (though that proposition may be arguable, given than climate lacks the strategic, and potentially psychological, aspect that is present in any situation involving human interaction, such as a financial market.)     Thus, the stunning demonstration of model error currently playing out in the financial markets should give pause to anyone who makes sweeping policy recommendations based on the predictions of climate models.   Not that I expect that it will.

In its oh-so-British, understated way, the FT echoes a theme expressed somewhat more intemperately in SWP-land:

An increase in the state’s economic power is necessary and inevitable, as it is the west. But unless Mr Putin and the president, Dmitry Medvedev, take care, Russia’s intervention will be riddled with turf wars and corruption. Oligarchs and bureaucrats could be divided, even more deeply than today, into hostile factions, riding roughshod over the interests of ordinary citizens. The market’s fragile grip on the economy could be undermined.

Russia’s leaders must guard against these dangers by ensuring that the funds are distributed fairly under the eyes of independent supervisors. The aim should be to safeguard the banking sector to ensure that the financial crisis does not turn into an economic depression. The personal ambitions of businessmen and bureaucrats must be subordinated to the interests of the country as a whole. Otherwise, even with all of its oil, gas and metals reserves, Russia will face a difficult economic future.

Good luck with “ensuring funds are distributed under the eyes of independent supervisors” and subordinating the interests of businessmen and bureaucrats “to the interests of the country as a whole.” (There’s always a first time, no?) “Turf wars and corruption” and “hostile factions” are inevitable. The only question is whether “war” is merely metaphor, or factual description.

In other words, the FT’s piece, though valuable to the extent that it acknowledges an important Russian reality, is akin to a prim, indirect Victorian discussion of a vulgar topic. Goo-goo* recommendations of this sort are usually risible even in more mannered political cultures. When applied to Russia, they are hilarious.

On this subject, Michel’s comment on the post just preceding this one provides details on the new Russian Gold Rush, where every industry is clamoring to get its hands on state funds. Check it out.

* “Goo-goo” was legendary Boston Mayor James Curley’s cutting epithet for various well-meaning municipal reformers, such as those from the Boston Good Government Association.

That’s the price of Urals-Med today. The $70 barrier has definitely been breeched. Now, it should be noted that Urals sells at about a $2 discount to Brent, and the Brent forward curve is pretty steeply upward sloping, so the Urals forward price should be above $70 for most of 2009. Nonetheless, the Russian budgetary cushion is getting thinner by the day.

Just a couple of comments re the still continuing debate between DR and Michel.

First, re OPEC–cartels are inherently unstable. The level of the equilibrium competitive price of oil isn’t really that germane to the ability of the cartel to peg the price above that level. The cartel must restrict output in able to do that. Every individual member has an incentive to cheat on its quota. In OPEC, as in most cartels, that cheating has been rife. In essence, Saudi Arabia has been the swing producer, and it almost unilaterally is the only force that reliably affects prices by reducing output. And Saudi wants a price of around $80. And at times (e.g., 1986), Saudi Arabia gets tired of bearing the entire burden of supporting prices. If it has to restrict output too much in order to prop up prices, it may repeat its 1986 performance and open the spigots to punish all the cheaters.

As an aside, perhaps some of Russia’s recent output stagnation/decline reflects its effort to act as a swing producer, though it may also reflect the inefficiencies associated with greater state control.

Second, re the great consumption debate. I don’t think that there is any doubt that Russian private domestic consumption has risen quite steadily over the past decade. In large part that reflects the low starting base and the resulting catch-up, the more efficient allocation of resources in the post-Soviet period, and the dramatic reallocation from heavy industrial production towards consumer goods. Moreover, per DR, it also reflects a favorable tax climate, with a low, flat tax rate. (One thing about Russia that I’d like to imitate in these parts.)

However, in some respects the consumption growth is a bug, not a feature, because of its flip side–the very low rate of domestic Russian savings. As a result, Russia is highly dependent on external capital, and current events are demonstrating the pitfalls of this reliance with a vengeance.

Relatedly, domestic investment rates in Russia are very low compared to other countries that have achieved and sustained high growth rates. Russian domestic investment is 18-20 pct. of GDP, as compared to the 30+ percent of high growth success stories.

But in the end, my long horizon skepticism about Russian economic prospects (should I say bearishness?) is not primarily rooted in traditional macroeconomic considerations. Instead, my skepticism is traceable to the weakness of property rights, the vulnerability of profitable businesses large and small to the predations of the state (of which corruption and “raiding” are two symptoms), and the brittle political/natural state institutions. As I said in an earlier post, Putin has created a sort of economic purgatory, better than the economic hell that proceeded it, but hardly ideal. And the political economy of the natural state system makes it very, very difficult to exit purgatory for something better. Moreover, although it may not be a highly probable outcome, rent-based politico-economic systems like Russia’s are vulnerable to instability and collapse. In a parallel to the girl with the curl (when she’s good she’s very very good but when she’s not she’s horrid): When they are orderly, they are very, very orderly, but when they’re not, they’re chaotic.

To me, it’s not necessarily the budgetary implications of a low oil price that creates substantial downside risks for Russia, though that’s not irrelevant. Instead, the major risk is that the system is predicated on distributing rents to keep the various clans happy. While the rents are big enough, and the clan members think the game will continue for awhile, the system can operate relatively well. When the rents erode, or economic shocks affect the distribution of rents to the substantial relative disadvantage of some, however, that stability can disappear almost overnight. Given the extreme weakness of formal institutions in Russia–and I don’ think any objective observer can dispute that formal institutions like property rights, courts, etc., are deficient there–the dissolution of the informal, relational bonds that hold things together can lead to substantial disruption.

The world is currently experiencing a major shock. (Duh.) This first major effect of this is to reduce the prices of natural resources, and the associated rents, that have been the basis for Russian politico-economic stability. Moreover, due to Russia’s dependence on foreign capital; its own self-inflicted wounds (Georgia, Mechel, BP-TNK, etc.); and its increased integration with the world economy, the world/US shock has had a disproportionate impact on Russian equity markets. Moreover, it is evident that the shock has had big distributive effects within Russia. All of these factors eat at the informal bonds that mitigate conflicts between competing factions.

Finally, the economic shock has created an environment favorable to the enhancement of the powers of the state (through acquisition of heretofore private companies at cheap prices). Even if the current structure survives the present stresses–probably the most likely outcome, even though the risk of a major blowup is higher now–this will have adverse consequences for Russian growth in the future, and public enterprises are inherently less efficient.

Michel and Da Russophile are engaged in an interesting debate on Russia in the comments to Check Out Michel’s Comments. I’ll add my two cents (or should it be kopecs?) here.

The main issues in the colloquy between these two gentlemen are (a) the breadth of Russian prosperity, (b) its dependence on oil prices, and (c) the likely future course of oil prices.

With respect to (a), official statistics are not that illuminating, and anecdotal evidence is seldom conclusive. My one anecdotal data point is from a friend who recently returned to Russia (not Moscow or St. Petersburg, but a large city) after 2 years in the US. She said that yes, things had changed for the better but that “You live in a different world, and should be grateful for that.” In brief, things were better, but a long, long, long way from what Americans or Europeans take for granted.

I can speak with a little more authority on (b) and (c). I’ll start with (c). Insofar as the future course of oil prices is concerned, the price is effectively hostage to the strength of the world economy, and that is not a good place to be right now. All indicators are for a deep recession world-wide in the coming year. To the extent that emergency interventions in the banking markets work, they will primarily affect the depth and duration of the impending recession. Given the inelasticity of the demand and supply for oil, even a modest downturn in demand translates into a substantial decline in oil prices.

With respect to OPEC riding in to save the day (for those long oil, anyways)–don’t count on it. OPEC output restraints didn’t really contribute to the skyrocketing price over the last summer. Every OPEC producer was pumping flat out, with the exception perhaps of Saudi Arabia (which increased output some in the summer) and Nigeria (which is continuing to experience disruptions due to MEND and other anti-government groups.) When producers are operating at capacity, a cartel is having no effect. When demand falls, and OPEC faces an excess capacity situation, an effective cartel could prop up prices, and collectively its members would like to do so, but the incentives to cheat on any such agreement to restrict output are strong. Historically, OPEC members have cheated substantially on their quotas, and the cartel’s influence on prices has been sporadic at best during periods of excess capacity. I therefore wouldn’t count on OPEC to provide substantial relief to Russia by keeping the oil price from falling too low.

As to (b), in some respects whether the price of oil (Urals or REB) remains above $70/bbl is a secondary issue. (Tuesday’s price for Urals-Med was $73.44. Netting out transport costs, that is very close to the $70/bbl figure.) Certainly, the lower the price, the greater the budgetary pain, and a fall below $70/bbl will, per Kudrin, result in Russia running a deficit. Even if the price is substantially higher, however, there is considerable room for doubt as to whether the additional revenues will be directed to meet Russia’s most pressing needs, which include, to name but a few, public health, infrastructure, and pensions. Prices even in the $80s–which are very likely, and maybe even optimistic over the coming year given the bleak economic outlook–will allow Russia to avoid running a deficit, but are probably insufficient to go far in addressing Russia’s health and infrastructure capital deficits, especially given the, ahem, “leakage” of funds that pass through government hands.

Anyways, keep up the conversation, guys. I’m enjoying it.

Treasury Secretary Paulson called an assembly of all the major banking families, and offered them billions in equity in exchange for preferred shares. The money sentence: “The capital injections are not voluntary, with Mr. Paulson making it clear this was a one-time offer that everyone at the meeting should accept.”

The first offer not to be refused. I doubt it will be the last.

I continue to believe that the Humpty Dumpty Option is worthy of consideration, and perhaps of another Don Corleone soliloquy. Although stabilization and recapitalization of the supermajor banks is certainly an important element to addressing the credit crisis, it will not be sufficient. It focuses on the biggest banks, and only on those in the US, but the problems exist at banks of all sizes throughout the US and the world. This intervention does not address the issue of the vast amounts of dodgy mortgage debt lurking in bank portfolios, and it is this dodgy debt that is at the root of the problem.

Interestingly, the Treasury seems to be moving away from the TARP scheme (praise the Lord). This may reflect (a) that it will take a long time to get the auction process going, (b) the Treasury’s dawning recognition that the auction program is likely to be impractical, and (c) that more urgent action was needed to stabilize things. This last consideration is somewhat worrisome, and I think that helps explain why other initiatives announced by the Treasury and other governments over the past couple of weeks have seemed to send the markets into a tizzy. The markets infer from every new move that the Treasury and other governments are signaling that things are even worse than originally feared.

Humpty Dumpty has numerous merits, some of which I pointed out in the original post. One advantage is that although it would require the exercise of Federal power to implement, it would not entail government ownership or direct investment, and could reduce the amount of government investment required to stabilize the banking system going forward. Under this alternative, the original investors in mortgages and mortgage derivatives would continue to own claims against these assets. This would limit the potential for wealth transfers between taxpayers and (current) asset owners. It would also limit the massive potential for mischief that accompanies the government’s holding large stakes in the financial system.

Such transfers would be inevitable under TARP, and it’s a heads we lose tails we don’t win proposition. If the transfer is from asset owners to the taxpayers (as would be the case when the government underpays), the program would do little to address the capitalization of banks, and could actually make them worse off, thereby prolonging the crisis and requiring additional injections of public funds later. If the transfer is from the taxpayers to the asset owners, well, that might effectively inject capital into some banks, but some of the windfall is almost certain to flow to asset owners who do not need assistance to avoid posing a systemic risk.

Furthermore, since it is almost certainly easier to value mortgage-based claims relative to one another, than in cash, valuation errors (and the related wealth transfers) should be smaller under Humpty. This would reduce the magnitude of the wealth windfalls–which again, under this plan, would be among asset owners who exchange their claims on the mortgage-based assets for shares in The Firm, and would leave the taxpayers out. In essence, The Firm would essentially pool and share valuation risk within the financial community (banks, hedge funds, and other investors.) This seems preferable than sharing that valuation risk with taxpayers. It should also be noted that if all asset owners participate, since many of them have diverse portfolios of mortgage-based claims, the variability of valuation errors on these portfolios will be smaller than the variability of valuation errors on individual components of them.

The Humpty Option also addresses the problem at the root, by undoing the complexity (and associated informational problems) created by financial engineering. Rather than razing that thicket, the TARP/auction alternative runs right into it. It would be infinitely easier to create a liquid market in shares of a portfolio of all the mortgage-based assets in question than in many of–let alone all of–the mortgage-based assets individually. If the liquidity discount on the individual assets is as large as Paulson and Bernanke suggested in touting TARP, the shares in The Firm would likely be much more valuable than the sum of the values of the individual assets even were the TARP program to improve liquidity in the market for the individual assets.

In other words, the Humpty Dumpty Option almost certainly would accomplish more than TARP, and without putting taxpayer funds at risk.

When thinking about Humpty over the weekend, a quote from Eisenhower came to mind (I quote from memory, but I’m sure it’s close to the original): “If a problem appears intractable, enlarge it.” That’s Humpty Dumpty in, well, if not a nutshell, an eggshell. Go large. Tackle the problem at the root.

It is not The Solution, but neither is making multi-billion dollar “investments” in the big banks. In conjunction with other efforts, however, it can make a big difference. Indeed, by mitigating the bad asset problem at no direct expense to taxpayers, it would reduce the cost of other measures necessary to restore the financial system to health.

By using the Don Corleone approach–and Paulson just crossed that bridge today–it would also be possible to avoid the adverse selection problems that will almost certainly bedevil TARP (and which would ultimately be the source of wealth transfers from taxpayers to asset owners.)

Right now, as the world financial system teeters on the brink, two songs are competing for the top spot on the SWP playlist: REM’s “The End of the World as We Know It” (the only REM song I can stand), and the Ramones’ “It’s Gonna Be Alright” (definitely not the only Ramones song I really like, let alone can stand.)

Which of the two will be prophetic?   Hopefully the latter, but who knows?

The Economist has two articles that cleave very closely to various SWP posts that predate their publication.

This one discusses the “collateral damage” of the SEC short-sale ban on the convertible bond market, and particularly its effect on banks. The 9 October article says that the effect on convertibles was “a typical example of the unintended consequences of meddling with the markets in response to populist pressures.” Gee, but that seems very, very similar to what I wrote on 27 September in “Unintended–But Totally Predictable–Consequences.” Specific use of the term “Collateral damage”? Check. Specific use of the term “Unintended consequences”? Check. Analysis of the damaging effect on convertibles market and on banks? Check. Criticism of stupid pandering policy? Check. Very pronounced similarities here, undoubtedly.

This one makes several arguments regarding commodity speculation that I have flogged repeatedly on SWP and in my Congressional testimony and WSJ piece. Here, the similarities aren’t quite as close, but the focus on looking for distortions in stocks and the lack of a direct channel by which fund money can affect physical commodity prices reprises two themes that I have emphasized repeatedly.

But, then again, maybe both things are so obvious that it’s no surprise that the Economist advanced the same arguments. But, especially with the short sale ban post, the similarities in argument and language make me lean towards rejecting the null hypothesis of “coincidence.”

Any thoughts, readers?

MIchel has some excellent comments to Under Pressure. His remark about the higher expectations of the Russian people (as compared to 1998) is very well taken. This is another factor contributing to Russian brittleness. A genuine improvement in living standards, the “splendid little war” in Georgia, American stumbles, European cravenness, and the steady diet of propaganda from the state controlled media have obscured Russia’s fundamental structural weaknesses, and fostered unrealistically high expectations about what the future holds for Russia. The country teeters on the economic brink–the world does, but Russia is arguably closer to the brink than just about anybody else–and if the deluge comes, a disappointed people that had put its faith in Putin and Putinism will turn on him (and it) in a fury.

Michel’s statement about the disconnect between the plans for an aggressive military buildup costing billions at the same time the country’s fiscal cushion is “melting before [their] eyes” is also right on the money. The $5 billion loan to Iceland, another extravagance apparently driven by geopolitical calculation, is another bizarre choice under the circumstances. Ditto the Venezuelan adventure. There is an air of unreality about all of this. The only thing that makes sense to me is that Putin, Medvedev, Sechin, et al, feel powerless to address the economic problems, so they are flogging the “Russia is Back”-military might-patriotism-derzhavnost line for all it is worth. They blame the US for all of the economic problems (and to be sure, the US has a lot to account for, but not all of Russia’s travails can be laid at the American doorstep), which feeds the hostility to the US, and exploit this with grandiose plans to rearm–by spending the money set aside for a rainy day. Memo to Vlad: It’s raining, dude. Like, really hard.

In the Under Pressure post I suggested that too many people viewed the reserve fund as a talisman. Evidently, nobody more than Putin and the siloviki. It gave them a sense of omnipotence that fueled their bumptiousness at home and abroad, near and far. This sense of omnipotence will melt along with the fund. And if and when that happens–and is seen to happen–Putin’s and Medvedev’s political support will erode, and their position will become precarious. How will they react? Most likely, with a combination of foreign adventurism and an intensification of political repression at home. Not a pretty picture.

I have often written that Russia is a natural state, a cartel of violence specialists that is held together by economic rents, primarily generated by natural resources. As I have noted, such states/cartels are fragile, and subject to collapse. Collapse occurs when (a) the rents dissipate, or (b) the time horizons of the colluding parties shorten. Natural states look strong pendant les bon temps roulez, but have a tendency to implode once the music stops.

The crash–crashes plural, actually–of the Russian stock market, the gridlock in the money/banking markets, and the decline in oil prices, are dissipating rents, and arguably convincing the various clans that the game will soon be up. Moreover, the financial crisis has weakened some players (Deripaska is a well-publicized example), which could tempt others to exploit this weakness and grab what they have left. This could induce a breakdown in the uneasy peace between competing factions of violence specialists.

What is occurring now is just the sort of crisis that threatens the natural state with collapse. The facade of order and control can quickly dissolve into chaos and conflict. Like glass, natural states are strong but brittle, and shatter when the stress becomes too acute.

It has been reported that numerous big state firms–most notably, Gazprom and Rosneft–are importuning the state for financial support. It is well known that these two firms are at the centers of two contending clans. They will be competing to get at the same money. Both are tightly connected to heavyweights in the Russian government and security services (to the extent there is a difference between the two.) A battle between the two would shake Russia to its foundations. If each–or either–senses that its future is in question, tacit cooperation is no longer an optimal strategy, and out will come the knives.

Everyone’s attention is turning to the stability fund. In virtually all of the commentary written since the beginning of the meltdown in August, the phrase “the $570 billion dollar stability fund” has been repeated like a mantra, an incantation that will ward off a return to 1998. As commentor Michel points out, however, the government has already committed a substantial fraction of this sum in various market and bank support schemes, none of which have stemmed the bleeding. Hence, the line of mendicants begging for a piece of the fund is getting longer, and more insistent. Kudrin, who has played Horatius at the Gate defending the fund against those who desire to divert it to their purposes, is under pressure. You think it was a coincidence that Storchak was just indicted? I don’t. Moreover, those now pleading for the money–Gazprom, Rosneft, the three amigos from BP-TNK–are really heavy hitters. I doubt that Kudrin, or Medvedev, or even Putin, can resist their pressures.

The market apparently has its doubts too. Credit default swaps (EEEEEEEK! CDSs! Run for the hills!) on Russian government debt rose 52 basis points to 352 bp, as compared to 36 bp in May ’07. If the stability fund makes Russia immune from default, why the bulge in CDS prices? (Part of that is due to an increase in the market price of risk in these unsettled times, but certainly part reflects a perceived increase in the probability and severity of a default.)

I think Michel has put his finger on the matter. He conjectures that “[m]any have been lusting after those billions for years, and the crisis was the perfect cover to launder piles of money from the reserves to the offshore accounts of friends of the regime.” That makes perfect sense, and today’s Moscow Times provides evidence for it: “Four major energy companies have asked the government to lend state money on market terms to help refinance foreign debt and buy new assets abroad as they become cheaper, a top oil executive said on Tuesday.” Cheaper. Riiigghht. That’s the ticket. No, I think the key word in the sentence is “abroad.” Like Michel, I read this to mean: “Give us money in the stability fund so that we can take it out of the country while the taking is good.”

In brief, although the existence of the fund makes survival of the current system in Russia more likely than it would be in its absence, it is not a talisman. If the crisis–in the US, in Europe, and in Russia too–shows anything, it shows that $570 billion can evaporate in a trice. That is especially true in a country like Russia, where the formal institutional safeguards are so weak. In a highly personalized natural state, rife with corruption, where the state is essentially the cash cow for aggressive and amoral individuals who are comfortable with the use of violence, when the deluge begins, no property is safe. So, to those who repeat “the $570 billion dollar stabilization fund” to lull themselves to sleep, I say–there are monsters under the bed. And it is at times like these that they come out and play.

In an earlier post I mused–in an abbreviated, bloggish sort of way–that reassembling subprime and Alt-A mortgage backed securities by bundling CDO tranches would improve liquidity in this market. My confidence in this intuition was strengthened by reading Gary Gorton’s much more thorough and penetrating analysis of the informational effects of the complexity of CDO structures, and the implications of these effects for the liquidity of the CDO market. (H/T to Marginal Revolution for the Gorton link.)

That has encouraged me to think bigger. What follows is basically a thought experiment, with a critique of the difficulties of making it a reality.

How big? What if . . . ALL assets backed by subprime mortgages were contributed to a single firm? (Still noodling over how synthetic CDOs would fit into this scheme.) The owners of these assets would receive shares in this corporation, which I will refer to as The Firm.

This would offer several advantages.

Most importantly, The Firm would effectively hold basic subprime mortgages. Bundling all the contingent claims on all the subprime mortgages would eliminate all the offsetting embedded options positions, leaving only the underlying mortgages.

Now these would not be easy to value, but they would be a lot easier to value than CDOs and CDOs squared, etc., because these products (as Gorton points out) embed complex option structures. The underlying mortgages have optionality (pre-payment, and especially default). Every slicing and dicing creates additional optionality–CDOs are compound options, CDOs squared are compound options on compound options, and so on. And every additional option increases complexity, destroys information, and makes valuation inherently more difficult.

The reduction in complexity–and the reduction of what Gorton refers to as the “informational losses” that result from the creation of complex chains of contingent claims on the underlying mortgages–would make the shares in The Firm substantially more liquid than the CDOs. Moreover, it is well known that lemons problems are less severe for portfolios than for individual assets that make up those portfolios. As a result, claims on portfolios (e.g., S&P 500 futures) are usually far more liquid than claims on the individual components of the portfolios. Thus, shares of The Firm would be a lot–a lot–more liquid than the CDOs contributed to it, and even more liquid than the underlying mortgages.

If, as is almost certainly the case, illiquidity depresses prices, the shares of The Firm will have a greater market value than the current market values of the CDOs, etc., that are contributed to the firm. This increase in market value would reduce the insolvency issues and questions currently dogging banks and other intermediaries.

This effect is essentially what the Paulson plan is trying to achieve through the creation of a market for the individual CDOs. Given the heterogeneity of the individual CDOs, however, in my view it will be much harder to create a liquid market in these individual components than it will be to create a liquid market for less complex bundles of them. (A sort of alchemy is at work here–putting together multiple complex things in the right way results creates a less complex thing. This is the KISS–keep it simple, stupid–approach to financial engineering.)

Financial institutions that contribute assets to The Firm will replace these assets on their balance sheet with shares in The Firm. This has two important effects. First, since due to their greater liquidity the shares are likely to have a higher market value than the “fair value” of the assets the banks give up, this innovation will increase the capitalization of the banks. Moreover, it will homogenize the balance sheets of financial institutions because the shares are identical and fungible. This will make it easier for banks to evaluate one another. This, in turn, may help rejuvenate the interbank lending and repo markets, ,which are malfunctioning primarily because banks do not know with any precision who is solvent and who isn’t due to the opacity of balance sheets that contain subprime exposures. (The shares can also potentially serve as repo collateral in both private transactions and transactions with central banks.)

Another potential benefit is that The Firm would internalize the benefits of restructuring the underlying mortgages and optimizing foreclosures. This could redound to the benefit of both (a) the shareholders (because the values of the CDOs are reduced because securitization means that those best able to negotiate restructuring of the underlying mortgage debts do not reap the benefits), and (b) the mortgage borrowers who enter into mutually advantageous restructurings with The Firm.

In a nutshell, putting the mortgage Humpty Dumpty back together to create a less complex, more homogeneous financial claim–equity in The Firm–would improve market liquidity and facilitate more efficient restructuring of mortgage debts, thereby easing the solvency and lemons problems that bedevil banks and the money markets.

Sounds wonderful, but the Humpty Dumpty solution as outlined above is akin to Steve Martin’s plan to make a million dollars without paying taxes: First, make a million dollars. I’ve cut straight to the end by assuming the magical creation of The Firm, just as Steve Martin assumed away the hard part of making $1 million without paying taxes.

The problem, of course, is getting there. There are myriad obstacles practical and political.

Most importantly, there is a major scale economy here. The benefits (per dollar of principal or asset value) are increasing in the fraction of subprime mortgage contingent claims that The Firm owns. If it owns all these contingent claims, it will end up with the least complex possible portfolio (simplest, not smallest)–the underlying mortgages, without all of the compound optionality, compound compound optionality, etc., embedded in the CDO structures.

Even though as a result of this scale economy it would be best to put everything in The Firm, it is hard to imagine that this outcome would occur voluntarily, without considerable coercion. Even though this approach makes the size of the pie bigger, and arguably much bigger, it will inevitably have distributive impacts which will induce collective action problems. Moreover, a voluntary approach would likely create adverse selection problems. I’ll consider each point in turn.

Contributors of assets would receive shares in the corporation. Given that the assets contributed are inherently heterogeneous, this raises the issue of how to determine how many shares would be distributed for each asset.

Now, mispricing (which is almost a metaphysical concept in this context) would lead to redistributions of wealth among the contributors of assets. (This is an important difference with the Paulson Plan, in which mispricing leads to redistributions of wealth between current asset owners and taxpayers. This is a potential political selling point for this alternative.) If The Firm gets all assets, this is merely shifting wealth around among asset owners, and from behind the veil of ignorance (which is almost completely opaque here), ex ante any individual asset owner is as likely to incur a distributive windfall as incur a distributive loss.

However, just as everybody thinks–or will assert–that their child is better looking than average, even if some have faces that could stop a clock, asset owners will think–or assert–that their assets are more valuable than average. They will fight tooth and nail to get the highest relative valuation of what they have. This will generate massive transactions costs.

The amount of money that could be redistributed could be immense. Voluntary negotiations among asset owners to form The Firm, and determine the pricing (in shares) of each asset to be contributed, would generate tremendous inefficiencies as the asset owners would negotiate to receive windfalls and impose the distributive losses on others. As Gary Libecap and Steve Wiggins showed in their analysis of unitization of oil fields, even when an agreement leads to substantial increases in aggregate wealth, rent seeking to receive redistributive windfalls can preclude the consummation of the wealth enhancing Coasean bargain. And the magnitude and complexity of unitization negotiations pale in comparison to those involved with the creation of The Firm.

Moreover, if contribution of assets to The Firm is voluntary, adverse selection problems are likely to be acute, resulting in incomplete participation. If The Firm sets a schedule of prices, X shares for AAA (at issuance) CDOs, Y<X shares for AA (at issuance) CDOs, etc., based on a the best available information about the average value of these various securities, asset owners with private information will tend to withhold the assets with higher than average values, and contribute the lemons. Thus, (a) The Firm is unlikely to acquire all of the assets voluntarily, and (b) will be stuck with the lowest quality ones.

There is likely be a critical mass effect here. Due to the scale economy discussed above, the value of the greater liquidity of The Firm’s shares will encourage the owners of assets that are undervalued relative to other assets by the share distribution formula to participate anyways because the alternative is to hold onto the assets or sell them individually in an illiquid market. (I.E., even if I know my asset is receiving a smaller share of The Firm than another asset of the same quality, I may still contribute it in exchange for shares since those shares are worth more than I could get by selling the asset as a standalone.) Since the liquidity benefit should be increasing in the fraction of troubled assets The Firm acquires, once The Firm gets big enough the adverse selection problem should disappear. The challenge, then, is to make The Firm big enough to start this virtuous cycle. This is not a self-starting phenomenon. There is something of a Catch-22; everyone will want to participate if The Firm is big, but how can it get big to start with? Asset owners may re-enact the old Alphonse and Gaston vaudeville routine: After you, Alphonse. No! After you, Gaston. No, I INSIST, Alphonse. . .

It should be noted that the valuation challenges in setting the prices in shares of The Firm for different assets should be less daunting than attempting to determine the prices of these assets in dollars (or equivalently, other goods and services). The values of subprime contingent claims are affected by a set of common factors, most importantly, real estate prices and interest rates. Errors in estimating one of these factors will tend to affect the values of different contingent claims in similar ways. For instance, if in determining values, real estate prices are assume to be lower than they are in actuality, the prices of all mortgage contingent claims will be underestimated. As a result, the errors in estimation of the values of the various contingent claims relative to one another (which is what is relevant in determining the allocation of shares) will be smaller in magnitude to errors in the estimation of the values of these claims to other goods and services.

Of course, due to the optionality of the CDOs, a Z percent error in the real estate prices assumed to determine the number of shares to be given for each asset will not lead to a Z percent error in each of the assets. So there will be errors in determining the relative prices. But due to the fact that all the assets at issue are affected by a set of common factors, it should be possible to set relative prices (i.e., the number of shares to be distributed for each asset) more accurately than it would be to set the prices of each asset in dollars–which is what the Paulson Plan attempts to do.

As a result of the collective action/rent seeking and adverse selection problems, it is highly likely that considerable coercion would be required to create The Firm. That is, the government would almost have to employ the Don Corleone option. (This could involve punitive taxation on the owners that do not contribute their assets, or abrogation of the CDO contracts that are not contributed.) It would truly take all the King’s Horsemen and All the King’s Men, exercising vast powers, to put Humpty Dumpty together again.

Given that the asset owners are numerous and include citizens of myriad nations (not just the US), the political and diplomatic outcry that would result from such measures would be deafening. More importantly, the exercise of such overwhelming coercive power is truly frightening, and would set troubling precedents. As someone who values free contract, and the sanctity of private contracts, and abhors the exercise of government power, I could not in good conscience countenance such a solution. But . . . given that other alternative actions that will be advanced if the Paulson Plan fails will also inevitably involve massive coercion, at the end of the day we may be confronted with choosing between the least coercive of two evils. Or put differently, we may have to determine which alternative offers the greatest value, once the costs of coercion are taken into account. If we come to that sticking point, The Firm, with CEO Corleone, may look good by comparison.

I should also note that one of the potential theoretical benefits of The Firm discussed above may prove problematic. Specifically, although in theory The Firm should be able to negotiate more effectively and efficiently to restructure underwater mortgages (because of its better incentives and information), in practice it would face tremendous political pressures that would impede its ability to achieve this outcome. The owners of The Firm–those contributing assets, or those to whom the asset contributors sell their shares–want to maximize the value of the underlying mortgages. But, the borrowers want to minimize the value of those mortgages, and they will be a powerful political constituency. Indeed, one can imagine that a company that could only be created by a massive exercise of Federal power would be the creature of that power, and would be used as an instrument to redistribute wealth from the owners of mortgages to the mortgage buyers. This would, of course, offset in whole or in part the salutary effects of the creation of The Firm on the balance sheets of financial institutions, and the follow on benefits to the money and credit markets, and the real economy. At the very least, given the trillions of dollars at stake, The Firm would be at the center of the biggest stakes political game in history. Public choice theory tells us that efficiency is not the most likely outcome of such a contest.

So, if we start at the end–the creation of The Firm, the proverbial Bad Bank on massive doses of steroids–this approach of attempting to reverse the effects of years of Frankensteinian financial engineering has some real attractions. It would not be a complete fix–the underlying mortgages are experiencing huge defaults, and as a result the value of The Firm’s shares will still be less than the principal amounts of the underlying mortgages, meaning that banks and others will still have holes in their balance sheets, albeit smaller ones. Even those smaller holes may be big enough to make some institutions insolvent. But we’ll have a better idea of which institutions are insolvent (which will help direct government funds to where they are most needed, and which should help mitigate the uncertainty that is effectively shutting down the corporate paper and interbank lending markets), and we’ll have smaller holes to cover either through recapitalizations or government performance of deposit insurance obligations. This approach avoids many of the problems with the Paulson Plan, which relies on buying the individual assets.

The problem is getting there. It will require coercion–maybe not mobs with pitchforks and torches besieging Dr. Frankenstein The Financial Engineer’s castle, but the government employing its powers of taxation and the ability to abrogate private contracts. Lots of coercion. That is a cost, indeed. But as Ronald Coase never tires of pointing out, in the real world we have to compare real alternatives to real alternatives, rather than to Nirvana. Maybe, as Churchill said of democracy, the creation of The Firm is the worst possible alternative, except for all others that have been considered or tried from time to time.

This concept is still a protean one. I think it has some merits that deserve consideration, but I am sure that there are difficulties that I have not yet discerned. Although it is speculative and theoretical, it is no less speculative and theoretical than the bailout bill just enacted into law. Moreover, I think it has some advantages over that bill. If, as I expect, the bailout plan does not work as hoped (and it is a triumph of hope over experience), the Humpty Dumpty Option deserves a look.

At the very least, I think that this thought exercise helps focus attention on a fact that has not received anything near the attention it deserves: Namely, that any attempt to deal with the subprime morass (or, as my former Naval Academy roommate, now a workout specialist for small banks, puts it, la cosa subprimo) should go to the root of the problem. As Gorton persuasively shows, that root is complexity induced by financial engineering that created dense layers of options on top of options. Reversing that complexity–putting Humpty back together, or, to mix metaphors, putting the toothpaste back in the tube–would go a long way to mitigating the problem. Such a reversal would inevitably involve coercion, so the question will be: is the cost of coercion worth it? As bad as things are, I can’t answer affirmatively today. Tomorrow. . . who knows?

So, for now, consider this a straw man that lays out a particular approach to attempt to strike at the root of the problem. I therefore encourage commentors to (a) point out difficulties, or new complexities that this alternative would create, and (b) propose other ways to attempt to reduce complexity through reverse financial engineering. For if the specifics of what I have outlined here are faulty, I have a strong sense that the fundamental intuition that such reverse engineering is the way out of this mess. If anybody can think of incentive compatible schemes, schemes that are voluntary and will not be scuppered by collective action problems, transactions costs, and adverse selection. . . please share them with the class!