This has been going on for weeks, where everything happens on the weekends:
The Bush administration asked Congress on Saturday for the power to buy $700 billion in toxic assets clogging the financial system and threatening the economy as negotiations began on the largest bailout since the Great Depression.
That’s only natural with the ongoing financial crisis, or crises – the US markets close Friday afternoon and the Asian markets don’t until Sunday evening, Monday morning on the other side of the International Dateline. So the weekend is when you drop the bomb – the big bailout or the big bank failure or the major bankruptcy or the big government takeover of this or that. This has been going on since the failure of IndyMac Bank on July 11, which was the second or third largest bank failure in United States history – depending on who is keeping track of such things – and the largest failure of a regulated thrift. Things only went downhill from there. Why should the weekend of September 20-21 be any different?
You just don’t want the markets to go all crazy – you use the weekend, in this case to reveal it will take a giant sum of money we don’t have to keep the world’s financial system from collapsing in a few days, and we had better act now. You withhold the real price tag until after the markets close. Markets are funny – people get all panicked, or all excited. We cannot have that. Stability matters – things should be orderly.
In Eat My Shorts – an overly clever and sarcastic title – you’ll find a discussion of one other way of assuring market stability as everyone is in a panic, banning short selling. That common market practice is the opposite of betting a stock will go up – it’s betting a stock will go down and making money as it goes down. You can make a lot of money shorting stocks, picking up the difference in price as the shares drop in value – sell at sixty, buy at forty and pocket the difference, then sell at thirty and buy at twenty and pocket the difference. It’s the mirror image of speculating on something going well – when you just know something is not right with a single company, or a whole market segment, you short the stock.
And that practice has been temporarily banned, at least regarding the shares of financial institutions of any kind.
But sometime short selling is just realistic – a few observant traders sensed something was fishy about Enron, and shorted the stock, and made money as Enron finally tanked. The man who wrote John McCain’s new economic plan, and who will be, it is said, the new Treasury Secretary should McCain win, Phil Gramm, had pushed through his famous “Enron Loophole” – part of the Commodity Futures Modernization Act of 2000, with its one special provision that exempted over-the-counter energy trades and trading on electronic energy commodity markets from any government regulation at all – and that made some nervous, and others skeptical. At the time, Gramm’s wife had just left Enron’s board of directors. Something seemed wrong – and something was wrong.
Or maybe the few who shorted Enron were cynics, but as before, cynical realists are always useful – they keep the rest of us grounded. And what are the grounds for the astonishing market rally of September 18-19 – the hope that the plan, for which there were at the time no details, and which many thought might cost a half-trillion, or maybe three times that much, and might return a profit one day, or not, fixes everything?
That may be so. But some were skeptical – and they are, for now, forbidden to act on their skepticism. That would cause what no one wants – that dreaded market turmoil, or something. This was an odd thing – enforcing positive thinking and banning negative thoughts, or at least making sure no one acted on those thoughts.
It was an exercise in mass psychology – for two days, since news of the big bailout leaked out, the markets soared.
And who better to comment on the mass psychology of markets than a friend who teaches marketing theory to graduate students at a prestigious New York business school? He saw the markets soar, and considered the ban on short selling, and sent an email along:
Stock market rallies CAN be built on the collective response to a MAJOR event – and thus can be seen as a “public vote” on the impact of a government action. But market response is NEVER a MACRO event or unified response to anything – it is ALWAYS granular in nature. “The Market” is always a collection of individual votes on how events (external or internal to any situation) will impact MY specific stock or investment vehicle.
And in this case I think it’s safe to say the uptick at week’s end (and it was a “tick” in proportion to the downward scale of the week) was NOT a vote on the eventual success of the government’s position as a player in the risk markets – that is: the position the government is taking considering anyone’s collective inventory of comment and analysis all week. Instead this market movement is a HUGE individual sigh of relief that I (me, my firm, my company, my stock) won’t be held responsible for the risk I have taken in the past. In a truly granular sense, all the not-so-little “me’s” won’t be held accountable. And collectively all the boys and girls are cheering – with their wallets! No detention for my stock (or the management team my stock represents!). No principal’s office here. No ruler across the knuckles from the nuns… or the POPE! No Siree! I’m free to play when school lets out for the weekend!
Personally, I’m not moving my portfolio in anticipation of catching any kind of growth swing. I’ll let the coaster go its way, because I’m pretty sure we’ve got deeper issues to solve. The bullies on the playground have merely been let out for the weekend! God help us all.
Peter Senge (The Fifth Discipline, 1990) has warned us – and should have taught us – that the toll of unforeseen consequences of any problem FIX that we attempt can surely be as or more damaging to the environment of a fragile eco-system than any original problem itself. And every “system” like our complex investment and financial systems is an eco-system by definition, and there’s nothing more fragile than the house of nakedly repackaged loan portfolios that have grown so exponentially in recent years.
Bottom Line – nothing stable in the long run coming out of Bush’s quite notable legacy! Foreign or domestic – there is nothing but deep stuff to wade in.
How deep? We will spend at least seven hundred billion dollars buying up toxic paper – bad mortgages and mortgage-backed securities that have no fixed or even hypothetical value, as those mortgage-backed securities were invented and sold, and disassembled and reassembled and resold in various new, mutant products, in an essentially regulation free market. And no one knows the underlying asset-worth with any of the actual bad mortgages – home prices will, everyone agrees, continue to drop like a rock, and no one can see the bottom. No one knows what any of this stuff is worth, if anything. Do we buy the stuff at ten cents on the dollar, or a penny, or fifty cents? Who knows what this stuff is actually worth, if anything. The idea is to just get it off the market, hold it, and maybe the government can sell much of this stuff later.
It seems like madness. We are buying IOU’s that have no fixed value – and can have no fixed value. And that leads to an interesting question. What makes an IOU worth anything?
In the Washington Post, Peter Fisher wrote an interesting discussion of that question – and he maintains that the likelihood that any IOU will be redeemed can have two different sources, which he calls asset-based and cash-flow-based underwriting. It’s not that hard a concept, and Michael O’Hare discusses it here:
Asset-based security is based on something the borrower promises to give you if he can’t or doesn’t pay what he promised. This could be a house, or a bunch of common stock, or a box of tulip bulbs. To make the loan, the lender has to believe the price others will pay for the asset will increase, or at least stand still – but doesn’t have to make any judgment about the borrower (except that he won’t split for Brazil with the asset in his suitcase). So you’re putting money out on assumptions about the behavior of zillions of people you haven’t met and know nothing about, with no attention to the character of the borrower himself. This seems odd: the “behavior of zillions of people” is not, in the end, like the “behavior of zillions of gas molecules” on which we bet our lives every time we fly. Stupid gas molecules, good; stupid investors, bad.
This sounds like our friend who teaches marketing theory, a discussion of mass behavior and granularity – but O’Hare is onto something else:
Cash-flow security is based on the lender’s expectation that the borrower will create enough new value (that others will pay for; no escape from risk, just managing it) to pay off the loan. A business loan to an entrepreneur, or an investment in his new project, is cash-flow based: the borrower has to tell the lender a story, with sufficient evidence, about how he will succeed in the enterprise. There’s no existing asset to seize – a couple of laptops and some second-hand furniture? – so the loan is a judgment about capacity. Buying stock in a big company, or lending to it, is actually similar: stock prices reflect an expectation of future capacity to create value, not an evaluation of liquidation asset value unless things are already in the toilet.
But then in the Post, Fisher is saying finance has evolved from mainly cash-flow to mainly asset-based judgments, and this matters a lot, as O’Hare explains:
Current asset-value lending is a bet on a market making a judgment as ill-informed about the flow of value to be expected as yours: that McMansion a two-hour commute from the city may have just sold in a frenzy for $2m, but can it really provide housing services each year whose net present value is $2m? And shouldn’t the buyer’s job prospects have something to do with your risk? Art prices display this nuttiness: a ten million dollar painting has to be worth thousands of dollars an hour to look at (how many people can crowd around a painting and get anything out of it? How many actually ever do, for anything but the Mona Lisa?) eight hours a day forever, or the price is nothing but a bigger fool bet.
Cash-flow investing is a bet on something much more solid, but it takes work to do it right and some real knowledge of a person, a real estate market, or an industry. Because it forces the exchange of useful knowledge about how complicated things work, it builds social capital and in the end it’s much more secure. Asset-based investing is ignorant of lots of important stuff and deeply asocial (the data you need is a bunch of numbers going across a Bloomberg screen) and turns out to be flaky.
That may be a bit arcane, but think of it this way – it’s all mob psychology based on little information. People bet on the asset value of quite hypothetical assets, or really, on all the various aggregations and re-aggregations of quite hypothetical assets, sliced and diced and repackaged again and again. It wasn’t like buying stock in a company you thought had a very cool and amazingly useful new product that everyone would buy – folks that, if they got some capital to expand by selling stock, would obviously make a ton of money, some of which would come your way when you sold the shares in the company you had bought early. It just wasn’t like that.
That’s why much of this comes down to mass psychology. Smart people knew they were buying and selling securities based on assets – IOU’s on collections of mortgages, some of which had to be based on actual assets, houses and commercial real estate, actual buildings with mortgages holders who would easily meet the payments or refinance at more manageable payments as they built equity – but either weren’t smart enough to know there was little or no asset-value there, or figured they’d buy and sell these things and make their money, and let someone else worry about the actual, underlying value. It’s just very odd that they called these things securities. The word had lost its meaning in all this.
But our marketing friend is right – the markets rallied when, after reality set in and everyone admitted these pieces of paper were a useful fiction that had been revealed to be a fiction, and thus both useless and absurd, the government said they’d buy all of it and get it off the market. No one will now be embarrassed, or unemployed, for playing make-believe for years.
As for this particular fix, see UCLA’s Mark Kleiman:
There seems to be a strong case for massive intervention to prevent a credit freeze that would damage the real economy. And there seems to be good reason to do it now – or at least for the political players to credibly commit now to doing something soon.
But I can’t work up much enthusiasm for writing a blank check to a Treasury Secretary who takes his orders from this President. And there are serious questions about how to ensure that the stockholders and managers of financial-services firms take as much of the necessary financial hit as possible, and the taxpayers as little as possible. That’s easier to arrange when you nationalize institutions (as in the AIG case) then when you buy assets. A related problem: preventing the abuse of the power provided by the new law either for personal enrichment or for partisan entrenchment.
What else to do at the same time: Bail out some homeowners? Provide some financial stimulus? Do something for the unemployed and the children without health insurance? Limit the salaries and bonuses of the geniuses who so mismanaged their institutions that they need a Federal bailout? Close the new version of the discount window to any firm that hires lobbyists?
This is a moment at which the money forces that can usually block progressive legislation need to get something through the Congress; that gives the Democrats some leverage to say “New Deal or no deal.” They shouldn’t hesitate to use that leverage.
What worries me is that the Paulson plan, which is now the plan on the table, will get the benefit of the panic. We should beware of the syllogism the Permanent Undersecretary uses on the Minister in “Yes, Minister” –
We must do something.
This is something.
Therefore, we must do this.
That’s mob psychology too.
And see the Princeton economist Paul Krugman:
I hate to say this, but looking at the plan as leaked, I have to say no deal. Not unless Treasury explains, very clearly, why this is supposed to work, other than through having taxpayers pay premium prices for lousy assets.
As I posted earlier today, it seems all too likely that a “fair price” for mortgage-related assets will still leave much of the financial sector in trouble. And there’s nothing at all in the draft that says what happens next; although I do notice that there’s nothing in the plan requiring Treasury to pay a fair market price. So is the plan to pay premium prices to the most troubled institutions? Or is the hope that restoring liquidity will magically make the problem go away?
See our marketing theory friend above on how any fix to an ecosystem can lead to unforeseen disaster. Krugman provides an example:
Here’s the thing: historically, financial system rescues have involved seizing the troubled institutions and guaranteeing their debts; only after that did the government try to repackage and sell their assets. The feds took over S&Ls first – protecting their depositors – then transferred their bad assets to the RTC. The Swedes took over troubled banks, again protecting their depositors, before transferring their assets to their equivalent institutions.
The Treasury plan, by contrast, looks like an attempt to restore confidence in the financial system – that is, convince creditors of troubled institutions that everything’s okay – simply by buying assets off these institutions. This will only work if the prices Treasury pays are much higher than current market prices; that, in turn, can only be true either if this is mainly a liquidity problem – which seems doubtful – or if Treasury is going to be paying a huge premium, in effect throwing taxpayers’ money at the financial world.
It seems an attempt to sway the mob, and Krugman objects:
And there’s no quid pro quo here – nothing that gives taxpayers a stake in the upside, nothing that ensures that the money is used to stabilize the system rather than reward the undeserving.
I hope I’m wrong about this. But let me say it again: Treasury needs to explain why this is supposed to work – not try to panic Congress into giving it a blank check. Otherwise, no deal.
But there will be a deal. We must do something, and this is something, so we must do this.
And the markets will rally, until short-selling is allowed again and the cynical realists, the short-sellers, are allowed back in – and then the crash comes.
And then you know what happens:
“A lot of those people will have to sell their homes; they’re going to cut back on the private jets and the vacations. They may even have to take their kids out of private school,” said [Robert] Frank. “It’s a total reworking of their lifestyle.”
… “It’s going to be very hard psychologically for these people,” Frank said. “I talked to one guy who had to give up his private jet recently. And he said of all the trials in his life giving that up was the hardest thing he’s ever done.”
So be it.