Opinionated Raconteur

Via Information Arbitrage’s Twitter feed, I see that the New York Times is reporting that the government’s plan for dealing with banks’ “toxic” assets may be amended to encourage individual investors to invest in funds that would take these assets of banks’ balance sheets:

During World War I, Americans were exhorted to buy Liberty Bonds to help their soldiers on the front.

Now, it seems, they will be asked to come to the aid of their banks — with the added inducement of possibly making some money for themselves.

This is monumentally stupid for a number of reasons.

Toxic assets are not bonds.

The comparison of these assets to War Bonds is misleading. Recall that loans that banks make are, from the perspective of the bank, assets. If this is counterintuitive to you, think about this way: if I loan you $10,000, I have a claim, in the form of interest and principal payments, to you over the course of that loan. From my perspective, that claim–the loan I made to you–is an asset because it generates cash flow to me, namely, those interest and principal payments.  Further, where War Bonds were straightforward, option-free bonds that were easy to value, these toxic assets are exceedingly complex, structured securities tied to thousands of loans, many of which are perhaps non-performing.

The valuation of these securities is very uncertain and very complex.

Let us recall a few salient points:

• The very banks which purportedly know the most about these securities are having such a problem valuing them that they want to suspend or eliminate mark to market accounting rules so that they can assign whatever value they choose to these assets
• There is no liquid market with which to readily assess these securities’ values
• American citizens have not proven themselves able to handle simple mortgages: why should we assume that they can properly value complex securities for which the banks themselves are having trouble assigning proper valuations?

This proposal has been offered for political, and not financial, reasons.

The New York Times article continues:

The idea is that these investments, akin tomutual funds that buy stocks and bonds, would give ordinary Americans a chance to profit from the bailouts that are being financed by their tax dollars. But there is another, deeply political motivation as well: to quiet accusations that all of these giant bailouts will benefit only Wall Street plutocrats. 

Let’s take a moment here to stop and consider what this means. The American public, we are told, is angry that their tax dollars are being used to bail out financial companies. To some extent, these taxpayers are likely right to be angry. So what is government’s response? Change the terms of the bailout program to encourage Americans to invest in these risky assets and promise them an opportunity to profit thereby. Does this sound familiar to you? What is government’s response to encouraging homeownership? Encourage Americans to invest in risky real estate assets by subsidizing the interest on mortgages and promise them an opportunity to profit thereby.

Well, we have seen the inability of your average American to properly parse the terms of the mortgage he is taking on. Why should we conclude that the average American is going to be able to parse the terms of any investment fund opened to his (small) wallet?

The only legitimate conclusion we can reach here is that this proposal is being offered not to assuage American anger, but to shift blame from the politicians to Wall Street: “Look,” our hero politicians say, “it sucks that these greedy Wall St. bastards took all your tax dollars. However, we have worked with them to create investment funds into which you can invest money. These funds should return X% to you over Y years.” Never mind all the details: a politician said it was a good investment! How is this any different than a banker telling a municipality how to lower its interest payments?

The average investor will not understand the terms or details of the investment being offered.

A simple rule for financial management is this: if you do not understand the terms of the investment you are being offered, walk.  Not because it is necessarily a bad investment, though it very well may be, but, rather, because managing your money properly requires that you understand what is being done to it.  Bernie Madoff’s victims and small towns in Tennessee can attest to this.

Recall that even that most august of financial institutions, Goldman Sachs, has admitted that its bankers, and those of its competitors, did not understand the risks of the securities they were creating from thousands of loans:

Inadequate regulation allowed securitization to damage systemic firebreaks. That major problems arose given the size of these capital flows is not, in retrospect, surprising. It is surprising, however, how widespread the damage has been throughout the global financial system – much like a forest fire that was unexpectedly found to have kindling in the firebreaks. Innovations that were intended to reduce risk – namely the spread of securitization, particularly in its application to low-quality assets, and the spread of complex financial holding companies – actually added fuel to the fire. It is important to note that securitization, by itself, was not problematic. Indeed, securitization did, for a time, reduce risk at the firm level and free up capital for lending. Accordingly, regulators allowed individual institutions to enjoy higher leverage ratios and lower capital requirements. In aggregate, however, securitization allowed many financial firms to build positions in (what unexpectedly turned out to be) very risky assets, often employing leverage while enjoying reduced capital requirements. The spreading of risk raised correlations across countries and across sectors of the financial industry, essentially turning the financial system into one highly correlated shared risk pool. At the same time, due in part to inadequate oversight of the credit rating agencies, securitization also lowered the total amount of capital in the financial system.

An added, though not nearly as important, part of the problem was the spread of the large multi-business financial holding company, which emerged full force in the last decade. These complex holding companies merged a wide variety of businesses, often with very different business models and operating cultures – most notably the mark-to-market culture of investment banks and the held-to-maturity culture of classic commercial banks. Mixing these models without centralized monitoring and sufficiently independent risk controls allowed firms to exploit differences (sometimes accidently) in the rules applying to different parts of the same firm.

While some firms were clearly able to manage these complexities, others failed to develop the needed systems and infrastructure, or did not allow these systems to operate with sufficient independence.

Risk will naturally flow to where it is least monitored and where capital requirements are lowest. There is nothing sinister about this – it is the “invisible hand” of the market at work. It is extremely difficult for regulators to identify in advance all possible loopholes – and equally difficult to close them all.

Rather than focusing on the individual problems that the current crisis has brought to light, we think the most viable solution is to force as much symmetry and equality of treatment of assets across all parts of a firm as possible, thus eliminating odd incentives that encourage activities like poor lending.

If the very bankers whom we repeatedly refer to as “the best and the brightest” and their ostensible regulators could not manage the risks now apparent in these assets, why should we assume that the average American should be exposed to these investments in the future?

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