Friday, January 30, 2009

Knightian Uncertainty and TARP

The moment I opened this window I knew that very shortly I would not remember what I am about to write. I have been slogging around in a swamp of economic theories as discussed by some of the smartest of contemporary practitioners of the dismal science. I therefore forgive both myself and the reader for not reading any further. Words like arcane, abstruse, opaque and just plain goofy come to mind.

By way of background I should explain how I found my way into this swamp. Last September when the stock market did that terrible plunge I, like most other ordinary people, began paying careful attention to economics, both personal and general. (They say that a man who has survived a ligtening strike watches the sky more than others.) It didn't take long for Nouriel Roubini's name to appear because he had predicted the currnet crisis for some time. So long, in fact, that I even heard someone use that old saw about even a stopped clock is right twice a day.

So I added Roubini's blog, RGE Monitor, to the places I track. I don't pay to be a premium subscriber but there is so much spillover I already don't understand that paying to get more would be like buying a hundred bicycles when I have neither the time nor space to use even one.

If all this rambling is starting to get dull, there is a reason. It is a prosaic introduction to the Knightian uncertainty.

Knightian uncertainty lies at the core of an essay by Ricardo Caballero, one of the many smart economists in Roubini's stable.
A Global Perspective on the Great Financial Insurance Run: Causes, Consequences, and Solutions advances what might be called a contrarian view of the current crisis and how world governments are reacting. I say "might be called" because I haven't come across anything telling me that governments are already reacting in an coherent manner to begin with. From where I stand, it appears that governments all over the world are running around like chickens with their heads cut off. And that observation on my part gets to the nub of Caballero's argument. In times like these, what's an investor to do? Where can someone like me and my wife, who have managed to live for years on a cash economy, going to put what little assets we have where they might be safe? Interestingly, obscenely wealthy petroleum magnates rich enough to build indoor ski slopes and refrigetated sand beaches in the desert going to put their idle assets as well?

Knightian uncertainty (capitalized because it refers to the late Frank Knight) is simply unmeasurable risk.

To paraphrase a recent secretary of defense, risk refers to situations where the unknowns are known, while uncertainty refers to situations where the unknowns are unknown. This distinction is not only linguistically interesting, but also has significant implications for economic behavior and policy prescriptions. There is extensive experimental evidence that economic agents faced with (Knightian) uncertainty become overly concerned with extreme, even if highly unlikely, negative events. Unfortunately, the very fact that investors behave in this manner make the dreaded scenarios all the more likely.

The sum of Caballero's point is this: insurance companies are in the business of handling risk, but financial institutions are not. So when financial institutions try to manage risk they are out of their depth.

The global demand for assets was particularly for safe AAA instruments. This is not surprising in light of the importance of central banks and sovereign wealth funds in creating this high demand for assets. Moreover, this trend toward safety became even more pronounced after the NASDAQ crash.

Soon enough, U.S. banks found a “solution” to this mismatch between the demand for safe assets and the expansion of supply through the creation of risky subprime assets: This consisted of pooling the latter on the asset side of an SIV, and to tranch the liability side to generate a AAA component buffered by the now ultra volatile “toxic” residual. The latter was then pooled again into CDOs, tranched again, and then into CDO-squared, and so on. At the end of this iterative process, many new AAA assets were produced out of very risky (subprime) claims.

The AAA tranches so created were held by the non-levered sector of the world economy, including central banks, sovereign wealth funds, pension funds, etc. They were also held by a segment of the highly-levered sector, especially foreign banks and domestic banks that kept them on their books, directly and indirectly, as they provided attractive “safe” yields. The small toxic component was mostly held by agents that could handle it, although highly levered investment banks also were exposed.

At this point most readers already got the point. We ALL got the point last September and continue to get the point with just about every news broadcast. For most of us the point is simply that we're in a steaming pile of you-know-what and no one seems to be finding a way out. At the end of the day, we look to government to protect us. Even the most doctrinaire CATO Libertarians know that it is government, not language, that separates men from animals. Traditional conservatives, quick to make snide ramarks about the nanny state, in times of war and crisis look to their uber-Mom to furnish both the military might and economic muscle to protect us from all enemies, foreign and domestic.

An this is where TARP comes in.

In this environment, financially constrained agents obviously cannot go about their businesses with the flexibility they once enjoyed. However, the real hope for a recovery, as well as the concern for a meltdown, lies on the other side of the spectrum, on the unconstrained agents. At this juncture of the crisis there are mountains of investment-ready cash waiting for some indication that the time to enter the market has arrived. But investors are frozen staring at each other, and by so doing, they are further dragging the economy downward. The normal speculative forces that trigger a recovery are for everybody to want to arrive first, to “make a killing.” But with so much fear around us, investors have changed the paradigm and they are now content with letting somebody else try his or her luck first, so we are stuck.

Other cash-rich investors see great investment opportunities in the not so distant future, but, in the meantime, they do not unlock their resources for fear that the temporary investments may turn illiquid, a process which in itself contributes to widespread illiquidity, or because the lack of competition brought about by crisis almost ensures a better deal in the future. And yet others go one step further in profiting from illiquidity and panic itself, by shorting run-prone financial institutions they close the circle of fear that fuels the runs.

We need to reverse this mechanism by restoring the appetite for arriving first. I do not mean to say that this recession is an imaginary one. On the contrary, I believe it is a very serious recession. My point is simply that good policy has an opportunity to bring the recession back to familiar turf, and when this happens, the recession will become a manageable one from which current asset prices, on average, will look like once-in-a-lifetime deals.

Caballero concludes by comparing developing economies with what, until recently, we imagined were "developed" economies. He poiints out that what is happing globally is very similar, writ large, to what happens from time to time in developing economies.

Essentially, the U.S. (and other) financial markets are experiencing the modern version of a systemic run as we had not seen since the Great Depression. It used to be that depositors ran from banks. Some of this still happens, but runs in modern financial markets, to be systemic, have to involve a larger class of assets. A run against explicit and implicit financial insurance is essentially a run against virtually all private sector financial transactions but for those with the shortest maturities. Thus, the modern lender-of-last resort facility has to be a provider of broad insurance, not just deposit insurance. This is what it will take to get us back into a reasonable equilibrium where we can initiate a recovery from a (more) “normal” recession.

If I understand what he said correctly, TARP, big as it seems, is but a drop in the bucket. Government, as the lender and insurer of last resort, must initiate recovery from a recession, but only after restoring reasonable certainty to a larger universe of unknown risk.

Here endeth the lesson by Ricard Caballero.
Thanks be to God.


Further reading here for those with an unsatisfied appetite...

The Step-By-Step Resolution to the Sub-Prime Crisis

Everything You Always Wanted to Know About Credit Default Swaps -- But Were Never Told

Finally, Daniel Alpert suggests that instead of cutting bailout deals with institutions on an ad hoc basis, the new government must set absolute criteria for deeming banks ‘in need of resolution’. After applying more stringent asset marks, the government should require any bank unable to prove at least 6% tangible equity net worth and Tier 1 capital ratios sufficient to be deemed ‘well capitalized’ under current measurements, to submit to something we call Special Administrative Resolution (“SAR”) by the government. Read:Inauguration, Aggregation and Aggravation”.

Despite that dry description, this last piece comes as close to excitement as professional economists dare tread.

The scheme du jour again focuses on our banking institutions’ “troubled” or “toxic” assets, rather than on the institutions themselves. Troubled assets? It’s as though we had the worst luck in some financial-genetic draw—a group of irascible, miscreant children in need of loving discipline. Toxic? Poisonous, yes, but not some unfortunate oil spill destroying pristine coastline or hobbling innocent birds.

So, at the risk of failing their class, those of us passing notes in the back of the lecture hall are prepared to raise our hands and ask (former) Professors Summers, Bernanke and Bair, “What the heck is your problem with wiping out the economic interests of existing common shareholders of toxic and currently systemically worthless (albeit critical) banks?” We don’t understand anyone’s reluctance, other than dyed-in-the- wool, scorched-earth ideologues, to have the banks start over with new capital—at first, the government’s, but in short time private capital, in lieu of taxpayers overpaying for assets at a price sufficient to support existing bank capitalization based on smoke, mirrors and overstated asset values. And here’s the real puzzle, Professors: None of you has a record indicating a profoundly ideological bent. What’s up with that?

Nope, we didn’t miss your lecture when you posited that if the government owns too much of the banks, the banks won’t be able to attract private-sector investment. With all due respect, guys and gal, that’s hogwash!


Are we na├»ve about the politics of all this? Perhaps. But following President Obama’s stirring first inaugural address, we are inspired by President Lincoln’s words, which Mr. Obama often quotes, and trust that our politicians will ultimately stand for the interests of our Union and economy when again touched, as surely they will be, by the better angels of our nature.” It is long past time to get off the unproductive treadmill of ideological limitations and address the real-world crisis in a pragmatic, productive way. That’s what Americans do in times of challenge. As of now, with our zombie banks and overstated bank assets, we more resemble Japan in the 1990s than the United States anywhere near its best. Let’s not keep that up, shall we?

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