Arnold Kling  

Morning Commentary

Another Definition of Democrac... Who Said It?...

Lawrence B. Lindsey writes,

Many assets are highly illiquid and the institutions that hold them, such as banks, are in the business of providing liquidity to the economy and holding such assets as collateral. Making those assets "mark to market" meant that reserves were drawn down and converted into ever more loans during the upswing, and now must be built back up at a time when asset prices are plummeting and capital is scarce. Instead, a more stable capital adequacy rule -- such as a leverage ratio that was based on the original asset values -- would limit this pro-cyclical behavior. This means that the complex approach taken in the Basel II discussions for international capital rules need to be scrapped, and the process restarted.

Whatever you do, don't go back to book-value accounting. That is what made the S&L crisis of the early 1980's so bad.

Speaking of the S&L crisis, Nicholas F. Brady, Eugene A. Ludwig, and Paul A. Volcker suggest that we need to resurrect the agency, called the RTC, that unwound the S&L's. With all due respect to the authors, I would subject that proposal to more careful scrutiny before trying it.

The RTC was bounded. It only had to deal with failed depository institutions. The problem today is not limited to any particular type of institution.

The RTC was passive. It received the assets after the S&L's failed. What Brady-Ludwig-Volcker are proposing is an active agency, that would "buy paper." Buy at what price? Using what guidelines?

Finally, Robert J. Samuelson writes,

What's really happened is that Wall Street's business model has collapsed.

Read the whole thing. While everyone is talking about tighter regulation for Wall Street, the reality is that the market has killed the business model before the regulators could get to it.

Part of the business model involved investment banks holding securities. I would suggest that this was not so much that they said, "Hey, let's hold securities for fun and profit." The private securitization business involves slicing and dicing cash flows. The low-risk cash flows are attractive, and the investment banks sell them. They keep the remainder ("toxic residuals," as they are known) almost as a loss-leader, while they collect fees from trading the good stuff. The problem is that, in Talebian fashion, the losses from the toxic residuals are wiping out years of fees.

Comments and Sharing

COMMENTS (6 to date)
eric falkenstein writes:

Actually, it was the reverse. If you read UBS's Report to Shareholders--which outlines the exact nature of their $40B writedown--they bought a lot of plain vanilla mortgage backed securities, created CDOs, and sold the weakest tranches at big fees. The senior stuff they could, or would, not sell. Because they were AAA bank and funded all assets at the same, ridiculously low rate, they thought the senior ABS on their balance sheet actually made money. In any case, they lost most of their money on the senior ABS, not the weak stuff.

Matt writes:

"Talebian" ???

Goggle couldn't nail it down, so give me a link and I will learn it!

Willem writes:

Thou should Google some more ;) :

A reply on this blog:
"Barkley Rosser writes:
Well, Eliezer is responding to the brilliant, but somewhat egomaniacal, Nessim Taleb and his Black Swan book, which trumpets this phrase repeatedly. Fine, but I don't think that it will necessarily convince a true Talebian as he is not clearly a Bayesian. Indeed, to carry out the Bayesian calculation, one must assume an underlying distribution on which to recalibrate. But that is one of Taleb's arguments: we do not know a priori, or even somewhat a posteriori, what the underlying distribution is, much less if there even is one or not.

I would remind that Bayes' Theorem has its limits as well, such as a continuous support and a finite dimensionality. Failure of the conditions can lead to convergence on cycles and other failures to get to the correct probability (Diaconis and Freeman, Annals of Statistics, 1988), even assuming that such exists in any meaningful sense, which for a hard-core subjectivist Bayesian is not true anyway.

Posted August 13, 2007 04:53 PM"

ananias writes:

Eric is correct, and indeed it's only that way round that it makes sense. Think about horse racing - nobody goes broke betting on long shots; it's the sure things that wipe you out. The senior tranches of the CDOs were considered sure things.

Chuck writes:

Speaking of horse races, you should check out the Kelly Criterion (link).

Chuck writes:

And while we're talking, with proper regulation, it didn't have to be like this:

Comments for this entry have been closed
Return to top