Stiglitz Is Wrong

Ok, I read on Tyler Cowen's blog that using negative words like "idiot" and "moron" increases the number of commenters, and presumably readers. Clearly my favorite flâneur, Nassim Taleb, has climbed the best-seller ranks with this rhetorical style, so, I'll give it a try. I think Stiglitz is intelligent and educated. But he is also incredibly biased in a totally predictable, simple-minded way. This is not a partisan critique, just look at his activity: he gives speeches about once every two days. Guys like that don't have time to look at the detailed data, or derive a fresh view, but rather fit it to their internal templates. They are using their position to 'make a difference', which sounds nice, but it just means you are an amoral, unthinking advocate. Think lawyer.

In that way, he is not thinking when he writes, merely advocating the best case for his big picture idea that markets should be sublimated to government control whenever there is not perfect information (no uncertainty or asymmetric information, i.e. always). He edited volumes 1-3 of the collected works of Paul Samuelson, with a heavy emphasis on market failures. He loves pointing out scenarios where a market equilibrium is not Pareto Optimum or vice versa (Pareto Optimum being the idea you can't make anyone better off without making someone worse off, a rather modest definition of optimality). Government failure is not interesting to those obsessed with market failure, a common blind spot in the Marxist tradition (very little in Das Capital outlines how communism actually works, it's mainly a criticism of free markets).

Anyway, in today's NYT he rails against Geithner's plan for several dubious reasons, but fundamentally because it is a subsidy to banks and investors. It isn't clear if his distinction between banks and investors is the difference between management and equity, or equity owners and bond owners. Whatever, his Big Idea is that there is always imperfect information, therefore markets are not optimal, therefore have the politburo control it. Here's the Nobel Prize winning argumentation in block quotes:

Let’s take a moment to remember what caused this mess in the first place. Banks got themselves, and our economy, into trouble by overleveraging — that is, using relatively little capital of their own, they borrowed heavily to buy extremely risky real estate assets.

Where's the data? Bank leverage, as measured by common equity to total assets, did not materially change over the past 15 years for banks. Did you mean "Investment Banks"? That did change, but only for a handful (ie, Citi (C) and Morgan Stanley (MS)). It's not true merely because you say it every other day when lecturing as Expert on Everything.

In the process, they used overly complex instruments like collateralized debt obligations.

This is the real tail of the dog. If mortgage prices did not collapse, CDOs would not have collapsed. CDO's facilitated risk transfer, if anything, it prevented a worse crisis by moving the effect of the housing price collapse out of banks and into Hedge Funds and Government (i.e. Fannie (FNM) and Freddie(FRE)). This diversification is generally considered a good thing, but here it is insinuated that it was the fuel for the risk taking. Sorry, the impetus was at the other end, with $5 Trillion in Community Reinvestment Act pledges for investing in 'traditionally underserved communities'--i.e., groups previously not lent to because they were bad credit risks. Mortgage innovations like low, and even no, money down, implies the greatest leverage was to the individuals, not the banks.

The prospect of high compensation gave managers incentives to be shortsighted and undertake excessive risk, rather than lend money prudently.

Anytime a bubble collapses we can say this, but this criticism needs more flesh on it. It seems to imply that any payment scheme that is a function of revenue generated, that does not have an infinite clawback provision, encourages excessive risk taking. That's a nice bargaining position for a socialist like Stiglitz. That may seem like a partisan shot, but it's true: he's always forgiving the state more control into economic activity, to the point that it always has veto power and generally sets the agenda and mission statement, compensation, etc. His ends dictate, with perfect predictability, his interpretation of events.

Banks made all these mistakes without anyone knowing, partly because so much of what they were doing was “off balance sheet” financing.

Partly, to be sure. But for commercial banks this was pretty small. The biggest problem was on balance sheets. Look at the data. Look at a regional bank like KeyCorp (KEY). Their stock has fallen 75%, and they lost $1B last year. Most of this was an increase in the provision for loan losses on their books. They had $1.25B in credit default swaps at the end of 2008, and noted (page 60 of 10-K ) "These swaps did not have a significant effect on Key’s operating results for 2008."

The problems of AIG and Lehman were of taking too much risk in CDOs and credit default swaps, and to this day I have not seen specifics of their balance sheet. That is, until I see what the reference assets for the swaps, I can't assess their actual solvency, or potential for insolvency (and thus a logical run by short-term debt holders). But those problems are not the problems of our banks, 7000 little companies that try to intermediate between savers and investors. Most Commercial Banks are not Investment Banks, their balance sheets are not dominated by marketable securities.

Stiglitz notes the problem of offering banks basically 6:1 leverage, and a 50% match-funding, by looking at the following scenario. Assume there is an asset with a price of $150, that will pay off $200 or $0 next period. A $12 investment by private companies, a $12 match funding by the government, and a $126 senior debt by government. The return on the 'total value' of this transaction is either +33% or -100% [$200 or $0]. Well, with 6:1 leverage and match funding, that means a 208% return in the up state, or a -100% return in the down state. The expected return: 54% {(208-100)/2}. What a deal! Meanwhile, government gets an expected -40% return on 7 times the capital.

A key here seems to be what the prices and returns really are. If you suppose such a bad transaction, clearly, it is a greater subsidy to the private sector. But given the government is trying to fix things without nationalization, presumably a subsidy is a given. The issue is, are these deals this much of a give away? I doubt it. When was the last time a pool of mortgages was worth zero.

Geithner's plan (.pdf) refers to pools of mortgages, not mortgage tranches. A tranche of a pool of mortgages can easily go to zero, especially the mezzanine tranches, but the pool itself? If this makes sense to you, you are, well, an idiot.

It seems like you are giving money away to fat-cats. The problem is, these are mortgages, so they are not 'idiosyncratic risk assets'. You cannot buy 100 of them, with a 54% return, and lock in that return. Instead, investing through time, and I doubt any investors are willing to put up large amounts (billions) in investments with a 50% chance of a negative 100% return. Further, the auction method of selling assets implies that even if this were a case of idiosyncratic risk (say, adverse selection made it 50% of these were worth $200, 50% $0), then somehow investors would be colluding to keep the return at these insanely high (54%) levels. Ah, the deals Captains of Industry make in the back rooms. The nice thing about greed is that it implies competition, and competition abhors easy profits the way nature abhors a vacuum.

Stiglitz notes how efficient government is in nationalizing banks. Who's to say how much value was saved, or destroyed, via government's take over of IndyMac (sold at a loss of $9B last January)? But this will only be worse if they take on lots of banks because then their portfolios will be politicized to the n-th degree, as then broader considerations will be in play. Consider that once they took over IndyMac they halted foreclosure on mortgages, leaving zombie properties where 'owners' had no equity in the properties, and bank's could not resell them. That merely added to their losses, and didn't help the little guy, it just delayed the inevitable resale of that property to someone who was a viable homeowner. Do that with 100 IndyMacs and you have really depressed the market, and the poor communities that do not need 'ownerless' properties. When the effective owner has no money in the house, it is not well maintained, managed, or re-allocated. Indeed, the 'owner' of the house in foreclosure limbo has zero incentive to do anything with the property, just wait and pray for hyperinflation (a potential plank II of the Treasury plan).

After the Great Depression, John Kenneth Galbraith wrote 'The Great Crash', and it was a best seller. The thesis was that greed and short-sighted risk taking, especially by corporate executives, caused the Stock market crash, which then caused the Depression. This was the standard perception for decades. Today, I doubt more than 10% of economists think that greed or short-sightedness was a singular, or useful explanation for the 1929 crash and subsequent collapse, or that the Great Depression was caused by the stock market crash.

Comments

[The Sim:]

oh boy..

you are right when you say the vast majority of banks do not have the leverage exposure of C or MS..

however, according to the 12/31/08 report of the OCC www.occ.treas.gov/ftp/... the FIVE largest commercial banks (including: C, MS, GS, JPM since as of oct. 08, there is no such distinction in America pretty much as IB vs CB anymore - they were all swallowed up under commercial bank regulations) -- anyhow, the FIVE largest commercial banks out of thousands are holding -- 95% of $200 TRILLION notional value of derivatives -- they are leveraged 40:1 assets vs equity!

All of the remaining total of commercial banks are only leveraged approx 1.4:1 which is generally a totally safe and conservative level, of course.

So $190 TRILLION out of $200 TRILLION derivatives (particularly interest rate derivatives - and see www.moneyandmarkets.co... for further analysis) are held by FIVE banks which are collectively leveraged 40:1 assets to common equity

(let's not even begin to discuss the Federal Reserve itself, which is self-admittedly [if you saw any of bernanke's recent testimony over the last few weeks] leveraged at least 50:1 and going higher..)

HELLO! MCFLY!

omfg..

2009 Apr 02 12:55 PM

[Bob 123:]

"CDO's facilitated risk transfer, if anything, it prevented a worse crisis by......"

Riiiigghhht......
So there was easy profit to be made by giving anyone who walked through the door and had a pulse a mortgage, no matter what their assets or income, because, hey, after all, risk free, someone else's problem.
Perhaps we should go back to the old days where the banks actually kept the mortgages on their books and were therefore prudent and did their due diligence regarding to whom they would lend money. Used to work.
Not only that, this CDS malarkey -- especially naked CDS's are analagous to all sorts of people having a fire insurance policy on your house. Not surprisingly, arson would quickly become a popular sport.
Big bad-ol Stiglitz. Yeah, he doesn't know what he's talking about. Just wondering what axe you have to grind with him? Who pays your salary?

2009 Apr 02 02:09 PM

[Tony Petroski:]

Stiglitz is wrong.
Falkenstein is right.

2009 Apr 02 06:51 PM

[EEB:]

The author wrote: "This is the real tail of the dog. If mortgage prices did not collapse, CDOs would not have collapsed. CDO's facilitated risk transfer, if anything, it prevented a worse crisis by moving the effect of the housing price collapse out of banks and into Hedge Funds and Government (i.e. Fannie (FNM) and Freddie(FRE))."

Falkenstein seems to assume that if risk is transferred it cannot also be increased or decreased at the same time. I would say that CDO's, etc. both transferred risk and amplified risk. The transfer was not the problem. The problem was the amplification. The fraudulent credit ratings led investors to take on much more risk than they should have. And this willingness to buy CDO's fed the bubble, which led to more bad lending, which led to more transfre and amplification of risk.

Also, it is true that if the housing prices had not collapsed, then everything would have been better. But it was a housing bubble. How was it not going to collapse?

2009 Apr 02 10:57 PM

[THofler:]

EEB,
CDO's certainly amplified the perception of risk, but...

I'm not any kind of expert on derivatives, but I believe that many or most CDO's are nonlinear mortgage backed derivatives. And the reality is exactly that risk is shifted between the tranches. Most discussions treat the value of all CDO's as being the same as MBS's only more opaque (& thus worth less).

If my understanding is correct, some CDO tranches are very nearly worthless or actually zero value, but at the opposite end of the spectrum there must be some tranches that are much more valuable than a plain old MBS.

2009 Apr 03 12:42 AM

[Fighting Yoda:]

The author is completely wrong about everything.
Banks did take on leverage, most of it using off balance sheet vehicles like SIVs etc. Investment banks went on 30:1, 35:1 – that also was totally ridiculous. Since IBanks have converted into banks now, that distinction is irrelevant.

CDOs were meant to diversify risk – the theory was if you take tiny slices of many mortgages – of different types in different geographies – the diversification would decrease risk. However contrary to models and history – all mortgages and geographies failed (due to the bubble)– so CDOs had to default. Everything got magnified with leverage.

Stiglitz’s basic argument is tighter regulation and less leverage. Makes all the sense in the world. Self regulation leads to poor behavior – if you don’t watch the kids they will do sill things. The bankers went on –a risk taking binge, after all bank executives had perverse incentive structure – play with house money, take unlimited risks. If it works in the short term – run away with fat bonuses. If things fail in the long run, the investors, tax payer will pay for it.

Once again, Stiglitz may not be right about everything, nobody is, he is conceptually very clear. He predicted this much better than everyone – Peter Schiff, Taleb, Roubini, Soros. But the problem is the fools who got everything wrong, every step of the way, continue to be in charge.

Stiglitz’s characterization of Public-private plan – “cash for trash”

2009 Apr 03 01:22 AM

[Tony Daltorio:]

Maybe you can explain to everyone how bailouts = "free market" capitalism? With free market capitalism,these companies would have been allowed to fail.


On Apr 02 02:32 PM Cetin Hakimoglu wrote:

> The Geithner, Summers, and Bernanke are doing a good job. I support
> the bailouts and stimulus plans. We need to continue to bailout the
> too big to fail and preserve free market capitalism so that the stock
> market keeps going up.

2009 Apr 03 09:35 AM

[Al-USA:]

Stiglitz is right.

Even worst, the banksters planned all along to privatize profits and soclialize losses... The American Oligarchy at work, plain and simple.

This fabricated "financial crisis" is being handled to secure the interests of the Oligarchy. IMF insiders who saw this first hand in emerging markets are stating the obvious in articles below.

Banks Counted on Looting America’s Coffers
tinyurl.com/bkezmt

The Quiet (American) Coup
tinyurl.com/dmspxm

Welcome to America, the World's Scariest Emerging Market
tinyurl.com/c8dpk8

Obama’s Ersatz(pseudo) Capitalism
tinyurl.com/csek3k

America the Tarnished
tinyurl.com/dy4gvt

Geithner plan will rob American taxpayers: Stiglitz
tinyurl.com/d564xq

Timothy Geithner's toxic plan
tinyurl.com/d8xsb5


"Fluke? Credit crisis was a heist"
tinyurl.com/cgugqm

"Following the A.I.G. Money"
tinyurl.com/d6xkbk

"Economic Fascism and the Bailout Economy"
mises.org/story/3333

"Behind the Financial Market Crisis?"
mises.org/story/3111

Hedge funds are the real AIG outrage
www.guardian.co.uk/com...

The Obama Deception Full Length
tinyurl.com/d4bnbk


Still, I imagine you will keep trying to defend your social class: the now completely corrupt financial elites.

2009 Apr 05 12:41 AM

[Al-USA:]

Here is another link, this one provided by SA writer which gives even more credence to the workings of the American Oligarchy.

Bill Black on 'Top Elites': All Are Presently Committing 'Fraud'
seekingalpha.com/artic...

2009 Apr 05 12:47 AM