Lingering financial crisis - a satirical explanation

My apologies for putting an old joke in this blog (Actually, of late I got tired of reading the bad news all over the net). Nevertheless, this joke does a pretty good job of explaining the lingering financial crisis and aptly ridicules the corporate world’s reactions towards solving this crisis. The joke:

Boat Race
Two teams, Team A and Team B decided to engage in a competitive boat race. Both teams practiced to reach their peak performance. On the big day, Team B won by a mile. Afterwards, Team A was shattered by the loss. Their morale sagged. Corporate management decided that the reason for the crushing defeat had to be found. So a consulting firm was hired to investigate the problem and recommend corrective action. The consultant's findings: The Team B team had eight people rowing and one person steering; Team A team had one person rowing and eight people steering. After a year of study and millions spent analyzing the problem, the consultant firm concluded that too many people were steering and not enough were rowing on Team A.
With this new finding they decided to go for another race. So as the D day nears, Team A decided to completely reorganize their team structure. The new structure: four steering managers, three area steering managers and a new performance review system for the person rowing the boat to provide work incentive.
The next year, Team B won by two miles. Humiliated, Team A's corporation laid off the rower for poor performance and gave the managers a bonus for discovering the problem....

Gaussian Distributions .. the building block of Risk management OR the building block of a financial CRISIS

I came to this topic as someone who understands a bit of statistics and a bit of engineering. The usual way to get Gaussian fluctuations is to add up lots of independent little fluctuations (the central limit theorem). The little ones (the individual traders in a market) have to act independently of each other, or the theorem doesn't follow. Obviously, in real markets, the traders' behavior is influenced by the actions of other traders. In the aggregate system, small fluctuations about the mean will still often be Gaussian, but that doesn't mean the big ones are. It was Mandelbrot that discovered "fat tails", that very extreme price movements are far more likely than the theories predict. His findings were initially rejected, and continued to be resisted even when they were replicated in other markets (and then proved out in the real world: a daily price move like that of the 1987 crash was so extreme as to verge on being statistically impossible). 

As a practical matter, non-Gaussian 1/f noise (as opposed to Gaussian -white noise) has been well known to radio engineers since the 1920s and 1930s.

I was shocked when I read a vice-chairman of the Fed , at the time of the LTCM breakup, saying that information feedback is always a stabilizing factor. Any engineer who has studied control theory knows the opposite is true. The math of control theory was first developed by Maxwell (his equations still haunt me), who studied a lever arm connecting a pressure gauge on a steam boiler back to the feed at the bottom of the coal hopper (for that reason called feedback). If the pivot is too close to the boiler (too much feedback), the boiler goes into uncontrolled oscillations and explodes.

Recently, I read a friend's blog whose batchmate from college had become a quant on Wall Street. He said, ofcourse they know that fluctuations aren't Gaussian, but Gaussian fluctuations are the only ones they could model. They're paid to develop models like everyone else's models, not to develop models that are correct !! Shocking but very true. I believe that his revelation is also pervasive because if anybody models in the fat tails, as against the market, the risk premium would be comparatively high, which means costlier end products and little or no sales.

Sometimes I feel that in the race to become effecient, we manipulate facts in our favour and undermine basic risks...

BAD BANK .... is this the only solution

This week, banks ran into yet deeper crisis - the sector is in more trouble than was feared.

In October, following a British lead, governments around the world recapitalised their banks. This drastic measure saved the sector from collapse. But, as the events of this week have demonstrated, the banks are still on the ropes. Bank of America required $20bn of capital and guarantees from the US taxpayer and Anglo Irish Bank was nationalised to halt a run by depositors. Deutsche Bank, revealed striking fourth-quarter losses. Banks are not lending, but are hoarding capital in readiness to absorb losses from existing bad loans and securities. Governments must now act swiftly to move ahead of the crisis. Ad hoc nationalisation of insolvent banks and recapitalisation of impaired ones is simply not enough. Governments must act to draw out the poisonous uncertainty caused by the toxic assets held by solvent banks.

The first option is to create a “bad bank”: in this model, the state would buy up toxic securities from a range of banks and hold them. This would force participating banks to declare large losses, but by removing these illiquid assets from the balance sheet, create certainty about their solvency. It would be a difficult policy to run: it would involve pricing assets that have proved unpriceable and require enormous, up-front costs. The US Treasury’s $700bn troubled asset relief programme was originally intended as a bad bank programme, but changed focus for these reasons.

A better solution, albeit one that must be worked out bank-by-bank, is the insurance model used at Citigroup and, this week, at Bank of America. Governments can, for a fee, issue insurance on the value of a bank’s unpriceable assets, making up the difference if they fall below an agreed floor price. Investors would know that the bank is secure – as with the bad bank model – but it reduces the need for already stretched finance ministries to find money immediately. Simply writing the insurance makes it less likely it will even be needed.

Even after that, however, governments may need to do yet more. They may guarantee credit yet further, perhaps even lending directly, in sectors where commercial lenders have all pulled out. Countries that used to rely on credit from abroad that has now disappeared, as is the case in the UK, may still be stretched even if their domestic banks extend themselves fully. Fixing the banks will not cause a return to growth: we are now caught in the jaws of a global recession. It is, however, a necessary precondition for recovery.

ZIRP (zero interest rate policy) – The two edged sword

From Bloomberg:

“The U.S. Federal Reserve will probably cut interest rates to zero percent over the next two months to staunch deflation, according to JPMorgan Chase & Co.”

Some economists are already feeling that additional policy easing could be appropriate ... given recent data and developments in financial markets, 'some' may have turned into ‘most’,

While this may prove to be correct, it certainly isn't an obvious move. First, most central banks regard getting below 1% short term rates is dangerous territory. ZIRP let to a deflationary trap for Japan, and there isn't a particularly good reason to think it will fare better here.

Taking the target rate to zero percent would not be costless for the Fed. Public confidence may drop and led to the perception that the Fed has run out of options. Some saw a risk that the inflation rate will fall below the Fed's objective of price stability.

In addition, once short term rates fall below 1%, money market funds have trouble operating profitably. The Fed may find itself not merely acting as a big player in the commercial paper market (money market funds are big buyers of CP), but becoming the ONLY player. That would not be good.

700 bn bailout from Game theory perspective

Game Theory explains why the 700 Billion bailout might not work ...

Lets assume that there are only two banks - Bank A and B.

The Fed proposes a bailout in which both Bank A and B sell risk assets to the Treasury. In this case, the result is a more regulated banking industry, with imposed limits to salary, but importantly markets are clear.

However, it is in BOTH banks interest to deviate from that because if Bank A (or B) believe the other is selling their risky assets to the Treasury; they will each be better off holding on to theirs. The reason is simple - when the other bank sells and they hold, markets will still clear and the bank that holds onto their risk assets can sell at the new market prices. This results in increased market share as they:

1. can pay more for talent
2. are less regulated
3. Don’t have the stigma of selling to the Treasury

The likely result? No bank sells voluntarily and markets remain frozen.