Take A Deep Breath: Some Perspective On The Financial Crisis

The Market

from the bailouts,-moral-hazard-and-adverse-selection,-oh-my! dept

I’ve been spending plenty of time talking to people, reading up and listening to various views on the whole financial crisis. Last week, I asked a bunch of folks I knew in the tech, economics and financial worlds for their thoughts on the situation and I’m hopeful that I may end up with a few guest posts out of it. In the meantime, I wanted to start with my own thoughts. First off: this situation is complicated. The deeper you dig into it, the more you can begin to sketch out a picture of what’s really happening, but no one (no one!) can accurately understand all the different variables at play here. Anyone claiming to have all the answers is wrong. They’re either ignorant or lying. Also, the blame game isn’t just pointless, wrong and silly, it’s dangerous. I’ve been seeing too many folks on both sides of the political aisle trying to use this crisis as a political football, and all that’s doing is making it that much more difficult to come up with real solutions. If you see anyone focus on playing the “blame game,” ignore them. They’re not worth listening to and they’ll only be misleading. Finally, any explanation you read that isn’t multiple-book-length will probably be greatly simplified — including this one. But I’m hoping that it at least kicks off an interesting discussion.

So, what happened?

Well, there are tons of good resources that can give you bits and pieces of it. A good place to start, however, may be The Giant Pool of Money podcast that was on This American Life a few months back (which we mentioned recently). The NY Times just had an article about what led to that podcast being created. It’s also worth noting (oddly not mentioned in the NYT piece) that the two reporters who put that together — Adam Davidson and Alex Blumberg — are collaborating on a new daily podcast and blog for NPR called Planet Money, which is fantastic. They’re also working on a new episode of This American Life for next week about the current crisis. That will be a must-listen as well, I’m sure.

But, the basic summary is that a chain of events all resulted in more and more money being put into riskier and riskier mortgages, where much of the risk was hidden away by computer models and the repackaging of those risky mortgages in bulk. Normally speaking, the idea of bundling up a bunch of risky projects into one actually does make some sense — because you’re figuring that while some will fail, the successes will greatly outweigh the failures. And, in many cases, that’s true (it’s basic diversification). But the problem was that very few, if any, of the models seemed to take into account the fact that these weren’t independently risky items, but that many were very dependent on each other. Thus, rather than a small group of risky deals going south, outweighed by the success stories, people started to realize that you could have a domino effect, where a large portion of the risky stuff going bad could actually lead to even more of it going bad. That’s just what you get for creating bad models that don’t take dependencies into account.

What made this even worse, however, is that a bunch of the risk was eventually pawned off to the least knowledgeable investor: the public markets. In a world where you’re always looking for the last sucker to invest, the public markets are always going to be your best bet — and many investment banks took advantage of that. While, historically, many investment banks were partnerships, where the partners understood the risk of what they were doing, once these banks were public, the risk was shifted from the folks who at least understood some of the more complex details to those who didn’t. Whether that rises to the level of fraud, in falsely portraying the real risk at hand, is something that we’ll leave to federal investigators to sort out. Either way, we had a long chain of players, who effectively kept “laundering” the risk through various ways until it ended up being held by people who simply had no clue how risky the products were that they owned.

Then, once stuff started to go bad, the dependencies started to snowball and make everything worse — and the confusion over how bad and how risky things were made those who actually had money on hand reasonably afraid to keep lending it to those who couldn’t accurately express the risk. That resulted in a lack of liquidity — effectively the oil in the economy’s engine. Without liquidity, a lot of stuff freezes up pretty quickly and dangerously. That’s what caused Treasury boss Paulson and Fed chair Bernanke to ask for the “bailout” plan.

Why are we “bailing out” those who created this mess?

Actually, while almost everyone is calling it a “bailout,” it’s not quite a true bailout, and it’s not clear that it really “rewards” those who created the mess. Like everything else, it’s quite complicated. Personally, I like Fred Wilson’s use of the phrase “The Splurge” to describe it, because in many ways it’s more accurate than a bailout. Basically, the government is asking for $700 billion to try to buy up distressed assets. The details suggest that it’s starting out with $350 billion, with another $350 billion to be handed out later, if necessary. There are plenty who believe that $700 billion is just the tip of the iceberg, and eventually that number will grow to be much higher.

So, why isn’t this a full “bailout”? Well, because the government would be getting equity back as well, and there are plenty of smart folks who believe that this could lead to the government making a profit. Indeed, buying up distressed assets historically isn’t a bad way to make a profit — if you know what you’re doing. Lots of folks tend to shy away from distressed assets, and a good fund manager can buy up distressed assets for pennies on the dollar and figure out ways to sell them down the road for nickels or dimes on the dollar. It’s a perfectly reasonable business proposition, and historically, there are plenty of stories of folks who made out like bandits buying distressed assets following bursting bubbles. So, if the government can drive a hard bargain and buy up these assets at a reasonable price, it could work.

So, the good news is that there’s a chance that the “splurge” could result in a best case scenario: it pumps liquidity into the market, stabilizes things, gets the economy moving again and lets the government profit.

But that’s the best case scenario. Others are a lot less sure, noting that the upside pales compared to the downside risk, and even if an upside scenario may seem a lot more likely, the cost of the downside is much, much bigger (at least $700 billion at this point, and perhaps more). In fact, there are those who suggest that a poorly done splurge will almost certainly make things even worse. And, plenty are pointing out that the smart money seems to be betting that the government is entering the game as the “last sucker” we were discussing earlier. Given that there’s still confusion over how the gov’t will value these assets, it seems reasonable to worry. Plus, there’s the thought that if the hard bargain is really a good bargain, then others will come in and do the deal — such as JP Morgan Chase buying up WaMu or Barclays with Lehman or BofA with Country Wide or Merrill Lynch. But, there’s a question of how much those companies can handle, and if it’s enough to keep the economy from stalling.

So, really, a lot of it comes down to how well such a government fund is managed — and right now that’s a huge open question. If it’s managed well, by folks who actually have the ability to get a pretty good read on the likely real value of these distressed assets — then the splurge plan could work wonders. But how often do you see the government do anything right — especially when it comes to managing money? So, while, in theory, I don’t have a problem with the government entering the market as a buyer, you have to worry significantly about the fact that it’s the government, and they’re prone to screwing things up badly — especially once politicians get involved. Once you have people trying to get elected on a regular basis messing around with the decision making, you know things are going to get bad fast. That’s why, if such a plan does need to move forward, I’m actually all for limited oversight from Congress if (and this is a big if) there’s real transparency into what the fund is doing. I might be more convinced if there were oversight from a group of economists instead.

Also, you’ve probably heard a bunch of folks warning about “moral hazard” lately, which is an economics term basically meaning that if you protect someone via insurance of some sort, it makes them more likely to do risky behavior. That is, if you tell someone you’ll protect their downside loss on something, they’re more likely to do it. Or, more specifically, if you tell someone that if they jump out of a tree, you’ll catch them, they’re more likely to jump out of that tree. In this case, the idea is that “rescuing” the banks makes them more likely to do risky things again, knowing that the government will rescue them. In this case, however, the risk of moral hazard seems overblown. This is hardly a pleasant time to be working in the financial sector, and I don’t think this is exactly an enjoyable experience. Plus, if the Splurge works by buying stuff at pennies on the dollar, that’s not going to be particularly pleasant either. It may be more like saying you’ll have insurance to fix your broken legs from jumping out of a tree. Yeah, you’ve got insurance, but the broken legs are pretty good incentive not to do this again.

Oddly, there’s almost no talk of the risk of adverse selection, which is moral hazard’s sibling in looking at any sort of “insurance” market. I would think that the risk of adverse selection is much greater here than the risk of moral hazard. With adverse selection, the problem is that when you have asymmetric information (one party has a lot more info than the insuring party), the riskier deals end up gravitating towards the insurer. Thus, the insurer thinks its covering a uniform population, but only the riskiest bets take up the insurer. That seems a hell of a lot more likely in this scenario. The government does not know how to value these distressed assets, but the banks selling them probably have a much better idea, and are more likely to try to pawn off the worst of the worst on the government — meaning that the gov’t may get stuck with assets that are more distressed than they expect.

Perhaps the most worrisome aspect of this is the rush to get this done. Deals done in a panic are rarely good deals. And while I can understand and agree with the idea that perfect is the enemy of good, rushing through isn’t a good idea either. Will it mean that some firms go into bankruptcy in the meantime? Yes, almost certainly. But is the whole economy going to collapse? Unlikely to happen right away, and it should be preventable with minor tweaks while the larger details are worked out.

But isn’t this just about Wall Street?

There’s a common refrain among many, many people, that this is just the result of greedy Wall Street bankers, and the proper thing to do here is to just let them all fail. It’s not that easy. The ripple effects here would be pretty serious — and while I don’t think the economy would fully seize up, it would be really painful across the board. The lack of liquidity in the commercial paper world (short term lending, mostly) would impact a lot of businesses that you might not think have such exposure to Wall Street. And that, in turn, could create an ongoing spiral.

It would stop somewhere, but where is anybody’s guess at this point, and it may be pretty far down a hole, with a pretty massive destruction of wealth in the meantime. Some may believe this is the best way to get through things (the rip the band-aid off quickly belief), but the overall damage could be significant, and not so easy to come back from. Ripping the band-aid off quickly doesn’t always yield the best result if it rips the scab with it, causing more damage. So, simply letting everything fail, while an option, could have serious long term consequences.

And what about Silicon Valley/Tech?

Well, for those of us in tech, the good news is that we’re more insulated than others. The tech industry is less reliant on investment banks for cash (with some exceptions) and, on the whole, doesn’t have huge exposure to the commercial paper markets either. There is some fear of a loss in customers, especially for those who service Wall Street — but there should be lots of integration work in the meantime. On the startup front, VCs still have plenty of cash for investing, and while they only put out cash calls on committed money when it’s needed, it’s unlikely that most limited partners (i.e., investors) in VC funds will be unable to meet those calls. The big investors, like university endowments, aren’t likely to be impacted too badly. You’ll likely see some slowdown in startup investing, as VCs get nervous about the overall environment and the potential decrease in exit opportunities.

But, for the most part, that should just mean better and stronger startups get funded, as the investors end up asking better questions, and only the best survive. Downturns are the times when the best startups get created.

I’d expect there also to be some fallout in the online ad market, for a few reasons. The mortgage/real estate industry has always been a big spender in the space, and that’s going to drop off (if it hasn’t already). Some of the other businesses impacted by the whole mess will also cut back on advertising. However, the market may start to consolidate around advertising models that actually show strong ROI, but will move away from “advertise and pray” models. Once again, the long run result may be better advertising models, rather than a lot of the crap we see today — and that’s a good thing.

To sum it all up

It is a huge mess, no doubt. The splurge is quite risky — and while I can appreciate the upside potential, if done right, that “if” scares me a lot. I’d be much more comfortable with it if it wasn’t being pushed through in its entirely in such a quick manner, with partisan players on both sides going on the news yelling at the other side each night. Instead, focus on a smaller initial package and spend a bit more time working out the bigger deal later, with a lot more input. In the short term, there’s still going to be a fair amount of bloodshed, and the downside will impact companies outside of the financial sector, but for those in tech, the good news is that we’re probably more isolated than other industries, though certainly not completely isolated. And, since everything is changing so rapidly, you never know what shoe might drop next.

However, in the long run, there is still money out there, and there are still opportunities. People will need to put that money to work one way or another, and rather than freaking out, now is a time to be looking for the opportunities created by this mess, and the tech industry is likely to have a lot of those opportunities. Remember that for every bubble bursting, something ends up getting devalued below its real value. The trick is just figuring out what it is before anyone else notices.

Filed Under: adverse selection, bailout, ben bernanke, economy, financial crisis, henry paulson, moral hazard, mortgages, splurge