the efficient markets hypothesis (EMH) does not imply the rational expecations hypothesis (REH)

TO BE NOTED: From Angry Bear:

"The REH vs the EMH

Robert Waldmann

I think I should explain a claim I made in the post below. I assert that the efficient markets hypothesis (EMH) does not imply the rational expecations hypothesis (REH).

The EMH states that asset prices are the same as they would be if everyone had rational expectations. The strong form EMH adds the assumption that everyone has complete information. The semi-strong form, like the REH has implications only for expected values conditional on public information.

The EMH makes no statement about individual portfolios. It is absolutely not assumed or implied that each investor has an efficient portfolio.

In contrast the rational expectations hypothesis says that the expected value of expectational errors conditional on public information is zero. It is, therefore, not a statement about prices only but about behavior generally. As used it definitely amounts to much more the assumption that observable aggregates have the values they would have if everyone had rational expectations. It is common for microeconometric models to be estimated the assumption of rational expectations. Clearly a statement only about aggregates does not have implications for micro data. This use of the phrase "rational expectations" to refer to individual behavior not aggregates is common and, as far as I know, uncontroversial.

The assumption of ratinal expectations also has important theoretical implications. For example, the first welfare theorem requires the assumption of rational expectations. It is absolutely not sufficient for aggregates to be the same as they would be if people had rational expectations. I think it is safe to say that the fist welfare theorem has a well established place in economic thought. The assumption that it is a matter of no relevance is not easily reconciled with the history of the profession.

In the post below, I assumed that this point is plainly obvious. Now I think an extremely elementary proof might be useful. The proof after the jump.




update: totally wrong math corrected.


there are 2 time periods t = 1 and t = 2.
In the model there are 2 assets. 1 is a risk free asset which is the numeraire. one unit of risk free asset gives one unit of consumption good in period 2.

There is also a coin which is flipped. It comes up heads in period 2 with probability 0.5.

The economy is populated by a continuum of agents indexed by i which goes from 0 to one, who maximize the sum of the log of their consumption in period 2. They have identical preferences and endowements. Each owns one unit of the risk free asset.

It is possible for them to bet on the coin. for a price p one can get an asset which pays 1 unit of consumption good if the coin comes up heads.

Rational expectations implies that agents know that the probability the coin comes up heads is 0.5.

If everyone has rational expectations, then the market will clear with p = 0.5 for each t. Each risk averse agent will find it optimal to invest 0 in the risky asset. there is 0 net supply of the risky asset. Markets clear.

This outcome is Pareto efficient and maximizes total utility.

The EMH therefore is satisfied if the price of the risky asset is 0.5.

Now relax the assumption of rational expectations. Assume that agent i beliefs about the probability that the coin will come up heads is i 1 if i>0.5 and 0 if i < 0.5.

The market clearing price is 0.5. at p = 0.5 half of the agents will buy 2 units each of the risky asset from each of the other half of the agents.

The EMH still holds. p = 0.5.

The outcome is somewhat different. In period 2 half of the agents consume 2 and half consume 0. The outcome is no longer Pareto efficient. Each agent has expected welfare equal to negative infinity.

now correct analysis of my original model.

Now assume that Assume that agent i believes that the probability that the coin will come up heads is i. The outcome is somewhere in between. The market clearing price is still 0.5 so the efficient markets hypothesis still holds. However, agent i will have consumption 2-2i if the coin comes up tails and 2i if it comes up heads. Since the agents, except for agent i = 0.5, are making mistakes, their true objective actual expected welfare is lower than it would be if they were rational. All but i=0.5 think that they think they are doing better than just playing safe but they are all doing worse. mr or ms 0.5 plays safe, invests all in the safe asset.


In the model with rational expectations, the optimal policy is laissez faire.

In the model with efficient markets but without rational expectations it would be preferable to ban gambling. Alternatively the state could impose a 100% tax in period 2 and distribute the receipts equally.

I think it is safe to say that there is a difference of interest to economists between a model in which the optimal policy is laissez faire and a model in which the optimal policy is confiscation and equal distribution of all wealth.

update 2: snark deleted.

Posted by Robert "

It has more to do with the fact that they are on balance sheets at values much higher than anyone is willing to pay.

TO BE NOTED: From Robert's Stochastic Thoughts:

"Sunday, March 22, 2009

Robert Waldmann

I think the reason the CDO market is frozen is that CDO owners are not willing to sell at the market clearing price, because they would then have to mark their remaining holdings to market. This is one hypothesis.

(after the jump I will re-review others and explain why I find them unconvincing)

I'd say that people are convinced that something else must be going on, because of an earlier example of market freezing. I say frozen markets are a sign that people care a lot about the latest price and will not sell an asset at a price higher than their perception of its hold to maturity value, because they don't want the transaction to be recorded in the market to which they mark.

So, why would broker-dealers have done such a thing say the last time markets froze ?
That would be during the Long Term Capital Management meltdown/Freeze up metaphor mixer.

Why lo and behold, it is alleged that markets froze because all broker dealers were manipulating the mark to market value in this book I read "Inventing Money. subtitle includes "long term capital management" or "LTCM""

The assets were long maturity calls on European stock indices. LTCM was massively short these options. The market price of the options became absurdly huge and trading volume fell to roughly zero. LTCM collapsed. Now given the absense of actual trading, the price to which they were marked was the list price as listed by broker/dealers. All major broker dealers were LTCM counter parties. LTCM had REPO accounts so if the mark to market value LTCM's holdings at a bank fell to zero, the bank could seize the holdings including a short position on a grossly overpriced option.

So long as all broker/dealers refused to sell the options for less and no one wanted to buy them for that absurd price, they could seize a valuable LTCM position.

It was rumored that broker/dealers were secretly trading the options at lower prices.
So, it is alleged, that the market freeze up then was pure fraud.

I just know what I read in this book. I don't know if it is true. However, I think the allegation makes it unwise to use the case to prove that market's freeze up for reasons other than dishonesty about the true value of assets.



Here I argue against three other explanations of the current freeze.

Another would be adverse selection. Only the worst of the CDOs are for sale so the market price is the price of the worst of the worst. This can happen if sellers know more about the value of assets than buyers (check) and buyers have to bid on assets and let sellers accept some of the bids and reject others (huh). The second condition doesn't hold. As I've argued repeatedly below, if I had the money I could offer to buy x% of a bank's CDO book at a y% discount but only if they sold me equal proportions of the book. Adverse selection problem largely solved.

Another would be that everyone is panicked (except Geithner, Paulson and Summers). or that everyone has to deleverage. This would really have to be everyone. With frozen markets willingness to buy even a small amount of the assets at a high price would be enough that the latest market price wouldn't be the latest fire sale price.

Another would be that everyone has to deleverage. Again *everyone*.

posted by Robert permalink and comments10:53 PM

Commenting on Drum again in one day

Drum argues that the US public will have to eat the toxic assets in any case and that Bank shares are basically worthless so who cares.

Now, it's true that if we nationalize we'd wipe out the shareholders of the bad banks. But although that's the right thing to do, it's also pretty small potatoes since stock prices have dropped so far that shareholders in bad banks have virtually no equity left at this point. (Sweden didn't even bother trying to wipe out shareholders when they nationalized Nordbanken in 1992, for example. They just bought out the minority shareholders at the highly depressed market price.) What's more, a lot of those shareholders are mutual funds and pension funds anyway. The amount of bankster wealth that would be wiped out in a nationalization is probably pretty small.

Look the aim is not to keep the banks going with worthless shares forever OK.
Shares are worth nothing now, but, if the Geithner plan works, they will be worth a lot. So will shares in nationalized banks. But if we nationalize the value shares which are actually worth something will go into the Treasury. Geithner's plan is not to keep zombie banks staggering around forever. If shareholders are not wiped out and if the plan works as promised, they will end up with a huge amount of money given to them out of your tax dollars.

Also, I know this is so totally 2 days ago, but remember that little dust up about AIG bonuses ? The issue is not the shareholders; they lost long ago. It is the managers. Will they be able to pay themselves £11 million a year (and claim it is $1 million ?). Will they be masters of the universe or subordinates of the subordinates of Geithner ?

CEO compensation is a tiny amount of money, even in banking. Total compensation over $250,000/yr for all employees is not. That's the money Atrios is after.

Managers at banks don't want banks to be nationalized. Geithner is willing to give hedge fund managers tens of billions of US dollars to protect the sacred power of the Bank managers who messed up.
posted by Robert permalink and comments10:42 PM

Commenting on Drum

update: Oh wow. Drum linked to this post. A Political animal stampede. I want to stress that, while I tend to use a confident tone, I really don't know anything about finance.

kevin Drum discusses Valuing the Toxic Waste

After all, if markets can overvalue assets on the way up — and obviously they can — then they can also undervalue them on the way down. There's a pretty good chance that the toxic waste in question really is worth more than the market is currently willing to pay for it.

It is hard for markets to freeze at a price far from subjective effective hold to maturity value. It is easy for markets to flow (opposite of freeze) at such prices.
The current situation is not just that many people are willing to buy Toxic Waste at a huge discount and some owners are willing to sell it. It is also necessary that no one is willing to pay a higher price for toxic waste which happens not be available in a fire sale. Someone should be willing to buy at least a little bit of an asset at say 90% of that persons expectation of its hold to maturity present value. That would be enough to give a market price which isn't absurdly low.

In contrast back during the bubble one could sell short a huge amount of toxic waste at its huge price without affecting that price. People were willing to buy a huge amount at that price. Current owners are just not selling huge amounts of toxic waste at huge discounts (the market is frozen remember). That's the difference. It really has to be that no one wants it except at a huge discount and that really means no one not fewer people than want to sell it at a higher price (so long as they won't sell it at the huge discount because they would have to mark down the identical assets that they still own).

a lazy shorthand that a lot of us have fallen into: namely the notion that the value of mortgage-backed securities is certain to keep plummeting because home prices themselves still have another 20-30% to fall. But these securities aren't backed by the value of the homes they represent. They're backed by mortgage payments. Home prices could fall by half, but the value of the securities wouldn't drop by a dime if homeowners kept making their monthly payments. Their value only drops if default rates go up.

So what causes default rates to rise? Falling home prices are certainly a factor, since it's more tempting to mail in the keys when your loan is way underwater. Rising unemployment is an even bigger factor: if you lose your job, you're more likely to stop paying the mortgage. And the crappy lending practices at the height of the bubble produced a surplus of buyers who have always been more likely to default than average.

I comment

You understate the effect of home prices on the value of mortgage based assets for two reasons. First the value of the assets is not just based on default rates, it is also based on cents on the dollar recovered through foreclosure. That clearly falls when home prices fall. Also, if a homeowners have positive equity I'd guess that even if they have say zero income, they can fend off foreclosure by taking out a second mortgage to pay the first (even if this debt is junior it is covered by the equity in the home). So default rates are higher for under the water mortgages for a reason different from mailing in the keys.

Obviously, then, there's tremendous uncertainty about future default rates. But the market appears to be valuing most mortgage-backed securities these days at something like 30 cents on the dollar. That's crazy. When you factor in recovery rates, it assumes that over three-quarters of all homeowners will default on their loans. That might be true of the absolute worst of the toxic waste, and it's certainly true of the equity tranches of even the better stuff, but on average? No way. 30 cents on the dollar simply doesn't represent a reasonable long-term value for most of this stuff.

But everyone is scared, and when there are no buyers prices get unreasonable.

Your argument rests entirely on the figure 30% which does sound low. In fact, it seems that it would be low even if we could be absolutely sure that all mortgage debtors will never make another payment. Recovery after foreclosure should be worth more than 30% of face value on average.

You assume that the figure 30% applies to all mortgages or, at least, to all securitized mortgages. Whatever gave you that idea ? What if the figure comes from mezzanine tranches of CDOs of by liars loan only MBSs ? There are some assets which no one will buy for more than 30% of face value. They are called toxic sludge. Are they representative mortgages ? I think that's unlikely.

A key point is that there are patient, brave deep pocketed investors still out there. Warren Buffet is one and he controls enough money that there doesn't have to be another one. If the current market price is so absurdly low, why isn't he buying? If he is worried about adverse selection and counterparties with more information picking lemons to sell him and keeping the cherries, then why not offer to buy say 1% of a banks total MBS and CDO of MBS book ?

I think the fact that this isn't happening shows that the prices banks demand for their toxic sludge are higher than justified by a sober patient valuation by an agent with a huge capacity to bear risk.

To get a market price of 30 cents on the dollar it has to be that no one is willing to buy even a small amount of the asset for more. Banks would be delighted to sell a little of an asset for a high price so they could mark the rest to that high price.

The claim that everyone is scared must be literally true. Everyone. Warren Buffet has to be terrified of maybe losing a billion while probably making many billions.
How likely is that ?
posted by Robert permalink and comments10:37 PM

Attempted DeLong smackdown meets It's a Dirty Rotten Job But Someone's Got to Do It.

Brad DeLong attempts to defend the Geithner plan. I consider this a good sign for the USA and a bad sign for Berkeley economics department economic history teaching. He is brilliant as always and almost convincing. I post some of his argument and all of my comment

Q: What is the Geithner Plan?

A: The Geithner Plan is a trillion-dollar operation by which the U.S. acts as the world's largest hedge fund investor, committing its money to funds to buy up risky and distressed but probably fundamentally undervalued assets and, as patient capital, holding them either until maturity or until markets recover so that risk discounts are normal and it can sell them off--in either case at an immense profit.

[snip]

Q: Why isn't this just a massive giveaway to yet another set of financiers?

A: The private managers put in $30 billion, but the Treasury puts in $150 billion--and so has 5/6 of the equity. When the private managers make $1, the Treasury makes $5. If we were investing in a normal hedge fund, we would have to pay the managers 2% of the capital and 20% of the profits every year; the Treasury is only paying 0% of the capital value and 17% of the profits every year.

We own the FDIC too so we are bearing 97% of the downside risk. Hedge fund investors can't end up with less than zero if the manager ends up with zero. This makes the analogy clearly false.

Second, the fact that hedge fund investors do it does not mean that it isn't essentially giving lots of money to already rich people in exchange for a chance to bear a lot of risk. You do not, in general, assume that investors are rational. You can't turn the efficient markets hypothesis on and off at will.

Finally, no one is willing to invest in someone's second hedge fund (well maybe someone is but it is dumb). If I have one hedge fund that is generating me income of 10 million a year and another one where I have limited risk, I might just take huge gambles with the second, to, you know, maximize the value of my option. If all my income comes from one fund, I won't be so casual about it becoming worthless. I think that hedge fund managers typically keep a lot of their wealth in their one fund too. The one example I know of LTCM was like that except for one manager who put more than all of his wealth in LTCM by borrowing to super duper leverage.

Investors can tell how much fund managers have taken out. I don't know anyone who invests in a hedge fund, but, I suspect, that if the manager takes a lot of money out of it, they switch funds.

The fact is that the Geithner deal will have highly positive expected returns for the private partners even if the expected returns on the investment are negative. Loss limited to 3% of the investment and gain equal to 17% of the gain is an extremely valuable Geithner put. This means that, if the private partners really are experts and know what assets are worth in expected value, they will pay more and the US government will have large expected losses.

If Geithner didn't want the USA to lose money, he could design the program so that hedge fund managers put of 3% of the capital and get, say, a 4% share. That way they would be willing to buy assets at 4/3 of their expected hold to maturity value *if* they were risk neutral, less since they are risk averse. This way I'd guess that they are willing to pay double their estimate of the expected hold to maturity value, because of the value of the Geithner put.

I admit that my guess has nothing to do with any calculation of the value of the option. I'm guessing that Geithner wants to buy toxic sludge at twice its hold to maturity value, because that is the only price at which banks are solvent -- that he wants to give banks the value of their toxic sludge but wants to pretend that he didn't do it on purpose. I am using the current market price as my estimate of the hold to maturity value. OK so I'm switching the efficient markets hypothesis off and on, but its the only estimate we have. I'd say there is a lot of wealth in the world and selling pressure can't keep assets undervalued for months.

The fact that CDOs are not being bought and sold doesn't mean that there is no one able to buy them because everyone is deleveraging. It has more to do with the fact that they are on balance sheets at values much higher than anyone is willing to pay. Current owners won't sell at the current market price, because they are not marking to the current market price not because they can't find buyers at the current market price.

Oh and adverse selection my ass. If I had a billion dollars, I could go to Goldman Sachs and say I want to buy 0.1% of your CDO proportional to your current portfolio. If you want to sell me some of them and not all of them, you can go to Geithner -- he's the one who wants to give you money. Doesn't seem to be happening does it ?

update: pulled back from comments

"The fact that CDOs are not being bought and sold doesn't mean that there is no one able to buy them because everyone is deleveraging. It has more to do with the fact that they are on balance sheets at values much higher than anyone is willing to pay. Current owners won't sell at the current market price, because they are not marking to the current market price not because they can't find buyers at the current market price."

You offer zero evidence for this proposition. You spend an enormous time on this blog arguing that markets are not efficient, but here insist on using the "market" price as a reasonable estimate of the net present value of the assets, even though there is no liquid market in these assets. You can offer hypotheses about why that is, but what we know is that the market doesn't exist right now. The vast majority of the "prices" that are being used for markdowns are fire-sale prices. It's absurd to think that the prices that distressed institutions are willing to sell at are real prices.

I'm glad you called this an "attempted smackdown," because it certainly doesn't succeed.

1:35 PM
Delete
Blogger Robert said...

I admitted to the inconsistency in my turning the efficient markets hypothesis on and off (and after accusing Brad of doing that).

On the substantive contested claim it is just not true that *everyone* is deleveraging. This is a fact, and I have evidence. Warren Buffet, for example, decided to pick up more exposure to Goldman Sachs. I don't need another example.

Brad's analysis is aggregate (he is a macroeconomist).

Now it has been alleged that no one is buying CDOs because the seller knows more about the CDO than the buyer so there is an adverse selection problem and there is an equilibrium of no trading except for fire sales.

I think this argument is based on an absurd assumption that all sales must be via market orders on double auction markets. There is no need for me to allow the seller to pick the lemons to sell me and keep the cherries. If I had the money, I could offer to buy 1% of a banks CDO book for, say 60% of face value. That is demand an equal fraction of all of their CDO's.

No one has done this. Banks are very eager to deleverage. Warren Buffet is buying -- something -- but not a part of any banks current CDO book. I think my explanation, for which you claim I present no evidence, is the only explanation which fits that fact, which I call evidence.
posted by Robert permalink and comments5:11 AM"

I think it would be useful of mathematicians and physicists to look into fresh water macro and express an opinion.

From Robert Waldmann:

"Background on "fresh water" and "salt water" macroeconomics

by Robert

Will Wilkinson asks what’s with the economics profession.

A bit more on the public relations quandary the economics profession ought to be in, if it isn’t already…

When I see DeLong more or less indiscriminately trashing everyone at Chicago, or Krugman trashing Barro, etc., what doesn’t arise in my mind is a sense that some of these guys really know what they’re talking about while some of them are idiots. What arises in my mind is the strong suspicion that economic theory, as it is practiced and taught at the world’s leading institutions, is so far from consensus on certain fundamental questions that it is basically useless for adjudicating many profoundly important debates about economic policy. One implication of this is that it is wrong to extend to economists who advise policymakers, or become policymakers themselves, the respect we rightly extend to the practitioners of mature sciences. There is a reason extremely smart economists are out there playing reputation games instead of trying to settle the matter by doing better science. The reason is that, on the questions that are provoking intramural trashtalk, there is no science.

Sadly, there is no one better to listen to.

Now before going on I note that Wilkinson does not address the merits of DeLong's criticisms or Krugman's. He uses a words to suggest that they are writing unprofessionally but he doesn't present a counter argument to their claims. I have quoted his full post. Nothing on the merits.

Instead he asks if disagreements between economists are so fundamental that there is no professional consensus useful to non economists. My brief answer is “yes.” A longer answer after the jump.

Update: Over at Kling's blog commenter Bill Woolsey hits the nail on the head.

Perhaps part of the problem we face in macroeconomics today is that a substantial part of the "macro" wing of free market economists really think that new classical macroeconomics is "true" because simple and formalistically complete models fit their notion of what is scientific.

After the jump you can read my verbose effort to say that.

By the way, Kling's willingness to criticize the arguments others present to support policy positions with which he agrees is really admirable.


It is like Ricardian equivalence. Because the model people (person) rationally saves to pay future taxes, we are supposed to assume this has a connection to reality?





Arnold Kling has already attempted to explain things to Wilkinson. He obtained a “department of huh?” from Brad DeLong and, for what it’s worth, two extremely intemporate comments from me (one was blocked as suspected spam because I provided to many links to support my claims which suggests something about the intellectual seriousness of comment threads at at least one blog).

While I claim that Kling’s take on the stimulus debate is absolutely inconsistent with facts in the public record which I found with a few minutes of googling, I share his general view on the divisions in the profession. He notes that there is more than one fundamental gulf which means that there isn’t a consensus among economists which would enable the few non economists who respect us to take our advice. I will mention three more just because I want to consider more economists than those discussed by Wilkensen and Kling and not because I think Kling left out anything relevant to his post

Kling discusses the policy advice of macroeconomists (and Fama). Not all economists are macroeconomists who think that it is there job to offer policy advice. He notes two divisioins left and right and fresh water and salt water.

Left and right correspond fairly closely to libertarian vs egalitarian in the US political spectrum, that is, closely to Democratic vs Republican positions on economics (except that there are leading economists well to the left of the Democratic party and well to right of all but the left fringe of the Republican party). It is a fact that, except for general support for free international trade, the range of views of economists is similar to the range of views of congressmen but somewhat broader. This is a wide enough ideological range that the methods of verification used by economists are absolutely unable to force economists on left and right to admit that economists on right and left have a point.

In the field of macroeconomics there is a much deeper division between macroeconomics as practiced at universities closer to the great lakes than to an Ocean (Fresh water economics) and that practiced at universities closer to Oceans (Salt water economics). The geography has shifted some as Fresh water economics has been exported. I’d consider Professor Robert Barro at Harvard to be brackish (with, he reports, noticed salty contamination in the first 6 months after he moved from U. Rochester) and the economics department at the University of Pompeu Fabra (in Barcelona) seems to be distilled. It is a little difficult to explain the disagreement to non economists. Frankly, I think this is because non-economists have difficulty believing that any sane person would take ffresh water economics seriously.

Roughly Fresh water economists consider general equilibrium models with complete markets and symmetric information to be decent approximations to reality. Unless they are specifically studying bounded rationality they assume rational expectations, that everyone knows and has always known every conceivable conditional probability. I’ve only met one economists who claims to believe that people actually do have rational expectations (and I suspect he was joking). However, the fresh water view is that it usually must be assumed that people have rational expectations.

Over near the Great Lakes there is considerable investigation of models in which the market outcome is Pareto efficient, that is, it is asserted that recessions are optimal and that, if they could be prevented, it would be a mistake to prevent them.

Salt water macroeconomics is basically everything else with huge differences between people who attempt to conduct useful empirical research without using formal economic theory and people who note the fundamental theoretical importance of incomplete markets and of asymmetric information and of imperfect competition (as in everything you think you know about general equilibrium theory is known to be false if markets are incomplete or there is asymmetric information or there is imperfect competition – Market outcomes are generically constrained Pareto inefficient which means that everyone can be made better off by regulations imposed by regulators who don’t know anything not known to market participants who also just restrict economic activity and don’t introduce innovations like, say, unemployment insurance).

Leading fresh water macroeconomists include Robert Lucas, Ed Prescott Thomas Sargent, Lars Hansen, John Cochrane, Larry Jones, Robert Barro (mostly), and Kevin Murphy (usually). Leading salt water economists include Paul Samuelson, Edmund Malinvaud, Jacques Dreze, Joseph Stiglitz, Robert Solow, Paul Krugman, Andrei Shliefer, Olivier Blanchard, George Akerlof, Robert Hall, Ben Bernankle, N. Gregory Mankiw, Christina Romer, David Romer and, and Lawrence Summers. Brad DeLong is also a salt water economist and he is very very smart, but last I knew, he was a little too far out there to be really a member of the economists club. I can’t classify Paul Romer.

Notably all of the above have made important contributions to fields other than macroeconomics.

In the US there is a strong correlation between Fresh and Salt and Right and Left. The correlation is not perfect: I understand that Hansen and Sargent are politically left of center. Hall is far right politically, Mankiw is right of center. and I must admit that I have no clue about Bernanke (who I have never actually, you know, seen in the flesh).

An important discrimminant is opinions of John Maynard Keynes. Fresh water macroeconomists generally seem to think that he was not a competent economist. Salt water macroeconomists claim (often implausibly) to be in some way his intellectual followers. Barro for example clearly doesn’t remember what is written in “The General Theory of Employment Interest and Money.” Mankiw, in contrast, advised the students in his macro class (including me) to read it again and again searching for insights.

Interestingly, the fresh water macroeconomists are certain that salt water macro is discredited along the lines of the Ptolomaic model or the Phlogiston hypothesis. For a while they called their models “Modern Business Cycle Theory” stating that all incompatible models were obsolete. In the current debate many have considered it sufficient to say that arguments for the stimulus are nonsense (e.g. Cochrane). The surprisingly low quality of contributions to the debate from the vicinity of Great Lakes has a lot to do with the fact that Fresh Water macroeconomists haven’t thought about fiscal stimulus in decades and sincerely believe that it is an obviously invalid proposal so obvious arguments against it might be valid.

Even more interesting, Fresh water macroeconomists do not claim that their models have not been refuted by the data. Rather they note that all models are, by definition, false. They do test hypotheses from time to time, but don’t explain what the point is. As far as I can understand, they claim that a model *can* be both false and useful and, therefore, their models *are* useful.

I understand that in the 70s and, maybe, the early 80s there was a heated debate between Fresh Water and Salt water macroecnomists. Now, it seems to me that there is a truce of sorts where each school of thought ignores the other – that macroeconomists have specialized not in the questions that they ask but in the answers.

I think that this is a very bad situation. Anyone can see that, when top macroeconomists are asked for policy advice, some support each of the different proposals which are under consideration.

Frankly, this truce seems to me to be unilateral. Many salt water economists claim (in public) to respect the contribution of fresh water economists. I know of no fresh water economist who has expressed anything but contempt for the contributions of salt water economists to the stimulus debate and I haven’t heard one word of praise of a Salt Water economist from a Fresh water macroeconomist other than Arrow, Samuelson or Solow. I added the phrase “in public” because I clearly remember one of the salt water economists on my list refer to the fresh water economists as “the crazies”.

update: The truce is over. There have been continual cease fire offensives violations, but the shrill blitzkreig is here.

As far as I can tell, fresh water economists have some respect for some thinkers other than fresh water economists. I think they have rather a favorable view of mathematicians and Physicists. I think it would be useful of mathematicians and physicists to look into fresh water macro and express an opinion. On the other hand, in principle they have great respect for general equilibrium theory, but they don’t listen to general equilibrium theorists at all. Top general equilibrium theorists are all at least left of center politically, the closest David Cass could come to naming an exception is Ed Prescott who, he said, uses general equilibrium theory and studies examples (snort).

Finally I have a view of how people can devote so much effort to working out the implications of assumptions which almost no ordinary people would find other than nonsensical if they understood them. Fresh water economics uses difficult mathematical tools. Students in fresh water graduate programs have to learn a huge amount of math very fast. It is not possible to do so if one doesn't set aside all doubt as to the validity of the approach. Once the huge investment has been made it is psychologically difficult to decide that it was wasted. Hence the school gets new disciples by forcing students to follow extremely difficult courses. Last I hear very few graduate students at U Minnesota came from the USA. Undergrads over there know what the program is like. If my information is not out of date, innocents from abroad are the new blood of fresh water economics."

Me:

Don the libertarian Democrat says:

Today, 2:40:56 PM

“I believe that there is a difference between Economics and Political Economy. Many FW theorists don't seem to agree with this, while SW ones do. My personal favorite is Alan Blinder. Political Economy necessitates that one cannot rely on math or models. They are of limited use. Some of the FW models are of some use, but they do not decribe laws of nature. At best, they are correlative reasoning dressed up with equations. They describe possible movements among different stats or facts. In our situation, there are good arguments for both trying government spending and tax cuts. While a large stimulus would be nice, we are somewhat constrained by debt. I would probably also use more QE. Wilkinson seems to believe that certainty or agreement is necessary for Economics to be useful. He is wrong. It is useful to Political Economy, which, while not leading to certainty, does lend itself to better and worse arguments.Finally, about science. There is often a lot more disagreement on theories than people believe.

"Without training in modern econometrics it is simply impossible to assume something that stupid."

Robert Waldmann with a good post on Angry Bear:

"Barro on Keynes Barro and Grossman

Robert Waldmann

Robert Barro wrote an op-ed in The Wall Street Journal. The substance of the op-ed is to report an estimate of the Fiscal multiplier 0.8 which is less than one. Thus, according to Barro, a stimulus will partially crowd out of investment, consumption or net exports and not just reduced leisure. Paul Krugman took Barro to task for using the huge WWII stimulus in his estimates, since the economy was at full employment during WWII. So have Matthew Yglesias using his Harvard BA in philosophy from Harvard and Kevin Drum using his BA in Communications from The California State University in Long Beach.

I might want to reassess Long Beach State, but I think the reason that Yglesias and Drum immediately make the same argument is Krugman is that Yglesias and Drum don't know about modern econometrics. Barro is using an instrumental variables regression in which wartime military spending is considered to be an exogenous variable which is correlated with government consumption. The implicit assumption is that we can safely assume that the fiscal multiplier today is identical to the fiscal multiplier during World War II, because the economy is basically similar. Without training in modern econometrics it is simply impossible to assume something that stupid. ( A GOOD POINT. I KEEP WONDERING WHAT BARRO'S PHILOSOPHY OF MATH AND THE HUMAN SCIENCES IS. )

There is also a severe gap in economic theory, at least as remembered by Robert Barro. Wouldn't one think that there must be some model( YES ) in which correlations( MATH IS A WAY OF EXPRESSING CORRELATIVE REASONING. HOWEVER, IT IS STILL SIMPLY CORRELATIVE REASONING. THE MATH IS SIMPLY A HEURISTIC TOOL. ) vary depending on the general conditions of the economy -- say like whether at current prices there is excess demand for goods or excess supply of goods.

Of course, no one could expect Barro to know that there is a vaguely Keynesian model, which differs from the neoclassical model only because of rigid nominal wages and prices, in which the economy can be in one of three different regimes, Keynsian (with insufficient aggregate demand), Classical (firms can sell as much as they want but real wages are too high so workers are unemployed) and repressed inflation (excess supply of labor and goods).

I'm mean who's ever heard of the Barro-Grossman model (A General Disequilibrium Model of Income and Employment Barro, Robert J.; Grossman, Herschel I.; American Economic Review, March 1971, v. 61, iss. 1, pp. 82-93 [stable JSTOR link added for those with access])? Certainly not Robert Barro.

The passage quoted by Krugman about what Keynes thought is inconsistent with The General Theory. However, it can be corrected easily. The accurate description of the history of economic thought is "John Maynard Keynes Robert Barro and Herschel Grossman thought that the problem lay with wages and prices ... will mean that wages and prices do not have to fall."

Look I sympathise. Like Barro, when I was young and reckless I did embarrassing things which I have tried to cancel from my memory. I really wish I could do that as well as he has."

The historical context must be considered when addressing the question of why people behaved as they did, even in economic behavior. This is what I call the Existential Context. The context of the 1930s was far different than ours.

Also, there is a difference between economics and political economy. Barro doesn't seem to see a difference. Too bad.

"severe poverty has increased since welfare was reformed is not mentioned in the discussion."

A good point by Robert Waldmann on Angry Bear:

"Welfare Reform "Not a Disaster" ?

Robert Waldmann

Pieter Beinart serves up some conventional wisdom in the Washington Post. Unfortunately he is totally wrong, because he hasn't checked the facts in the past 7 years.

Beinart wrote

"Older liberals remember .... They also remember the welfare reform debate of the mid-1990s, when prominent liberals predicted disaster, and disaster didn't happen."

Oh didn't it ?

Try telling it to the severely poor

Beinart is a lazy fool, as I argue after the jump.


I'm afraid Mr Beinart will be down to one example soon. The welfare reform was promptly followed by an amazing boom which no one predicted. Then he lost interest in the issue. Beinart decided that, since poor people did OK in the late 90s, welfare reform was a good idea.

What happened with welfare reform and without an extraordinary boom ? The number of Americans in "severe poverty" grew 26% from 2000 to 2005, that's what happened. "Severe poverty" is severe, "A family of four with two children and an annual income of less than $9,903 - half the federal poverty line - was considered severely poor in 2005."

So welfare reform worked great didn't it ? Now one might argue that the problem was that the economy was horribly bad from 2000 to 2005 (and the comparison is with 2000 not 1996) however the 2005 severe poverty rate was the highest in 32 years including the severe recession in 1982. The immense severe poverty rate was achieved with moderate unemployment.

All data from this McClatchy article

Beinart only concludes that welfare reform wasn't a disaster, because he only paid attention to what was happening to the poor for a few extraordinary years.

In 2000 one could argue whether the improvement in economic conditions of the US poor was due to the booming economy, due in part to the booming economy and due in part to welfare reform or more than 100% due to the booming economy which more than undid the damage of welfare reform. Now, with more data, it might still be possible to avoid reaching the third conclusion, but I haven't read the argument. The fact, the plain simple fact, that severe poverty has increased since welfare was reformed is not mentioned in the discussion.

This is important, because the nonsensical clearly false claim made by Beinart is definitely the conventional wisdom. Notice that Obama only promised to cut the taxes of 95% of US families. The other 5% mostly weren't those so rich that he proposed raising their taxes (that would be between 1% and 2%). They were the poorest who could only be given more money by unreforming welfare.

It is well known that welfare reform was followed by an improvement in the economic conditions of the poorest Americans. The minor fact that this is no longer true and hasn't been true for years is not worthy of notice. "

This does need to be addressed. The lack of a decent social safety net is essential for even a small government arrangement.

" The credibility they sold was worth tens of billions to the financial innovators who bought it."

Robert Waldmann on Angry Bear about the Credit Ratings Agencies:

"Waxes poetic about the lost credibility of the AAA rating. For possible comic value I share my reflections.

What went wrong with the ratings agencies ?

I think the central problem is that the ratings agencies long provided a service of immense value to society, and were paid a tiny fraction of that value to do so. The loss of credibility of the ratings is one of the causes of a terrible recession ( TRUE ). This loss is more likely to cost the world trillions in lost output than mere hundreds of billions. Sure seems that the credibility of the ratings agencies was worth, at least, hundreds of billions to the world economy. That dwarfs the market capitalization of the ratings agencies ( TRUE ).


We lost that because we collectively decided to take it from them rather than paying them what their credible ratings were worth. For decades they provided messages of one to three letters which were collectively worth hundreds of billions per year. They were paid their costs plus a normal profit margin, just as if it wasn't a miracle that so much value could be created with so little effort.

Their credibility was immensely valuable but not to them.

Then they were tempted by innovative financial instruments and also got tired of getting only a tiny fraction of the social value of their services. So they sold their credibility for a few billions. The problem is credibility gets damaged in the deal( LOST ). The credibility they sold was worth tens of billions to the financial innovators who bought it( VERY TRUE ). They converted it into cash, but they have paid themselves much of that in bonuses and blown the rest buying into their own spin. Now it's gone ( I HOPE SO ). If I knew what it came from in the the first place, I would have an idea as to how to recreate it, but I never figured that out ( TRY FRAUD ).

"They said that they didn't quite understand it, so I'm going to try to explain what a synthetic bond is. "

This post is going to go all over God's green earth, so put on a decent pair of shoes. Also, if you carry a shillelagh, please don't prod me. I'll move as fast as I can.

I need to first introduce a new hermeneutic rule called "Searle's Sagacity", which I learned from my teacher John Searle. I believe that he acquired it from Austin, but I'm not sure. Anyway, here it is:

If a person can't explain something simply, then they don't know what they're talking about. The only exception being Kant.

Now, there's also a corollary to this, which is that questions should be simple and comprehensible, and meant to elicit a simple explanation. This rule is constantly violated, because you have to, in effect, appear less educated than you are. Most people find this one a bit rough, preferring to ask questions that demonstrate that they know more than the person being questioned.

Here's another rule, not so pleasant for me. It's called Hardy's Harangue. It's not really a harangue, but, since it's a bit rough on me, I'm giving it the flavor or taste of overdone:

"There is no scorn more profound, or on the whole more justifiable, than that of the men who make for the men who explain. Exposition, criticism, appreciation, is work for second-rate minds. "

Frankly, I'll take being a second-rate mind. Since my blog is based upon exposition, don't expect any first-rate thinking on it. But you didn't, in any case, so no problem here.

If you want to blame people for my "compulsory mis-education", although I chose to go to college, you can blame John Searle, Hubert Dreyfus, Gregory Vlastos, George Lakoff, Bernard Williams, and Paul Feyerabend. Actually you can't, since they were excellent teachers.

Williams, Vlastos, and Feyerabend have passed on, but Searle, Dreyfus, and Lakoff, are still with us, thankfully. Williams and Vlastos were wonderfully kind and decent human beings, who tolerated my presence out of pity, probably, besides being geniuses. Feyerabend and I had a different relationship. He was never, actually, my teacher, since I eventually dropped three courses of his that I started. The final straw was when he claimed that Wittgenstein knew nothing about math. My feeling was that, even if true, it shouldn't be pointed out. Even though never truly his student, I had innumerable hours of conversations with him, that involved mutual criticism bordering on insult. Nevertheless, we got along very well over a long period of time until his death.

Most people remember the ending of The Brothers K where Alyosha tells the boys to remember this moment, in order to have it as a reference point to guide them in their lives. Something similar happened to me with Prof. Vlastos. When I was tossed out of graduate school, I went by his office to see him. I was feeling sad, but also elated, because I had been very unhappy in graduate school. Professor Vlastos told that he was very sorry that this had happened, and that he didn't think it was good for philosophy, since I reminded him so much of Walter Kaufmann. Now, even if he had said this just to make me feel better, it still means more to me than anything that has ever been said to me about myself. Once Gregory Vlastos has compared you to Walter Kaufmann, you don't really care what anyone thinks about you. This kind of moment is important for all of us, because it helps protect us from the vagaries and vicissitudes of human life. Even though I'm melancholy by nature, this moment is with me always. Hoorah For Vlastos! And Walter Kaufmann has had a huge influence on my life, which I might talk about someday. As an aside, the Gargoyle Of Emerson Hall was Prof Dreyfus.

This leads us to Felix Salmons explanation of Synthetic CDOs. Here it is:

"Over the past few days, two very smart people have asked me about a passage in Michael Lewis's cover story for Portfolio in which he talks about synthetic CDOs without actually using the term. They said that they didn't quite understand it, so I'm going to try to explain what a synthetic bond is. Once I've done that, the Lewis passage should be a lot more comprehensible."

I have to admit to not liking the Lewis piece, precisely because I didn't feel that he did a decent job explaining these investments. I did a previous post on his post.

"Let's start with a simple single-credit synthetic bond. You're an investor, and looking at the credit markets, you see that IBM debt is trading at attractive levels, especially around the 5-year mark, where they yield about 150bp over Treasuries. You'd really like to buy $100 million of IBM bonds maturing in five years, but IBM isn't returning your calls (they have no desire to borrow money at these spreads), and there aren't any IBM bonds with exactly the maturity you want. What's more, even the bonds with maturities nearby are illiquid, and closely held: there's no way you can just blunder into the market and buy up that many bonds without massively skewing the market, since the overwhelming majority of the bonds are just not for sale."

Why do you want these IBM Bonds? Do you know something special about IBM?

"So you buy a synthetic IBM five-year bond instead, taking advantage of the much more liquid CDS market. Essentially, you take the $100 million that you were going to spend on IBM bonds, and you put it into a special-purpose entity called, say, Fred. (In reality, it'll be called something really boring like Synthetic Technology Invetments Cayman III Limited, but Fred is easier to remember.) First, Fred takes the $100 million and invests it in 5-year Treasury bonds."

Fine. You've created an artificial IBM bond for yourself. Good for you. Game over?

"Next thing, Fred goes out and sells $100 million of credit protection on IBM in the CDS market, using the $100 million of Treasury bonds as collateral. The buyer of protection will pay $1.5 million per year (150 basis points) to Fred, and in return Fred promises to pay $100 million to the buyer in the event IBM defaults, less the value of IBM's bonds at the time. The buyer knows that Fred is good for the money, because it's already there, tied up in Treasury bonds."

The answer is "no", because Fred has to go out and sell these things. Here's my question: Doesn't Fred have to believe that there's a demand for his product in order to sell it? So, whose going to buy insurance on IBM bonds? And why? See, I'm sensing that Fred has an agenda here beyond mirroring unavailable IBM bonds. Are you?

"So long as IBM doesn't default, you get not only the $1.5 million per year from the buyer of protection, but also the interest on the Treasury bonds. You wanted to buy IBM bonds yielding 150bp over Treasuries, and that's exactly what you're getting: the 150bp from the CDS counterparty, and the Treasury interest from the Treasury bonds. At maturity, assuming IBM still hasn't defaulted, you get your $100 million back, the CDS contract has expired, and Fred has no contingent liability any more."

It's like an insurance transaction, including premiums.

"The effect is identical to holding an IBM bond -- and you can even sell your interest in Fred, just like you could sell an IBM bond. If IBM defaults, you lose your $100 million, but you get back the value of an IBM bond -- which again is the same outcome as if you'd bought an IBM bond for $100 million and IBM defaulted."

Should you sell these things it is. Otherwise you just own Treasury Bonds.

"But the key thing to note is that IBM itself is not involved in the transaction at all. It doesn't matter how few bonds IBM has issued, there can be many times that amount in synthetic IBM bonds, just so long as there are enough people out there willing to buy and sell credit protection on IBM."

Actually, IBM is involved, because you might have an influence on their bonds and stocks. You just didn't buy a bond from them, although, since a bond is a loan, I don't see why they couldn't accomodate your enthusiasm to loan them money.

"And just as you can create a synthetic IBM bond, you can create a synthetic bond portfolio, made up of credit default swaps on any number of corporate names or even mortgage-backed securities. The special purpose vehicles in those cases sometimes sell protection on a lot of different names; sometimes they just sell protection on a liquid CDS index. Either way, the returns that those vehicles offer are basically the same as the returns on buying the underlying securities -- if those securities were easily available."

Okay. We get the "pro" argument. Liquidity and efficiency of capital.

"Now that we've understood all that, we can return to Michael Lewis's piece, where he's talking about a chap called Steve Eisman, who was buying protection in the CDS market, and is sat at dinner next to one of his counterparties, who was selling protection.

Whatever rising anger Eisman felt was offset by the man's genial disposition. Not only did he not mind that Eisman took a dim view of his C.D.O.'s; he saw it as a basis for friendship. "Then he said something that blew my mind," Eisman tells me. "He says, 'I love guys like you who short my market. Without you, I don't have anything to buy.'¿"
That's when Eisman finally got it. Here he'd been making these side bets with Goldman Sachs and Deutsche Bank on the fate of the BBB tranche without fully understanding why those firms were so eager to make the bets. Now he saw. There weren't enough Americans with shitty credit taking out loans to satisfy investors' appetite for the end product. The firms used Eisman's bet to synthesize more of them. Here, then, was the difference between fantasy finance and fantasy football: When a fantasy player drafts Peyton Manning, he doesn't create a second Peyton Manning to inflate the league's stats. But when Eisman bought a credit-default swap, he enabled Deutsche Bank to create another bond identical in every respect but one to the original. The only difference was that there was no actual homebuyer or borrower. The only assets backing the bonds were the side bets Eisman and others made with firms like Goldman Sachs. Eisman, in effect, was paying to Goldman the interest on a subprime mortgage. In fact, there was no mortgage at all. "They weren't satisfied getting lots of unqualified borrowers to borrow money to buy a house they couldn't afford," Eisman says. "They were creating them out of whole cloth. One hundred times over! That's why the losses are so much greater than the loans. But that's when I realized they needed us to keep the machine running. I was like, This is allowed?"

What Eisman is saying is that there were mortgage-backed securities, and then there were synthetic mortgage-backed securities; when the banks ran out of actual MBS to sell to investors, they sold them synthetic MBS instead. And yes, that was allowed."

They created products to fill the demand for a sold out product.

T"here is some hyperbole here, though. While there were undoubtedly a lot of synthetic MBS issued, they weren't a large multiple of the real MBS issued, as the "one hundred times over" quote would suggest. Which is quite obvious, if you think about it: there weren't a lot of people like Steve Eisman willing to short the MBS market -- and you need them, to take the other side of the trade."

Yes. The other side of the trade is actually the issue. Who's buying these things? And why? What's the demand being filled?

"In fact, most of the synthetic MBS issued were issued by banks which kept the underlying mortgages on their own balance sheet. Rather than put the mortgages directly into a CDO and sell that to investors, they kept the mortgages themselves and bought protection from the CDO on them -- creating a synthetic CDO which mirrored (and which they could sell to hedge) their own holdings. Why did they do that? That's the story of the super-senior tranche, and will have to wait for another day."

They keep them on their own sheet, which allows them lower capital requirements for the other tranches they sell. They also make more money by divvying the bundle up, and selling it in parts, as well as fees.

Here's my comment, which didn't get answered:

Posted: Nov 29 2008 11:11pm ET

"So you buy a synthetic IBM five-year bond instead, taking advantage of the much more liquid CDS market.'

What's your fascination with IBM bonds? There are lots of bonds out there. Does this investor have some special knowledge?

"Next thing, Fred goes out and sells $100 million of credit protection on IBM in the CDS market, using the $100 million of Treasury bonds as collateral."

Fred's motives are somewhat clear to me, in the sense that you've explained what he says his interest in these IBM bonds is. But whose the buyer? Someone who actually owns IBM bonds, and wants default protection? Or someone who doesn't like IBM's chances? Surely someone needs to feel they need this default protection before they purchase it? In other words, when Fred looks at IBM, since he's creating a product to sell, doesn't he need to have seen some reason for assuming that there's a demand.

By DonthelibertarianDemocrat

Basically, the points I made above. I think that the motive for a product is more important than the product. But Felix has descibed a product without telling us where the demand comes from. In order to mirror the IBM bonds, Fred has to Sell a Product.

Now, Robert Waldmann comments on Angry Bear:

"Given this story about the use of CDSs, I understand why Felix Salmon is convinced that they are not financial WMDs and why he is so angry that AIG was allowed by counterparties to issue CDSs without posting collateral. I also think that the story is very different from CDS reality.

Over at his blog, I asked Felix Salmon three questions

1) Why wouldn't interest rate swaps serve just as well ?

2) Why set up Fred when Fred's assets must be worth more than Fred's liabilities so there is no obvious point limited liability 100% share ownership of Fred.

3) Also if 100% collateral is posted, how can the notional value of CDSs be greater than the US national debt ?

After the jump, I explain why I find these questions challenging."

Now, these are interesting questions, but they are still technical. Who is Fred selling his product to? And why?

"1) If I want to be long IBM bonds and Own Treasury bonds I can make a synthetic IBM bond with interest rate swaps can't I ? I think the cash flows with my counterparty are exactly the same, if neither of us goes bankrupt. Thus, I think that the immense popularity of CDSs must be based either on bankruptcy law (related to the super senior tranche ?) or on accounting standards and capital requirements, or both. "

Well, here he's correct. It's the capital requirements. But that only explains the seller again, and is frankly what Felix said that he was going to explain.

"2) Why set up a a special purpose entity. I mean that has to cost something. They are set up for a reason, either to limit liability or to make balance sheets look better. "

The reason is more fees and lower capital requirements. Yes, it does cost something, which is why you have to sell it. Again, the buyer?

"3) Clearly not every dollar in CDS was collateralized 100% by US debt. There isn't enough US debt. I think it must be true that most were only partially collateralized. AIG might be an extreme case, but I think it just must be true that CDSs were used to leverage up and not just to synthesize bonds."

Correct. But here again, Felix will probably explain that next. My problem is still there's no good explantion of a simple transaction involving buying and selling, supply and demand, the basics.

"OK now my efforts at answers. Remember I am very ignorant and mostly guessing."

Join the crowd. At least Felix answers you.

"On bankruptcy law, you have to realize that it's not your father's bankruptcy code.
Bo Peng explains

Generally speaking, in bankruptcy code, derivatives counterparty claim[s] can go right through Chapter 11 protection and force liquidation. Chicago Fed in fact had a research paper in 2004 (thanks to Seeking Alpha reader emrald) analyzing the original rationale behind and the unintended consequences -- cliche of the month? -- of this exceptional treatment of derivatives.

oh my.

I think this means that if Fred's parent (I'll call it Zeke) goes bankrupt, Fred's counter-party gets to grab the T-bills and no bankruptcy court can stop it. This would not be automatic from the definition of CDS, but Zeke and Fred's counter-party would both benefit from writing the contract that way."

I don't see it quite the same way. They can force liquidation, but other claimants, taxes, for example, could preceded their claims.

"Now if equity in Fred is counted as one of Zeke's assets and Zeke has a binding capital constraint, a fast one has been pulled. These assets are not part of the pool split up among creditors in the case of bankruptcy, because Fred's losses (value of collateral minus value of the CDS) go 100 cents on the dollar to the counter-party. Also if equity in Fred appears on Zeke's balance sheet, then Zeke's creditors may be mislead. If they assume that all equity in special purpose entities is quite likely worthless now, then a whole lot of crisis can be explained."

Surely these people know the law, otherwise they wouldn't use it. I don't see the evidence that someone is being fooled here.

"Clearly not all CDSs were used to make sythetic bonds. For one thing Lehman brothers had liabilities including CDSs on its balance sheet (OK its 10-Q report). For another they were listed at fair market value which was vastly below notional value until recently. Now it seems to me clear that if firms can goose their equity to debt ration they will and clear that CDSs are very useful for that purpose so long as they are not 100% collateralized. "

That's the plan.

"I'd guess that Fred wouldn't own Treasury securities equal to 100% of notional value, but rather a lower ratio with a trigger that if the market price CDS reached ninety something percent of the value of the collateral, the collateral could be seized immediately. This means Fred could suck money out of Zeke or Zeke would have to lose 100-ninety something suddenly. Now a totally unexpected actual default would not be insured by Fred (which would go bankrupt). That is, this use of the CDS market would be to take opposite bets on the CDS price, not to insure risk. But, I mean we know that was going on."

If that's the law. I'm not sure how these CDSs are being used in his example. He seems to believe that bets on this company's viabilty take precedence over actual debt obligations of the company. I simply don't know the law.

If IBM defaults, the CDSs will work out independetly of IBM, between the Insured and the Insurer. The CDS in Felix's example are completely independent of IBM. They're simply tied artificially to its fate.

But Waldmann asked some good questions.

Here was Felix's response:

"Posted: Nov 30 2008 11:49am ET

Hi Robert -- I really was just trying to explain synthetic bonds, not anything about the larger CDS market. And synthetic bonds are really a very small part of the CDS market.

I'm not sure how you could possibly create a synthetic IBM bond using interest-rate swaps alone -- where would you get the credit-risk component from?

As for Fred's structure, it's worth remembering that these are synthetic bonds we're talking about here -- and the whole point of a synthetic bond is that it can be bought and sold in the secondary market, just like a normal bond. You can't talk about "Fred's parent" because no one ever needs to know who Fred's shareholder(s) might be.

By Felix"

So, my bottom line is that neither the post by Lewis or Felix Salmon really explained the problem. What people want to know is why people buy them. In this explanation, they seem to be creating a product without a clearly defined market, which doesn't make sense. I'm not saying that either doesn't know what they're talking about, but that explanations are much harder to construct than many people believe because they involve, not simply knowing something very well, well enough to simplify it, but also being able to explain it clearly.

So, I'll keep Hardy's Harangue, although I think explanation much harder to accomplish than he seems to believe. And I'll keep Searle's Sagacity, even though a person who knows a subject very well can have a hard time explaining it simply.

"they trusted the ratings agencies and that they assumed that the national average house price would certainly not decline. "

Robert Waldmann on Angry Bear agrees with me, I think, about the Citi problems with CDOs:

"Eric Dash and Julie Creswell who argue that Citibank took insane risks holding CDOs on its books, because of a failure of the fixed incomes risk management team, reckless 'short termism' and two amazing mistakes. The two alleged mistakes are that they trusted the ratings agencies and that they assumed that the national average house price would certainly not decline. These are actually similar mistakes as at least one rating agency, S&P, making the same insane assumption about house prices.

They write:

when examiners from the Securities and Exchange Commission began scrutinizing Citigroup’s subprime mortgage holdings after Bear Stearns’s problems surfaced, the bank told them that the probability of those mortgages defaulting was so tiny that they excluded them from their risk analysis, according to a person briefed on the discussion who would speak only without being named.

Later that summer, when the credit markets began seizing up and values of various C.D.O.’s began to plummet, Mr. Maheras, Mr. Barker and Mr. Bushnell participated in a meeting to review Citigroup’s exposure.

The slice of mortgage-related securities held by Citigroup was “viewed by the rating agencies to have an extremely low probability of default (less than .01%),” according to Citigroup slides used at the meeting and reviewed by The New York Times.

and

C.D.O.’s were complex, and even experienced managers like Mr. Maheras and Mr. Barker underestimated the risks they posed, according to people with direct knowledge of Citigroup’s business. Because of that, they put blind faith in the passing grades that major credit-rating agencies bestowed on the debt.

and finally

To make matters worse, Citigroup’s risk models never accounted for the possibility of a national housing downturn, this person [who worked in the CDO group] said,

This is amazing. It's not as if no one with an Op-Ed column in the New York Times was discussing the possibility of a national housing downturn. I can't believe that this was an honest oversight. The anonymous source doesn't say either "“I just think senior managers got addicted to the revenues and arrogant about the risks they were running. As long as you could grow revenues, you could keep your bonus growing.”

Wow.

Brad Delong argues that 43 billion is a small part of Citibanks problems. He is talking about market capitalization not book equity which matters given capital requirements. I mean also not a tiny part, and 43 billion here 43 billion there and soon your talking real money. "

I actually believe that this was either fraud, negligence, or fiduciary mismanagement.

"the value of the reputation of the credit rating agency is so huge that no client can afford a large enough bribe.

Robert Waldman on Angry Bear addresses the following:

"The meaning of AAA changed after the introduction of CDOs and is different for corporate bonds and CDOs. Those are facts which an economic model should seek to explain. I have an explanation. What is your competing theory ?"

This means that implicit collusion can be maintained. That is, there is an equilibrium in which both agencies give generous ratings to new instruments and both damage their reputations when the crash comes. This is an unusual result. For a plain old cartel it is more difficult to maintain a collusive equilibrium -- a firm can profit in the short run by deviating. In this case, deviating to toughness is costly in the short run and well deviating is always costly in the long run because of the other agencies response.

So in this equilibrium, they rate sludge AAA. Then the crash comes and -- so what. They all have roughly equal amounts of egg on their faces. We can't do without credit rating agencies. They will still get as much business rating non-innovative assets as they would have if they were both tough. The new class of assets might vanish, but that was inevitable given the fact that the new assets are very risky and offer modest returns. The agencies profit from the period in which the toxic assets were issued and rated. So long as they gave similar ratings, the damage to both of their reputations won't hurt them at all.

Of course it will hurt investors who will have to do more research on their own, since they can't trust the credit ratings agencies as much as they would have been able to trust them in the world without financial innovation."

Okay. This is an answer to a question that I asked about Moody's: Namely, why should anyone trust them now?

The answer seems to be we have to, or at least trust someone who's as poor at this ratings business.

So, I asked this question:

"So in this equilibrium, they rate sludge AAA. Then the crash comes and -- so what. They all have roughly equal amounts of egg on their faces. We can't do without credit rating agencies. They will still get as much business rating non-innovative assets as they would have if they were both tough. The new class of assets might vanish, but that was inevitable given the fact that the new assets are very risky and offer modest returns. The agencies profit from the period in which the toxic assets were issued and rated. So long as they gave similar ratings, the damage to both of their reputations won't hurt them at all."

Why don't new ratings agencies, unsullied by this stupidity, start up and compete? What's the entry problem?
Don the libertarian Democrat | Homepage | 11.16.08 - 2:37 pm | #

Here's the answer:

"Dear I forget who Why doesn't a new credit rating agency enter about now ? I sure wouldn't advise anyone to try. The reason is that a credit rating agency is only worth anything (to its shareholders) if it has a reputation better than "who is that ?". This means that there is a huge barrier to entry. I would think that a new credit rating agency would have to rate for free for years and years before anyone would pay them anything.

That is to say I think that, even now, Moody's S&P and Fitch have valuable reputations -- less valuable than they were last year but still much better than no reputation at all."

Well, if there's an impossibility of entry, then you don't need to worry.

Here's my next comment:

Here's another point from "I forget who". The only way that your explanation works, namely, as long as they're all equally awful, is if there is an impossibly high entry fee. Since that's the case, you're pretty much stuck with your list of choices, however poor. It's true that you can do your own research, but that has its problems as well. However, if they're all equally awful, at least you could try and get them to compete on fees, so that you would at least pay the least amount that you can for this product. That, I believe, is regulated.
Don the libertarian Democrat | Homepage | 11.16.08 - 11:44 pm | #

We'll see if there's an answer.

Here's an older post on ratings agencies:

"Wednesday, October 22, 2008

"products that later turned out to be extremely risky, and in some case, worthless. "

NY Times posted on the congressional hearings on the ratings agencies. How timely:

"Members of Congress leveled sharp criticism at the major credit-rating agencies Wednesday morning, as the House Committee on Oversight and Government Reform held a hearing on these firms’ role in the current economic crisis.

Several lawmakers vented their frustration over what they considered to be egregious lapses at the agencies, Fitch, Standard & Poor’s and Moody’s.

Mark E. Souder, a Republican from Indiana, described their conduct as “gross incompetence.” Another lawmaker read from a series of instant messages, sent by employees of S&P, in which one analyst said they would rate a deal even if it were “structured by cows.”

In many cases, these ratings agencies assigned super-safe, triple-A ratings to structured products that later turned out to be extremely risky, and in some case, worthless.

These investment products, such as mortgage-backed securities, were created by financial institutions ostensibly to mitigate risk by pooling loans and selling parts of them off to investors. But many of the loans that were packaged in these securities were made to people with poor credit histories, little equity in their homes or overstated income."

Here's my comment:

“In the final few months of 2007, Moody’s downgraded more bonds than it had over the previous 19 years combined”

Interesting post on the FT by Sam Jones on Moody’s and the rating system:

“Then, on August 16 last year, after an internal revision of its ratings practices, Moody’s made an announcement that heralded the beginning of the credit crunch.”

And:

“The action was the first in a series of surprises for the credit markets. In each of the succeeding weeks, it seemed, Moody’s and the other rating agencies had more bonds to downgrade. And each set of downgrades was a convulsive shock. In the final few months of 2007, Moody’s downgraded more bonds than it had over the previous 19 years combined. Panic gripped trading floors. Titanic structured vehicles, created by banks to warehouse their “riskless” mortgage bonds, became untouchable for short-term investors. As a result, two big German banks revealed that they were within a whisker of collapse, and virtually overnight all the world’s banks stopped lending to one another.”

Please read it.

Let’s see, that was…about a year ago. Nice work

— Posted by Don the libertarian Democrat

And another post:

"Friday, October 17, 2008

"In the final few months of 2007, Moody’s downgraded more bonds than it had over the previous 19 years combined"

Interesting post on the FT by Sam Jones on Moody's and the rating system:

"Then, on August 16 last year, after an internal revision of its ratings practices, Moody’s made an announcement that heralded the beginning of the credit crunch."

And:

"The action was the first in a series of surprises for the credit markets. In each of the succeeding weeks, it seemed, Moody’s and the other rating agencies had more bonds to downgrade. And each set of downgrades was a convulsive shock. In the final few months of 2007, Moody’s downgraded more bonds than it had over the previous 19 years combined. Panic gripped trading floors. Titanic structured vehicles, created by banks to warehouse their “riskless” mortgage bonds, became untouchable for short-term investors. As a result, two big German banks revealed that they were within a whisker of collapse, and virtually overnight all the world’s banks stopped lending to one another."

Please read it.