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A systemic understanding of the crisis – and a solution proposal

This is my understanding of the financial crisis, and a suggestion for resolution.

The basic understanding is that the entire network of mutual obligations represented by the advanced derivatives is a cancer that is superfluous to the functioning of the economic system, but can potentially completely disrupt it. Hence it needs to be isolated and removed.

This is the core proposal:

* Freeze the worldwide secondary wholesale instruments market (CDS, CDO and other advanced derivatives).  Build a firewall between this part of financial institutions and the other parts (retail and primary instruments).

* Address the liquidity impacts on the retail and primary wholesale (stocks, bonds, options etc.) parts of the financial system through Government loans (in anticipation of a full buyout) against the assets represented by the secondary wholesale instruments.

* Unwind the advanced derivative position (over months) on paper.  Settle the positions against the loans (after the system stabilizes).  This will cause some institutions to fail – allow them to do so.  Some will also fail in anticipation of the unwinding.  But building a firewall between the traditional economic system and the securities market (which is frozen and eliminated) will eliminate domino effects and prevent a global meltdown.

This is effectively the same as “buyout of the securities”, with loans pending final settlement.  But it adds firewalls that prevent securities from absorbing the liquidity being pumped in, and eliminates moral hazard.

Reasoning after the jump.

Thanks to Texas Gray Wolf for his feedback on a seed version of this.  I am including his feedback as the first comment.

My understanding of the problem

I am an information systems professional and systems researcher, not an economist, so my understanding may be flawed – but maybe it is helping to see the problem as a whole.

My understanding is that the core of this problem is a network of mutual obligations.  There are two parts to the problem: gap in actual underlying value, and lack of transparency of valuation and exposure.  The first results in solvency problems and some liquidity problems, the second in massive trust and liquidity problems.

We can conceptually separate the financial system into two parts: a traditional economic system consisting of retail financial products and services and primary wholesale products (stocks, bonds, options, futures etc), and a secondary wholesale products market consisting of securities and advanced derivatives (CDS, CDO and others).

I recently read that AIG consisted of 80+ member institutions, every one of which was solvent.  However, the parent company had a toxic securities balance sheet that brought down the entire system.  

My understanding is that this is pretty much the case in every financial institution: the business units that trade in securities are the major problem, and they are clearly separable from the retail products and services units, and probably from the units that handle primary investments.

The traditional economic part of institutions (and the worldwide economy) is in trouble because stocks are overvalued, and there are losses due to bad debts that have to be absorbed.  However, this by itself would simply be a conventional recession, not a meltdown of the worldwide financial system.  The meltdown is triggered by the network of mutual obligations represented by the securities, whose nominal face value is mindbogglingly enormous.

However, my understanding is that if we could somehow magically unravel the complete network of mutual financial obligation, we would find that the total net deficit is precisely equal to the losses actually arising from the traditional economic system (total value of bad debts and consequent losses).  In other words, the network of mutual obligations is solely mutual agreements about how to divide up losses produced by the traditional economic system.

Here is a picture that shows the dynamics of the system as I understand it.

Imagine if the securities weren’t there at all.  Would there still be a meltdown/depression crisis, or merely a recession-causing problem?  The only difference the network of securities makes is that it changes which particular institutions absorb the losses.

The reason this network is causing a crisis is because the face value of the obligations is insanely huge, and their real value is completely opaque.  This means that any individual institution is completely unable to deal with drops in the (notional) value of its securitized assets. This is a reinforcing loop, because the resulting lack of trust itself causes drops in value.   So every single individual entity in the financial system has a problem – any of their balance sheets can go hugely negative overnight depending on the (trust-based) market value of the securities.  But the overall system problem is actually smaller than the problem of the individual institutions – it is limited to the total bad debt losses.  Left to itself, the traditional economic system is totally capable of settling that – it will go into a recession that reduces home prices and investment & 401k values, but there will be no meltdown or depression.  (I think this is why many people are questioning whether it is a real economic crisis or simply a financial institution crisis). Infrastructure and other government spending can reduce the depth of the recession.

So the key is to find a systemic solution that will let the traditional economic system operate and not let the runaway systemic problems of the financial system jam up the works of the traditional economic system.  I view the financial capitalist system (the securities markets) as a cancer that needs to be cut away to not infect the sick (but not dying) parts of the economic system.

Solution

Step 1: Freeze the entire worldwide advanced securities market.  No new issues, no claims.  This will keep that system from absorbing any of the liquidity pumped into the system by a bailout.

Step 2.  Build the firewall.  Require every financial services institution to separate its balance sheet (and operations) into two parts: one that deals with the traditional products and services (including the stock and bond markets), and another that deals with securities.  They probably already do this, for the most part.  Encourage them to value securities at “reasonable levels”, but prevent any movement of value from one part to the other.  (Even debts that are paid off only represent changes in expected value of obligations, as I understand it, not any actual movement of value).

Step 3: Create a single database of the entire worldwide securities portfolio with terms.  Once the network is frozen and the balance sheets are separated, this should be simple.

Step 4: The freeze will kill liquidity in the traditional operations.  Pump new liquidity into that system by providing a (bailout) government loan against the securitized asset portfolio as collateral.  The firewall between the operations will ensure that this keeps stock prices up and keeps the retail activities flowing.

Step 5: Unravel the network of mutual obligations.  Assess the expected net present value of underlying retail assets (mortgages, credit card debt etc), factoring in the probability of default.  Use this information to determine the net value of each institution’s portfolio.  Perform a virtual settlement that liquidates the entire worldwide securities portfolio (and the loans), distributing the actual losses from the bad debt among the institutions.  Loan settlement can be delayed until the economic system stabilizes, to avoid precipitating systemic crisis.  Loans could even carry 0% interest, if that’s what it takes to avoid aggravating liquidity problems.

Step 6: Many institutions will end up in the red.  Let them go into bankruptcy and settle up.  The government could provide relief for the worst-affected 401k holders and for individuals who file for bankruptcy as a result of the losses.  This will inject further liquidity that will reduce the recession.

Step 7: Do not reinitiate financial capitalism (advanced securities) until the systemic impacts are fully analyzed and appropriate controls have been worked out.

In short, the idea to cut away the securities cancer from the traditional economic system and sort out its impacts over time.  If every international trader knew that the firewall was being built and that only institutions that made really bad decisions would die, there would be no meltdown.   Instead of trying to address the problem at the individual player level (where the problem was created and is still unmanageable), the problem should be addressed at the level of the global financial system.


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/ 7 Comments

7 comments

  1. swaminathan

    I had posted a brief and early version of the core proposal on MyDD, and Texas Gray Wolf provided some excellent feedback (thanks!).  I have tried to address it partly, but it still makes some valid points.

    The loans idea works too (and in fact the current plan would allow that — it’d allow nearly anything, since it’s way too vague and open-ended). The difference is that a loan implies payback; you could give a long lead time before the first payment, but otherwise you risk just eating up the liquidity in the troubled companies in making loan repayments.

    I’m not sure buying the assets outright and managing them (ala the RTC) isn’t the right plan. The taxpayers are still not on the hook for as much because we’re not just giving the money out, we’re buying and managing assets that will later be resold.

    Also it’s a much easier springboard to providing consumer-end mortgage relief. It’s harder to make an argument from principle that a company which got a government loan based on bad mortgages has an obligation to change things on the consumer end of those mortgages. On the other hand, it’s easy to make an argument from principle that says, if the government has had to buy out your bad mortgage (effectively paying off part of what you were unable to pay) that your end of the payments should diminish by the portion the government paid off (otherwise essentially the same mortgage is going to be paid twice). Or, if you’re doing a full RTC-style plan (which I generally prefer) it’s easier to say that, if the government is your mortgage-holder, they should have an interest in keeping you in your existing home rather than incurring the higher cost to society of making you homeless (and that the government should not profit from usurious interest).

    I agree about the principle that consumer-end mortgage relief is facilitated by an actual buyout rather than a loan.  So perhaps the loan should be a down payment towards a buyout.  That is, freezing the securities itself implies that the Government is buying them all, at real value (to be estimated).

    What I am trying to do here is to get beyond reactive responses to the crisis to a true systemic understanding of the nature of the problem.  Lack of economic expertise makes that difficult, though 🙂  Hope those of you with more expertise can help validate or point out flaws in the thinking.

    I am seeing a lot of fear as to whether a bailout will actually solve the problem.  The only way it will solve the problem is if we go for a deep systemic solution.  The problem is to determine what such a solution would look like and how to implement it.

  2. Chris Blask

    and like you, as an IT guy it bears a lot of internal logic that I appreciate, I just don’t know what the real implications are to someone who understands all this stuff better than I do.

    Hopefully some Grand Financial Minds will enter the debate.  I share the sinking feeling that you mention that the three-pager bill Bush flippantly tossed out will not be the end of things.  A cut-out-the-deadwood approach feels a lot more reassuring, and since the psychology of comfort-levels has an enormous amount to do with economic systems’ ability to function, that may be a huge plus to your proposal.

    -chris

  5. spacemanspiff

    Thank your for posting this and thanks for sharing on the Moose. I hope you stick around and post some more of this goodness.

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