Goldilocks on Wall Street

Greetings to all. I am the new Chair of the Dep’t. of Computational Social Science at the Krasnow Institute for Advanced Study at George Mason. Jim has graciously invited me to contribute to his blog. I am an economist with broad interests in economic theory and policy, behavioral economics (how people depart from perfectly rational behavior), cognition (thus my Department’s natural connection to Krasnow), and computation (my Ph.D. is from Carnegie Mellon).

Under normal circumstances I would comment here on matters of basic research and science policy. But the current financial environment is sufficiently grave that I will take the liberty of discussing the proposed bailout of Wall Street.

For the last year or so banks have been sufficiently worried about the risks posed by the mortgage-related assets of their peers that most interbank lending has become expensive (as measured by the so-called TED spread, for instance). Indeed, in the past couple of weeks such interbank activity has nearly dried up—this is the ‘credit crunch.’ Such short term lending is an important activity in the day-to-day operations of major banks, and its demise has led to the Fed providing short term credit facilities to keep overnight and other short term lending and borrowing going. But what we don’t really know (yet) is just how bad bank balance sheets look. It is reasonable to assume that many are weak—thus the urgency with which bailout legislation has been crafted and voted on—but just how weak is not known. The big problem, as I see it, is that bank solvency is not really knowable ex ante, i.e., before a rescue plan is implemented. Here’s why:

Economists are wont to focus on prices to explain the inner workings of the economy. An important part of proposed bailout/rescue plans is use of certain auction mechanisms in order to ‘discover’ the proper prices for ‘toxic’ mortgage-backed securities and related financial assets that troubled firms wish to take off their balance sheets. The functioning of these auction mechanisms is critical to the performance of the bailout, but the exact nature of these mechanisms is not yet specified. Indeed, there is a ‘Goldilocks’ flavor to how such auctions have to function in order to relieve the credit crunch. Currently there is no market for the most toxic of these assets—they are illiquid and their value may be very close to $0. If a government auction for them produces very low prices for such assets then the troubled banks selling them will benefit little from such sales and may be made insolvent. If these auctions produce prices that are too high then taxpayers will be on the hook in a big way and banks will get recapitalized from a true government bail out—welfare for Wall Street even though these same institutions have earned staggering profits in recent years. Instead of auction prices that are either too low or too high it is hoped that the Treasury auctions find prices right in the middle, sufficient to keep the banks operating and thus restoring confidence so interbank lending can resume at reasonable rates. Thus Goldilocks.

The trouble with this whole approach to finding the ‘right’ price for a particular mortgage-backed security (MBS)/collateralized debt obligation (CDO) is that the real determinant of the value of the underlying mortgage assets depends on the health of the overall economy. If the near term recession is mild or even non-existent then stable home prices would result, meaning higher auction prices for distressed mortgage-related securities would be in order. If a longer, deeper recession is in the cards then lower auction prices for MBS/CDOs are justified, even though this would likely ‘take out’ several large banks. In the case of a big recession/depression then the value of many mortgage-related assets is probably close to $0 and many banks will be insolvent.

If one looks at the economy in a static equilibrium way, as is conventional in economics, then one might say there are multiple equilibria in the picture I have laid out: low housing prices and insolvent banks represent one equilibrium and higher housing prices and stabilized institutions are another. Unfortunately, unless one has a reasonably accurate model telling you the effect of a bailout on the real economy, it is going to be guesswork as to which kind of bailout plan leads to which equilibrium. In an economy with multiple equilibria, a specific bailout plan, in essence, selects the final outcome for the economy by picking prices paid for ‘toxic’ securities. Prices that are too low might in advertently ‘kick’ the economy down to a deep recession or depression equilibrium.

The real problem, it seems to me, is that we have only the crudest understanding—zeroth-order models and gray beard guesses—for the overall effect of alternative bailout plans on the real economy. The great 20th Century Economics Nobelist Herbert Simon often argued that we, as a nation, need much more support for basic research in the social sciences. Imagine the ‘return on investment’ today from a few million dollar research program that had created a reasonably-accurate, quantitative model of the current financial system? Maybe it would be saving us a few trillion dollars right now.