Tuesday, October 21, 2008

The earthlings are liars

In my humble opinion in the core of the global credit crisis is the issue of lying and trust. It is not a question of liberalization vs. regulation, it is not a question of capitalism vs. centrally controlled economy.

Here is what happened as I see it. Money searchers -entities representing groups of people such as insurance companies, retirement funds, public bodies- were willing to pay money to other people -bankers- who can get them some more money.

So these money finders went out looking for people who were willing to give money for something they wanted to have too much -wanna be home owners-. To squeeze money from as many money givers as possible the money finders lied to the money givers, making them make commitments on payments that they could not fulfill in 2, 3 years time. The money finders did not care, since they made their money when they sold these payment commitments to money searchers. They did not even sell money to money seekers, they sold promises to give money. They sold promises from people whom they fooled to get more money.

The money seekers trusted the money finders, who in turn fooled people to make promises. Now money seekers had other friends who trusted them, and they were willing to buy these promises to pay money for even more money. Money seekers trusted on money seekers who trusted on money finders who fooled people to make promises they could not meet. With every layer the values of the promises grew exponentially, whereas the credibility of these false promises decayed.

In the end everyone was lying to everyone, and everyone was happy.

Until the moment came when the simple truth, the fact that most of the money givers were not able to give their money, opened up a crack in this wall built on lies. And as with most of the things built on lies, the wall began to crack. No matter how much cement you have to fill the cracks, the wall will collapse.

The same thing could have happened in a centrally controlled economy, as a matter of fact it did in the communist countries. The result would have not been a credit crunch, but starvation.

So when we are building the walls up again, the issue of trust between the lender and borower should be the uttermost importance. How to build this web of trust globally will be the key challenge, and may even not be possible.

I suggest this great article by Thomas Friedman, which helped me shape my thoughts.


Engin Kurutepe said...

today, I did hear the most distilled summary of the whole financial crisis we're having, not un-similar to your explanation: it is profitable for a bank to give credit to people (knowing very well they have no realistic chance of repaying) and then to repackage and sell that debt on to another investment institution. it is disastrous if all banks do this.

this issue, in essence, is very parallel to the problem of sharing in P2P networks. it is desirable (and profitable) for a user to download without uploading but disastrous if everybody does it.

Engin Kurutepe said...

if we continue on that line of thought, this can be reduced to prisoner's dilemma, and does not necessarily have to do with lying, but just with short-sighted and plain stupid nash-equilibria.

i can continue on rambling how research into these problems might one day yield a better economic system, where entities in the system are more than simple homos economicus.

maybe i should start my own blog.

Ahmet C. Toker said...

you should start your own blog. here is how i see it. there are incentives for people not to lie -reputation in p2p networks is an example- in daily situations. because if one owns the reputation of a liar, he will find it harder to make business in the long term. credit histories are nothing but distributed databases of such reputations. with securitzation, the distance between the debtor and collector increases arbitrarily. and there is no incentive for not to lie. the bankers, home owners, hedge fund managers do not share a medium of trust.

Mehmet Küçükbeycan said...

Considering the recent credit crunch, there are lots of issues to be discussed and there are lots of people to be blamed. Moral hazard in today's business is that wall streeters, bankers and brokers are playing with other men's money with high leverages. Therefore, risk taking is excessive.

It will be utopia to execute everything just by trust or leave it to conscious. In my opinion trust can be secured by regulations in the world of greed. You know the old saying which goes like "Do not even trust your father" which is especially valid for trade affairs.

Information asymmetry increases due to securitization. That’s why we have got rating agencies and audit companies. These institutions show your “reputation” and reliability. Once again sub-mortgage crisis shows how these institutions failed.

thuan said...

the word "greed" adequately sums it up for me

Ahmet C. Toker said...

I think the idea that this crisis could have been, and future crisis' can be avoided by regulation is an illusion. Regulators are men, who have limited capabilities, who would be faced with many bright brains working to get around the regulations. Here is an excerpt from conversation between two S&P analysts:

Rahul Dilip Shah: btw: that deal is ridiculous
Shannon Mooney: I know right ... model def does not capture half of the risk
Rahul Dilip Shah: we should not be rating it
Shannon Mooney: we rate every deal
Shannon Mooney: it could be structured by cows and we would rate it

(source: http://bigpicture.typepad.com/comments/2008/10/sp-its-not-our.html)

in a infinite horizon repeated prisoners dilemma, if the punishment is harsh enough, the nash solution is the cooperative one. moral hazard argument is same as decreasing the punishment, thus making future crisis due to non cooperative behavior more possible.

greed is wanting more than you can possibly have. but the problem with the world economy was that everyone thought they could get more. it seems greedy only in retrospect.

Mehmet Küçükbeycan said...

If you think that the possibility of people who might "get around the regulations" is a solid reason for not considering regulations than why bother to make laws. After all, it have never stopped criminals to get around.

Regulations in financial markets do not necesserily mean to stop or punish derivatives. Although innovation in finance might slowdown through regulations, it will also increase transparency. In a more transparent market, you can decrease information asymmetry.

A few weeks ago New York Times ran an article showing that back in 1997 how Alan Greenspan (former Chairman of FED) and Robert Rubin (former Treasury Secretary) did not take heed to the warnings about derivatives. According to the article, Brooksley Born (head of the Commodity Futures Trading Commission between 96-99) was concerned that unfettered, opaque trading could “threaten our regulated markets or, indeed, our economy without any federal agency knowing about it,” she said in Congressional testimony.

Ahmet C. Toker said...

as you say, laws do not stop criminals. my point is that assuming that there would not be crisis' with more regulation is as realistic as assuming there would be no crime with better laws.

my opinion is that there will ALWAYS be crisis. more effort should be given to how to deal with the crisis', rather than how to avoid crisis'.

my favorite friedman quote is the one that is also wrongly misquoted by naomi klein in her shock doctorine:

"Only a crisis—actual or perceived—produces
real change. When that crisis
occurs, the actions that are taken depend
on the ideas that are lying around. That,
I believe, is our basic function: to develop
alternatives to existing policies, to keep
them alive and available until the politically
impossible becomes politically

there were simply no good ideas lying around. the paulson plan was only 3 pages long!

i am on the same page with you on transparency.