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Of Modeling, Risk, Financial Innovation, and Liquidity Crises

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February 21, 2010 – Comments (10)

I was reading the Feb 13th issue of The Economist and they have a section on risk and risk modeling for financial institutions. The one that I thought was particularly relevant was the article about liquidity risk - "When the river runs dry: The perils of a sudden evaporation of liquidity". The whole section is a very well written set of pieces, as most Economist articles are, but was not as hard-hitting as I think the topic deserves (I think a lot of punches were being pulled and a lot of the conclusions for future systemic risk were not being fully drawn).

"But binv is just a permabear, and he's always coming up with reasons to be bearish, and we just had a massive stock market rally. So why should we listen to him?"

..... You shouldn't.

I am not going to sit here and make some argument about why I am the finest macroeconomic mind around, nor am I going to try to convince and dazzle you with my charting prowess.

I am an analyst. I make observations. I examine the macroeconomic landscape and I draw conclusions.

I lay my observations out for you to follow.

So you read them and you agree with them, or you read them and you disagree, or you ignore them altogether. It is immaterial to me. Because the point of this post is not to convince you of anything. The point of this post is to share information and observations. I will draw and share my conclusions, and I offer them to you if you are interested in reading them. But your conclusions are up to you.

But more to the point, I am not bearish for the sake of being a bear. I would much rather be long. I would much rather be bullish. I am a very optimistic guy, and I want to invest in companies and the US economy for the long term. But when I honestly assess the problems that our economy faces in the near term (next couple of years) and the actions that have been taken to deal with those problems, I am utterly unconvinced that they are being solved or in some cases even taken seriously.

This is ultimately why I believe that the current environment suggests that investors should still be very defensive. That is my honest $0.02. I have no agenda other than to call things like I see them.

Yet I know something about modeling, creating mathematical representations to describe phenomena. But more importantly I know quite a lot regarding the limitations and abuses of models.

Modeling

I have stated before that I am a thermal and structural analyst for the Aerospace industry. I create mathematical models to describe physical systems on a daily basis. And it is very important that these models are accurate, as there is often very expensive hardware performance dependent on the predictions from these models.

Also I have made the argument that financial systems are quasi-physical systems (one example from here: First and Second Derivatives of the SPX - http://caps.fool.com/Blogs/ViewPost.aspx?bpid=298547), that is they display properties such as inertia, capacitance, flow, diffusion, and respond to inputs such as impulses, step functions, ramps, etc. I am not making the argument that you can model financial systems and physical systems in a strict one-to-one manner, rather I am saying that there is often a corollary between the two systems and an understanding of physical systems will often given you insight into the behavior of financial systems.

Physical systems are inherently non-linear.

Even something as simple as a beam in bending, which is described by kinematic, equilibrium and constitutive relationships, has non-linear terms in them. For engineers to be able to work with these relationships in a practical manner we make simplifying assumptions. In the case of the beam equation above, we assume a small angle approximation (sin theta = theta) and this allows us to linearize many of the relationships.  And this is a very good approximation for small deflections and angles. Whenever you look up a beam diagram to determine the deflection or bending moments from a particular load case, baked into those relationships are these linearizing assumptions. The point is that these assumptions allow you to build and successfully analyze very complex systems, but you must always be aware of their limitations. Deflections cannot be extrapolated infinitely because at some point the linearizing assumptions are no longer valid, and non-linear effects become very important.

The key concept here is that there is a range of conditions over which these linearized systems can be properly analyzed, and cannot be extrapolated out indefinitely with out serious error (i.e. the model gives you false predictions).

I keep talking about linearization. Why is this so important? Linearization means that effects can be added to each other to give a valid composite result. This is the principle behind superposition. An example would be a fast transient signal on top of a slower transient signal: such as the temperature response of a filter wheel on an Optical Bench that is responding to diurnal temperature swings, or the flutter response of a control surface relative to a wing which is responding to the air stream. Superposition is the key for models to be able to accurately predict the responses of several combined inputs.

Then there are some effects that are non-linear and have no linearizable simplifcation: Radiation and Convection from a high temperature exhaust plume as the vehicle moves from atmosphere to vacuum, the effective clamping constraint (degree of freedom) of card locks on a PCB as the chassis goes from low frequency to high frequency vibration, etc. When your system is subjected to these non-linear inputs then the must be tested and verified against these inputs.

This brings together the next key concept: When a system is subject to inputs, especially non-linear inputs, or an input will cause the system to behave in a non-linear fashion, the model must be correlated to these conditions. Using a model to extrapolate beyond correlated conditions will lead to inaccurate predictions

Together, these concepts of model correlation and the range of applicability for a model are the basis for all aerospace analysis and testing procedures. Think about it, do you design a new thruster that has a new plume shape and temperature profile and stick it on a satellite and just launch it? What if it doesn't work the way your model predicts (non-linear behavior). What if it breaks hardware? What if it ends the mission? It is impossible to retrieve a satellite and fix it when it is in orbit 22,000 miles above you. This is why models and hardware are verified before they are deployed, so that you can be sure they work and you can be sure that the model will predict all of the situations the system will encounter on orbit (sun angles, surface degradation, shadowing, thruster pulse timing, etc).

What this does it allows you to retire risk. The more you know about your system, and the better your models predict the system behavior through correlation, the more confident you are that the system will behave for conditions that are similar to the ones that you tested for. AND RETIRING RISK WILL GIVE YOU CONFIDENCE THAT YOUR MODEL WILL ACCURATELY PREDICT SYSTEM BEHAVIOR AT THE EXTREMES (i.e. IN A CRISIS)!

Risk and Financial Innovation

Good economics, just like good engineering, should be BORING!.

Models should be clean and as simple as possible, so that they can be vetted by multiple analysts that should agree on the interpretation of the results. And when new designs are introduced in (which happens all the time in engineering), the design must be tested thoroughly and the models describing the behavior of the new design very well understood before the design goes into production.

The term "financial innovation" should scare the SH** OUT OF YOU!!. For 2 reasons:

a-1) There was never any mechanism by which these instruments (CDOs, CDSs, MBSs, etc.) were truly exercised before mass proliferation within the marketplace. The first time we saw how these derivatives reacted during a crisis was when they collectively represented more than the GDP of the entire world.

It would be the same as designing a new satellite, putting it in a thermal vacuum chamber and testing it for nominal conditions only. Then doing some handwaving and saying "yeah it works fine at hot and cold conditions too". Are the radiators properly sized for the hot case? Is there any heat leak to sensitive components during hot conditions? Are the heaters properly sized for the cold case? Are there any conditions where the propellant freezes creating a catastrophic scenario? These are the questions that you want to have answers to on the ground before you launch, where you can take action if the system does not perform as expected. That last thing you want to have happen is to find out there is a major system design flaw on orbit.

Same with these financial instruments. The last thing you want to have happen is to find out that these responded to crisis conditions not at all like you expected while in the middle of a crisis. Yet that is *exactly* what happened.

a-2) It didn't really matter anyways because this instruments were fraudulent to begin with: Financial Carcinoma -- Denninger: Did You Need a PhD For That? - http://caps.fool.com/Blogs/ViewPost.aspx?bpid=322718

So why did these models perform so poorly? Why was risk so grossly under-represented?

Because the financial systems these risk models are trying to describe are also extremely non-linear

Models such as Value at Risk / VAR are fine for short term forecasts where the liquidity environment is known. But leverage greatly alters the liquidity environment and a very small change in leverage can completely change how liquid any asset is. Does that change its underlying value? YOU BET IT DOES!. An MBS is worth the fully securitized cost only if somebody is willing to pay you that amount for it. And if liquidity is only available to purchase that asset in a highly leveraged environment, then its value is a function of liquidity and leverage. Regarding Economic Debates and Opinions: The Fallacy of "Purely Objective" Analysis - http://caps.fool.com/Blogs/ViewPost.aspx?bpid=305849.

Additionally these models looked at housing risk simply from a historic default rate standpoint, without considering the possibility of a massive fall in the underlying assets (housing prices) and how that would further impact the default rate. (Effects combining in a very non-linear fashion).

There are quite a lot of financial environments that are non-linear and sometimes even binary, such as a highly leveraged liquidity environment.

The current and next generation of modeller's will benefit themselves and all of us by adhering to the Modeler's Hippocratic Oath: http://www.financialmodelingguide.com/financial-modeling-tips/tips/financial-modelers-manifesto/:

* I will remember that I didn’t make the world, and it doesn’t satisfy my equations.
* Though I will use models boldly to estimate value, I will not be overly impressed by mathematics.
* I will never sacrifice reality for elegance without explaining why I have done so.
* Nor will I give the people who use my model false comfort about its accuracy.
* Instead, I will make explicit its assumptions and oversights.
* I understand that my work may have enormous effects on society and the economy, many of them beyond my comprehension.


This is the reason why I *always* put caveats on my analysis and projections. Because any analysis, whether physical, financial, TA, EWP, etc., is an approximation and a projection, nothing more.

Liquidity, Liquidity Crisis, and why another Crisis is Extremely Likely

So we have discussed modeling and risk. And we have already had a major financial crisis and a stock market crash. Since all these effects are known, isn't the risk retired? If we are aware of some of the underlying problem, haven't we fixed them?

NO, not by a long shot.

There is a big difference between captital risk (and so called Value At Risk / VAR models) and liquidity risk. And as you will see in some of my conclusions, the latter is the one that gets significantly less attention and is significantly more dangerous. And why I ultimately believe that all of the actions of the Treasury and the Fed have almost guaranteed another liquidity crisis in the future, and has done nothing to ameliorate the underlying problems.

First, lets start with the Great Deleveraging Event of 2008. From above, I talked about how all these derivatives reacted to the collapse of liquidity and how leverage across the board began to dry up.

But why did conditions abate? Did the market just "have enough" when it came to deleveraging and the equity market find a compelling valuation bottom back in March 2009? NO

b-1) If you want to know why liquidity returned to the market, then read this fantastic post by Kristjan Velbri: Dollar Liquidity Swaps & The Financial Crisis. The reason why the Dollar rallied and then peaked while the market bottomed in March is because of massive Dollar Swaps pumped into the market by the Fed. That's all. There is no fundamental strength in the US Dollar. There was a crisis reaction into dollars by the Deleveraging Crisis in 2008 (in order to buy Treasuries / the standard "safe haven" move) and then the Fed flooded the market with Dollar Swap agreements to force liquidity in 2008/2009.

b-2) There was no meaningful valuation bottom found, as I have stated many times. Is the Market Fairly Valued? Did the Market Achieve Any Meaningful Bottom Back in March? - http://caps.fool.com/Blogs/ViewPost.aspx?bpid=320237 and The Long View - http://caps.fool.com/Blogs/ViewPost.aspx?bpid=314202
       
Okay? So maybe this is how it went down. But why am I stating that there will most likely be another liquidity crisis?

Because nothing was fixed!! All the old problems were simply wallpapered over and the same instruments with the same models are back en vogue!!

Here is a list of reasons why the underlying causes of the Liquidity and Deleveraging Crisis of 2008 are still around and worse than ever!

c-1) These assets were never allowed to be properly valued by the market. Congress extorted the FASB to allow for "mark to imagination" and "extend and pretend" valuation, so that financial institutions could keep these toxic assets on their balance sheets unimpaired. Former Regulator Talks Fraud and the Big Bank Getaway - http://caps.fool.com/Blogs/ViewPost.aspx?bpid=344209

c-2) Despite the collapse of several derivatives markets in 2008, the disproportionate size of these "assets" to any meaningful metric (such as GDP of the world), and the systemic risk of the size of these assets .... they are still growing. Financial Crash Risk Increasing Exponentially as Derivatives Monster Continues to Grow - http://www.marketoracle.co.uk/Article15437.html

c-3) The Fed is backstopping the CDS market to allow for, and in fact encourage, the more rapid proliferation of derivatives. PSW: The Fed / CDS Development - http://caps.fool.com/Blogs/ViewPost.aspx?bpid=340700

c-4) The recent rule changes regarding Money Market Redemptions has an even larger moral hazard then first observed. Connect the Dots Before Financial Depressurization - http://caps.fool.com/Blogs/ViewPost.aspx?bpid=335085 and my response - http://marketthoughtsandanalysis.blogspot.com/2010/02/flag-day.html#comment-33841524

There is One Last Issue That Puts this Whole Discussion Into Perspective

I and many others talk about a lot of terms that are important to the conversation, and many that I discussed above, but there is one term that is important beyond all others:

maturity transformation

What this means is to borrow short in order to lend long. It is the basis behind behind our entire financial system. And financial failures are not simply a random and rare by-product, but is actually a "feature" of this system.

I have linked to these two articles before, but I have never featured a post around them. But they are extremely relevant:

Maturity transformation considered harmful: an unauthorized biography of the bank crisis -
http://unqualified-reservations.blogspot.com/2008/09/maturity-transformation-considered.html


The Misesian explanation of the bank crisis - http://unqualified-reservations.blogspot.com/2008/10/misesian-explanation-of-bank-crisis.html

These post were written by Mencius Moldbug of http://unqualified-reservations.blogspot.com. His blog is extremely interesting (although it is a bit out there sometimes / fairly often). He is a Computer Scientist who likes to look at issues from an almost diagnostic point of view. I first started reading him in September 2008 (when he wrote these posts) with his discussion of Fractional Reserve Banking and Mises Banking.

The point of these linking to these posts is to not advocate for an Austrian Banking System (not because I don't think it is a good idea, but because it won't happen), but rather it is to show you from a very logical and easy to follow reasoning why liquidity crises happen to begin with.

Once you read these posts, and then go back up and re-read points c-1 through c-4 again, you will see that the Federal Reserve's / Treasury's / Congress's absolutely irresponsible actions of not allowing financials to fail, by backstopping derivatives to further encourage the taking of risk (not only for hedge fund but for Money Market Managers as well!!!) are setting conditions up for an Epic Fail even worse than the first Deleveraging Crisis.

It is not a foregone conclusion, but I think a reasonable person looking at all of these fact can say that it is a possible, if not likely, outcome.

10 Comments – Post Your Own

#1) On February 21, 2010 at 6:58 PM, Option1307 (29.69) wrote:

Is there Spark Notes version of this???

J/k Bvine. Excellent and thought provoking as always.

It is not a foregone conclusion, but I think a reasonable person looking at all of these fact can say that it is a possible, if not likely, outcome.

I know we have touched on this countless times in the past, but the nearterm future does not look bright. There are so many problems out there economically and, I agree, many of the initial situations have only become worse. That's not to say that I think we are going to crash and burn etc. but I just don't believe everything is "fixed".

However, the issue I have been having lately is, does that even matter, does WallStreet care? Honestly, so what that our economy is still trash, unemployment is at 25 yr. highs, and we are printing money faster than, well, ever. I have always believed that these things will eventually catch up with us, we will someday have to pay the price for these lingering problems. But, I have no idea when that will be. We all know that markets tend to love being irrational (see tech bubble and housing bubble etc.)! So the question becomes, do these factors eventually catch up with the markets, or have we lost all sense of reality?

I know one thing is for certain, the current valuations of the market and unrelenting rise the last yr. scare the crap out of me. I still have my long term plays in tact, but I've exited most of my  short term/trading positions. I strongly believe the risk/reward at current level is not in favor of being long.

Time shall tell.

On a sort of random side note, have you every thought about how wildly different the tech crash was in comparison to the current financial crisis. When the tech bubble exploded, many companies died out or at the very least were crushed and a decade later have yet to regain those losses (see Nasdaq etc.). There was almost a cleansing feel to things, weeding out the weak, and letting the market price things "fairly". At least sort of.

However, compare that to the current crisis. Ok we lost a few financial firms, and yes a lot of high beta stocks are still way way off their all time highs (even with 300-500% gains). But to me at least, it just feels different this time. Most of the crap companies that were polluting our economy in the first place are still around and many have become even more entrenched in our life (cough, GS, cough. In many ways, we are right back to where we were in late 2007/etc. Almost as if the financial crisis that took us down all the way down to 666 on the SP500 didn't occur. This just doesn't feel "right" IMO.

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#2) On February 21, 2010 at 7:11 PM, chk999 (99.97) wrote:

This is an awesome post. Non-linearity is one of the annoying facts of life, but you can't get away from it. The physical world has lots of examples like in a flowing stream. Double the amount of water and the stream's erosive ability more than doubles. (Which is why the few large floods do much more than a proportionate share of the landform changes in a watershed.)  Learning about non-linearity is something everyone should do and I this this post should be read by everyone interested in investing so that they are not fooled by things changing suddenly and dramatically.

There is one thing I think needs more debate here. Fractional reserve banking has a good point that the hard money people keep missing. Various handfuls of gold coins in people's safes and strongboxes are not capital. They just sit there. Deposit the coins in a fractional reserve bank and suddenly they become capital that can make the economy grow. It is no accident that the rise of FRB starting in the 1860 and the growth of the world economy happen at about the same time. The solution to the borrow short/lend long problem is to have adequate capital reserves at the bank to deal with the unevenness of the loan repayments versus the deposit withdrawls. Getting rid of FRB throws out this baby with the fiat currency bathwater.  

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#3) On February 21, 2010 at 8:51 PM, binve (< 20) wrote:

Option1307,

Thanks man!

Is there Spark Notes version of this???

LOL! How about: "Crisis not averted, just postponed" :)

So the question becomes, do these factors eventually catch up with the markets, or have we lost all sense of reality?

I agree. I think markets are disjointed from reality but I think it catches up soon (first half of this year). Establishing defensive postitions now or getting out of the market altogether is probably a good call.

On a sort of random side note, have you every thought about how wildly different the tech crash was in comparison to the current financial crisis. When the tech bubble exploded, many companies died out or at the very least were crushed and a decade later have yet to regain those losses (see Nasdaq etc.). There was almost a cleansing feel to things, weeding out the weak, and letting the market price things "fairly". At least sort of. However, compare that to the current crisis. Ok we lost a few financial firms, and yes a lot of high beta stocks are still way way off their all time highs (even with 300-500% gains). But to me at least, it just feels different this time. Most of the crap companies that were polluting our economy in the first place are still around and many have become even more entrenched in our life (cough, GS, cough. In many ways, we are right back to where we were in late 2007/etc. Almost as if the financial crisis that took us down all the way down to 666 on the SP500 didn't occur. This just doesn't feel "right" IMO.

I couldn't agree more. Like I said above: Because nothing was fixed!! All the old problems were simply wallpapered over and the same instruments with the same models are back en vogue!!. I think the biggest mistake was not letting financials fail. If we did we would be bottoming now and starting to truly recover. Now the problem still lay ahead of us and will be much worse. My $0.02. 

I don't say this lightly. Like I said at the beginning of the post, I am an optimistic guy, and I would much rather be fundamentally engaged in the US economy from the long side. But there is very little economically speaking that does not look like it will get worse before it gets better.

Thanks for the comment!

chk999 ,

Thanks man! I really appreciate that!!

Non-linearity is one of the annoying facts of life, but you can't get away from it.

Exactly.

Building complicated models that describe behavoir in well-understood condtions and then operating the system within those conditions = good.

Buidling complicated models that describe behavior in poorly understood conditions and then extrapolating behavior out to conditions never observed and assuming linear relationships = bad.

You have to think, how much money was litterally thrown away because of bad modeling practices?

There is one thing I think needs more debate here. Fractional reserve banking has a good point that the hard money people keep missing. Various handfuls of gold coins in people's safes and strongboxes are not capital. They just sit there. Deposit the coins in a fractional reserve bank and suddenly they become capital that can make the economy grow. It is no accident that the rise of FRB starting in the 1860 and the growth of the world economy happen at about the same time. The solution to the borrow short/lend long problem is to have adequate capital reserves at the bank to deal with the unevenness of the loan repayments versus the deposit withdrawls. Getting rid of FRB throws out this baby with the fiat currency bathwater.

There are some good points in this argument and I will just add my $0.02 and make a few observations on your comments.

I am a believer in gold as a store of value, but I am not advocating a move to a strict monetary metal backed currency. But I think the Federal Reserve System that we have now is *deeply* flawed. Because the control of our money supply is given to politicians (in fact the establishment of the Federal Reserve was done to get around the constitution - the Congress shall not have the authority to coin money), because the politically expedient action to any economic crisis has been inflation / currency devaluation.

So while the current fiat-only money system allows for longer booms, I think it leads to larger busts (and we are still in the middle of the current one, not at the end). Becuase in a fiat-only system, where inflation is always present, it forces everyone to become a speculator in order to keep up with inflation. And speculation is always dependent on perceptions. And when perception changes, liquidity evaporates, as I discussed above.

Imagine if a dollar saved really was a dollar earned. The next for risky speculation would be far less than is demanded by our system now.

So while I agree with your statement that private captial is the initiator of economic growth (in fact private savings of the citizens of a country is *always* the genesis of a major economic growth cycle), I think our current system does nothing to protect that capital investment.

So if a monetary-metal only system is not the answer, a major overhaul of our current monetary system is certainly called for. Raised reserve requirements, a non-inflationary monetary policy, and abolishment of the Federal Reserve would be a first good step. I think FRB could be retooled so that it was much fairer for everybody and much more robust than it currently is. The chances of that happening? Approximately 0.0% :)

Thanks for the comment!!.

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#4) On February 21, 2010 at 9:56 PM, binve (< 20) wrote:

Crap, those links are messed up. Here they are corrected:

 Maturity transformation considered harmful: an unauthorized biography of the bank crisis -
http://unqualified-reservations.blogspot.com/2008/09/maturity-transformation-considered.html


The Misesian explanation of the bank crisis - http://unqualified-reservations.blogspot.com/2008/10/misesian-explanation-of-bank-crisis.html

 

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#5) On February 21, 2010 at 10:39 PM, binve (< 20) wrote:

I would like to encourage everybody to read the blog posts above in comment #4 (the corrected versions of the one at the end of the main post). They are some of the best thoughts ever written about the financial crisis and why it was the liquidity crisis aspect that initiated it. Here is an excerpt of the first link:

When we ask: "what caused the bank crisis," we need to distinguish between proximate and ultimate causes. Our focus today will be on the ultimate cause. But first, let's get the proximate cause out of the way.

...

The ultimate cause, however, is a matter of financial engineering. It has nothing at all to do with elections or politicians. Politics explains where the bad mortgages came from. Politics does not explain why they caused our financial system to lock up like a clogged fuel pump, or why no one can price or sell these instruments. Pricing dubious and complicated securities is what a financial system does. So why isn't it happening? What is the engineering mistake that caused the financial system to be so sensitive to this relatively minor piece of graft?

The engineering mistake is an accounting practice called maturity transformation. In the best CS tradition - I consider it harmful.

Maturity transformation might also be called monetary time travel. It is an accounting structure which permits a financial institution to pretend that it can teleport dinero from the future into the present. High-tech modern finance can do many cool things, but this is not one of them.

The price we pay for this illusion is a fundamental instability in the lending market. To most economists, this instability is a Diamond-Dybvig dual equilibrium. To Austrian economists, it's the Misesian theory of the business cycle. And in plain English, it's your common or garden bank run. The present crisis, which is by no means over, has many fascinating and devilish modern characteristics - but old Beelzebub is easily discerned beneath its raiment.

Modern computerized finance is especially susceptible to the bank-run bug, because in the last twenty years it has adopted an awesome array of incredibly beautiful and fragile modeling techniques. Unfortunately, all of these models assume a stable or single-equilibrium pricing environment. They do not allow for a phase change between dual equilibria. Doh!

Why has this mistake gone unrecognized? The basic problem with maturity transformation (MT) is that, while it is a bad accounting practice, it is not a new bad accounting practice. MT is not some horrendous monetary Guantanamo unleashed upon us by the corrupt Bushocracy. Nor is it a form of financial Bolshevism devised by the Mussulman Candidate, Barack Osama. Oh, no.

Maturity transformation is the heart and soul of the Anglo-American model of banking. Our current round of MT dates to the founding of the Bank of England in 1694. Lombard Street (which is still a good read) describes it in a nutshell. MT is inextricably woven into our political system, our accounting system, our profession of economics, even our Wikipedia. Despite the fact that it has been causing booms, busts, and crashes since Pennsylvania Avenue was a swamp.

Or so, at least, I assert. Obviously it's a somewhat dramatic assertion. But I think it's possible for you to use your own brain cells to understand why MT is harmful. You don't need to trust me, or anyone else. The problem is just not that hard to follow.

You may know maturity transformation as "fractional-reserve banking," which is one common case of the practice. A financial institution practices MT whenever it "borrows short and lends long," ie, promises to deliver money in the short term based on the fact that it is owed money in the long term. For example, in a classic fractional-reserve bank which takes checking deposits and uses them to fund mortgages, the bank's promises have a term of zero (your money is available whenever you want it), and its mortgages are repaid across, say, 30 years.

But few of us have operated a bank. I want to explain intuitively why maturity transformation is a basically corrupt practice. And for that, we'll need a more down-to-earth example.

Suppose you lend a friend of yours from work, Bobby, a thousand dollars. He agrees to give you the money back, plus fifty for interest, next week. The week is the term or maturity of the loan.

Bobby then lends your K to a friend of his, Dwight. Dwight is about to ride up to Humboldt to spend three boring weeks with his loser parents. Which will suck, but which will also enable him to score a pound of weed and hitch back with it. The weed can be moved for $1500 - but the three weeks is non-negotiable.

So the glitch arises when you buttonhole Bobby by the water fountain and mention that it's Monday. "Yeah, right," he says. "Man, hey, do you want to go in for another week? I'll give you another fifty. That's a good rate, man." This is, you agree, totally fine. You have just rolled over your loan to Bobby. Next week, you do it again. And the week after that, Dwight gets in. He pays Bobby $1300. And Bobby comes to you with $1150, still smelling faintly of Humboldt.

You have just had a successful customer experience with the Bank of Bobby and Dwight. You profited. Bobby profited. Dwight profited.

But is what Bobby did cool? Is it right? Did it display probity? We'd have to say - no.

At least, we would have to say this intuitively. We have not yet applied our logical faculties to the matter. We have just used the awful Bobby, and the still more horrendous Dwight, as propaganda props. Can we smear the noble art of banking with these dank characters?

The basic problem with this transaction is that when Bobby said he wanted to borrow a grand for a week, he was lying to you. Bobby is a user. He knew he could get away with stretching the loan from one week to three, and he did. If he'd just asked you for a three-week loan, everything would have been fair and square. But you might have said no.

What do you want to know when you lend someone money - whether it's Bobby, or Citigroup? You want to know that they'll pay you back. Or at least, that the probability of repayment is high enough to be justified by the interest rate on the loan.

To standardize this decision, our ancestors developed the art of accounting. Bobby, or Citigroup, opens the kimono and shows you two lists. One is the list of promises Bobby, or Citigroup, has made. For instance, Bobby has promised to give you $1050 in a week. This is sometimes known as a liability. The second list is the list of things Bobby, or Citigroup, owns - for instance, Dwight's promise to deliver $1300 in three weeks. This is an asset.

As a lender, what you want to know about Bobby or Citigroup is that they are solvent. In other words: Bobby has enough money to pay you back. Solvency is computed by subtracting liabilities from assets, the result being equity. For instance, if these are the only transactions on Bobby's balance sheet, and if we assume (a big if) that Dwight's promise is actually worth $1300, then Bobby's equity is positive $250, and he is solvent.

Note that when you consider solvency, you are not asking whether Bobby can pay you back. You are asking whether Bobby can pay all his creditors back. For instance, if Bobby has also borrowed $1000 from your officemate Dave, but lent it to his ex-girlfriend Angelique, who spent it all on meth, his equity is negative $750, and he is insolvent - or bankrupt. He can pay you or he can pay Dave, but he can't pay both of you.

There are two keys thing to remember about insolvency. One, it is a sort of event horizon; you cannot borrow yourself out of bankruptcy. No one has any good reason to lend to an insolvent party. Two, it is a collective decision: Bobby is either insolvent with respect to both you and Dave, or he is solvent with respect to both. He can either make good on his promises, or he can't.

But absent Angelique, when we use the solvency test to evaluate Bobby's business, it looks like a good one. Bobby is solvent. But he also had to lie to you to get the loan. Something is not quite right here.

If Bobby shows his balance sheet to a trusted third party, perhaps an auditor or regulator, the auditor will agree that Bobby is solvent. If you ask Bobby whether he can be trusted, he refers you to the auditor, who tells you that Bobby is solvent. But if you saw his actual balance sheet, you wouldn't do the deal. Our accounting model is simply not doing its job. Or is it?

Enough with Bobby. Let's look at an actual bank. FooBank, a classic fractional-reserve bank, has a billion dollars in demand deposits - that is, liabilities of zero maturity, which are continuously rolled over when its depositors fail to withdraw them from the ATM. It has $50 million in the vault, and $1.1 billion in fixed-rate 30-year mortgages, giving it equity of $150 million.

Note that $1.1 billion is not the total amount of money owed on FooBank's mortgages. It is the current market price of the mortgages. Ie: if FooBank sold the mortgages to some other financial institution, it could get $1.1 billion for them. (Because interest rates are always positive, that means the total payments over 30 years will be much more - let's say, $1.5 billion.)

So our question is: should you put your money in FooBank? If you give FooBank a demand deposit, can you be sure that it will be there when you demand it at the ATM?

Our first answer is: yes. Whatever your deposit is, it's a lot less than $50 million.

Our second answer is: no. Because FooBank, like Bobby, is a maturity transformer. It owes $1B, now. It expects to receive $1.5B - over the next thirty years. Dwight is sure taking a long time up in Humboldt! FooBank has only $50 million in the vault to pay its $1B in demand deposits. If more than 5% of its customers demand the payments they are contractually owed, FooBank is screwed. If you are not among the first 5%, you're screwed too. What's FooBank going to do? Will the ATM print out a message telling you to go up to Humboldt, and find Dwight?

Remember, back when we were considering Bobby's solvency, we established what you want to know as a lender: that the borrower (Bobby) will be able to fulfill all his promises, not just yours. There is no such thing as selective default. And there is absolutely no reason to assume that your fellow depositors won't all show up at the same time.

When you don't turn up and withdraw your demand deposit, you are effectively rolling over a loan to the bank. And from the bank's perspective, there is no difference between rolling over a loan and finding a new lender. So FooBank is staking its undefeated record in promise fulfillment, which might be impressive in a Bobby but is pretty much required in a bank, on paying back its old loans by finding new lenders. Um... where have I heard that before?

Our third answer is: yes. Because we've forgotten something, which is that FooBank is solvent. It may not have $1 billion in the vault. But it can raise $1 billion - quite easily, by selling its $1.1 billion worth of mortgages.

In a modern digital market, this can be accomplished on the spot. It is a simple matter of software. As customers line up at FooBank's ATM, red flags go up, mortgages are sold - presumably to FooBank's competitor, BarBank - and trucks full of cash from BarBank arrive. At the end of the day, FooBank has no deposits, and $150 million in assets. It returns these to its stockholders and closes down. Call it an immaculate bank run.

This is a worst-case scenario. It won't happen. And the fact that, in this worst-case scenario, everyone gets their money back, is what makes it not happen - because the motivation for a bank run is that, in a bank run, not everyone will get their money back. Problem solved.

Our fourth answer is: no. Because we've forgotten something else, which is that maturity transformation doesn't actually work. At least not in a physical, literal sense. You cannot actually teleport money from the future to the present. FooBank can't - and BarBank can't.

To understand the problem here, let's think a little bit about what makes FooBank's mortgages "worth" $1.1 billion. We tend to use words like "worth" and "value" as if they represented absolute, objective, physical characteristics. A kilogram of iron will always weigh a kilogram. But what makes a package of mortgages "worth" $1.1 billion? Merely the fact that if you put it on eBay, the high bid will be $1.1 billion.

This, obviously, depends on the bidders. Mortgages, like everything else, are priced by supply and demand. Even if we hold the demand for mortgages constant, pushing $1.1 billion of them onto the market in one day is likely to depress the market price. And why should the demand be constant? We certainly have no basis for this assumption. Let's poke a little harder on this one.

First, we need to think a little harder about interest rates. We are used to thinking of interest rates from the customer's perspective, in which they are a return on investment. From a banker's perspective, however, an interest rate is the price of future money in present money. For example, a 10% annual interest rate means that I can buy $110 of 2009 money for $100 in 2008 money. This is an exchange rate, just like the exchange rate between dollars and euros.

To know the correct price of a future payment - such as the payments on FooBank's mortgages - we need to know two variables: the probability of default, and the interest rate. Let's assume (this assumption is not valid in reality, as we'll see, but breaking it will only make the problem worse) that the bank run has no effect on the probability of default. Let's assume, also, that FooBank's mortgages are perfectly good and have a minimal default probability.

But the interest rate for our 30-year mortgages is set by supply and demand. Clearly, because we are in a maturity-transforming banking system, a considerable quantity of that demand comes from maturity transformers such as FooBank. And ultimately from its depositors. Ie: maturity transformation in the mortgage market, by magically transmuting demand for zero-term deposits (money right now) into demand for mortgages (money 30 years from now), has vastly lowered 30-year interest rates.

So when FooBank's depositors pull their money out, mortgages go on the market and mortgage interest rates go up. This increases 30-year interest rates across the market - lowering the price of mortgages. That $1.1 billion isn't $1.1 billion anymore.

Worse, we have arbitrarily assumed that the run does not extend to BarBank. In fact, we have assumed that BarBank, in some way, pulls in $1.1 billion of new deposits - because that cash in those trucks needs to come from somewhere. But, since our bank run is not the result of any problem restricted to FooBank (whose mortgages are good), it can only be a systemic run. That is, all depositors everywhere realize that the banks simply do not have the present money to repay them - and their so-called "solvency" is a result of long-term interest rates that do not reflect the actual supply and demand for 30-year money.

Thus, the entire banking system is certain to implode. And implode instantly. The result: a landscape of shattered banks, people who have lost their deposits, and very, very high (but perfectly market-determined) interest rates. Moreover, housing prices will decline - because they, too, are set by supply and demand, and high interest rates mean expensive mortgages.

Another way to think of this is to realize that the Diamond-Dybvig model (see the original paper, here) is not quite right - there is no "good equilibrium." The so-called equilibrium in which depositors leave their money in the bank is unstable. You can see this by observing that the probability of a bank run is never 0, and the value of a deposited dollar cannot exceed the value of a non-deposited dollar - ie, the exchange rate between a dollar in the bank and a dollar under the mattress cannot exceed 1:1. But since a bank run can occur, a dollar in the bank must be worth slightly less than a dollar under the mattress - to compensate for the probability of a bank run. Eg, if the probability of the run is 0.001, and the bank returns only 50 cents on the dollar after a run, the value of a dollar in the bank is 0.9995 dollars in cash. This disparity creates withdrawal pressure, which is a feedback loop, and the run happens.

If this hurts your head, just think of the maturity-transforming banking system - FooBank, BarBank, MooBank, and all their competitors - as a single bank. This system has, like Bobby, made promises that it cannot physically fulfill, because physically fulfilling them would require actual, physical time travel. There's simply no way this can be good accounting.

Essentially, what we're looking at is the collapse of a market-manipulation scheme. The banks have been collaboratively bidding up 30-year money by buying it with 0-year money that belongs to someone else. The situation would be no different if they were bidding up, say, copper, or Honus Wagner baseball cards. They have created an artificial pricing environment, based solely on the carelessness of their depositors in rolling over loans. Once the scheme is exposed, the price of Honus Wagner cards crashes, the banks have spent the depositors' money on goods whose price has considerably declined, and massive insolvency is revealed.

It helps to understand the use and misuse of the word liquidity in this environment. The proper and original meaning of liquidity is the existence of a market with instant trading and small bid-ask spreads, such as the stock market. For example, a house is not a liquid asset in this sense, because setting up a housing sale is very difficult and expensive.

But liquidity has come to mean something else: the presence of maturity-transformed demand for long-term assets. As we've seen, the price of 30-year money in a market where banks can balance 0-year liabilities with 30-year assets is one thing. The price of 30-year money in a market in which all the demand for 30-year mortgages comes from 30-year lenders (for example, a 30-year CD - an instrument which does not even exist at present) is very different.

Thus, when a maturity transformation scheme breaks down, the market is said to be illiquid. In fact it is perfectly liquid in the first, original sense of the word. It is just revealing the actual market price of 30-year money as set by 30-year supply and demand - an interest rate so horrifyingly high it makes any 30-year mortgage at 6% more or less worthless. (Actually, the "fire-sale" market for mortgages today is still well above this price - it is set more by speculation that the MT switch will flip back on, I think.) This phenomenon appears to resemble genuine liquidity, because assets are "hard to sell" - but they are hard to sell only because those who now hold them have them on their books well above the market price, and don't want to sell for less.

Professor Bernanke's recent mention of "hold-to-maturity" price reflects this intentional misunderstanding. Economist Willem Buiter clarifies:

    The MMLR [lender of last resort] supports market prices when either there is no market price or when there is a large gap between the actual market price of the asset, which is a fire-sale price resulting from a systemic lack of cash in the market, and the fair or fundamental value of the asset – the present discounted value of its future expected cash flows, discounted at the discount rate that would be used by a risk-neutral, non-liquidity-constrained economic agent (e.g. the government).

Ie: the long-term interest rate on Treasuries. Which is still set by maturity-transformed demand (especially, via the central banks of China and the Gulf states, which back their currencies with Treasuries).

Professor Buiter's definition of this rate as "fair" reflects the institutional assumption of the economics profession that MT is a good, clean, and healthy thing. In reality, it is concealing the most important price signal in the world: the present demand for future money. MT adds present demand for present money into this market, utterly and irrevocably jamming the signal.

The basic problem with the toxic assets that are clogging up the banking system today is that there is no market mechanism that can reveal Professor Buiter's "fair value." Any such mechanism needs to solve for two variables at once: it needs to create a market in toxic mortgages in which the players are banks paying with maturity-transformed money. Otherwise, the default risk of the loans cannot be calculated by comparing their price with the price of Treasuries. The risk-free interest rate in a market in which MT has broken down is much higher than the risk-free Treasury rate. This rate is unknowable. And you can calculate default risk from price only if you know it.

Moreover, banks have no incentive to buy these toxic mortgages, turning MT back on in the market - at least not until the price hits its rock-bottom point, at which MT is completely off and 30-year supply is met by 30-year demand. Nor is there any way to see when this point has been hit, because there is no genuine maturity-matched market, and there are plenty of speculators betting on some kind of intervention. And the implied interest rate at this rock bottom is so high that the houses which collateralize the mortgages may be almost worthless.

And our fifth - and final - answer is: yes. Because FooBank, BarBank, and MooBank are all FDIC-insured.

Actually, this is not even quite right. At least according to this story, FDIC is basically empty. It had only $45 billion last time it reported, and it surely has a lot less now. This to "insure" something like $4 trillion in deposits. You might as well defuse a car bomb by wrapping it in toilet paper. FDIC "works" because it is backed by the Treasury, which of course has the Fed's "technology, called a printing press" - ie, Ben's helicopters - behind it.

In other words, when you make a bank deposit, you have acquired not one but two securities. One is a promise from FooBank to pay you on demand. The other is a promise from USG to pay you if FooBank doesn't. Because the promise is denominated in dollars, USG can print dollars, and USG has no reason to welsh on this promise, the dollar on deposit is truly worth $1. Not $0.9997, $1.

Note that we have just discovered the missing dollars from last week's post - or some of them, anyway. These dollars are contingent - they only come into existence in special cases, such as a bank run - and they are informal. But as informal, contingent dollars, they exist nonetheless. If the Fed prints money to bail out FDIC, it is a bailout - just like Paulson's bailout, the Fannie and Freddie bailout, the AIG bailout, etc. There is no law requiring bailouts. But they seem to happen anyway.

For that matter, Treasury obligations are risk-free for exactly the same reason. This is how the US can run a $10 trillion risk-free debt in a world with only 825 billion actual dollars. It is simply assumed that well before Treasury would default, the "technology, called a printing press," would be used to bail it out. There is no formal guarantee of this. There is simply every incentive to do it, and no incentive not to do it.

This whole beast is an incredibly cumbersome and bizarre accounting structure. And it simply cannot be understood without reference to these kinds of informal obligations. In accounting, the word "informal" is essentially equivalent to "criminal." Simply put: the whole thing stinks.

Moreover, we can construct a formalized equivalent that has the same outcome, uses maturity-matched accounting, and is completely unacceptable from a political standpoint. In fact, it's more than unacceptable. It's ridiculous.

Consider FooBank, with its FDIC guarantee in place. The infinite printing press guarantees FooBank's liabilities to its depositors. This leaves FooBank free to use the depositors' money to buy 30-year mortgages, while assuring them that they can redeem at any time.

A much simpler approach is for FooBank to simply store the deposits in its vaults, and have FDIC make the mortgage loans - in a quantity equalling FooBank's deposits. This produces: exactly the same safety for FooBank's depositors; exactly the same demand for mortgages; and exactly the same risks for FDIC (which is, of course, exposed to the mortgage risk).

And it's also utterly ridiculous. Basically, it means that mortgages are cheap because Uncle Sam is printing money and lending it. When you want a mortgage, you apply to the government. Moreover, the connection to FooBank's deposits is utterly unnecessary. There is no reason that FDIC has to restrict its mortgage issuance to FooBank's deposit base, tying it to the irrelevant convenience question of whether depositors prefer their money in a vault or under the mattress.

What this thought-experiment tells you is that, if you believe in maturity transformation, you believe it's good public policy for the government to print money and lend it. Homeownership, after all, is important! President Bush says so, so it must be true. This raises the question of why, if it's good for Uncle Sam to engage in this practice, it's not good for everyone. Why not license private entities to engage in the essential public service of counterfeit lending? The counterfeit spender drives up prices and is bad for everyone, but the counterfeit lender creates a liability for every dollar emitted... anyway. We are in the realm of absurdity.

We are now in a position to understand the crisis as a whole. What happened is that a shadow banking system appeared, which performed maturity transformation without formal FDIC backing. Participants in this market assumed that large or "too-big-to-fail" institutions, such as Lehman, Bear, AIG, etc, were effectively recipients of an informal Federal guarantee, just like FDIC itself, the traditional banks, Fannie and Freddie, etc. But they had reached the edges of informality and walked off the cliff into delusion.

Furthermore, the financial models that players in the shadow-banking market used simply did not incorporate the possibility of a maturity-transformation crisis. They lived in a world of Lombard Street accounting, in which MT was just normal. The fact that MT only works with a lender of last resort who can print money (or, under the "classical gold standard," compel market participants to accept paper at par with gold, as the Bank of England did during the Napoleonic wars), did not exactly bring itself to their attention. Nor did the fact that they were treating private corporations as perfectly-insured counterparties.

Essentially, Wall Street (a) thought it was a free market, and (b) assumed that MT in a free market just works. Both of these assumptions were wrong. The financial system was both free and protected, but the part that was free was not protected, and the part that was protected was not free. And the border between the two was completely informal, and was set in an ad-hoc, after-the-fact way by panicked bureaucrats in Washington.

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#6) On February 22, 2010 at 10:18 AM, tdoodler (24.38) wrote:

Exvcellent Post!

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#7) On February 22, 2010 at 2:53 PM, binve (< 20) wrote:

Thanks tdoodler!

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#8) On February 22, 2010 at 3:23 PM, russiangambit (29.16) wrote:

> Good economics, just like good engineering, should be BORING!.

Exactly. And the same goes for any well designed system.This is what I keep repeating at work too - keep it simple. And it is not for my benefit, I can deal with complexity fine . But when you put a system to the test of thousands of users who don't exactly understand all ins and outs it is bound to brake if it is too complex to manage. The same with finance - so many complex products, where many users don't understand them and many others who understand simply ignore the issues because it is easier for them.

As for linearity, isn't it amazing that people seem to be hardwired to expect linarity  - the mean reversions, extrapolation of current to the future? We only started understanding non-linearity last 200 years and we made amazing progress everywhere ( 300-400 years for the brightest of us). Up unitl then everything was built pretty much on the idea of linearity and leverage ( and I mean physical leverage here).

I actually see money as energy. You can't get it from nothing, you have to do something productive to get it. But energy gets lost ( i.e. wasted)  due to resistance ( non productive activities). In the universe the amount of energy is vast but limited and it keeps diminishing until one day it ends. With money we got central banks that take the role of gods on themselves and think they can efficiently manage (a dn produce and destroy) the amount of energy and availability of it in our monetary universe.  And then we get surprised that the system keeps going hot and cold and we can't seem to keep it in balance and it is about to blow up? First thing we should try is to stop playing gods. Playing gods tends to end badly according to the collective human memory relayed to us in various myths.

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#9) On February 22, 2010 at 3:39 PM, binve (< 20) wrote:

russiangambit,

Thanks for the comment!

The same with finance - so many complex products, where many users don't understand them and many others who understand simply ignore the issues because it is easier for them.

That's right. And even the financial industry did not know who to price these instruments when the leverage and liquidity evironment changed. Then when it because obvious what they were worth ($0.25 on the Dollar), then they lobbied congress to change the accounting rules so they could be left on the books unimpared. Que Bella!! And so while everybody is turning a blind eye to this festering abcess, derviative continue to grow (Hey, if we don't have to write down the actual values, lets chase some more yield!!). And so while more money chases more yield and gets further locked into more toxic crap, the stage is being set for another liquidity crisis that will make 2008 look like a cakewalk.

As for linearity, isn't it amazing that people seem to be hardwired to expect linarity  - the mean reversions, extrapolation of current to the future? We only started understanding non-linearity last 200 years and we made amazing progress everywhere ( 300-400 years for the brightest of us). Up unitl then everything was built pretty much on the idea of linearity and leverage ( and I mean physical leverage here).

Exactly. People not only expect linear extrapolations but are completely unware of cyclical behavior beyond a few months or a year. We have lots of history on very long cycles that people hand wave away all the time.

I actually see money as energy.

I completely agree!!! In fact, that I how I approach TA also. Tastylunch and I were having a great conversation about this a few months ago. This post Why Arithmetic Stock Charts Are Worthless - http://caps.fool.com/Blogs/ViewPost.aspx?bpid=290893, comments #12-#15. I think you might be interested in it.

With money we got central banks that take the role of gods on themselves and think they can efficiently manage (a dn produce and destroy) the amount of energy and availability of it in our monetary universe.

Exactly.

Thanks for the great comments!!..

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#10) On March 08, 2010 at 7:38 AM, dwot (42.85) wrote:

Interesting comments on linearity.  That is something that I have noticed, over a small segment something appears to be linear and for very short term purposes it is ok to do a linear extrapolation, but if you look at this stuff longer term more often it is a curve.

There was an interesting article that I read 3-4 years ago that show the range of how far out estimates got over time and it was like two exponential curves reflected over the axis of estimate.

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