Insolvency versus Illiquidity

Emmanuel Derman has an interesting post about how we got into the present mess. His argument is essentially that the bubble created a class of assets that were way overvalued and holders are insolvent, and that this spilled over into other asset classes that people could not judge the quality of. So you have insolvency in some classes inducing panic that causes illiquidity in other classes.

As everyone fled the insolvent and illiquid securities they lost confidence in the economic future and stock prices fell, and people felt poorer and spent less and companies projected less future profits and fired people who then spent less money and so they drove other companies that depended on them to do badly and so on and so on.

The administration is trying to cure insolvency and illiquidity with stimulus, but stimulus is mostly a cure for illiquidity. They are using a medicine for living people to revive the dead. The best thing would be to ring fence and restructure only the insolvencies and to stimulate the illiquidities. The desperate effort to treat insolvency with stimulus and the Chicken-Little warnings about the consequences of not doing so detracts from the confidence necessary to restore liquidity.

I find this argument very insightful. But there is another point to remember. That is the change in leverage. As we go from 30-1 leverage to 2-1 leverage assets that were not toxic now seem to be. Risk aversion leads to this loss of leverage and to the flight from these assets. So there is a point to the argument that some of these assets may become viable if confidence is restored. Derman's point, however, is that this will not be possible if we don't bury the dead. That is an important point to remember.

Problems with the TALF

The Administrations program to increase lending to consumers, TALF, the Term Asset-Backed Loan Facility, is having trouble getting started, the Washington Post reports.

Officials envisioned TALF supporting tens of billions of dollars a month in new lending, saying it could eventually total $1 trillion. But in March, when it was launched, it backed only $4.7 billion in auto loans and credit cards. For April, it logged only $1.7 billion.

One big problem is the fear of government restrictions on investors in the program. Not just current restrictions built into the law, but future changes that might appear at the behest of Congress:

There are restrictions on the business activities of participants in the program. For example, investors who control more than 25 percent of a fund that benefits from the loans face restrictions on their ability to hire immigrants using H-1B visas.

But perhaps more significant than any established limitation on the business practices of TALF participants is a fear that the government could retroactively change the terms, exacting new limits on what investors can pay their executives, for example, or trying to claw back profits that firms make in the program. The recent outcry over bonuses paid to executives at American International Group has heightened those fears.

This points to the problem of implementing potentially sensible policies when Congress may be involved. The limitation on H-1B visas is idiotic. The potential for further harm is great. This is especially so, given the comments of the Chair of the Congressional Oversight Panel of the TARP, Elizabeth Warren. Given her pronouncements I would be paranoid about participating in any government sponsored program.

An important point is that policies that are theoretically beneficial can be horribly implemented when Congress gets involved. This is a source of big government failure than can offset any market failure.

Economists' Grand Project

John Kay has an interesting column about the grand project of supplying microfoundations for macroeconomics. I think the last part is worth quoting:

Max Planck, the physicist, said he had eschewed economics because it was too difficult. Planck, Keynes observed, could have mastered the corpus of mathematical economics in a few days – it might now have taken him a few weeks. Keynes went on to explain that economic understanding required an amalgam of logic and intuition and a wide knowledge of facts, most of which are not precise: “a requirement overwhelmingly difficult for those whose gift mainly consists in the power to imagine and pursue to their furthest points the implications and prior conditions of comparatively simple facts which are known with a high degree of precision”. On this, as on much else, Keynes was right.

His point is that the effort to reduce every argument to a single model causes us to ignore behavior that is crucial to the stuff we want to explain.

Russian Court Shopping

The New York Times today reports on the dispute between Telenor, a Norwegian cell phone provider and Alfa Group, the powerful Russian investment group. They are partners in the cell phone provider VimpelCom. The dispute arises, apparently, from a dispute over strategy:

The Siberian litigation blossomed from a simple dispute between Telenor and the Alfa Group, a Russian financial investment company, over plans to expand a jointly owned business, the VimpelCom cellphone company, into Ukraine. The companies are also in court in Manhattan, Geneva and Ukraine.

That a dispute over whether to invest in a Ukrainian provider ends up in an Omsk court is interesting enough. What is more interesting is that the suit was brought by an unknown tiny investor in the British Virgin Islands that owns .002 of the shares in VimpelCom. And that a dispute over a bacon producer may have entered into the final court decision.

This is certainly a case where expert use of the courts may lead to western shareholder expropriation, not new in Russia. The interesting question is whether it will lead to a strike of foreign investors regarding Russia. Is it another Lena Goldfields (see previous post)? My guess is that the impact will be minimal, especially regarding potential investments in oil and gas. But we shall see.

Back to the Blog

One intense month is over and I am back to the blog. Many events to catch up on. We had three great conferences. At the Brookings Institution we had a conference on "After the Reset: U.S.-Russian Leadership for Global Financial and Energy Security." Then we had our second annual conference on auction at PSU. And then in partnership with the Volatility Institute at NYU and Nobel Laureate Rob Engle, we had a conference on "Volatility in Distressed Markets."

It was an exciting month, but now it is time to get back to work.