Friday, October 03, 2008

Yves and Megan - A class act!

Yves Smith and Megan McArdle - two of the most important voices in the current day finance and economics come together over a wide-ranging chat. Yves talks about wide array of things I like including Mandelbrot and Peter Lynch. Fantastic interview – must watch all 67 minutes of it!

Here are a few comments I have based on the interview.

Size of the financial system is huge and you have to shrink to manageable size before you can rescue it.
Yves and Megan mention that the government would have to buy an asset valued on the books at 70cents at 75 cents to capitalise the system. Now we have a system where company accountants set the floor and government tries to fund accordingly. 

I think it would be better if instead of capitalising the system, government set itself up as buyer of last resort. Lets say if government sets a price at which it will buy those assets at 30cents. Thus government would set the floor and then investors can compete for price discovery.

The central point here is what is the amount government should value it at. In the case of housing at least it might be a little easier. Average (median) house prices should be around 20-30% lower than average (median) incomes. That can be set as the bottom in case of housing.

Of course this is way to simplified.

Embedded leverage – defaults increase from 3% to 6% impacts capital adequacy disproportionately.
What happens if this happens to higher rated tranch – i.e. AAAs? In such a scenario, the entire basket (all tranches AA, BBB etc) get impacted. Going forward this is what is likely to happen. I think this is much more likely and dangerous!

Falling dominoes – system that’s far more interlinked for its own good
There are few metaphors on stopping the falling dominos. The first is what is called the scorched earth policy. Here you create controlled destruction to offset the oncoming destruction. So to stop forest fires controlled fires are used. Second is containing the damage. This is how they stop flooding of submarines in case of water breach.

Yves invokes references from Mandelbrot - that was fabulous I thought. It leads us to solutions for self propagating replicating and cascading systems. These systems must have identified points for intervention. Yves refers to these points and need to create such points. 

The dominoes set-up for world records usually use such points. In case the dominoes accidently fall. Using these points you can isolate the rest of the system by decoupling at those points.

Yves recommends regulatory constraints on who can trade what with whom. That is one way. Other way is to continuously test the system - like hackers test the IT system security of enterprises. Thats because no matter what regulations you can set - there will be ways to break it.

10-year reduction in mortgage defaults – why you cannot trust it?
This is one exceptional point raised in the question. If 10 years data tells you that mortgage defaults are reducing will you believe it? It depends! In fact Taleb actually warns of exactly this. 

Aesop has a fable wherein the Ogre keeps its life in a little bird and thus becomes powerful. The hero has to attack the bird or in this case the underlying asset. If house prices exceed the median incomes and stray way out of line then you know that the last 10 year data is misleading you.

Finally -Yves Smith the dictator – Manhattan Project

Now this is one part that I would really love to hear more of. that section was too brief. I think we need to prod Yves into a plan for the Manhattan project. Very amazing Yves and Megan.