December 05, 2010

A New Framework For Finance

The problem in finance that lead to the 2008 collapse is intellectual, not criminal. Wall Streeters genuinely believe in their sophisticated mathematical models. They have not been trying to lie, cheat, or steal. They believe that their work generates higher efficiency, better liquidity, and huge benefits for society. Many on Wall Street are still fundamentally puzzled by the events that lead up to the Lehman collapse.

Obviously Wall Street is missing something.

The crisis... has served to discredit mainstream finance theory, and especially its key idea, that capital markets are efficient. The idea that prices are always right and that capital markets exert their own self-discipline—the so called efficient market hypothesis—has received a deadly challenge.

So the real question is an engineering question: if we cannot build a stable financial system on MPT and the EMH, then what principle are we missing? How does one build a financial system that can stand up under its own weight?

The boxed quote above is from banker-turned-LSE-economist Paul Woolley. Woolley has proposed that classical financial models are missing one basic, but fundamental detail. By adding this detail back in, he offers up a more modern analytical framework for finance that might just be the salvation of the world economy.

Bankers are People Too

Wolley noticed that booms and busts like Lehman 2008 can be understood by modeling the fact that investors do not invest directly, but through investment managers that collect their own fees.

He suggests that the basic reason for many market failures is information asymmetry: investment managers using innovative techniques have far better information than the principal investors. Bankers rationally exploit this asymmetry to extract high rents while shirking as much responsibility as the market will withstand. Escalating rents eventually lead to ballooning use of opaque management, fragile pricing, and market collapse. By turning the camera of economic modeling inward onto the banking industry itself, Woolley outlines a model explaining the mechanisms leading to astronomical risk-taking in periods of financial innovation.

This chapter advances an alternative paradigm that seems to do a better job of explaining reality. Its key departure from mainstream theory is to incorporate delegation by principals to agents. The principals in this case are the end investors and customers who subcontract financial tasks to agents such as banks, fund managers, brokers, and other specialists. Delegation creates an incentive problem insofar as the agents have more and better information than their principals and because the interest of the two are rarely aligned.... Introducing agents both transforms the analysis and helps explain many aspects of mispricing and other distortions that have relied until now upon behavioral assumptions of psychological bias.

The above is from Woolley's chapter in "The Future of Finance: the LSE Report", which is available to read here. He proposes a number of policy fixes based on this analysis (mainly centered around changing incentive systems for bankers).

Better than Throwing Stones

A recent piece in the New Yorker discusses Woolley's work and asks "What Good is Wall Street?" The article attributes several colorful quotes to Woolley:

“Why on earth should finance be the biggest and most highly paid industry when it’s just a utility, like sewage or gas?” Woolley said to me when I met with him in London. “It is like a cancer that is growing to infinite size, until it takes over the entire body.”
“There was a presumption that financial innovation is socially valuable,” Woolley said to me. “The first thing I discovered was that it wasn’t backed by any empirical evidence. There’s almost none.”

But Woolley has done something better than just throw stones at the banking industry. By advocating that we must model bankers as independent agents with different information and motivation than principal investors, he has proposed a new quantitative framework for finance, and a possible new way forward.

Posted by David at December 5, 2010 08:48 AM

How do we know to what degree government itself is the cause of the problem?

Posted by: Peter H at December 6, 2010 02:29 PM

Now Pete, let’s be fair. There is enough blame for everybody in this. Dave’s right, the mathematicians were wrong. And they were wrong on two specific points, one that leads to the other.

The two flaws were the assumption real estate prices are only affected by supply and demand. With a fixed supply of real estate, and a growing demand of population, the prices would always go up. Second was the assumption “correlation” was fixed.

What is correlation? Think of it like an insurance company insuring homes. Imagine the home down the street catches fire, and is totally destroyed. What is the chance your home will suffer the same fate? Assuming standard rates of low correlation, there is a low chance that your home will be burned as well. But instead, let’s say you lived in Florida, and the house down the street is destroyed by a hurricane. Now what is the chance your home will suffer the same fate. Nearly certain. That’s high correlation.

In the mortgage industry, the models assumed that the stable default rate, with it’s accompanying low correlation rate would be sustained. After all, if the family down the street defaulted on their loan, that didn’t mean you would too.
What they didn’t consider was what if three people on your street defaulted. And then the bank has three homes to unload. Now the theoretically fixed supply of real estate just went UP! And your home value just went down.

In fact your home value went down so much, it is now worth less than your mortgage. Here’s where everything goes awry.

See, we all have an “implicit put” on our mortgages. Meaning we can “put” or give our bad investments to someone else, releasing us from responsibility for any mortgage cost in excess of our home’s value. Back to the example above, let’s say you bought a standard King County home in the summer of 2007 for about $300,000. You put 3% down, paid some points, and moved in to it with a $291,000 loan at 6%, and start living the American Dream. By the end of 2010, your home has dropped in value by about a third, and now can only be sold for $200,000, but your mortgage is still above $280,000. And you are paying 2% more than current loans.

What’s a wise home owner to do? WALK!!!

“Put” the house back to the bank, fully satisfying the loan. Take out a new, smaller loan, and move into a new house. But now your neighbor follows your lead, and the market gets flooded. Legally, the borrower knew that if things went bad, he could “put” all his losses back to the lender.

But the lender doesn’t care either, know why? The mortgage has already been sold to (wait for it) Fannie Mae or Freddie Mac. The lender didn’t even care if you were EVER going to repay the loan, because they knew one of these Government Sponsored Entities (GSE) would buy the loan, and would never be exposed to risk. Guess who else doesn’t care if you default? The investors in GSEs care don’t, because their investment risk is implicitly put to the federal government who guarantee Fannie and Freddie’s solvency. And the government doesn’t care either, because they can always just raise taxes, or get a loan (and raise taxes later), or print more money (and implicitly tax us by lowering the value of the tax payer’s savings).

In the end, the system of “implicit puts” has removed the negative incentives from everyone involved in the transaction, effectively guaranteeing the outcome we got.

Posted by: Roger at December 11, 2010 04:34 PM
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