One of the things the current crisis highlights is the way in which monopolies die: with a bang, not a whimper.
The core of the issue that the troika of Bernacke, Paulson, and Cox are struggling with is that Fannie and Freddie were monopolies (OK, they were technically a duopoly, but any business executive or game theorist worth their salt know how to participate in a duopoly to extract monopoly rents.) AIG, in some markets like credit-default swaps, was also a dominant player. Their monopolistic behavior drove other competitors out of the market, behavior that was aided and abetted by their political stroke.
There are two fundamental forces at work as financial services firms such as Fannie, Freddie, and AIG (and Enron before them) grow. The first is related to the benefits of pooling risk. Any given security or insurance policy has a risk profile that can be approximated by a statistical distribution. As the number of securities grow, assuming that these risks are somewhat uncorrelated, the per-security risk of the pool shrinks (the total risk of the pool may still grow, but at a much lower rate than the face value of the security). This is the most important economy of scale for a financial firm.
The other force at work is that as any organization grows, it becomes more governed by perception than by reality. The height of the organizational pyramid grows, and the person at the top gets further and further away from the “facts on the ground.” The CEO eventually ends up in a “virtual” world, one in which lower level employees (and in the case of mortgages, originators) feed information up the organization in a manner that becomes more and more abstracted and manipulated at each layer. At the top, you get very aggregated information (revenue growth, default rates, etc.) that can, for a long time, remain disconnected from reality. Because of this distance, CEOs rely on trust and loyalty more than facts and evidence, since even the “facts” they receive are communicated through intermediaries (mid-level executives) that they must trust.
This simple fact of organizational life means that CEOs manage in a world of perception that can become radically disconnected from the facts. They spend a lot of their working hours managing perceptions and cultivating relationships, and this effort places a special premium on subordinate loyalty, who in turn learn that they boss can’t handle the truth. So, the CEOs make really lousy decisions (or non-decisions) that hurt the firm in the long run, but make them look great (and pay them well) in the short run. This is a major diseconomy of scale.
In the normal give-and-take of a competitive market, individual firms pay a steep price for letting perception and reality get out of whack – their competitors (often smaller and more nimble) take market share and eventually force a reckoning with the facts. But when the firm is a monopoly, this check on their behavior is gone, and the disconnect can grow greater and greater until there is a major correction such as we are witnessing today.
In the case of financial services firms, this situation is compounded by the fact that there is so little underlying equity in the firm. It has been reported that Morgan Stanley only had $3 of equity for every $100 of assets. So when a major disconnect is exposed between the perceived value of their assets (e.g. subprime mortgages) and their true value, there is not enough surplus capacity (i.e. equity) to absorb the correction. This means they either raise a bunch more equity, or they are out of business. In other words, they are bankrupt.
Now, in addressing this situation, so far the troika has acted fairly prudently. Their stepping into Fannie and Freddie simply affirms their government-approved monopoly status, and makes them accountable to their guarantor. Ideally, this takeover will lead to a gradual dismantling of these giants, and the restoration of true competition. The “bail-out” of AIG is, in fact, not a bail-out but instead an alternative form of liquidation, in which the Fed or the US Treasury or both will act as “debtor-in-possession” lenders while the profitable portions of their business are auctioned off. This may, in fact, be a more orderly way to liquidate than bankruptcy for a firm of this size and scope. Judgment call, but a reasonable one.
The Fed actions to inject huge amounts of liquidity into the market are also probably make sense. In a situation where assets move in very large amounts, insufficient liquidity can destroy the entire system. This is, in fact, what happened in the Great Depression, where the Fed tightened liquidity so much that we entered a deflationary spiral that killed the “real” economy. To be sure, adding this much liquidity will cause big inflationary pressures, but those are longer term challenges that are dwarfed by the risk of deflation.
Where the troika probably goes too far is in now setting up a “Resolution Trust Corporation” style buyer-of-last-resort for distressed assets. The expense and moral hazard of such a plan is almost certainly more greater than the benefits of letting a thousand flowers wilt. It also takes a market that can function reasonably well (so long as there is sufficient liquidity, which they have certainly provided) and convert it into a monopoly.
Now, the devil is in the details, to which we do not have access. It is certainly possible that the problem is so big that we have no other choice. But I think it is right to be skeptical and ask intelligent questions about what, exactly, is going to happen.
Finally, what is most remarkable about this entire situation is that it is basically a panic by institutional investors – the professional money managers. Individual bank deposits have hardly budged, largely because most of them are insured. (I had breakfast yesterday with the CEO of a large regional bank, and he said that his deposits have actually been growing at a healthy clip. Interesting.) This “panic of the pros” is part of the reason the press is going nuts, and the press drives the politicians to “Do something, dammit!”
Given that the money managers have largely built their businesses by giving people the impression that they are smarter than the market, what we are dealing with then is a complete meltdown of the “perception class” – investment pros, press, politicians – that has driven perception down so far that it is well below reality. That is what panic means: the world of perception << the world of reality.
However, eventually, these two worlds will realign. This can either happen by the recovery of their nerve or the deterioration of the real economy.
I pray that it is the former.
L3
