Black Swan Free World (7)

On April 7 2009, the Financial Times published an article written by Nassim Taleb called Ten Principles for a Black Swan Free World. Let’s look at them one at a time…

7. Only Ponzi schemes should depend on confidence. Governments should never need to “restore confidence”. Cascading rumours are a product of complex systems. Governments cannot stop the rumours. Simply, we need to be in a position to shrug off rumours, be robust in the face of them.

Hyman Minsky’s Financial Instability Hypothesis talks about the financial markets working in three regimes, Hedge, Speculative and Ponzi.   Under Hedge financing, investments generally have sufficient cashflow to pay both principle and interest.  Under Speculative financing, investments generally have cashflows sufficient to pay interest, but depend upon rolling over financing to continue.  Ponzi financing does not have sufficient cashflows to pay either interest or principle.  Ponzi financing requires that values will increase enough to pay both principle and interest to repay financing.

Speculative financing requires a belief that the value of the collateral will be stable to justify future refinancing or rolling over of the financing.  That belief could be called confidence.

Ponzi financing requires a belief that the value of collateral will grow faster than the interest rate charged.  That belief requires a significantly higher amount of confidence.

There are several other levels that a financial business could operate.  For example, the value of the collateral could be viewed in terms, not of its current value, but of its value in an adverse scenario.  A very conservative lender could then make sure that each investment used that adverse value as the actual amount of collateral granted.  In that situation, the investor does not want to rely upon the belief that the asset value will be stable.  A significantly more aggressive investor will want to make sure that their portfolio in total adjusts the value of collateral for the possible loss in an adverse situation, allowing for the effects of diversification in the portfolio.

Credit practices in the US have drifted against the path of having the borrower put up cash for that difference between adverse value and current value.  Instead, practice has changed so that the lender will hold capital against that adverse scenario and charge the borrowed the cost of holding that capital.

What has changed with that drift, is who will bare the losses in the adverse scenario.  That has shifted from the borrower to the lender.  So the loan transaction has changed from a simple credit transaction to a combined credit and asset value insurance transaction.  (Which makes me wonder if the geniuses who thought of this thought to charge appropriately for the insurance or if they just believed that if the market bought it when they securitized it, then the price must be right.)

This will look different from the former loan business where the borrowed bore the asset value risk because the lender will have fluctuations in their balance sheet when the adverse scenarios hit and the collateral value falls below the loan value.  And that is exactly what we are seeing right now.

In addition, as we are seeing now, when there is a extremely severe drop in the value of collateral, having the banks hold the risk of the decline in collateral value, then a drop in the collateral will have a significant impact on bank capital.  The impact on bank capital may have a major impact on the bank’s ability to lend which will impact on all of the rest of the economy that had no connection to the impaired asset class.

So to Taleb’s point about confidence,  it seems that he is stating that lending practices should revert to their prior level where collateral was valued under an adverse scenario.  Then there will be little if any confidence involved in the lending business.  And less chance that a steep drop in any one asset class will spill over to the rest of the economy.

So the dividing line would be that the financial firms that could be subject to future government bailouts would need to value collateral pessimistically and to avoid loans that are not fully collateralized.

Sounds SAFE.

But here is the problem with that proposal…

If any other firms, outside of that restriction are permitted to lend in the same markets, business will ultimately shift to those institutions.  They will be able to offer better loan terms and larger loans for the same collateral AND in most years, they will show much higher profits.

Bad risk management will drive out good.  The institutions that take the most optimistic view of risk, those who have the most confidence, will drive the firms with the more pessimistic view (whether that is their own view or the view imposed by the regulators) out of the market.

And then when the next crisis hits, regulators will find that the business has shifted to the non-regulated firms and they they will instead need to bail them out, unless they make it illegal for non-regulated firms to do any of the kinds of finance that is related to a government’s need to bailout.

Then the bank would almost always have real collateral and any drop in confidence could be resolved by assigning that collateral over to someone with cash and settling any needs for cash that the lack of confidence creates.

Taleb is not clear however whether he is referring to banks or the financial system in general or to the government with his statement.  The discussion above is about banks.

Trying to think about this idea in the context of the entire financial system, I wonder if he was suggesting a return to the gold standard.  When there was a gold standard, there was no need for confidence in the currency.  If you stay with the current currency regime, then the confidence idea, I suppose, relates to the question of inflating the currency.  If the government does seem to consistently hold the money supply at a reasonable level in proportion to the economy, then there will not be a problem.  However, I cannot think of any way of looking at the floating currency system that does not REQUIRE confidence that the government will hold inflation in check.

Applying the idea to the government, I would also say that confidence is required there as well.  A government that could be counted on to fund fully for spending programs would instill confidence, but there could be no surity, especially under the US system where the next congress could immediately trample on the good record of a all preceding governments.

Black Swan Free World (10)

Black Swan Free World (9)

Black Swan Free World (8)

Black Swan Free World (7)

Black Swan Free World (6)

Black Swan Free World (5)

Black Swan Free World (4)

Black Swan Free World (3)

Black Swan Free World (2)

Black Swan Free World (1)

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