There are two basic investment risk models, one based on projected cash flows over a long period of time, discounted at a variety of future interest rate scenarios, and one based on short term correlations of expected market values.  I call the first model the actuarial model, and the second the financial model (pejoratively, the Wall Street model).

Under ordinary conditions, the financial model looks better.  It asks, “Can we make money in the short run versus our capital costs?” The  actuarial model asks, “Can we assure that we will be solvent under a wide number of economic scenarios over the long run, some of which might be quite severe?”

During boom conditions, the financial model wins, while those following an actuarial model are branded fuddy-duddies.  During bust conditions, those following an actuarial model survive, while many following the financial model don’t.

There were many on Wall Street that claimed to be following a WOW “Worst Of the Worst” model.  I remember interviewing the chief risk officer of one of those firms in 2005 — Bear Stearns.  Talked a really good game.  To be fair, so did the risk manager of Goldman Sachs that year.  I assume most of the risk managers of Wall Street had their WOW models — after the crisis with LTCM, they had to look at the correlations on risk assets going to one in a crisis.

My guess is the WOW models were largely ignored, and the more common VAR models followed.  Perhaps Goldman And Morgan Stanley gave more weight to the worst outcomes, but hindsight is 20/20.  They might have survived in spite of themselves.

My point: you’ve got to survive in order to win.  Models that emphasize current profits at the expense of survivability get whacked during large busts.  Even if they survive, the hole that they must crawl out of is deep.

The economy is highly variable, and the financial economy as a derivative of it is even more so.  Companies that think long-term with respect to risk management tend to survive crises; they have limited their risks, and left returns on the table during the boom times.

Survival is a major part of the game.  Look at previously successful financial companies.  It doesn’t matter how well you did in the past if you are down 90, 95, 99% over the last two years.

As such, for those that invest in financial companies, evaluate their survivability.  How likely is it that they will get hit badly?  Are they overleveraged?  Do they need additional financing?

Actuarial models focus on the long run, and analyze survivability.  Why aren’t they used more frequently?  The actuarial models indicate a greater need for capital than VAR models.  More capital left in reserve means a lower return on equity, and a lower stock price in the short run.

High quality management teams for financials place more value on their long-run (actuarial) risk models.  They want to make money over the long term, if they can.  Those that focus on VAR will do better in the short run, until the next big bear market hits.  For value investors, stick with the quality players relying on long-term risk models.  Momentum players are free to play with the VAR users, but keep your stop orders ready.

When someone proposes a strategy for dealing with the economic crisis, he undertakes a hard issue.  There are many conflicting priorities:

  • Don’t harm the taxpayer much.
  • Arrest the decline in asset values.
  • Protect the solvent banks.
  • Increase the flow of credit to the rest of the economy.
  • Prevent the contagion in credit uncertainty from spreading.
  • Facilitate price discovery on illiquid assets.
  • And more, depending upon the most recent disaster.

The recent talk in Washington is over guarantees, Bad Banks, and more.  I’m a skeptic on all of these, because you can’t get something for nothing.  Now, it is not as if I haven’t made my own series of proposals:

But others have proposals as well:

I’m going to modify my Aggbank piece, because it represents my best thoughts on what could be done to minimize the uncertainty to all parties involved, leading to a simpler, more transparent bailout.

Aggbank should solicit offers of assets, with prices.  It should then publish that it will buy so much of assets that have been offered, so if anyone is willing to sell it cheaper, submit their offers.

The winning offers hand over the assets and receive cash in return.  They also issue equity to Aggbank the difference between par and the price paid, in exchange for an equivalent equity stake in Aggbank. The Aggbank equity stake is reducible/increasible if the eventual value of the asset sold proves less or more than the price it was sold for. [Changes in Bold]

The main idea here is that the auctions should produce reasonably fair results, leading to price discovery.  (Banks learn what their assets are worth.)  The secondary idea is that any subsidy to banks should be limited.  If an asset purchase price is high, they lend more money to the government, and give less stock, in exchange shares in Aggbank.  Vice-versa if the purchase price is low.

Now, Aggbank shares are a high quality asset, given that it is a “full faith and credit” institution of the US Government.  Capital charges on it would be low, as they are for FHLB common stock.  The difference here is that the amount of Aggbank stock eventually received depends on the value of the assets purchased, when they are sold.  Positive variances add to the number of shares, and negative variance decrease the number of shares, pro-rata.

The beauty of this idea is that the government does not have to be worried about whether the auctions are working perfectly right or not.  The second step after the auctions trues things up, as Aggbank stakes are increased or reduced.  Third, this allows banks taking losses to issue equity to the government, which will help them recover.

A proposal like this would give the banks time to heal, and would limit losses to the taxpayers.  The eventual payout form the liquidation of Aggbank would approximately give each bank back its pro-rata portion of value contributed.  It would give banks time, while facilitating price discovery in obscure structured lending markets.

Depressions, and severe recessions, attract protectionism.  It’s the nature of the beast.  So long as political pressures are “to do whatever it takes to create prosperity” at home in the short-run, governments will target spending to domestic firms (an increasingly squishy concept in a global world).  What politician would defend to local constituents a bailout package where foreign firms directly benefit from the expenditure of domestic tax dollars?

Though I did not vote for him, I appreciate the principled approach that President Obama is taking here.  He is taking a longer view, and wants to avoid trade wars.  Few politicians take the longer view; that is why they not statesmen.

By their nature, economic crises make people short-termers.  They look to what will help themselves survive amid volatility.  The long-term good of many would involve patience, and a willingness to not press for short-term advantage.  Perhaps Kings could do that, though often they didn’t, but democratic officials are on a short leash from their electorates.

Even Authoritarian places like China tend toward protectionism, though.  Their legitimacy is based on their ability to deliver continued prosperity.  There is increasing unrest in China during this slowdown; expect the Chinese government to do what it can to appease its populace, including measures that protect local businesses.

That’s why I am not surprised at protectionist impulses at this time.  They are short-term rational for politicians, while long-term irrational for economies.  This is just another reason why we are foolish to trust in politicians to assure our economic well-being.  Their short-term orientation is out of sync with what it takes to manage an economy.

We will be best off if after this crisis we realize that the government played a starring role in creating it, and mismanaging it.  Were there businessmen to blame?  Yes, but they took their cues from financial regulators that stopped regulating, and an accomodative monetary policy.  The government did not do its job right, assuring the value of currency/credit.


Additional Notes:

1) Now Barney Frank wants to hand over oversight of systemic Risk to the Federal Reserve.  As if they can do their current job well — the Peter Principle is in action here.  I was joking about it last year, but why not create the Federal Office for Oversight of Leverage [FOOL]?  After all, the tasks of monetary policy are considerably different from those of containing systemic risk, even though they are related.

2) Speed really benefitted us during the original passage of the TARP, right?  No, it didn’t.  So where does Timothy Geithner get off urging speed at this point?  Speed does not eliminate bad debts.  Speed does allow for many venal legislators to push their own pet projects, and use a crisis to disguise their efforts.

3) Read Yves Smith’s piece:The Bad Bank Assets Proposal: Even Worse Than You Imagined.  Our government resists letting banks fail, and then letting the FDIC/RTC2 reconcile them.  They would rather intervene to let marginal or defunct entities live.

There are two groups of nations in the world.  There are those with bad banking systems and too much financial leverage, and there are those with too much industrial/commodity capacity.  These two groups, which comprise most of the world economy, are symbiotic.  The nations that developed their industrial/commodity capacity did not want to import goods from their clients; they were forcing savings on their nations.

So they accepted assets, mainly bonds, of the nations that bought from them.  This stimulated the borrowing economies as interest rates fell, and there was a speculative boom.  Financial companies expanded, making loans they should not make.  Investors pushed up the prices of energy, basic materials, industrial and financial stocks.

It was a thing of beauty.  It was a house of cards.  We can view it as a buildup of operating leverage in one group of exporting nations, and a buildup of financial leverage in the importing nations.

Now, on the other side of the bubble, we have collapsing financial leverage among the importers, leading to a fall in demand for the exporters.  Thus the crisis is global.

For an analogy, think of the tech bubble.  Some companies financed other companies that bought their gear.  They continued to do so, booking sales, while not receiving any real cash.  Then when the companies buying the gear could not pay, both buyers and sellers suffered, and stock values plummeted.

These lists are stylized, but reflect my view of the world:


  • United States
  • United Kingdom
  • Eurozone


  • China
  • India
  • OPEC
  • Brazil
  • Russia
  • Canada
  • Australia
  • Japan
  • Other Asian Tigers

Really, it would be better to break the world down by industry, but there is enough correlation within nations that this characterization works, with a little hand-waving.

This is what makes this depression so tough.  The importers have to eliminate bad debts, while the exporters have to eliminate excess productive capacity.  As with Japan in the late 80s, they overinvested in things that the world would not need in the 90s.  So it is now, and every policy choice is painful.  Making the situation worse is that the crisis is global, but it is the payoff for the exporter nations behaving as neo-mercanilists.  Remember, the mercanilists, the exporters, were the ones that lost originally.