The Weekly Report
Welcome to the Weekly Report. This week we use the words of Ben Shalom Bernanke to describe why the $700Billion bailout will fail. I am going to assume the Bailout is enacted in one form or another and is probably announced around the Far East market opening times. However, there is a possibility that if Congress has not agreed then no soothing words will be forthcoming and a crash in share prices is used to "galvanise" action. We shall see.
What does Ben see as the biggest problem in the markets, be it shares, assets, commodities, bonds or derivatives?
Where better to find out than by examining his paper "Long term commitments, dynamic optimization and the business cycle" submitted in May 1979 as part of his Doctor of Philosophy degree at MIT.
Ben divided the work into 3 short essays, each a"theoretical study of some form of long term commitment made by economic agents". As Ben is an academic he has belief in his own pre-dispositions, his work stands as an interpretation of what he thinks happens in the world, in this case the world of investment. This week I want to concentrate on his analysis in Chapter 1, the problem of making "irreversible investment decisions when there is uncertainty about the true parameters of the stochastic economy" entitled "On the timing of irreversible investments"
I think it is most apt considering where we are in financial history. I shall quote his work as we go along.
Basically Ben is stating that the timing of an irreversible investment is based on incomplete information and as the timescale shortens the lack of information makes the irreversible decision harder. Add into the mix a period of uncertainty and high volatility and the investor is left with 2 decisions.
If the investor decides to enter a position in such conditions then the position is likely to be irreversible and takes away the ability to "react flexibly" on receipt of new information.
However the investor can make a different decision (an echo from Jessie Livermore?) and that is not to commit to a position, instead waiting to "find out the long term implications before they act."
This reaches deeply into the thought processes of Ben Bernanke, the paper studies the "making of durable, irreversible investments." Could anything written by Bernanke be more apt to the current situation? I think not. Ben goes on to explain an irreversible investment:
"Once a machine tool is made......it cannot be transformed into anything very unlike a machine tool without prohibitive loss of economic value - this is what we mean by irreversibility"
We shall come back to that remark later.
Ben goes on to explain why irreversibility creates an "a-symmetry" between the acts of "investing and not-investing", something I would read whilst thinking "short selling ban". He goes on "if an agent invests and new information reveals that he should not have, then he cannot undo his mistake; his loss accrues over the life of the investment. If an agent fails to invest, when he should have, he can still make up most of the loss by investing in the next period (Ben is referring to the business cycle)"
This has major implications for the bailout. Even Ben has to admit that the pricing of toxic debt, all those securities he is willing to swap for cash is incomplete to the extent that he cannot do anything other than offer a ball park figure, a guess.
What we have is an irreversible investment being touted on behalf of the US taxpayer. We have a lack of transparency, a lack of pricing, a refusal to acknowledge if the trade is of suitable size to reach the desired investment target and most importantly a lack of new information to decide whether we should "go in" or "stand aside".
Bernanke and Paulson have shortened the time horizon, through the constant referral to "urgent action is required or face meltdown". This ensures that Congress have to make a decision on incomplete information. They are forcing Congress to disallow the ability to stand aside by not allowing them to wait for new information. It is manipulation of the highest order and in Bernanke's own words "an a-symmetric" situation between "investing and non-investing".
Even Ben knows that forcing this issue is wrong, as he states:
".....when the environment is in a state of flux or uncertainty, a wait-and-see approach is most profitable and investment is low."
So why is Bernanke ignoring his own thesis, the building blocks of his own academic house, to allow what he knows is a bad investment? Because he believes it can be changed into a good investment.
Bernanke and Paulson are as much in the dark about what the toxic debt is worth as everyone else. To say that the buyers have left the room is an understatement; no one trusts an instrument that cannot be priced.
So during the week Bernanke said it would be a good idea to buy these assets at either a higher price that quoted, for those that have a quote or pay full price on the hope that by maturity they will have recovered to original face value. This is an attempt to force the buyers to recognise that a high bidder has entered the fray, not so much to ensure a higher price is fixed but to provide a quality boost, a government assurance, if you like.
Thus even at low current prices the toxic debt has a measure of quality it did not possess at the beginning of last week, almost like it has had an upgrade from a Credit Rating Agency. Was this a not so subtle attempt to try and remove some of the uncertainty and flux from the markets?
Either way the decision for Congress should be to adopt a "wait and see" approach and not to invest on behalf of the Taxpayer whilst the information is incomplete in current market conditions. For Bernanke to go against his own advice must surely place doubt upon his credentials and integrity as Chairman of the Federal Reserve.
The bailout will fail because it is a bad investment and it is Bernanke who told you that that "If an agent invests, and new information reveals he should not have, then he cannot undo his mistake; his loss accrues over the life of the investment." Remember a machine tool once made cannot be changed without major economic outlay. Bad debt, repackaged and sold as an investment is subject to the same forces, it cannot be changed without incurring a high cost. This deleveraging, the unwinding of the greatest credit based bubble in history is not over, the losses are not finalised; the information is incomplete.
Whilst all of this gives us an insight into the thinking behind the bailout, or rather the apparent haste in which it has been conducted I have uncovered something else that would also add to the doubt about Bernanke's thinking.
In his book "Nonmonetary effects of the financial crisis in the propagation of the Great Depression" Bernanke worried (correctly, in my view) that the lack of credit and credit facilities and the higher price of credit had a greater effect that the decrease of money stock. However he thought such effects would have the biggest effect on smaller rather than larger firms.
However as quoted in "The banking panics of the great depression" by Elmus Wicker, Temin devised a test of Bernanke's hypothesis. In his simulations "he found that all of the coefficients of the Bernanke regressions have the wrong sign; that is, in the more concentrated industries, the fifty largest firms suffered the largest decline in production."
Now whilst this might seem to be nit-picking it does raise a very serious and important point. Bernanke is turning away from his own work and thoughts to support the bailout. Worse he may very well be doing so on very incorrect assumptions.
I have to ask is he capable of doing the job entrusted to him? Is he the academic weak link?