By contrast, finance has become enamored of quantification to an unexpected degree. Value at Risk (VaR), the now-ubiquitous way to measure market risk, volatility, and assess capital requirements for financial trading, is a quantified measure of commensurated risk. That is, the various conditions around different sorts of assets are transformed (and made comparable) via this quantified metric. Stocks, bonds, private equity, mortgages, consumer credit, currencies, all are transformed into risk-measurable assets.

But the problem with VaR has become somewhat evident in recent history, and there are some moves afoot to replace VaR with something…well, something resembling the ‘expertise’ and intuition-based measures found more often in the Art World than on a trading floor:

What should replace VaR? We should reintroduce the spirit behind the way we calculated risk before VaR took over on trading floors and in the offices of regulators in the early 1990s. That means using intuition and experience-honed common sense. It means accepting the principle that toxic assets should be considered riskier than liquid assets—and that fancy math and past performance can be deceiving predictors that often deliver a lethal dose of leverage. We need rules and risk committees that limit a bank’s “bad” leverage by requiring much more capital to cushion, say, a subprime collateralized debt obligation than to offset Treasuries. It’s time to give up analytics so that real risk can be revealed.

On one level, I’m astounded by the call to ‘give up analytics’ in order to reveal real risk. On another, it’s a reasonable shift away from quantification, and back towards a kind of ‘qualitative’ commensuration.

The CMBS’s that have disappeared of late are securities backed by commercial loans (that market seems to have disappeared for now). It is interesting to note: a) that structured finance is not gone, and that b) it looks like something like $12B worth of securities have been issued using funds guaranteed by the federal government.

I could imagine, but don’t really know for certain, why a bank would prefer to securitize debt from the TALF funds. If it were my institution, I would pair the TALF assets with non-TALF monies (which are potentially much more dubious, given that delinquency rates on these kinds of loans are also climbing sharply), call it gold, or at least gold-plated, and then sell these to investors. I would make money on the transaction, get some of the loans off my books, and make that low-low-cost, low-low-risk Fed money work for me.

I know it’s too soon to start thinking about the ‘lessons’ we are learning from this crisis/event, because we’re still in it, but I am struck at this point by the way banks are trying so hard to return to business as usual. It may not happen, and we will almost certainly have some new oversight over the next year or three. But those expecting a ‘new’ Wall Street, or the ‘end’ of Wall Street, in my humble opinion, could not be more wrong.

Scholars learn to fear the literature in graduate school. I remember Professor Louis Wirth, one of the distinguished members of the Chicago school, putting Erving Goffman, then a fellow graduate student of mine, in his place with the literature gambit. It was just what we all feared. Believing Wirth had not given sufficiently serious attention to some influential ideas about operationalism, Goffman challenged him in class with quotations from Percy Bridgeman’s book on the subject. Wirth smiled and asked sadistically, “Which edition is that, Mr. Goffman?” Maybe there was an important different between editions, though none of us believed that. We thought, instead, that we’d better be careful about the literature or They Could Get You. “They” included not only teachers but peers, who might welcome an opportunity to show how well they knew the literature at your expense.
-Becker, p. 136

I’ve run across a varient of this problem often in discussions of finance, risk, regulation – though it’s common enough in most arenas. The problem is this: you need to have some knowledge of a subject to speak intelligently about it. But if the knowledge required to legitimately speak is set too high, then only experts are able to participate in consequential discussions that affect many, many people. Do you have a degree in finance? Spent ten years working on Wall Street? No? Then why should I listen to you?

This contention manifests in various guises. ‘Friedrich Hayek dealt with that’, or ‘your suggestion needs to take into account the Modigliani-Miller theorem.’ Or (as in the overrated Animal Spirits) a more subtle variant that posits all possible economic activity and politics on a continuum between Adam Smith and John Maynard Keynes. All of these are fair to a point – after all, reinventing the wheel is a waste of time, and we really should allow for the fact that some people know more than others when it comes to understanding (understanding what to do about) modern finance.

But these are also exclusionary tactics, and we should not overlook the fact that ‘experts’, particularly experts in professionalized fields (finance, law, academia, medicine) are susceptible to normative isomorphism – a fancy way to say that when everyone gets their MBAs from the same top 25 management schools, their language, outlooks, ideas, opinions, will tend to converge. This is the massively problematic aspect of having all of our regulatory officials coming out of the same Wall Street firms they are regulating. Not that they are necessarily ‘captured’ out of the box, but that everyone in the field’s assumptions tend to converge. And so someone who proposes, say, to simply do away with derivatives altogether, is seen as too much an outlier to be taken seriously.

As to solutions, I think there are two ways to deal with the problem. The first is to make participation in the conversation not dependent on performing some kind of requisite wink-and-nod to the dominant literatures/language/assumptions. This can get ugly, as Lena pointed me to a recent episode of TAL, which deals with people representing themselves. And if you peruse the political landscape of opinion, it’s more than a wee bit daunting to take seriously the people who suggest we should abolish the Federal Reserve. But then again, the ‘experts’ have completely screwed the pooch over the last decade, and why should we continue to listen to them?

The second approach means making the debate more accessible for more people, so that you can argue with the professionalized assumptions of your discipline, but these cannot be assumptions so rarified that you can dismiss people because they don’t want to stipulate at the outset to your formula and the assumptions it contains. That is, you need to make arguments that are accessible and make it possible for people to legitimately disagree with you. The ‘bar’ for legitimate participation cannot be a PhD and a decade of experience, but a good-faith effort to learn enough about a subject that pointed questions can be debated.

Perhaps this is asking too much. I’ll end with Becker:

The literature has the advantage of what is sometimes called ideological hegemony over you. If its authors own the territory, their approach to it seems as natural and reasonable as your new and different approach seems stragne and unreasonable. Their ideology controls how readers think about the topic. As a result, you have to explain why you haven’t asked those questions and gotten those answers. Proponents of the dominant argument don’t have to explain their failure to look at things your way.
-Becker, p. 147

And his solution? We should require serious people to routinely look at their subject matter in different ways, sometimes vastly different ways. Be respectful to experts, but don’t be crowded by the them. Use the literature, but don’t let the literature use you.

The first approach, then, would impose regulation on financial services organizations. I would include a pretty wide range of organizations: commercial banks, investment banks (not that there are any of these left), hedge funds, pension funds, mutual fund (and holding) companies, private equity funds, futures trading companies, REIT funds. This is a partial list. But conceptually, it’s any organization that participates in the keeping and investing of customers’ funds, business funds, or state funds.

Some organizations are multi-headed hydras in this sense – Citigroup does all of these things and more, nationally and internationally. Goldman Sachs trades its own accounts (called proprietary trading), brokers government bonds, manages mutual funds, and manages financing for its clients (Mergers & Acquisitions, bond issuance, etc). But your local probably does more than one of these things, and your state’s pension fund does too.

This episode of This American Life captures some of the regulatory gamesmanship that happens between federal/state financial regulatory agencies and the organizations they are supposed to be overseeing.

Still, if you think the problem is that these are sprawling organizations that are too big to fail, too big to manage, too influential to be regulated, then the answer is to break them down into their constituent parts or else to regulate them all as the simplest thing – banks. This is the reason why Galbraith’s suggestion is to give over regulation of systemic risk to the FDIC: “If institutions like hedge and private equity funds are to be considered as posing systemic risks similar to banks, they can be declared to be banks, and regulated as such. Money market mutual funds, which are now subject to insurance, can be reconstituted and regulated as narrow banks…The problem of regulation will be simplified, if we recognize that the crisis presents an opportunity to simplify, restructure and downsize the entire structure financial system.”

The challenge with this approach is that financial institutions can differ pretty dramatically, while at the same time fulfilling the same financial function. So OTC derivatives traded by a pension fund are monitored differently than the same trades by a commercial bank.

The alternative approach, which is more in line with what I would want to do, is to care less about the institutional forms of financial firms and more about the activities that they engage in. For instance, in order to securitize debt it is necessary to create a new corporation to transform that debt into investor shares.

no limited liability corp, no securitization

If we had a functioning rating system, we could use it to price these derivatives independently of the financial services organizations selling/buying them. Still, one alternative is to create an independent entity that doesn’t just slap a ‘good to go’ label on the things, but actually values them. But there remains the problem that, if a pension fund in Wisconsin needs to have a bond rated AAA in order to buy it, financial services orgs will try desperately find a way to slap a AAA rating on it (sounds like hot dog-making to me).

Or, if the SEC wanted to exceed its authority, or if we wanted to make life more difficult for financial services orgs and easier for the rest of us, we might consider disallowing these kinds of limited liability corporations. First, they are in the Caymans and other places only because tax liabilities are lower and secrecy is higher. It is just another form of regulatory arbitrage. And if there is just no possible way to structure derivatives in the US, another alternative is to simply disallow OTC derivatives altogether and have everyone trade stuff on existing exchanges. The analogy for me here is that 99% of us seem to get by with the denominations of $1, $5, $10, $20, $100, etc. It is not perfectly efficient. But the benefits of standardized, transparent commodities I think outweighs the costs to the tailored efficiency for individual firms. (this deserves its own argument, and it’s provocative: it may be the case that the public benefits of derivatives is small. Period.). The fact that Tim Geithner can say he receives letters from firms who argue they need OTC derivatives notwithstanding, we do not need them.

I don’t know how we might accomplish these goals, but at minimum, one suggestion is transparency. We ought to know who controls these limited liability corporations, what assets back them, and a plain-english translation of their values. And if that is not possible, if the only people who can accurately gauge the value of these assets are their issuing organizations, then these instruments should be disallowed.

The article is about the problem of size and complexity in financial services organizations. Watts argues that we ought to pay attention to:

a general trend toward building ever larger and more complex networks. In recent years, hundreds of millions of people have rushed to join online social networks, while billions more rely on e-mail and cellphones to stay connected to friends and coworkers all day, every day. Technologists wax lyrical about “Metcalfe’s Law,” which posits that a network’s “value” increases in proportion to the square of the number of people or devices in it. And system designers revel in the ability of networks to improve a system’s overall efficiency by dynamically distributing computer-processing load, power generation, or financial risk, as the case may be.

And the answer is that we should prevent firms from becoming big and complex enough to be deemed “too big to fail.” For Watts, too big to fail is too complex to exist. Fair enough. But this is suggested in a complete absence of any content of what financial services firms, hedge funds, or other trading organizations actually do. For instance, are we speaking about proprietary trading positions in various markets that tie them together, like multi-strategy hedge funds (.pdf)? Or are we speaking about a firm that acts as a clearing member for a bunch of other firms, as it was the case in 2007 when the top 10 investment banks were counterparties to 90% of all credit market trades? Or are we speaking of firms that are/were wildly leveraged, like Bear Sterns (or its subsidiary, the magical Everquest Financial and its CDO-squared monster Parapet)?

In other words, Watts’ version of systemic risk only makes sense if we just put brackets around a disparate set of practices, encompassed in varied institutions, and call them all “a series of complex, interlocking contingencies.” Well, sure, a complex system of interlocking contingencies does indeed sound like it might create systemic risk. But it doesn’t say much else. And let me be clear that I’m on board with the problem of systemic risk. I just don’t know why it makes sense to think of financial markets as the same as email, and electric grid, or an epidemiological event.

So what instead? First, I think we need people with substantive knowledge of what financial services organizations do. This is not a way of saying that only finance people and economists should be figuring out what to do (these are the people, after all, who made this disaster), but it is a way of saying that abstract knowledge of risk or organizations or networks is insufficient. Securitization is not just an interlocking contingency – or rather, it is, but that’s saying almost nothing. The roots of that contingency, including the measurements of risk in the creation of new assets (as Yuval Millo would suggest) and the institutional and legal conventions of creating a limited liability trust incorporated in the Caribbean to launder asset-backed securities into invest-able shares (as I would suggest) are where the action is.

The financial crisis was driven by a confluence of 4 factors: 1) a social technology that transformed specific assets into abstracted risk; 2) a communications and computational technology that allowed these new financial instruments to be calculated and traded; 3) an institutional environment that facilitated the creation of unregulated investment vehicles and rated the resulting derivatives that they produced; and 4) a large pool of leveraged, conventionally-allocated investments that exacerbated systemic shocks by translating them into other markets. In this alternative view, the causes of the financial crisis are a social and technical trading technology, a specialized set of investment vehicles, and a conduit between these vehicles and the rest of the world of finance.

When you have (1) abstract risk, you increase the danger that the people who know how to manage the originating risk are not going to be the same people (or even kinds of people) who are actually managing the risk. When that abstract risk is (2) reified by a pricing technology, it lends a kind of stability and confidence in the qualities of risk that are quite likely unwarranted. If, by law and custom, you can then be (3) able to ‘package’ that into a discrete entity like a fund or trust or structured investment vehicle, you make it seem like there is a really big separation between the new, abstracted, measured risk and the originating risk. And when you have organizations and investors who trade these packaged entities alongside other kinds of entities, all now measured in terms of their abstract risk, you create avenues to spread risk systemically from one kind of market to others.

If you think of the financial meltdown as a sub-prime mortgage crisis, or a credit crisis, you are, in my humble opinion, mistaking the catalyst for the cause.

For instance, a trust can take in assets from various streams of financial value and then distribute these resources according any number of guidelines, in equal shares. Something like this (a ‘unit trust’) looks a lot like a mutual fund, in that a diverse amount of capital gets transformed into investor units. There may be rules about which assets get distributed first, second, third, etc., and to whom.

Financial services companies and hedge funds use trusts to do three kinds of things: 1) mix and match differentially-risked assets to ‘create’ an asset that conforms to a desired level of risk and return; 2) make investment assets opaque, or, in the words of Grégoire Mallard, to close the ‘black box’ of finance; and 3) ‘streamline’ (or avoid) regulation around foreign ownership of US assets, and other slightly-shady but probably not outright illegal tax dodges. This last use is probably the most important one in most instances. For example, additional tax burdens are in place for foreign owners of US assets, and if 1 in 100 investors is a non-US citizen, then an investment fund would have to mess with the tax system. A trust is often used to get around these rules. It is a case of de jure regulation in place, and burdensome, dodgy ways to get around that regulation (which is not as terrible a way to do things as it appears, but that’s a different post).

A specific kind of investment trust is – or was – a structured investment vehicle. Structured investment vehicles existed as a kind of fund from its inception by Citibank in 1988 until the last SIV was liquidated in October 2008. They are a kind of investment trust that sold short-term commercial paper, and then used the money to purchase longer-term bonds. In effect, they would borrow money in the short term, and then lend money in the long term. Since long-term loans had generally higher interest rates than shorter-term loans, they would profit on the difference.

Sound innocuous, no? Look at the yield curve for US Treasuries. Borrow in the short term, then keep rolling over your investments (borrowing again and again) as your long-term investments mature. This is what banks do, after all. However, SIV’s were designed not as banks, really, but as super-duper investment vehicles. About three-quarters of their long-term assets were not US Treasuries, but Asset Backed Securities (ABS), and Mortgage-Backed Securities in particular (MBS). These are assets based on bundled, securitized housing loans. These bonds were much higher-yielding than treasuries.

But even before these various asset-backed securities went boom, investment vehicles that take in assets on the one side and dish out distributions on the other side had been used to, well, screw investors for some time. Frank Partnoy noted a particularly nasty variety (in F.I.A.S.C.O., natch), known as the MX. In this tasty vehicle, zero coupons (bond payments with no interest attached to them, just a single lump sum) were combined with IOettes (interest-only slivers, the pieces of mortgaged backed commodities with high interest, high volatility, and robust-and-risky chances of repayment). Effectively, this was combining lead (the zeros) with gold (the IOettes).

So, the interest-piece was worth a ton, and the zeroes worth little. Then the two were smooshed together in a trust vehicle set up in the Caribbean. The ‘average’ cost of these instruments was booked by Japanese investors as a cost (gold + lead) / 2. Got it so far? Two pieces, one more valuable than the other, with their costs averaged.

And then, days later, half the units were sold. But because the investment vehicle was set up with its own particular rules for distributions, it required that the most valuable assets (the IOettes) were distributed in the first half of the trust units. The Japanese investors then booked the value of these units as revenue. Ta-da! In two days, profits galore! Of course, 29 years later the rest of the units (the lead) would be liquidated, at a massive loss. But by then who would remember? Who would care?

And this is the point. The abstraction of finance in theory provides an unambiguous social good – it efficiently distributes capital where it is most needed in the economy. In practice structured finance has been the playground for massive amounts of fraud (legal and illegal) for decades. Evidence for this predates by decades the craziness of 2007-

One way is to just decide, you do this part, I’ll do that part, and we’ll split the proceeds. This is very local ownership. It is tied directly to you and your friend’s relationship, the specifics of the business venture, the particulars of the agreement you forge. For the current purposes, I want to call this concrete finance.

An alternative way to divvy up your company is to create shares of one sort or another.

How to divvy up the profits from you & your friend's cookie business.

What you’ve done formally is to create an instrument to stand in as financial value. It’s a kind of abstraction. The ownership no longer depends so specifically on the relationship between you and your friend. The rights to ownership, and maybe future profits and losses, are now formally invested in the shares, not just in your relationship. When you agree to partition the company into shares, you are turning the rights to future management and earnings into these more abstracted instruments.

What makes them ‘abstract’? Well, they become abstract in two distinct but related ways. First, the shares themselves are worth something. So ownership of the shares are ‘worth’ whatever profits come out of your business at the end of the year, plus they are worth whatever someone will pay to get those profits. If your business is great, with bright prospects, someone might well be willing to pay a premium for your shares. Or expect a discount if your business’ prospects are lousy. This means that there are actually two values to shares, a representational value and a market value: the representational value is how much value the shares stand in for (i.e., your share of the profits), and the market value is how much someone would buy or sell those shares for.

The second way they become abstract is that the value the shares can be thought about in ways that are not specific to the business that you started. For you, the shares are a shorthand for the blood, sweat, tears, and rewards you get for taking chances on and working in your business. For someone else, the shares can be represented as cash returns over time. And these cash returns over time are compare-able to other cash returns over time from other kinds of things. For instance, owning a totally different kind of business, buying and selling rare coins, or lending money to arms dealers all have ‘cash returns over time’ that can be compared favorably or unfavorably to your shares. In this way, what was once only understandable as a local, concrete financial arrangement between you and your best friend gets brought into the wider universe of other financial stuff. This is what I want to call abstract finance.

What's a pension fund manager doing with shares of a cookie business? Making profit.