The Mugwumpery

The December Liberty has an excellent article on the origin and causes of the current global financial crisis; probably the best on the subject I’ve read – From Reform to Crisis by Jim Walsh.

There is plenty of blame to go around – like most man-made disasters, the causes are many and interlocking, and certainly no one intended the result.

One of the generally agreed-upon ingredients was the lack of transparency in extremely complex, yet widely traded, derivatives – mortgage-backed securities, SIVs, CDOs, CMOs, CDSes, etc.  The opacity of these instruments made it extremely difficult to evaluate their underlying risk and value, which in turn made them hard to price and trade in volatile markets.

Which is a shame, because in principle the trading of derivatives, even (or especially) complex ones, offers significant economic benefits to society – these will be lost if the current panic results in this market being regulated out of existence.

But the transparency problem does need to be solved.

My friend Fred Hapgood mentioned that this ought to be the kind of problem that computers are good at solving.  He’s right.

According to Walsh’s article:

SIVs and CMOs were pools of standard MBSs sliced up (often into 64 equal parts) and reassembled according to their riskiness, geographic concentration or other standards. In some cases, Wall Street whiz kids would break a 30 year mortgage into individual securities based on each of 360 monthly payments; then they would bundle thousands of the one-month payments into larger securities offerings. Finally, CDOs were pools of CDSs sliced up and reassembled to reflect default risks more precisely.

It’s easy to understand why these instruments are opaque – their risk and likely return depend on that of multitudes of other derivatives, which in turn depend on hundreds or thousands of individual mortgages and loans, sliced and diced every which way.

In principle these factors can be fully evaluated (after all, they ultimately depend on the creditworthiness of individual borrowers, something the financial world has always coped with). In practice evaluation is impossible because it can only be accomplished by pouring thru thousands of pages of documentation describing the assets and conditions represented by a derivative, and then doing the same for each of the other derivatives of which the derivative is comprised, etc., traversing the entire tree of rights back to the individual borrowers.

As Fred said, this is exactly the sort of thing computers are good at.

So, my proposal is that an appropriate regulatory body should define an XML schema to exactly describe the chain of rights, conditions and assets represented by any traded derivative.  Issuers would be required to legally define the derivative in terms of the XML schema, which would be publicly posted in machine-readable form.

The schema would allow derivatives composed of other derivatives to be simply described as a set of links to (or copying of) the XML descriptions of the constituent instruments, with appropriate operators for expressing conditions, time-dependency, etc.

I imagine the regulator would require these XML descriptions to be posted in such a way that a potential trader could find them online in a uniform way – for example, an exchange might maintain a single database with links to the XML descriptions of all traded instruments.

The rest is details.

A standardized XML schema and the single rule that issuers must describe their offerings using the schema should allow automated analysis of arbitrarily complex instruments, all the way down to each individual loan or other asset.  Each trader could do their own analysis, with their own assumptions and rules – the XML data would supply only the definition of the instrument to be analyzed.

It seems to me that this would solve the transparency problem in a robust and extensible way.  Full information would be provided in a usable form before trading.

Since a portfolio is just an aggregation of assets, entire portfolios could be analyzed in the same way – by buyers, lenders, shareholders, regulators, and analysts.  Markets would then be able to sort out, by the usual means, which kinds of derivatives make sense, who is solvent, who is taking risks, and how much.

I’d love to hear criticism of this idea.

Today NPR, that bastion of reasoned, intelligent and thoughtful reporting (as opposed to the crass celebrity-and-sensation commercial outlets) ran a typically panicky story about the documentary “Two Million Minutes”.

According to NPR, the film illustrates the looming downfall of American society as children in developing countries study and learn vastly more in school than their US counterparts. As a result, the next generation of Americans will be illiterate, innumerate, and utterly ignorant of science, history and geography. The sky will fall and Americans will be reduced to foot-washers and burger-cookers to Asian technocrats.

Two points.

First, economics is not a zero sum game. Other countries becoming more productive – even more productive than Americans are – does not hurt the US standard of living.

While it’s certainly true that American primary and secondary schools are pitiful (because they lack competition – compare America’s excellent, and highly competitive, colleges and universities), still, panic is not called for. Productivity determines living standards – nothing else. Americans are becoming more productive, not less, even if other countries are catching up.

Economics is not war. There are no “winners” and “losers” – everyone gets what they produce, be it great or small, and regardless of what others get.

It’s natural that countries like China and India, which still experience poverty that makes even the poorest Americans appear middle-class, are struggling very hard to improve their standard of living; much harder than Americans do or need to. This is admirable, but eventually when these countries catch up to first-world living standards undoubtedly they, too, will start taking some time to smell the flowers.

Second – education only goes so far. The brightest people will always be able to learn what they need to know without much effort, and the dumbest, sadly, will not be able to learn much no matter what effort is put into education. All nations have their share of genius and idiocy.

The December IEEE Spectrum has an article about online game “cheaters” and “gold farmers” who use bots or cheap labor to earn virtual money, which they exchange for real money, and how bad this all is.

According to the article:

For example, in Ultima Online, gamers can make money by cooking and selling chickens to tavern keepers. Thurman programmed his characters to buy raw birds from the butcher and then prepare the food. Ordinarily, a gamer can cook only one bird at a time, but Thurman automated the process so that his 30 PCs could cook as many as 500 birds at a time; he sold them in huge quantities to the taverns.

Chinese “gold farmers” earn virtual money the old-fashioned way:

Unlike Thurman, the Chinese workers actually do go out into the “worlds” and game. But they do so in teams, which gives them a distinct advantage in certain situations. For example, they can gang up on giant monsters whose slaughter will be rewarded with big piles of gold.

I wonder what’s so bad about this? Imagine for a moment that this was happening in the real world – the result is there’s plenty of yummy chicken in the taverns, and fewer dangerous monsters running loose. Who could complain?

OK, maybe the game is less fun when people can just buy stuff (with real money) instead of earning it in the game. But it seems to me that’s more a problem with the way the game works than with the “cheaters”.

Yet I wonder – isn’t this what people are complaining about when somebody invents a machine that “puts people out of work” or brings in low-paid immigrant labor? How dare they make sure there’s plenty of yummy grapes at the supermarket, or cheap clothing to keep poor people warm?

The world still gets the yummy grapes (or widgets, whatever), and the people who are “put out of work” get to do something more useful with their lives than pick grapes or weave cloth all day (like, say, making something new that hadn’t been made before). Seems like a win-win all around to me.

I guess there are people who will complain about anything.