Wednesday, February 11, 2009

Harry Markowitz--Father of Modern Portfolio Theory--on the current Financial Crisis

As long as the hard or impossible to value assets remain on the balance sheets of banks the financial crisis is unlikely to be resolved. It seems to me that government regulators are afraid to address this issue. Perhaps they are worried that when the public finds out how much 'phoney baloney' paper is owned by these banks it will cause a financial panic. It will certainly cause additional vilification of the kind that has never been seen before.

If we don't do something quick it is likely that we will go the way of Japan--a lost decade.

In his short paper Harry Markowitz outlines a strategy for dealing with the current financial crisis.

Here are Marowitzs' four major points.
1. Take a census of the institutions that own various instruments—CMOs, CDOs, CDS, and the like—noting the assets, liabilities, and “rules ofthe game” of each instrument. Although this proposed survey is large, it is no larger than
such government efforts as the U.S. Census Bureau’s Annual Survey of Manufactures.
2. Calculate the direct and indirect exposures of each instrument. For example, CDO A contains Tranche B of CMO C, etc., and thus is exposed to these amounts of those underlying mortgages. The mathematics of tracing out these direct and indirect relationships is similar to the techniques by which a search engine (e.g.,Google) finds thousands of web pages that match a given phrase.
3. Aggregate the direct and indirect exposures of a given instrument (and the instruments of a given institution) into meaningful categories. Simply knowing that a given instrument is directly or indirectly exposed to a long list of mortgages is insufficient. These mortgages should be aggregated in various ways (e.g., by zip code and late-payment history). The leverage of the instrument and of the institution
that holds it should be analyzed, both directly and indirectly (e.g., has the institution borrowed to buy a tranche in an instrument that is itself leveraged?).
4. This information should be disseminated on a need-to-know basis to various parties, including stockholders, counterparties, regulators, and academicians. As with Census Bureau data, the more public disclosures may be aggregated more than those disclosures that are less public.
In my opinion much of this will happen sooner or later. Hopefully, not after it is too late.

Here is a snippet below. To read the paper go to

Proposals Concerning the Current Financial Crisis

Credit Default Swaps

Among the pieces of paper (or book entries) that played a prominent role in the current crisis, credit default swaps deserve special mention. CDS are insurance against the default of various obligations. Some insure against the default of corporate bonds, for example. Others have obscurity problems like those of CDOs because they are, in fact, insurance against the default of CDOs. Questions about obscurity—namely, the direct and indirect exposures of CDS to various risks—
should be addressed as part of the process of tracing out the direct and indirect exposures of such instruments as CDOs. But even the straightforward “nonobscure”
CDS have not been well understood. Presumably, credit default swaps are called “swaps” rather than “insurance” to avoid the level of reserves required by regulators to back insurance policies. But CDS are insurance and, in fact, should
require greater reserves than does life insurance.
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