13 Aug “This isn’t right. It isn’t even wrong.” – Wolfgang Pauli
Wolfgang Pauli is the source of this excellent quip. More famously, he is responsible for the Pauli exclusion principle, which asserts that no two electrons can exist in the same quantum state. Were he alive today, maybe Dr. Pauli could help us straighten ourselves out of the financial system crisis by demanding the same high standards in how we count assets and prove financial assertions.
not right+not wrong=not science
A lot of nonsense has been written in the name of finance, and a lot is being written today about the causes and cures of the subprime crisis. Much of the latter is politically motivated, designed to deflect blame and promote the broader application of self-serving pet theories. The distraction value of these debates is very high. That is why Richard Alford’s focus on science in his discussion of the open letter “Economics is hard. Don’t let bloggers tell you otherwise” is a refreshing direction for the dialogue to move.
two assets backing the same liability
The other interesting Tweet on Yves Smith’s 8/13 feed is about rehypothecation. In the context of revolving portfolio finance (aka corporate finance) this goes by the name of leverage, but in non-recourse receivables-backed finance (aka securitization) it goes by another name, one that Dr. Pauli would understand. It is fraud. Asset-liability parity is a precondition for all securities to go to market. Unless 100 cents of real asset value backs the 100 cents of liabilities issued, the lender will lose money with 100% certainty while the borrower and financial arranger make out like bandits.
two sides of the same intellectual coin
These two points are actually related–not only in Dr. Pauli’s mind but also in financial system governance and engineering.
A simpler way of approaching Richard Alford’s posting is to think about the rating process as a rehypothecation of company business receivables at different rates; these rates are based on the “gold-like” certainty of repayment, with AAA suffering an average level of impairment so low as to be beyond human intuition, AA slightly riskier, etc. Carried to the limit, this process of rehypothecation is the valve of leverage getting into the macro-economy. And, in a world where the traditional role of banks has been superseded by debt capital markets, think about the assignment of structured ratings as a de facto replacement for the Fed window.
A structured rating process that has integrity is also the control mechanism for balancing leverage with fundamental working capital demand. When business is brisk, clients pay on time and business receivables can be pooled to perform to a AAA standard, the borrower can borrow cheaply based on current receivable performance. When business slows, it costs more and the leverage in the system goes down.
But structured finance, like economics, isn’t easy. It isn’t intuitive, can’t be learned from cyberbabble. It requires rigor, which means mathematical training; and consistency, which means financial training. The good news is that it can be learned. And, it can empower an economy to transform itself towards doing more good than harm. That’s a scary – but inspiring – thought.