September 30, 2008

In an editorial printed in a type face larger than usual (*), the Financial Times proclaims "market freedom is not a "fundamentalist religion". It is a mechanism, not an ideology." The editor doth protest too much, methinks. Without an operational definition, market freedom as such can hardly claim scientific rigor and so must belong to the ideologic sphere. More helpful is to design better market mechanisms.

One side effect of the current crisis of financial markets is to drown small but significant events.

Take Eric Lichtblau's reporting (**) of the guilty plea by "a former foreign service officer" who "looked through the files of nearly 200 people [out] of his "idle curiosity"" (1). Idleness is used here to minimize the gravity of the case, another Lady Godiva reflex. In reality it should be taken seriously as the mother of all evil. The Pellicanos of this world know precisely how to convert such "idle curiosity" into rich, illegal gains.

Now read Joe Nocera's story about how Google freely manipulates the rules behind its AdWords recommendation system (***). "The problem with monopolists [...] is that they just can't help acting like monopolists. [...] They are always right and everybody else is wrong."

Together these two events highlight the importance of looking at information markets at all scale factors. Above a certain size, the natural blindness to one's responsibilities comes necessarily at others' expense. At the opposite end of the spectrum, no one is too small to ignore. In control of data, simple reading rights being enough when the data is confidential, anyone has the potential to generate disproportionate liabilities.

No doubt such scale considerations should apply to the plan proposed by the US Federal government to address the current crisis. But if market freedom is to be truly restored, one must first put a stop to the price delusion.

As Floyd Norris explains (****), the plan authorizes the US government to buy a wide range of securities. By paying more than the so called market price, per force a "fire-sale price", the government would indirectly "recapitalize the banking system". By paying no more than what they are really worth, the so called "hold-to-maturity price", the US government would not lose any taxpayer money. Gillian Tett provides a meatier metaphor (*****). The difference between hold to maturity and fire-sale prices measures the amount of rot in the system. Buying securities at their "true price" and holding them until this price is recognized is like freezing rotten meat for a while in the hope it will be fresh again when thawed.

As both authors make clear, at issue is the difficulty of estimating the hold to maturity price. For Floyd Norris, a lot depends on modeling the future, the housing market recovery to begin with. For Gillian Tett, much depends on uncovering the past, "partly because there appears to have been widespread fraud in the mortgage brokerage world".

While presenting a sample taken from the Bear Stearns portfolio (******), Vikas Bajaj gives another, very present reason. Shear complexity. Quoting Andrew Feltus on "even trickier investments", he writes "no two pieces of paper are the same".

No wonder there is today no credible mechanism to determine such hold to maturity prices before maturity. Commenting on a suggestion by the Federal Reserve Bank chairman, Flyod Norris states that "auctions of disparate securities with one eager buyer and sellers of varying desperation [are] unlikely to [show] the "hold-to-maturity value"". Without a proper market, isn't such price a delusion? Hasn't, according to Jennifer Hughes (*******), the same Mr Bernanke declared when pressed to soften accounting rules, "nobody knows what the true hold-to-maturity price is"?

What market fundamentalists forget is that the invisible hand they worship requires two very visible conditions to work its magic. Good data and lack of consensus on future trends. As truth by popularity faddishly turn rational bets on the future into sure things, market freedom feeds bubbles. To fight future bubbles, we submitted last week that one can at least compel abettors to shoulder the bets they recommend and limit large bettors' folly. Today we wish to stress that no solution to the present crisis can avoid the cost of digging data from past deals.

This is what value markets are all about. On a traditional price market, large quantities of same quality goods are represented by a single variable: the price which balances offer and demand. On a value market, large quantities of actors seek to match their several interests in exchanging heterogeneous goods described by a number of criteria. Job markets are a leading example. No two resumes are the same, the same job at two different companies appeals differently to candidates.

To go beyond an act of faith backed by taxpayers' pockets, the US Federal government must ask the best professionals for the list of criteria which accurately describe the so-called toxic securities it proposes to buy. Offered price is of course one of them but, were I asked my naive view of mortgage-backed instruments, I might mention interest rate, time to maturity, past redemptions, exposure to the worst housing markets, names of the originators, names of the mortgage managers...

Asking for data is not the same as having the data. But since it is reasonable to take missing data at its worst, one expects potential sellers to find it rewarding to fill up the blanks. Encouraged and regulated by the government, competent, independent experts could propose their investigative services and back their results with a recommendation, more valuable than endorsements by monopolistic rating agencies.

From this dispassionate perspective, a reverse auction mechanism suffers from two flaws. The first is to set up the US as sole buyer. Contrary to market idolaters, I see no intrinsic evil in government intervention but, as a monopolist, the government is no better than private interests. If credible data becomes available, why not a cross auction mechanism, where everyone is free to participate on both buying and selling sides?

Symmetric, cross auctions require the buyer to submit a profile as well as the seller. The US government may offer better terms price wise but a seller might prefer a private buyer with fewer strings attached. A mutual match on a value market is not justified by price alone.

When operating under total confidentiality, cross auction mechanisms can provide buyers and sellers with an opportunity to test the market and discover prices. This is the second flaw of the proposed US plan. By enabling government agents and advisers to idly look at the action, it raises the risk of insider trading and conflict of interests, discouraging all market actors unless too desperate to care for privacy.

The US Federal government does not have the luxury of time. Leadership rests on faith. But the US leaders should heed Lawrence Summers' Keynesian reminder (********). "The more people who are unemployed the more desirable it is that government takes steps to put them back to work by investing in infrastructure". Rather than bridges to nowhere, why not an infrastructure robust enough for modern financial markets?

ePrio has shown how to create fair, decentralized, confidential mechanisms. It's a fact. Will prevailing ideologies prevent it to be put to the test?

Philippe Coueignoux

• (*) ................ editorial column (Financial Times) - September 27, 2008
• (**) ............. Ex-Employee Pleads Guilty To Viewing Passport Files, by Eric Lichtblau (New-York Times) - September 23, 2008
• (***) ........... Stuck In Google's Doghouse, by Joe Nocera (New-York Times) - September 13, 2008
• (****) ......... A Pledge to Help That Hurts, by Floyd Norris (New-York Times) - September 26, 2008
• (*****) ....... Putting dodgy assets in deep freeze will not remove the rot, by Gillian Tett (Financial Times) - September 26, 2008
• (******) .... Rescue Plan's Basic Mystery: What's All This Stuff Worth?, by Vikas Bajaj (New-York Times) - September 25, 2008
• (*******) .. Bernanke is right to resist calls to soften fair-value rules, by Jennifer Hughes (Financial Times) - September 25, 2008
• (********) . Taxpayers can still benefit from a bail-out, by Lawrence Summers (Financial Times) - September 29, 2008
• (1) this privacy violation concerned the current US presidential candidates among others, as related in a previous fillips.