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Credit and
Credibility:
Are banks crazy, or a cartel?
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21 June, 2011
When a government (let us say, in Athens) could possibly renege on
promises made to banks who loaned them money or bought their bonds,
which that government is unable to fulfill without draconian cuts to
public services, all right-thinking people attack the feckless
politicians and threaten a collapse of confidence and the world
economy. This is a DEFAULT! Other governments and the IMF might jump in
to pour money into the state coffers, on the condition that they flow
out the other end into the investors' pockets.
But when a government (could be in Athens, or in London, or for that
matter Madison, Wisconsin) has made promises of pensions to government
employees, but has failed to fund them adequately, it is short-sighted
and greedy for these civil servants to insist on these promises being
honoured.
Why is a default such a terrible thing? Because, they say, if the
country defaults on its debts it will be shut out of the credit
markets. Hmmm. Let's suppose it is true. Why? Suppose you own a bank,
and your thinking of lending to one of two countries, let's call one of
them Piigsia and the other Sameria. Both are heavily indebted.
Piigsia introduces crushing austerity measures, while Sameria
repudiates its sovereign debt. Which of those countries would you
rather loan your bank's money to? The one that's shown a great
willingness to pay off its debts but is financially crushed, or the one
who may be more likely to try to weasel out of its debts, but is
eminently capable of paying. Solvency is not merely (or even primarily)
a state of mind. I mean, what good is it to have the current government
express a willingness to pay off its debts, knowing that it's likely to
be punished by voters for these "good" intentions? Maybe they just don't want to be serial defaulters, so having avoided
defaulting this time will encourage them to default on the next batch
of loans.
As for Sameria, it sucks for the other banks that have lost their
money, but why should I give up a chance to make a good profit for the
sake of punishing Sameria for hosing my competitors? In fact, in a
competitive market, why shouldn't I be happy that my competitors have
made a loss, and just try to get better conditions for my loan?
That's why I wonder if there isn't something of a cartel or class
solidarity in the way bankers behave, rather than a free market. Yes,
they compete, but fundamentally they see themselves as collaborators in
enforcing each others interests. No one is going to jump in to
The alternative is that bankers just aren't very smart. It's not
really an alternative... There's no reason why bankers couldn't be dumb
and criminal. I used to think that bankers were pretty sharp, even if
they were dull...
Stolid, to be sure, perhaps grubby or conservative or philistine or
narrow-minded, but within the constraints of their worldview and their
interests, I figured they knew what they were doing, how the world
works (in
its most dreary and quotidien aspects), and how to turn that
understanding into
a profit. Events of recent years have forced me to reconsider. In a
country
whose economy is comprised of financial institutions to (approximately)
99.7%,
and whose most unwavering political conviction is that all institutions
of the
nation would be improved by making them more like banks, this is not
unlike the
position of a Vatican native who has begun to doubt the existence of
the
pope.
Now, it may be that the problem is the business journalists who
interpret the bankers than the bankers themselves. At least as
presented in public, their whole conception of risk seems bonkers.
Consider a typical sort of comment -- hardly the most egregious -- on the current unpleasantness, by BBC
business editor Robert Peston:
Here's the thing. If any eurozone member were to leave the euro, if Greece or
anyone else were to adopt its own independent currency, the cost of borrowing
for pretty much every other eurozone member - with the exception of Germany,
Luxembourg and the Netherlands - would rise.
The reason is that euro membership would no longer be forever. So
anyone lending to Spain, Italy or even France would have to be
compensated for the risk - however remote - that their euro-denominated
debt would one day convert into something tied more directly to the
health of their respective economies and the strength of their
respective public-sector balance sheets.
Now looked at by the usual standards of logic, this doesn't make
any
sense. Imagine a man coming sitting down with his wife and telling her
"I've been having an affair, and my life with you seems unbearably
dreary, but on the balance I've decided that staying with you is better
than leaving." Would she then breathe a sigh of relief and feel
reassured that their marriage is "forever"? Or would she decide that
it's only a matter of time until a bigger crisis comes. Or you live on
the top floor of a skyscraper. Along comes a gale-force wind that
cracks the foundations and twists the girders. But the wind subsides,
and the building is still standing. Whew, you say. This is a tough
building. Glad I won't have to worry about it falling over. (I'm
reminded of the way seventeenth-century French investors are reported
to have bought annuities on the lives of greybeards, presumably on the theory that they'd already shown a propensity for long life.)
If Greece
leaves the euro, I can see that this might be a template for others; on
the other hand, it would depend a lot on how Greece fares on its own.
If it does badly, that might frighten the others. In any case, it seems
inconceivable that someone could look at this sorry mess and think,
well, Greece has stayed with the euro, and crushed its pensioners
rather than repudiate even the meanest of its bonds, so I guess I'll
never have to worry about Portugal again?
Shadow probability theory: The zero-one law for default
There seems to be an alternative form of probability theory in effect,
where
all events have probabilities that are either 0 or 1, but we need to
figure out which it is. It's not as though the reality where Athens
descends into near civil war and emerges with an austerity package
passed by a couple of votes, and the alternative reality where the
package fails by a couple of votes, are vastly different in terms of
what they predict about the future willingness of "Greece" to honour
its debts. But at least the financial commentariat seems to treat them
as though they were. (Obviously, the difference matters more to current
holders of Greek debt, but even there, it seems that there's a
continuum of meanings and projections that could follow from, say, a
single missed coupon payment.)
From a probabilist's point of view, the reports
of credit agencies also seem batty. I mean the ones of the form:
"Consolidated Counterfactuals bonds are rated BBB-, but we have a
"watch" on it, and we are likely to downgrade it soon". I take a credit
rating to be a way of describing a range of probabilities of the
company or country defaulting on its loans. What can it mean to say,
"The probability of a default is currently 0.1, but there is a
significant chance of it increasing to 0.2 in the next month. This
could only make sense if there is some event X that we are waiting for,
and if X happens the probability of default goes up, and if it doesn't
the probability will go down, and it all averages out to 0.1. But then
a "watch" would be a purely neutral statement, something like, we
expect the default probability to be volatile over the next month,
equally likely to go up or down. That's certainly not how it gets
reported in the financial press. (I'm reminded of the Robert Heinlein
novel, The Moon is a Harsh Mistress, which I read as a teenager. Lunar
colony secessionists go to war against Earth, guided by a sentient
computer that compulsively computes odds of their ultimate success
based on current status. At one point there is a discussion that even
then troubled me: The computer has just lowered the estimate of
the probability of success to one in nine. "Getting worse?" the
protagonist asks. The computer replies: "They’ll get worse for months.
We haven’t reached the crisis." Later the success probability drops to
one in thirteen after the rebels initiate a propaganda effort directed
at the Earth public. The protagonist protests that the computer had
agreed that this was a necessary step toward victory. The computer
"explained patiently, “it increases risk. That it is necessary risk
does not change the fact that risk is increased.”" If a step is
necessary to success, it can't be that carrying out that step lowers
the probability of success.)
An extreme example is this recent report:
"Standard & Poor’s would cut the U.S. credit rating to its lowest
level and Moody’s Investors Service said it will probably reduce its
ranking if the government fails to increase the debt limit, leading to
a default. S&P would lower its sovereign top-level AAA ranking to
D, the last rung on its scale if the U.S. can’t pay its debt, John
Chambers, chairman of the company’s sovereign rating committee, said
today." So, how can it be that the debt is today AAA -- which is
generally understood as a declaration of close to zero risk of default,
at least as low as possible -- but that they also can declare that they
believe that the US might plausibly default on its debts next month.
And if you think what they're really saying is that the "default" isn't
a real default, but only political theatre, then what's the point to
lowering the rating to D after the fact?
There is one reasonable interpretation that makes sense of all this:
When the credit ratings agencies rate sovereign debt -- at least, for
wealthy countries -- they are doing something similar to what Gallup is
doing when it predicts the outcome of the presidential election,
namely, doing publicity work for their real money-making business. (For
Gallup, that's market research; for S&P it's rating private debt
and equities.) No one really looks to S&P to tell them whether US
treasury bonds are a safe investment -- or German or British or even
Greek sovereign debt, for that matter. The goal of these announcements
is simply to provoke headlines, and create the impression that this
ratings agency is a big player. It's a bit like the rooster who
threatens that the day won't start if he withholds his crowing.
Retail banks and the zero-one law
I've long found the practices of US lenders peculiar, particularly
the
apparent belief that credit should only be extended to those with a
credit history. One imagines an 18th century banker being leery of
lending to to someone for the first time, someone who has had no
practice of borrowing and repaying. Will they understand what it means
to pay interest? Can they count? But today, dealing with money and
basic banking functions is not a specialised skill. It seems strange
that someone who has declared bankruptcy will be able to obtain some
sorts of credit, whereas someone who has not taken out a loan before
often will not be considered for a credit card or loan under any terms.
(Obviously, there must be some route into the system. For myself and my
friends it was special offers for credit cards to students. Student
loans count as well, I guess. I'm not sure how the non-students manage
it. Perhaps with a co-signed loan, or a deposit-secured credit card.
In the UK, I found that there was basically only one lender (Natwest)
who would even consider us for a mortgage, because I applied with less
than 2 years remaining on my work permit. It seems odd that they would
have loaned me money when I had first arrived in the country (I have a
5-year residency permit), but not in the two year interval between the
end of year 3 and the end of year 5. (Actually, well into year 7, since
it takes well over a year to get a work permit renewed.) It's zero-one:
All other banks, apparently, will not even consider an application on
any terms from a foreigner who has been here too long, until he's
gotten permanent residency. It's hard to imagine what the risk is that
they're trying to exclude. It's not as though a sneaky foreigner can
take out a mortgage and then abscond with the house. In our case it was
particularly risible, since my co-applicant is German, so doesn't need
a visa, but that changed nothing in the status of our joint
application. Again, one would think that in a free market there would
be more
competition for the custom of respectable foreigners. (It would
probably not be reasonable to link this to Britain's never-flagging
xenophobia. In Canada, the most foreigner friendly country I've had
dealings with, we couldn't even get any sort of credit card without
permanent residency.)