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Anyone Else Awake? Is the Knowledge System Broken?
I’m so awake I could lace on my running shoes and do twenty laps around Central Park. I know they say this is the city that never sleeps, but from what I can see, looking out the window, that too is just media hype. The lights are off, the streets are empty, and I guess everyone but me is snoring soundly.
Well, for anyone else who’s awake–Istanbul friends? You up?–Hernando de Soto just sent me a link to his latest piece in the New York Times, which is really interesting. (Yes! Hernando de Soto sent an e-mail to me, personally! I don’t care if I’m just on his assistant’s mailing list. It made my day.)
Here we are, three years into the global financial crisis, and we’re still flying blind. We don’t even know what we don’t know. What we do know is that we’re stuck in a huge contraction of private credit; no one is making enough loans and investments to expand or start businesses and get the economy growing. The remedies applied by U.S. and European governments tried to treat the symptoms — bad debts, shaky banks, floundering businesses, people losing their homes, rising unemployment, currency wars — and not the disease.
Had those symptoms been the real cause of the crisis, “vulture capitalists” should have swept in by now. They should have spotted the signals that send knowledge of who is in trouble and — following the laws of supply and demand — picked up on the cheap the potentially lucrative remains of the nonperforming assets and transactions, correcting the deficiencies that led to them.
They would have bought a block of old houses and revamped it into a 20-story high-rise with two restaurants and ample parking.
They would have taken over an airline unable to fill its first-class section and rearranged it into a discount, no-frills option with twice the number of seats per plane. That hasn’t happened to any significant degree. Why?
Why indeed? Here’s his answer: The knowledge system is broken.
You could say that the knowledge organized by property and transaction records plays the same role in credit that DNA plays in biology: it stores the long-term, measurable information that governs how the different cells of the body come together.
Balance sheets that once clearly signaled facts, allowing outsiders to infer what that company owned — and owed — have too often been mutilated. Some companies in difficult financial situations can legally resort to “off balance sheet accounting”— transferring the bad news to less visible ledgers, called Special Purpose Entities (SPEs) — or to sweeping information regarding their debts into illegible footnotes. When Enron collapsed, it had 3,500 SPEs. …
Economic activity has been allowed to cross from the rule-bound system of property, where facts and interests are recorded and built into useful knowledge, into the incomplete legal space of global finance, where arbitrary interests trump facts and paper swirls mindlessly …
How can anyone be comfortable extending loans if balance sheets don’t signal all the facts? If those who hold the assets and the risks cannot be easily located? How do you know which banks and countries are solvent, if you cannot determine how many toxic assets they hold; if the legal owners of mortgages can’t be found; if banks can’t clear their books because courts continue to stop foreclosures because titling is unclear; if there is little information on whether those who claim they can cover risk defaults have the assets to do so? …
As tragic as it was that a number of homeowners of modest means couldn’t meet their mortgage payments and some were forced to turn over their houses to their creditors, nonperforming debts estimated to be worth less than a trillion dollars were hardly enough to trigger a historic, persistent credit contraction. But they did, because the credit that was contracting was not anchored in bills and coins but in the knowledge contained in property reporting and signaling systems, which had deteriorated.
When that paper ceases to be reliable, when it no longer functions as a signal for collateral, as an enforceable guarantee, a credible assurance, or a reasonable measure of risk, then — Whoosh! — private credit vanishes. Just as your identity does when you step up to the immigration counter and discover you’ve lost your passport.
That’s what happened when the subprime crisis exploded. The derivatives that financed the nonperforming sub-prime mortgages were rapidly losing value, threatening to cause a run on the banks because there was — and remains— so little property knowledge about them.
Read the whole thing. What do you think? Is he right?
If so, how do we fix it?
Published in General
He is certainly spot on when it comes to real estate. For those who have not been following the entire MERS fiasco you would do well to give it a look. It is now all but impossible to determine who owns the majority of outstanding mortgages in this country. The level of fraud is as breathtaking as the lack of effort to resolve the situation, indeed Congress has made several attempts to legitimize what occurred. Only a madman would invest in real estate when property titles are so unclear.
Hi Claire,
As a researcher in the field of IT, I’ve followed Hernando de Soto for some time–looking at IT as a facilitator of property rights. There are many efforts to create exactly the standards and accountability that he is talking about. XBRL–XML tagging at the financial reporting level–is one such effort that has a lot of traction at the government level. My personal preference (and research interest) is XBRL GL which is an open tagging structure for financial transactions–simple and transportable via the web.
Hernando de Soto is right–there is a knowledge deficit that create economic friction in financial transactions. Unfortunately, there seems to be a lot of force exerted on the side of keeping it that way.
The fun of studying philosophy is the same now as it was with Socrates: “I know nothing except the fact of my ignorance.” The high-level theories we assert with confidence are built on the low-level assumptions that we learned from others, most of which we never bothered to check ourselves. Philosophy, properly done, is the constant review of what we otherwise take for granted. What we assume or take for granted is often the source of our downfall.
And so, let’s do some philosophy …
Strategy is the logic of making decisions based on what you rationally expect others to do. But there is a “breakdown of knowledge” when you no longer have any way to rationally predict what others are going to do.
Politicians are heavily to blame here, because despite their assurances the contrary, there’s no way we can afford their beneficence without huge taxes. They want to present these programs as if someone else will pay for them, but the reality is that they’re spending our money … it’s just earned sometime in the future.
Uncertainty kills strategy, which in turn ruins investment, which stops growth. You want growth? Dispel uncertainty.
…nobody–neither tenant nor landlord–has any secure right in or knowledge about anything. So all improvements must pay back instantly and credit is unknown.
I’m halfway through the book myself, and I’m in awe of it.
To my mind, The Mystery of Capital, along with Coase’s The Firm, the Market, and the Law and David Friedman’s Law’s Order form a compelling trilogy about how deeply intertwined laws and markets are, and how much the flourishing of a free market depends on a good legal framework.
I’ve decided “market failure” is a meaningless phrase unless the legal framework under which the failure happened is taken into account.
Or you could call what you describe a hubris bubble… ·Dec 3 at 9:42am
Yes, this is another problem. We have entirely too many people who think like John Maynard Keynes, by which I mean:
The combination of some folks who have no interest in anything outside their narrow area of expertise, with other folks who believe they are the world’s expert on everything because they have read some Wikipedia articles is not a good thing.
Well if knowledge about value of property and housing is what has been lost then it might make sense to correct the “perception” of value of property and housing. It is what I call fake money. Property and housing was never worth what we were told, it was always based on inflated value based on supply and demand. Just because someone said the property was worth an amount and someone paid this amount and someone financed this amount does not make it so. So if we assume it was based on falsehoods and overinflated lies then we must assume the correct value is what it will fetch today. This is an unpleasant reality to those who claim they are experts on buying, selling, financing, brokering, predicting trends and policy on real estate since they were scammed more than most. This reminds me of the time I bought a used car and thought I had a great value, till the next day when I went to start the car to find the battery was junk and I needed to purchase a battery. Just because I believed it was valued at what I had agreed to pay did not make it so.
Following my previous post; my solution, to move away from the post-war thinking of housing as an investment up-scaling at several intervals, retirees selling to extricate themselves from their mortgage, moving where housing is cheaper and buying a bigger better home, to housing as a pre-war model. A home is to be lived in, paid off in thirty years and sold with a modest gain. The first model requires inflation and necessitates rising wages leading to boom and bust cycles, less savings for retirement and college. My standard is young families. Young families will fuel the rise in housing prices (Demand) to a certain point, but when they feel too squeezed (They begin to see housing as cutting into their families well being) they will abandon the market and cause a bust or correction. The latter denotes long incremental valuation, modest homes, stable neighborhoods, life long neighbors, planned obsolescence school life cycle, substantial life long savings for retirement and college, Now I know others are going to say post – war investments are in the home, however the miracle of compound interest is in time – changing homes and up-scaling busts long term investments.
So I have two more points the first a prediction – warning, the second a solution to the current horde of toxic assets.
We have yet to see non-high risk homeowners abandoning their homes. These are families who still have great stable jobs, who are affluent and continue to pay their mortgage. But what they have is a monthly mortgage payment for a home worth $1.5 million but is now worth $600,000.00. They will come to realize they were scammed by the overvaluation of housing. They will realize they will never see their home rise back to $1.5 million (Since the valuation was a scam in the first place). The idea of walking into their mortgage company and asking for a refinance to a $600.000.00 level would be smiled up on or laughed at. So what to do – abandon their down payment from their previous house sale – stop paying their mortgage and save what they would have paid for a fairly substantial down payment, abandon their home – laughing at the mortgagee as they are left holding another useless home and bid their time till they can buy a correctly valued $600,000.00 home?
An idea for a solution:
Anyone can buy a foreclosed property with certain caveats:
Must be a conventional loan – 20% down – no mortgage insurance.
Must be a conventional loan from the mortgage company holding the foreclosure.
Can either be a 15 year or 30 year mortgage.
The mortgagee cannot bundle and sell the loan.
In return for the 20% conventional loan the Federal government will allow the buyer of said above foreclosed property a special capital gains timeline:
If sold in the first year 100% capital gains is required.
If sold in the second year 6/7 capital gains is required
If sold the third year 5/7, fourth year 4/7, fifth year 3/7, sixth year 2/7, and finally the seventh year would require 1/7 the capital gains.
The eighth year would require no capital gains if sold.
Then the ninth through fifteenth year the capital gains would rise incrementally by 1/7 till the fifteenth year 100% capital gains would have to be paid.
Late Boomer..”Well, from the inside of the mess it looks to me like we had a knowledge bubble. Like an asset bubble you think tou have something of value when you really do not.”
I think this is correct. Models gave a faux impression of precision to the rating of aggregates of mortgages; of course, it is also true that many of the people who *should* have been turning a critical eye on those models had strong personal incentives not to do so.
As I believe I’ve remarked here before, PhDs with IQs of 145, in conjunction with MBAs with IQs of 135, approved approved sets of mortgages that never would have been approved on an individual basis by an old-line banker with an IQ of 115.
I really do dislike the use of this term ‘toxic asset’ that has entered the lexicon. It’s such a misnomer. An asset is still an asset. That means that it still has value and can be exchanged for something of value; converted into on-hand cash, for example. Toxic implies that one is harmed by being within proximity. I swear this: if I ever hear a politician within my proximity talk of toxic assets I will immediately step up to the plate and offer my disposal services of said assets…at no cost, even. Let’s not buy into this crap; words do mean things.
Part 1
Sometimes when things just get too complex one must return to the fundementals. Bankers are not Social Workers and they are not Realtors. The initial problem of the bubble was caused when the Bankers were forced to become Social Workers and loan money to people who had little chance of paying it back. The illusion that this hopeless scheme could be handled by complex market instruments was punctured by the reality of people defaulting. This explains in simple terms the source of the problem. Now to explain what has been happening since.
Part 2
With the destruction of the normal credit market the regulators came in and asked the Bankers to be Realtors. In a normal Real Estate Transaction a Buyer and Seller enter into a contract at arms length with the help of agents and lawyers on both sides. This highly regulated six party ‘dance’ provides tremendous protection for both the Buyer and Seller. Now enter the Banker with his ‘Short Sale Addendum’. The Addendum allows the sale to be contingent on the Bankers approval. However, the Banker is providing no new credit. The bad loan was already made and the Banker is acting as partner to the Seller. If the Banker actually was a partner an offer would be made and accepted or rejected in a few days or at most a week as in normal transactions. Instead, idiot Bankers attempt to ham fistedly manipulate the deal to extort more money from the transaction. Most of these deals either fall thru or take months just to get the contract signed by the bank.
Part 3
The solution is simple Bankers are not Realtors. Their power to manipulate transactions in a short sale should be curtailed. Drastically reduce the ability of Bankers to involve themselves in actual Real Estate transactions and the market will come back like a rocket. People will take their loss and move on. Prices will bottom and start to come back up. Get the Bankers OUT!!!
I do not think you can understate the importantance this point. Older bankers were reluctant to say, “Can you explain that to me in terms that I can understand?”
While I think that De Soto is properly drawing attention to core defects in the lubrication system, sometimes the problem with the car is the idiot at the wheel. The raw hatred expressed by this administration daily for any element of the economy that does not fall in line with his pay to play ethic. It was not sufficient for this rabid mongrel to disown the GM bondholders, proudly proving himself above the law, but he also ran the dealer list against the FEC contributor lists and closed the Republican-owned dealerships.
That was about all the information any free market capitalist needed to see. Solyndra was hardly the first clue that Obamanocracy was in no way a meritocracy.
In Western Europe, free markets have largely been laughed at for generations, firm in the knowledge that Uncle Sugar could be counted on in a pinch and security lay in kickbacks and back scratching. Say goodnight, Gracie.
The outrage over the bailouts won’t be mollified by the bitterly dishonest unemployment numbers. And the GOP establishment is horrified at the thought of producing a reform candidate. Only crony capitalists and their elected corruptocrats need apply.
I De Soto’s point is spot on – lack of knowledge caused excess speculation. When things were on the way up – everybody assumed the assets were more valuable than they really were. Now on the way down, everybody is assuming the worse.
This uncertainty combined with regulatory uncertainty, tax uncertainty, and currency uncertainty increases the risk of any investment dramatically. You may know your area of the economy well, but in this environment 80% of the risk is in areas that you don’t control and can’t evaluate well. Hence the hesitation to invest.
What to do:
1) Simplify Tax Code
2) Improve disclosure on financial assets
3) Have stock analysts put sell recommendations on companies that they do not have a clear balance sheet picture (well I can dream on this one) or bond rating companies put junk ratings on debt of similar companies. (Ask companies about off balance sheet assets / liabilities. )
4) Regulatory roll-back.
5) Stop government backing of loans etc which just allows complacency.
LB…I’m not referring to older bankers who may have been confused by statistical models and were reluctant to challenge them in public; I’m referring to bankers of, say, 30 years ago who would have been approving or non-approving *individual loans* with less “benefit” of oversight by various systems.
The point being that when reality is abstracted into only-quantitative form, information is inevitably lost. It might be obvious when you meet Mr Smith and Mr Jones and look at their loan applications that neither one of them has a snowflake’s chance of repayment, but aggregate 10,000 Smiths and Jones’s together and it becomes easier to fool yourself. (And others)
My interpretation of “knowledge bubble” is that it’s about believing that more knowledge about a particular situation exists than is actually the case.
David Foster,
Sometimes they were the same guy.
Your interpretation of “knowledge bubble” matches mine. We weren’t as smart as we thought we were, just like we weren’t as rich as we thought we were.