THE BLOG
11/10/2008 05:12 am ET | Updated May 25, 2011

Fear and Reason on Wall Street


Cross-posted at the NDN Blog.

New York City -- In his classic 1841 book Extraordinary Delusions and the Madness of Crowds, Scottish journalist Charles Mackay pinned the blame for financial panics on the herd instinct. As interpreted by financier Bernard Baruch who wrote an introduction to a reprint published after the 1929 Crash, otherwise intelligent people in a herd "act like blockheads." As fear trumps reason and emotion rules, people in panics lose their ability to act rationally and instead move with the herd.

While Mackay's analysis was prescient for its day, if panics were due only to irrationality, they would be a lot easier to solve. Neither Mackay or Baruch had available to them modern tools for understanding decision making by participants in a market. However, the branch of economics known as game theory suggests that people acting entirely rationally can still cause a disaster. And this, more than just irrational panic, is the problem we face today.

As bubbles inflate, it can be entirely rational to go with the herd since, as the saying goes, "the market can stay wrong longer than you can stay solvent." And when the market crashes, it is rational to sell with the herd as well. At the moment, it is all too rational for banks not to lend to other banks whose balance sheets they mistrust -- the root cause of the current freezeup in credit markets. Thus, the current panic cannot be resolved merely through the return of calm and rationality alone.

The best known game in game theory is the so-called prisoner's dilemna. Without going into all the hoary details, it describes a case in which two people, if they act in their own interests, ie rationally, achieve a worse outcome than if could only cooperate.

This problem is known as a collective action problem. A simple version might be two children who want the same toy. If they share the toy, they both benefit. However, if they fight over the toy, each hoping he or she can wrest if from the other but break it, neither gets to play, a worse outcome than if they had shared. Similar situations occur all the time in business negotiations and diplomacy as in international disputes that lead to costly wars.

In the current financial world of complex derivatives that have sliced and diced the rights to streams of income among a galaxy of players, some regulated, some not, in the hope of spreading risk, what we have is a collective action problem on steroids.

To provide just one example, mortgage holders are currently engaged in a game of chicken with borrowers. Too often, mortage holders have been unwilling to modify loan terms so that borrowers can actually repay. The result is foreclosure and the forced sale of the asset, a lose-lose situation for both parties in which each achieves a worse outcome than if they had worked out a deal. Yet it is rational for each party to hold out for a better deal.

Fortunately, there are several answers to collective action problems. All involve shifting the decision from a collective or group to a single person able to cut the Gordian Knot to do what is best for all concerned. This can be achieved by turning the matter over to a higher power such as a court or judge. It can be achieved by the government passing a law that determines how the spoils are divided. It can be achieved by the two parties merging into one. Or it can be achieved, if the parties will need one another in the future -- though this would not seem to help in the current case.

In the Panic of 1907, JP Morgan locked the heads of finance of the day in his library and forced them to come together to provide funds to stop the panic. More recently, in 1998, New York Fed President Gerald Corrigan knocked Wall Street heads together to get them to bail out Long Term Capital Management (with only Bear Stearns refusing to play ball). If you seek a more extreme measure, in the famous panic of 33AD, Tiberius banned all interest payments for three years among other measures. One of the disappointments of the management of the crisis so far has been the inability of the Fed to force Wall Street to act together in its collective interest. There has been no shortage of meetings with the Wall Street titans locked in a room. Again and again, however, they have put their individual interests ahead of their group welfare and the Fed has come up short in forcing them to work together.

In contrast, earlier this week a number of Attorneys General negotiated a win-win settlement with Countrywide that cut through the Gordian Knot by modifying loan terms to make loans sustainable for customers. This is a good example of a higher power, in this case the government, settling cases involving borrowers and a lender in a way that will ultimately benefit both -- but that the two sides negotiating alone probably would never have achieved.

To tackle the collective action issues in the current crisis, the Fed, Treasury and other regulators, attorneys general and judges working with the Congress should take the following steps:
  • Pursue more settlements such as that with Countrywide that keep people in their homes.
  • Get tougher in forcing financial institutions to work together to solve the crisis.
  • Accelerate the process of merging weaker banks into strong ones.
  • Work to replace the disaggregated complex securities that currently splinter ownership into simpler securities amenable to decisionmaking. In this regard, a plan that replaces unsustainable loans with sustainable ones -- but that does not give a blank check to banks as with the McCain plan -- would be helpful.
  • In the context of real estate securities, where legally possible, pass rules simplifying loan terms and allow bankruptcy judges to modify loan terms.

These steps are needed to address the very real collective action problems that, until remedied, will continue to feed the financial crisis even if fear subsides.