By Jeff Harding.
As readers of this blog know, I am a big fan of Nassim Nicholas Taleb, author of Black Swan and Fooled By Randomness. He is an independent thinker and he has enlightened us on some basic epistemological issues about investment risk. He seems to embrace the Hayekian-Misean concepts of the fallacies of explaining human behavior through mathematics. He has popularized Benoit Mandelbrot’s discovery of fractal geometry and its application to investment analysis. Really interesting, fundamental stuff.
Therefore, I hate to criticize someone I highly admire, but I think he is way off the mark with his solution for solving the economic crisis.
Here is his latest video where he explains his ideas. It’s short and interesting. Please view it and then, see my commentary, below.
Taleb has discussed this idea before. Here is his exposition in a previous article on the same topic:
The only solution is to transform debt into equity across all sectors, in an organised and systematic way. Instead of sending hate mail to near-insolvent homeowners, banks should reach out to borrowers and offer lower interest payments in exchange for equity. Instead of debt becoming “binary” – in default or not – it could take smoothly-varying prices and banks would not need to wait for foreclosures to take action. Banks would turn from “hopers”, hiding risks from themselves, into agents more engaged in economic activity. Hidden risks become visible; hopers become doers. The only solution is to transform debt into equity across all sectors, in an organised and systematic way. Instead of sending hate mail to near-insolvent homeowners, banks should reach out to borrowers and offer lower interest payments in exchange for equity. Instead of debt becoming “binary” – in default or not – it could take smoothly-varying prices and banks would not need to wait for foreclosures to take action. Banks would turn from “hopers”, hiding risks from themselves, into agents more engaged in economic activity. Hidden risks become visible; hopers become doers.
His general analysis of the causes of the crisis is dead-on. I couldn’t say it any better. He does have a tendency to see the world through black swan glasses, but then I suffer from the same syndrome when it comes to Austrian economic theory.
But … You can’t solve the crisis by converting debt to equity. And this is where we part.
1.) Banks are saddled with home mortgage debt (which he calls “toxic”), but the numbers are ahead of him: foreclosures are continuing at a high rate, and bank loan loss reserves are at an all-time high as they raise more equity. This problem will be solved before any efforts to convert debt to equity will occur. Also, Federal regulators are making it impossible for banks to renegotiate bad loans. They are requiring them to write down loans, come up with more equity, and tighten lending standards. By the time the politicians get around to changing the rules, the loans will be long written off.
2.) Much of the debt is on homes that have no equity left. Recent studies have shown that about 25% of homeowners ditch their homes, not because of their inability to pay, but because of negative equity in their home. With prices still falling, it would not be practical for banks to do this. Banks need to get this debt off their books. Why wait 5 years for this stuff to recover?
3.) Many of the loans are held by investment trusts, not banks. Much of the debt in this country has been securitized, and their trust structures don’t allow for such renegotiations.
4.) The shadow foreclosure market (those behind in payments is estimated to be up to 1.5 million homes, on top of the 1.2 million that are in foreclosure. With prices continuing to fall, why keep capital tied up in a wasting asset? Yes, I realize that the housing market is starting to recover, but bottoming out is different than a robust housing market.
5.) The big issue now is not just home mortgages but commercial mortgages. That market is huge and is hitting the economy right now. Would having them convert this debt to equity solve the banks’ problem? The reason these properties are in trouble is that the dynamics of the economy have changed. Much of this market is overbuilt and won’t come back. Keeping these investments alive won’t change their inevitable failure.
6.) The quickest road to recovery is to allow debt to be written down/off and recapitalize banks, not permit banks to become investors with their failed borrowers. The sooner capital is diverted from failed investments to new profitable ventures, the sooner the recovery.
The cure prescribed by Dr. Taleb would only delay a recovery. As we’ve discussed before, the real problem is in not allowing debt to be eliminated. You can’t by fiat declare what was once debt to now be equity. There are substantial and important economic distinctions between the two. The Japanese tried that and failed, resulting in 19 years of economic stagnation. Whether you call debt “equity” or just leave it on the books waiting for things to improve has no economic difference. Certainly, such capitalization of debt can’t be treated as capital for purposes of Tier 1 equity requirements. So, what good does it do? None.
What harm will it do? Much.
This is a complicated topic, and I don’t think Taleb has done it justice.