Transcendental Generalization

An earlier post mentioned the benefits of letting banks fail. This NPR article discussed interest-rate reductions given to some borrowers facing foreclosure. In this case, the FDIC gave these breaks after taking over IndyMac Bank. Update: This article discussed an FDIC proposal to help up to 3 million homeowners that could be “…the biggest event we’ve seen here as far as helping people avoid foreclosure.” This article covered some of the pitfalls of executing such a proposal—the possibility of helping people who were (or are) simply greedy and failing to help people who were duped into borrowing money.

Anushka wrote,

you put energy, in the form of risk, love, et cetera, out there and hope that you get something that makes you feel good back in return

In my teen years, I used to think about this enough to assign it a term—”interaction efficiency”. A stimulating conversation had high interaction efficiency. Unrequited love had low interaction efficiency.

I grew out of thinking in terms of interaction efficiency.  Let me try to recreate why.

After some study of the Bhagavad Gita, I began to observe that we constantly generate countless expectations, especially of other people. Though they are frequently useful and correct, our expectations are imperfect because they necessarily come out of our personal experience, which is a miniscule sliver of reality.  When we expand our knowledge beyond our personal experience, we frequently realize our expectations were silly or at least unreasonable. Interaction efficiency was just my way of measuring how well or poorly another person has met (or exceeded) my personal expectations. It therefore came out of a self-centered and frequently unreasonable perspective on relationships.

As a student of artificial intelligence, I knew our ability to generate expectations is at the center of our intelligence. Our brains develop models of the world and we expect it to conform to those models. Some of those models are “hard-wired,” developed by evolution as our species adapted to the natural world. Our perceptual systems depend on such models. Humans additionally have the capacity to generate “software” models, systems of expectations that we alter over years of learning. The expectations we generate are usually subconscious and therefore impossible to verbalize. To expend physical or “emotional” energy with the unstated expectation of an uncertain return—and then to measure the return—seemed very, very foolish.

Now, it is true that some expectations can be verbalized, and the likelihood of their being met can thereby be increased. However, people frequently agree to something and then fail to deliver—not because they were acting in bad faith, but because they did not fully understand what was expected, or did not fully predict what would happen during the give-and-take. These possibilities are admitted only by a compassionate mind.

To be honest, we concern ourselves interaction efficiency only when others have failed to meet our expectations—when we have expended some physical or emotional energy and not seen the expected return.

Therefore, to dwell on interaction efficiency seemed self-centered, unreasonable, foolish, and intolerant.

Relevant to this admission is simple advice from my grandfather that my mother passed on to me: Your generosity should not exceed your capacity.

When I first heard this advice, it seemed a truism: your generosity cannot possibly exceed your entire reserve of potential physical energy or your entire store of emotion. However, under a true and deep understanding of this advice, capacity means something that seems much smaller: “the amount you can afford without having expectations of return”.

On the surface, this interpretation seems limiting. It seems to constrain you to giving from a smaller store and therefore giving less. However, this is one of those constraints that actually triggers creativity.

When I oriented my thinking in this way, I discovered there was a large store of things I could give away without expecting anything in return. By intentionally “limiting” my capacity for generosity, I focused on what was valuable to others. I found a source for this within myself, and retained physical and emotional energy to mine that source. There were things I could give that were simply cheap.  There were things that were “worth it” because they were good for me—generating a return, if you will—but still gave other people a chance to “generate a better return” for me.

I could smile more.  I could send more holiday cards and touch-base e-mails.  I could ask people questions about themselves.  I could forgive other people for their mistakes and forgive myself for mine. I might not be able to cancel my workout to meet a friend for lunch, but I could certainly invite a friend to join me at the gym.

When I stopped doing things that generated expectations of return, I put others more at ease.  I stopped being resentful when they didn’t meet my expectations and started being more pleasantly surprised.  I stopped focusing on “what this person is failing to do for me now” and started focusing on “what this person seems to succeed at, all the time”.

I realized this is what is behind Covey’s recollection of the parable of the goose that lays the golden egg, about Production vs. Production Capacity, behind what Brian Tracy called “achieving more by doing less,” behind “working smarter, not harder”.

When you engage in this type of thinking, you are being true to yourself.  As a human being, there are a set of things that you, uniquely, must do. I believe this set is defined by your genes, your culture, and your history—the combination of your nature and your nurture. It is your calling.  By focusing on the places you can be generous without expectation of return, you practice your calling and refine its definition.

“This above all: to thine own self be true,
And it must follow, as the night the day,
Thou canst not then be false to any man.”

—William Shakespeare, Hamlet

If this seems ridiculously obvious to you, then I’m sorry to have wasted your time. It was a long, hard lesson for me to learn, and I continue to observe people (of all ages) who have yet to learn it. On the one hand, this may be about nothing more than growing up and maturing. On the other hand, I think that may be exactly what it means to see goodness or divinity in people.  I also think this type of thinking lies at the source of great leadership and organization, in politics and business.

This showed up in my inbox…

Once there was a little island country. The land of this country was the tiny island itself. The total money in circulation was 2 dollars as there were only two 1-dollar coins circulating around.

There were 3 citizens living on this island country.  A owned the land. B and C each owned 1 dollar.

B decided to purchase the land from A for 1 dollar. So, now A and C owned 1 dollar each while B owned a piece of land that was worth 1 dollar.

The net assets of the country were now 3 dollars.

Now C thought that since there was only one piece of land in the country, and land is a non-producible asset, its value must definitely go up. So, he borrowed 1 dollar from A, and together with his own 1 dollar, he bought the land from B for 2 dollars.

A had a loan to C of 1 dollar, so his net assets were 1 dollar.

B had sold his land and gotten 2 dollars, so his net assets were 2 dollars.

C owned the piece of land worth 2 dollars, but with his 1 dollar debt to A, his net residual assets were 1 dollar. Thus, the net assets of the country were now 4 dollars.

A saw that the land he once owned had risen in value. He regretted having sold it. Luckily, he had a 1 dollar loan to C. He then borrowed 2 dollars from B and acquired the land back from C for 3 dollars. The payment consisted of 2 dollars cash (which he borrowed) and cancellation of the 1 dollar loan to C. As a result, A now owned a piece of land worth 3 dollars. But since he owed B 2 dollars, his net assets were 1 dollar.

B loaned 2 dollars to A. So his net assets were 2 dollars.

C now had the 2 coins. His net assets were also 2 dollars.

The net assets of the country were 5 dollars. A bubble was building up.

B saw that the value of land kept rising. He also wanted to own the land. So he bought the land from A for 4 dollars. The payment consisted of 2 dollars borrowed from C, and cancellation of his 2-dollar loan to A.

As a result, A cleared his debt and he got the 2 coins. His net assets were 2 dollars.

B owned a piece of land worth 4 dollars, but since he owed C 2 dollars, his net assets were 2 dollars.

C loaned 2 dollars to B, so his net assets were 2 dollars.

The net assets of the country were 6 dollars even though the country had only one piece of land and 2 dollars in circulation.

Everybody had made money and everybody felt happy and prosperous.

One day, an evil thought came to C’s mind. “Hey, what if the price of land stopped going up? How could B repay my loan? There are only 2 dollars in circulation. I think, after all, the land that B owns is worth at most only 1 dollar, and no more.”

A also thought the same way.

Nobody wanted to buy land anymore.

In the end, A owned the 2 dollar coins. His net assets were 2 dollars.

B owed C 2 dollars. The land he owned, which he thought was worth 4 dollars, was now worth 1 dollar. So he had a net liability of 1 dollar.

C had a loan of 2 dollars to B, but it was a bad debt. Although his net assets were 2 dollars, his heart was palpitating.

The net assets of the country were 3 dollars again.

So, who had stolen the 3 dollars from the country? Of course, before the bubble burst, B thought his land was worth 4 dollars. Actually, right before the collapse, the net assets of the country were 6 dollars on paper. B’s heart was palpitating.

B had no choice but to declare bankruptcy. C had to relinquish his 2 dollar bad debt to B, but in return he acquired the land which was worth 1 dollar now.

A owned the 2 coins; his net assets were 2 dollars.

B was bankrupt; his net assets were 0 dollars. (He lost everything)

C had no choice but to end up with land worth only 1 dollar

The net assets of the country were 3 dollars.

This is the end of the story, but there was a redistribution of wealth. A was the winner. B was the loser. C was lucky to be spared.

1. When a bubble is building up, the debt of individuals to one another in a country is also building up.
2. This story described a closed system in which there was no other country and hence no foreign debt. The worth of the assets could only be calculated using the island’s own currency. Hence, there was no net loss.
3. An over-damped system can be assumed when a bubble bursts. In this case, the land’s value did not go below 1 dollar.
4. When a bubble bursts, the fellow with cash is the winner. The fellows owning the land or extending loans to others are the losers. Their assets’ value could shrink. In the worst case, they go bankrupt.
5. If there had been another citizen D either holding a dollar or another piece of land, and if D refrained from taking part in the game, he would neither win nor lose, but he would see the value of his money or land go up and down like a see-saw.
6. When the bubble was in the growing phase, everybody made money.
7. If you are smart and know that you are living in a growing bubble, it is worthwhile to borrow money (like A) and take part in the game, but you must know when you should change everything back to cash.
8. The phenomenon described in the story applies to stocks as well as land.
9. The actual worth of land (or stocks) depends largely on psychology (or speculation).

This speech by Chairman of the Federal Reserve Ben Bernanke was a disappointment. It clearly articulates what happened and some of what was intended, but fails to answer the critical question: What line of reasoning concluded this was the best course of action? Failure to answer this question makes Bernanke look very weak and a bit vacuous.

I thought this sentence was eloquent:

“Great uncertainty about the values of financial assets, particularly more complex and opaque assets, has made investors extremely reluctant to bear credit risk, resulting in further declines in asset prices and a drying up of liquidity in a number of funding markets.”

However, this was unsatisfying:

“To avoid unacceptably large dislocations in the mortgage markets, the financial sector, and the economy as a whole, the Federal Housing Finance Agency (FHFA) put Fannie and Freddie into conservatorship and the Treasury, drawing on authorities recently granted by the Congress, made financial support available.”

Bernanke says nothing about why the dislocations would be “unacceptably large”.

“In the case of AIG, the Federal Reserve and the Treasury judged that a disorderly failure of AIG would have severely threatened global financial stability and the performance of the U.S. economy. That judgment reflected our assessment of prevailing market conditions, AIG’s central role in a number of markets other firms use to manage risks, and the size and composition of AIG’s balance sheet.”

I’d like to hear more about this judgment. How severe a threat was the failure? Why was an “orderly wind-down” (mentioned earlier in the speech) not pursued for AIG?

Then, there is this statement about the Troubled Asset Relief Program (TARP) established by the Emergency Economic Stabilization Act—the big piece of legislation that passed last week.

“The TARP’s purchases of illiquid assets from banks and other financial institutions will create liquidity and promote price discovery in the markets for these assets. This in turn will reduce investor uncertainty about the current value and prospects of financial institutions, enabling banks and other institutions to raise capital and increasing the willingness of counterparties to engage. More generally, increased liquidity and transparency in pricing will help to restore confidence in our financial markets and promote more normal functioning. With time, strengthening our financial institutions and markets will allow credit to begin flowing again, supporting economic growth.”

Bringing the government (really, current and future taxpayers) in as a purchaser may promote the “discovery” of prices, but those prices will be inflated. Government intervention will certainly not promote the discovery of intrinsic value. Hence, investor uncertainty about the current value and prospects of financial institutions will be perpetuated, not reduced. The hot potato of losses will merely be passed to the tax payer. On the other hand, fast and “orderly wind-down” of banks would have promoted discovery of prices likely to be at or below intrinsic value.

“Second, the $700 billion allocated by the legislation is not an authorization to spend but rather an authorization to purchase financial assets. The Treasury will be a patient investor and will likely hold these assets for an appreciable period of time. Eventually, however, some assets will mature, and the Treasury will choose to sell others to private investors. Financially, in the long run, the taxpayer may come out either ahead or behind in this process; in light of the many uncertainties, no assurances can be given. But the ultimate cost of the program to the taxpayer will certainly be far less than $700 billion.”

It is incredible that Bernanke attempted to pass such statements by a large group of educated economists. Elementary finance, the kind understood even by illiterate street vendors, tells us that profit is only assured if the return rate on an investment exceeds the interest rate paid for borrowing to make it. Many of the assets to be purchased are backed by “underwater” mortgages with negative value. Patience will not turn these radioactive assets into gold. A loss being virtually guaranteed, the question is how big it is, who incurs it, and over what time period it is allowed to drag down the investor. Bernanke states with certainty that the loss will be “far less than $700 billion,” but if there were any truth to this, or evidence to back it, banks would be using it to shore up their balance sheets, not facing liquidation.

Value investors frequently seek what is termed GARP, Growth At a Reasonable Price. The speech suggests that the Federal Reserve seeks growth at any cost. Such naivete in the Chairman of the Federal Reserve is deeply disturbing. I expect the US Federal Reserve to be more sophisticated. I expect it to understand that the economy is a dynamic process subject to cycles. I expect Bernanke to understand that short-term shrinkage (yes, even a recession) may be inevitable but that it can be accelerated, preparing the way for unfettered long-term growth.

This is one of those times when accelerating through the intersection allows you to escape with hardly a scratch, while slowing down only places you smack in the center of a massive pileup. Indeed, you have a moral obligation to speed through, thereby reducing the size of the accident and remaining able to help the victims. And I expect the Chairman of the Federal Reserve to be driving the car, not rubbernecking from the sidelines.

In a discussion with a friend, we came up with another reason why letting banks fail would have been a good idea—it would have helped borrowers who had overextended themselves.

When a lender fails, another institution generally acquires its assets (including mortgages) at fire-sale prices.  If such an institution acquires a sub-prime loan at pennies on the dollar, it is generally willing to negotiate the terms of that loan, in order to reduce the risk of it defaulting. What this means is that a borrower who cannot make payments can get some leeway on the interest rate, payment frequency, and possibly even the principal.

Turns out this is exactly what Bank of America is doing with sub-prime loans it acquired with Countrywide financial.

Warren Buffett’s support for the $700 billion bailout has perplexed me. He has in the past argued for regulation of financial markets, but he seems too independent a thinker to accept the first proposal to come out of the Treasury department. And he seems too decent to publicly put his (or even Berkshire Hathaway’s) financial interests ahead of US taxpayers’. (The government bailout would rescue or otherwise benefit the financial services companies Berkshire is invested in.) However, according to this Fortune article Buffett validated my fear that the government will “buy the liabilities at inflated prices, to cover the banks’ rear ends”:

Buffett also noted that the presence of the government in the transactions would raise the price of assets above the absolute firesale levels for which they could now be sold. That would benefit the banks trying to unload them.

It was interesting to hear further elaboration by a couple of the 200 economists who signed a petition against Treasury Secretary Paulson’s original proposal.

I have heard complaints that when Bear Stearns, Washington Mutual and Wachovia failed, JP Morgan Chase and Citigroup bought their good assets at pennies on the dollar, while the government guaranteed their depositors and took over their bad loans.

I’m not complaining about that. The government seized these liabilities in the orderly liquidation of the failed banks. It did not buy the liabilities at inflated prices, to cover the banks’ rear ends—as Paulson seems to have proposed. Furthermore, the FDIC has a pool of insurance dollars from a long history of collecting premiums from those banks. It does not need to borrow hundreds of billions of dollars from foreign countries or from future tax payers to guarantee depositors.

What happened was simply the proper functioning of the FDIC and the US bankruptcy system. These institutions were established long ago to handle financial crises like the current one, and their personnel are experienced in such matters. These institutions already cost US tax payers some money, but not an additional $700 billion concentrated in the hands of a single individual.

I know that banks continuously assign values to other banks. That’s why they can act quickly when there is an opportunity to acquire one at bargain prices. It is possible that neither the FDIC nor the US bankruptcy system are so well prepared. However, it would cost a small fraction of the $700 billion for the government shore up these institutions to handle the current crisis quickly and efficiently. They could even hire people from the failed banks!