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Friday, September 26, 2008

Game Theory: Why the Bailout Won't Work

[ via EconompicData ]

A GREAT post. This absolutely nails it on the head.

Read this carefully. Make sure you understand it. This is exactly what will happen. Each agent (bank) will act in their own self interest.

Ignore the clowns on CNBC. They're pumping a bailout that can't succeed.

More on general Game Theory here.

Game Theory: Why the Bailout Won’t Work: “Lets assume for the time being that there are only two banks; Bank A and Bank B.

The media / political pundits would have you believe the likely outcome of the bailout is the top-left box in which both Bank A and B sell risk assets to the Treasury. In this case, the result is a more regulated banking industry, with imposed limits to salary, but importantly markets clear.

HOWEVER, it is in BOTH banks interest to deviate from that.

Why? Simple. If Bank A (or B) believe the other is selling their risk assets to the Treasury; they will each be better off holding on to theirs.

Why? If the other bank sells and they hold, markets will still clear (in theory) and the bank that holds onto their risk assets can sell at the new market prices. This results in increased market share as they:

*Can pay more for talent
*Are less regulated
*Don’t have the stigma of selling to the Treasury (think of what selling portrays to the market)

This is even worse in the “real world” as all banks have the incentive to wait for other banks to sell risk assets to the Treasury to clear markets.

The likely result? The bottom right box in which no bank sells voluntarily and markets remain frozen. While there were many problems with the initial plan, at least there was a 100% incentive to sell the assets.”

BTW, EconompicData is a great blog I read daily. Complex economic 'stuff' made simple, and understandable... and full of pretty pictures.

42 comments:

Anonymous said...

One other reason is the planned penalties in executive compensation in companies that accept the money. I believe that the executives would risk everything to save their $.

dougiefreshhh said...

this nails it Ben.

Now expand to global markets/banks..and it gets really scary.

Make Bank A = US
Make Bank B = China

...and run the numbers. When countries start pulling the triggers for the sake of self interest... it could get REALLY scary.

Anonymous said...

Another game theory from Russ Winter: http://wallstreetexaminer.com/blogs/winter/?p=1933#more-1933

What if the super banks simply wait until the smaller banks go under - then purchase their assets on the cheap, only to mark them up and sell them to the gov't? That would recap these institutions without them having to pony up their securities...

The big banks will race to take over the smaller ones once this deal is passed. It's already happening... Bear Stearns, Lehman (Barclays purchases after BK), Merril, and now Wamu... Who will fail this w/e??

Charles Butler said...

Predicting the extent to which the bailout 'works' presumes some sort of inside track on what it's supposed to accomplish. There is much more to this than meets the eye. A good starting might be to note the evident confusion between the definition of 'the banking system' and that of 'banks'.

Gregor said...

I like the example, but, when there are more than 2 players I think the example's outcome will change. No matter how the plan is designed, there will always be incentives to both sell the securities to the Gov, and then NOT sell the securities to the FEDS. At some price, giving up some equity and taking a salary cap becomes worth it.

Michael Kent Nguyen said...

I agre with gregormacdonald, nice try though.

A for effort, F for FUN T___T

Anonymous said...

i think bank a will sell its assets to bank b. then bank b sells its assets to bank a. paulson buys bank a and b assetts and sells them back to bank a and b ....we find out that bank b bought it's own assets back. same for bank a.. both banks go WTF.

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