Getting Lost in the World of Complex Investment Vehicles

There is a reason why certain brilliant minds come up with incredible works of art, are known for their contributions to the betterment of the entire world, or simply for their understanding of the world’s practicalities as seen through the “eyes” of economic theory. There are usually no surprises when such “Beautiful Minds” are also found deserving of the Nobel Prize.

Take as an example John Forbes Nash (who won the Nobel Prize for economics in 1994) and his contribution to the game theory. More than five decades after he wrote his PhD dissertation, the Nash equilibrium — or lack thereof in certain instances — can still explain why certain economic events occur.

The Nash equilibrium is a proposed solution to a “game” between two or more players, whereby none of the players has anything to gain if they change either the rules of the game or their own strategy unilaterally. Considering the status quo among the players and their offsetting strategies, Nash equilibrium has been achieved.

A variation on the Nash equilibrium is something called the Prisoner’s Dilemma, in which the equilibrium does exist, but in terms of both players “cheating” and switching their strategies sort of midstream. Since “cheating” is considered an inferior game solution to “not cheating,” such a strategy is also deemed inherently unstable, and thus incapable of achieving real equilibrium.

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One could say that when the world hit the 21st Century, the “game” was elevated to a whole new level. A number of economic events since 2000 have contributed to what we now fearfully label as the global credit crisis.

The late 1990s were marked with exorbitant stock market valuations, which resulted in a bubble and then a spectacular crash. To prevent the recession, the Fed dropped interest rates all the way down to one percent in 2003 and kept them at that level for an entire year. As a result, another two more bubbles were created — the credit bubble and real estate bubble.

With easy credit, largely artificial economic expansion and continuously elevated money supply, the institutional pools of money swelled to historic proportions, and they simply had to do something with it. And what did they do? They created an enormous market for structured investment vehicles (SIVs), the size of which grew to $350 billion.

Structured investment vehicles are bank-run types of investment that were created with the intention of exploiting the imbalance between short-term borrowing rates and typically higher long-term expected returns on mortgage-backed securities, for example.

The only problem with bunches of mortgages packaged together and wrapped in the issuing entity’s credit rating (and not the credit rating of each asset included in the SIV) is that the players really don’t know the rules of the game, which is why they cannot also devise an applicable investment strategy.

As a result, one side (buyers) has to base their strategies on information provided by the other side (sellers). In other words, since buyers have no other recourse but to believe every word coming out of sellers’ mouths, Nash’s equilibrium has been distorted because sellers have every incentive to “cheat” and buyers have virtually no maneuvering space to “cheat” as well, or to establish at least the inferior equilibrium, the Prisoner’s Dilemma.

If only the consequences of playing this game were not so serious and so far-reaching. Not only is the subprime lending market in trouble, but so are the banks that created those ill-fated SIVs, the investors who bought them, and even solid, innocent loans that were bunched together with a number of bad apples.

At this point, unfortunately, there isn’t much anyone can do. We’ll keep watch at the Fed’s next week’s meeting with the Reserve Board, where the credit market will top the agenda yet again, as will the issue of whether to further trim interest rates. Most observers agree interest rates will continue going down for the time being. However, what no one is certain of is how much further down interest rates will have to go to resolve today’s flavor of the Prisoners’ Dilemma. It seems these days that it is darned if you do, and darned if you don’t.