Merton on the Financial Crisis
By Arnold Kling
I enjoyed his comments on asset valuation. He wonders whether the issue is that the assets cannot be valued or that key players (bankers, regulators) don’t want them to be valued.
He takes what I call the “geek” side of the suits vs. geeks debate. His view is that the assets are not necessarily undervalued. He emphasizes the nonlinearity, put option nature of the assets. Another key point is that it does not take complex derivatives to create embedded options. Many ordinary assets have embedded options, with resulting nonlinearity.
Rather than blame new instruments and complexity, he blames the disconnect between nonlinear instruments and linear thinking. This shows up in the process of rating AIG as AAA, which did not take into account the nonlinear risk of their swap portfolio.