Tuesday, September 23, 2008

Game Theory

Game Theory is the branch of mathematics that attempts to quantify social decision making. When two or more parties are involved in a mutual decision making process, it is necessary to create a profile or approximation of the other party's behavior. This is particularly relevant in an auction process.

As I have mentioned before, the sale of these poor quality assets will depress the amount of capital on the seller's balance sheet. The amount of capital depletion depends on the difference between the most recent marked to market price and the execution price. As a result, the seller may reveal the fact that they are insolvent. It is also a signal to regulators that the institution has risk management issues. Information of this type is quite valuable. When (if?) short selling is allowed, speculators would easily see the target on the backs of these banks.

Therefore, in order for the process to get rolling, the Government would actually have to pay a premium to the seller to compensate them for the follow through effects of the sale. This is where Game Theory comes into play: how much of a premium do the Feds pay?

Side note: Paulson just finished his testimony in front of Congress. He sounded pissed.

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