**Comment (10-27-2008) from:**

**Name: Hugh Ching**

**Affiliation: Post-Science Institute**

**Address: PO BOX 2663, Fremont, CA 94536**

**Email: ching@postscience.com**

**Phone Numbers: (510) 745-7604**

**Billing code: 4810-25-P**

**DEPARTMENT OF THE TREASURY**

**Development of a guarantee program for troubled assets.**

**AGENCY:** Department of the Treasury, Departmental Offices.

**ACTION:** Notice and request for comments.

Subject: **How To Determine Value, and Premium**

Value can be defined as the sum total of all the future benefits and
losses to infinity in time. Value is generally expressed as the price or
the rate of return on investment. Insurance premium depends on value
determination and will be commented on after the comment on value in the
following paragraphs.

In order to specify the inputs to value determination to infinity in
time, all the inputs are expressed as approximate time invariant
quantities. The inputs are obtained from comparisons to past data. Only
time-invariant quantities should be compared to the past.

**The price depends on the future expectations. The price should not be
compared to past prices.** The price to be calculated changes
continually to infinity in time, with the continually changing future
expectations. The price is a time-variant quantity.

The standard of rigor of science is empirical verification. In order for
empirical verification, phenomena in science must occur within a finite
time duration. The correctness of the price paid cannot be empirically
verified because the price changes continually to infinity in time. The
concept of a time-variant quantity does not exist in science. Being
impossible to be empirically verified, social science needs to subscribe
to a rigor more stringent than that of science. The solution of value
needs to be mathematically rigorous.

**Full disclosure is an important and practical characteristic in price
determination. Full disclosure should include the methodology of
calculation and all the inputs to infinity as well as the output.
Government regulations on valuation should include the requirement of
full disclosure, which will enable full accountability in the future.**

In fact, the whole process of price determination is to relate the price
and all the factors affecting the price from now to the infinite future
in a mathematically rigorous fashion. When it is mathematically
rigorous, the solution of value is a non-violable law of nature in
social science, as non-violable as mathematics.

Free market championed by **Milton Friedman** might function better than
a market regulation by man-made laws, but free market is only free
within the limit set by the non-violable laws of nature in social
science.

Friedman and I had some heated communications during the last years of
his life on the existence of non-violable regulations of nature. The
debate turned two old friends into intellectual adversaries. There is
also a debate among top economists on returning to government regulation
in view of the current crisis. But, for me, Milton Freidman is still the
only thinker in the twentieth century who had built an intellectual
mountain.

Friedman with the quantity equation of money (PQ=VM) could have save our
current economy from another possible Great Depression. The equation
**Price x Quantity = Velocity of Circulation of Money x Money Supply
(PQ=VM)** requires that the circulation and the supply of money be kept
up with the gross national product. The equation, after further
examination, could be another important law of nature in social science,
while the problem of excessive national debt, which is a man-made,
self-imposed financial discipline, is hardly noted during the current
crisis.

Briefly, the problem of value can be described as the satisfaction of
the cash flow equation, **Cash Return = Sum Of Cash Flow + Cash From
Resale**, for the price and all the resale prices to infinity in time
and space. For multiple commodities with uniform functionality, the
quantities for each price are summed to form the quantitative supply and
demand curves whose intersection gives the equilibrium price.

**Gerard Debreu** has described the problem of value with mathematical
rigor in his book ***Theory of Value***. On page 34 of the book, he uses
a discounted cash flow equation to determine the temporal dependence of
the price. **Kenneth Arrow** asked me once: **"What's wrong with
discounted cash flow model?"** My answer was that in order to discount
correctly, a different discount rate should be used for each and every
year, and having to use different rates made the method impractical. The
rate, as an input, should be an approximate time-invariant quantity,
which should be obtainable from comparison to past rates and can be used
as a market comparable in the future.

Arrow's question actually raises a serious criticism of the fundamental
concept of modeling in knowledge. In science, where the problems are
simple, the discrepancy between a model and the reality is generally
within a tolerable range. But, in social science, where there are around
fifty variables, as exemplified by the number of inputs to the solution
of value, reality generally cannot be simplified into models.

**Benedict Spinoza** advised to "**follow reality and avoid using
abstraction"** and to **"solve a problem in its entirety**." Today he
would be against methodology based on modeling and methods, which assign
weights to different factors based on time-series analysis of past data.
The cash flow equation used in the solution of value is the realistic
accounting of cash flow. To solve the problem of value in its entirety,
the solution must include the consideration of all the future
consequences to infinity in time and space, as Debreu has insisted in
his book.

In computer hardware chip design, knowledge is distinguished into
structural and descriptive. The structural knowledge deals with how the
circuit works, and the descriptive knowledge, how it looks like. Social
scientists also use mathematics descriptively and structurally. However,
any solution in social science should a structural part. In particular,
the solution must be deterministic in that the number of equations must
equal to the number of unknowns. In the solution of value, the
deterministic set of equations and unknowns can only be collected when
the consideration is taken to infinity in time.

**Paul Samuelson** initiated the descriptive mathematical approach in
economics. Mere description of a problem, regardless whether the
language is English or mathematics, would still leave the problem
unsolved. Debreu, at least, solved the spatial dependence of the problem
of value with a structural approach involving the fixed point theorem.
And his mathematical description using set theory has greatly clarified
the problem of value.

The insurance company, being the last to hold the bag of responsibility,
has the full burden of knowing the values of all things happened before.
The guarantee program for trouble assets is, fortunately, sponsored by
the government, which has unlimited power to print money and highest
authority, but is still subordinate to nature. Even the government must
observe the non-violable law of nature in the form of the solution of
value.

To guarantee troubled assets is like to insure a car after an accident.
What is needed is an estimator of damage, and the insurer can raise to
premium in the future based on the estimation. The estimator is an
appraiser of value. The determination of the premium for insuring
troubled assets should start from the determination of the value of
troubled assets.

Very roughly, the partial premium for one troubled part of the asset
might be

**Premium = (Sum of default principal and interest payments + Mortgage -
Value of collateral of asset)/Number of premium payments + Premium for
untroubled asset**

where for trouble assets the last term is generally small compared to
the first term on the right side. For real estates, the asset is
mortgage backed security (MBS). Even for an untroubled asset, the risk
of MBS depends heavily on the value of the real estate.

The wholesale default of credit default swap (CDS) on MBS is most likely
due to the incorrect method used in determining the value of the
premium. Those methods used by AIG and Fannie/Freddie should be
seriously questioned.

Both the collateral, which is the real estate, and the premium for
untroubled asset (MBS) involve the valuation of the real estate. The
situation might seem to be complicated by the possible absence of a
market. But, price should not depend on market comparable prices and
should depend on expected future cash flows.

The value of real estate, for example, can be calculated easily using
the valuation software on the web:

http://www.123is.com/fedreal.htm

One of the immediate applications of the above valuation system is to
calculate the effect of interest rate on price. Just doing two
calculations by changing the current interest rate and the resale
interest rate by one percent will show the change of the price due to
the change of the interest rate. Changing the interest rate from 6.5% to
5.5%, the price changes by 9.15%.

The determination of the price should depend mainly on the comparable
inputs of rents and rent increases, not on market prices, which are
generally incorrect in a depressed market. The above valuation system
has successfully predicted, and could have prevented, the Savings and
Loan Crisis and the Subprime Woe by detecting market over-valuation.
During these financial crises, no reasonable inputs, no matter how they
are stretched, could justified the price in the valuation system.

Value can also be expressed as the expected rate of return on
investment. The problem of value can be considered the determination of
the price when the rate of return is known, such as for real estates, or
the rate of return when the price is known, such as for stocks. The
expected rate of return on investment, like all the other inputs, except
the price, is a time-invariant quantity.

Deterministic price determination takes one iterative loop. Calculation
of the rate of return requires two iterative loops, one for the price
and the other for the return. Stock valuation involves time-varying
inputs for an initial finite time interval, as shown at the web link:

http://www.123iss.com/fedstock.htm

The priorities of proposed projects should be based on the expected
rates of return. For example, the toxic assets could have one of the
lowest rates of return because the rate, when the assets are
over-valued, is most likely negative, by definition. However, investing
in and guaranteeing the troubled assets could have, due to the high
risks involved, very high rates of return, when the premium is not
prohibitively large.

To behave as a private investor with nearly unlimited funding, the US
government for long-term consideration should decide its priorities in
terms of the expected rate of return. The following is a short list of
investments with their approximate rates of return from Post-Science
Institute:

1.  Venture capital investments (rate of return \> 100% per year)

2.  Real estate development (50% to 100%)

3.  Small business (40%)

4.  Commercial real estate (15% in 1980s and 12% in 2000s)

5.  Mature large corporations and banks (10%)

6.  Stocks (5% to 150%; each company has its own rate of return)

7.  Houses and condos (10%)

8.  Road, bridge, and other infrastructure building (5%)

Capitalism must survive through continual innovations (\>100% rate of
return). Mankind gets about one major innovation in a generation or 25
years. The most recent two are the PC Revolution based on the
microprocessor and the Internet.

Money matters, but is not everything. The left side of the equation PQ
in PQ=VM plays equally important role. Our current crisis is also caused
by the decrease in PQ after the low-tech housing industry, which is used
to fill up the vacuum left in the economy after the crash of the
Internet industry, can no longer sustain the economy.

Post-Science Institute would like to recommend investing part of the
economic rescue money on revitalizing the disrupted Internet explosive
growth, which is the main innovation of the current generation with its
supporting innovations in multi-media, wireless technology,
nanotechnology, etc.

All the other untested emerging innovations, such as new energy sources,
particularly nuclear reactors, and environmental projects, should only
be funded publicly after their rates of return have been calculated.
Thus, a correct solution of valuation should take one of the highest
priorities.

There should be enough evidence from the S&L Crisis, the Subprime Woe,
the failures of Fannie/Freddie, AIG, Bear Stern, Lehman Brothers,
Washington Mutual, etc. that we need a correct solution of price
determination and that the market comparison method generally used in
price determination is incorrect.

The market comparison method in real estate or actuarial analysis in
insurance is just the blind following the blind until everyone falls off
a cliff in a financial crisis. The fall of AIG should be ample proof
that actuarial analysis does not work for insuring MBS.

Incorrect solutions of value create irrational market participants.
Irrational market participants produce incorrect market prices.
Incorrect market prices cause financial crises. Conversely, correct
solutions of value creates rational market participants and correct
market prices. **When all market participants, including the government,
use correct solutions of value, most past, present, and future financial
crises should be predictable and avoidable.**

The permanent solution to our financial crises, which are certain to
grow in severity, is to enlist knowledge-centered greatest minds in our
society to outthink the ingenuity of money-centered inventors of
financial instruments, which will also grow in number and
sophistication.

The Federal Reserve, Treasury, FDIC, and SEC should jointly establish a
valuation center to search, verify, recommend, and teach valuation
systems and for their own operations.

One of the most important contribution of the rate of return calculation
is in: **How To Set Interest Rate.** The logical economic relationship
should be:

**Inflation Rate \< Interest Rate \< (Expected) Rate of Return**

where the rate of return should be calculated for all the major business
and industry sectors and for the main investment types within each of
these sectors.

Solving the complete problem of value described by Debreu should be the
first step in the development of a new social science based on value.
The correct solution of value should be the foundation of rational
decision and policy making and should be able to solve most of our past,
present, and future financial crises.

**Money can offer temporary relief for our economic pain, but only
knowledge can provide permanent solutions and real progress to our
society.**

Thank you for your attention. Hugh Ching, Post-Science Institute