December 22, 2008
2008: Too Little - Too Late!...2009: All will be Fine?
At this season, it is traditional to reflect upon the past year and look forward to the next 12 months.
Prediction is tough. If on 1 st January 2008, you had predicted that, by the following December, half of the US banking system would be nationalized and Goldman Sachs would be a commercial bank (losing a couple of billion dollars in a quarter for the first time ever), you would have been whisked off to the funny farm pretty quickly.
2008 was a funny year - not funny ha-ha, but funny - Yuk!
2008 was the year of transition; the transition matrix to be precise. Using a Credit Transition Matrix, based on ratings from Standard & Poors etc., and with days, sometimes weeks, of historical data we were able to price a First to Default Credit Default Swap quicker than you could say 'default event'. But the Lehman settlement debacle showed that transition matrices had more holes than a cobweb and were just as dangerous if caught in the middle.
Trillion was the number of 2008. In mathematics, trillion belongs to the set of so-called 'scary numbers', figures so huge that their only purpose is to frighten people; like the size of the universe, or the cost of a cup of coffee in hyper-inflationary Germany. But no bailout in 2008 could be considered worthy of the name unless its eventual cost was predicted to be over $1 Trillion. In the first (of many) bailouts, it is reported that when asked how the figure of $700 billion was arrived at, an official of the US Treasury allegedly said, "No real reason, we just wanted a big number to catch everyone's attention". Too little, too late - a Trillion would have caught their attention. A billion has become chump-change - share-prices don't even move on the loss of a billion anymore. And with Bernie Madoff, fraud has become hyper-inflationary. As an operational risk event, this $50 billion loss is so far out in the tail that the remainder of the operational loss distribution is made irrelevant. At last - a single point distribution?
2008 was a sad year. After a long illness, banking regulators eventually succumbed to Narco-Kuklosis (also known as 'Asleep at the Wheel' syndrome). This incurable disease, which particularly affects citizens of the Swiss city of Basel, is very painful, causing the spinal column to disintegrate in the presence of investment bankers. And, unfortunately, the disorder will go uncured for some time, as FRINK (the Foundation for Research Into Narco-Kuklosis) has placed all of its endowments with Bernie Madoff for investment.
Hindsight is sexy, but Foresight is sexier.
In 2009, I foresee that:
- Early in the year, the new US Secretary of the Treasury, Timothy F. Geithner, will invite Raul Castro to Washington, to get lessons on how to nationalize banks properly.
- Bernie Madoff will plead guilty, but use the Systems Risk defense, 'I really should have upgraded from Lotus 1-2-3 to Excel a few years back'.
- Gazillion will be the new trillion.
- In mid-year, Standard & Poors will issue a new credit transition matrix, with 100% (probability of default) in every cell. They will argue, with some justification, that at least it is more accurate than the current one!
- S&P and Moodys will then retreat to a silent convent to reflect upon their past sins.
- And finally, regulators will regulate - No I take that one back, much too far fetched.
As I hear the psychiatric nurses hammering on the door, I predict that we will wake up on 1 st January 2009, and realize that 2008 was just a bad dream. We will delete 2008 from our Blackberries, like a one-night stand, and cross it off our Christmas card list.
Our New Year's resolution will be to get back to doing what we do best: buying stuff we don't need, with money we don't have, on credit from banks with no ethics, regulated by supervisors with no clue.
Don't worry, 2009 will be just fine - for insolvency practitioners.
Posted by pjmcconnell at 03:15 AM
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December 13, 2008
Best of all Possible Worlds
Milton Friedman "The only relevant test of the validity of a hypothesis is comparison of prediction with experience"
One of the great snow jobs of the past thirty years is the assertion that "efficient markets" equals "free markets" equals "capitalism and democracy" and mom and apple pie. For its proponents, to criticize the Efficient Market Hypothesis (EMH) is akin to attempting to clone Lenin from his Kremlin mausoleum. But EMH is not about free markets, it is merely a conjecture about 'information' and how investors SHOULD use information to participate in financial markets.
EMH is covered in immense detail on immeasurably Internet sites so it is unnecessary to describe in detail here, other than to note that in its 'strong-form' the hypothesis states that investors cannot consistently earn 'excess returns' over a long period of time.
Pity nobody told the schmucks on Wall Street, before they gambled our pensions in the credit crunch casino!
Another way to state the EMH hypothesis is that the market will right itself eventually. According to the theory, 'rational' investors, who have the same information, will arrive at the same price for a traded asset guided, no doubt, by the invisible hand of Adam Smith.
Like Voltaire's comic hero Candide, Alan Greenspan (Emperor of EMH) is the eternal optimist, believing that all he had to do was tweak the Fed interest rate and, markets being efficient, everyone would naturally behave sensibly.
In his recent testimony to the US Congress, Dr. Greenspan said he was in a "state of shocked disbelief" at what happened in the US credit markets. Note he was not shocked at the millions of people thrown out of work as a result of his beliefs, but, as he whined, that the "self interest of lending institutions failed".
I have news for Dr. Greenspan, every Wall Street firm did have all the market information they needed to make rational investment decisions, since they were busily reporting record profits based on the crazy asset prices that everyone was turning a blind eye to. The efficient marketers knew well that the bonus bus was racing out of control down the mountain but wanted to be the last one off just before it went over the cliff.
The impact of the dominance of EMH in financial market theory on approaches to financial regulation cannot be denied.
If EMH is right then, since the market will right itself naturally, there is little need for regulation - why try to second-guess the all-powerful market? In this financial Utopia, all regulators have to do is to ensure that market information is made as widely available as possible and, hey presto, as Candide would say 'all is for the best in this best of all possible worlds'.
In this parallel universe, markets don't have to be regulated, they will, since they can do no other, regulate themselves. As a consequence, over time, self-regulation has become the name of the game and financial regulators around the world have fallen over themselves trying to get out of the way of self-regulators, happy to receive advice from the banks themselves on how they should be regulated. Basel II is just one such example of pandering to self-regulation.
But what if EMH is wrong, or at least not always right? It is but a mere hypothesis after all and one that has been severely tested, as Milton Friedman would say, by experience (not least in our pockets). The beauty of EMH however is not that it has never been proven correct (except by definition) but that it cannot be proven wrong since any counter example is considered by its adherents to be merely a statistical outlier. So one individual (say, for argument's sake, Warren Buffett) may make outrageous profits over a prolonged period, but not everyone did, QED - EMH must be true!
Debate has raged for years about whether EMH has any validity, not least between the efficient marketers and the proponents of Behavioral Finance. Behavioral Finance, which has achieved respectability since one of it originator - Daniel Kahneman - received a Nobel Prize in 2002, states basically that far from being 'rational', people are sometimes stupid, very stupid. And there is a growing body of experimental and real-world evidence that Dr. Kahneman may not be too far off the truth. People may not always 'beggar thy neighbor' in the zero-sum game of the efficient market, but instead often tend to 'follow thy neighbor', even if it is down a financial blind alley.
But what if both theories were, at least in part, correct. Investors may indeed tend to make rational economic decisions if there is an abundance of 'good' market information, but where information may be lacking they may do something 'economically irrational'.
It is worth posing the question: what should regulators do if Behavioral Finance is in fact correct, even if only in certain conditions? In such a situation, regulators, and their political masters, just cannot stand on the sidelines since 'irrational' or 'human' behavior (depending on which theory one subscribes to) can have very serious consequences, as we have witnessed in 2008. Regulators just have to wake up and realize that some people sometimes do idiotic things. Regulators have to regulate, a forgotten notion but still useful nevertheless.
What this means is that regulators, instead of letting banks do their own thing, have to again begin to ask tough questions, such as 'tell me once more why you are lending money to people who cannot pay it back'? The answer that 'everyone else is doing it' is of course no longer valid, but should instead warrant the rejoinder - well stop it or you are grounded! The regulator as parent rather than friend.
Following the precautionary principle, regulators should always remain skeptical about economic theories, as they come and go like any other fashion. However, human behavior remains constant, and regulation is as much a social science as a mathematical one. Maybe the Fed should be hiring psychologists as well as rocket scientists?
Regulation is often characterized as a pendulum, swinging one way then back again. But in this age of the digital watch, does anyone in Generations X or Y know what a pendulum is? I prefer instead to envisage the beautiful parabolic arc of the executioner's axe - at one end benign, at the other deadly. Regulators are now at the cutting edge of regulation and they had better get sharp about what exactly they are going to do to intransigent bankers. If they don't, they will be on the chopping block themselves.
But efficient marketers are nothing if not optimistic, as Dr Greenspan assured Congress "This crisis will pass, and America will reemerge with a far sounder financial system". Candide's mentor, Pangloss, expressed EMH more lyrically when he said 'private misfortunes make the public good, so that the more private misfortunes there are, the more everything is well'. In other words, even though you may have lost your job, your home and your pension, treat it as a learning experience.
So as you queue patiently in the line for the soup kitchen, please take the opportunity to discuss the finer points of Modern Portfolio Theory with your neighbor, the ex-regulator.
Footnote
The author has begun work on a bridging theory, a 'grand theory' if you like, which is tentatively called the Inefficient Behavior Supposition (IBS) that in lay terms states, "If people don't know where they are going, they won't get there".
In more technical terms the IBS theory postulates that
E (RD | I(In)) = 0
or the Expectation of a Rational Decision (RD) given Incomplete (I) Information (In) is zero where I is a monotonic Incompleteness function, bounded on the interval [0,1].
Basically, this says that without good data we are as likely to get any decision wrong as right! Unfortunately, we can never know when we have all the information that we need?
Posted by pjmcconnell at 10:32 PM
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