Four triggering factors of a major financial bankruptcy

Global Europe Anticipation Bulletin ^ | November 16, 2007 | GEAB staff

[AndyJackson]

While extra liquidity will keep the financial system from locking up on this orbit, longer term, how do you see this relieving the ultimate problem that we have an interlocking system of credits based on people writing checks they can't cash, all leveraged with crosslinked derivatives that assures us that any default anywhere is only going to clog the court system, which by the way might not be a bad outcome.

Defusing the problem requires reducing the debt burden on society, which will require what it always has, defaults and rapid inflation, unless you can see some other way for it to play out.

[geopyg]

My one grandfather was a builder back in the Depression and did quite well for himself - I think it was mainly upper class homes. My other grandfather was a tailor and although not rich, was able to keep his own store going - I suppose for new suits for the wealthy as well as repairs to old clothes for folks that couldn’t afford to go out and buy new. (I sure won’t like it if I have to go back to wearing “darned” socks though like my mom used to make me wear!)

[AndyJackson]

then some modicum of the same deflation of assets happens with all such institutions, so everyone is net the same.

The problem is that it is not uniform. The bank owes me cash on a 2 yr CD that was then loaned out on a real estate deal whose assets are now lower than before. Who loses? The bank? They cannot lose much because their capital is only a small fraction of the total risk. It is either me, or the FDIC pays off the account, and this "socializes" the loss. Everyone pays.

[bad company]

What does BDS mean?

Bush derangement syndrome.

http://en.wikipedia.org/wiki/Bush_Derangement_Syndrome

[ConservativeMind]

The beauty of the foreclosure market is that a reasonable residual value is had.

All the money on that investment isn’t gone. Real estate valued at $5 million might be worth $4 million now, but even some of that was built into the price of the loan to the borrower. And other assets the borrower may have would also help to collateralize it further.

This is not an issue where people are left with “nothing” for which the government must step in.

This is for investors who assumed the risk to be the ones to hurt.

[bjs1779]

My one grandfather was a builder back in the Depression and did quite well for himself - I think it was mainly upper class homes. My other grandfather was a tailor and although not rich, was able to keep his own store going - I suppose for new suits for the wealthy as well as repairs to old clothes for folks that couldn’t afford to go out and buy new. (I sure won’t like it if I have to go back to wearing “darned” socks though like my mom used to make me wear!)

Thank you for that. That's the way it was done, pure honesty. Sorry about those socks though!

[RockinRight]

Got a live one here...

[Moonman62]

When our country was founded it was deeply in debt with a severely devalued currency. Some thought it was hopeless, but a few decades later Andrew Jackson had the debt paid off.

We're in much better shape today that when the country was founded. A Federal Reserve that stops blaming inflation on the economy and embraces growth and full employment as desirable would allow regular people to afford a comfortable life without going into too much debt. On the political side I would like to see a retun to more supply side or classical economics.

[investigateworld]

I would have thought after the Barings Bank disaster, all the financial institution's would have taken a long hard look at derivatives game.

But instead, everyone's a player now. That tells me they know the US Gov't is ready to step in.

[Warlord]

Do you even know what “market efficiency" means? Young turks bilking individual investors? Intellectual laziness does not help your argument.

[NVDave]

Yes, I’m quite familiar with the “efficient markets” hypothesis (EMH). I’m also familiar with the research debunking the idea.

Here’s the simplest debunking possible exhibited this fall: the behavior of the automated quant funds. The “efficient markets” hypothesis says that irrational behavior by some investors is offset by other investors in market arb actions.

Where the EMH proponents have utterly failed is in predicting the rise of large pools of highly leveraged market action following the chasing the same sectors/trades.

Likewise, the EMH proponents have utterly failed to take into account the fact the some credit market derivatives simply fail to take into account all the “what if?” possibilities. For EMH to be valid, all possible events that would cause market movements would need to have a) vehicles to recognize a gain/loss as a result of those actions, and b) a market in which there are two sides to the trade in those vehicles.

The LTCM fiasco showed quite amply that a) there are events that the markets don’t price, and b) the “smart” people don’t act any more rationally (or intelligently) than the “irrational” people.

Oh, and here’s a recent article that popped up when I did a Google for hedge funds, dark hair, etc: Kinda funny that the guy basically lived exactly what I’m talking about:

http://www.portfolio.com/executives/features/2007/11/19/Blaine-Lourd-Profile#page1

[NVDave]

I just thought of a wonderful analogy for the EMH: string theory in physics.

Like string theory, EMH has been the basis for reams of papers in finance, lots of PhD defenses, etc. It has been a wonderful horse for lots of academics to ride.

Trouble is, just like string theory, it falls down in the real world and exhibits no predictive skill. In the physics world (as in finance), people are starting to attack these theories by pointing out this lack of predictive skill of these theories.

[Warlord]

EMH holds that errors in the market price of an asset are unbiased (i.e., deviations from true value are random). Markets achieve such randomness when arbitrage operators trade away consistent mispricing (EMH doesn't predict that the "noise" of irrationality is traded away completely, only that the noise that remains presents no bias). While it's true that arb ops, to be worthwhile, require significant leverage, as mispricing is most often quite subtle, EMH makes no “predictions” about leverage.

You learned the wrong lesson from LTCM. The problem in the LTCM case was the assumption of persistent market liquidity, not that "smart" people are no better than others.

It's not clear what you mean by "credit market derivatives" and "what ifs". At the end of the day, we'll likely learn that the current problem springs from deficient underwriting standards caused in great part by the separation of mortgage underwriters from economic risk. The loose standards presented a potential for significant default correlation in periods of stress. Quite likely, the models used to analyze mortgage credit based securities underestimated stress case default correlations.

The risk shifting made possible by the credit market products developed in the last 20 years provides much social benefit. In the future, however, when the markets shake out, sponsors will likely need to retain some more economic risk to assure adequate underwriting, and better default correlation assumptions will be built into the models. Nevertheless, the death of leverage is greatly exaggerated. New risk shifting technologies will develop, smarter in design than older approaches.

The envy of the old men of "Main Street" is no less of a problem than the greed of young turks of "Wall Street." Wall Street and Main Street depend on one another. Each has its role.

[Warlord]

So, that “way to grow rich” is hard toil using old and inefficient technologies, along with child labor and industrious horses. Before you dismiss the “credit system” and “pools” as means to poverty, think about updating your model.

[NVDave]

The problem in LTCM was that “smart” people wouldn’t observe what the market was telling them. Instead, they chose to hang onto their intellectual dogma, persisting in the belief that they were the rational force in the market. That’s the lesson of LTCM: Nobel winning economists are treated no differently for illogical assumptions than chumps on the street.

OK, you still believe in EMH: here’s another counter-example:

If we believe that EMH is true, then no one should be able to beat the average market performance for any extended period of time, right? Well, what do we make of Buffett, Soros, et al? EMH postulates that in the long run, no one is able to consistently return excess gains.

Next problem with EMH: If it were true, then why would the “rational” money managers be paid so handsomely on Wall St? Let’s say that EMH is true. Then EMH tells us that there is no point in paying anyone on Wall Street to manage money for other people with any promise of increased returns, much less *charge* investors to place their money with these people.

Clearly, since there are over 6,000 hedge funds, and ever more coming out every day, Wall Street professionals, ie, the “rational” forces in the market, don’t believe in EMH. If they did, they’d all walk off the job and tell investors to put their money into the Vanguard 500 index fund and be done with it.

Therefore, it is clearly obvious that Wall Street doesn’t believe in EMH - and those are exactly the “young turks” that I’m speaking of. If they don’t believe in EMH, and they’re supposed to be the “rational” side of the market arb (with us “little people” being the other side), then just where and how is EMH supposed to happen, hmmm?

OK, last nail in the coffin of EMH: “semi-strong” EMH says that all public information is discounted into a stock’s price, and that only non-public information can offer any advantage. Let’s put completely ignore strong EMH, since the hedge funds clearly don’t believe in strong EMH - that’s why they won’t make their trade positions public.

Semi-strong EMH says that all public information is discounted and that neither technical nor fundamental analysis will yield excess returns.

OK, on the fundamental side, there’s Value Line proving semi-strong EMH wrong. Oh, and Buffett.

On the technical analysis side, there’s the Turtles (among many others) who have proven semi-strong EMH wrong. Matter of fact, not only did the Turtles prove semi-strong EMH wrong, the Turtles proved that technical analysis can be taught and that people who followed a set of systematic rules could achieve superior gains.

[grey_whiskers]

Wall Street achieves “market efficiency” by using the “it is different this time” promises of young turks to bilk the wealth out of individual investors and put it into their pockets.

Always has. Always will.

You just confirmed a vanity I need to write.

Cheers!

[grey_whiskers]

On the technical analysis side, there’s the Turtles (among many others) who have proven semi-strong EMH wrong. Matter of fact, not only did the Turtles prove semi-strong EMH wrong, the Turtles proved that technical analysis can be taught and that people who followed a set of systematic rules could achieve superior gains.

I've heard of the other folks you mentioned but not these 'Turtles'.

Could you provide a reference?

Cheers!

[NVDave]

Here’s a quick synopsis of the Turtles:

http://www.tradingblox.com/originalturtles/story.htm

Since I’m piling on the evidence against the EMH, I’ll add that simply reading Jack D. Schwager’s books (Market Wizards, The New Market Wizards and Stock Market Wizards) shows that contrary to the dogma of semi-strong EMH, it is not only possible to achieve higher gains with only public information, there is a small group of people who can do it fairly consistently and most of them don’t rely on fancy mathematical modeling. The Turtles are famous because their system wasn’t based on esoteric finance mathematics, but disciplined trend-following and loss containment - pretty simple stuff:

http://bigpicture.typepad.com/comments/files/turtlerules.pdf

[AndyJackson]

A Federal Reserve that stops blaming inflation on the economy and embraces growth and full employment as desirable would allow regular people to afford a comfortable life without going into too much debt

Debt is the result of inflation caused by expansion of credit. Debt is part of the mix of money, and if your refuse to accept debt in this economy, your ability, as an average member of society, to house, clothe,feed and school a family of 4 is very marginal, since everyone else has accepted debt as a way to pay for it.

The theory is old. Von Mises and the Austrian school wrote about it, and so did Greenspan in his earlier years before he became Fed chairman and took the road to hell. The Federal Reserve is largely to blame, but so is the congress complicit in spending money they don't have.

[Warlord]

You offer little evidence of persistent bias in market prices. You hint at such bias, but you fail to consider that the "œcounterexamples" may involve portfolios that simply entail more risk (e.g. Soros' currency bets) or assets not susceptible to EMH (e.g., Buffet's purchase of a control position in an insurance company). The performance of actively managed mutual funds actually tends to prove EMH. Research indicates that fees paid for the active management of a portfolio of securities that trade in liquid markets are wasted in terms of risk/return. Actively managed funds exist nevertheless because people will waste some money for the sake of convenience.

EMH predicts a tendency toward randomness in pricing error for markets with sufficient liquidity, not a absence of opportunity for excess profit. The opportunity for alpha abounds for people who deal in illiquid assets (e.g., as we speak, young turks are forming funds to purchase mispriced mortgage backed debt products; Buffet acquires and manages companies) or employ ever-evolving arbitrage models (that is, the smart folks who enforce the EMH tendency). Also, purchasing a control position in public companies presents opportunities. Leverage makes all this stuff possible. It's a beautiful thing, really.

The main reason strong form EMH doesn't hold is that insider trading laws discourage the activities that would enforce strong form efficiency.

I'm afraid that you've merely nailed a caricature of EMH into a coffin.