Thursday, March 27, 2008

The Failure of Finance

(Naked Capitalism) Two loosely related and thoughtful posts today point up some of the ways that the fundamental frameworks of how participants think about and relate to financial markets are breaking down. Note that this development is separate from the fact that financial institutions look pretty wobbly. Instead, these two writers, Roger Ehrenberg and Cassandra, highlight two different, but fundamental ways that investors' mental models about markets are under serious strain.

This is a more troubling issue than might be obvious. It is very unnerving to have core assumptions proven wrong, or at least not as reliable as you thought. This repudiation of widely-held beliefs (starting with the cliche "safe as houses") is going to produce dislocations that will feed into institutional stress.

Ehrenberg and Cassandra attack this phenomenon from very different vantage points. Ehrenberg discuses how some of the assumptions underlying much of modern finance have failed; Cassandra, although also taking a similarly analytical starting point, about how gains and losses are usually distributed in market, focuses on how the recent disruptions are likely to lead to radical changes in investor behavior, namely revulsion towards financial assets.

When I started out in the securities industry (1980) stocks were regarded as speculative. Investors still recalled how people had been wiped out in the Crash, how it had taken until 1954 for the Dow to return to its 1929 levels. The 1950s and 1960s had been good times for stocks, but again, the 1970s showed them to be losers once again. Investor Peter Lynch said that stocks were the best investment when the public regarded them as risky, and most speculative when they were widely regarded as safe. The idea that equity investing could be perilous is still deemed antique in many circles, but the grind of credit contraction will erode the faith in most financial assets.

This is a long post because both authors have worthwhile observations. I encourage you to read both their views. Cassandra's observations also shed light on the inflation vs. deflation debate, which has been gnawing at me.

First, "(Dis)continuous Time Finance" from Ehrenberg:
I grew up in a time when markets were considered to be "continuous.".... Liquidity was presumed to be available. And while markets could and did gap due to an event, new information, etc., it could and would clear with transactions taking place at the new level. The financial markets, through price discovery in the presence of liquidity, conveyed valuable information that could be used for both security selection and asset allocation. The field of financial economics, as such, was predicated upon the existence of bids and offers and, therefore, liquidity. And this phenomenon was assumed to persist across time.

But this is not the world I observe today; quite the contrary. Price movements are not only discontinuous, but the notion of liquidity across time as traditionally assumed simply does not exist. Something has happened to rock the prevailing academic paradigm. Have the experiences of the past six months essentially blown a hole through the heart of modern financial theory?

.....consider what Merton said back in 1987 as it relates to capital markets:
The conscious motivation for creating a capital market is to provide the means for financial transactions. However, an objective consequence of this action is to produce a flow of information that is essential for all agents' decision-making, including that of those agents who only rarely transact in the market.

You see, the problem is that without transactions it is hard to get information, and without information it is hard for people to transact. We are caught in this Catch-22, the Fed's prescription for which is injecting hundreds of billions of dollars into the financial system. And while this creates money, it does not necessarily create liquidity in the instruments for which no bids are available. Why? Because potential investors are sorely lacking information, either intrinsic to the securities or extrinsic in the form of observable market prices. This is partly due to the complexity of the instruments in question, the structured asset-backed market and related derivatives. And while this problem is not intractable, it is easy to imagine that getting sufficient information to make educated bids will take quite some time.

Another problem is that an element of liquidity was predicated upon the faith and belief in the ratings system. A AAA-rated security was available for purchase by trillions of investment dollars, AA-rated fewer trillions, A-rated hundreds of billions, and so on. But now that we've seen tens of billions of AAA-rated securities marked like junk, the very foundations of the institutional investment model have been shaken. Trust has been shattered. No trust, no liquidity..... we can't and don't live in a riskless world. The problem is that too many investors and market intermediaries thought we did. This was telegraphed by the historically low levels of volatility during the latter part of 2006 and into early 2007.

Today we live in a world fraught with risks that we barely understand, risks that modern financial theory doesn't have great answers for. A new model is needed that incorporates the effects of discontinuity as an outgrowth of, among other things:
Complexity - structured securities, derivative instruments;

Interdependency - widely disseminated holdings that can pollute portfolios globally, hundreds of trillions in counterparty exposures;

Intermediary errors - ratings that don't reflect the risks, financial institutions with weak control environments and poor risk management practices; and

Bad actors - originators, underwriters, traders and managers with mis-aligned motives.

....Our models and academic frameworks needs to be robust enough to handle these occurrences and to provide a model for maintaining liquidity, price discovery and information dissemination. Based upon today's market action we've got a long way to go.

Cassandra's post, "Liquidity Tug-o-War??" is quite long; I've omitted her colorful and insightful analysis to focus on her conclusions. She starts by discussing the until recently ever-rising tide of liquidity and notes:
....understand that one will lose half the value of the paper every four to six years, despite the tamer prevailing rate of so-called inflation as measured by government officials and apologists for unfettered liquidity creation. Such a reality is sufficient for those with such paper to avoid its accumulation by (a) spending it immediately (b) converting it to other stores of value (c) borrowing it in order to do 'a' or 'b' or both above....

Even if your view of the real, as opposed to nominal inflation rate isn't quite that dire, foreign holder of the dollar have seen those kinds of losses. Back to Cassandra:
And so credit growth, fueled by rising asset prices and ever-more confident lenders, is likewise positively skewed. Like the first skaters testing the ice, they proceed slowly, whereupon confident of its integrity based solely upon the fact that they remain above the surface of the icy waters, signal to the others that all is fine in slippery Golconda. Of course this is overly simplistic. There are in reality many forces at work: agent vs. principal issues; keeping up with the jones'; and all manner of behavioural biases that serve to reinforce the alledged prudence of one's herd-like actions and penalize the questioning of the same, for no one benefits from caution, not least the individual. At least until the edifice is too large for its foundations. There are of course limits to how many can safely glide upon an ice-sheet of certain thickness. Exceeding such threshold limits results in rapid fat-tailed catastrophe with no recourse. Eschewing analogies, revulsion destroys credit and collateral values in vast quantities. It crushes the price of core asset values in real estate and equity, and cremates securities that use these assets as collateral. The size of core asset value destruction in our present case being measured perhaps, ultimately, in the double-digit trillions....

But mega-revulsions do more. They scar the psyche, irrespective of whether by natural consequence of falling in under the weight of the edifice, or in response to man-made pressure such the Volcker's Saturday night massacre. Our current predicament is the former, the result of multiple attempts to prevent recession over the years, with diminishing marginal returns to the priming almost guaranteed that much of the investment would of marginal quality and ultimately wasted. Lenders, accustomed to lognormal distributions begin to rework risk under more symmetrical regimes. They reduce existing leverage to save powder and prepare for worse to come, much like the body will warm the trunk at the expense of the extremities. And like the body they do this not as opportunists but in self-preservation. Ray Dalio's Bridgewater in their latest research report makes the following points:
The financial market unraveling is, as we've described, 'the Big One". What we have meant by this is that the implications of the last six months will impact how the financial system will work for years. Both directly and indirectly (through the literal profits and incomes associated with the financial sector) and indirectly (through the benefits of credit creation) the economy is more reliant upon the financial sector than ever. The virtuous circle of easy credit and rising asset prices leading to increased consumption and therefore increased incomes has been fueling the economy for so long that it has been taken for granted. The reverse of this cycle will have profound implications for the economy, and we have only just begun to see those implications upon the real economy.

It is a natural and logical reaction. This is what the beginning of a cascade feels like, and one that only will end with the eventual uprightness and sustainable leverage atop the system, corresponding levels of consumption related to output, and asset values that are either reasonably well-discounted or known, at the very least, to have stabilized in the longer-term. We are not there yet, and every bank - whatever their domicile - knows this, hence are reticent to lend except to all but the most creditworthy, and on terms that provide more than just compensation for there remains a reasonable probability that price discovery continues in a direction that erodes one's margin of safety. Falling asset prices, in turn, kills the speculative animal spirits. Why build a new shopping mall when the existing ones can be had for less than the cost of new construction? Time shares will trade at hilarious distances below where they were sold in the primary market. And banks, flush with assets recently foreclosed have no appetite to project-lend when they are recently - involuntarily - long the last cycles excesses. Again the chain of dependencies numerous and complex, but the end result is the same: more destruction in collateral values and hence both liquiidity and the supply of dollars.

The remedy for this is clear. Rapid Price discovery. Writedowns. Recapitalisation where required. This will return confidence, albeit upon a much diminished capital base, and much diminished risk-appetites on the part of financial lending institutions. A reordering of the deck occurs: leveraged asset holders - whoever and whatever they leveraged against lose, as do the previous financial sector shareholders. It is against this backdrop that I raise the ultimate question for Moldbugs and those in dread of helicopters and printing presses alike: Is it even remotely plausible that authorities can replenish anything remotely like what's been lost, or what will be lost? Is not "reflation", or Fed gestures to bridge recapitalizations for systemic lubrication anything more than a drop in the bucket to what has been destroyed, making inflationary fears resulting from Fed or Governmental actions a canard? The liquidity resulting from securitisation, wanton misuse of the shadow banking system and its conduits ARE ALREADY out there. Much of it having ALREADY circulated and coursed through sytsemic veins is in the hands of foreign Official entities. They can spend it, but they can multiply it, won't multiply. Moreover, the effects have already been seen in the BRICs in the form of raging economies, buoyant mercantilist exports, vaulting commodity prices, and the $1000+ Kruggerand. But that was then, and this is now. Replacing some of the destroyed credit and liquidity surely can be but a salve upon a lost limb. It will, in the end, simply be inconsequential in the grand scheme of what's gone before and what is to come.

Longer term, I will defer to Moldbugs of the world and not challenge their assertion that the probability that the current reign of fiat money will end. But here, and now, I am far less concerned with the inflationary effects of TAF, TSLF, fiscal packages or outright nationalisation of financial institutions when the need arises since I believe that the credit so destroyed by this revulsion, and the associated cascades and intermediate-term behaviour changes far outweighs the remedial impacts of authorities.

I find this a persuasive line of argument (although I am always interested in other views), namely, that the scope of the deleveraging will overwhelm the efforts of the authorities to reflate.

I have mentioned before that Our Chairman Bernanke takes great comfort that determined monetary authorities can reflate from the example of the US in 1933-1934. But remember, the operative word is reflate, not forestall deflation. 1933 was after massive bank failures and deflation had already occurred. And the FDIC was established in 1933. It is unclear how successful purely monetary measures would have been if unaccompanied by institutional reform.

That is a long way of saying that Cassandra has given an argument for my gut instinct that if the credit crisis cannot be arrested (and I think that's high probability; the problem is too big for the government to fix it), the path we are on is deflationary rather than inflationary. Even if the Fed aggressively expands the monetary base, increased cash hoarding will mean that we will not see correspondingly large increases in money supply. And a contraction in near-money will more than offset whatever pump-priming the Fed can manage.

We can only hope to be so lucky as to get stagflation.

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