Tuesday, 30 September 2008

Containers, credit and Nassim Nicolas Taleb

Reading Marc Levinson’s influential book, The Box, about how shipping containers changed the world has made me think of a new way to approach the credit crunch.

The general thrust of Levinson’s book is that containers massively reduced the cost of shipping, meaning the end of traditional docks, and associated industries, and separating industry from the restraints of transport. Things could be sent anywhere, from anywhere. Hence China.

As with most single-issue economics books, too much weight is put on the book’s main subject, while other important factors are downplayed or ignored. Levinson makes no mention at all of wider political or economic trends, such as pressure for free trade, increased capital movements and the Cold-War-inspired inclination of the US to open up its market to south-east Asian imports.

But this critique is not my link to the credit crunch. Instead, it is Levinson’s rather brief point about the container’s role in the introduction of ‘just in time’ industrial production, where materials are transported (often long distances) at precise times, in different factories.

His point was that the container helped allow a much higher-risk and lower cost form of production to develop. Containers were one part of a technological shift reducing inventories and allowing producers to outsource work that had previously been done inhouse. Vertical integration was out, horizontal integration in.

What does this have to do with the credit crunch? Well, the same explanation seems to apply to the financial industry. For leaner inventories read lower capital measures, for outsourcing of work, read ‘originate and distribute’ rather than hold-to-maturity.

From this perspective, the banks’ main crime may only have been to copy what the rest of industry was doing (MBAs anyone?) and assume that widespread disintermediation would reduce risk and improve efficiencies, as it seemed to have done in the wider economy. What wasn’t known was that horizontal integration and disintermediation would reduce smaller risks but increase the likelihood of a ‘Taleb distribution’, ie lots of small gains but occasional massive losses.

Using a container-ship-inspired analogy, it must seem to banks that the withdrawal of liquidity is as unexpected and as unlikely as waking one day and finding the sea has been completely drained. But from a Taleb perspective, the credit crunch is simply a black swan sailing into view.

Up and down

Market volatility today has been enormous. Likely to be a once in a lifetime experience, seeing shares fall and rise by 10-20% in a day. That level of volatility suggests there is no, zero, nada understanding of what is going on.

Here's something else that's going up and down. At least it's slightly more predictable than the markets.

Monday, 29 September 2008

How banks can be both good and bad

This is the best explanation I've read of why banks are going bust but can still going. It also explains why TARP might not be a great idea.

Friday, 26 September 2008

God and money

The challenge of life is often to make decisions during times of uncertainty. The larger the uncertainty, the more difficult the decision. However, many of the most important decisions cannot be avoided, however uncertain the situation.

As a result, human societies have developed a variety of methods to overcome uncertainty, some sophisticated, some sensible and some that are downright silly. But often the importance of these methods is not their accuracy but their ability to progress decision-making.

One of these approaches is religion. Religion operates as a mechanism to overcome the innate information problems of life. For some, at the end of rationality comes religion, partly explaining the tension between science and religion.

Of course religion is not the only mechanism for overcoming uncertainties of life. Another is heroic belief in human institutions and rationality. This is what the Enlightenment was about, and this movement appears to have reached some kind of peak in the mid/late 20th Century, when people really believed that everything was about to be discovered, and man would have, and should have, total control over his environment.

In recent decades, Western societies appear to have retreated somewhat from such both fuedal-era dependence on spiritual leaders, and modernist-era belief in big science, largely because of the Enlightenment and then the realisation that everything was more complex than first imagined. And so uncertainty has returned, and this has made us slightly uncomfortable. Hence post-modernity, and all the angst associated with it.

After the retreat of the state, and big-state worship, came the belief that the markets could, almost magically, resolve the difficulties of complex modern societies. People talked of the ‘invisible hand’, though rarely in the way that the phrase’s original author intended.

Humans tend towards faith, and so it was almost inevitable that their trust in the market would go too far. Hence the current problems we can see in the financial markets.

It could be worse, however. In the first half of the twentieth century, people’s obsessive faith in the nation-state led the world into massive, and murderous, wars. Meanwhile, previous generations’ faith in religious leaders led not to peace and prosperity, but centuries of mysticism, peculiar practices and institutional corruption and money-making on a scale that dwarfs even the largest of today’s City bonuses.

As such, it is difficult to read the recent comments of the Archbishops of York and Canterbury, criticising the workings of the financial markets with much respect. Indeed, I am tempted to believe that their problem with the market is not really drawn from a moral perspective but because market solutions to society’s problems appear to be in competition with those advocated by God’s right-hand men.

Wednesday, 24 September 2008

Give me money!

Nikki and I are running a half-marathon on 5 October. After quite literally days of training we are not at all ready to race but raring to go.

We'd love your support, but more importantly we want your sponsorship! We're running for the Starting Blocks charity, which helps fund young athletes for the 2012 Olympics.

To sponsor us, there are TWO things you can do - either click the Paypal link below and you'll be taken through to a page and there you can transfer us the grand sum of £5. We promise not to spend it on silly things.

Or, if you don't want to do this, give us cash next time you see us! We promise to only hassle you until the end of time.

Pay Us Now!

Tuesday, 23 September 2008

Sod the markets

Reading through my (occasional, but often furious) daily output commenting on political blogs, I can detect in myself a continuing disappointment with left-wing thought.

In the last couple of days, the outpourings of leftists over at Open Democracy have been attracting my ire. Here’s a few reasons why.

First, Open Democracy seems rarely if ever been interested in finance. Now, however, we have daily comments, all of them from the same ideological standpoint. This is hardly long-term, or unbiased, reporting. It rather smacks of joining the party late, and with little to say.

Ann Pettifor is one of the most frequent commenters on the site, and her contributions are disappointing. Pettifor has been one of the few (only?) left-wing writers to focus on finance (as opposed to fantasies about the subject) over the last decade. It is, therefore, a let-down to find that she has little or nothing more interesting to say than the ignorant and confused types that make up the bulk of leftist finance commentary.

State and market, according to these reactionary folk, are distinct ideological entities operating at either end of the ideological spectrum. Therefore, they say, you are either ‘for’ one or the other, and events are understood as a zero-sum game between these two.

Therefore, recent events have seen the state ‘win’ and the market ‘lose’, heralding the commenting classes to write a plethora of redundant articles about the end of markets and the rise of socialism.

This is complete nonsense, but it has the worrying potential for traction. However, actual political programmes currently appear rather unlikely, as these market critics seem to lack any sense of what to do, or have such ideologically loaded recommendations as to be a total nonsense.

Amongst Pettifor’s recommendations are ‘a week long bank holiday’ (ie stopping the dreaded market from operating) and allowing state-mandated regulators to step in to value assets, thus restoring power to the state over the market.

This is a fantasy version of price discovery and human behaviour. Prices can’t be set by government fiat – that’s what markets do. Fantasy market prices devised by over-worked and under-skilled bureaucrats, amidst panic brought on by abrupt bank shutdown – this is policy-making of the type that Argentineans have grown sadly accustomed to.

In reality, we do need the left, but we need one that currently seems not to exist.

A consistent voice that highlighted areas where market penetration is unhelpful is needed. A perspective that realises that markets do not automatically allocate fairly is also needed. But this view also needs to recognise that the market is just a process, and the ideological baggage attached to it by both left and right is downright unhelpful.

Such views will not come from Cold War era antagonism and ideological grandstanding.

Edited to add: interestingly, FT columnist Martin Wolf puts forward a number of similar recommendations to Pettifor in his piece today. Doesn't mean I've changed my mind though!

Some very large numbers

Brad Setser notes down some very big numbers.

The analysis, he says, "also helped me try to think through whether $700b is a lot a money or a little bit of money, relative to the enormous challenges the US now faces supporting a financial sector that is gravely ill. I was reminded just how big the balance sheet of the US financial sector is — and just how much of that balance sheet is tied up in the real estate market."

Here's some figs:

"This math also seems consistent with data indicating that the commercial banks hold $3.7 trillion in mortgages and another $1 trillion in corporate bonds (a category that should include ABS) — i.e. up to $4.7 trillion in exposure. The thrifts report about $1.2 trillion in mortgage exposure (mostly from mortgages, “private” MBS and colateralized mortgage obligations sum up to under $100b). The broker dealers have $270b in corporate bonds (think ABS) — not a huge exposure. But they over half ($1.6 trillion of a $2.8 trillion total) of their assets is just labeled other."

The rest is here.

Monday, 22 September 2008

What's the plural of Nostradamus?

I was asked at a party over the weekend whether anyone had foreseen the financial firestorm that we are currently experiencing. Lots of people had, I replied, and two of these are becoming widely known.

The first is veteran investor Warren Buffett, the so-called 'sage of Omaha'. He has many fans in the world of US finance, and these have pulled up his predictions of 2003 that the world of finance had grown over-mighty, and was set for a fall.

He predicted that it would be the unregulated spread of derivatives that would trigger the collapse, which I would say has been only half-true. More like derivatives were one factor amongst many – a symptom of a wider malaise rather than a cause.

The other apparent prophet of gloom is Nouriel Roubini, whose reputation has soared as the markets have plunged. Last year he wrote a 12-stage list of financial collapse, which has proven to be reasonably accurate – and certainly a great deal better than much of the over-confident guff that was being predicted by others at the time.

Others claiming prescience include Ann Pettifor, slapping herself wholeheartedly on the back for predicting the debt crisis back in 2003. Well, the book she wrote was entitled ‘Debt and Deflation’, but she seems to think that half right is good enough. Just like those folk in the City.

And your author? Well, he was wondering about securitisation and the housing markets five years ago too (the links at the now defunct ak13 are a little worn, I hope to fix them soon). But there's much of me that wished today I was rich rather than right.

Thursday, 18 September 2008

Excess leverage 1

A discussion yesterday with a friend got me to try the near-impossible: defining the reasons for the credit crunch in a few words.

I got it down to "excess liquidity and the slackness of product creation associated with it".

It's not bad but I'd like to add the phrase "environment of complicity" in there somewhere too, because I like it.

And that excess leverage? Where did that come from? Largely from the central banks, cutting interest rates to the bone through the first half of the decade, but also the authorities cutting back on regulations.

Here's some detail on the SEC slashing its leverage limits on broker dealers. Only five were given exemptions, and three of those (Bear Stearns, Lehman, Merrill) no longer exist. The other two? Goldmans and Morgan Stanley.

So, what is an emerging market?

Defining an emerging market nowadays is quite difficult, given that commodity wealth has made many such countries extremely rich.

However, wealth does not equal class, and the weaknesses of institutional structures help delineate merely the rich from the developed.

Events in Russia this week are a great example of this.

How bad can it get?

So how bad can it get? How much further down can the markets go? What else can happen?

Well, the easy answer is ‘no-one knows’. The more difficult answer is ‘it will probably be worse than you think’.

This is because we are experiencing the hangover after 10-15 years of accelerating growth in the financial sector. And financial deals are peculiarly, and particularly, associated with confidence.

This year has seen this confidence ebb away, which is why the money markets keep grinding to a halt. However, few of the markets built up during the boom time seem to know how to weather low confidence market conditions.

For instance, the only busy capital market I can see at the moment is the collegiate syndicated loan market, which is a high trust world stuffed full of sensible, experienced bankers. It may also not be a coincidence that these bankers do not receive huge bonuses, but live on their salaries.

So why has the credit crunch gone on and on, and how much worse will it get?

One reason is that few alternative market paths have opened up. Instead, many market practitioners appear to have spent 2008 simply waiting around, hoping that things would go back to how they were.

This has not been a successful strategy, and has certainly contributed to the crisis we are experiencing this month.

Deals do not just happen, they have to be crafted, built up using a keen eye on market conditions and others’ varying incentives. During the boom time, doing deals became too easy –largely because of excess liquidity. The craft of doing deals will have to return before the financial world can restart, and these deals may have to be built on structures that do not currently exist.

Edited to add: This NYT article suggests that the entire structure of the financial industry will change, and so bail-outs that we've seen this week are only (very large, very expensive) sticking plasters.

Wednesday, 17 September 2008

Financial analysis, Aussie style

"As the financial Armageddon continued yesterday, the Babcock & Brown and Macquarie Group model is out of date and needs fixing -- immediately."

Big problems down under - and there's European repercussions also.

Less money

In the markets, prospective borrowers are often told to act now because it is not possible to predict what might happen later.

More often than not, nothing happens later and borrowers might wonder why they paid more then rather than now. 

However, what's happening now in the markets is different. Borrowers that have their debt in place are sitting pretty - particularly if they locked in cheap funds during the golden era of 2004-2005 - while those needing to refinance might have problems.

Just ask HBOS, or Macquarie.

As this FT article notes, three of the top five bond houses are now gone, and banks' liquidity is drying up faster than my local pub on a hot summer's day. Less liquidity means less debt means tough times ahead for those that have relied on cheap funds and still need more.