“Apart from a couple of interruptions in the 1990s,” writes Henry Kaufman, “the green light for credit availability has been shining brightly.” Kaufman, we read in Marc Faber’s latest “Gloom Boom & Doom Report”, has identified three structural changes in modern finance. These changes-we call them the three Ations-are what’s brought us to the brink of a global credit contraction and, perhaps, a recession.
The first “Ation” is securitisation. It’s the magical process by which a liability (a mortgage) is turned into an asset (a mortgage-backed bond). Kaufman says a tidal wave of securitisation has swept the markets. “Conversion of non-marketable assets on a massive scale has changed the very nature of financial assets as well as the character of financial behaviour…The sharp increase in tradable assets has influenced the culture of financial markets in important ways-from stimulating risk appetites, to eroding traditional concepts of liquidity, to fostering the attitude that credit is usually available at reasonable prices.”
Kaufman later points out a big problem with this first Ation. The less frequently a securitised asset is traded, the more difficult it is to price. A new market is created, creating liquidity where none existed before. But if you can’t sell it, what is it really worth? Value, as the French economist Bastiat showed, is only realised in an exchange between two parties.
The second Ation is the digitalisation of financial trading. Kaufman says that information technology “has bolstered the easy-credit outlook now commonplace among investors”. As markets have been linked globally by information technology networks, financial information flows nearly instantaneously, computerised trading and transactions are executed without delay.
Or, if you want it in simpler terms, you can compare it to the “bottomless fries” served at Red Robin restaurants in the States. Red Robin is a burger joint. And burgers are nothing special. But the “bottomless fries” ARE special. Bottomless means exactly what you think. The supply of fries never ends. You keep eating, they keep serving.
The economic equivalent of bottomless fries is Say’s law, roughly stated that supply creates its own demand. The proliferation of securitised assets has created a demand for them. Cashed-up pension funds, sovereign wealth funds, and mutual funds, not to mention loaned- up hedged funds are all looking for assets to buy. The boom in digital trading, continuous information flow, and securitisation has created a boom in the global base of tradable (or at least buyable) assets.
But the third Ation is the one that causes the most trouble. Quantification. There is a tendency – especially strong in the statistically-mined States – that financial markets can be turned into tidy spreadsheets with clear buy and sell signals that fully account for the inter-market relationships between dozens of variables. It’s goofy, of course, to think that any mathematical model can accurately predict the behavior of a complex, organic system. But sometimes, it appears to work.
The quantitative models that drive some hedge funds strategies and much of the program trading on Wall Street do seem to work when market volatility is low. That is, in the absence of irrational behavior, when the relationships between asset classes and other variables remain constant, certain models work. Those models stop working when the world starts changing. And if you haven’t noticed, change is a lot more constant than stability.
Kaufman concludes that the combination of those three Ations has led to a loss of discipline in the market. You get non-bank lenders lending money, without being fully conscious of the risks of failure. Risk itself is lost in the shuffle, at least for awhile.
But capitalism can’t work without real risk. Risk enforces discipline not so much because it rewards effort and entrepreneurship, but because it ruthlessly punishes failure. If the capital markets don’t punish bad judgment by allowing a firm to fail, then capital itself is wasted, tied up in ventures that don’t produce anything of value-not for the bank, the company, the shareholders, the public, or the government (in the form of tax receipts.)
What we need these days is a little more spectacular failure. We’ll get it eventually, of course. But if the Fed or other central banks try to bail out markets this week, the day of reckoning will be rescheduled for a bit later. That gives us more time to buy gold.
Markets and Money
Know of any other dangerous ations? Leave a comment below.