Oh, what a wonderful Indian Summer…
We’re not talking about the weather. It’s rainy and cold here in London.
We’re talking about the financial markets.
This past summer the financial markets got hit with the subprime problem. All of a sudden, hedge funds went broke…stock markets wobbled…and people lined up in front of a British bank, desperate to get their money out. They were afraid that the thing would sink and take their money down with it.
Within hours, the financial authorities swung into action. They threw open the doors and said: drinks on the house! The Bank of England effectively guaranteed all bank deposits…and the Bank of the United States of America, the Fed, lowered its key lending rate and also put more new money into the banking system than at any time since 2001.
“Liquidate labour…liquidate the banks…liquidate the stock market…” that was Andrew Mellon’s response to the credit crunch of the early ’30s. He thought a good house cleaning would straighten things out. But 75 years later, ‘liquidate’ was transformed into ‘liquefy’. And, with the central banks’ ‘open bar’ policy, it looked for a while as though the party might keep going for a while longer. Stocks rallied. The problem was “contained”, said US Treasury Secretary Henry Paulson.
And for a while, it did look as though the scorching summer was over.
But then…back it came. In September, Wall Street’s biggest firms began to announce writedowns…a billion here, two billion there…and pretty soon this was beginning to add up to real money.
Today’s news from Bloomberg tells us that the losses at Citigroup (NYSE:C) – America’s largest bank…and the one that most aggressively exploited the credit bubble – might rise to US$13.76 billion. Other firms are taking big losses too…
Alas, those smarty-pants financial models they used had some flaws. Goldman Sachs (NYSE:GS) said it got hit by a 25 sigma event – or 25 standard deviations from the norm…or the sort of thing that comes along only once in the life of the universe. That’s what their mathematical models told them.
But what were they thinking? The models were nonsense…elegant, sophisticated confections based on assumptions that just weren’t true. As we explained here in Markets and Money , there is no way to measure genuine ‘risk’ in the real world. You never know what will happen. And when you think you know, you merely set yourself up for a colossal failure. If you think you know that stocks always go up, for example, you buy them at any price – even outrageously high levels. Result: you create the conditions for a crash. Therefore, you’ve caused the very thing you were trying to protect yourself against.
It’s obvious to even a first-year maths student that you can’t compute real risk…and that markets have feedback mechanisms than tend to short circuit any kind of broadly followed modeling technique. Still, the deviants at Goldman and elsewhere saw no profit in intellectual honesty. The money was to be made by bedazzling the chumps with fancy formulae and incomprehensible new trading instruments. In place of real risk, they merely inserted volatility…as if the lowest price a derivative contract could sell for tomorrow was no lower than what it brought yesterday, no matter how many new junk derivative contracts entered the marketplace.
Ah, there was another error…assuming that these contracts were independent of each other. The modellers figured that they could calculate the pricing of a CDO tranche as if it stood blissfully apart from the real world of market panics…and investor hysteria. They imagined that their models would function normally…even when investors were abnormally spooked.
Instead, when the trouble began, investors suddenly realised that the pricing models were useless. They wondered what really was in those contracts they owned…and what they were really worth. Buyers went on strike. They would bid only US$20 on a lot the seller was offering at US$100. Suddenly, buyers and sellers, lenders and borrowers, couldn’t get together. They didn’t know what anything was worth…and didn’t want to find out the hard way. The credit markets had seized up.
As the big firms reported big losses, big heads began to roll. Every day brings word of a new Wall Street honcho who has been given a few million and told to pack up. Warren Spector…Stan O’Neal…Chuck Prince…
Of course, all of this is good, clean fun. It’s actually a pleasure to see that what goes around coming around. It couldn’t have happened to a nicer bunch of guys. Everyone likes to see Wall Street get what it has coming. Trouble is, the trouble doesn’t stop there.
Markets and Money