Why are there continued jitters on the world markets?
1) Uncertainty over who will lose how much from mispriced CDOs/CLOs has led to unwillingness by banks to lend cash they may need to solve their own problems as a result of the credit crisis.
2) Lack of trust after credit rating agencies mispriced the risk of the CDOs/CLOs has led to a lack of trust in ones still being sold.
So, as with the last crisis from similar uncertainty and lack of trust — the crisis of faith in corporate results and their auditing after the Enron and Worldcom collapses — the key is renewal of transparency which can lead to renewed trust.
Markets can only be efficient if they’re truly transparent and trusting.
And efficient markets are good for us all as they’re the building block of economic growth.
Monday, September 10, 2007
Wednesday, August 22, 2007
A lesson to us all
I was interested to read the lead opinion in The Economist this week, on the lessons of the credit crisis.
Most obviously it’s been a lesson to all involved in the markets about the dangers of not ensuring well enough that you’ve priced the risk of assets accordingly. It’s also shown there are structural defects in the regulatory system which allowed the risk of this event having wider, more catastrophic, implications for the wider economy to exist at all. And not just in the US — given the enormous interconnectedness of the global economy, for all of the world’s major economies too.
It’s also further proof that anyone who believes in the strong version of the efficient markets hypothesis (the idea that all available information is factored into market prices so quickly there’s no room for arbitrage or fraud) is clearly wrong. Or at least it can’t be true all the time, especially when risks are mis-priced, as the CDOs based on sub-prime mortgages clearly were here.
Once again, the semi-strong version of this idea seems to hold truer to reality. The fact that the Fed had to intervene at all is proof. That said, the efficiency of the markets is now providing the necessary correction.
The other lesson I would draw is that old one about not allowing familiarity (or habituation, if you want to give it its Sunday name) to allow you to become desensitized or complacent about the risks your business is taking every day.
If you’re a tightrope walker and succeed in not falling off from January 1 till December 30, you surely don’t want to allow yourself to become complacent enough to think the risk of falling off is any less on December 31. Of course it’s just the same as every other day.
The other problem with some of the big US banks involved in this crisis was that because they had complex theoretical and computer models created by very smart people based on assumptions that worked 364 days a year, or every days for many years, they allowed themselves to fall victim to the kind of “boiling the frog” attack (where risk and danger increases so slowly you don’t see it coming) that famously brought down Long Term Capital Management in 1999. Their model didn’t allow for the possibility that Russia might default on its sovereign debt. But it did and it cost LTCM billions.
Financial strategy text books will tell you there is no risk only where there is absolute certainty. We all need to remember that every day.
Most obviously it’s been a lesson to all involved in the markets about the dangers of not ensuring well enough that you’ve priced the risk of assets accordingly. It’s also shown there are structural defects in the regulatory system which allowed the risk of this event having wider, more catastrophic, implications for the wider economy to exist at all. And not just in the US — given the enormous interconnectedness of the global economy, for all of the world’s major economies too.
It’s also further proof that anyone who believes in the strong version of the efficient markets hypothesis (the idea that all available information is factored into market prices so quickly there’s no room for arbitrage or fraud) is clearly wrong. Or at least it can’t be true all the time, especially when risks are mis-priced, as the CDOs based on sub-prime mortgages clearly were here.
Once again, the semi-strong version of this idea seems to hold truer to reality. The fact that the Fed had to intervene at all is proof. That said, the efficiency of the markets is now providing the necessary correction.
The other lesson I would draw is that old one about not allowing familiarity (or habituation, if you want to give it its Sunday name) to allow you to become desensitized or complacent about the risks your business is taking every day.
If you’re a tightrope walker and succeed in not falling off from January 1 till December 30, you surely don’t want to allow yourself to become complacent enough to think the risk of falling off is any less on December 31. Of course it’s just the same as every other day.
The other problem with some of the big US banks involved in this crisis was that because they had complex theoretical and computer models created by very smart people based on assumptions that worked 364 days a year, or every days for many years, they allowed themselves to fall victim to the kind of “boiling the frog” attack (where risk and danger increases so slowly you don’t see it coming) that famously brought down Long Term Capital Management in 1999. Their model didn’t allow for the possibility that Russia might default on its sovereign debt. But it did and it cost LTCM billions.
Financial strategy text books will tell you there is no risk only where there is absolute certainty. We all need to remember that every day.
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