A V Rajwade: When risk becomes uncertainty - III

WORLD MONEY

Some instruments are so complex that it can take investment banks' computers entire weekends to value them!

Even as a measure of calm has returned to the financial markets, cautions are being sounded. The president of the Bundesbank described the events as "a classic bank run" "" but on a different class of financial intermediaries like hedge funds, conduits, SIVs and SIV-lites. In the US, the number of foreclosures in the current year is expected to go up to 2 million, up from 1.2 million last year. This means that one of every sixty house-owners will be thrown out of his/her house, a rate not seen since the Great Depression of the 1930s. And, this is not the end: as many as 2.5 million adjustable rate mortgages (ARMs), where the initial rate was kept low to attract the borrower, are due for re-pricing next year. Quite often, a fall in home prices has been followed by recession. Could we see history repeating itself this year? There are some signs: US car sales in August showed a fall.

Speculation about the future apart, the recent turmoil has clearly manifested the dangers of complex derivatives, a point I have often made. (In A demon of our own design, a book I am currently reading, Richard Bookstaber argues that "complexity clothes catastrophe!") Some of the instruments are so complex that, as Gillian Tett wrote in the Financial Times a couple of weeks back, it can take investment banks' computers entire weekends to value them! Personally speaking, I have learnt to be wary of any derivatives described as "extra," "dynamic," "absolute returns," and so on! To quote from an article by Caroline Baum on Bloomberg, "in a complex market .... everyone involved profits by keeping the investor in the dark."

Recent events have brought to the fore the limitations of computerised trading systems. Their big plus factor is the absence of human emotions like fear and greed. But they have other weaknesses: when several participants use similar algorithms for decision making, they also rush to the exits simultaneously, leading to lack of liquidity, and converting measurable risk into uncertainty. There are other technical reasons why, quite often, participants are on one side and markets overshoot: rational risk management decisions at the micro levels lead to macro-level overshooting. To give a couple of simple examples, if a currency starts rising, the stop-losses of players who had shorted it, start getting hit. They, therefore, start buying the currency to square their positions, leading to its further appreciation. The same is the case with derivatives. If you have written a call option and the underlying starts going up, you need to increase the delta hedge. This itself adds to the demand for the currency and fuels its further rise. And, the stronger a trend, more the followers! In short, such technical factors and theories of behavioural finance rather than efficient markets, are perhaps closer to describing the nature of the beast.

One tenet of behavioural finance is the confirmation bias, which most participants suffer from. This makes people ignore the "news" which goes against the currently accepted wisdom, and look at only the confirmatory pieces. In practically every situation, both positive and negative factors are present. Something happens and suddenly the focus shifts from positive to negative, often leading to overshooting on the other side. In the present instance, in a couple of months, the credit market has moved from a mood of ultra-cheap credit with no questions asked, to extreme caution even in respect of short term investments!

For students of and participants in financial markets, there are several lessons in the recent events:

If you are making money (above market yields on AAA bonds, for example), there is obviously a risk lurking somewhere;

Are you being adequately compensated for taking it?;

The crucial importance of exit routes, that is, market liquidity;

The obvious risks in borrowing short to invest in long term assets; or over-leveraging generally.

None of these rules require sophisticated financial models. No wonder Warren Buffett, who follows most of them, does not rely on mathematical models, and is suspicious of over-quantification "" but is still the world's most successful investor!

Tailpiece: The recent events also manifested an old belief of too many market players: so long as I am making money, don't interfere "" but please, please rescue me when I am in trouble! This sentiment was probably best manifested in the interview of a hedge fund manager on CNBC. "Bernanke is being an academic! It is no time to be an academic ... He has no idea how bad it is out there. He has no idea!... My people have been in this game for 25 years. And they are losing their jobs and these firms are going to go out of business, and he's nuts! They're nuts! They know nothing... The Fed is asleep!"

avrajwade@gmail.com