Tuesday 21 October 2008

From Wild West Financial Markets to Civilised Financial Markets

It is the financial markets topic again - you cannot ignore the elephant in the room.

First of all it is a myth that a market can self-regulate itself. There are wise heads but peer pressure pushes them down - I recall a top fund manager during the dot com tech boom who resisted buying into nonsense shares that had no proven revenue streams let alone an earnings history, this wise head was sacked because his employers were losing business to funds that were trading tech shares. Needless to say when the fall came this fund was among the casualties.

An independent voice with some power/authority is necessary to protect people from themselves. This is not an issue in the private economy, but where employees are running public listed companies owned by shareholders, then it is only right that the regulator should be given powers to act as this voice.

One of the reasons for the current mess is that credit derivative swaps (CDS) were being traded privately between financial institutions. Together with other grey and Over The Counter (OTC) trading - all perfectly legal and all unmonitored - the amounts involved trillions of dollars and none of which was or is transparent. This morning on the BBC Radio4 Today programme it was said the market will discover who is holding the Lehman CDS and have to pay up. This makes a nonsene of risk management. CDS are used as an insurance to protect against, say, a bank going under - the CDS counterparty pays if the insured goes under, so no one wants to be in that position.

The insurance market will only allow John Smith to insure the life of John Smith. Mr Hitman Jones can not insure the life of John Smith, for obvious reasons - legislation that came into effect in 18th c. if I heard right - so the same obvious reason should apply to use of CDS to protect a company. Creating an external CDS market traded by hedge funds creates an incentive to attack the insured. While the offshore hedge funds are free to trade what they like and with whom, the problem has been that so-called 'safe, low risk' institutions like your high street bank have ended up holding CDS counterparty positions.

I'm not convinced that we are witnessing an endemic fault of the capitalist financial system - there's a lot of talk about this in the papers and that Marx's Das Kapital is a number one seller in German bookshops. Rather, what we need is to move from the wild west financial system to the civilised financial system. Any public company involved in grey and OTC trading must have these trades transparent and recorded for public inspection. The regulators need to apply some simple rules to protect people from themselves for the benefit of everyone else in society - when that does not happen we have the bust we see all around.

Friday 10 October 2008

The Big Bail Out Circle - the Chancellor's missed £500 billion trick

The £500 billion set aside by the UK government to bail out the banking system seems to me missing the target. There are about 60 million people in the UK and of these we can estimate one sixth have a mortgage. Now if the prime minister used this tax payers' money to give each person with a mortgage £50,000 it would do wonders for the economy and especially the weak housing market. Financial burdens would be lifted on many households, and people would feel the world is wonderful and doom and gloom would lift. Not only that, but by circulating the money directly through mortgage bank accounts, the banks themselves would still get the money to ease their fluidity problems - a double whammy if ever there was one.

Unfortunately this idea would never take off, it would spark riots by those people without mortgages demanding their fair share.

Of course we all suffer if the banks go under but unless the rules of the game are changed, we are unlikely to learn from the mistakes of the sub-prime crisis that started this chain of events. Someone should give the regulators a copy of Nassim Taleb's Black Swan - the case is argued there that the finance community has been using risk models based on thin tail, Gaussian (normal or bell curve) event probability distributions, whereas actual markets have fat tails: bad things happen more often than in equilibrium conditions.

The regulators should also demand more information about what the financial community is actually up to, a case for proactive use of Business Intelligence. But the sub-prime fiasco is at its roots a mis-selling scandal that was clothed to look triple A by derivative instruments, in turn based on faulty risk models - a rather ugly mess.