How Much Debt is Good Debt?

Debt is now one of the most talked about issues in current affairs. Debt seems to be everywhere. Governments are borrowing to finance their spending. House buyers are taking on mortgages to 'get on the housing ladder,' and millions of young people are borrowing to put themselves through college. The slightest sign that interest rates might change can send shockwaves through financial markets.

But debt has got a bad name. Excessive mortgage lending lay behind the 2008 financial crisis, inflating a house price bubble while parceling out financial risk to investors distant from the original loans. National governments around the world, from the US to the UK, Greece to Japan, are struggling under piles of debt; many countries have received bail-outs and others are on the brink of default. And student loans have created a higher education bubble, with so many students graduating from Universities that many now struggle to find ‘graduate-level’ employment [the Financial Times has run some fascinating analysis of the situation in the UK - helping confirm my earlier conclusion that the new tuition fees regime is hopelessly unsustainable].

As a result we see much talk of 'deleveraging,' meaning a reduction in the overall level of debt in the economy. This process is inevitably a source of economic stress, at least in the short run. If people slow down their spending, in order to pay off their debts, the economy stops growing and may go into recession. This phenomenon lay behind Japan's economic stagnation since the early 1990s, and seems highly likely to take hold in Europe.

All this begs the question, how much debt is good debt? We could moralize about the issue, and say no debt is good, a position taken by some religions and political ideologies*. At the opposite end of the spectrum, the laissez faire view would suggest any debt is acceptable so long as both parties are happy to enter in to it. However, it was this attitude that led to the financial crisis. The structure of the financial system was set up in such a way that there were huge problems of incentive misalignment, information asymmetry and misjudged risks.

To answer the question 'how much debt is good debt' we need to go back to some straightforward economic fundamentals. Taking out a loan is good so long as we invest the money we receive in something that yields a return greater than the interest payments required. The archetypal example is someone purchasing a car on credit. Owning a car means greater mobility, thus a greater range of employment opportunities and higher future wages. The extra wages can then pay off the debt. This cost-benefit calculus is the best way to assess whether a loan is wise, whether you are a government minister looking to borrow $50bn for rail investment, or a young person borrowing $200k to go to college.

Seems simple, so what's the problem? The problem is that we rarely know with any precision whether what the future return is on our invested cash. For government infrastructure projects, teams of consultants are hired to make projections 30 years into the future - but in truth their estimates are little better than guesswork. No one can possibly foresee how the transportation market will progress in the next 30 years. Likewise, it is fruitless for a young person to try and guess how much a University degree will be worth over the course of their career. The UK government is keen to highlight statistics such as 'Graduates earn an average of £100k more than non-graduates over their career,' but this is disingenuous, in fact it is dangerously misleading. While the statistical methods used to calculate this are quite sophisticated, and take into account that it is more able students who choose university, the analysis faces the fundamental difficulty that it uses historical data. It is therefore inappropriate to draw the inference that this 'graduate premium' will continue to apply, since far more young people are now going to University.

One economist who understood the risks of debt and its role in financial crises was Hyman Minsky. Minsky identified three types of borrowers. The first are genuinely creditworthy, the ‘hedge borrowers,’ able to pay back both principle and interest from incoming cash flows. The second are ‘speculative borrowers,’ able to keep up their interest payments, but not to pay back capital. The third are 'Ponzi' borrowers, who can pay back neither capital nor interest from their cash flows, and rely on asset values appreciating indefinitely – which they clearly cannot.

Minsky saw that in a booming economy, more and more credit is extended until it is eventually offered to the Ponzi borrowers. When it becomes clear that much of the capital will never be repaid, the boom turns into bust, and falling asset values can drive all three types of borrowers to default, even creditworthy hedge borrowers. As the economist Nouriel Roubini foresaw, this cycle describes well what played out in the 2008 financial crisis.

Unfortunately Minsky’s work still lies outside of the mainstream of economic education. Until more economists take the vicissitudes of human behavior into account, and take Minsky’s work more seriously, I fear we won’t learn from history, and so we are condemned to repeat it.


__________________________________________________

*Sharia law, for example, forbids interest payments and requires any loan to be backed by a physical asset with an associated income stream; it is telling that Sharia-compliant investment products fared better than Western funds during the recent crisis.

Nassim Nicholas Taleb's Antifragile in 1000 Words (not 500 Pages)

What is the opposite of ‘fragile’? Most of us would naturally give the answer ‘robust’ or ‘resilient.’ Nassim Nicholas Taleb, however, points out that this is incorrect. An object is fragile if it suffers negative consequences from volatility or stress, he reasons. The direct opposite, then, is not a lack of consequences, as robustness implies, but rather positive consequences from volatility or stress. 

Thus Taleb introduces the concept of ‘antifragility,’ the central idea to which everything else in his book is tied back. He argues that antifragility is a very general concept, but one that has been pretty much overlooked in science and philosophy up until…his book. He provides examples of things-that-are-antifragile in a wide range of domains. In physiology, muscles strengthen after being stressed; in finance options become more valuable when markets are volatile; in the media an attempt to supress information leads to its wider dissemination (the Streisand effect). Evolutionary processes lead to antifragility at the system level as environmental volatility kills off weaker members of the population.

Once you get beyond the enticing prologue, the rest of Taleb’s tome is a rather painful read. It contains many interesting ideas but they are wrapped into an exposition that seems designed to alienate. Taleb expresses a disdain for most other human beings, and comes across as an arrogant know-it-all. To give an example, even though Taleb lauds the efforts of entrepreneurs in taking risks and pushing forward technological progress, he gives obnoxiously unflattering descriptions of the few technology practitioners he has actually met:

“Technothinkers tend to have an ‘engineering mind’ – to put it less politely, they have autistic tendencies. While they don’t usually wear ties, these types tend, of course, to exhibit all the textbook characteristics of nerdiness – mostly lack of charm, interest in objects instead of persons, causing them to neglect their looks. They love precision at the expense of applicability. And they typically share an absence of literary culture.” [p.314]

As an ardent fan of Taleb’s earlier books, “Fooled by Randomness” and “The Black Swan” I made the effort of seeing this one through to the end¹. As such, I shall try to summarize three of its core concepts, which in addition to the notion of antifragility, make up the meat of the book.

1.) Non-linear Effects
The human mind deals quite easily with linear effects. Double an input and, as a first approximation, we tend to expect output to roughly double. If you drive twice as fast you get to the destination in half the time. If you put in 10% more effort you expect a result 10% better, and perhaps to end up 10% more tired afterwards. 


We find non-linear effects less intuitive. For example if you drive twice as fast you use up four times as much energy, so your fuel costs will be four times higher. And in some circumstances, being 10% better than average at something can earn a payoff 100x the average. In reality, non-linear effects abound.

In Taleb’s earlier books he looks at our poor understanding of probability, and so in this book he combines this with the concept of non-linear effects. Fragility, for example is a non-linear response to a shock, where small shocks have no effect but large shocks have a catastrophic effect. This changes our interpretation of variance²: an increase in variance makes large shocks, and thus catastrophic impacts, more likely. A high variance regime is therefore qualitatively different from a low one. We observed this in the financial markets in 2007-08 when the above-normal volatility brought us close to financial Armageddon.

2.) Causal Opacity
Uncertainty is one of Taleb’s favourite topics, and in this book he focuses a lot on the uncertainty that surrounds causal relationships. He is extremely sceptical of theories about causal mechanisms. Many systems in the world are highly complex, so our attempts to rationalize them are often futile. It is wiser to be honest about our ignorance and focus instead on empirical regularities and phenomena than abstract theories.

A key field in which this philosophy has practical implications is medicine. Taleb believes we should rely on medical intervention a lot less than we presently do. His key insight here is that the negative side-effects of interventions are potentially large, and intrinsically opaque. Some side effects take decades, or generations, to manifest. The risks inherent in any medical treatment are impossible to quantify, so the wise approach is to be conservative and only intervene for very serious conditions.

Taleb further points out that doctors and pharmaceutical firms have skewed incentives in favour of providing treatments. Doctors want to be seen to be doing something – and Pharma companies want to make a profit. Taleb urges readers to be resilient to minor problems, letting the immune system do its job; after all, the immune system is the result of millennia of evolution which has given us a degree of antifragility.

3.) The Ethics of Transfers of Fragility
It is clear throughout the book the Taleb harbours a visceral anger towards the Western elite, firstly for promoting a culture of competitive materialism, and secondly for fixing the system so the dominance of the elite is perpetuated.

Taleb identifies that transfers of fragility (and antifragility) are a key method by which those with power prosper. A transfer of fragility means we make ourselves antifragile (i.e. susceptible to large gains) by making others more fragile (i.e. vulnerable to large losses). Many examples of this exist in the asymmetries of the financial system. For example fund managers take a large proportion of their fund’s profits but do not pay up if the fund make a loss. A bond trader who makes a large profit gets a bonus, but the worst-case if he or she makes a large loss is to get fired, while the loss is borne by the bank. Even the banking system as a whole has an asymmetric incentive to take risks as it can be bailed out by the government if it loses.

The more fundamental insight is that while we tend to notice first order monetary transfers (e.g. taxes and welfare payments), we also need to think probabilistically about such transfers. Any conditional cash transfer can been viewed as a probability distribution, so we must consider the higher order moments, for example the variance and skewness, of these distributions when we consider the ethics of such transfers. A transfer that seems equitable and ethical if we look at the ‘expected’ payoff may be quite biased once we take the whole probability distribution into account.

Taleb is clearly an intelligent guy, so I can only conclude that the abrasive presentation in much of his book is a result of his disdain for copy editors and an attempt to cause controversy. I could easily have written an entire blog post about the things I dislike about the book. However it does contain many ideas of value, of which I hope I have given you a flavour here. 

*******************************************************
1  If you do decide to pick up a copy of Antifragile, my suggested reading plan would be the prologue and Book 1, then skip directly to Books 5, 6 and 7.

2 And not just variance: the interpretations of the other higher moments change, with skewness and kurtosis also important.


 

Is Economics On the Verge of a Paradigm Shift? David Orrell's Economyths and the Perils of Financial Engineering

Is economics on the verge of a paradigm shift? This is the question raised by David Orrell’s excellent book Economyths, in which he dissects the flaws at the heart of neoclassical economics and argues not only that it is not fit for purpose, but that it is responsible for many of society’s current problems. As a book that sets out to ‘change your world view’ it really fits the theme of this blog. While I had an existing scepticism of the state of economics when I began reading it, the book has really opened my eyes to the breadth and depth of the problems, and did so in a rigorous but also highly readable way.

The book is neatly structured in ten chapters, each of which is focused on different problem with economics. Orrell re-visits the early thinkers from the classical school of economics to tease out where the foundational assumptions of the field came from. It turns out that many of the problems of modern economics can be traced back to the influence of physics, which led to an atomistic and deterministic view of human behavior. This paradigm served us well initially, and led to some useful insights about the nature of markets. But economics has become elevated to the status of mathematics, in which any theorem is deemed to be true as long as it can be derived from the accepted axioms. Few academics at the heart of the economics establishment outwardly question these axioms, and those that do are often marginalized and labeled as ‘heterodox’ ¹. In trying to become more like a science, economics has ended up becoming more like an ideology.

Orrell describes a wealth of data that should lead us to doubt the axioms and theorems of neoclassical economics. People are not rational; markets are not efficient; the policy prescriptions drawn from economics aren’t working. He deftly draws on some of the alternative schools of economics (e.g. behavioral economics, ecological economics) and brings in the work of some allied fields that could have major implications for the way we think about the economy (e.g. neuroscience, psychology). Far from being a pessimist, he points towards some areas of scholarship that could be the basis for a paradigm shift in economics, highlighting in particular the fields of network theory and complexity theory².

Having attempted to summarize the book, I would like to highlight one idea in particular which plays a small role in the book but made a big impression on me. Dwelling on the modern job title of ‘financial engineer’ (people who develop new financial products, such as CDOs, CDSs, etc.) Orrell observes that in every traditional engineering discipline there is a formalized code of practice and a requirement to build a ‘factor of safety’ into the system³. In fact safety-critical mechanical and structural products typically have a safety margin of over 100% (i.e. they can withstand double the load or stress they are designed for before they break). This extra layer of redundancy means that even when the products (whether cars, airplanes, or buildings) encounter extraordinary conditions, outside of their design specification, they will still function. When a product fails, the firm that built it is legally liable for losses and the engineer who designed it can be personally held responsible.

One could well imagine that the effective functioning of the economy might be deemed  safety-critical. A malfunctioning economy leads not just to discomfort but to starvation, deprivation and a rise in the suicide rate. And yet there is no formalized code of practice for modern financial engineers⁴. They do not have to build in margins of safety into their products. They are not held accountable when the products they develop fail. This observation is not just based on the 2008 financial crisis, in which financial engineering playing a massive part, but in many previous crises such as the junk bond debacle in the 1980s and the bankruptcy of Enron in 2001.

Prompted by Orrell’s comparison, I’ve begun thinking about other sectors in which unorthodox types of ‘engineer’ are involved in developing mass market, safety-critical products. Food engineering is an interesting one: a majority of food we eat in the West has been processed by a big corporation and has been mathematically optimized to be as appealing as possible for the least possible cost to the producer. This is why the foods contain so much Salt, Sugar and Fat (the title of another book I want to read, by Michael Moss). To the companies, the long-term health effects of these products are a secondary concern, and if we get ill it isn't the food companies that will be held liable. How would things be different if food engineers were held to the standards of traditional engineers? Could they build in a ‘margin of safety’ to make it hard for us to over-consume unhealthy ingredients, and easy for us to get the nutritional sustenance that we need?

Economyths is far from the only book out offering a penetrating critique of the financial system, but it is one of the best⁵. Moreover, by pointing towards possible paths forward it goes further than many other books in the ‘crisis economics’ genre. Orrell shows that the crisis isn’t just with the financial system, but with the intellectual system that underwrites it, and as Thomas Kuhn pointed out, it is a sense of intellectual crisis which acts as a catalyst of ‘scientific revolutions.’ If Orrell is correct, a scientific revolution in economics is already underway.

******************************************************

1 Interestingly Orrell suggests that many economists are unhappy with the current state of affairs, but don’t question it in public for the sake of their careers and credibility.

2 I was pleased to read this as both these fields are close my own interests.

3 Upon Googling 'margin of safety' the first reference I find is to an appropriation of the term in the field of value investing, so while the concept clearly exists in finance it is not part of a financial engineer’s design responsibility.

4 The CFA Institute's Code of Ethics is probably the nearest equivalent, but it is rather narrowly applicable to fund managers, who by all accounts seem to routinely flout it anyway.

5 Another one which I’ve just begun reading is Nassim Nicholas Taleb’s polemic Antifragile – I look forward to reporting on it shortly.

Why David Cameron's Foreign Trade Claims are Flawed

I don’t tend to pick on individual politicians to criticize, but David Cameron’s piece in today’s London Evening Standard newspaper is worthy of some commentary. You can find the article here.

Let’s analyze what he says:

“This country is in a tough global race to succeed… the world does not owe us a living, we have to earn it.” – this much I agree with. We are, indeed, part of a global economy in which countries compete for economic activity.

But the message of Mr. Cameron’s piece is that we are being successful at attracting foreign investment. He trumpets major capital investments from abroad in the UK telecoms and energy industries and in real estate development. He seems to entirely miss the point that the kind of economic competitiveness that matters most is the ability to produce exports.

As a nation, the UK consumes vast amounts of imported goods, mostly paid for on credit, and as long as the country fails to increase its own exports, it will be increasingly indebted to the countries that supply these goods. Imports help people live wealthy-seeming lifestyles today, but then the debts are left over for future generations to pay off.

The three industries mentioned above, telecoms, energy and real estate, are all services sold back to the people within the country. No exports there, I’m afraid. Just highly inflated housing prices in London, as a direct result of foreign investment in the capital’s real estate. Well done, Mr. Cameron, for attracting all of that investment. Kudos.

Something that might benefit the country, and lead to products and services we can export, is innovation activity. And a good way to stimulate innovation is by supporting entrepreneurship.

Maybe Mr. Cameron realizes this, as he says, “the red carpet is rolled out for entrepreneurs.” But for some reason that doesn’t ring true, for example if the would-be entrepreneurs are from outside the EEA and have to jump through laborious hurdles just to get a visa. Last week Theresa May announced a new policy clearly tailor-made to attract thousands of foreign entrepreneurs: a £3,000 bond that must be deposited before visitors from some select countries are even allowed in the country. Cameron, to his credit, had the good sense to quash this one, but in generating so much uncertainty and confusion much damage has already been done. The sudden and arbitrary changes that are regularly being made to the Byzantine student visa and post-study work visa regulations also exemplify the country’s enthusiasm for attracting talented foreigners.

The third thing that irritated me in the article is Cameron’s joke about his most recent trade mission, “Just last weekend I was in Kazakhstan (but I missed out on the camel’s milk).”

I will leave critiques of his sense of humour for another time. Why, I ask, is our Prime Minister visiting Kazakhstan to attract investment, a country that ranks 133rd out of 176 in Transparency International’s corruption perceptions index, and in the bottom 15% of the World Bank’s control of corruption measure? A country that shoots dead protesters who dare to oppose the oil and gas industry? Is it because these unstable, autocratic, petrodollar-backed regimes are the only ones who both need and can afford one of our biggest actual exports, namely weapons?

Cameron has the gall, two paragraphs later, to trumpet the UK’s “stable democracy, where there are property rights and the rule of law.” He clearly cares very dearly about these things. We may as well put out a sign saying, “Billionaire oligarchs from despotic backwaters welcome here!”

Then, finally, comes the Battersea Power Station project, the “jewel in the crown” of the infrastructure investments Cameron cites. This will be backed by an £8bn investment and will “create 15,000 jobs.” Never mind the fact that jobs created on building projects are only ever temporary, and no substitute for sustainable job-creation. The thing that struck me here was the irony of it. The source of the funding – Malaysia.

Maybe Mr. Cameron is not familiar with the history of economic crises, but if he were he would surely stop boasting about foreign investment being the route to riches. Malaysia, Thailand, Indonesia and their neighbours know this well, from their experience of a financial crisis in 1997. Long before the credit crunch showed the Western world that laissez-faire capitalism has its risks, South East Asia experienced a severe currency crisis and long recession due to the aggressive inflow and then flight of foreign capital. Foreign investment is neither a stable nor a sustainable route to economic growth.

Whether the Battersea project will come to fruition remains to be seen, and I don’t have strong opinions either way (I give its odds of success maybe 1 in 3). But its use by Mr. Cameron as a piece of propaganda is entirely disappointing. Economic growth is important (though not nearly as important as most politicians think) and if the UK wants to pursue it the country needs to look for competitive industries inside its borders that create value for customers elsewhere. There is, perhaps, one investment referenced in the article that involves exports: the Tata group’s purchase and expansion of Jaguar-Land Rover. This investment has helped re-juvenate British manufacturing and create long-term jobs. When Mr. Cameron comes back with more of these type of investments to shout about, it might be worth getting excited about.

Strategic Delegation and the Cypriot Financial Crisis

An interesting thing happened in the eight days between the ‘first’ Cypriot rescue plan was announced on Saturday 16th of March and the ‘second’ plan was announced on Monday 25th March. The Cypriot parliament voted down the first plan, rejecting the levy on deposits and sending the President back to the negotiating table. But it also voted to allow the President to make a new agreement, which could include a bank levy (renamed as a 'restructuring'), and which would not need further Parliamentary approval. This is a noteworthy event: the Parliament relinquished its own decision-making ability. In a situation where the stakes are so high, for a powerful actor to give up its own power is, on the surface, quite shocking.

Why did it happen? It seems to be a textbook case of strategic delegation. The idea of strategic delegation was introduced by Thomas Schelling in his seminal 1960 book, The Strategy of Conflict. Schelling’s work highlights something that, from the perspective of economics, is paradoxical: having one’s choices restricted is sometimes a good thing. In traditional economics, freedom to choose between more options is never a bad thing, as each option may lead to a better outcome. Schelling shows that in multi-agent negotiations, less choice is sometimes better.

When our negotiating opponent makes their choice based on what they expect us to do, it can be an advantage to have very limited options. As a result, it can be beneficial to commit oneself to a particular course of action before the strategic interaction even begins – and let the opponent react. The classic example of this is set in a military conflict: a defensive force ‘burns its bridges’ to cut off its means of retreat. Realizing that the defensive force cannot retreat, and preferring to avoid a fight to the death, the attacking force does not advance. In Schelling’s terminology, the defensive force has made a credible commitment to stand and fight, and this in itself is enough to win the day.

Schelling identifies two uses of a bargaining agent. The first is to pre-commit oneself to a course of action, as in the burning of bridges strategy above. The second is to gain from using an agent whose incentives differ from one’s own.

When the Cypriot Parliament delegated power to the President, it was a highly strategic maneuver. They knew that the resolution of the crisis would require accepting a bailout, and that negotiating the bailout would require painful sacrifices be made on behalf of the Cypriot people. They realized that while they might privately support an agreement that causes pain, there is a high chance that in a public vote a painful agreement would, again, be rejected. The Parliamentarian’s objective is to make a decision that is popular, so they have an incentive to not be seen to support a bank levy. They chose to ‘bind their hands’ to prevent themselves from interfering in the future. The President, by contrast, had the overwhelming incentive to resolve the crisis, so he was appointed as an agent, and, ultimately, a scapegoat who could take the blame for an unpopular agreement.

To some, Game Theory is easy to dismiss as a parlor trick, a mathematical abstraction with little relevance for the real world. However the work of Thomas Schelling illustrates just how relevant it is to every moment of every day – hence why he won the Nobel Memorial Prize in Economics in 2005. Much of his work was inspired by the tension of the nuclear arms race and potential for Mutually Assured Destruction. In a world once again threatened by nuclear conflict, we could do worse than to revisit Schelling’s classic work to help us make sense of the situation. 

72 Hours to Decide the Fate of Cyprus: Will it Go Down Like Lehman Brothers?

The financial crisis in Cyprus is presently at a critical juncture. Having rejected a tax on bank deposits early this week, the government needs to come up with another option for financing, or face a liquidity crisis in the next 72 hours that renders the country effectively bankrupt.

From here there are several things that could happen, of which I list three in the order of relative likelihood that I would assign them.

     1.) The Russian government contributes to a bailout

The reason for proposing the bank levy initially was that the EU and IMF are unwilling to completely bailout Cyprus themselves. The EU and IMF funding is structured as loans. Despite the fact that the extra sum required is small compared to bailouts in other Eurozone countries, the Cypriot economy cannot support any greater level of debt than is currently being planned. What is needed is more 'equity' rather than debt, either from a direct fiscal transfer, or an internal source such as a bank levy. 

A fiscal transfer would be untenable to the EU, and Germany in particular, for two reasons. Firstly, this would set up a 'moral hazard' problem, such that other countries lose the incentive to be financially responsible. The impetus for austerity measures in Greece and elsewhere would be severely weakened. Secondly, a key beneficiary of the transfer would be Russian depositors, who were outspoken opponents of the bank levy as originally proposed. A bailout that transfers EU funds directly to wealthy Russians is rather unpalatable, both ethically and politically.

This leaves the Russians themselves the most likely participants in a bailout agreement. It is their own citizens that stand to lose out from default, and the Russian leaders have already shown their solidarity with the depositors, even if they are using Cyprus as a tax haven.

     2.) A bank levy is reinstated on large deposits

Having observed the outcry at taxing deposits universally, the Cypriot leaders probably wish they had limited it to large deposits in the first place. It is far more politically palatable to place a windfall tax on the wealthy than on the poor. They even amended the proposed bank levy before the vote in parliament, but by that time it was too late as it had already lost all support. However, since Cyprus is so low on outside options, a resurrection of a tax on larger deposits is a real possibility.

     3.) Default

There are many commentators arguing that default will not be allowed to occur, and EU authorities will relent and cave in to a larger bailout. In my view, default is a very real possibility. I outlined above why the EU is unlikely to provide a direct fiscal transfer; such a transfer is beyond the remit of the IMF and anything less than an equity injection will leave the Cypriot banks insolvent. This means the European Central Bank will cease providing them with cash, and they will be bankrupt.

In this case the likely consequence would be a Cypriot exit from the Euro. The mechanics of how this might be conducted were closely examined in case it were needed in Greece. The banking system would be put on hiatus while the currency is switched to Cypriot Pounds. Bank assets and liabilities, including customers' deposits, would be re-denominated. The new Pounds would instantly depreciate against all the major currencies. Simultaneously the government would probably default on its external debts, either directly (by ceasing payments) or indirectly (by denominating the debts in Pounds and printing money, leading to hyper-inflation.) In short a lot of people would lose a lot of money, and they would end up wishing they had accepted the bank tax originally proposed.

From the perspective of the rest of the Eurozone, the great big unknown in this situation is the knock-on effects. 

A very good parallel here is the Lehman Brothers bankruptcy at the peak of the credit crunch in 2008. This was allowed to happen by the US authorities on precisely the 'moral hazard' grounds that make the EU reluctant to completely bail out Cyprus. The Lehman bankruptcy had devastating consequences, which were unanticipated largely due to the opaqueness and intrinsic complexity of connections in the financial system. Small details, like where assets were parked overnight, went on to have major ramifications as it led to different bankruptcy laws being applied. With a national economy we are faced with a whole different set of opaque connections, complex dynamics and ambiguous legal territory.

The EU leaders know all this, and yet may still allow it to happen. If nothing else (and assuming the Euro survives the contagion), a Cypriot exit would provide a test case for how a bigger Eurozone nation might later conduct an exit.

My thoughts go out to the leaders currently negotiating the future of a nation. I hope you bring us back from the edge.

When Genius Failed: LTCM and the Flawed Assumptions of Modern Finance

 

The story of Long Term Capital Management, a hedge fund that collapsed dramatically in 1998, is instructive to anyone with an interest in modern finance. Roger Lowenstein gives the definitive account of the rise and fall of LTCM in his book ‘When Genius Failed’, now part of the business-lit canon.

When it was founded in 1994 LTCM was notable for the outstanding pedigree of its partners, a mixture of experienced traders and renowned academics, including Myron Scholes and Robert Merton, two professors who helped invent option pricing theory and would later share a Nobel Prize. The premise was simple: they would identify small anomalies in bond prices, then make massively leveraged bets that the anomalies would disappear. Relying on economic theory and past data on market movements they could identify theoretical mis-pricing in the market and profit from the correction in market prices.

The fund initially made terrific returns, peaking in April 1998 with a 300% profit, a sum of over $4bn. Between that point and September 1998, the fund managed to lose a spectacular $4.5bn, reaching the point where its imminent bankruptcy threatened the whole financial system. How did such smart people lose so much money? Leverage and bad luck both played a part. But fundamentally the fund based its trades on the same assumptions that underlie much modern financial theory, assumptions that have repeatedly proved to be untrue. Here are three:

1. Governments debt is ‘risk-free’
   Until recently it was expected that powerful governments would never default on their debt. This belief was eroded by various crises, and in the mid-nineties the conventional wisdom was only that nuclear powers would never default. LTCM expected this to hold and was seriously caught out when Russia stopped paying its creditors in 1998. Nowadays it is accepted that even developed nations may default (they have simply accumulated so much debt), but nevertheless the US Government is still considered a ‘risk-free’ borrower. The concept of the ‘risk-free rate’ indeed lies at the heart of the equations used for investment decisions – so accepting that there is no such thing would require a new ‘relativistic’ framework at the heart of finance. With the US deficit out of control and its politics in paralysis, maybe the invention/adoption of a new framework is overdue.
    
2. Markets are efficient, or tend towards being efficient*
   
   While it is generally accepted that markets stray from being efficient in the short run, many economists still believe that in the long run prices always converge with intrinsic values. Many investors, including LTCM, base their investment decisions on this assumption. In LTCM’s case, it served them well for several years – but backfired massively in 1998 when prices became more volatile than any of the ‘fundamentals’ would suggest they should have. Instead of cutting their losses when markets moved against them, the managers of LTCM were so confident that they increased their positions. The ‘Efficient Long-Run’ is a dangerous myth, and while many academics recognise this (and are working out why prices move irrationally) it is a myth that endures.
3. Your trades do not move the market
   
   Finance theory is based on the perspective of a small investor whose individual actions do not affect market behaviour. One corollary of this is that there will always be a buyer for one’s assets, at the market price. LTCM was a long way from this theoretical ideal. With over $100bn in assets placed on a fairly small number of trades, it was like a whale in a swimming pool: the slightest move could make waves in the markets. It entered into trades so large that it could not exit them without prices in the market dropping. When liquidity in its markets (mostly exotic derivatives) dried up, it was left with no means of ‘cutting its losses’ on losing trades.

____________

Perhaps astoundingly, these assumptions are still widely believed and still guide much of the financial industry and government policy. The implosion of LTCM should have been a wake-up call, but instead it was patched up and things returned to business-as-usual, sowing the seeds for the 2008-09 financial crisis. Many prominent investors and academics have been openly questioning these assumptions for decades (Soros, Buffett, Stiglitz and Shiller to name a few) but as yet the core of the finance establishment is yet to change. Perhaps the absence of a convincing and functional alternative theory is holding back change? Perhaps, herein lies an opportunity to come up with something new?

*'Market Efficiency' is the idea that prices of assets reflect all available information about the current and future value of the asset and as a result all assets are properly priced (i.e. price = intrinsic value)

The Trouble with Financial Services: Why Regulators Fail

Last year I wrote about the difficulties inherent in organising healthcare services. Another industry with in-built instability is financial services. Several characteristics of this sector make it especially difficult to regulate effectively. I have explored some of these below.

Financial regulation is in a constant state of tension between two approaches. The ‘Laissez-faire’ (i.e. hands-off) approach advocates minimal interference, based on the assumption that the best interests of society are served through free markets. The alternate approach (‘interventionist’) suggests that free markets often act irrationally; they require close supervision and restrictions to avoid damaging financial crashes, amongst other problems.

The decision of where in the regulatory continuum between these two extremes a particular regulator should sit is fraught with difficulty. I’d like to draw attention to four particular problems.

1.) Complexity
Financial systems are full of feedback mechanisms that we don’t completely understand. The actions of millions of market participants combine to set asset prices, provide capital and transfer risks. What happens in the markets affects their behaviour, which in turn has an effect on the markets. George Soros calls the feedback patterns ‘reflexivity’ and blames the recent financial crisis on it.

Complexity in the markets might be seen as a good reason not to intervene, as regulators’ actions are liable to have ‘unintended consequences’. However it could also justify interventions which prevent increases in complexity (such as restrictions on derivative products). Regulatory rules may also help companies deal with the unexpected (such as capital requirements for banks). Market complexity is a double-edged sword that makes regulators’ jobs extremely difficult.

2.) Revolving Doors
The Oscar-winning documentary ‘Inside Job’ highlights how top roles in financial regulators are frequently filled by ex-bankers. This isn’t surprising, given the specialised knowledge these roles require. However it can reasonably cause concerns about conflicts of interest. Social ties, political contributions, and the ‘revolving doors’ between jobs in regulation, banking, and lobbying create strong disincentives to individual regulators taking hard line.

3.) Race to the Bottom
Financial services firms can base themselves where they like. As a result, some countries try to attract them by offering low regulatory burdens. The risk that firms will flee financial centres such as New York or London is a major disincentive to regulators in the US and UK from tightening up their supervisory regime.

4.) Financial Innovation
As Merton H. Miller explained in his 1986 paper on Financial Innovation, “the major impulses to successful financial innovations have come from regulations and taxes.” More specifically, financial institutions use new products as a way to get around regulatory restrictions, rendering them ineffective. (As an example, the US withholding tax on interest payments remitted abroad triggered the creation of the market for Eurobonds, to allow US firms to raise money outside of the US.) In addition, continuous financial innovation makes it extremely difficult for regulators to stay up-to-date with the latest financial instruments being created.

This is a very cursory treatment of a subject that could inspire whole volumes. I am sure I have missed out other important reasons behind the difficulty of regulating financial services. Ultimately, it will be the widespread recognition of these potential roadblocks to effective regulation that allows us to make progress overcoming them.

Too Big To Fail - The British Brains Behind the US Response to the 2008 Financial Crisis

I’ve recently read Andrew Ross Sorkin’s book on the Global Financial Crisis, “Too Big To Fail,” often described as the definitive account of how the events unfolded. It starts with the emergency rescue of Bear Stearns in March 2008, then plots the series of decisions which ultimately led to the collapse of Lehman Brothers, the takeover of Merrill Lynch by Bank of America and the bail-out of the banking system.

While I lived through these events and followed the press coverage eagerly at the time, the book sheds a fascinating light on the behind-the-scenes manoeuvring of the Wall Street CEOs and the government regulators. It has changed my perspective on some of the decisions that were made and reminded me of the magnitude of the task that was asked of the leaders in the banks, the regulators and the government.

One of the biggest changes in my view on the matter is a new-found respect for how effectively the British regulators reacted to the crisis, in comparison to their American counterparts. On a long list of issues, the British government and regulatory bodies took decisive action that the American regulators would not stomach – yet in many cases were later forced into copying.

• US regulators were strongly resistant to a ban on the short selling of financial companies’ shares, until they saw the positive effect it had in the UK.

• In the weekend before Lehman Brothers collapsed, Barclays was in negotiation to take it over. I didn’t realise before that this was blocked by the UK government. If a deal had gone through, Barclays could ultimately have been jeopardised, so it seems in hindsight to have been the right call.*

• In late 2008, when it became clear that wide-scale action was needed to help banks survive the write-downs on bad debts, the US government was planning to buy the poor-quality loans directly from the banks. This was the plan that was ‘sold’ to Congress. However, in practice it is barely workable – the government just does not know how much to pay for the loans. The solution was instead to make capital injections directly to the banks in exchange for an equity stake: the US chose this route after it had been successfully implemented in the UK.

• In a twist of irony, the UK bail-out was optional and several banks (including Barclays) were sufficiently strong they did not need to take government funds. In the US, which loathes government interference with ‘free enterprise,’ the top nine banks were forced to take bail-out funds (so that the weaker among them didn’t look bad).

The UK has a long history of showing leadership in the fields of economics and finance (I’m thinking in particular of the great economist J.M.Keynes). Reading this book made me realise that the UK still has an edge in these fields – one that will be required going forward as the country faces continuing challenges from fiscal tightening at home, the Eurozone debt crisis, and many other problems on the horizon.

Note
*Barclays later acquired the US broker-dealer unit of Lehman Brothers out of administration, getting the bit of the business they wanted at a knock-down price

The Search for Symmetry: How bankers' bonuses can set-up the wrong incentives

In my last post I described how the Scalability of transactions allows banks to pay large sums to attract the best people. But there is another feature of the bonus system that is equally fascinating, and goes some way to explain why banks suffered such massive losses in the 2008-09 financial crisis.

Bonuses are, by their nature, asymmetric. Employees get paid a base salary. Then those who perform particularly well may get a bonus on top. The ones who perform particularly poorly do not, as a rule, get a fine, or an ‘anti-bonus.’ The worst that can happen to them is they lose their jobs.

In non-financial jobs this asymmetry is not such a problem, as the contribution the employee makes to their company is also asymmetric. A great employee can create a lot of value for their firm, but a bad employee doesn’t destroy equivalent amounts of value. Take a law firm for example: highly productive associates may work lots of billable hours doing quality work. Their firm benefits from the work and pays them a large bonus to try and retain them. A poor associate, who works few billable hours and does poor quality work, will get no bonus, and may get the boot. But the poor performer is unlikely to lose the law firm a lot of money, as the work is quality-checked before it goes to a client – the deficiencies are noticed and rectified by the good performers.

However the financial sector, or more particularly the trading sector, doesn’t work this way. On investment banks’ trading desks, the banks’ own funds are put at risk by traders taking positions on the financial markets. If the desk makes a profit, the traders get a cut, which can lead to multi-million pound bonuses for ‘top performers’. However, if the desk makes a loss, the traders are not exposed to the downside. They may lose their jobs, but it is the bank that has to foot the millions or billions of pounds of losses. This asymmetry gives traders an incentive to make large and risky bets, whether or not they are the best thing for the investment bank’s bottom line.

This kind of behaviour is a key cause of trading scandals such as Jerome Kerviel’s €4.9bn loss at Société Générale. But moreover, it led to an accumulation of risky assets (such as securitised loans) on banks’ balance sheets, and helped sustain the over-valuation of these assets in the run up to the recent financial crash.

In the wake of the crash, banks and regulators are looking hard at how performance ought to be rewarded. Multi-year guaranteed signing-on bonuses for star performers are being phased out. More bonuses are being issued as restricted stock, which becomes worthless if a trader leaves the firm; this gives them a financial penalty if they lose their job, a kind of ‘anti-bonus’ if they perform particularly badly. Likewise with ‘clawback clauses’ that can retrospectively reduce a trader’s bonus if the positions they take turn out to make a loss in the long-term. These kinds of a reforms are a promising step in avoiding a repeat of the crisis; though they also add an element of the unknown and untried: I would not be surprised if the new set of incentives for bankers leads to some unintended consequences further down the line.