When Is the Market Wrong?
The surprising thing about financial crises is that they come as a surprise.
Both the stock market and the bond market are supposed to be forecasting mechanisms. They ‘discount’ the future — meaning they figure out how much something is worth by estimating its future returns.
If this is the basis of value in the markets, then how do crashes happen?
Why don’t the markets see them coming?
Or, more precisely, how do markets get things wrong enough for crashes to happen?
Nassim Nicholas Taleb has several excellent answers. In his book Skin in the Game, he explains one way incentives can deliver a crash in a rational, predictable way:
‘Whenever there is a mismatch between a bonus period (yearly) and the statistical occurrence of a blowup (every, say, ten years) the agent has an incentive to play the risk-transfer game. Given the number of people trying to get on the money-making bus, there is a progressive accumulation of Black Swan risks in such systems. Then, boom, the systemic blowup happens.’
The technique to becoming rich quickly in financial markets is to transfer risk from today into the future and then leave before the future and its reckoning arrives. In its simplest form, this could be making a loan to someone who you know can’t afford it but that probably won’t default within the next five years.
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Usually, the aim of the game is to leave for a different bank before the gig is up.
Or, sometimes, you go into government service. Then you can get lauded for your selfless public service, which consists of cleaning up the mess you created in the financial system. After all, you do have a credible claim on being an expert in the particular asset class that created the crisis.
Funnily enough, people wonder why there was such a lack of accountability after the crash of 2008. Barely anyone got arrested because those working in the public sector and doing the arresting were the ones who should’ve been arrested for their past activities in the finance sector.
The head of the European Central Bank (ECB) helped Greece hide its debts to get into the EU while working for a bank, and then cleaned up the mess with emergency lending from the ECB.
The former chief of Australia’s financial regulator ASIC securitised mortgages for a French bank that got into trouble in 2008 largely because it held those assets, which many Australian institutions invested in too.
The former head of Bear Stearns is running Donald Trump’s trade war at the Treasury. And the US bailouts of 2008 and 2009 were run by former investment bank CEOs at the Treasury too.
The good news for those looking to create wealth in as quick a time as possible is that transferring risk far enough into the future to avoid the consequences is not so hard to do.
Selling your soul is the most difficult challenge — where I failed miserably in my attempt working at an investment bank. If you’re more successful than me at this step, you can go on to sell financial products that allow you to transfer risk into the future.
All sorts of financial products seem designed for this kind of business.
Credit default swaps are like insurance. You only need to pay out when there’s a default. Which happens rarely enough for the salespeople to be long gone with their bonuses accumulated in the meantime. Or, if you bet big enough, the government will have to bail you out to cover all those insurance policies you wrote.
Options writing strategies, long-term loans that can be securitised, mortgages that reset to higher rates, and many more products allow you to make profitable deals before their true value is exposed. Profitable for the salespeople, that is.
Consider AIG, the linchpin that failed in 2008, triggering the worst of the financial crisis according to one version of the story. AIG sold insurance on financial markets. A bit like picking up pennies in front of a steamroller. When the steamroller came in the form of the crisis, AIG’s low-risk strategies got flattened all at the same time.
Long-Term Capital Management, the name giving it away, was much the same. The Asian financial crisis steamrolled it.
If you think this sort of thing has been solved by recent regulation, you’re wrong. Regulation makes it worse.
Business Insider reported last month that Deutsche Bank is dumb enough to continue using the same risk metrics that failed in 2008. The headline of the story read ‘Deutsche Bank lost 12 times more than it thought was possible in one day of trading’.
Of course, Deutsche Bank is hardly alone in its use of the so-called value-at-risk (VaR) model. It’s required by law, so everyone has to use it to manage their risk. No matter how many times it fails because it’s too short-sighted.
The VaR charade gives you another answer to our question ‘When do markets get it wrong?’
You can transfer risks to come due in the future (when you’ve left) or you can do the honourable thing and comply with the law.
As long as you do what the regulations require, you can’t be blamed for a crash — well, not enough to get sued or lose your past bonuses. You can get away with anything, within the law. Overreliance on VaR is one example.
So those are two ways markets get it wrong: transferring risk to the future and following the rules carefully, consequences be damned.
But are markets completely useless at predicting the future?
No, and the answer to sifting the good from the bad is surprisingly simple.
The only metric that matters
The good news is that the market provides some pretty decent metrics for trying to predict the future. You just need to apply a particular filter for who you listen to.
The German economics newspaper Handelsblatt reported that hedge funds are betting a combined billion euros against the shares of Deutsche Bank and Commerzbank. Specifically, they are shorting the stock.
Short selling is the accountability mechanism of market. The key is that short sellers have ‘skin in the game’, the focus and title of Taleb’s book.
Short sellers aren’t just investigating dodgy businesses. They aren’t just telling people what’s wrong. They aren’t just looking for illegal practices or non-compliance with the law. They aren’t just forecasting what’s going to happen.
They are doing the only thing that really matters — betting on it. They stand to gain or lose based on the outcome.
Having skin in the game, according to Taleb, is the only honest prognostication. When he was asked about a particular stock’s prospects on TV, he only answered that he didn’t own or short the stock. Any other comments would’ve been hollow, because having skin in the game is the only true validation of a credible opinion.
So are the markets wrong?
Using Taleb’s filter of skin in the game, what do the markets look like to you?
Central bankers have bid up asset prices with freshly printed money — the ultimate version of no skin in the game.
The US’ fiscal deficits are so wildly out of control that government spending on interest hit an all-time high despite just passing through a period where interest rates were extraordinarily low. Do you think policymakers have skin in the government budget game?
Brexit is being negotiated by a ‘Remainer’ — does Theresa May have skin in the Brexit game? Hardly. May’s game is keeping her job, not delivering Brexit.
And what about the euro?
The future of the euro hangs by an Italian thread. Do Italian politicians have skin in the game of keeping the euro alive?
Until next time,