Niall's virtual diary archives - Tuesday 25th March 2008

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Tuesday 25th March 2008: 1.51pm. Bleh I feel groggy! After coming back from a lovely time at Megan's where she cooked me lobster, I sat up smoking sheesha and reading the Economist which had just arrived. I was really rather glad to see they were writing about exactly what I had been writing about here, except that they were also calling for severe & swift disciplinary measures to be taken with implications of dealing with bank CEO's much as Enron's were - by hauling them out in handcuffs.

That I think unfair - they, like Enron's top brass, had very little choice in their behaviour. They are also being scapegoated because every single fucker in the entire community is guilty as sin of doing exactly the same, and they want sacrificial lambs quickly executed to deflect any possibility that the entire edifice may be called into question. And that, oddly enough, is exactly what I want to talk about next - why and how the hell all this came to be in the first place, and what should replace it? And what the hell does any of this have to do with biosphere warming and cooling with regard to biodiversity as mentioned in the entry before the last one?

I went through last entry about how the financial system works, how there are booms & busts and how both governments and banks form a virtuous circle which bails the other out of trouble by basically sucking wealth out of society. These are all very powerful people, and what I have just written about is rare to find printed - I hear that books by George Soros cover very similar ground. However don't get me wrong - all hierarchies involve a transfer of wealth from poor to rich, that's the privilege of leading one's populace, and it has been a consistent feature of all civilisations - so I have no moral problem per se that governments and banks conspire together to vampire off society. What I do have a problem with is the extent to which they try to hide their behaviour - see Confessions of an Economic Hitman by John Perkins - which they only let him publish well after the events in question.

I should also add that I have no problem per se either with important institutions being bailed out and the costs of their failure being taken on by society - in fact, as my upcoming book Freeing Growth shows, the single most important character of Western civilisation which has enabled its greatness is how well it handles failure. In most societies eg; eastern ones, failure is shameful and it is covered up, denied and not accepted - which in large part has led to the malaise in Japan in the past decade as bad loans haven't been written off. A similar problem currently faces China which has been financing much of its recent growth with negative real interest rate loans, which should they go bad, the Chinese mentality will try to hide rather than expose. A similar affliction has made Africa as bad as it is today - as I point out in my book, Winston Churchill was incompetent in his stint at the Admiralty in the first world war and directly killed tens of thousands of British servicemen with his ineptitude - yet he learned his weakness, so during World War Two he knew to delegate as much as possible to more competent others and had the lowest workload of any prime minister in nearly two hundred years. He was much better at being a charismatic leader than managing - yet had he been permanently blacklisted, Britain may well have lost WW2 without him. As I strongly reiterate in my book, failure and failing well is FAR more important than succeeding - and this is exactly opposite the logical positivist tradition of the West which tends to only see what happens rather than what was avoided.

This brings me to the topic of avoiding risk - and this one single topic has more than anything defined the modern world. Ignoring the vast realms of protective legislation (safety laws and such), financial economics in essence simplifies investment into "how best to externalise risk" ie; to shift risk to oneself onto someone else. I won't go into the mechanics of it - read about the CAPM if you'd like to know. In essence, you spread your investments between risky ones and less risky ones in order to maximise your total return for the least amount of risk - and one of the major assumptions of financial economics (like all economics) is that the market is infinitely large relative to any single investor, and therefore can receive infinite amounts of risk.

That works fine when a majority of investors aren't actively also trying to externalise their risk which until the 1980's was probably true. Thus the majority of investors were risk sinks and the risk sources could happily dump as much risk into them as they liked. Let me explain by an example: say you're a farmer who needs a minimum income next harvest of £10,000 otherwise you'll go bust. Now the weather is variable, sometimes you get a bumper harvest (say worth £20,000) but other times you might not (say £5,000). If you absolutely need that £10,000 as an absolute minimum, you can take out an insurance policy costing £5,000 which will guarantee that you'll get £15,000 no matter whether there is a bumper harvest or not. If there is a bumper harvest, the insurer gets £10,000 in profit, if not he loses £10,000.

What's just happened is that the farmer has externalised his risk. He, the risk source, has sold on his risk to another. We all do this every day with home insurance, and absolutely can one take out insurance on stock price movements. This can all get very complicated - one can take out an insurance contract (called a derivative, or future) on say if the price of X exceeds Y for longer than time Z but not if the price of A is lower than B at some other time C. This is what is called structured finance and the theory behind it is that you can plan for worst contingencies with the least loss in profits. This ability became fully legal in the 1980's, and has boomed since. Why?

It all has to do with balance sheets prepared by accountants to show profit & losses you see. There is a very thorny topic in accounting called "cost accounting" which is simply "how do you estimate the value of something" - believe it or not, many, if not most, costs are unknowable because their value is unknowable. As I showed last entry, the value of money oscillates vastly over very short periods of time and no one even realises it - which presents a horrendous problem for trying to present a realistic picture of how well a company is doing. Remember, if cash flow drops too low, all those buildings and factories become unsellable and thus become worthless overnight. Think of the example of that farm - he needs a minimum of £10,000 to keep operating, if he falls below that his entire farm becomes worthless overnight. I am exaggerating and over-simplifying to make my point, but in essence this is how it works. This is why firms try to externalise their risk as much as possible, because accountants when faced with a risky investment will apply a discount rate which means they hack off a percentage to reflect the chances of the investment going bad. For example, if you know that 5% of all your loans are currently going bad, it makes sense to write down the "true" value of your loans as being 5% less than what you lent out.

The trouble is that we live in a risky world, and the market is NOT infinite and can NOT take on infinite amounts of risk. It HAS to go somewhere, and when that somewhere overflows, it collapses. Banks take on risk from firms and individuals and try and diversify that risk onto others, but all they really can do is spread the risk around in the hope that if one part collapses, the others will support it. At some point though, too much risk accumulates in too many parts all at once, then the entire thing bombs and some other risk sink sucks in the risk. In the case of banks, it is government who takes on the risk - and as government IS the people, they just hand the risk right back to the people who sold it on in the first place - but in the new form of higher taxes, fewer schools and higher inflation.

So far so good? This stuff is NEVER taught at university level. You will NEVER hear any of that explained in any finance or economics course. The only way you'll ever hear of it is to read the Nobel prize winning authors who invented CAPM and such, and they mince their words so finely that it is extremely difficult to see what they are really truly saying. Yet the very brightest do understand this, and furthermore they understand that no one wants to hear that our entire civilisation is dooming itself - sadly they only tend to be explicit after they have retired and no longer need to attract research money.

Time for a little more detail on how exactly too much risk accumulates in one place and the whole thing dives. What I'm about to explain is a gross over-simplification, and it's a little inaccurate, but it's close enough to be good enough.

Remember our structured finance? Remember how it's basically a set of insurance contracts against some future eventuality? Well, after you've taken out the contract, you can sell it at any stage for what it's currently worth - so, our farmer may learn that the upcoming summer is almost certainly going to be a bumper harvest and therefore will sell his insurance early so he can reap all of the bumper harvest rather than the insurer getting it. Obviously, as more & more people realise that a bumper harvest is likely, such insurance contracts rapidly lower in price to whatever the average consensus is that the contract is worth - so obviously enough, if a bumper harvest is a near guarantee, then insuring against failure is very cheap. You thus get a zooming in to something's true value the closer it comes in time as more accurate information about the future becomes available.

This is both good and bad. When it works, it works well. Sadly, in the case of a speculative bubble, expected future values can vastly exceed something's true worth, and unlike investment shares in companies (on a stockmarket) which are legally protected so you can only lose what you invest and not a penny more, you can lose many hundreds of times your investment in these insurance contracts (also called derivatives, or futures). This is because, effectively, derivatives are basically gambling on the future, so if you take very good odds on the expected near guarantee that there will be a good harvest, if there is a highly unexpected very bad harvest you suddenly lose the inverse which is many hundreds (and sometimes thousands of times) your initial investment.

In the case of Bear Stearns and Northern Rock, they combined all of what I have just explained. So let's take Northern Rock - it is a high street bank which gives out mortgages to people. This debt comes with some risk, so Northern Rock takes out insurance against people not paying it back fully with Bear Stearns (this is called securitisation) and other banks because that removes the discount rate the accountants apply to account for potential bad debts - thus its mortgages become worth more, and thus so does the company. Bear Stearns then spreads around that risk still further with yet other banks. Then say the mortgage market very unexpectedly goes bad as it did in the US - suddenly you have a massive payout of the insurance polices, each chaining from one to the next to the next - but because each banks has externalised its risk to all the others, they ALL get it in the neck and they ALL lose a fantastic amount of money - currently quite a few trillion dollars at best estimates.

However that alone isn't what kills the banks - they're not that stupid, and there are regulations preventing really stupid behaviour since 1929. No, oddly enough what kills banks - or indeed any large organisation, including entire governments - is the very human emotion of loss of trust, just as it did in 1929. I mentioned this last entry in connection with the problem that no one knows what a firm's current cash flow looks like, and therefore no one knows whether the firm has any liquidity.

The problem becomes that when those banks are off making unwise investment choices as previously described, they are constantly upping what an unwise investment is worth at the time - it's why it seems wise, because the apparent high return appears to be worth the risk. That means that on the book accounts, their net worth sky rockets due to an accounting principle called Mark to Market which simply means that something is worth whatever you can currently sell it for, not what it might actually be worth say sometime later on. Sounds sensible right? But remember our house example - which becomes worthless if cash flow is too low to sell the property - under Mark to Market, because cash flow drops so severely from paying out all those insurance contracts, suddenly lots of other assets in the bank become very worthless very quickly. That means that when a correction happens, one's accounts suddenly go from being extremely healthy to being extremely poor in a matter of hours. So, generalising the example, when liquidity dries up as you can't sell anything due to lack of liquidity (a vicious circle), then via Mark to Market accounting your company becomes worthless very quickly. Do you understand now why Bear Stearn's share price dropped from $93 to $2 so quickly? It literally became worthless. Why? Because money's value changed so quickly & drastically! This is why I say that money doesn't exist!

Generalising still further, you can now see why failing to inject liquidity in 1929 made the entire world economy worth a fraction of its value very quickly indeed. Injecting too much liquidity causes inflation and once again the entire world economy gets ill very quickly. It's a constant balancing act - a fine line between recession and boom.

And do you now understand what structured investment actually does? It hides risk by getting it off your own balance sheet and into someone else's, it probably even reduces it somewhat, but does NOT eliminate it. By getting it off individual firm's balance sheets and onto some other firm's, it simply makes the entire edifice extremely complicated and highly delicate. This is what caused Enron to fail - I have investigated Enron in some detail, and I really doubt anyone in there actually knew they weren't making a profit because how it had structured its debt was so incredibly complicated that even with five years for accountants to study the books after its collapse, they still don't know how much of a profit or a loss Enron was making at any one time. To think Enron themselves knew as it was happening is wishful thinking - and as it's just happened again in the entire financial sector starting with US mortgages, I'm pretty sure they have been making paper profits for the last decade or so. They have probably actually been running at a massive loss for years - it's just the accounts didn't show it, but now they are beginning to do so.

And now you see we get onto the meaning of recessions and booms. Markets, as it is often said, mostly work via greed and fear - not two of the best human emotions. However before fear and greed can come into play, they require trust - that the accounts say something close to what is correct and that when a firm says it is healthy, that it really is healthy. When the accounts and annual reports suggest that most of the risk has been diversified off into securities (insurance contracts), and thus its balance sheet looks much healthier due to a much lower discount rate, a firm looks much less risky than it really is because the market cannot absorb infinite risk and thus feeds risk back onto all firms but just in a different fashion.

Next entry I'll tackle how precisely we developed such a ham-fisted, stupid, inefficient and counter-productive way of handling risk. We didn't use to just pass risk around like some ticking bomb, in fact America and Britain became world empires precisely through embracing often incredible risks and trying (& failing) repeatedly until they succeeded, often with terrible costs in lives. Be happy everyone!

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