Business Skeptic

Efficient financial markets are supposedly a hallmark of our modern capitalist system. The vast portfolio of financial instruments is touted as providing global liguidity at low cost to support productive investment and thus improve economic growth and development. I have no doubt that new capital market technologies and infrastructure have reduced the administrative cost of capital and has thus made investing more efficient and cost effective, thus providing a improvement in capital and investment productivity. However, I question whether the system has involved into global on-line gambling and the “capital efficiency’ argument is merely a marketing whitewash.

An investment vehicle value, by definition, can be represented by a probability distribution. Trading, transactions and hedging are the result of differential view points regarding this probability distribution. I purchase an investment because I believe that it is currently undervalued based on upon “my” opinion of the future and how it differs from the imputed market consensus embodied in the current price. Said another way, I am betting that I can “beat the house” (where the house is the market consensus of the expected value of the probability distribution). This is fine and is the way that financial vehicle pricing is supposed to work and it is this dynamic and continuous trading flux that provides financial liquidty. If we all agreed on valuation, then no one would trade except when their personal circumstances required a change in investment strategy. Considering transaction volume and frequency, it is mathematically easy to prove that the bulk of trading has nothing to do with changing investor economic and life circumstances warranting a change in investment strategy but rather the continuous betting on differential views of the future outcomes. As mentioned before this at its foundation is the key to financial market liquidity.

There is an important presumption in this analysis, and that is that the “differential betting” is restricted to the amount of capital that is required by the global value creation machine. Or more specifically, you must have a differential outcome believe regarding the value that can be generated from a given amount of capital, since that is what defines the probability distribution. Therefore, the amount of financial instruments should be reasonable proportional to the underlying productive capacity of the economy and invesment capital employed. If the amount of “betting” exceeds the underlying productive capacity and invested capital, the market is no longer operating as a liquidity engine but rather speculative gambling in which, since there is no productive economic capacity underlying the speculation, must result in a negative return (a zero sum game minus the cost of transaction).

The global financial markets currently appear to be awash in speculative gambling, unsupported by global economic capacity. The worldwide value of credit is currently 4 times the global GDP. Hence the world has borrowed 4 times more than its output. If you assume (mathematically supported of-course) that value is created by increases in productivity, and that the rate of productivity is on average less than 10% per year, then it could be centuries before our investment market and our productive capacity are in alignment. More worrying is the amount of credit derivatives in the market. Currently there is 10 times more value in credit derivatives than in the underlying credit on which they are based. Stated a different way, the total value of worldwide credit derivatives is 40 times the value of global GDP. Since there is no economic rational between the total value of derivates and the underlying productive global capacity, the derivatives market is far more like a gambling casino than an efficient capital market.

There is a substantial difference between Las Vegas and global credit markets. In Vegas, the probability distribution of any game of chance is fixed and regulated. The probability distribution is not influenced by the amount of money being gambled. The probability I will beat the house in Black Jack is the same whether I bet one dollar or one million dollars. The difference in global credit markets is that the micro probability distribution (the probability distribution for each “gambler” can be altered by the amount the gambler invests, but the overall macro probability distribution does not change. Since there is no productive capacity underlying the bet (as there is no productive capacity in a deck of cards) the consolidated outcome of the game is at best zero sum (some will win and others lose). However, because of the interrelated nature of the capital markets, the size of your bet can alter your odds. If your odds improve, then consequently someone else’s odds must go down, since the game remains zero sum. Gamblers that have the resources to place the biggest bets, hold the financial markets hostage and thus, cannot be allowed to lose. Somebody has to pay. In order to pay, you must have productive assets (economic capacity), hence the final payer (I can use the word bail-out) must be those that actually produce something, product output. That means you and I. The government will step in and save the gambler and you and I will foot the bill in increased taxes and lower economic growth. When there is 40 times more money betting on the outcome than the outcome can support, there is going to be some serious problems. Ooops, I’m late. The serious problems have already arrived.

The subprime crisis is becoming a field day for our society’s addiction to the blame game. I am not going to heap additional fodder into the cannon of public opinion. While questionable acts and motives abound in this situation, they did not cause the crisis but are an artifact of the real reason behind the collapse. The chilling fact is, the crisis would have occurred regardless, because it was engineered to fail from the very beginning.

A free market, whether mortgage backed securities, structured investment vehicles or coffee, is a dynamic system that is stabilized by feedback. A free market is defined by feedback. The process of negotiating a price, the force pushing a market or transaction to equilibrium is feedback. It was the structural lack of systematic feedback which caused the crash.

There are three essential characteristics for feedback to effectively stabilize a system. These are:

Relevant Information: The feedback signal must be directly related to the feed forward momentum of the system.

Timeliness: There must be a minimum of delay between the information feedback and forward signal. Too much delay causes the system to become unstable and it becomes increasing out of sync with the controlling information.

Amplitude: The strength of the information. Basically is the feedback signal strength strong enough to be heard over the noise and strong enough to effect the system process.

Structured investment vehicles, for which I am including subprime mortgage backed portfolios, where constructed in a manner which precluded effective feedback. In a structured investment vehicle, the base transaction (the feed forward signal) was dissected into multiple components. Repayment risk was decouple from credit risk, which was decoupled from interest rate risk, which was also decoupled from base asset value risk. Now under the mathematical laws of associative commutation, the whole is just the sum of the parts, and hence nothing related to the underlying base transaction is affected by this dissection.

The first notice of caution should have arisen at this point. Specifically, the reason for the dissection was that the parts could be sold for more than the whole (this is due to different risk / return profiles of the different buyers of the parts). One should ask at this point, whether there is a financial equivalent to the Second Law of Thermodynamics, the conservation of energy. Ask yourself a simple philosophic question. I take a pie and if I cut the pieces just the right way, I end up with more pie. Don’t think so, but this is a philosophic argument. The actual math of valuing structured investment vehicles does work and I don’t want to get into that here. It is the system dynamics regarding feedback which are broken.

What essentially happened is that by dissecting the base transaction, we decoupled the parts from the information flow about the whole. Information about the underlying asset could not be so precisely partitioned. Hence, each part had a market but it did not have relevant information feedback, because the information market was not and could not be partitioned and parsed along the same mathematical rule of the SIV.

In addition to the lack of relevant feedback, the partitioning of the base asset resulted in large time delays in information flow between that which effected the base asset and its parts. Part of this was due to the loss of information relevancy, context and fidelity and also because of the long and many hands that the parts had passed through. Image you are at an open air market negotiating for a hand woven rug. Each time you counter offer, your offer is broken in different pieces of information and each piece of information has to go to another city for an answer. Your counter price goes to a city 10 miles away, your delivery desires yet to another city and the warranty yet a third. Not only is this highly inefficient, the lack of relevancy and context of each information piece is likely to cause valuation problems.

The last aspect of broken feedback is amplitude. The strength of the feedback signal declines both because the signal is divided into parts and secondly because it begins to dissipate and lose its strength as it travels the long distances to the owners of the various parts.

The subprime and other Structured Investment Vehicles were designed to fail because they were engineered in a manner that seriously compromised the necessary feedback that systems rely on to be stable.

The amount of correction is a function of the three broken variables. As the time delay gets longer, the amount that the part values can diverge from the base asset’s value grows exponentially. As the relevancy of the information declines, the feedback declines in inverse proportion of the loss of relevancy. Lastly the reduction in amplitude, due to signal loss, reduces the feedback by the gain factor of the system which is proportional to the risk adjusted (almost a oxymoron in this context) compounded rate of return over the maturity of the base asset. Stated in somewhat mathematical terms, a structured investment vehicle such as subprime mortgage backed securities can diverge from its correct or feedback stabilized value by the following equation:

dV = 1/ a RIR * (TD)**et*(1/(A)**eM)

Where:

dV = diverged value of parts compared to base asset.

a = proportionality constant

RI = Relevant Information Ratio (Less than one)

TD = Time delay. This is a multiple of market trading speed.

t = time between initial investment and calculation.

AL = Amplitude. This is always less than one because of signal dissipation.

M = time to maturity.

In a perfectly free market with transparent information and almost instantaneous transactions, the calculated dV (divergence value) is unity. Or the sum of the parts equals the whole. In feedback compromised systems, there can be considerable value divergence. However, like quantum mechanics, this probabilistic divergent value function must eventually collapse to unity at either maturity or upon inspection. Hence the “created” value must collapse to zero. Welcome to the now.

A second principal for effective and successful capitalism is the need for an educated consumer. Adam Smith’s capitalism assumes that consumers will act in a rational manner and attempt to maximize individual utility. Rational buying behavior requires an educated consumer, knowledgeable with regards to the domain and specifics of the transaction.

Unfortunately the practice of “educating” the consumer is more notable in its breech than its practice. The sub prime mortgage market is great example. The consumers lured into purchasing homes they could not afford were certainly not educated by the mortgage bankers. People need to attend school and pass exams to earn the right to drive an automobile, but no competency is required to go into debt for hundreds of thousands and risk one’s economic future. Capitalism cannot nor should it protect people from their own stupidity, but neither should it take advantage of it. An uneducated consumer should be helped and educated, not seen as a target market and exploited.

This goes back to the founding principal of Adam Smith’s “Wealth of Nations”. Capitalism must be build upon a solid foundation of cultural morality. Many notorious rip-off’s have hidden behind the defense of “the free market”. But think about it. Like selling mortgages to people who could not afford them, should be we marketing pharmaceuticals or health savings accounts directly to consumers that have no medical training. Watch advertisements and see if the seller is trying to educate you or overtly keep you from being “rational”.

The freedom to decide is a strength and virtue of our society and economy. However, along with such freedom comes responsibility. Do the right thing.

I am concerned that too many companies and executives take a mechanical view of capitalism. Just because something is legal, it sells and is profitable, does make it ethical, right or moral. It is instructive to go back and reread the original doctrine of Adam Smith.

Adam Smith was a philosopher and not an economist as most people believe. A major prerequisite for the success of his economic philosophy; “the invisible hand”, was that capitalism must be built upon a strong foundation of cultural morality. The engine that keeps capitalism vital and productive, is integrity and ethics, which form the framework and scaffold by which investment and resource allocations are made.

In many ways, Adam Smith’s capitalism contained a strong flavor of market paternalism.

Today’s capitalism often appears to be based on the philosophy, that as long as it not explicitly illegal, then anything goes and let the market decide. These shadow capitalists even use the US Constitution in defense. “Freedom of Speech” etc. Bust ask yourself, Does the economy really need sex and violence on television? Violent and disgusting movie trailers during prime time family viewing? In a country with an epidemic of childhood obesity, do we really need to be pushing nutrition free, sugary breakfast “foods” directly to children? How about marketing pharmaceuticals directly to consumers that have no medical education? What about companies that market totally ineffective nutriceuticals and homeopathic remedies? The economy is filled with products and services that are ineffective and destructive, but profitable.

It’s not just the sellers of goods that should take a moment and reflect. Media companies, talk show hosts and even news reporters tout “stories” that help to market products that are wasteful, fallacious and in fact down right dangerous. This is not capitalism, but exploitism. Capitalism is the engine of productivity and productivity is the only way in which a society, economy and an individual attains greater wealth. By allowing and encouraging consumers to spend resources on ineffective and destructive products and time wasting endeavors, the entire economy suffers. I am not advocating legislation, governmental control on any other “anti-free market” intervention. I am simply asking for business leaders to simply be leaders and stand up and defend true capitalism.

The business press is awash in books on leadership. One of the most important aspects of leadership is doing the right thing when under pressure to make the numbers, and focus on the wealth of the shareholders. Business leaders should constantly be asking themselves; “does this product or service really benefit the consumer and society”, not simply, “will it increase earns per share”.

Just because something is legal does not mean it is right. Just because you can sell something, does not mean the world will be a better place because you produce it. Have some backbone and lead. Say, “I could, but it’s not right, therefore, I won’t”!

My favorite quote and a personal guiding thought is: “Manners are more important than Law”.

Respect the consumer, the economy and the core tenet of capitalism. Do what is right.