The Danger of Mixing Markets: Risk, Reward and Unintended Consequences
The dangers of mixing a low-risk market and a higher-risk one: When you have a room on fire, opening a door to a fire-free free room doesn't help put it out.
I am very critical of neoclassical economists and central banks, and their assumptions about the economy, which I see as increasing inequality, making productivity worse all while generating economic desperation and social disorder.
If we pause for a moment to consider the time in which the ideas and concepts of Friedman’s monetarism and Robert Lucas’ neoclassical economics and “neoliberalism” became part of the collective wisdom, markets really were different.
In the 1970s such theorists may have been operating under the apparently sensible assumption that investment performance or stock price would actually be tied to a company’s real-world performance.
Roger L. Martin has Roger L. Martin, Dean of the Rotman School of Management at the University of Toronto has written an entire book on the subject of shareholder value, called Fixing the Game.
He gives the example of a problem for companies and investors alike: a stock that was initially offered and sold to the public at $20 is sold, and re-sold, eventually rising to $100. The company only got $20 from selling its share to the first investor, but the investor who buys it at $100 is going to expect it to perform much better.
Writes Martin:
“The company needs to earn 15 percent on $100 per share of expectations capital, even though it only has $20 of real capital with which to do it. Rather than a 15 percent return on its real equity (or $3/share) it has to earn a 75 percent return on its real equity (or $15/share), a deeply challenging task and one that even the best companies are unlikely to achieve over time.”
Pursuit of profit through “shareholder value” alone undermines the company by increasing the long-term risk for the company, its employees, and the broader economy. Jurisdictions in Europe and elsewhere have sought to “reduce the influence of free-floating shareholders and maintain (or even create) a group of long-term stakeholders (including shareholders) through various formal and informal means.”
Despite all that, it still seems hard to argue against maximizing shareholder value or profit. Isn’t maximizing profit the whole point? It is generally accepted that it is.
There is a simple argument for why shareholders shouldn’t take all the benefits. As Gaël Giraud put it,
“Ownership implies full liability... Full liability was actually the implicit assumption of Friedman (1953) when he claimed that, in the long-run, markets are efficient.”
The investment market has changed since the 1970s. The focus on “shareholder value” was one just aspect of it.
There is investment and there is investment: some kinds of investments provide a company with capital to grow or expand: venture capital, bonds, new stock issues.
While real-economy corporations and industries still need to the work that way there have been a number of changes with “financial engineering.”
Initial public offerings (IPOs) used to serve the function of raising money for a new company. Now they are often used as a way for startups and venture capitalists to cash in on a company they have already built.
New formulas and computers allowed for the easy calculation of the prices of new kinds of financial products like bond options and derivatives were created.
Before these innovations, bonds were dull and safe: you bought them, held them, and when they matured you got your money back with interest.
In some ways, these financial instruments were often a twist on old ideas - they were presented as a way of guarding against losses through a form of insurance.
For example, in investment-speak, “Buying long” means you are buying a stock with the expectation of holding on to it, and getting dividends, because you think the company will do well.
If you think that a business is about to fail, you can “short” the stock, which means that if the price drops, you can collect on the loss. “Shorting” is really a kind of insurance - because instead of buying a share or a bond once, you have to keep paying them so long as the price stays up. That’s why you can lose a lot of money from it.
An important point about the real economy vs the financial economy: in the “real economy” you can have a “win-win” - because you are using money to pay for a product or service: you’re using money to get something that’s not money. Neoclassical economics, as I have mentioned many times, does not model lending, banks or money, and just treats everything as a flow of goods and services for goods and services.
When it comes to financial speculation, and insurance on speculation, it is a zero-sum game. If you are winning, it is because someone else is losing.
The financial deregulation of the 1980s and 1990s dismantled what is the equivalent of a building safety code for the financial industry — including oversight, making sure that banks had enough money in reserve in case of a crisis, and keeping retail and investment banks separate.
The financial industry created financial products that were crafted to turn low-return investments into higher-return investments.
So instead of bonds, bond options. Instead of mortgages, mortgage-backed securities. Instead of savings, insurance. Instead of stocks, stock price derivatives.
One of the reasons it happened is that in the 1970s, Fischer Black, Myron Scholes, and Robert Merton developed mathematical formulas that allowed investors to calculate risk and, therefore, do a better job of pricing options and derivatives on investments.
Instead of just buying stock in a company, or bonds in a company, and selling them when the price went up or down, you could put down money to buy shares at a particular price in the future. If the share price was higher, you could exercise your option, buy them and sell them the same day, and take a profit. If it was lower, you could let your option slide, and take the loss of the option.
The fancy word “derivative” is from calculus - on any curve, you can figure out the angle.
Now, options on shares are nothing new — they have been around for centuries.
The innovation was that the Nobel economists had found a way of pricing them in a way that appeared to eliminate risk. They adapted the Itō calculus, a formula developed by a Japanese mathematician for tracking rockets (or nuclear missiles) in flight. It dealt in multiple variables — the three dimensions of space, as well as acceleration and time, and included uncertainty (or they thought they did)
It was called the Black-Scholes formula, and using it, brokers could use it to calculate how much a “call option” would be worth at any given time in the future.
“The fractions depend on five factors, four of which are directly observable. They are:
the price of the stock;
the exercise price of the option;
the risk-free interest rate (the annualized, continuously compounded rate on a safe asset with the same maturity as the option); and
the time to maturity of the option.
The only unobservable is the volatility of the underlying stock price.”
The economists who developed it won the Swedish Central Bank’s fake “Nobel Prize for Economics” in 1997 - a year before its 1998 meltdown that nearly brought markets around the world to a standstill.
If you are tracking a rocket in flight, it may explode — but it will still have its own momentum and follow the laws of physics. That is not true of value of a stock: its value depends on a change in information, not physics. And information can be contradictory, wrong, and it can change extremely quickly.
A collapsing stock comes about like a plot twist in a story - because that can happen in markets. Accidents, crises, fraud.
And these collapses can be contagious, and is not limited just to companies that have deals that go sour. Entire sectors, like tech, or energy, can be affected because it the collapse of a single company raises doubts about the sector it belongs to. When there is a serious collapse, it can start a domino effect where well-run, efficient companies are taken down along with the companies that started the crash.
Just the opposite happened: the high risk of stock market speculation transmitted to the traditionally low-risk mortgages and bonds, making them much more dangerous.
Too Big to Fail?
The phrase “too big to fail” is ambiguous: it seems as if it means “this thing is so big that it couldn’t possibly fail” when it really means “this thing is so big that it can’t possibly be allowed to fail.”
The double meaning is a little like the old Saturday Night Live sketch where a retiring engineer tells his colleagues “You can’t put too much water in a nuclear reactor,” then leaves. His young colleagues don’t know whether they should put water into the reactor or not, and spend the entire time arguing about it. (It explodes).
The idea that banks that required taxpayer bailouts after 2008 were “too big to fail” is because the knock-on consequences of failure would be disastrous.
Banks failed around the world, and the central banks printed trillions of dollars to buy the failing assets off investors - through so-called “quantitative easing”. The risks were contained, at incredible cost, but nothing since then has been done to further reduce them.
In fact, there was far more criminal and corrupt behaviour driving in the middle of the crisis than has been acknowledged - forging people’s signatures in fraud schemes that were run like an industrial production line.
However, most investigations only resulted in fines and no admission of wrongdoing, even when the fine was in the billions of dollars. Banks could have been broken up into a series of smaller banks, so that the risk of any one failure could be contained, but that has not happened.
Even more troubling, actual criminal activity is going unpunished. For example, HSBC was convicted of money laundering with Mexican drug cartels and terrorist organizations. HSBC had $19.7 billion in dealings with Iran, shipped $7-billion out of Mexico to the U.S., and broke rules to carry on business with Iran, Burma and North Korea. They were fined $2-billion — one month worth of profits — but no one was convicted because a conviction could trigger a clause that would prohibit dealings with the U.S. government. That punishment — for money laundering for drug cartels and terrorists — was deemed too severe.
As the International Consortium of Investigative Journalists has reported, HSBC hasn’t learned its lesson: “HSBC moved vast sums of dirty money after paying record laundering fine”
In June 2013, Bloomberg reported that
“traders at some of the world’s biggest banks manipulated benchmark foreign exchange rates used to set the value of trillions of dollars worth of investments.” It is a market that sees “$4.7-trillion in trades a day, and is one of the least regulated.”
Banks were found to be manipulating the “LIBOR” (the London-Interbank Offered Interest Rate), which is a global interest rate — “the most important figure in finance,” according to The Economist, which referred to the scandal as “the rotten heart of finance.” “It is used as a benchmark to set payments on about $800 trillion-worth of financial instruments, ranging from complex interest-rate derivatives to simple mortgages. The number determines the global flow of billions of dollars each year.”
Traders and banks in London were found to be manipulating it for their own interest, rather than setting the rates according to the actual market. Among other problems, this triggered a $4-billion payout by U.S. municipal governments in “interest-rate swaps,” but The Economist suggested manipulations of LIBOR had been happening since the late 1980s.
We have rules to stop people from doing dangerous and stupid things. We put locks on our reinforced doors. We have regulations and barriers to slow things down. We quarantine people with contagious diseases. We reinforce doors and build strong locks to keep intruders out.
Many of the reasons for disagreeing with libertarian arguments about people being “free to choose” is that they aren’t accounting for the transmission of risk, including to themselves.
The concepts of risk, opportunity, and chance are all closely linked. We all understand “nothing ventured, nothing gained.” We all know that there are activities that are low-risk and low reward. We know that everything has a cost. But when it actually comes to seizing an opportunity, the potential gains from the reward may blind us from the risk involved — or it may be hidden.
For example, the rationale (or, perhaps the sales pitch) behind creating mortgage-backed securities — buying millions of mortgages from banks, treating them as if they were shares from a company, and selling them to investors around the world — is that the housing market in the U.S. always went up, and was therefore safe (this was not true).
That is just one example of a “financial innovation” — derivatives, credit default swaps, and the strategy followed by Long Term Capital: They were all supposed to lower or minimize risk, but did just the opposite.
In Liar’s Poker, Michael Lewis described his time at Salomon Brothers, which had been a staid bond trading company that ended up playing a key role in the Savings & Loans scandal. Lewis himself became “the biggest swinging dick” on Wall Street.
The Garn St. Germain Act of 1982 allowed Savings and Loans to reduce the amount their total deposits on hand. This money is usually kept in reserve to protect institutions from a bank run, or a downturn. It’s a buffer against bad times. Lowering the amount they had to keep on hand freed up money, which Wall Street invested and promptly lost. S & Ls started to go broke. Over 700 failed and had to be bailed out at taxpayer expense. Another reason for struggling S & Ls? The federal reserve’s focus on fighting inflation, and the collapse in real estate prices in Texas and elsewhere due to falling oil prices.
The 2008 financial meltdown was, in part, because someone somewhere thought it would be a good idea to make people’s mortgages a Wall Street investment. The 1929 stock market crash was also driven partly by real estate speculation in Florida. Property in the southern U.S. has been involved in stock market bubbles and devastating crashes dating back to the Mississippi Scheme in France of 1720.
What do 300 years of property bubbles in the southern U.S. have in common - aside from real estate? Its about the transmission of risk, from one area of the economy which is risky and speculative — financial markets — to areas of the economy that generally aren’t, like owning a home or property.
They are mixing markets, from one which is low-risk and low-return, which spreads income widely, to one which is high-risk, and high-return for a tiny few, wiping everyone else out.
That is the fundamental problem with the housing market in the U.S. and Canada: the housing market is seen as existing to fulfill the needs of investors, not the people who need a place to live. And it is investors who have driven up the cost of housing - and by investors, I mean the people who own the bonds and mortgage backed securities.
There used to be rules that kept investment and retail banks separate in the U.S.: the Glass-Steagall Act (or parts of it) that stood from 1933 until 1996, when it was repealed under the Clinton administration because it was “no longer needed.”
One of the ideas of promoting home ownership (as opposed to renting) is that it provides people with a way to build up their personal wealth. You can spend your entire life renting, and die owning nothing, or you can spend your life paying off a mortgage and die leaving a house worth something.
Turning people’s mortgages, which are supposed to be stable and safe into something that can be bought and sold in the millions, and steeply devalued in minutes by investors in another country looking to minimize their losses is a bad idea.
In part of his Ten Heresies of Finance, Benoit Mandelbrot writes:
“[Experts] assume that “average” stock-market profit means something to a real person; in fact, it is the extremes of profit or loss that matter most. Just one out-of-the-average year of losing more than a third of capital — as happened with many stocks in 2002 — would justifiably scare even the boldest investors away for a long while. The problem also assumes wrongly that the bell curve is a realistic yardstick for measuring risk. As I have said often, real prices gyrate much more wildly than the Gaussian standards assume... Real investors know better than the economists. They instinctively realize that the market is very, very risky, riskier than the standard models say. So, to compensate for taking that risk, they naturally demand and often get a higher return.”
Experts make many mistakes thinking that markets are more regular than they are. Later in the same chapter, Mandelbrot writes that an IBM colleague asked him about a “some MIT professor [who] had found a systematic way to beat the stock market.” The professor in question was Stanley S. Alexander, and his formula was
“Every time the market rises by 5 per cent or more, buy and hold. When it falls back 5 per cent, go short and hang on... He calculated that an investor who had blindly followed such a rule from 1929 to 1959 would have gained an average 36.8 per cent a year, before commission.”
Mandelbrot wrote Alexander a letter asking
“Which of several possible prices, specifically, had he used in calculations?” to which the reply was a dismissive, “It doesn’t make any difference.””
As Mandelbrot notes, it did:
“It made the difference between a 36.8 per cent profit and a loss of as much as 90 percent of the investor’s capital...Alexander had [used] daily closing prices... The real world clipped his profits on the way up and stretched his profits on the way down.”
How Insurance Can Transmit Risk
We all understand the idea of insurance - and some investments are modelled on financial ways of trying to reduce risk while in a way that balances things out.
For example, the idea of “options” comes from agriculture. In the spring, if a farmer plants a crop, they don’t know what it’s quality will be or what the price may be when it is harvested - but they do know their costs. So, they may cut a deal with a buyer to buy it at a particular price. If the farmer is lucky, it’s more than the market price, if they’re unlike it’s lower, but either way it reduces their risk and also stabilizes prices.
Since most of us are consumers, we tend to see the individual, consumer point of view. But if you are the insurer, your rates, payouts and everything else are dependent on things staying as expected. And if things go sideways, and a crisis happens and the insurance — and investments — aren’t properly structured, instead of preventing risk, you have built a machine to transmit risk.
The whole thing about insurance is that you are pooling your resources to deal with an issue where you know some things are going to go wrong, but you don’t know when or to who. If everyone has to save up ahead of time the cost of the operation or accident, people will require huge savings all the time. If we all chip in and are all covered for a smaller fee, it means people don’t have to save up or go into debt. It’s more efficient.
If the insurance price is based on the fact that historically, there have never been more than 6 in 1000 bad events a year. If it starts to exceed that, and there isn’t enough of a buffer or resource, the risk transmits to everyone, because everything starts to fall short. There just aren’t enough financial resources to match the need, and that means the actual resources to deal with the crisis won’t be there.
Insurance companies get around this by buying insurance themselves, or “reinsurance” - however, a series of insurance and re-insurance companies can spread risk, as one shock that falls outside what’s expected triggers another - because each insurance contract was underestimated risk.
“Risk transmission” or contagion, is very real, and this is how it spreads. One of the causes of the 2008 meltdown was “Credit Default Swaps” which were supposed to be a kind of insurance to reduce risk. Instead, they spread risk like a lit fuse, setting off a chain reaction of failure through global institutions around the world.
The Credit Default Swaps were triggered by “subprime mortgages” that had been packaged, bundled, and turned into securities investors could buy, (Collateralized Debt Obligations, or CDOs). Mortgages used to be between a homeowner and their local bank. Banks used to worry about whether someone could pay back their mortgage. But because mortgages were being packaged into investments, if someone couldn’t pay their mortgage, it wasn’t the bank’s problem anymore.
Instead of being careful about who they gave mortgages to, and making sure they would be paid back, banks actually got paid for every new mortgage they gave out, no matter how risky.
No one was managing the risk. The gatekeeper used to be the local bank that held the mortgage, but since the risk was now being held by investors, banks had an incentive to lend as much as possible whether borrowers could afford it or not. The risk was shifted to the borrower and the investor, with retail and investment banks in the middle both profiting.
Why was this so combination of mortgages and high finance so dangerous? Because they were mixing markets, and they were blind to risk.
In a footnote in The Big Short, Michael Lewis explains that this risk calculation was a challenge for the International Swaps and Derivatives Association (ISDA).
“ISDA had been created back in 1986 by my bosses at Salomon Brothers, to deal with the immediate problem of an innovation called an interest rate swap. What seemed like a simple trade to the people doing it — I pay you a fixed rate of interest in exchange for you paying me a floating rate — would end up needing a blizzard of rules to govern it. Beneath the rules was the simple fear that the party on the other side of a Wall Street firm’s interest rate swap might go bust and fail to pay off its debt. The interest rate swap, like the credit default swap, exposed Wall Street firms to other people’s credit, and other people to the credit of Wall Street firms, in new ways.”
The hazards of mixing markets is incredibly important, but totally neglected, including at the national and international level.
As Roger L. Martin wrote, the risk of mixing markets is also one of the core problems with shareholder value.
“While it is not possible to entirely eliminate the self-interest of executives, the authors posited that we could better align that self-interest [and] eliminate agency costs by giving agents meaningful amounts of stock-based compensation, actually making them shareholders as well as executives... the theory had the unfortunate effect of tying together two markets: the real market and the expectations market.”
As others have discovered, linking two markets, one high risk and one low risk, does not mean that the low risk one will calm the high-risk one down: risk bleeds from the high-risk market to the low-risk one. If you have two rooms next to each other, one with no fire in it and one where the furniture is ablaze, it is not going to help to open a door between the two with the hope that the room with no fire will quiet the inferno next door.
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