The Failure of Finance

Two loosely related and thoughtful posts today point up some of the ways that the fundamental frameworks of how participants think about and relate to financial markets are breaking down. Note that this development is separate from the fact that financial institutions look pretty wobbly. Instead, these two writers, Roger Ehrenberg and Cassandra, highlight two different, but fundamental ways that investors’ mental models about markets are under serious strain.

This is a more troubling issue than might be obvious. It is very unnerving to have core assumptions proven wrong, or at least not as reliable as you thought. This repudiation of widely-held beliefs (starting with the cliche “safe as houses”) is going to produce dislocations that will feed into institutional stress.

Ehrenberg and Cassandra attack this phenomenon from very different vantage points. Ehrenberg discuses how some of the assumptions underlying much of modern finance have failed; Cassandra, although also taking a similarly analytical starting point, about how gains and losses are usually distributed in market, focuses on how the recent disruptions are likely to lead to radical changes in investor behavior, namely revulsion towards financial assets.

When I started out in the securities industry (1980) stocks were regarded as speculative. Investors still recalled how people had been wiped out in the Crash, how it had taken until 1954 for the Dow to return to its 1929 levels. The 1950s and 1960s had been good times for stocks, but again, the 1970s showed them to be losers once again. Investor Peter Lynch said that stocks were the best investment when the public regarded them as risky, and most speculative when they were widely regarded as safe. The idea that equity investing could be perilous is still deemed antique in many circles, but the grind of credit contraction will erode the faith in most financial assets.

This is a long post because both authors have worthwhile observations. I encourage you to read both their views. Cassandra’s observations also shed light on the inflation vs. deflation debate, which has been gnawing at me.

First, “(Dis)continuous Time Finance” from Ehrenberg:

I grew up in a time when markets were considered to be “continuous.”…. Liquidity was presumed to be available. And while markets could and did gap due to an event, new information, etc., it could and would clear with transactions taking place at the new level. The financial markets, through price discovery in the presence of liquidity, conveyed valuable information that could be used for both security selection and asset allocation. The field of financial economics, as such, was predicated upon the existence of bids and offers and, therefore, liquidity. And this phenomenon was assumed to persist across time.

But this is not the world I observe today; quite the contrary. Price movements are not only discontinuous, but the notion of liquidity across time as traditionally assumed simply does not exist. Something has happened to rock the prevailing academic paradigm. Have the experiences of the past six months essentially blown a hole through the heart of modern financial theory?

…..consider what Merton said back in 1987 as it relates to capital markets:

The conscious motivation for creating a capital market is to provide the means for financial transactions. However, an objective consequence of this action is to produce a flow of information that is essential for all agents’ decision-making, including that of those agents who only rarely transact in the market.

You see, the problem is that without transactions it is hard to get information, and without information it is hard for people to transact. We are caught in this Catch-22, the Fed’s prescription for which is injecting hundreds of billions of dollars into the financial system. And while this creates money, it does not necessarily create liquidity in the instruments for which no bids are available. Why? Because potential investors are sorely lacking information, either intrinsic to the securities or extrinsic in the form of observable market prices. This is partly due to the complexity of the instruments in question, the structured asset-backed market and related derivatives. And while this problem is not intractable, it is easy to imagine that getting sufficient information to make educated bids will take quite some time.

Another problem is that an element of liquidity was predicated upon the faith and belief in the ratings system. A AAA-rated security was available for purchase by trillions of investment dollars, AA-rated fewer trillions, A-rated hundreds of billions, and so on. But now that we’ve seen tens of billions of AAA-rated securities marked like junk, the very foundations of the institutional investment model have been shaken. Trust has been shattered. No trust, no liquidity….. we can’t and don’t live in a riskless world. The problem is that too many investors and market intermediaries thought we did. This was telegraphed by the historically low levels of volatility during the latter part of 2006 and into early 2007.

Today we live in a world fraught with risks that we barely understand, risks that modern financial theory doesn’t have great answers for. A new model is needed that incorporates the effects of discontinuity as an outgrowth of, among other things:

Complexity – structured securities, derivative instruments;

Interdependency – widely disseminated holdings that can pollute portfolios globally, hundreds of trillions in counterparty exposures;

Intermediary errors – ratings that don’t reflect the risks, financial institutions with weak control environments and poor risk management practices; and

Bad actors – originators, underwriters, traders and managers with mis-aligned motives.

….Our models and academic frameworks needs to be robust enough to handle these occurrences and to provide a model for maintaining liquidity, price discovery and information dissemination. Based upon today’s market action we’ve got a long way to go.

Cassandra’s post, “Liquidity Tug-o-War??” is quite long; I’ve omitted her colorful and insightful analysis to focus on her conclusions. She starts by discussing the until recently ever-rising tide of liquidity and notes:

….understand that one will lose half the value of the paper every four to six years, despite the tamer prevailing rate of so-called inflation as measured by government officials and apologists for unfettered liquidity creation. Such a reality is sufficient for those with such paper to avoid its accumulation by (a) spending it immediately (b) converting it to other stores of value (c) borrowing it in order to do ‘a’ or ‘b’ or both above….

Even if your view of the real, as opposed to nominal inflation rate isn’t quite that dire, foreign holder of the dollar have seen those kinds of losses. Back to Cassandra:

And so credit growth, fueled by rising asset prices and ever-more confident lenders, is likewise positively skewed. Like the first skaters testing the ice, they proceed slowly, whereupon confident of its integrity based solely upon the fact that they remain above the surface of the icy waters, signal to the others that all is fine in slippery Golconda. Of course this is overly simplistic. There are in reality many forces at work: agent vs. principal issues; keeping up with the jones’; and all manner of behavioural biases that serve to reinforce the alledged prudence of one’s herd-like actions and penalize the questioning of the same, for no one benefits from caution, not least the individual. At least until the edifice is too large for its foundations. There are of course limits to how many can safely glide upon an ice-sheet of certain thickness. Exceeding such threshold limits results in rapid fat-tailed catastrophe with no recourse. Eschewing analogies, revulsion destroys credit and collateral values in vast quantities. It crushes the price of core asset values in real estate and equity, and cremates securities that use these assets as collateral. The size of core asset value destruction in our present case being measured perhaps, ultimately, in the double-digit trillions….

But mega-revulsions do more. They scar the psyche, irrespective of whether by natural consequence of falling in under the weight of the edifice, or in response to man-made pressure such the Volcker’s Saturday night massacre. Our current predicament is the former, the result of multiple attempts to prevent recession over the years, with diminishing marginal returns to the priming almost guaranteed that much of the investment would of marginal quality and ultimately wasted. Lenders, accustomed to lognormal distributions begin to rework risk under more symmetrical regimes. They reduce existing leverage to save powder and prepare for worse to come, much like the body will warm the trunk at the expense of the extremities. And like the body they do this not as opportunists but in self-preservation. Ray Dalio’s Bridgewater in their latest research report makes the following points:

The financial market unraveling is, as we’ve described, ‘the Big One”. What we have meant by this is that the implications of the last six months will impact how the financial system will work for years. Both directly and indirectly (through the literal profits and incomes associated with the financial sector) and indirectly (through the benefits of credit creation) the economy is more reliant upon the financial sector than ever. The virtuous circle of easy credit and rising asset prices leading to increased consumption and therefore increased incomes has been fueling the economy for so long that it has been taken for granted. The reverse of this cycle will have profound implications for the economy, and we have only just begun to see those implications upon the real economy.

It is a natural and logical reaction. This is what the beginning of a cascade feels like, and one that only will end with the eventual uprightness and sustainable leverage atop the system, corresponding levels of consumption related to output, and asset values that are either reasonably well-discounted or known, at the very least, to have stabilized in the longer-term. We are not there yet, and every bank – whatever their domicile – knows this, hence are reticent to lend except to all but the most creditworthy, and on terms that provide more than just compensation for there remains a reasonable probability that price discovery continues in a direction that erodes one’s margin of safety. Falling asset prices, in turn, kills the speculative animal spirits. Why build a new shopping mall when the existing ones can be had for less than the cost of new construction? Time shares will trade at hilarious distances below where they were sold in the primary market. And banks, flush with assets recently foreclosed have no appetite to project-lend when they are recently – involuntarily – long the last cycles excesses. Again the chain of dependencies numerous and complex, but the end result is the same: more destruction in collateral values and hence both liquiidity and the supply of dollars.

The remedy for this is clear. Rapid Price discovery. Writedowns. Recapitalisation where required. This will return confidence, albeit upon a much diminished capital base, and much diminished risk-appetites on the part of financial lending institutions. A reordering of the deck occurs: leveraged asset holders – whoever and whatever they leveraged against lose, as do the previous financial sector shareholders. It is against this backdrop that I raise the ultimate question for Moldbugs and those in dread of helicopters and printing presses alike: Is it even remotely plausible that authorities can replenish anything remotely like what’s been lost, or what will be lost? Is not “reflation”, or Fed gestures to bridge recapitalizations for systemic lubrication anything more than a drop in the bucket to what has been destroyed, making inflationary fears resulting from Fed or Governmental actions a canard? The liquidity resulting from securitisation, wanton misuse of the shadow banking system and its conduits ARE ALREADY out there. Much of it having ALREADY circulated and coursed through sytsemic veins is in the hands of foreign Official entities. They can spend it, but they can multiply it, won’t multiply. Moreover, the effects have already been seen in the BRICs in the form of raging economies, buoyant mercantilist exports, vaulting commodity prices, and the $1000+ Kruggerand. But that was then, and this is now. Replacing some of the destroyed credit and liquidity surely can be but a salve upon a lost limb. It will, in the end, simply be inconsequential in the grand scheme of what’s gone before and what is to come.

Longer term, I will defer to Moldbugs of the world and not challenge their assertion that the probability that the current reign of fiat money will end. But here, and now, I am far less concerned with the inflationary effects of TAF, TSLF, fiscal packages or outright nationalisation of financial institutions when the need arises since I believe that the credit so destroyed by this revulsion, and the associated cascades and intermediate-term behaviour changes far outweighs the remedial impacts of authorities.

I find this a persuasive line of argument (although I am always interested in other views), namely, that the scope of the deleveraging will overwhelm the efforts of the authorities to reflate.

I have mentioned before that Our Chairman Bernanke takes great comfort that determined monetary authorities can reflate from the example of the US in 1933-1934. But remember, the operative word is reflate, not forestall deflation. 1933 was after massive bank failures and deflation had already occurred. And the FDIC was established in 1933. It is unclear how successful purely monetary measures would have been if unaccompanied by institutional reform.

That is a long way of saying that Cassandra has given an argument for my gut instinct that if the credit crisis cannot be arrested (and I think that’s high probability; the problem is too big for the government to fix it), the path we are on is deflationary rather than inflationary. Even if the Fed aggressively expands the monetary base, increased cash hoarding will mean that we will not see correspondingly large increases in money supply. And a contraction in near-money will more than offset whatever pump-priming the Fed can manage.

We can only hope to be so lucky as to get stagflation.

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  1. Anonymous

    wow. cassandra can write — the first to provide me with a glimpse of the cosmic scale of this catastrophe. no place to hide. better go meet the neighbors, learn to play an instrument and tell jokes, entertain ourselves. and maybe write a book about a central banker whose focus to his life and his studies, his greatest fears, comes to pass despite his foreknowledge and his most extreme efforts. “We will avoid the mistakes of the Great Depression. What happened to Japan will not happen here. We have to much knowledge, too powerful of tools.” Oh, and aside from all the implications of this disaster mentioned in the article, I could add one more: for the average Joe and Jane, economic growth at 10% a year now is looking pretty good, even if the price is a Communist Party dictatorship.

  2. s

    How will the governement expropriate the stocks of GLD? Maybe thoserebate checks should be used to buy IMF gold

  3. Anonymous

    In all the hand wringing over the possible contraction of credit I find it instructive that no one is talking about the more severe collapse of demand for the same credit.

    While deflationary end games always sound plausible, they never happen. Putting arbitrary constraints on the printing press may be virtuous but in the end seem contrived to make deflation arguments work.

  4. j

    Ehrenberg’s summary is quite good, but really has nothing whatsoever to do with a presumed failure of “continuous time finance”, which only has to do with the supposition of calculus methods in quantification. Second and higher order derivatives and jumps at points of continuous time are allowed.

    The crisis is about liquidity, which is an age old topic. There is nothing much new conceptually in what happened with regards to liquidity risk. It’s merely an event that transgressed the stunted imaginations of those who calculated the standard deviations that went into the risk models. This tends to happen when the world changes, and when those who calculate statistics do so on the basis of implied stasis.

    Cassandra is on the right track with the deflation aspect – a gifted writer, but ponderous in the analogy department.

    Along the lines of the credit deflation effect, it would be interesting to see something thoughtful written on the application of the idea of “creative destruction” in the eventual unwinding and resolution of the credit crisis.

  5. eh

    Modern ‘financial engineering’ has worked fine for those it was primarily designed to benefit, namely its purveyors, those who earned big salaries and even bigger bonuses from it.

  6. Richard Kline

    If one gets deflationary _conditions_ because money is hoarded, or is frozen in inactive or distant institutions, or credit contracts because banks won’t lend, public financial authorities can have some influence on the outcome. (Even the latter, i.e. charter new bank-like institutions with capital and a mandate to lend.) But if one gets actual deflation because assets simply aren’t worth the values they were being traded at and borrowed against, there is nothing ANYONE can do about it. Eventually, either assets find a sustainable price—price discovery—or new and different assets are generated and traded. . . . There is nothing the Fed or the Treasury or Congress can do about the deflation of our irrationally valued assets. Many of these assets still _are_ assets, i.e. houses, equity shares, etc., although derivatives based upon cash flows from them may well be totally worthless in many cases now. But these assets are just worth less.

    I’m with Cassandra: our best hope is _rapid_ price discovery, while the public authorities keep a firm floor under capital and the banking system so that basic economic function continues apace.

  7. Anonymous

    There is one reason and one reason only for having an elastic currency. So that the FED can manipulate the price level.

    Of course, that doesn’t mean the FED can affect relative prices eventhough they are sure trying. And who knows? By favoring the asset they choose for their open market operations they may even succeed at that in the short run.

  8. Anonymous

    Rapid price discovery? Be careful what you wish for… you might not like the prices you discover.

    Somehow the opening paragraphs of H. P. Lovecraft’s Call of Cthulhu seem apt here:

    The most merciful thing in the world, I think, is the inability of the human mind to correlate all its contents. We live on a placid island of ignorance in the midst of black seas of infinity, and it was not meant that we should voyage far. The sciences, each straining in its own direction, have hitherto harmed us little; but some day the piecing together of dissociated knowledge will open up such terrifying vistas of reality, and of our frightful position therein, that we shall either go mad from the revelation or flee from the deadly light into the peace and safety of a new dark age.

  9. Anonymous

    I agree with the idea that the credit crisis is deflationary, and that the Fed’s attempts to reflate will not lead to money supply inflation. If anything, Bernanke has shown that he’s too tight.

    But that doesn’t mean we won’t see price inflation, because the price inflation will be coming from a different source, and that’s an energy supply and demand imbalance, and possibly a food supply and demand imbalance deriving partly from the energy imbalance and partly from abnormal weather patterns.

    And you don’t have to remind me that energy demand will go down in a declining economy–we can agree on that in advance. But energy production is declining at a faster rate than the demand decline rate.

    So, what I see coming is a long-term, grinding, very very slow shrinking of the world economy, but with higher prices for food and energy taking a continally higher percentage of the world’s income. The only way we could avoid such a permanent slow decline would be with serious investment in increased energy efficiency, and that’s problematic right now because of the credit crunch, which is partly due to Bernanke’s tightness with money supply.

    And the higher food and energy prices will probably trigger gold bug buying while people can still afford to buy into that pyramid.

    But the ultimate source of this crisis is shrinking energy supply, which is something few of the economists or finance guys will understand for a long time.

    Moe Gamble


    The current crisis stems from fears of solvency, which in turn reduce liquidity. Not the other way around.

  11. Anonymous

    “But the ultimate source of this crisis is shrinking energy supply.”

    My inclination is to end that sentence with American hubris, not energy supply.

    The unraveling of the financial markets, and the ensuing chaos to follow, feel to me like a perfectly natural parallel process mirroring the irresponsible, short-sighted, reckless behavior performed by our top political leadership.

    The suits on wall street have been taking their cues from their political leaders.

    The world has been fast losing “trust” in America and its largely “American-exceptualism-believing” population for some years under our current regime.

    The world is indeed discovering the price or inherent worth of America.

    Pre-emptive war, torture, rendition, institutional law-breaking, illegal domestic spying, politising of the Dept of Justice, suspension of habeas corpus, etc, etc.

    All derivitives of a power/money mad economic and political system on steroids.

  12. foesskewered

    Anon March 27, 2008 11:45 AM

    nice quote from lovecraft but don’t you think we might already be in the dark age/fringes of it without even knowing it, the renaissance was about innovation but it was also about seeking true knowledge and information which is sorely lacking from the financial engineering sector as it stands; Ehrenberg , in that aspect, makes more (succinct) sense than cassandra. Just like the serf/master paradigm in the dark ages, investment banks have in their greed, ignored the very instruments generating their wealth and the hordes who have followed them blindly. Just as the Renaissance was about the rediscovery of information and knowledge lost, it’s also about an independence of thought the spirit of which was lost in the dark ages; so individuals and institutions in the financial community have the opportunity to re-establish themselves and the intellectual “processes and systems” which should be at the core of their operations.

    Yves, it’s another dumb question but technically speaking , isn’t stagflation more of a temporary phase, a kind of bridge between inflation and deflation periods?Deflation is more or less predicated on 2 factors; the ability to spend and the willingness to spend. It will be ironic that the buildup to a world war was a factor in shifting the economy out of the depression in the 30s but that political instability of present times might well increase deflationary pressures. Any ideas anyone?

  13. Richard Kline

    In the US, changes in commodity prices such as grains but especially oil, will be upward, yes. However, this doesn’t represent price ‘inflation’: it represents price ‘appreciation.’ Our overvalued currency has for some time disguised to American buyers the more realistic valuations of many things that we buy, including commodities which everyone else around the world buys also. Now, we will appreciate what they have been paying! But more seriously, this isn’t inflation, it’s re-valuation.

    The worldwide picture is more complicated, but I would describe it as appreciation as well. That is worldwide demand for many commodities now has the potential to exceed worldwide supply, at least during times of shared economic expansion. With demand above supply, price will assuredly rise, but this simply represents a _real increase in value_ of the commodities in question: they are worth more.

    If everyone, or just A Certain Special Country, prints money or in the modern variation pixelates vapor-credit to purchase increasingly expensive commodities, we could see inflation on top of appreciation. Some of the spike in commodities of the last half dozen years is of this variety as US vapor-cred ballooned price, which in turn promoted large-volume speculation in commodities which has further pushed up prices.

    Prices are multi-strata because they have multiple inputs. It’s important to break out these input trajectories separately for analysis, at least the major ones. Single variable attributions for economic trends are most always inaccurate to the point of being flatly wrong. That was the real issue with ‘globalization models’ mentioned in another post today: they were restricted to one or two variables particularly to the advantage of Anglo-American capital while neglecting other strata in market creation.

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