About the Theory of Efficient Markets

I have just read a book, The Crisis of Global Capitalism, by George Soros. It was written in 1998, but oh so fit for 2008. Soros is a critic of the efficient markets hypothesis. I think he is right in saying that markets do not succeed in finding a balanced state, but act instead like a wrecking ball that swings uncontrollably around a point of stability.

In this book he describes a phenomenon, which he refers to as reflexivity. In systems that are made up of humans, like all markets obviously are, the ground truth is not independent from those that are trying to observe it. Instead, there is a constant bidirectional relationship between the observers and the observed. Similar problems are encountered in observing elementary particles, hence the Heisenberg uncertainty principle.

The book was written as a reaction to the Asian financial crisis and the Russian collapse. These events started a strong flow of capital to the established capital centers of New York and London. These flows made up the peak of the tech bubble. They were further prolonged by loose monetary policy. Now we are observing the turning point, where the wrecking ball hits the wall and turns back towards the point of stability.

If we want to actually reach the point of stability and stay there, there would have to be some kind of forces that would slow down the velocity of the ball while it speeds towards the point of stability. At the current situation, the global financial system is like a car without shock absorbers.

Every automation engineer knows that dampers are essential for stability. Why is it so hard for economists to realize that?

Credit Default Swap Counterparty Risk

The enormous amount of counterparty risk that is associated with the $45 trillion market in credit default swaps seems to be finally hitting the radar screens of mainstream news outlets. Unfortunately this reporting interest is way behind the curve, as the said counterparty risk is being triggered in a big way in the problems of the ACA Financial Guaranty Corp.

The Wall Street Journal published a front-page article titled "Default Fears Unnerve Markets" by Susan Pulliam and Serena Ng. It is an excellent overview of the troubled CDS market.

Today, a struggling bond insurer, ACA Financial Guaranty Corp., will ask its trading partners for more time as it scrambles to unwind more than $60 billion of insurance contracts it sold to financial firms but can't fully pay off, according to people familiar with the matter. The contracts were intended to protect Wall Street firms from losses on mortgage securities and other debt they own.

The problem is that the insurer itself is teetering -- with repercussions across the financial world. Some of its trading partners, called counterparties, already are writing off billions of dollars because of its inability to pay.

This is the reason why some deals that looked like "free lunches" in February 2007 are not so free after all.

With many bond values falling and defaults rising, especially in the mortgage arena, some institutions involved in these trades are weakened. This has investors and regulators worried that, through such swaps, some market players could spread their own problems to the wider financial system.

"You are essentially counting on the reliability of strangers" to pay up on their contracts, notes Warren Buffett, the Omaha billionaire. In some cases, he says, market players can't determine whether their trading partners have the ability to pay in times of severe market stress.

What the article omits, though, goes even further. It doesn't mention that a very big part of these CDS contracts are written by synthetic CDOs that are by definition not prepared for major payments at all. If they were, they would not have been closed in the first place.

The current problems are all derived from the proliferation of belief in the efficient market hypothesis. This theory, which posits that market valuations carry meaningful information about the real world, is basically self-defeating.

A high proportion of credit market participants look at prices, believing that those prices actually represent expectations of future defaults, which they do, initially. Then those market participants start to make investment decisions based on the price level, resulting in even smaller risk premiums. These same investors now think that the reduction in risk premiums is a signal of lower risk, even though the price reduction was caused by their very own uninformed investment decisions.

This is just like Winnie the Pooh following his own tracks in the snow, round and round again, until a moment of truth arrives. The music stops, and some of the players are left without seats.

The Unsustainable Level of Public Debt in the US

A very sobre analysis of the problematic US debt situation was published in the Houston Chronicle this week. The column, titled "Wake-up call's for us all", was written by Loren Steffy.

On Monday, Moody's Investors Service, one of the credit-rating agencies that blessed those pungent loans that now beleaguer Citi and Merrill, warned that the U.S. could lose its triple-A credit rating within a decade.

That's a wake-up call for the rest of us.

We are addicted to spending. We buy based on want rather than need or ability. The bills are a worry for later, a someday that we postpone like a dentist appointment.

When the unsustainability of the US public debt becomes increasingly mainstream, it is going to be interesting to see the diversity of proposed solutions. It is a certainty that some of the proposals will contain fascist or other authoritarian ideas. It's going to be a hard time for champions of anti-authoritarian ideals.

Nostalgic for a Crack-Up Boom

An article titled "And the good news is ... hard to find" in the Observer by Ruth Sunderland discusses the developments in the financial markets.

It is hard to recapture the mood of this time last year. In January 2007, the City was still riding high, private equity was still on its buying spree, shoppers were still spending, house prices still soaring and Gordon Brown was still hailed as a paragon of economic competence. Northern Rock still seemed a decent bank; it delighted shareholders by kicking off the reporting season with a hike in its dividend, largely in anticipation of new rules that would allow it to hold less capital.

This paragraph is a perfect description of the sources of the problems at hand, which are caused by a runaway crack-up boom. Unsustainable credit expansion is initially caused by lax monetary policy, then further sustained by irresponsible dismantling of the financial safety buffers. Those buffers would have been provided by demanding reasonable levels of capital in depository institutions. Instead, the level of leverage in the system was allowed to grow like there's no end.

What leaves me wondering, is how Ms. Sunderland can write with such a longing tone for such a destructive trend. Did she really expect such financial self-destruction to go on forever? What is so wonderful about house prices soaring to levels that are out of the reach of first-time buyers?

It is indeed very hard to recapture an irrational and sentimental mood while being face-to-face with harsh reality. The humongous pile of bad debt that was created by this stretch of irrationality is now backing the savings deposits of the whole industrial world. The depositors are screwed, no matter which way the situation is defused. In the UK, it seems that the burden is going to be put on the taxpayers.