30 August 2007

too much confidence

Martin Hutchinson is the author of "Great Conservatives" (Academica Press, 2005) -- details can be found on the Web site www.greatconservatives.comT

he rapid rebound in the world’s stock markets following the Fed’s cut in its discount rate demonstrated again the central feature of the current market: investors have far too much confidence that all will turn out well, without major economic calamities or even market downturns. For their own wealth and that of the US and world economies, the quicker we can inject some healthy worry into their outlooks, the better.

The problem is: confidence sells. Indeed we need a fair amount of confidence in order to get through our day successfully. Psychologists have demonstrated that our natural state is to imagine ourselves more capable than we really are, imminently about to make the big breakthrough in our careers, able to forecast with more than usual accuracy which investments will do best for us. While it is notoriously the case that most institutional investors fail to beat the averages over the very long term, it is inescapably the fact that most private investors do even worse, buying high, selling low, being absurdly prone to following fashion and missing the performance of the stock averages by a substantial margin. The only thing that prevents us falling into terminal depression is that most of us are too lazy or poor at record-keeping to benchmark our performance properly against the indices.

The investment management and brokerage industries flourish through our optimism; that’s why most market commentary is relentlessly bullish. Of course, over the last 25 years relentlessly bullish market commentary has been right most of the time, with only the occasional regrettable lacuna in 1989-91 or 2000-02. Brokers, whose worst nightmare is the investor who sticks his money into an index fund and forgets about it, have made large fortunes over that period by convincing us that their bright new strategy is the one that will infallibly lead us to riches. Institutions themselves are not immune; otherwise the hedge fund and private equity fund industries, distinguished more for the size of their fees than for the superiority of their returns, would have no customers.

At the top of the cycle, of course, the perpetual optimists have credibility - also money. Ken Fisher, the broker whose perpetually bullish commentary infests the Internet, is a billionaire according to Forbes. In his new book, annoyingly advertised to me by e-mail, he claims investors believe three falsehoods: high price-earnings ratios make stocks risky, rising oil prices drive stocks down and big budget deficits are bad for the economy. I would argue that two out of three of those "incorrect" beliefs are bedrock principles of economic understanding and the third is true in most cases. However he’s a billionaire and I’m not, so let us pass on. As I said, optimism sells….

Confidence and salesmanship are particularly lucrative in the more high-tech portions of the financial market, where disclosure is limited and understanding even more so. Products such as securitization and derivatives have enabled deals to be done that would have been impossible in days when lenders knew their borrower the old-fashioned way.

The entire subprime mortgage market rested on this. In the days of savings banks lending directly to homeowners, the lending officer was responsible for the credit risk, so the WalMart cashier buying a $700,000 home didn’t get a mortgage. Today the people who have some chance of meeting the WalMart cashier, the mortgage broker and the loan origination officer, have no interest in anything beyond ringing up an extra fee. Meanwhile the originating company and its investment banks are mostly sales conduits, whose responsibility is diluted by the large number of loans in the packages they sell. The ultimate investors haven’t the faintest idea what they are buying, but buy it because it offers a high yield and their competitors are buying similar junk. With confidence, the wheels of commerce are well oiled and everybody is happy.

Now examine the situation when doubts emerge. The WalMart cashier may of course have no intention of making payments on the mortgage at all, in which case he has about 6 months free rental of a $700,000 house, plus the chance of a capital gain if the local real estate market is REALLY hot and he sells before they foreclose on him. The deadbeat’s situation thus stays the same whether or not confidence is good. However imagine the less extreme case, in which the WalMart cashier attempts to service the mortgage, perhaps making mortgage payments through the multiple credit cards he has acquired.

If confidence remains strong, the WalMart cashier has a good chance of selling the house at a profit. He also has an excellent chance of finding a friendly mortgage broker and appraiser, enabling him to refinance the mortgage for a larger amount, possibly at a lower interest rate (after all, having made some mortgage payments, he has graduated from "subprime," if not to prime then maybe to "Alt-A" status!) to pay off his credit cards. Either way, the mortgage gets repaid and everybody is happy.

Now suppose confidence has disappeared. In this case, the WalMart cashier defaults, because he can’t refinance or sell. The investor notices that the default rate on his mortgage bonds is increasing, so tries to sell the bonds. Quickly, the market price drops and investors for new mortgage bonds of that class disappear. Since new subprime mortgage loans are still being originated, everybody’s balance sheet quickly fills up, and the subprime mortgage market closes.

The same effect has become apparent in the leveraged buyout market. As with the subprime mortgage market, buyouts in the last year or so have been carried out for the corporate equivalent of $700,000 houses by the private equity fund equivalent of the WalMart cashier. A syndicate of banks would lend the fund the necessary purchase price, and syndicate the loans rapidly around the secondary loan and junk bond markets. While confidence remained, the private equity fund was able to report fictitious increasing values on its corporate holdings, audited by a major firm, naturally, and pay its principals 20% of the notional profit as "carry." (The principals then added public policy insult to financial chicanery injury by declaring this on their tax returns as a capital gain.) Only occasionally did the fund have to sell a company for something close to the appraised value, to keep confidence high and the game going.

Only when confidence lessens do these transactions cause difficulty; in this case, the loans cannot be sold off to the junk bond markets. Apparently $300 billion of LBO debt is now sitting on bank balance sheets, while banks that have committed to further transactions are desperately trying to wriggle out. Again, an initially modest decline in confidence has caused the market to close.

The same principle operates in the hedge fund arena, this time involving derivatives. Here, confidence and salesmanship allow the hedge funds to accumulate huge amounts of capital, then leverage themselves further from the banking community, pledging supposedly risk-free assets as "collateral." Their quantitative investment techniques work well provided there’s enough money behind them - they can force the market in the direction they need it to go. Borrowing yen at 2% and lending Australian or New Zealand dollars at maybe 6% or 7% is easy money while you can force the yen down and the Aussie dollar up, preventing any unpleasant losses on your currency mismatch. Derivatives trades allow the reality to be obscured and sometimes bring additional returns.

Once confidence ends, the markets move in the wrong direction on their own and even the weight of hedge fund money becomes insufficient to force them into submission. Complex derivative contracts, particularly those involving options, become illiquid and the models driving the investment strategy cease to work. Thus hedge funds using these strategies can suddenly report losses of 30%, 40% or even 100%.

Market action in the last ten days suggests there is still ample confidence in the system. Most participants are after all young and well paid (which itself tends to make them over-confident) and barely if at all remember the last significant credit market downturn, in 1989-90, let alone the last big one in 1973-75.The US stock market is off only about 5% from its peak, and is well up for the year. The yen carry trade appears to have resumed, with the yen showing weakness against the dollar. Countrywide, one of the biggest mortgage lenders, has been bailed out with an equity injection from Bank of America. BNP has figured out a way to price its subprime mortgage bond funds again.

This is not a good thing. The spread of securitization and derivatives has enabled more bad deals to be done, confidence to be raised to a higher and more irrational level and the asset bubble to be prolonged. By increasing the opacity of the market, these new techniques have weakened its ability to price risk appropriately.

Needless to say, when confidence finally disappears, the market outcome will be very bloody indeed. We have already seen this, in a blip in the inter-bank market similar to the darkest days of 1974, in which banks have been forced to pay more for simple overnight funding because counterparties did not trust what hideous losses might be hidden in their dealing rooms. This first time around, injections of cash from the Fed and the ECB prevented the panic from worsening. However panic will return, and at some point the world’s central banks will be unable to dampen it down. In the end, when all becomes opaque, all becomes uncertain and market confidence dies. Roll on that day, for ending the wave of overconfidence is a necessary corrective; the longer it is delayed, the more expensive the denouement will be.

At that point, market participants will doubtless wish that a healthy suspicion of new apparently painless ways of making money had been maintained throughout.

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