3 September 2009

There is no free lunch and nothing is more risky than "risk free"

On risk...


But, just as the economic concepts of the “Paradox of Thrift” or “Fallacy of Composition” teach us, what is good for an individual household or organization is not necessarily good for the broader economy or nation. As articulated above, we believe that risk-avoidance has stifled business investment and restrained true innovation. And if every individual and organization is trying to lay off or disperse risk, it merely aggregates and mutates elsewhere, making it difficult to identify and mitigate/manage the consequences thereof.

In fact, it is our position that attempts at risk-avoidance only hastened the arrival of those consequences. Each bad SFR or commercial mortgage written in the early 2000s, for instance, no matter how seemingly innocuous—i.e., no matter how much collateral value ostensibly secured the property or what kind of debt service coverage the borrower’s stated income provided—hastened the paralysis in the securitization markets we are now observing. The fact that such loans were available was a testament to the excess liquidity in the secondary mortgage markets. That liquidity created an asset bubble and perverse incentives throughout the mortgage food chain. Soon, notwithstanding the Herculean efforts expended to avoid risk, it became readily apparent that borrowers could not even afford to make the first, teased-rate payment on their mortgages and investors could not rely on agency ratings of securities backed by those mortgages. Shortly thereafter, the truly unthinkable—a certifiable “black swan” event, in our estimation—occurred. Residential real estate value values began to decline and global fixed-income investors had no appetite whatsoever for securities backed by residential real estate loans. But really, this could not have been unexpected. Risk is cumulative. Every incremental exposure brings an individual or organization closer to a day of reckoning. So, once again, trying to avoid risk only intensifies and accelerates the arrival of its consequences. Risk has to be managed, not ignored.

For way too long, America was enjoyed a standard of living it hadn’t earned—at every level of society. Consumers freely spent money they hadn’t worked for, merely borrowing it instead. Corporations reported record profits (and, concomitantly, peak equity market valuations) by stanching the flow of investment into research and capital goods instead of stepping up their commitment to adding true economic and social value. Yet, neither consumers nor corporations felt they were taking any chances. Consumers were confident that sharp increases in the value of their homes and 401ks—after all, housing and stock prices went in only one direction, up—would cushion the blow of any temporary employment setback and provide for both growing debt service requirements and retirement. Businesses saw no need to invest in the future—or any real improvements to existing products—when consumers lapped up current offerings with such zeal. The sentiment seemed to be that introducing genuinely new products would not alter the demand function meaningfully. And, once again, credit intermediaries believed that they did not have to truly underwrite mortgages or price them fully for the associated risk as long as they could sell or securitize them almost immediately. Whatever risks remained—the potential losses on retained interests or loans that would not sell readily—would almost certainly be mitigated by rising home values.

The end result was a country that could only manufacture credit and export jobs—as opposed to value-added goods and services. After all, how much value is created when a dollar passes from doctor to lawyer to insurance agent to mortgage broker (in a refinance) to used car salesman to bartender.. and so forth and so on. The abrupt withdrawal of liquidity and contraction of credit didn’t create the deep recession we are now enduring; they merely exposed a languishing economy bereft of any new ideas and, certainly, any direction or higher purpose; the earlier, rapid expansion of credit—perhaps by design—merely papered over this sorry state of affairs.

The biggest of all risks is taking none. That has been the risk borne by the U.S. populace for most of the last three decades—and, from our point of view, the risk we still bear. Today’s recession and the slow growth it portends in the years ahead are perhaps just a reminder from the global financial markets that there truly is no free lunch.

Didier Sornette and Wei-Xing Zhou had a big crash signal on the S&P500 for 2004/05, but it died under the weight of the credit bubble...like the trade I placed on it... we live and learn.

WITH 20/20 hindsight, financial crashes seem inevitable, yet we never see them coming. Now a team of physicists and financiers have bucked the trend by successfully predicting a steep fall in the Shanghai Stock Exchange.

Their model, which employs concepts from the physics of complex atomic systems, was developed by Didier Sornette of the Financial Crisis Observatory in Zurich, Switzerland, and Wei-Xing Zhou of the East China University of Science and Technology in Shanghai. The idea is that if a plot of the logarithm of the market's value over time deviates upwards from a straight line, it's a clear warning that people are investing simply because the market is rising rather than paying heed to the intrinsic worth of companies. By projecting the trend, the team can predict when growth will become unsustainable and the market will crash.

Sornette, Zhou and colleagues applied their model to the Shanghai Composite Index, which tracks the combined worth of all companies listed on the Shanghai Stock Exchange, the world's second largest. Early this year, the index gained 50 per cent in just four months. In July, the team predicted that the index would start to fall sharply by 10 August (www.arxiv.org/abs/0907.1827). The index duly began to slide on 4 August, falling almost 20 per cent in the subsequent two weeks.

Anyone hoping to exploit the model for profit should think twice. "If enough investors take action based on our predictions, the evolution of prices will probably be affected," says Zhou.

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