Monthly Archives: November 2010

Lucy sets the ball.

Charlie Brown goes to kick the ball.

Lucy snags the ball away.

“Oh, good grief!”

Does this remind us of Wall St. vs. Main St.?

As long as there is a “Lucy” to present an opportunity, there will always be a “Charlie Brown” to fall for it. Similarly, there will always be increasingly complex derivatives and people to invest in the derivatives. It’s only human nature.

Humans learn from time to time, however, just when we do, something new comes along to deceive us. Nowadays, investment banks are hiring lawyers for the sole purpose of drafting ever-complex financial derivatives.

What’s the problem? Well, how do you value a contract that the salesperson doesn’t even understand? And if the goal is profit, where’s the incentive to be truthful? This poses a tremendous problem when recording long-term assets. Sure more regulation would be nice, but how likely is this going to happen?

At least conservative buy-side analysts are on our side, right? Good grief.

First, a joke (disclaimer: I didn’t write this, but found it here):

There are two sides to a bank’s balance sheet – the left side and the right side.
The problem is that, on the left side, there is nothing right,
and on the right side, there is nothing left!

This joke may be hilarious now, but a few years ago, not many bankers were laughing.  In 2007 and 2008, banks were watching as their marketable securities (more specifically, mortgage-backed securities) were adjusted to market value (mark-to-market pricing). These adjustments were resulting in serious, unexpected losses for banks.  The bank’s “valuable” securities were not so valuable anymore.  To balance the balance sheet (as assets decrease, so must liabilities), banks started loaning less (aka “credit crunch”).  Furthermore, lenders who were given MBS as collateral wanted their money back from banks (these MBS investments were not looking so prosperous anymore).  We all know the end to this story (think Lehman Brothers and a global financial crisis).

In a boom, mark-to-market pricing is great as it increases the “real” value of a bank’s (or, say homeowner’s) investments.  But in a bust, the value of these assets falls very quickly.  Why didn’t accountants catch this? Why weren’t financial analysts with their fancy models shouting warnings?

Because these people are human, and sometimes humans see one thing, but choose to believe another.   The title of Steve Lohr’s New York Times article enforces this idea: “In Modeling Risk, the Human Factor was Left Out.”

As long as there are people who want to make money, but not lose it, there will be bubbles and financial crises — even if we have the models to “predict” them.  Emanuel Derman states in the article, “The models were more a tool of enthusiasm than a cause of the crisis.”  The very models that should have implied, “things are going to get bad!” people interpreted as, “quick, make as much money as you can while things are good!” As the article states, in the good times, Wall Street will chase profits.

Andrew Lo, director of M.I.T. Laboratory for Financial Engineering, suggests more restraint, and better regulation, could have helped smooth the impact of the bursting housing bubble.

Perhaps a history lesson would have, too.  Before Wall Street ever had sophisticated models – in fact, before there was “Wall Street” – humans were creating bubbles.  For example, the Tulip bubble in Holland in the 1630s and the South Sea bubble in England in the 1790s.  During the Tulip Mania, tulip bulbs were so valuable the Dutch would trade 12 sheep (a valuable asset) for just one bulb.  (Substitute “tulip bulbs” with “real estate,” and “12 sheep” with “more borrowed money than you can afford to pay back,” and you have the same scenario today.)

So who is to blame?  Accountants, hedge fund managers, bankers, analysts, homeowners?  Try blaming mankind itself; as long as there are humans, there are going to be accountants who mark-to-market, hedge fund managers who short sell and homeowners who borrow more than they should. And there will always be another bubble (bonds anyone?).