Friday, September 19, 2008

Three step plan to "fix the street"

There have been a lot of people screaming "fix wallstreet" or less rationally "Punish all the greedy capitalists, put them all in jail" etc... etc....

What bothers me is the economic ignorance inherent in these screams.

In almost all fields of human endeavor, reward is based on risk. If you want high rewards, you have to accept high risks; and when people invest, that's exactly what they are doing. Risking to reap rewards.

For some reasons, leftists have never understood this. Sometimes when you risk, you get big payoffs, sometimes when you risk you take big losses. That's just the way things are.

Markets don't prevent losses; and when a company goes out of business, that isn't a "market failure"; neither is it necessarily an indicator that anyone was doing anything illegal, or immoral, or unethical. In fact, it's a market success, because assets will then be reallocated to more efficient competitors in the market, and given another chance to appreciate in value.

Businesses fail, even when they are managed in accordance with all laws, regulations, and standards of ethics; because people make incorrect decisions... or just have bad luck, or more importantly bad timing.

The first thing any leftist screams when a big company goes out of business is "investigate them"... but why? Investing poorly isn't a crime, and usually, neither is bad decision making or bad management.

When it all shakes out, what's going to come out of all of this chaos in the financial markets is a lot of screaming, some pointless showy investigations by congress to prove that they are "doing something"; and maybe a show trial or two because someone made some paperwork errors.

What we're not going to find is a massive pattern of fraud, deceit, lawbreaking, or ethical violations; because that simply didn't happen here, at least on the brokerage house side of things (it did on the mortgage side of things; FNMA and FHLMC clearly had a pattern of fraud going on to inflate earnings, hide loses, and confuse risk analysis) .

What happened was, that the way companies allocated their investors capital became further and further divorced from the real world; and risks became harder and harder to evaluate; and lots of people made bad decisions.

The thing is though, we SHOULD be screaming... Hell we should all be imitating Jim Cramer right now; but not for the reasons the economic ignorati screech on about.

No, we should be screaming, because brokerage houses are playing games with the economy, and games with trillions of dollars of investors capital. They're doing it to make money for themselves at the expense of the investors they supposedly represent.

Or perhaps I should say traders capital; because people think they're investing in companies, when really what they're doing is trading. The problem is, the brokers have people convinced they really are investing.

The do it by dancing fast enough, and "explaining" convincingly enough that most people never catch on, that they brokers don't even understand what they are doing themselves; they're just trying to stay ahead of the trend and buy low sell high.

Well... sometimes they miss the trend.

And it's all legal, and even ethical, (at least by the standards of the financial world).

The thing is, there are only so many vehicles for growth investment, and only so much capital that needs to be raised... and there's an AWFUL lot of money out there looking for a place to grow.

At some point, there was just too much money chasing too few high growth opportunities; so brokerages invented new ways to bet the capital they manage.

Rather than direct capital to efficient competitors, and make money on the earnings, and growth of those companies profits (as is the supposed intent of capital markets); these new ways were designed to make money on... essentially betting that psychology would push things one way or the other faster than real world results would. Then, they invented other ways of hedging those bets in case the psychology worked faster or slower than they bet on

The real world moves very slowly, but psychology doesn't; and you make more money on motion than you do on straight growth and earnings.

Play your cards right, with enough market power, and you can make money on every turn. Go long and and loud, drive the volume, and take profit at the top of the market; then watch the trend reverse, and follow you out of your position, and short it at the bottom. You, and the people you're trading for, make money on both sides of the transaction; and you make two comissions and two fees to boot...

...But nothing actually happened with the company whose stock you just made money twice with.

These synthetic securities, derivatives, and complex instruments were all designed to basically allow a higher risk (because their relationship with actual money and business on the ground was complex and tenuous), for a higher reward, than a simple stock position could get you... and then to mitigate that higher risk, by supposedly combining multiple countervailing properties so that if one went down, another would go up etc... etc...

Either way, it was just a wager on a guess, based on a number and a thought; not an investment in a profit making enterprise with real workers, real assets, and real people working to make those profits and assets appreciate.

So that's the way it works. You're not investing, you're trading. Even if you follow a buy and hold philosophy, and invest for "value"; unless you're in it for the dividends (and comparitively few companies pay worthwhile dividends, if any, anymore), you still have to buy low and sell high to make money. Every time you buy or sell, your broker is right there, making money on the trade, not the growth or earnings. You make money, so does you broker. You lose money, your broker still makes money.

Unless of course your broker is right there in your position with you... or unless you are actually buying your position from your broker, and selling it to him; which is often how small individual trades work, with the brokers buying and selling large chunks of commonly traded issues, and making money on the intraday volatility, fulfilling your trades out of their large positions.

In terms of purse market economics, it's a very inefficient market; with imperfect information and poor allocation of recources to efficient market competitiors.

Such is life. There's no such thing as a perfect market, there never has been and there never will be; but the equities market in America today is awfully far from it's ostensible purpose, and from what most people believe it is and does.

Most critically, people believe the state of the equities market reflects the state of the economy. In reality they are very poorly coupled, in some freaksih dance where the lead and follow roles swap constantly, with snap the whip swings as they do.

The only way to "fix" this, is to end the decoupling of capital from the companies it is directed to; and drastically reduce the incentive towards volatility.

If you want to "fix the street", it will take three things:

1. Ban equities trading in, and securities based on, synthetic instruments (including complex, composite, and derivative instruments)

2. Ban all short selling (not just naked short selling)

3. Ban programmed trading

Of course if you did that, the massive investment banks, brokerage houses, financial services firms etc... would all lose MASSIVE amounts of money, because they would not longer be able to be bookies... they'd actually have to... Oh I don't know, put real capital into real businesses that do real things?

And short selling? There is no movement of capital to an effective competitor in a short sell; it's nothing but one person betting that another person is going to lose money. It's a pure wager... and often it's a self fulfilling wager because shorts are "market indicators".

Often people defend short selling as a valuable indicator that a company is poorly managed, or overvalued; and to an extent this is true; but it is still a wager on losses. No market efficiency is lost by someone simply selling their position rather than short selling; and capital motion is more closely coupled to the actual output of the company, rather than the volatility of its stock.

So ban derivatives and bundles and MBS's and CDS's and CMO's and all these other synthetic instruments. Ban brokerages and traders from making money by betting that other people will lose money. Basically, remove the incentives to volatility, and let the money get allocated where it will see the most growth.

Take the massive crash that results for what it is; the deflation of speculation, and the removal of a mode of decoupled trading; not the failure of the fundamental industries that the market is supposedly based on.

For while, we'll have massive problems; but eventually, the standards for risk evaluation, and liquidity management will come back to a sane norm.

In the short term, there would be liquidity problems all over the place; because no-one would understand how to direct their money. The thing is, the money is THERE, and without these complex securities to invest them in, it's going to be directed somewhere. The last thing people want to do is sit on their money and let inflation eat it.

Eventually, as things settle out, instead of directing capital into risky bets on psychology, that capital will be directed into actual profit making enterprises (or at least ones that plan on making a profit; I should note that startups are even riskier, and have even higher rewards, than complex instruments).

The net result is that everyone will make more money as growth is encouraged and new businesses get easier access to capital. The market becomes more efficient.

...Well, everyone will make more money but the brokers and traders who depend on the speculative volatility of issues, and the decoupled nature of complex instruments.

After that, we ban programmed trading.

All trades must be done by humans, all decisions must be made by humans, and a signature must be there from someone who is personally responsible for every trade.

Programmed trading looks for early indicators. As every house looks earlier and earlier, and scrutinizes harder and harder so they can beat the trend, they actually CREATE those indicators before the businesses they are supposedly investing in actually have any real change in their status or output; especially when shorts get programmed across a sector to hedge against the volatility of a single issue (This is one reason why when one bank puts out bad news, other banks see a hit as well - yes, this is grossly oversimplifying, I know, but this piece is already long enough).

These indicators then ripple through other programmed trading systems and create yet more indicators accelerating a false trend; until the programmed systems see indicators (again most likely false positives, or rather self fulfilling prophecies) for profit taking, which then dumps out and reverses the spiral.

The whole system is essentially a way for brokers and traders to make money on the volatility; rather than the movement of capital to efficient competitors, which is the real intention of an equities market (or at least of a capital market, of which an equities market is generally intended to be one)

Oh and I'm not even going to get into how the government distorts equities markets with regulation here. Suffice it to say I understand how much of a problem it is (or at least as much as anyone can... no-one really knows how much government screws up the market), but it's a different problem than the one I'm talking about now.

The combination of synthetic instruments, short selling, and programmed trading, just multiply each other; to the point where a 5% increase, or decline, in overall market value for the entire market in a single day is considered a relatively normal thing (yes, it's a big deal, but it's not so big a deal that its the end of the world)

Think about that for a second.

The companies that the street is theoretically investing in didn't actually lose 5% of their collective value overnight. The deposits in the bank that lost 90% of its market value overnight didn't suddenly disappear from the vaults. The mortgages they hold didn't lose all their value overnight (ok, some of them did, but most of them didn't).

The only thing that changed was the trend, and those chasing it; and the harder you're trying to chase the trend, the more volatile you will be, the faster you have to jump and run... and it just makes the brokers and traders and speculators more money...

...unless they get caught on the wrong side of the trend...

Back in the real world, you try to invest in good companies that will make real money by selling their goods and services; and those real companies try and make real money selling those goods and services. Meanwhile, the brokerages and traders, and speculators chase the trend up, then they chase it down, because they make their money on the change, not on the growth and earnings; all the time pretending they aren't just playing a gigantic game of duck duck goose with a couple trillion dollars.

The only way to stop it, is to ban equities investment in anything other than real companies doing real business; and to ban the computers from making the decisions.

Of course, we won't do that. Maybe we shouldn't even do that. Certainly the libertarian in me says that capitalists should be able to make whatever risky wager they feel like.

The problem isn't so much the wager, as it is that people are pretending what they are doing isn't gambling over other peoples behavior and psychology. So long as we allow investment markets to direct capital into ephemeral creations of nothing but numbers and confidence, instead of real businesses making actual money, that will be the case.

The libertarian in me says fine, let them do it; but make them stop pretending there is anything real backing these bets up.

Make them state in plain language that all of these instruments are just betting slips and psychology, not real companies making or losing real money. Make them state in plain language that when their betting slips go up it doesn't mean that any real money has been made by a real company; and when their betting slips go down, it doesn't mean that any real money has been lost by any real company (well, except the companies doing the betting).

...of course if we forced them to be honest about it, almost nobody would play.