Posts tagged Finance

‘Speculators may do no harm as bubbles on a steady stream of enterprise. But the position is serious when enterprise becomes the bubble on a whirlwind of speculation. When the capital development of a country becomes the by-product of the activities of a casino, the job is likely to be ill done’

This quote by John Maynard Keynes in 1936 formed the final words by David Tuckett in his pioneering emotional finance book Minding the Markets. In Minding the Markets, Tuckett explains how he believes that modern economic theory is unsuitable in light of the wild market fluctuations of today, and he, like Keynes did, believes that the markets are not as efficient as the economic theories on which they are built would suggest.

David Tuckett has a background in both economics and psychology putting him in a somewhat unique position of being able to comprehensively analyse the role that psychology plays within the financial markets. To do this he interviewed a sample of hedge funds managers various times over a number of years (before and during the sub-prime crisis), evaluating the affect that the competitive environment had on them, how they made investment decisions and how the associated gains and losses affected them.

Perhaps most interesting of Tuckett’s findings was the pressure on hedge fund managers to achieve exceptional returns in conjunction with lower-than-usual risks. This goes against the fundamental relationship between risk and reward; the higher the risk the higher the reward. The pressure on managers to find stocks that met such criteria resulted in them entering a ‘divided state’. A divided state is ‘an alternating incoherent state of mind marked by the possession of incompatible but strongly held beliefs and ideas’ which Tuckett says causes an influenced perception of reality. This is exacerbated by the need to constantly outperform benchmarks, meaning hedge fund managers are under pressure to be exceptional without being too different from the rest of the industry.

I am a firm believer that current market theories are flawed. Markets cannot be truly ‘efficient’ in the modern world due to the sheer amount of information and quantity of market players. Psychology and emotions play a part in every decision that we make, particularly those where the stakes are high. This is highlighted by Tuckett when he evaluates past investment decisions made by the hedge fund managers. Each of their investment stories had strikingly similar characteristics; mitigated risk through a unique position in the market, strong and reliable management, visibility of future revenues. Using interview scripts he shows how similar each of the buy stories were and illustrates how the hedge fund managers, whilst incorporating all of the vast analysis available to them, had to make their final decision through emotion or gut feeling rather than logic.

Whilst money managers may do everything possible to make decisions based on rational logic, the markets are not devoid of emotion. The sooner economic theorists acknowledge this the sooner we will be able to develop a better understanding of what makes the financial markets tick. For the next generation of prudent investors, it will be essential to have an understanding of the role that emotions play in the markets.

‘Buy Sell’ picture source: http://www.sharesinv.com/articles/2012/03/16/behavioural-finance-4/

The major issue for the global economy over the next few years is how the developed world will safely delever. On the most part this means keeping unemployment down, but when you look to Europe socialising the loss through default still can’t be ruled out. The most beneficial way for Europe to delever would be through actual economic growth and whilst recent moves by authorities point to stronger fiscal consolidation there are still many underlying issues that need to be addressed before growth can be reasonably expected. This absence of growth is likely to be exacerbated by the limited options available to policy makers in the developed world. Whilst their efforts to instil confidence through active monetary policy have been noble, a true lasting effect is yet to be seen. Markets remain volatile and fiscal intervention may be all they have left.

What this also indicates is a growing reliance on central banks. Australia is creeping into deficit territory and most economies continue to be affected by the ongoing problems in the developed world. Investors will have to be aware of the substantial impact that central bank intervention can have on the markets and act accordingly.

As I said in my previous post, investors expectations of returns are due an adjustment. The returns across asset classes over the previous couple of decades have been an anomaly. Growth will be low for the foreseeable future and without growth you can only sensibly expect low returns. The only investing style to really buck this trend is the ‘Risk On, Risk Off’ approach which takes advantage of volatility and heightened investor sensitivity.

Here is an assignment I did for the Contemporary Issues in Finance module whilst at university. The assignment was to write an Economist article that investigated whether the regulatory proposals being made during the crisis were indicative of a convergence of international financial systems. 

Mid-Crisis Regulation

I find a lot of the hype on Facebook boring. Its seems everyone is still interested after its monumental failure of a public offering. What I do find interesting though is that people didn’t see today coming.

Facebook has has its worst day so far (and there have already been some pretty awful ones). Its has hit new lows as a result of some pre-IPO selling bans being lifted, but how did people not see it coming? This morning I read an article  where Michael Pachter (managing director of equity research at Wedbush Securities) was quoted as saying, “I don’t think Thursday will be momentous at all” and related it to opening night of a new movie, “just because you can see it doesn’t mean you will”. It is difficult to see how he came to this conclusion considering Facebook has done little but spiral. It posted a loss in its first set of results, has had companies stop advertising (very publicly) and has shown absolutely no grasp of how it is going to capitalise on mobile. Had I been in possession of shares over the last few tumultuous months I would have been itching to shift them. The shares have miles more downside to break into and I have no doubt that they will. Couple this with the lifting of further selling bans due in November and the bottom looks nowhere in sight.

I actually have faith that they will pull off the mobile element which is so vital to the long term success of the firm. I also think that, once they are nearer to their bottom, they could represent good value for the long term investor. Until then though, a lot of the 1.9bn shares that will have selling bans lifted over the next 9 months will continue flying out the door.

London Whale - John Cole

JP Morgans ‘London Whale’ beached itself on the front pages again yesterday. This time revealing that the loss incurred by ‘it’ was not the $2.3bn as shown in the cartoon but indeed a mammoth $4.4bn that has caused them to restate first quarter earnings. This will no doubt add a petrol cans worth of fuel to the ongoing regulatory fire that has caused Ed Milliband to give his (rather nasal) two-pence worth. Maybe he should focus more on holding his tea.

But nonetheless the news today has reaffirmed the focus on what regulatory measures should and need to be introduced to the financial system. As a result I think it is worth having a look at ring-fencing and whether it is the answer to crisis prevention. 

Ring-fencing is nothing new. It was part of the Glass-Steagall act introduced in the US in 1933 and the banks managed to operate fairly well under it. This may have been due to the fact that it was somewhat overlooked as regulation and it is argued that when the ring-fencing was repealed by the Gramm-Leach-Bliley Act in 1999 the banks were already operating as though the ring-fence had never been there. But if you look at JP Morgan as an example, their share price the year before this act was repealed was considerably more than it is today. Furthermore, in the time running up to that they prospered, giving out consistent dividends from March 1987 onwards. It is arguable that since the Glass-Steagall act was lifted they have prospered considerably more but I would attribute that more to the globalisation that rapid technological advance allowed rather than being able to mix retail and investment banking interests.

Today ring-fencing is included in the latest regulatory initiatives for both the US and UK. For the latter it forms part of the Vickers commission final report and the Dodd-Frank act for the former. But are these proposed reforms are enough to prevent future disaster? An article by Laurence Kotlikoff, author of ‘The Economic Consequences of the Vickers Commission’, highlights with great poignancy the shortcomings of the proposals. Breaking the ring-fences down into ‘Good’ and ‘Bad’ banks, he goes into the types of assets that good (ring-fenced) banks could hold as well as well as the degree of leverage they can use on these assets. Using his example, ‘good banks would be able to borrow £25 for every pound of equity and invest it all in gilts’. The result being that if gilt prices dropped 4 percent, the commissions good banks would fail. This is a very scary thought.

Kotlikoff actually argues, quite persuasively, that by pushing the bad banks outside the ring-fence and thus segregating them completely from any form of bailout assistance will increase the chances of financial collapse rather than eliminate it. Advocates of ring-fencing will argue that this is the intention and by ‘removing’ this moral hazard, bankers will act more conservatively. This couldn’t be more short sighted. Initially this might happen; banks will have to improve their balance sheets to ensure that investors don’t flee from the added risk. But realistically, as soon as the bull market takes hold again and the going gets good, these investment arms will leverage till the cows come home. And before you say that the shareholders will naturally regulate them just remember how many people were asking questions in the run up to the sub-prime crisis? Few. The majority were going home grinning at their capital gains as I am sure they will do again.

So how do you regulate the banks? Well I don’t envy anyone who is tasked with this and I suspect it will take a few more crises before we even get close to knowing. What I do believe though is that we are looking at regulation wrong. As Kotlikoff points out, ‘good assets go bad’ so how can we build regulation that specifies what is good and bad, risky and not risky. Surely it has to be built on different foundations. For this I think the English legal system has a lot to offer in terms of guidance (ignoring financial law for now). The English legal system is admired the world over for its ability to get justice. Many attribute this to how the various laws allow for enforcers to actually pass ‘judgement’ and use discretion to assess whether the accused acted improperly.

In its current and proposed state, financial law requires institutions to maintain certain levels of capital at a ratio to the amount of risky assets they hold (amongst other measures). This presents a grey area, how do we determine what is actually safe and what is risky? Ultimately this is down to opinion. Kotlikoff reinforces this by pointing out that Spanish, Lehman and AIG bonds used to be considered safe, good assets. So new regulation should focus not on risk, but on providing a set of laws that require the people working within these institutions to act in a prudent manner. The laws should provide scope for severe punishment and accountability against those who do not operate on sound judgement. To give example through the sub prime crisis, proper regulation would have allowed those who did not act with the utmost prudence to be prosecuted (and very few have). Automatically we think of the credit rating agencies who gave AAA ratings to securitised sub prime debt that either they didn’t fully understand or didn’t pay enough attention to. If the regulation allowed it, every person involved in giving these ratings should have faced charges for negligence. This should also extend beyond the rating agencies and apply to every single person who knowingly had contact with these products. Investors who didn’t fully understand what they were buying for their clients portfolios should be prosecuted. It is their duty to do this.

I am not saying that every time an investment doesn’t achieve its intended return, people should go to prison. Investments will always go bad. What I am saying is that new regulation should prosecute those who do not operate with the best intentions and the utmost prudence. Until we are able to predict risk with 100% certainty, risk based regulation will not work.

UPDATE - Loss now up to $5.8bn

I woke up this morning to a fascinating article by Martin Taylor, chief executive of Barclays at the time Bob Diamond was running Barclays Capital.

The article, as Rory Cellan-Jones put it (@ruskin147), shows that Bob Diamond ‘had previous’. Rory also rightly wandered why this story had not had more media focus.

In the article Taylor explains how Diamond had proposed a fivefold increase in exposure to Russian counterparties at a time when Russia appeared to have an appealing domestic bond market. Taylor who chaired the credit committee disagreed and only authorised a ceiling of half that amount. Later in the year Russia defaulted and the ceiling put in place should have limited BarCap’s exposure. This wasn’t the case as Diamond had ignored the limit and significantly increased their exposure. Not only had he increased the exposure but he had tried to cover it up by marking the counterparties as Swiss or American. I think this shows a serious flaw in Diamond’s attitude to rules and highlights that there is likely to be far more revelations in the ongoing Libor scandal. Perhaps more importantly though, it highlights that the board, knowing of Diamonds previous misdemeanours still opted to put him at the top of the company later down the line. Maybe Barclays lack of alignment with public interest and goodwill spread further than just the heads that have rolled recently?

As one former bank executive was quoted as saying, ‘It would be a very good thing if an awful lot of people lost their jobs in a lot of banks’. ‘Not because I wish them ill, but because only by making many examples will you get through to people that this is a very important business’

If this is the tip of the iceberg for Barclays then it will be well worth avoiding in the near future. The Libor probe is being extended to many other banks (bottom of article), which when coupled with the ongoing banking crisis may show investors red flags for the sector as a whole.

For the UK, GDP figures have confirmed that the UK is in a double-dip recession (link). This news may have had more of an affect on the markets if everyone wasn’t so excited by the Euro news which raises the question, ‘is this a fickle rally?’. If the UK is still in recession then surely when this good news wears off nothing will have changed?

Well, the answer depends on your point of view. Fundamentalists might say that until the underlying issues with the UK economy are fixed, any market rallies will be short-lived. Another way of looking at it requires a pinch more optimism and a belief in positive feedback loops. If I look at my portfolio before leaving work on Friday and it is up 1.44% (like the FTSE 100 at the time of writing - FTSE100 quote) I might be a bit happier this weekend. That might mean that I decide I will eat out tonight, book that holiday or buy that television, which, in turn, might mean that businesses make more money this weekend, which in turn will create growth.

Who knows what people will decide to do this weekend and who knows whether the Fundamentalist or the Optimist will prevail, one can only hope.