Black Swan Free World (6)
On April 7 2009, the Financial Times published an article written by Nassim Taleb called Ten Principles for a Black Swan Free World. Let’s look at them one at a time…
6. Do not give children sticks of dynamite, even if they come with a warning . Complex derivatives need to be banned because nobody understands them and few are rational enough to know it. Citizens must be protected from themselves, from bankers selling them “hedging” products, and from gullible regulators who listen to economic theorists.
It is my opinion that many bubbles come about after a completely incorrect valuation model or approach becomes widely adopted. Today, we have the advantage over observers from prior decades. In this decade we have experienced two bubbles. In the case of the internet bubble, the valuation model was attributing value to clicks or eyeballs. It had drifted away from there being any connection between free cashflow and value. As valuations soared, people who had internet investments had more to invest in the next sensation driving that part of the bubble. The internet stocks became more and more like Ponzi schemes. In fact, Hyman Minsky described bubbles as Ponzi finance.
In the home real estate bubble, valuation again drifted away from traditional metrics, the archaic and boring loan to value and coverage ratio pair. It was much more sophisticated and modern to use copulas and instead of evaluating the quality of the credit to use credit ratings of a structured securities of loans.
Goerge Soros has said that the current financial crisis might just be the final end of a fifty year mega credit bubble. If he is right, then we will have quite a long slow ride out of the crisis.
There are two aspects of derivatives that I think were ignored in the run up to the crisis. The first is the leverage aspect of derivatives. A CDS is equivalent to a long position in a corporate bond and a short position in a risk free bond. But few observers and even fewer principals considered CDS as containing additional leverage equal to the full notional amount of the bond covered. And leverage magnifies risk. Worse than that.
Leverage takes the cashflows and divides them between reliable cashflows and unreliably cashflows and sells the reliable cashflows to someone else so that more unreliable cashflows can be obtained.
The second misunderstood aspect of the derivatives is the amount of money that can be lost and the speed at which it can be lost. This misunderstanding has caused many including most market participants to believe that posting collateral is a sufficient risk provision. In fact, 999 days out of 1000 the collateral will be sufficient. However, that other day, the collateral is only a small fraction of the money needed. For the institutions that hold large derivative positions, there needs to be a large reserve against that odd really bad day.
So when you look at the two really big, really bad things about derivatives that were ignored by the users, Taleb’s description of children with dynamite seems apt.
But how should we be dealing with the dynamite? Taleb suggests keeping the public away from derivatives. I am not sure I understand how or where the public was exposed directly to derivatives, even in the current crisis.
Indirectly the exposure was through the banks. And I strongly believe that we should be making drastic changes in what different banks are allowed to do and what different capital must be held against derivatives. The capital should reflect the real leverage as well as the real risk. The myth that has been built up that the notional amount of a derivative is not an important statistic and that the market value and movements in market value is the dangerous story that must be eliminated. Derivatives that can be replicated by very large positions in securities must carry the exact same capital as the direct security holdings. Risks that can change overnight to large losses must carry reserves against those losses that are a function of the loss potential, not just a function of benign changes in market values and collateral.
In insurance regulatory accounting, there is a concept called a non-admitted asset. That is something that accountants might call an asset but that is not permitted to be counted by the regulators. Dealings that banks have with unregulated financial operations should be considered non-admitted assets. Transferring something off to the books to an unregulated entity just will not count.
So i would make it extremely expensive for banks to get anywhere near the dynamite. Or to deal with anyone who has any dynamite.
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