Thursday 29 January 2009

Common sense in the financial markets? Shock horror!

Just like the, now legendary, Captain Chesley Sullenberger, age, wisdom and experience can count for far more than simulators, 28yr old "masters of the universe" and Phd grads. George Soros, oft criticised for "breaking the Pound" some years back nailed some of the gross inefficiencies that contributed to the financial crisis we now have to struggle through.

In an article in The Financial Times today, Mr Soros deftly picks through the mire of regulatory oversights, their lack of grasp of the asymmetry of long and short positions and the opaqueness of many derivative instruments. He described the snowball effect of hedge funds, fat with cash, combining to short bank equity with long CDS positions to take massive bearish bets on some of the largest financial institutions. This capital "bullying" had the, hardly unexpected, result of sapping confidence in the whole sector. This reduction in confidence further enhanced the hedge fund profits by demolishing the banks ability to lend and borrow forcing them into a corner. Soros calls this "reflexivity" and its something not modeled in orthodox financial theories.

Soros argues that the catalyst for the seizing up of the financial sector was the Fed and The Treasury allowing Lehman to go under. The inability of many CDS or any other form of OTC (over the counter) counterparty to settle their transactions rendered the system frozen. The lack of interbank lending looks set to continue until confidence returns.

The sheer size of the outstanding CDS contracts defies belief. When I spoke at The TraderTech conference late last year, the total notional outstanding CDS nominal exposure was more than $400 trillion, yes TRILLION Dollars. The nominal is not just IOUs but multiplicities of exotic structured instruments with, I kid you not, legal documents extending to well over a thousand pages (densely written and leaglese too). The opaqueness of these instruments requires tedious unraveling and without a clear picture of what is owned, the tendency is to mark down the asset price.

None of the cataclysmic problems were forecast by the financial models, whzz-kids, VAR specialists or Phds. With little management information feeding through to the boards of the big financial institutions, all seemed well in the world and profligate spending, borrowing and $1.2m office refurbs continued. It was always going to pop when the boards no longer understood the companies they were running.

Perhaps a little more common sense or standing back and seeing that there were some glaring inefficiencies feeding the bubble (rating agencies being a clear example - I'll be writing on that topic separately) would have stopped us getting so close to the systemic breakdown we now face.

I know that I'd prefer a 55yr old captain of my financial 747 if it encountered danger than a over-confident 28yr old with a first class degree in maths more concerned with getting over his hangover and wondering if Jenny Smith from payrolls is up for it. Perhaps Mr Soros, though wrong-footed at times is the Chesley Sullenberger of the financial world. Age, experience and an holistic approach to the capital markets is a breath of fresh air and I know who I'd trust in a crisis.

Friday 23 January 2009

Time I started to write!

Morning paper and coffee time is often when most ideas and observations happen in my CityOdds world.

This morning was the turn of The Times and an article about two musicians seeking funds to help them produce an album. Firstly, good on Martyn Shone (the guitarist) for getting out of the moribund banking business and embarking on an adventure with the band Honey Ryder. The curious and innovative thing about this band was the choice of method of funding. Forget going to a bank where the large cheeky chappie ignores the customer then refuses any help in the money department - this model seems dead for some time - why not try selling shares in the band instead?

Selling shares is not new but in such a small size it is. As Sean Park, of Nauiokaspark, correctly points out that risk can be broken down into small units, repackaged like Lego and built into a variety of shapes to suit the buyer or seller. In today's information centric world, the size of these risk "quarks" it is shrinking. Shares in Honey Ryder are £3,500 each and only 100 available - small by company standards but enough to launch a pop career..

So how do you value the share? Here comes the fun bit. There are no fundamental ways to value this share - its just hope and your guestimate of the odds of them succeeding. Offer me £10 if I can predict whether a coin lands heads, on a fair flip, and I'll pay up to £5 to enter the game. £5 is thus the fair value of the share, it matters not that the coin has not yet been flipped. It is the prospect that values the share. Its up to the fans to see whether they think £3,500 is a fair price to share in the band's success. You won't find these shares being sold by your local IFA!

Do I like Honey Ryder? - they seem funky, cool and I'd happily have a drink in a bar with them but I bet they don't know what a revolution they are beginning...the story has only just started and the time when financial products are bought rather than sold is coming...

More soon..