By Satyajit Das, a risk consultant and author of Traders, Guns & Money: Knowns and Unknowns in the Dazzling World of Derivatives
Wall Street Revalued: Imperfect Markets and Inept Central Bankers by Andrew Smithers (2009)
The Road to Financial Reformation: Warnings, Consequences, Reforms by Henry Kaufman (2009)
In a sense, this crisis is about values (the prices paid for many assets) and the rules (regulations governing financial markets). It is also about rules (rigid model based formulations of price) and values (ethics or the lack thereof). These two books provide different perspectives on the issues.
In Wall Street Revalued, Andrew Smithers, an experienced practitioner (in fund management and now as a consultant), explores the value of stocks. This is a theme that Mr. Smithers has written about before, most notably in his 2000 book Valuing Wall Street which together with the Robert Shiller’s better known Irrational Exuberancepresciently highlighted the overvaluation of new economy Internet stocks.
Wall Street Revalued argues that assets can be objectively valued and managing asset prices should be one of the central functions of central bankers. Mr. Smithers’ asserts that denial of these fundamental principles lay at the heart of the global financial crisis. On valuation, Wall Street Revalued favours the “q” ratio (the replacement cost of a company’s assets) and cyclically adjusted price-earnings ratio over the previous ten years (a measure also adopted by Professor Shiller).
Eloquent and persuasive, Mr. Smithers make his case well with the advantages of brevity and an abundance of charts and Tables. But some problems remain.
It is not clear how earnings or accurate replacement values can be forecast. This is particularly so at inflection points in economic history – I am sure horse and buggy makers were “cheap” on replacement cost and PE measures after the advent of non-equine modes of transportation. The ability of obscurantist accountants and derivative professionals to affect company earnings and cash flows has become increasingly important. The effect of leverage (both obvious and disguised) also affects these numbers perhaps more that Mr. Smithers acknowledges. How are these to be dealt with at an acceptable level of certainty?
If precise valuation were possible then surely the entire idea would have enabled computers loaded with Mr. Smithers’ data and insight to generate significant excess returns. Markets may deviate from fair value for varying, sometimes lengthy, periods. Echoing Minsky’s famous formulation – “conditionally coherent”, Mr. Smithers argues that markets are “imperfectly efficient”, fluctuating around their fair value.
The question then is over what time horizon will be the true value be achieved? As Keynes stated: “…this long run is a misleading guide to current affairs. In the long run we are all dead.”
As every sensible trader knows, the price you pay is always wrong. If you sell then by definition you are lowest price in the market. If you buy, then your bid is the highest. They also know price is what you pay while value is what you hope and pray for. The mysteries of value remain.
Before Nouriel Roubini, Marc Faber and the others, there was Henry Kaufman – the original ‘Dr. Doom’. He too saw the crisis coming (this disease is clearly infectious!). The text contains an entire section on his prophetic and neglected early warnings.
Road to Financial Reformation provides a personal (at times) and insightful overview of the global financial crisis and brims with suggestions for reform to avoid a future recurrence. Intended for financiers and regulators involved in the industry, the book is a thoughtful analysis of the main issues.
Dr. Kaufman’s major concern is the blind faith in models and questionable innovations. He is critical of the rapid increase in size and concentration of financial institutions. He identifies how securitisation of bank loans “created the illusion that credit risk could be reduced if the instruments became marketable” and led to a decline in the credit quality of debt. He also shrewdly identifies how the idea of liquidity altered from assets (what you could sell) to one centered on liabilities (what you could borrow).
His solutions are unsurprising. He advocates a single regulator and increased regulation. Amusingly, he urges that “amid the blizzard of quantitative, technical offerings…courses in economic and financial history should be required for all business degrees.” As Marx warned history has a tendency to repeat first as tragedy and then as farce. It is not entirely clear why the simple study of it would prevent this.
The reliance on central bankers, on the part of both Mr. Smithers and Dr. Kaufman, to prick asset bubbles and take responsibility for regulating the financial system is brave.
Recently, Ben Bernanke, President of the Federal Reserve, confessed: “I did not anticipate a crisis of this magnitude.” Mr. Bernanke further acknowledged shortcomings in a more traditional area of central bank expertise – ensuring the adequate capitalisation of banks. It is far from clear that central bankers would be capable of identifying mis-valuation and acting on it. Most tellingly, traders and investors did not prove particularly able at this task. And they were better paid than central bankers.
Regulation and governance generally rely on enforcement and strict compliance. Dr. Kaufman conveniently neglects mention of the fact that he had a seat on Lehman Brothers’ board and a member of its finance and risk committee.
The octogenarian Dr. Kaufman was joined on this committee by a Broadway producer, a former officer of US Navy, founder of Spanish-language TV station and a former chairman of IBM (from some 13 years ago). The 5 directors had been on Lehman’s board for a collective 55 years. It appears that there were two meetings of finance and risk committee in 2006 and 2007. The composition of the committee is especially puzzling as there was no inkling that the investment bank was contemplating ownership of warships or producing musicals or programs for Spanish language TV.
Whatever the book’s other considerable insights, Road to Financial Reformation does not make the case for the capabilities of central bankers and other worthies oversighting either the markets or individual institutions. It may ultimately be a case of values rather than rules.
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“The octogenarian Dr. Kaufman was joined on this committee by a Broadway producer, a former officer of US Navy, founder of Spanish-language TV station and a former chairman of IBM (from some 13 years ago). The 5 directors had been on Lehman’s board for a collective 55 years. It appears that there were two meetings of finance and risk committee in 2006 and 2007. The composition of the committee is especially puzzling as there was no inkling that the investment bank was contemplating ownership of warships or producing musicals or programs for Spanish language TV.”
I love Das – not only is he super smart, he has a wit that just won’t quit.
The more finance I read, the more I see parallels with medicine – lots and lots and lots of data, highly educated proponents with intricate and plausible theories, much of it conflicting…and no cures. I accept I am going to die. Accepting I will not get real returns of 6 or 7% in the markets has actually been more difficult… but now that I accept it, I am strangely calm. (still, wish I had saved less and spent more on sex, drugs, and rocknroll).
I find the comments by Das to be engaging and somewhat amusing. I’ve read Dr. Kaufman’s book and found it interesting and insightful. I’ve not read the Smithers book. After 40 years of managing money I’ve concluded that ‘value’ does not exist as an entity or concept unto itself and that there are only prices.
I never believed the Efficient Market Hypothesis and always felt that CAPM and Black-Scholes were off the mark because you can’t really mathemitize the variance of perception and the expectation that it creates in the market. I’ve also held the view that all ‘value’ lies in the future. The profit I hope to make is entirely dependent on the accuracy of the guess I make today. The guess I make today is dependent on the platform I am standing on today. Where are we in the current cycle, it’s a sine curve segmented into four parts; recession, recovery, expansion, contraction. Buying opportunities occur during the transition between recession and recovery. Selling opportunities exist during the transition between expansion and contraction. That, in my view, is the proper role of looking at history, from where have we come and where are we headed. What is our position in the cycle.
Of equal importance is the necessity of knowing what events operated as triggers of market activity. What legislation has been in force? What global conditions influence perceptions and the accuracy of those perceptions.
Buy and hold is a potentially foolish tactic. The best strategy is to be flexible and recognize that setting tactical holding periods and profit objectives works reasonably well. I’ve also learned that size is the enemy of performance. The larger the portfolio, the harder it is to achieve exceptional returns. Sometimes, preserving the purchasing power of the total portfolio is an exceptional performance.
Reflections on history are useful in the endeavour of understanding and solving a problem. Our financial problem today flows out of the economic dogma that government can ameliorate or mitigate the consequences of malapplied factors.
If we are to have a free market economy, the presence of government must be limted to a police function. By themselves markets will not punish malfeaseance. Unprosecuted fraud fosters fraud.
The money supply exists in two parts; the currency, plus credit money. Credit money takes the form of demand deposits. It is the wanton extension of credit that is a critical factor in the problem at hand. Couple that with the fact that our currency is a pure fiat currency which generates a powerful propensity to spend today because the currency will buy less tomorrow and you have the basis for the morass we are in today.
The credit crunch was and is not the least bit about liquidity, it was and is about insolvency. A large number of banks were and are bankrupt.
Quitting America is so HARD to do.
Beaten and bruised, all black and blue.
Your body now so tired and worn
with little energy for muscles torn.
The mind shattered with what you now know
to be true – what you must do.
With reason gone awry
you’re thinking for the few.
Your heart broken with the sense of betrayal
by a lover with everything for sale.
Commodified in your body from the womb to the tomb,
it beats forever in the cold of winter gloom,
yearning for funeral flowers to bloom.
Your soul sinks ever deeper into the
spiritual abyss, wondering and wandering
if there’s something more to despair and
emptiness.
Body worn,
Mind shattered,
Heart broken,
Soul emptied,
Then comes the light…
Quitting America is so EASY to do!
Long may you run…
Just one big scam with us bled dry in the end.
I’m full out, not going to play the game one second longer, not going to kill myself, others or the planet to enrich these sociopaths.
Earth-ship house built with my and the kids hands on a few acres near live beach, off the grid! Run now my ex-pats, time is short and when gods country implodes its not going to be pretty. Hell why pussy foot around just impeach Ideobama for any reason and insert Palin w/McCannon as VP that should bring the final chapter around much quicker and with out all this tiresome mid book character building slow mo action, crescendo please!
Skippy… its been fun gang, roaming history, finance, economics etc. Good luck with the chuckholes up on K st. and Wall st. God put them there and only he can kick them off, even if its just in their heads, thats still one hell of a belief to over come.
PS Yves good luck with the book, although I won’t be reading it. I already know the plot and don’t need forensics to tell me that people shot, murdered, mangled, raped, drugged, kiddyfiddled, and all the other horrible things some must do to others in order to satisfy them selves and think themselves natural born elites, seen enough up close.
Pitchforks are too good for them really, thrown into a mass pit and bulldozed over would be more fitting! Au revoir to the madness of beasts whom pose as men, and the thinking of their deads as if that may enlighten us to a ploy in tricking them to act other wise.
Indeed, Skippy, indeed. Sounds like you’ve done your homework.
At this point the best course of action is to get out of the way. America is the Titanic post iceberg acquaintance. She’s taking in water fast, Sir, and the rats are swimming away from her. Yeah, the rats… they always know when a ship is sinking, and they always swim away in time. We need to be like the rats.
Once again I feel compelled to post my famous Dr. Vinny’s 5-easy step prescription for average rat’s continued health and well being:
1.) A residence outside of the US and Western Europe.
2.) 2+ passports (so you need dual citizenship). Remember, when the shit hits the fan, not only you won’t be able to leave the US with an American passport, but most countries will likely close their borders to the millions of American “rats” that will flee.
3.) Enough physical gold and silver to survive for at least 20 years.
4.) A high quality blue-ray recorder, large-screen digital TV, and digital cable service, so you can record in high definition the collapse of the evil western world as we know it. You really do want to capture every gory detail, my friends!
5.) A stockpile of high quality coffee and a decent cappuccino machine, so you can maximize your viewing pleasure of the recordings made in step (4) above. If you don’t like coffee, tea is good too.
Now, if you have not already covered items (1) through (3) above, I suggest you get to work on it ASAP.
Vinny G.
From the guy that crawled out of the sea of two worlds, winters with the elitists 5 coarse meals with watered down wine on Sundays and summers on the old school farm cutting hay with my own John Deer A.
Joined the Army to escape the family madness, personally invited to a SF team by its Capt on co op training exercise, did time in South America and South Africa providing community security to those with means and power.
thought I was transferring to a kinder gentler world upon inserting my self into the National and International corporate world. Only to find more buddy fkn and depravity in all my years before combined, the people, top self CEO, Lawyers, politicians investing seed monies for large shipments of drugs and other goodies into the states LOL. franchise distributions systems et al, the right people to pay off or invite to little party’s to wet them down so as no to squeal, off shore teen sex party’s.
I’ve seen the lot, stood on the side lines, its massively pervasive in our culture and Avg Joe and Jane have not a clue. All the time learning, studying, finding new information from all over the planet, cross referencing everything. Ben Franklin was a member of a little hell fire cub with get together held under a castle in France (silly out fits, rituals to boot and busty French Lady’s LOL. This game has been playing a long time and may be over cooked, there is a burning smell coming from the oven..eh.
Skippy…BTW list is complete with additional resources and diversity incorporated, out of the way islands with friends abodes if necessary.
PS Vinny, DownSouth, Doc H, Richard K & Richards, Bruce K, I on the Ball, fresno Dan, et all I hope nothing but the best for you all, hell even you Dan D. For there is just to much historically impacted thermal mass to contend with I fear.
PSS Yves much of the world lives like hamsters in modular habitats, for the enjoyment of its builders and nothing else, sophistry and complexity are the gates and drapes to hide their crimes of depravity, good luck with exposing what has been hidden for so long to any real effect, this world is truly a two class system with .001 having any real say in the maner of things.
Best to you my friend …
Quitting America is so HARD to do.
Beaten and bruised, all black and blue.
Your body now so tired and worn
with little energy for muscles torn.
The mind shattered with what you now know
to be true – what you must do.
With reason gone awry
you’re thinking for the few.
Your heart broken with the sense of betrayal
by a lover with everything for sale.
Commodified in your body from the womb to the tomb,
it beats forever in the cold of winter gloom,
yearning for funeral flowers to bloom.
Your soul sinks ever deeper into the
spiritual abyss, wondering and wandering
if there’s something more to despair and
emptiness.
Body worn,
Mind shattered,
Heart broken,
Soul emptied,
Then comes the light…
Quitting America is so EASY to do!
Long may you run…
Rocking comment; i always was a hedonist.
The beef I have with replacement value is that it basically assumes an efficient market where anyone can build a factory and sell a product into a given market. Anyone interested in building a new Microsoft or Google?
Oversight of the finance industry will only come from without …
We need another great abolitionist like John Brown whose plan to abolish slavery could easily be updated and ported over to abolish debt slavery.
Excerpt;
“There are compelling reasons. First, the plan was not absurd. Brown reasonably saw the Appalachians, which stretch deep into the South, as an ideal base for a guerrilla war. He had studied the Maroon rebels of the West Indies, black fugitives who had used mountain camps to battle colonial powers on their islands. His plan was to create panic by arousing fears of a slave rebellion, leading Southerners to view slavery as dangerous and impractical.
Second, he was held in high esteem by many great men of his day. Ralph Waldo Emerson compared him to Jesus, declaring that Brown would “make the gallows as glorious as the cross.” Henry David Thoreau placed Brown above the freedom fighters of the American Revolution. Frederick Douglass said that while he had lived for black people, John Brown had died for them. A later black reformer, W. E. B. Du Bois, called Brown the white American who had “come nearest to touching the real souls of black folk.”
Du Bois was right. Unlike nearly all other Americans of his era, John Brown did not have a shred of racism. He had long lived among African-Americans, trying to help them make a living, and he wanted blacks to be quickly integrated into American society. When Brown was told he could have a clergyman to accompany him to the gallows, he refused, saying he would be more honored to go with a slave woman and her children.
By the time of his hanging, John Brown was so respected in the North that bells tolled in many cities and towns in his honor. Within two years, the Union troops marched southward singing, “John Brown’s body lies a-mouldering in the grave, but his soul keeps marching on.” Brown remained a hero to the North right up through Reconstruction.”
More here …
http://www.nytimes.com/2009/12/02/opinion/02reynolds.html?_r=1&scp=1&sq=John%20Brown&st=cse
Deception is the strongest political force on the planet.