Market turmoil: How the s*** hits the fan

Call me old-fashioned, I don't care. I've never believed in financial instruments, especially the genre they call derivatives. No, not for me these sexy tools that financiers and stockbrokers use to manage risk. My feeling was always that the guys who created these instruments were just trying to make a fast buck (via handling commission) at the expense of greedy (and hapless) investors.

But, of course, I simplify. And, why not? It would seem that the entire financial edifice that has been created since the late 1980s is built upon two basic principles; profit and hedging risk.

Let's look at each of these twin pillars, shall we?

The fallacy of endless profit
I call it a fallacy because wise men know that everything and, I mean, EVERYTHING, follows the laws of Nature, particularly physics. What goes up WILL come down.

Everything has life-cycles. Every single living thing. And, companies and their products are no different. They are introduced to the market. Initial popularity brings in revenues. Forecasts of revenues go up and up. Grand announcements are made to improve the product. Worst of all, plans are made and implemented, to raise money from investors and banks to finance expansion. Then, Lo! and Behold!, the demand for the product falters. The product's life cycle is waning. Revenues fall. The company gets into financial distress. Investors cry foul. Banks commence legal action.

Conspicuous consumption
The term conspicuous consumption was introduced by the economist and sociologist Thorstein Veblen in his 1899 book The Theory of the Leisure Class. Veblen used the term to depict the behavioral characteristic of the nouveau riche, a class emerging in the 19th century as a result of the accumulation of wealth. Veblen's brilliant insight is still relevant today.

Just open any glossy magazine and you are inundated with must-haves; cars, clothes, jewellery, mansions. The expression keeping up with the Joneses is an understatement. In this era it is more like shove it up the Joneses faces.

This wannabe phenomenon is pertinent to what I'm saying, because how does one finance an aspirational lifestyle? The drudgery of one's day job is just enough to pay the mortgage on the house and car and, household expenses. But, to get the extra edge you have to put your money to work. EPF annual interests is hardly enough for one roti canai a day, or so many think.

So, this impetus forms the base the world over. Pension funds are under pressure to put the money to work. Insurance giants, like AIG, are under pressure to put money to work. Banks are under pressure to put money to work.

Putting money to work
At this stage, the money is called investment funds. Somehow, by the stroke of a financial wizard's wand (or pen or PC, whatever metaphor you wish), one's hard-earned savings becomes available to the financial wizards (but, are they really wizards or, like Mickey Mouse, they are merely wizards' apprentices?).

In its most basic form, money can work for us when we buy property to rent out or, arrange for fixed deposits that yield a periodic return. For more excitement, one will trade in ordinary shares of publicly listed companies. Here one can receive a paltry dividend and, possibly capital gains from rising share prices. That is the upside. The downside is that share prices can fall, too. But enough of this. This is not a story about small investors.

How do banks and investment funds put our money to work? Yes, it is the money from deposits and pension contributions. And, they put the money to work everywhere. They buy shares of publicly listed companies. They invest the money in debt securities like bonds and derivatives.

But, these young boys and girls who work in banks and investment funds are smart kids. They realise that with their money being invested all over the place there is this thing called risk.

Managing risk
I'm no financial or mathematical expert. I was very far, far away from being even remotely competent in my Additional Maths in school. But, like you, I do know how to grasp, in a very loose sense, some concepts, like risk. Basically, its a cool word for the idiom, don't put all your eggs in one basket but at a higher order of thinking, of course.

As far as I understand the evolution of the financial instruments called derivatives, it arose when investment bankers and funds realised that there is a value to being able to calculate differences between the yield from one instrument in one place with another instrument in another place. These differentials, as it turns out, can be turned into new financial products and be traded. There was money to be made from trading on these financial products that had very minimal links to the real world. These financial products were derived from real products like bank loans, bonds or shares and stocks, hence the moniker, derivatives.

So, new products kept being conceived by bright, young mathematically-minded, economics or business-trained hotshots.

To borrow a hackneyed Chinese expression, this is a classic case of using money to make money. Except that it is more like, using money to make money to use the money made to make more money (I told you it is abstract).

Losing track of risk
This is why the subprime mortgage crisis that has created the financial maelstrom in the U.S. is so ironic. It is a case of risk-management-type financial products being poorly or negligently risk-weighted so that risky instruments were placed in the same basket as low-risk instruments and given a triple-A rating by the rating agencies. That is what you get for leaving billion- and trillion Dollar decisions with young boys and girls.

Obviously no one had a clue or, risk algorithm that could calculate the downside risks of the CDO instruments. Note the anguish and indignance in Bill Saporito's words in his Time magazine article on this phenomenon:

Then there's the nonsense that ratings agencies shoveled out about the risk levels of collaterized debt obligations (CDOs), how this new bit of financial wizardry deserved AAA and AA designations even though it rested partly on a foundation of subprime mortgages. It was all justified by super-sophisticated models — way too sophisticated for "you" to understand — that looked back at real estate pricing and foreclosures and couldn't conjure a scenario in which the holders of the most senior parts of these tranches wouldn't get paid.

Perhaps no one figured that subprime mortgage holders were 10 times as likely to enter into foreclosure as people who made downpayments and could document their ability to pay. "This poor performance in the subprime market calls into question the capabilities of lenders, securitizers and investors to reliably estimate peak charge-off rates," warned Joshua Rosner, managing director of Graham Fisher & Co. and Joseph R. Mason, a finance professor at Drexel University in a paper in early 2007. When all the indicators went bad — delinquencies and interest rates up, home prices down — the agencies started yanking the ratings on CDOs by the carload. As the number of subprime delinquencies started to climb, and the magic mark-to-model accounting that the investment houses used to value their AAA and AA CDOs got market-tested — as in, "What will you give me for this piece of paper?" — the game was over.

Fundamental questions about the profit paradigm
We can blame the investment banks that cobbled together the CDOs. We can blame the ratings agencies. We can blame pension and investment funds for demanding growth in profits year-on-year. But, we can also blame contemporary society for lionising and lauding individuals who has the most wealth. We read Forbes and Malaysian Business to see the annual tally of the richest. And, we wannabe like them.

This is what happens when we put money to work in the hands of others. If our money was invested in a business that we manage and operate ourselves we wouldn't care a hoot whether this year's profits is higher than last year's, especially in economically uncertain times like these. We would be happy to maintain a profit similar to last year's. I wrote about this in Flat is the new up.

I'm not saying that we should all be business people or, put our savings under the bed. But, each of us, in aggregate, form the human society. Just as the environmentalists tell us to start the conservation effort from our homes first and, foremost, we have each got to realise that putting our money to work by putting our money in the hands of the financial boys and girls may not always be the best risk option.