Evan Davis - The City Uncovered Episode 3

Evan Davis delivered the last episode in his 'Uncovered' Series tonight - 'When markets go mad'

Tonight's subject was 'price discovery'  - what it means, how it works and how it can sometimes go wrong...and how this relates to the fascinating world of 'behavioral finance' and ultimately how our natural emotions can affect our decision making abilities.

Price discovery - What it means

The basics of supply and demand control the price in any 'free' market. If more people want something the price goes up, if less people want something the price comes down. This concept reveals itself in 'normal' market conditions as continually small increments around what is termed 'value'. When the stock markets are operating in this manner it's possible to benefit and to a certain extent 'control' these movements, simply by selling when an instrument is over-valued and buying when its under-valued. In trading terms the level at which the instrument is considered over-valued is termed 'resistance' and the level at which its considered 'under-valued' is termed 'support'.

Wild market swings can occur during 'normal' market conditions. This is an accepted fact. For example in 2007, Wheat doubled in price from $7 to $13 before quickly returning to around $7. Why this happened is explained below.

How it works

In normal market conditions, the 'value' price of an instrument has a relationship to it's fundamental price. The 'value' price for a bushel of wheat takes into account, the cost of production, storage and  distribution - fundamental components, together with 'supply' and 'demand'. When this lot is thrown together, out pops a 'fair' value for a bushel of wheat. In early 2007, adverse weather conditions had severely impacted the supply of wheat. Crop reports began to hint at supply problems - (remember the film 'Trading Places' and the importance of the report on Orange Juice?). These supply problems quickly drove the price of wheat to record highs. At the same time, farmers, realising the additional margins to be had from Wheat, switched from growing soybeans and corn to growing wheat. As this additional supply filtered back into the market, so the price quickly reduced. The natural laws of a free market prevailed - BUT the swings were super-normal.

Fischer Black (an American economist) and one of the authors of the famous 'Black-Scholes' equation stated that Free Market theory means prices are usually somewhere between double and half of their fundamental value! 

And how it can sometimes go wrong

Lets head back to sub-prime in the US....Banks stocks rose in the US because of the increasing amounts of mortgage backed securities that they were trading. As they lent more to mortgage companies, who in turn securitised more debts with the banks, so the stocks rose even more. Ascertaining what the fundamental (fair) price of a bank is, is hugely complex at the best of times, however as their loan books continued to explode, it became even harder. As the first signs of trouble began to filter through the US economy (increasing numbers of foreclosures), investors in banks, driven by their emotions (greed), continued to purchase bank stocks - and their stocks continued to rise. Banking stocks were now rising in a manner that was inconsistent with 'price discovery' and 'fair value'. As foreclosures increased, so banks themselves, began to doubt their valuations. Suddenly the emotion of the investor switched from greed to fear and banks valuations began to fall sharply. Again 'price discovery' and 'fair value' played no part in these huge falls.

What is evident here is that bubbles and crashes have little to do with fundamental valuations and ALL to do with the behaviours of those who participate in them. 

Behavioral finance

Behavioural finance is a well known subject areas and has been studied by some of the greatest economists in modern times. And yet, we (the investor) continue to make the same mistakes! We trade on our emotions, we buy because we are greedy and we sell because we are fearful. Studies were done on professional traders during the tech bubble/bust in the early 2000's. It was noticed that during periods of profit, traders displayed higher levels of testosterone, which lead to increased risk-taking and more bravado. During the bust period, traders displayed higher levels of Cortisone, the body's natural way of dealing with stress, and a way of suppressing bad memories. Greed and Fear are natural emotions and removing them from your trading is extremely difficult.

The greatest traders however HAVE removed them from their trading. They can admit when they wrong and they can make rational and informed decisions irrespective of their emotion. They do not follow crowds, they do not listen to others, they have trading plans and they stick to them. These people are few and far between, but it is these people that will continue to profit in the markets in good times and in bad.

Evan Davis - The City Uncovered Episode 2

Mr Davis delivered another fascinating insight into the often murky and little understood world of high finance. His mission tonight - to shed some light on the intriguing world of the "Hedge Fund".

Hedging basically means managing your risk. Risk management is fundamentally about transferring the risk (there's more to it than that, but for the sake of simplicity.....). Risk transference has been around for centuries. Edward Lloyd in his coffee shop in the 1600's offered insurance to major shipping firms. He'd charge them a premium and in return he would insure them against the occurrence of 'an' event - typically the ship sinking. If the ship sunk, he'd pay the firm some cash. If the event didn't happen, he'd pocket the premium. His coffee shop became Lloyd's Of London (not Starbucks as some of you may be thinking....)

Similarly, producers and users of raw materials or commodities, would use a mechanism called a Future to transfer their risk. Futures or derivatives started life as being a way for these buyers and sellers of, for example wheat, to protect against future price movements. For example a brewery uses wheat to make their booze. If they sell their booze for £2, they need to be able to control the price of their raw materials to ensure their profits. Wheat prices can vary widely - wheat crops are not only heavily subjected to the weather, but also the growing global demand - in 2008 wheat prices doubled (before halving again). Lets say your £2 pint of booze consists of 40p's worth of wheat. If wheat prices go up, your margin on your beer reduces. By buying a Wheat Future, you can profit from the increase in the price, hence offsetting the loss you make when you buy the wheat itself. For companies that trade in the underlying commodities, the futures market represents the perfect hedge. They have managed their risk effectively.

The watershed 'moment' for the still relatively archaic futures industry was 1973. A group of economists worked out a way of providing accurate futures prices of stocks and commodities. In effect making them exchange tradeable - meaning anyone could trade a future.

Now instead of Futures just being traded amongst those with vested interests in the physicals, futures trading was now available to the 'speculator' and was traded on regulated exchanges. One of the elements of futures trading is called leverage - Leverage allows me to 'control' for example £1,000 of stock, but only have to 'put up' £100. (10:1 leverage)

As the Futures markets developed, so the concept of the Hedge Fund evolved. The traditional Hedge Fund would typically have investments that were un-corrolated and hedged, meaning they could profit if markets went up or down. Their weapon of choice became the Futures contract.

In the 1990's some of the finest minds in the US including the economists from 1973, created a hedge fund called Long Term Capital Management (LTCM). Their product was simple in concept and was potentially 'a perfect hedge'. Using some pretty complex maths they identified 'similar' US bonds whose price's had diverged. They would then go Long on bond and Short the other, betting that the bonds would converge. The strategy worked, but make real money they needed to invest huge amounts, which they had no problem borrowing from Wall Street. Their strategy also required them to be heavily leveraged - at their peak their leverage was 28-1. All went well for a couple of years and they made incredible returns using this strategy. Their downfall however began when Russia defauled on their debt - effectively devaluing the rouble overnight and causing a ripple throughout the financial system. LTCM themselves had little exposure to the rouble, but because those banks they had borrowed from did have exposure, the markets got jittery and the problem cascaded toward LTCM. They lost $550m in a single day and it was clear they were heading for bankruptcy. The Federal reserve stepped in and effectively bailed them out to the tune of $3.5bn - ensuring a controlled collapse, and thus preventing a potential meltdown. A company that appeared to have created a risk free hedging product, that had made their investors millions of dolars, now lay in ruins.

Roll the clock forward to AIG. The largest insurance conglomerate in the world. A company that understood risk and had grown from a market capital of millions to billions in a couple of decades. AIG in 2008 was very different to the AIG of the 1990's. They were in effect a huge financial services company. They ran a hedge fund out of their London office that had huge exposure to a product called Credit Default Swaps. A CDS provides a creditor with protection against the debtor defaulting on a loan. If the debtor defaults, the creditor in paid under the terms of the CDS. AIG had a gargantuan liability on CDS of $400bn and as companies began to default on loans, so they were obliged to pay creditors under the terms of the CDS. As global economic conditions deteriorated, so more companies defaulted to the point where AIG could not themselves pay their clients. The government of the USA bailed AIG to the tune of $180bn. It was not insurance that killed AIG, its was derivatives.

It was appearent that corrolation had been created where there had never been any corrolation before - Derivatives did not cause this financial crisis, but they seem to have accelerated it.

Evan Davis - The City Uncovered Episode 1

Tonight BBC2's "city series" featured a fascinating documentary presented by the appealing presenter of the Dragons Den - Evan Davis.

"The City Uncovered" presented a logical and sometimes frightening account of how the global banking crisis unfolded. Ex CEO of Northern Rock, Adam Applegarth and Dick Fuld of Lehmans Brothers were presented as the villains of the piece, but as this incredible story unfolded it became clear that Davis believes that villains existed at almost every level in the complex and fragile house of cards that is global finance. From the bankers and the ratings agencies, to the customers and the regulators and even to rocket scientists, no-one appeared totally blameless.

And you know what? I agree with him. My generation became accustomed to cheap credit. I've had huge self-certified mortgages, I have credit cards with staggering credit limits. I have a sizable interest only mortgage. I have very little savings (bar the ever eroding capital in my house). And I don't think I've done anything wrong, I've not broken any laws. I have simply made use of the credit I was offered. But do I have an obligation to understand how banks can make this money available to me? Should I have stepped back and wondered how they can lend me huge sums, with me only paying the interest? Or should I have expected the banks and their regulators to protect me from their greed? In truth only a very few people understood exactly what was going on in the wholesale markets. Even fewer fully understood how debt was being securitized and sold on.

Davis's narrative presented a clear explanation of the chain of events that unfolded to cause this crisis. For the sake of posterity, I'm going to record them here in as simple a terms as possible.

The origins of banking date back to China via Venice and Marco Polo. On returning from his travels he explained how paper was used in place of cumbersome assets such as gold. This revolutionary invention suddenly made it much easier to trade. Instead of paying for items in gold, paper could be used as a guarantee or a bond. This in turn made it much easier to borrow and lend. The Christians in Venice felt prevented from lending (and earning interest) as this was implied as incorrect in the bible. So, it became the responsibility of the Jewish community in Venice to become the bankers. They would borrow at a certain interest rate and lend at a higher rate - making the margin as their profit. This concept quickly spread throughout Europe and America and formed the basis of the banking industry as we know it.

Fast forward to the US in the 1850's. Two German brothers, The Lehman's began a simple trading business, the explosive growth of the cotton industry lead them to begin accepting cotton as a form of payment. This spawned their second business as cotton traders. Their business grew to form one of the worlds first and biggest investment banks.

Meanwhile on the other side of the Atlantic in Newcastle, England the company that was to become Northern Rock opened for business. Their model was far removed from Lehman's. Northern Counties Permanent Building Society, began accepting deposits from local people. They would save until they could afford their own home. They were in effect a classic retail bank - taking savings from local people at a certain interest rate and loaning to other local people (to buy their own homes) at a higher rate. Northern Counties Permanent Building Society operated in this way for over 100 years.

So as retail banks went about their business of taking deposits from retail customers and loaning this money back to them in the form of mortgages, investment bankers were busy trying to figure out how they could get a piece of this pie. The solution - securitization, or CDO's (Collateralized Debt Obligations). These complex financial instruments enabled investment bankers to underwrite mortgage debt, package that debt up into a financial instrument and sell these debts to investors. This made sense to the retail banks, because now the mortgage debts that had traditionally sat on their balance sheets as a risk, were now no longer their problem. It made sense to the investment banks as they were earning huge returns on these CDO's. The problem with being a retail bank was that you relied on your customers deposits - your growth was restricted. Because CDO was such a profitable product for investment banks they began to lend to retail banks to fuel their lending - this is known as the wholesale money market or inter bank lending. In return the investment bank would securitize the mortgage loans and make big returns selling these products to investors.

Because securitization was such a profitable product, investment banks were keen to loan as much as possible in order to sell on the CDO's. They turned their attention to people who they had traditionally never loaned to before - the poor. In effect, this was the turning point. Instead of the CDO being a by-product of lending, the CDO was now THE reason to lend. It was suddenly possible for people with poor financial credit worthiness to borrow money. The fire was now raging out of control and yet very little could be done. This cycle of borrowing and lending and re-borrowing and re-lending, meant that banks were making huge profits. Banks shareholders were happy, borrowers were happy, banks were happy and ratings agencies were happy because of the huge fees they were making. There was no turning back.

As the range in the quality of these loans became wider, so the products became more complex. Banks would now package different qualities of debt together in their CDO's, selling triple A rated loans with no problems, but finding themselves saddled with more risky debt. Still this wasn't a major problem as long as borrowers continued to meet their obligations and the value of the underlying assets didn't drop. Unbeknown st to all those happy home owners and credit junkies, the situation was now so precarious, that the slightest change in economic conditions would bring a total collapse in the global financial markets.

This slight change was the slowing of the US housing markets. As loan defaults increased, concerns were raised over the quality of debt that banks had on their books. This led to an almost immediate collapse of the Interbank lending market. It was now simply a question of time before the cries of help were to be heard.

That cry of help came from Northern Rock, who had built their business model around borrowing from banks in the short term via the overnight money markets and loaning (at a higher rate) in the long term . Using this model, they had grown their share of the UK mortgage market from 2% to 17% in less than 5 years. As it became harder for Northern Rock to borrow they very quickly became unable to service their debt. Their capital reserves disappeared in a matter of days and they requested emergency funding from the bank of England. Panic spread throughout their customer base and the first run on a UK bank in over 100 years ensued.

As the situation gathered momentum, now it was the turn of the investment banks to feel the wrath. Their business models, which had so heavily relied upon income from CDO's, were now unsustainable. Bear Sterns was the first to go, aided by the US government, and with their share price hovering at all time lows, they were quickly bought by JP Morgan. The attention then turned to Lehman Brothers. With their capital based eroded and no deal to save them Lehman's were declared bankrupt on September 14 2008 - an institution with a proud 150 year history had vanished forever. If there was panic before this landmark event, then what ensued was global pandemonium.

Suddenly no institution was safe, Merrill's, Goldman's and Morgan Stanley in the US and LloydsTSB, HBOS, Barclays and RBS in the UK were now in grave danger of going to the wall. Mass panic lead to huge stock market volatility which in turn caused further problems for these banks as suddenly their capital bases were eroded further. Only the intervention of global governments and the pumping of billions and billions of dollars into the banking system prevented a global meltdown. We are by no means out of the woods; the global banking system still sits precariously overlooking the precipice and ther are no doubt more obsticles ahead.