Friday, September 14, 2007

Is It the Market's Fault?

Great article (in French) by Jean-Marc Vittori of, entitled "The End of the Market?"

He describes the summer of 2007 perfectly:

[Thanks to for the image.]

"Rotten season! Right in the middle of summer, a thick fog obscured world finance. Then a storm broke. Impossible to see the waves that engulfed a German bank, blocked Australian and French funds, and shook the financial hallways around the globe. Lacking sufficient visibility, banks refused to lend to each other, starting a liquidity crisis. Now everyone is sitting on pins and needles waiting for the next surge, with no idea where it will come from."

Some paraphrasing:

Capitalism used to utilize that tool of great transparency that was the market; and it worked so well, or at least did up to now. The market used to give us exact figures that communicated supply and demand ratios perfectly.

The moulder of this tool was the world of finance, the very same world that now seems to be working without it. He asks: Do we really need a tool that the financial world has abandoned?

To prove his point, he gives several examples of what a researcher at Natixis (a French investment company) calls "closed capitalism." There are four types of companies that wear themselves out trying to make their stocks disappear off the screen. We can ignore the first one, those buyers of their own stocks or those of their competitors who are simply trying to improve the price.

The other three are the private equity firms that retire businesses away from the public eye in order to restructure them in peace, the businesses held in private hands (mostly family companies that have always been run close to the vest), and the state-run financial entities created with the foreign exchange surpluses of nations like Russia and China.

These last are becoming more and more hefty. For the time being, they've contented themselves with buying participations in existing companies; but by 2015, they will have enough money to buy everything listed on the stock markets of Euronext, London, Frankfort and Milan, and make them all obscure.

"As for bonds, there's another mechanism that leads to the same result. Over the space of one decade, the profession of banking has completely changed. It used to be that banks were houses of good reputation, collecting savings and issuing bonds at low interest, selling them on the marketplace in order to be able to lend money at a higher rate to make their profit.

"Now, banks have become immense debt-aggregating and -marketing machines, issuing the instruments themselves or through intermediaries. It's called 'securitization': they consolidate debt instruments, twist them around, and sort them out into 'tranches' that they sell directly to customers for a commission.

"The [precise price-determining] market has given way to a kind of approximation process. It's true that at the first level--the issuance of debt instruments--and at the second one--resale--a true market doesn't much exist, as we saw during the August panic.

"Even the role of the rating agencies has changed. It used to be that they informed the market by evaluating bond issuers' capacity to reimburse. Now, they are just rubber-stampers. They work with the banks in creating the obligations, and then they issue the certificate of approval that justifies their acquisition."

I agree with most of this, except I'm not so sure the rating agencies are such evil co-conspirators as described. However, there are several points he doesn't mention:

1. Banks and financial institutions have turned to this seeming free-for-all blind market with great enthusiasm, it is true; but he fails to mention that banks have been suffocated in their market inventiveness for centuries now by an overbearing federal bureaucracy. What the regulators forget is that you can suffocate banks, but you can't suffocate the market. It simply flows up around the impediment, as it has done in this case (with the banks' complicity, of course--they're no dummies).

2. Securitization and the credit derivatives that sprouted from them were the new kids on the block, bright and shiny, free from federal interference due to the new, more free-market orientation of the supervisors, and thus squeaky clean. Everybody and his uncle wanted some.

3. There was lots of cash to invest, probably due to a combination of excessive central-bank-issued liquidity, pegging by US trading partners, and the relative desirability of the US investment climate in the global marketplace (the tallest dwarf syndrome).

4. There was even more liquidity focused directly at these markets issued to excess by quasi-government mortgage buyers (Freddie and/or al.).

5. The combination of 1-4 created a bubble in these instruments that is only now coming to light for what it is; and those who over-consumed will have to bite the bullet if they can, or get bailed out if that's an option, or deal with their own demise. (The BIS [Bank for International Settlements] has been screaming about this for years. See my earlier post and near the bottom of this article.)

6. In the future, the securitization and dependent credit-derivative markets will become more transparent as these instruments are traded in a more orderly fashion, and as (hopefully) central banks get a handle on the money supply, hopefully by leaving it alone. (I don't think I'll hold my breath on that last part.)

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