Limits Of Markets_spreading Risks In An Uncertain World

The limits of markets: Spreading risks in an uncertain world By: Procyon Mukherjee The last decade saw unprecedented changes in the functioning of the financial markets, whether they operated ‘freely’ and ‘fairly’ is a matter of debate, but the denouements have little room for debate as to the nature of the implications on policy actions for the future. The spate of innovations in these markets were triggered by the need to find instruments that could systematically deal with risk and simultaneously create an environment where growth could be maintained in a large portfolio of stocks in an economy that had reached maturity and that had long ceased to be local. But the effects of risk and its temperance through the innovation was more a creative destruction of the human psychology that challenged the limits of ‘bounded rationality’, as framed by the thesis of Kahnemann and Tversky. Recently I chanced on this example of risk taking while driving on the highway, where two drivers shared a car. When the question came to sharing the effects of speeding violations made by each driver, the risks taken by each driver increased under the condition that fines were to be shared than under the condition when each was responsible for his own action and therefore for the violation as well. This is a slight deviation from the original Kahnemann-Tversky model that proved that we are more risk prone when it comes to fending against losses, while risk averse when it comes to deriving benefits from gains. This example tends to prove the point that when risk is shared between participants then people become more risk prone than when they were alone to shoulder risk, the precise model followed by the investment banks in spreading the risk through the introduction of the credit default swaps and creating a product that could be traded in such a way that it left the trails completely rootless to the origin, a brilliant recipe for disaster as the world saw in good time. The maturing of re-insurance market and its growth in the last decade attracted innovation in the form of other hedge instruments like the credit default swaps that worked in a slightly different manner than re-insurance. While re-insurance worked in a regulated environment, CDS worked in an unregulated territory (thanks to the Commodity Futures Modernization Act 2000) and the former depended on Law of large numbers to hedge risks by setting loss reserves and counter-balancing, while the latter thrived on offsetting with other dealers and transactions in the underlying bond market. But the Midas touch of innovation lay in the fact that owners of insurance contracts had to have an interest in the product in form of ‘owning’ the debt for example, whereas for the buyer of a CDS does not need to own the underlying security or other form of credit exposure; in fact the buyer does not even have to suffer a loss from the default event (Mark Garbowski (2008-10-24). "United States: Credit Default Swaps: A Brief Insurance Primer" …"like insurance insofar as the buyer collects when an underlying security defaults ... unlike insurance, however, in that the buyer need not have an "insurable interest" in the underlying security". The unregulated environment of CDS made any amount of exposure possible as Lehman and AIG underwrote due to lack of transparency which hastened their demise, but it would be interesting case study to understand the market forces that failed to act

when the risk was being multiplied in a common pool of transactions where many participants were acting as counter-parties as guardians of risk. The failure of the market to act in good time is an indication of the limits of markets when information is imperfect, the very subject on which Stiglitz or Akerlof got their Nobel. But the frenzy that such market behavior helped to proliferate and exude through a range of products starting with stocks, housing, and other assets and commodities, is a matter of deep introspection that many have started to delve into. My enquiry would be limited to two defining questions:

1. If markets have limits and there is need to intervene, as in the case of recent deluge of bail-outs, how does the future look like for markets in general and financial markets in specific terms?

2. If savings balances investment in U.S. in form of housing and stocks, and the severe shortfall in savings is balanced by the flow of ‘outside’ money into U.S. how does U.S. in absence of long term leading indicators of economy exude the confidence that its government deficit of earning over spending not have implications for future generations living in depravation while the present enjoy partial benefits? I would try to delve into the first question by framing the first puzzle: If markets are free how could we create giants in the likes of GM and Chryslers who were not efficient by any standard and were not the best in terms of customer satisfaction, but still were able to grow bigger and bigger every year by either creating barriers that were engineered to stop entry of competition in their segments or were based on invisible subsidies that the tax payers were unable to see, but were forced to dole out that replaced the pool of funds that could have been otherwise used to grow the economy? The growing of the big and the shrinking of the small cannot be explained so easily by the invisible hand of the market, as the market is supposed to work on the principle of efficient allocation of available resources aimed at maximizing gains for the sum total of all the participants, not partially for some while worsening for the whole. Partial benefits for some while increasing losses for the entire pool of consumers is a more recent study, empirical observations can be relied on as follows: Investment banking example: The giants created by Wall Street in the likes of Investment Banks: Goldman Sachs, Morgan Stanley or Meryl Lynch raises the obvious question if markets created them did they generate value for the whole? How do we measure this value for the whole society? What are the metrics to be used? The answer to this question is perhaps yes, they did add value for the whole, because they created products and services and opportunities that did not exist before and thus create enormous wealth for the society, for example they created the whole paradigm of mergers and acquisitions that consolidated industry players, they helped companies to trade in block shares and create wealth, they insured risk and thus created opportunities for people to take risks that could create wealth, they themselves returned money on equity to the extent of fifty percent thus creating wealth for the existing shareholders and the list could go on. But at the same time when they created products for the market that over-leveraged various asset classes in the market they multiplied risks and that in unregulated territories brought in severe distress to the markets. The markets through the self correcting mechanism did bring in parity by the de-leveraging process, but it

wasn’t through the natural mechanism that we are so familiar with but through interventions of the government and the Federal Reserve and at great peril to many participants in the market. Automotive Example: Creation of giants by the markets (left to themselves !) is a debatable topic, at least in the context of the North American market, since for many years these markets were on protected turf and only recently when the world became more a level playing field the situation dramatically changed. If choice is limited and trade is restricted through visible or invisible means markets would only allocate inefficiently and the participants in the market would through an asymmetric transmission generate value for some while neglecting the same for the rest. The best example is the power of large GM with market shares so huge that every rule by the book could be written to their advantage starting from garnering mortgage rates to dealer discounts to name anything that matters. Unfortunately all that really mattered was the product itself and the service whose decadence missed the reality check by the markets that apprised them, the financial markets in particular and the time delay in response saved the day for GM for a very long time. The increase in the power of the financial markets to influence the ultimate fate of corporations is a more recent phenomenon, with the worldwide web providing a unique opportunity for increasing transactions that increases activity and speed that increases the ability to take positions that would have been otherwise impossible to achieve. The double digit growth of the financial markets in the last decade dwarfs the pale 5% growth of the pharmaceutical market or even less for the rest of the markets. But the ubiquitous nature of power of intervention to preside over the other markets is quite a recent phenomenon. With 18% of U.S. GDP being linked to the Financial markets and with the plethora of products that channelizes money from all over the world into these markets, the power is hardly to be questioned, but the nature of market forces that modulate demand and supply into these markets leaves many questions unanswered. With large part of the information flow being in the hands of some of the participants, and with the problem of Giants and Goliaths playing the game of dice that would chart out the destiny, the denouement is a foregone conclusion; the giants win in most occasions, while Goliaths make big wins in all rareness. The low long term interest rates provided the icing on the cake for the financial markets to thrive. The housing boom was orchestrated with innovations on credit default swaps, the surge in stocks came from the euphoria about the future that the real economy failed to stimulate. But the markets had limits to self-correct. In fact it took a quite a protracted period of gloom to stabilize with foreclosures and bankruptcies to correct, which could have been corrected without these happening had the markets had the intrinsic ability to proactively change the course of movements that are unsustainable. The greater emphasis on indicators that are surreal (the financial markets have a special fondness for such indicators) and the rapid innovation in this area gives us the nature of direction in which Financial markets want the rest of the markets to move. The firms that have not gone public and whose shares are not traded on the stock exchange perhaps have fared far better in the recent downturn, as they did not have to mirror themselves for every action to find how the markets responded, not on their products but on the various metrics that the financial markets decided to measure them with. The generation of wealth and its erosion however did not happen in an equitable manner and the spoils were never shared amongst the participants. Even in this example there is reason to believe that the power of big over the small prevailed. So in the final analysis there can be no doubt that markets are limited in their scope when it comes to self-correction, as the world is entrenched in a myriad of products and services that could influence us in a million ways, but fail to create symmetry. If supply would find its own

demand and if demand is created from the natural consequence of needs and innovation, why would we have such large movements leading to generation and erosion of wealth? At least selfcorrecting markets would have avoided such overture by punishing those quite early in the game. On the contrary the punishment in the recent case went beyond the boundaries of market participants. I still fail to understand how stocks globally can grow at double digit rates while the world economy still crawls and the media could be agog with news of the wonders of growth in all forms. The future is being reshaped through interventions that would stymie the rise of unfettered money supply into products that do not serve any useful purpose for the whole society. The increased volatility in commodities is itself the sign of this increased supply that is not regulated by any means. The derivatives environment itself would need a thorough oversight that would rein in the nature of activities that waxes and wanes the turgidity of the markets. We still have a long way to go to make markets responsive to needs of the common man, a sheer waste this one that ignores the potential it entails in terms of growth in a wide array of possibilities. To my second enquiry I have a predicament that drawing from the future is a norm of the current times as the human mind is entrenched in a belief that the rate at which money needs to be discounted must be high, in fact too high thus generating the unambiguous feeling of great comfort in enjoying everything in the current moment through consumption and leaving precious little for the future. But if discounting rates are high, so should be the long term interest rates, to balance out, something that baffles me until I saw the movement of interest rates in that direction very recently. The world of consumption can only be stopped through the northward movement of long term interest rates, something that would be derogatory to the cause of current consumption, but that is the way to balance over-consumption that brings no good to the society. The world still has two compartments; one is full and the other empty. It is only by filling the one that is empty we should focus, not filling the filled that can only over-flow. The policy actions for the future should rather be directed towards this ideology if we do not want the future generations to spend their precious years working hard for the checks that we are drawing now; balance can only be restored if focus shifts to virgin markets, far away from the rustle and bustle of the developed markets where efficient use of capital is limited and innovations would rather create distortions instead of making overall gains happen for the whole. Policy actions by the Government should be directed towards this objective, not creating conditions where Paul-Peter principle could be proliferated with increased fervor.

By: Procyon Mukherjee Zurich 3rd June 2009