A wild day on the markets

The Dow Jones Industrial Average fell nearly 1,000 points today, the largest intra-day fall since 1987.

It’s not quite certain yet what caused it, with some blaming an “erroneous trade”, possibly via human error or a computer glitch. It seems the initial fall, whatever the cause, then triggered many more sells as paranoia over the global situation, particularly Greece, grew. Crazy!

Prior moral hazard and the credit crisis

Were inextricably linked.  A quote that illustrates this to me strongly came from a Bloomberg article today.  The ECB decided to tell the countries that have high soverign debts to go to hell, and now that they aren’t going to take on the risk themselves private investors aren’t willing to and are selling.

This makes sense, previously people purchased the junk on the basis that someone else would pay for it – high return low risk!  Now that they have to face the real risk profile they are like “f**k that”.  However, Bloomberg (or at least David Kovacs) stated:

The reason the market is horrified now is Trichet said it’s not even being discussed. Smart investors are basically selling risk(y) assets

No s**t.  An asset appeared low risk, and now it is high risk, and the expected return is (at most) unchanged – so the risk adjusted return is lower.  No wonder they want to sell.

Now we are in a crisis, and if there is a run on good quality debt because of concerns we have to do strange things – sure.  But we need to come up with a system that rips this moral hazard out of the system.  It is the moral hazard that helps to drive crisis after crisis ultimately.

Open Source software vendors: recession resistant?

Apparently Red Hat, a vendor of a commercial linux distribution, has been doing well during the recession. This makes sense intuitively, people are looking for ways to cut costs due to the economic climate, and giving Microsoft less money seams to be a good way to go about it.

This reminds me of a classic interview question people get asked by investment banks, “Can you think of an asset with a negative beta?”

So next time someone gets asked that question they can say something besides “funeral homes” (stocks brokers jump out windows during recessions etc.. the most common answer or so I’m told!) . They can say that open source software vendors might also:)

Cramer v Stewart: a bit disappointing

I just watched the Jim Cramer vs Jon Stewart showdown on The Daily Show and I’m just not as impressed as some others. Stewart’s real problem with Cramer seems to be that he should have known that the meltdown was coming and told his viewers. By advising them to buy stock that he should have known was bad he is jointly responsible for the fomentation that led to the stockmarket crash. There are two reasons why I’m not convinced: Read more

How I learned to love the bubble

This fascinating article about experimental economists’ research into financial bubbles suggests that bubbles are a natural event on the way to equilbrium. The researchers set up an artifical market with identical assets, known dividends and a finite end period. With the value of the asset clearly defined in each period by the remaining dividend payments, the researchers expected prices to closely track the asset value.

Again and again, in experiment after experiment, the trading price runs up way above fundamental value. Then, as the [final] round nears, it crashes.
. . .
Based on future dividends, you know for sure that the security’s current value is, say, $3.12. But… you don’t know that I’m as savvy as you are. Maybe I’m confused. Even if I’m not, you don’t know whether I know that you know it’s worth $3.12. Besides, as long as a clueless greater fool who might pay $3.50 is out there, we smart people may decide to pay $3.25 in the hope of making a profit. It doesn’t matter that we know the security is worth $3.12. For the price to track the fundamental value, says Noussair, “everybody has to know that everybody knows that everybody is rational.”

Read more

No fiddling while Rome burns

Anyone who’s been concerned at the size of executive remuneration at financial firms will be excited to hear about Credit Suisse’s latest move. Rather than allowing its executives to fiddle as their mortgage backed security investments cause the balance sheets to go up in flames, CS is paying its executives bonuses in illiquid mortgage-backed securities.

I wonder if, given the risk associated with those assets, their bonuses will be correspondingly higher. I wouldn’t want to be the one explaining to shareholders that bonuses were surprisingly high this year, but it’s actually OK because…[drowned out by lynch mob]

ht: Megan McArdle