mindmoneymarkets

Extended volcanic weekend reading

I've had a lot of time to kill over the last few days thanks to busy travel schedule made even busier by the volcano. We were due to fly from Vancouver at 4 on Thursday via the cheapo Canadian Affair (Thomas Cook airlines). The website kept saying the flight was due to leave for Gatwick at 7.15 PM, just 3 hours delayed. Several phone calls to their customer service claimed the same. This was despite everyone else in the entire world knowing that Gatwick was closed unlikely to open in time for us to land. 

Shoddy customer service is par for the course in my experience with Canadian affair. With low expectations we arrived at the airport, walking past the closed BA desks to a small but confused mob of people at the Canadian affair desks.

One hapless chap was trying to tell us what was going on, not helped by the fact that not a single Canadian affair central office bod had deemed it useful to stay up late, so no-one at their end could be contacted.

The plan was to fly via Glasgow then a 12 hour coach ride down to London. People we confused as to why crappy little Thomas cook was flying and not BA etc. The captain was brought out to explain that Glasgow was open and the cloud had lifted over that airspace. We had been given one of the slots in the lottery.

Eventually we took off for Glasgow, but landed in Manchester with a mercifully shorter coach ride to London. We didn't realise just how lucky we were to make the wedding on Saturday until we saw the news in the UK and saw the full extent of the flight ban.

Anyhoo, on to the book review....

The delays over the weekend weren't too bad and with all the travel we've been doing, I've been able to finish off too very good books. 

Reckless

The first is Reckless: The Rise and Fall of the city by Phillip Augar. I was a big fan of his previous book - Merchants of Greed, written about the dangers of investment banking from a first hand perspective. It was very well researched and prescient given what was to come with the Credit Crunch.

Reckless (also released as Chasing Alpha), takes a wider look at the City of London and how it rose to prominence in the last couple of decades and the implications this had during the credit crunch. Augar takes a look at the political, regulatory and geographic factors that all contributed to the city's success. The FSA's light touch regulatory environment played a crucial role in ensuring business took place through London.

With the election debate raging in the UK, the political implications are fascinating. The book is apolitical, explaining how previous governments all played their part. The biggest blame has to go to the most recent labour govt though as the city boomed to dangerous levels under their watch. It seems the govt was too entranced by the money pouring into public coffers to dare question the risks that over reliance on this sector posed. Rather like the banks and hedgefunds themselves who were quite happy to dance until the music stopped.

I enjoyed the book and thought that the sections on regulation and the history of the city were particularly strong. Some sections were disappointing though with the section on Northern Rock revealing nothing more than has already been reported elsewhere.

I'd recommend it though particularly with the UK general election round the corner. This and the next book I'll be mentioning both give lie to Gordon Brown's claim that Britain has been an innocent victim of a US led global credit crunch.

Far from being an innocent victim, consider the following:

• 50% of the dangerous OTC derivative trades went through London thanks to the light touch regulation. The recent Goldman's headlines involve a trading working from a desk in London.
• The same regulation played a role in the collapse of Lehman brothers thanks to the use of their repo 105 accounting sleight of hand, made possible by lighter UK accounting rules. 
• Many British traders were involved in the creation of the Credit Default Swap market as Gilliant Tett outlines in her book I review below.
• AIG Financial Products was the division of AIG responsible for the Lion's share of the firm's losses due to taking on CDS liabilities. This division based mainly in London. 

Fool's Gold

With irony, I finished Gillian Tett's Fool's Gold, just as the news was breaking on the Goldman Sach's charges. The story chronicles the creation of Credit Default Swaps and other OTC derivatives by focusing on the small JP Morgan team responsible for their creation.

I was absolutely gripped by the narrative. Not only is the book well researched, it is a heck of a good read. We start with the tales of the close knit group excited by the financial game changer their created and move forward through the years as other banks latch on to the idea without fully understanding its implications.

The JPM team originally applied CDS to commercial loans but couldn't figure out a way to apply to mortgage securities due to lack of past data and concerns over correlation. Other banks quickly out paced JPM with their derivatives trades as they applied CDS to the one area JPM couldn't get to work - mortgages. Three times they tried to figure out what they were missing, what other banks had spotted that they couldn't and each time stepped back from the deals.

The truth was quite simple as the Goldman's case implies. Other (investment) banks either did know about the risks and pushed through deals anyway, or just didn't understand what they were buying and selling. 

The are some incredible lessons to be learned for ones personal trading such as not trading markets,  ideas or strategies you don't understand.

I found Fool's Gold to be absolutely fascinating and highly recommend it.

Will the FSA catch the next big scam?

Fascinating interview with Harry Markopolis, the guy who exposed Madoff, but was never listened to. Hat tip Barry Ritholtz

This line stood out for me:

"The five commissioners of the S.E.C. are securities lawyers. Securities lawyers never understand finance. They don’t have the math background. If you can’t do math and if you can’t take apart the investment products of the 21st century backward and forward and put them together in your sleep, you’ll never find the frauds on Wall Street."

Could the same be said about the FSA, not just in relation to scams, but to what the banks are up to?

Free market proponents would argue that financial markets can regulate themselves. Evidently this is not the case. The problem is with the hypercomplex deals that most people including banks and pension funds do not understand. This story is a good example of this happening.

The author's conclude:

Christopher Whalen, a senior vice president and managing director of California-based Institutional Risk Analysis, said that foreign banks "got stuffed" in the Caymans deals, but that Wall Street dealers typically averted litigation by buying back failed securities at a discount to avoid court fights. Any investors who sued would face the threat of being "blackballed" — shunned by Wall Street firms, he said.

The CDO devastation, Whalen said, underscores the need to close a "disclosure loophole" that allows Wall Street to avoid publicly reporting these deals.

This is not markets regulating themselves, its the wild west. 

In fact, I kind of like that analogy as it sums up the behaviour of many financial firms effectiveness of the regular/ sheriff - Too many bandits.

The ugly side of human nature is to stuff over the other guy because you believe he's thinking the same thing. Goldman's Sachs have been described as a big vampire squid wrapped around the face of humanity. Perhaps it's not Goldman's actions per se that have damaged financial markets, but what it does to the psychology of other players in the field. As I outlined in this post, you're more likely to cheat if you believe your peers are doing the same.

If one of the biggest players in the markets is looking out for number 1 at the expense of others, its hardly going to have all the other players scrabbling for the moral high ground. 

Swimming naked

I love this quote from Warren Buffet:

"It's only when the tide goes out that you find out who's been swimming naked"

For me it kind of sums up this whole financial crisis. From RBS to Greece, the common thread is of companies and governments engaging in a) high risk strategies for short term gain with long term liability b) financial jiggery pokery to hide bad news c) both of these.

There is a quite frankly amazing post from FT Alphaville about the currency swap deal performed by Greece aided by Goldmans which to all intents and purposes hid the truth so they could enter the euro.

The incredible part is the S&P wrote on warning on this deal 8 years ago.

The best quote is here:

"In sum, de facto borrowing swaps do not have a positive impact on fiscal flexibility. If anything, they help to undermine transparency and, therefore, jeopardize trust in official accounting. Where uncertainty about the effective debt exposure of a government increases, an additional risk spread on the concerned issuer’s securities might be demanded by investors, thereby potentially defeating even the intended short-term purpose of improving the cash flow."

Again it brings up another thought from another wise man of finance.

When asked if there have been any financial innovations of use in recent years, Paul Volcker replied.."the ATM".

Richard Thompson has some prescient stories on the misuse of financial derivatives in his old but excellent book, Apocalypse roulette. The standout is perhaps the bankrupting of Orange County CaliforniaI'm an certainly no expert in these complex deals, indeed, I think that's the point. In some cases you have to be a rocket scientist to understand them and their implications. This is fine as long as there are well placed rocket scientists on the side of the speculators/ companies/ governments and on the regulatory bodies. In the case of Greece though, it seems that the regulator was behind the curve, just as the ratings agencies and numerous financial bodies failed to appreciate the real risk with the sub prime market.

Perhaps that's just human nature. If something is arcane and complex, the human mind has trouble fully appreciating risk that it cannot see or feel. We fear a high cliff, adrenaline kicks in, but what about the risk of Greece defaulting due to a complex currency swap?

Whatever the case, history seems to be repeating itself. To quote a not so wise man, it's dejavu all over again.

My own thought is that regulators need to put more stock behind the emerging field of behavioual economics. You can't control people, but with a greater understanding of human biases and blind spots, regulators (and perhaps the public) we might be able to avoid the aforementioned apocalypse roulette.

The Daily Trading Coach

Just received my copy of Brett Steenbarger's Daily Trading Coach.

Only flicked through it, but it looks like exactly what I need right now. Looking forward to getting stuck into it over Christmas.

Thin Slicing Blink

I'm a few chapters into reading Malcolm Gladwell's Blink. An entertaining read and Gladwell certainly knows how to spin a good yarn.

But in keeping with the advice I've read so far in Blink, I thought I'd share some potential criticism based on my initial reaction

The central tenet of the book is that we should not ignore our gut feelings – Although we can't articulate why we know something, sometimes we just get a feeling and often this can turn out to be right.

He's provided some very good examples so far of how powerful our subconscious mind can be. Another good book on this sort of thing is consciousness by Rita Carter. Essentially consciousness is what we experience milliseconds after something is happened. The conscious brain is the output of a giant filter and the bits of life we are aware of. The unconscious brain receives a heck of a lot more information and it is impossible for all of this to make it to the surface. However some of it can reach our autonomic nervous system and cause a reaction like sweaty palms. Phobias are a good example of this.

Gladwell also has some good examples of the tennis coach being able to know when a player will double fault. He can't say how he knows, he just knows. The pre-conscious brain is picking up things that the conscious brain can't articulate. Is this a bad thing? Gladwell is right, we probably do place too much emphasis on conscious decision making.

On this I agree.

However, so far, all of Gladwell's examples have involved people using their instincts to make better decision – with the benefit of years of experience. The guy who can predict the outcome of a marriage has been studying it for decades. Guidance counsellors etc performed only slightly better than chance in being able to predict the outcome of a marriage, but how often do guidance counsellors get to see the eventual outcome of a marriage?

Although our preconscious mind is very powerful, it can also be very stupid. In their book 'mistakes were made' Aronson and Tarvis provide some graphic examples of when our gut feel gets it completely wrong. A Police training strategy in the US that showed officers how to look for hidden clues that demonstrated guilt in a suspect. It turns out this training was downright dangerous and responsible for many wrongful convictions. In this case, their training taught them to listen to their gut feel.

There is also mountains of literature on the stupid mistakes we make when it comes to money, especially when we let our natural reactions take over.

Experience + gut will generally (but not always) be more powerful force than someone just acting on intuition.

The firefighter who knew how to get out of the building was using experience + intuition. The people able to judge character traits from viewing someone's room are doing so from a position of experience. We've been around people all our lives so we have all built up experience in this area. That's the difference.

So it is interesting and yes we should listen to our intuition more, but I hope he stresses the opposite side of the coin more. When to listen to your intuition and when not to. Something tells me he won't do enough of this, it might ruin the story. I'll update the review when I've finished the book.

Just a gut feel!