Monday, December 31, 2007

What We Learned in 2007

Review time, class. What did we learn this year?

We learned "liquidtiy" and "risk" don't mean what many of us thought they meant.

The transition from cash to credit has been so pervasive as to go unmentioned – until this year's "liquidity crisis." Henry Kaufman called attention to the New Financial Order in a WSJ op-ed:
In the decades that followed World War II, liquidity was by and large an asset-based concept. For business corporations, it meant the size of cash and very liquid assets, the maturity of receivables, the turnover of inventory, and the relationship of these assets to total liabilities. For households, liquidity primarily meant the maturity of financial assets being held for contingencies along with funds that reliably would be available later in life. In contrast, firms and households today often blur the distinction between liquidity and credit availability. When thinking about liquid assets, present and future, it is now commonplace to think in terms of access to liabilities.
That's why this year's meltdown is now more accurately called a "credit crisis."

Wall Street took pride in its ability to assess, measure and manage risk. Wall Street not only failed, it didn't know what it was up against. In an earlier post, we referred you to a John Bogle's talk containing an instructive quotation from the late University of Chicago economist Frank H. Knight:
. . . uncertainty must be taken in a sense radically distinct from the familiar notion of Risk, from which it has never been properly separated. The term “risk,” as loosely used in everyday speech and in economic discussion, really covers two things which . . . are categorically different. The essential fact is that “risk” means in some cases a quantity susceptible of measurement, while at other times it is something distinctly not of this character. A measurable uncertainty, or “risk” proper, is so far different from an immeasurable one that it is not in effect an uncertainty at all.

* * *
The facts of life in this regard are in a superficial sense obtrusively obvious and are a matter of common observation. It is a world of change in which we live, and a world of uncertainty.
Wall Street believed measurable risk was divisible. If packages of risky loans were sold to hundreds of investors, no one investor could run more than a modest risk of loss. Turned out that real risk–uncertainty –is viral. The more you spread it around, the more there is.
In a recent Washington Post column, Robert Samuelson described the 2007 crisis this way:
Since 1980, America's financial system has changed dramatically in ways that are now arousing widespread anxieties. Many loans once made directly by banks are "securitized": packaged into bondlike securities and sold to investors (pension funds, investment houses, hedge funds and banks themselves). There's been an explosion of bewildering financial instruments -- currency swaps, interest-rate swaps and other "derivatives" -- that are used for hedging and speculative trading.

Until recently, the transformation seemed a splendid success. Credit markets had broadened; risk was being spread to a larger spectrum of investors. So it was said. This was an illusion.
Will the new year bring high-net-worth investors who are more reluctant to borrow from their private bankers?

Today's Wall Street Journal sees a "flight to simplicity." Will investors amateur and professional turn from complexity to the simple comforts of stocks and bonds?

We'll find out in the new year.

There are known knowns. These are things we know that we know.

There are known unknowns.
That is to say, there are things that we know we don't know.

But there are also unknown unknowns.
There are things we don't know we don't know.

– Donald Rumsfeld

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