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Asteve
Activist
Posts:930
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| 22/05/2008 10:45 AM |
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I posted this in a discussion about derivatives elsewhere:
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My take is that derivatives are exceptionally powerful market
manipulators. They're pitched as being a mechanism by which market
forces are stabilised... but I think the converse. I think options,
futures and derivatives act in different ways - depending upon the type
of entity the derivative acts upon...
1. Some entities have
flexible supply and flexible demand. The price and margin on these
entities are driven down by improved forecasting of demand. The
suppliers are marginalised and the consumer benefits... especially if
consumers are free to alter demand patterns. This effect has definitely
marginalised first-world farmers - placing supermarkets, for example,
in a commanding position to profit at the expense of their suppliers.
"Investing long" in such derivatives is suicide - unless you have
specific information about an entity-specific crisis... or you're
having fun playing roulette with someone else's money.
2. Some
entities have fixed supply... this makes little difference except that
the derivative now represents only demand speculation - not supply.
With only one free variable, this is just a degenerate form of (1) and
prices are likely to fall as a result of decreased demand. (If I *knew*
I could "hire" the community lawnmower on Sundays, the only day I'm
free to mow, I'd not likely buy my own - hence driving down demand.)
3.
Here's the counter-intuitive notion: credit derivatives. Credit
derivatives drive down the cost of credit - just like the derivative of
entities above. They drive down the cost of borrowing - which
dramatically increases the amount of money that can be borrowed against
any given income stream... which drives up the value of all assets
suitable as collateral... including debt... hence a virtuous/vicious
cycle (depending upon whether or not you own real assets to start the
ball rolling.
Credit derivatives can be though of as insurance
for lenders. I don't worry about my car being torched while parked -
because I'm insured... I park anywhere I like. In a sense it makes me
reckless... and the same effect could be found with all forms of
lending... Once a credit derivative is obtained, there is no further
need to worry - or so you might think.
The problem, of course,
is how can the risk of the credit be mitigated? I could underwrite a
£100 loan made by a loanshark to "friend" by putting £100 in a secure
box and promising that to the loan-shark should my "friend default" -
or maybe do the same with a £200 watch - if I didn't have the cash.
But, of course, if I have sufficient capital to underwrite the loan,
why should I let the loanshark profit/take advantage of my friend? Why
don't I lend my friend the money, or borrow it on their behalf... at
favourable terms... because I've assets and (s)he hasn't? Therein lies
the nonsense in the proposition of credit derivatives.
How does
it really work? Well, the loans aren't underwritten at all... the
issuer of a credit derivative just promise to make good any defaults -
because they have sufficient assets to pay off a tiny proportion of
defaults - and, historically, there have only been a tiny number of
defaults... and miraculously - in the looser credit conditions that
happily coincided with initial expansion of credit derivatives (cheaper
borrowing) defaults tended to zero. [Which is logical, why would anyone
default if - on running out of cash - they could always borrow more
against the same assets? No-one who owned a house - no matter how much
debt was secured on it - could logically default... so, it followed
that giving cheap mortgages to the credit impaired made sense.] Another
"benefit" also rapidly arose: the debt of borrowers was perfectly
suited as collateral to underwrite credit derivatives (virtual
circle/vicious cycle - depending on your perspective - again.)
In
concrete terms, the name of the most popular credit derivative is a CDS
"Credit Default Swap". These are traded but not in an open market, as
such. Total nominal contracts in CDS have been expanding exponentially
in recent years - and vastly exceed global credit... making it clear
that issuers of CDS have become nervous about the risk and tried to
hedge that by buying a CDS to offset the risk of the CDS they sold... a
frantic game of pass-the-parcel... with the parcel getting hotter by
the second. Some non-conclusive evidence exists that nominal
outstanding CDS contracts are in excess of $40 trillion (yes, that's
the units!) or about 10 times world GDP at the time of the leak.
The
most alarmist of responses is to look at the CDS markets and have an
epileptic siezure at the size of the numbers. This misses the point...
however... many of these contracts will cancel out - and represent
insured amounts rather than realistic losses... but it is still
alarming for two reasons:
1. In an unregulated market it is
impossible to determine which CDS contracts have substantial default
risk and which do not. This means that most companies that hold
financial instruments which depend upon CDS contracts have accounts
that can't be independently verified in any meaningful way.
2.
The same lack of regulation gives rise to another risk... where the
assets used as collateral form a cycle of dependency - and, hence, are
all worthless. This bears an uncanny resemblance to the "Split Cap"
fiasco of 2004 where "Split Cap Trusts" (details unimportant here) saw
they were beating the markets... so, rather than invest in the markets,
they decided to invest in each other to keep the party going. It is
interesting to note that the Spit-Cap fiasco was the most recent
scandal before Northern Rock... and one where John Tiner (then head of
the FSA) intervened to get the perpetrators off with a fine for a small
fraction of their ill-gotten gains... It is anecdotally interesting
that Tiner quit the FSA just before Northern Rock hit the headlines...
and went to work for New Star asset management... the fund managers he
helped out after their "Spit Cap" scandal came to light.
One
thing we can conclude from the seizure of the credit markets is that
they'd become too 'optimised' to cope with any unexpected shock – such
as subprime defaults or falling house prices. The upshot is that – when
lending re-starts, it will not bear any relation to previous lending –
for at least 10 years – and that the value and supply of financial
assets is entirely uncertain at present... but almost definitely vastly
over-stated in financial accounts.
From the perspective of a
fellow angry renter, one awfully clever idea I've just had is that we
should set up a derivative market for rental contracts and house
prices. That would put the cat among the pigeons, wouldn't it?
I'm serious... anyone else think this is a good idea? Anyone have any practical suggestion as to how it could be achieved?
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chefdave
Activist
Posts:481
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| 24/05/2008 6:32 AM |
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Whilst awfully clever and clearly well researched this isn't a serious proposal is it?! A can't even set up the VCR let alone a derivatives market for rental contracts and house prices. I'm sure landlords can get insurance for defaulting tenants anyway and I know that small and medium sized business' can certainly insure against the risk that one of their debtors defaults.
Although you're dead against the idea I genuinely believe that a land tax is the best way forward at present, its certainly many times simpler and doesn't require a phd level knowledge of economics and finance in order to gain results. |
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Asteve
Activist
Posts:930
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| 24/05/2008 8:20 AM |
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A serious proposal? Well, it's a serious idea... it's the concept that I tried to illustrate.
Frankly, move from income to land tax is doomed - you need to achieve consensus - and if you think setting up a derivatives market would be hard, consensus is impossible... especially as almost all politicians own substantial land. Call me a coward if you like, but I prefer to fight easy downhill battles than uphill ones that are all but assured failure.
For the derivative market to succeed, there is an important property: the traded derivative must be settled physically - not by cash equivalent. There is already a mechanism to 'spread-bet' on the Halifax price index - but this is settled in cash, not houses, so it has little or no effect on the price of houses themselves... plus, real people have little reason to use this to reduce their exposure.
There are various ways this idea could be applied to the housing market - all of which would have a positive effect. A derivatives market is nowhere near as complicated as you might think. The essential feature of a (futures) derivatives market is this: Prices are agreed not for today, but for some period in the future... nothing more; nothing less.
In the context of shorthold assured tenancy rentals, I can see substantial benefits... For a tenant, there would no longer be the necessity - when moving from one place to another - to pay for a big overlap... in order to secure a new home... thus, if a contract were available for a new residence to be guaranteed available on a specific day in future - then there would be no need for a period of occupancy of two residences. For a landlord, the same 'future contract' offers the prospect to find a new tenant to move in without a substantial void. Such a facility appears fair and equitable but seriously favours tenants - since it, effectively, expands supply and gives them time to make the market compete for their business.
In the context of house sales, the same idea could work wonders too. By agreeing prices, maybe months or years into the future, those who intend to sell are able to reliably establish the value of their home in advance of having found somewhere to move. This means that, for example, those intending to retire and downsize can know in advance what their current house will be worth - and can enter into similar future contracts to secure their new home. The advantage to the home-owner will be that they are not priced-in; unable to move... and subject to loose their new home due to broken chains or a house that simply won't sell. By knowing their budget they are also less likely to over-bid on their new home - hence offering financial peace of mind. The advantage to the buyer is more subtle... by extending the lead time, there is no need for an estate agent to set the price... this can be done by the market. By excluding valuations by surveyors and estate agents - relying solely on market forces - instead of houses sitting empty waiting to sell, with the assumption that the agent's valuation was right and the world is wrong, the market would define the price. Think of it a bit like ebay for houses.
So, I hope you can see that the above ideas are not complex to understand... but they do act as derivative markets, which, if you followed my original post, I hope you will see, definitely will drive down prices. At present the market for real-estate is lop-sided... it disadvantages the buyer in the long term and the seller in the short term. All that needs to be done to make a success of this idea is to present the vendor with short-term advantages in order to benefit the buyer in the long term. There is no need for legislation (certainly nothing as politically explosive as a tax change) and does not be adopted universally in order to be a success.
It definitely could work... the reasons for it solving the housing crisis do require some moderate econometric analysis... but we don't need to convince anyone else of that aspect in order for it to work. All that is required is for people to be free to chose if they pick a price today, or a price in 2,3,6,12,24,36 or 48 months. They don't need to understand the market-wide consequences of their individual decisions - which should always be mutually beneficial.
When I had the idea I was thinking about a website to rival RightMove... crossed with Ebay... both of which, I hasten to add, are thriving businesses. While only an embryonic idea, if potential problems can be ironed out, I can imagine investors jumping at implementing it -- the potential profits and spin-off opportunities look very lucrative. There's definitely a gap in the market. The biggest stumbling block I can see relates to conveyancing/agent licensing... I recall that Tesco wanted to set-up a houses for sale thingummy last year - but ran into legal difficulties... I can't remember why.
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chefdave
Activist
Posts:481
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| 24/05/2008 8:54 AM |
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Ok, so its a futures market for housing, something which we don't have yet. However as with all commodities there is nothing here to stop investors piling in in order to drive up prices just as is happening to food and particularly oil at the moment except that the bubble isn't in the land itself rather in a contract as to what the land is likely to fetch in 2,4,6,8 month's time.
How does that help me when a load of 'entrepreneurs' decide to block me via the use of this system when trying to secure a home? Do you think that when Poland entered the EU and it became clear that an influx of Poles was iminent in 6 months time these contracts would have increased or decreased in price? How would that affect people simply tring to get on with their lives?
(Sorry for being ultra-cynical btw if it gets off the ground I hope you earn enough money that you're able to litterally swim in it like that Mcduck character I used to watch on Saturday's as a kid!)
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Asteve
Activist
Posts:930
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| 24/05/2008 10:23 AM |
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Cynicism is fine... and - at the moment - I'm mostly just thinking out loud... (which, if I had present plans to implement this myself, I'd not be doing...) The problems in Poland are primarily attributable to the Polish Zloty having had a preposterously weak exchange rate... which, I think, can be put down to IMF policy to correlate GDP with creditworthiness... rather than a more logical assessment of debt-free potential. In short, the way for a country to maximise the value of its currency is to engage in as many frivolous transactions as possible... and, by appearing "busy" - their economy appears to grow - driving up the value of their currency in the context of international trade. Polish people who've been working in a country with a strong currency (the UK, for example) will have no problem affording the more expensive houses when they return home... though things won't be as easy for those who've been working in Poland. This is a damning indictment of the IMF's approach to credit rating sovereign states - but this is a separate issue to the price of homes relative to the price of labour and commodities within a country.
How does this help you when a 'load of entrepreneurs' try to block you from owning a home by out-bidding you? I'll try to explain... but, first, we need to establish the motivation of the 'entrepreneurs'. Entrepreneurs don't buy homes to exclude other people from establishing a quality of life... they do it to make money for themselves. They make a judgement about the likely future value of assets based upon past performance - then “invest” (speculate, really). They're encouraged by unsubstantiated forecasts that rental value will spiral upwards - and that their asset will appreciate. Likely subconsciously - in many cases - the entrepreneur will make their decision without any concern for the fundamentals of the market - for example - future credit conditions; future earnings potential for potential buyers; cash savings of potential buyers - etc. etc. What they'll do is say "Bricks and mortar have been a great investment for X years - I see no reason that this should change." Well, guess what - this is exactly what happens with stock market bubbles... they hurt one group of people as they inflate - and another when they burst. The last stock market bubble was the TMT bubble - which was sparked by a real innovation - and widespread investor ignorance. Houses are not a new idea - so there is no similar explanation for their rapid appreciation. Houses have appreciated as a consequence of the nature of a balance sheet in Western accounting... where greater debt-based finance for an asset leads to higher asset prices which leads to greater debt-based finance etc. etc. in a vicious cycle (virtuous circle). The challenge is to break that cycle... and keep it broken. What starts the cycle is uninformed optimism among home-buyers which leads them to accept higher prices than are appropriate in the market. This is a simple consequence of the way the market functions... the home owner appears to hold all the cards – and they demand buyers compete... plenty of uninformed buyers with plenty of freshly borrowed money – and the price goes higher... no matter how insane that might, in reality, be. It is all about information... the buyer is disadvantaged as they are lead to believe that HPI is inevitable – so buying sooner rather than later is always the most sensible financial move. The vendor is empowered by the partisan behaviour of the estate agents they employ. The futures market addresses these false market indicators. The futures market accurately predicts now the price that the market will pay for the asset in future... it kills the irrational idea of HPI dead. It turns a house into a commodity rather than an asset.
The point of the derivative/futures market is to establish the minimum fair price. It empowers buyers over sellers – but it does not drive prices down to zero... it pushes them down to a fair market price. It won't eradicate speculators – and doesn't attempt to do so – but speculators in a futures market do not occupy houses – and, hence, do not artificially restrict the supply and drive up prices. Speculators in a futures market serve a purpose.... in a way that speculators in a 'spot' (i.e. immediate sale) market do not... speculators who over-bid loose money by driving up the futures price of new-builds... causing more supply – which is then, once again, subjected to market forces.
Another way of thinking about it is this: a futures market allows a fair and rational price to be set... this will drag prices down in a market that is over-valued – and support a market that is under-valued. In either case, the futures market helps regulate supply to meet demand by giving advance warning of shifts in future demand – giving people the opportunity to profit by meeting an economic demand rather than blindly speculating that there will be more debt in future.
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plainservice
Concerned Citizen
Posts:93
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| 27/05/2008 7:04 AM |
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I have no comment to make about your idea, since I don't
understand it and an attempt to understand it would make my head hurt
too much says Homer! :-)
ASteve: What makes me cringe is that your solution involves the City.
For me the City represents a bunch of crooks. I saw a headline on this
weekends FT, which says that City bonuses have
sky rocketed - well how can this be when banks are making a loss? WHO IS PAYING FOR ALL THESE BONUSES?
I have lost confidence and money in the City. Many years ago, I wanted
to buy some shares to invest so that that it could help with me a
deposit. After reading a newspaper article which said that BT shares
good prospects and [b]City analysts said that their target value is £25
per share. The price was £14 per share. I bought lots!. Guess what
happened? The price of BT shares fell to £2.[/b] So I lost a lot of money!!! :-(. It has
been many years and my BT share price have still not recovered. So what
happened?. Were the City analysts stupid? Or where these analysts
trying to sucker in private investors into buying BT shares because
they knew BT was headed for troubled times?.
What about Pensions? My parents have been paying into private pensions
for well over 30 years. Their investment made 0% over 30 years. So what
were they doing with my parents money? No doubt, it paid for those nice
city bonuses and flash cars. Though countless people are in the same boat with under-performing Pensions.
What about Endoment Mortgages? How many people go suckered into taking
those out, finding out they are faced with major shortfall in their
mortgages. The funny things is that the endowment investments are
loosing people money. The fund managers are earning a ton of money and the company running these endowment
investments are making millions for their shareholders - there is something wrong here?.
And all those US mortgages backed by bonds. Where do you think the
money for the bonds came from? US Pension investments perhaps?. What about those ratings agencies?
What about the Insurance industry - are they any better?. The latest
fad is to sell people Critical Illness Cover - yet the BBC revealed,
people who were sick and needed to claim found that insurance companies
managed to find loopholes not to pay the sick. e.g. so if someone
suffered a stroke they were told it is the "wrong type of stroke". (I personally have been robbed by several thousand pounds on car insurance....)
And another thing. Why did not the the Thief of Northern Rock walk away
with £700k payout, whist the staff working on the cash counter who earn £12k only get two weeks redundancy if fired?. There is social injustice here!
What about the .com era? How much money was sucked into that? Most of it a big con job. Few good companies came out, but the majority are down the toilet.
Sadly, for me the City is a corrupt place.....
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slicedcake
Activist
Posts:313
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| 27/05/2008 10:55 AM |
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Posted By plainservice on 27/05/2008 7:04 AM
ASteve: What makes me cringe is that your solution involves the City.
For me the City represents a bunch of crooks. I saw a headline on this
weekends FT, which says that City bonuses have
sky rocketed - well how can this be when banks are making a loss? WHO IS PAYING FOR ALL THESE BONUSES?
That's just what I'd think, -your money in their (risk taking) hands.
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Asteve
Activist
Posts:930
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| 28/05/2008 5:34 AM |
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Plain & Sliced (my, that sounds like a loaf of bread)...
If what you intend to tackle involves money, I'm afraid, the 'city types' will be involved. If you don't consider them (and here I don't mean pay them huge bonuses, but - rather - acknowledge their existence and the risks their practices pose to everyone else) then any strategy is doomed. The point about my suggestion is that it need not be implemented by city-types... it merely analyses why city-types have been successful and turns the tables on them. The only thing about my suggestion that is counter-intuitive is that seemingly small advantages on an individual basis might easily have massive systemic effects. For example, if we can avoid void periods in rentals, and the average let property expects 2 months void per year, that is equivalent to increasing the rental stock by 20%... the effects on rental prices, however, are not linear to supply. As supply meets and exceeds demand, prices collapse - and all rental prices will spiral downwards to approximate the lowest possible cost of supply. With ~1m homes on the market for potential owner occupiers... and, I suspect, a further 2m to join them over the next 2-3 years... then, the key to solving the housing crisis to get these vacant properties either sold or on the rental market... thus achieving the same magic for those who have funds and want to buy somewhere permannent.
While I may sound a bastard, I think that when people buy shares, they accept the risk inherent. If you want rock-solid returns and zero risk, that exists: NS&I investments. Incredibly easy to set-up; Zero chance of loosing your money; positive returns every month; incredibly small chance of making a significant profit.
Endowments were a major scam - but, like with shares, it should have been obvious that under performance was a risk; I'm morally opposed to insurance (though that doesn't mean I don't pay it - only that I know I'm being exploited.) I find the compensations proffered by financial institutions to be obscene... but, I wonder, will times now change? I'm unsure, but watch on with interest.
The TMT bubble was the first bubble of my adult life - and I was in technology. Compared to the mainstream, I knew my stuff... (sorry to trumpet blow) but it was obvious by 1998 that something very odd was happening. The Y2K hysteria was utterly surreal. Companies were floating for tens of millions of pounds... where I could have done a better job in a porta-cabin in six months with £100K. The writing was on the wall. In 1999/2000, I did my first 'investigation' into investment... ISAs were new and were suckering the public into buying quickly to achieve tax advantages. I talked to several "Financial Advisers"... a horrific experience... which turned frightening when it transpired that they didn't even grasp Bayesian probabilities - yet were attempting to advise on investments armed with little more than a sales brochure and a historic graph. I wasted many hundreds of hours... I read everything... and considered thousands of ISA investments... every single one I considered to be dangerous; ill-described and dishonestly presented. As I was rejecting each option, I was absolutely staggered to find that people who had scant appreciation of what the Web was (let alone the skills to set up internet operations for companies) were confidently putting their life savings into the first technology fund they came across... with no explanation other than "It doubled in value last year". I felt these people looked down on me as being 'young and inexperienced' - but within a couple of years the sob-stories came in. Most lost over 90% of their investments... one man lost 98% of his pension - he was well over 60 years old. I felt sorry for these people on a personal level, but can't help feeling judgemental too. They decided to take unquantified risks for potentially massive rewards - which, unsurprisingly, back-fired. If such people deserve to be free to speculate, they deserve to be free to hit the ground with a thud when it turns out that they're as thick as pig-excrement and have behaved accordingly. I'm only really miffed that hard working people today will pay through social hand outs because so many decided to play the lottery with their savings and pensions. I think a good rule of investment is that if you can't identify who will value your investment more highly than you do, then you're the end of the chain and it is you that will loose your savings to earlier 'investors' - if you buy.
A bubble today may well be forming in certain kinds of foreign direct investment... it seems unlikely to me, for example, that money invested in Indian and Chinese businesses by westerners can be efficiently allocated. An interesting question, for investors, however asks if there will be greater fools to come that will attempt to jump on the bandwaggon - and, if so, how much do they want to risk speculating in "emerging markets" (AKA the 3rd World)
Pensions are a nightmare... made worse, in my opinion, by government intervention. The fact that pensions are so slippery, I feel, is one of the reasons for the booming BTL investment industry... which exploits people desperate to provide for their own future, but with either insufficient intellect or effort-ethic to establish how bad an "investment" they are being sold. I'm hoping a SIPP may prove to be my personal solution - but, I have to admit, I've still got a hell of a lot of research if I'm going to be able to move confidently on this. I am hoping the government don't move to further complicate things for me with more baroque and ill-defined tax disincentives... though, I realise, this would be in-character with other government financial policy since 1997.
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