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The inmates had taken over the asylum

By Prof. Brett King

16 October, 2008

With the recent collapse of Lehman Brothers, the bail-out and rescue package from the US government for AIG, the EU rescue package, Merrill’s sale and so forth, many are asking if the full impact of sub-prime is still to be felt. Learned commentators like George Soros have said that the worst may be yet to come depending on how quickly the central banks and governments stay ahead of the crisis. Whatever the case, no one is likely to deny that the impact of this financial disaster will be felt for a very long time, perhaps changing the future market participation model in a fundamental way. The real issue here is why did it happen, and have we learned something from the sub-prime crisis?

To examine why the impact of sub-prime has been so complete and so devastating, we need to understand the fundamental changes in investment behaviour that have come into play in investment houses and financial institutions over the last 20-30 years in developed economies. With the deregulation of the US financial markets starting in the 1970’s, the repeal of the Glass-Steagall Act in 1999, and the internationalization and globalization of US financial market strategy, we saw a gradual shift in investment behaviour toward more aggressive risk strategies and more adventurous and creative financial structures. Emerging from this environment were broadly two types of institutional investment behaviours. The first was a long-term horizon view that is embodied by the likes of perhaps more rational investors like Private Equity investors, VC firms, and market makers like Buffet and Soros who believe that you pick assets that are undervalued, or try and improve the value of an asset through strategic investment and good management/governance. Then over a medium-term investment horizon you can build a portfolio of assets appreciating in real value. The second predominant behaviour was to pick an asset whose price is low, track or trade to build momentum in a sector or niche, and look for opportunities to leverage off strategic investments in that sector through clever financial instruments or financial mathematics to capitalize on price gains, or even create the perception of value to raise the price.

Arguably the initial evidence that demonstrated this behaviour was becoming institutionally accepted was exhibited when the likes of Michael Milken (who almost single-handedly created the market for high-yield bonds also called junk bonds) became popular heros of the markets during the 1970s and 1980s. This was a price and analytics driven approach to investment trading, with no real concern over the underlying asset value. The objective for traders like Milken was simply to maximize the benefit of a trade, and value really didn’t need to have a lot to do with this type of investment strategy if the price was right. Speculative or price-driven trading has the sole aim to pick winners where the current price range is viewed as opportunistic for future price gains. Speculation is, of course, nothing new. The Dutch experienced it with the great Tulip Crisis of 1593, the impact of the Wall Street crash of 1929 and the dot com bubble were also keen evidence of speculative driven market behaviour. The thing that has changed in recent decades is that where speculators normally are reined in by more rational investment behaviour, we’ve seen the largest institutional investors taken over by those who argue through financial mathematics and analytics on the basis of price trade/strategy without a strong appreciation of the underlying asset.

In recent times, Islamic finance has become an emerging field of interest from developed markets like the UK, through to emerging markets in Asia and the Middle-East. Islamic finance and banking products have the same purpose as conventional products except that they are bound by the rules of Shariah. The basic principle of Islamic banking is the sharing of profit and loss and the prohibition of Riba (usury or interest). Most Islamic products are based on a Shariah compliant contract, and secured by an underlying asset – essentially an asset-backed securitization. The reason I rais this is that interestingly the US sub-prime crisis would never have occurred under Shariah principles because the creation of financial instruments that speculate on price are simply not allowed. Under Islamic finance, unless the product can be supported by a contract attached directly to an underlying asset where downside risk is limited, Shariah simply doesn’t allow such speculation. This is an underlying precept because Islamic finance is essentially seen as a social tool, and not purely a mechanism for profitability. The so-called developed economies, could certainly learn from the principles of Islamic finance in today’s crisis.

The speculators and traders who have dominated Wall Street and the global financial markets for the last 20 years, have finally began to learn that just because you can manipulate or effect price and just because you can create value through clever instruments, doesn’t mean you can create value. Value is something that comes only through taking a longer-term, more strategic view of investment. The more you manipulate the instruments away from the underlying real value of an asset, the more speculative the investment becomes and the more susceptible to manipulation.

The sub-prime crisis was a result of unchecked speculative behaviour and analysts trying to be clever with financial instruments that were intended to hide debt off the balance sheet in special investment vehicles, or re-classify the risk associated with an underlying asset from very risky to a AAA rated investment class proposition. The underlying assets shifted from becoming real-assets to speculative financial instruments that were placed in between the original sub-prime “assets” and the market.  The inmates had taken over the asylum, and those that argued on value where dismissed as traditionalists who did not understand the market mechanisms of the modern financial system. The investors who have consistently held you buy something you believe in, you nurture something of value or you buy when an asset is undervalued have essentially been proven right.

It is time to bring back the appreciation of value economics and long-term market participation, and not just speculative participation based on price alone. While it might be a little bit more boring on the markets without such dynamics and volatility, we need some sanity back in the global financial markets for the time being. Let’s hope we’ve learned our lesson and we can inject some real value into the equation, instead of trying to create value from pure speculation and clever financial mathematics.

About the Authors

Brett King is one of the former staffers of the training offices in Dubai that was formerly recognized by the American Academy of Financial Management, a global organization dedicated to improving the skills and careers of financial professionals everywhere. .

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