Can We Use Reflexivity to Analyze the Current Crisis?

After giving a brief introduction to the concept of reflexivity last post, I will try to use the "theory" to analyze the current credit crisis. I will make several generalizations during this discussion, but bear with me.

First off we should define the crisis we are discussing. Since the summer of 2007 the credit markets segment of the capital markets has been locked up. Liquidity has evaporated in many previously highly liquid debt markets - auction rate securities, collateralized debt obligations, student loans, etc. The key here is how we define the underlying trend. I define it as a tightening of credit across the board. This is not a subprime crisis, or a mortgage crisis, it is a credit market crisis and it has painted a broad brush across most debt markets.

This underlying trend of credit contraction, unchecked, has several negative implications. Mainly, as credit contracts to certain asset markets, the value of the assets in those markets falls. Let's use a house for example. A house may be worth $1,000,000 if credit is widely available for anyone to borrow 100% of the house's value in order to purchase the home, however when credit is withdrawn and is only available up to 80% of the value and the borrowers are constrained by additional income requirements, etc. the value of the home may fall to $500,000. The price decline may be assymetrically greater than the decline in credit availability but I assume the prices ARE a function of the credit availability.

That is a great micro example of the phenomenon of credit contraction, but you can imagine how it is affecting the banking sector (the creators of credit). The banks have extended massive amounts of credit and then hold that credit as assets on their balance sheet, either in the form of a retained loan portfolio or possibly securitized loan products. Ironically enough, the value of these "assets" are impaired on a macro level just as credit contracts on micro level. Why is this bad? The banks are forced to write down the bad loans on their balance sheet, but their liabilities do not necessarily decrease by the same percentage. Assets - Liability = EQUITY. Banks make NEW loans based on the equity they have available to lend. Banks which have declining equity also tend to reign in the amount of loans they are making and the try harder to control the quality of loans they are making. This in turn subtracts credit from the market. What does this give us? A vicious cycle of credit contraction and asset price declines along with many bank failures.

Now lets tie this back into the reflexivity analysis. The above layout is my personal (UNBIASED - ;) j/k) analysis of the underlying trend - this reflects the "cognitive function." This however is not the end of the story.

The next segment of the reflexivity analysis is the participating function or manipulative function. This is where human interaction with the underlying fundamentals either vis a vis market participants or regulatory action affect how the process unfolds and at what speed. The current bias of market participants is that the economy will recover in the second half of 2008 and the credit crisis will be over soon. Regulators are encouraging this perception by explaining the credit market issues as a crisis of confidence. (Aren't they all crises of confidence.... ;) j/k)

Anyways - let's call the regulators the following: the Federal Reserve, the US Treasury, SEC, and Congress. They are trying to arrest the fall in asset prices and thereby restore confidence to the credit markets. How are they doing this? They are exchanging very liquid securities (i.e. US treasuries) for securities of dubious value (i.e. mortgage backed securities, etc.) The banks who participate in these loan agreements then become more liquid and trade treasuries for cash as need be, whereas previously the mortgage securities may have only traded for $0.85 on the $1.00 that was instead received from the FED as the government participant.

The FED has also dropped the fed funds rate precipitously to encourage credit expansion. Unfortunately for the FED they have as of yet been unable to arrest the underlying trend underway as of yet. Some of the banks have written assets down more aggressively than others, but it has become readily apparent to the astute observer that we would have had multiple bank failures by now if not for the bailouts of Countrywide, Bear Stearns, and now WAMU. It is also clear that the FED is willing to backstop and favor certain banks to attempt to keep some strong ones in the market (i.e. JP Morgan.)

How can we reconcile these two countervailing forces? What is stronger? I think the underlying trend is more important and will triumph. I think it is too early to buy US financials and investors should stay short the US market as thing will get worse before they get better.

The analysis of course would not be complete without discussion of the unintended consequences of the participant's bias. The massive government backstopping and intervention in the market has resulted in continued pressure on the US dollar with it hitting new lows every day. Commodity prices hit new highs with oil around $120 per barrel. Perhaps more importantly the US government is threatening the integrity of our currency and public debt situation in the long term in order to apply a short term bandaid. Let's hope that there are still resources left over as the crisis continues to accelerate.

Regards,

BG

Reflexivity - What Does That Mean?

Last post I discussed a new book by George Soros covering the current credit crisis and rehashing his theory of reflexivity. This post will explore the framework of Soros' "theory" and discuss whether it is of any value to anyone other than Soros. Soros insists that now more than ever the theory can guide and help us through this difficult time and failure to recognize its potential now will set us back severely in the future.

I don't doubt that reflexivity is meaningful to Soros. He has a long track record of success in both business and philanthropy, but is it really something that both policy makers and business people can apply to the current situation on their own without a brain transplant? :)

Soros' basic point......... as I understand it....... is that whenever we try to analyze human behavior or events that involve human participants we are unable to gain any true knowledge into what is going on. We can formulate working hypotheses that may be able to explain certain processes, but these postulates are only useful as long as they work. It is basically inevitable that they will be proven wrong as the bias that facilitated their utility disappears or is revealed. Mankind's understanding of ourselves and the universe around us is constantly changing / evolving, that in turn will effect what humans do. How can we have some uniform theory or principles governing human behavior if that is the case? Soros' point is that we can't ....... at least in the traditional sense .......... of developing some kind of math problem or theorem that guides us.

So what can we do? First we can recognize our inability to gain true knowledge of the human condition as it extends to business, politics, friendship, whatever the issue may be. Second when we do try to "understand" a certain process or issue we can try to identify two of its main components.

The first component is the mechanics of the actual underlying process. What is the underlying trend and what are its effects / implications? He calls this the "cognitive function" because we are just trying to get as unbiased an understanding of what is happening without judging how or why.

The second component is what he calls the "participating function" or manipulative function. This addresses the bias possessed by participants in the process and any regulatory authorities which are monitoring or supervising the process. Sadly, they tend to perceive the process they are participating in as an absolute governed by some kind of universal law when in fact they are just operating under the prevailing bias of the moment. The list and examples of these is long......... Nasdaq stocks in 2000, real estate market over past five years, value traps in banks and financials over past 12 months.

The maximum profit opportunities in financial markets tended to arise for Soros when he was able to develop some particular insight into the underlying trend and then make some kind of unbiased assessment as to its strength or potential. When the underlying fundamentals reached a point far enough away from the prevailing bias it was then an optimum time to take major positions or make major bets in a certain direction, as when the prevailing bias was recognized as false the bottom tends to fall out of the market and windfall speculative profits might be made.

Soros use of this theory of reflexivity has helped strengthen his conviction at certain times and enabled him to stay and make large profits while others folded or doubted themselves. There are of course several issues with this approach.

Mainly is there anyone other than Soros that is really capable of applying this theory? Who is smart enough or experienced enough to possess the judgment to correctly analyze the current trend and then also be able to tell when the prevailing bias has become unsustainable?

My personal opinion is that most people cannot apply this theory for any use. It may provide a useful framework for making decisions under uncertainty, but it seems to me that everyone who applies it will apply it differently due to their own bias and misconception.

I don't think that is enough though. I think to fully explore the theory we will have to work through two or three examples of unfolding trends /bias and make some forecasts regarding the eventual developments using the theory.

Then maybe in retrospect 2 -3 years from now we can see how my own bias' clouded my analysis at this time.

-BG

A Guiding Light Through the Darkness?

I know...I know.....the title of this post is pretty corny. I was shocked and excited to find out that George Soros released a new book just this past Wednesday titled "The Credit Crisis of 2008." Soros is one of my all time heroes in terms of his accomplishments and ability to analyze this complex world of ours through a unique looking glass. He has written many books over the past 20 years but none of them deal directly with the financial markets.

He has written extensively regarding George Bush and a failure of the United States politically, but the last book that he wrote regarding the economy, investing, financial markets was in 1987 and was titled "The Alchemy of Finance." This is a classic classic book on investing, trading, speculation and I have read it several times. I don't think that it is pure coincidence that Soros decided this spring to publish a new book about his view of the financial future of our country / the world. I also don't think it is a coincidence that Soros has taken control of managing the wealth of his foundation again after a 7 year hiatus after farming it out to external managers back in 2000.

This is an unprecedented time of change in the world and just as Soros perceives huge risks this time around, I am also sure he is back because he sees the opportunities for huge speculative profits for those who grasp the implications of these changes and are willing to take the associated risks.

I have read the new book already and I think the ideas in it are excellent. Still, even for Soros who has challenges with the English language, I thought it was poorly written. The theoretical part where he discusses his theory of reflexivity is a very significant and essential part of his discussion but it is still very murky reading. Despite trying to discuss the concept for 20 years and explaining how important the theory is - Soros basically reprinted his previous discussions on the topic. This would not be a problem except for the fact that the explanations were never sufficiently clear in his previous works.

So Im thinking that it might be an interesting exercise to write a few posts over the coming weeks concerning the theory of reflexivity and Soros' expectations regarding the forthcoming five years and what is in store for both America and the financial markets. Soros repeats ad infinitum how important the theory of reflexivity is, but what use is the theory if he is the only one that understands it and can apply it? Also, what use is the theory if 100 people apply it very differently and it yields no uniform results other than to make us more conscious of our own limited understanding of the events unfolding before us.

Anyways let's give Soros the benefit of the doubt here and assume based on his track record that he has something useful to say here and it is worth trying to understand. I will not do a chapter by chapter summary / book review. Instead I think I will break the posts into a discussion of the theory and then Soro's application of that theory to the current crisis. My aim will be more than to just paraphrase. I'm hoping that we can dissect the "theory" of reflexivity a bit deeper in order to see how much is there. We will also try to use plain English for the discussion!!!

Regards,

BG