Modern finance: a voodoo science?

You've heard of voodoo economics, but how about voodoo finance?
The ratings agencies have taken a lot of flack for having to downgrade their ratings on many mortgage-backed securities and structured products. And indeed, their business model (in which they are paid by investment banks to rate products sold by the banks) may lead to a conflict of interest. But if anybody was seriously expecting the ratings agencies to provide definitive pricing and risk evaluations, they were giving far too much credence to the power of modern finance.

To think ratings agencies (or anyone else) can pin a 'true' valuation or price to a financial asset reflects a fundamental misunderstanding about the nature of financial values.

Too many factors are at work, in particular psychological and emotional factors, for the æmathematical approachÆ that the agencies rely on, to give 100% reassurance. Even more important than emotion: the future is an undiscovered country. Nobody knows whatÆs going on there. And it is future events which make or break the investor.

The problem with valuations is at the heart of the ongoing financial crisis. ItÆs no longer just a credit crisis, because the ability to ævalueÆ a product is supposedly a key skill of modern finance. In equity, for example, bankers look at future returns, discount that return at the risk-free rate, look at company, industry, regional and macro risk and come up with an answer. Debt and other securities have similar rigorous, rational assessment criteria. But recent events have shown that despite the seeming thoroughness of this process, itÆs actually pretty useless when markets dry up.

Investors do seem confused about valuations. There is no other explanation for the dichotomy in equity and debt values over the end of the summer. Equity markets dropped back and then resumed climbing to new highs. It's illogical - equity and debt are simply variants of money, and both must be equally affected by major events.

The failure of traditional valuation approaches is also reflected in the Western investment banks æwriting downÆ debts and flailing around trying to price esoteric mortgage-based products. They simply donÆt have a clue (which is why the write-downs keep getting worse) because liquidity has disappeared.

It's tempting to conclude that valuing an asset has nothing to do with laborious research into its æpriceÆ or ævalueÆ. The essence of the market is two individuals engaged in a trade finally reaching an agreement that justifies the asset at a certain price. In other words, it's the act of trading that creates a value in the asset. The lesson for investors is that they should not expect asset prices to be related to any intrinsic quality or worth. Values and prices are up for grabs, all the time.

The psychological appeal of finance to investors is similar to the appeal of horseracing û which is why many former æbookiesÆ were hired in the City of London as the finance sector exploded in the late 1980s and 1990s (I should know, I was one). But the similarity between a banker and bookie goes further than skill at mental arithmetic (presumed rather than actual in my case). Both industries offer the hope to their clients that delving through vast amounts of data can lead to success. Both promise to predict the future from that data. And both are equally liable to failure.

The similarities donÆt end there. Take structured products in finance. These have all the hallmarks of the betting products you can buy at the track. One of the most popular products in my time was the Yankee. A Yankee consists of 11 bets involving four selections in different events, that is six doubles, four trebles and one four-fold. A minimum of two of the selections must be successful to get a return.

Confused? So were most people, but the huge rewards promised by these highly unlikely combinations made them shell out more for these æstructuredÆ bets than for the simpler and safer straight bets. Clearly, complicated bets with bizarre names satisfy the investor/gamblerÆs craving for the semblance of sophistication. After all, the very fact you can throw around names like æCanadianÆ and æSuper YankeeÆ gives you a certain cachet û even if you do end up losing your shirt.

ThatÆs not to say that skilled, professional gamblers donÆt exist. Over short periods, they can beat the laws of average. But the point about a gambler is that he is fully aware that he is ægamblingÆ, that is, relying on uncontrollable, random events as much (or more) as judgment. Much of the finance industry seems to be aimed at suggesting you are not gambling - that financial techniques are now so evolved that risk or chance has been eliminated. Recent events suggest thatÆs very much not the case.
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