The turmoil in global financial markets is taking its toll on investors and general public. We the tax payers are forced to bailout imprudent bankers and clean the mess they have created over the last 7 years. The British PM and the Chancellor say without a bailout, the UK economy would have come to a standstill and the effects of the recession would have been exacerbated. Search for the culprits of the continuing mess is still on. Prime suspects are CEOs of major investment banks taking home multimillion pound bonuses thanks to the toxic waste they have created, branded well and sold to unsuspecting investors. Hedge funds are also singled out. They are the smaller villains in the market, looking for quick profits, punishing weak members in the flock by short selling and engaging in all sorts of games using leverage in organized and over the counter markets. It is said that we are now in the era of “de-leveraging”, i.e. “cash is the king and safest bet in the turbulent times.” De-leveraging is like detoxication after clubbing and binge-drinking. We don’t necessarily stop drinking and become teetotal for the rest of our lives after the fresher’s week’s excesses. It is prudent to stay away from alcohol for a couple of days to give over-working liver a break; however a total abstinence will be quite a socially deviant and probably socially-depriving behaviour in this historical epoch of “drink to be social”.
We should expect a good detoxication period in financial markets which may last a year or so. However, the dust will eventually settle and confidence in the essentiality of creating new financial products to be the leading players in financial markets will be restored. It was that kind of confidence among bankers that led to invention of exotic products, which eventually pushed the markets into turbulence. Market professionals are imitative creatures like the rest of us. They like to imitate products created by their rivals. Just as we follow unsolicited fashion without any practical necessity motivating us, market professionals create and imitate products without a universal practical need/demand called for by investors. However stakes of innovation and imitation is much greater in financial markets than following fashions in social life due to the nature of the beast. Global investment banks create products and then create the demand for them by spreading the word about how great and must-have their product is. Then they create a market for the products by becoming market-makers. They promise investors that there will always be a market for their products. But they can refuse to buy them back if the informational asymmetry they enjoy evaporates all of a sudden and everyone realizes the toxic nature of the product. Informational asymmetry between the market-maker and the buyer means that the house always wins unless the law-enforcers say no. This was the case in February 2008 when major global investment banks refused to buy back auction rate securities, a type of debt instrument which was invented by a global investment bank back in the 1980s. It was only after a law-suit filed by investors in New York, the banks accepted to buy back more than 50 billion USD worth securities as such.
Probably in hindsight, investors’ perception about auction rate-securities will be like our current feelings about dungarees, not so glorious, are they? But can we be 100 per cent sure that the latter will never make it back and we won’t flock to high-street shops to buy a nice pair of dungarees? Like fashion objects, financial products are cyclical in nature, some will be in vogue and sexy while others will be seen as old-fashioned and boring. Investors will be convinced by product designers that it is sexy to buy exotic products again. Not only will it be sexy, but it will also be very profitable to buy them when the demand for such products will be soaring again. After all, supply and demand mechanism still works in the markets and no one can afford to be left out when the buying frenzy means profits even if the product traded is actually toxic waste that may eventually explode and poison the whole system. As long as there is no fundamental change in the way the innovation is regulated, more cyclical global crises are to come. After all, it is millions of tax-payers who take the brunt of reckless behaviour of few thousand market professionals imitating each other and creating collective irrationality clandestinely until it turns into a systemic crisis. So whatever trickle-down effect financial innovation is claimed to bring to public, it takes more than it has given to the public in a crisis like this. It is time prudence, simplicity, and transparency become fashion among market professionals.