Complex Securities – Current Issues
Posted on July 3, 2012
Keller Graduate School of Management, DCNY
DeVry Northeast Scholar Conference, 2012
Topic: Lack of understanding of the secondary markets (by Frank Owarish, Ph.D.)
Issues
- The markets: the markets have grown in size (volume of transactions) and in complexity (types of transactions); in addition to the auction markets (NYSE, NASDAQ etc) the OTC markets have expended tremendously; transactions are increasingly done electronically; the markets have become globalized (in the sense of being interrelated and mutually affecting each other (time zones considerations, local/international economic and financial news); stocks listed in one market can be traded on another and often do so with variances; there are those who know so (generally institutional investors including hedge funds) and take advantage of it as compared to those who do not.
- The game: speculation has taken over with large volume of short term transactions as compared to the long term horizon of investing; the large players drive the markets often through computer trading; the rip tide effect; less sophisticated investors often panic and sell to minimize their losses as compared to those who know better and hold on; the losers sell at very low prices which represent bargains for the big guys that conduct sweeps to then later resell at higher prices reaping huge profits.
- Information: there is on the one hand not enough information available to the average investors (the right kind of information that is) as compared to what is available to the more sophisticated investors; there is an information overload on the other hand which can be confusing to the average investors. The sophisticated investors e.g. hedge funds always benefit from strong market efficiency whereas the average investors struggle with the weak or the semi-weak markets efficiencies which should be better called market inefficiencies. The EMH no longer stands the test of reality. While the academics have favored EMH for a long time, the practitioners have always called it ‘pure rubbish’.
- Hedge funds: have all the information they need in sophisticated computer-based models and analysis so that the random walk for them is in fact a sure walk; the hedge funds are starting to comply with the new SEC reporting requirements, minimally; they are also developing new financial creatures, stealth in nature, below the SEC ‘radar’.
- CDS and CDOs: CDS are non standard insurance-like contracts. Banks and insurance companies are regulated, the CDS market is not. Commercial banks are the most active in this market. CDS were seen as easy money for banks when they were first launched more than a decade ago. Investors flocked to the swaps in the belief that big corporations would seldom go bust. The CDS market then expanded into structured finance such as CDOs that contained pools of mortgages. It also exploded into the secondary market further, where speculative investors, hedge funds would buy and sell CDS instruments from the sidelines without having any direct relationship with the underlying investment. They are betting on whether the investments will succeed or fail, almost like race horses. The situation is exacerbated by the heavy trading volume of the instruments and the secrecy of the trades. An original CDS could go through 20 trades or so; when the default occurs, the so-called insured or hedge party does not know who is responsible for making up the default and if that end player has the resources to cure the default. It is easy to understand the ripple effects.
- Private companies’ securities: generally this is an area of the securities markets which is relatively obscure. Sharespost.com is breaking in new ground.
- Random walk theory: the random walk is no longer as random as it sounds; the fact is that with sophisticated computer-based systems and modeling, it is now possible to see clearly through the walk which is now a sure thing; the walk is still random in the sense of how investors interact with the markets but the movements are largely predictable.
- Wall Street innovators versus the government regulators: according to the WSJ the innovators are always ahead of the regulators and that can sometimes have a steep price. On the other hand, regulations are not always the answer necessarily!
- Ways of ‘domesticating’ the secondary markets: (a) more information and disclosure, and/or (b) more regulations or approval process, and/or (c) select markets open to select investors.
- Games companies play: investors should finally wake up to the reality that the business valuation done in the context of fundamental analysis which is then compared to market prices has one serious flaw; often forgotten, overlook or not so well known is the fact that in the US, a section on market risk is mandated by the SEC in all annual reports submitted on Form 10K; the company must detail how its own results may depend directly on financial markets; this is designed to show, for example, an investor who believes he is investing in a normal milk company, that the company is in fact also carrying non-dairy activities such as investing in complex derivatives or foreign exchange futures. Whoever overlooks this crucial consideration is going to have an unrealistic picture to base investment decisions on.
- Root causes: in the final instance, all the financial ‘screw ups’ seem to originate from the repeal of the Glass-Steagall Act (GSA) in 1999. It would be recalled that the GSA separated investment and commercial banking activities for good reasons which have been forgotten. At the time, ‘improper banking activity’ or overzealous bank involvement in stock market investing activities was deemed the main culprit of the financial crash. (Source: Investopedia). Will there be the necessary intellectual honesty to go back to what is right or arewe going to keep on mudling throgh from disaters to disaters (e.g. JP Morgan Chase, Barclays)? Will there be the political will to come up and adopt a modern version of the Glass-Steagall Act? The financial crsis of 2008 and the ongoing financial uncertainty could be the main reason that the US economy is struggling so hard to recover! Is it obvious that Dodd-Frank does not go far enough?
On this particular issue, common sense seems to be gaining ground:
Weill calls for splitting up big banks
On the other hand: Banks bristle at breakup call
http://www.cnbc.com/id/48355620
Note: the analysis is derived from a compilation from various sources