Sheer Size

My most favourite
subject is SIZE.

In economics
better known as:

QUANTITY or Q.

In most microeconomic 'models' we encounter 'quantity' in relation to 'price'. We -historically- came to understand these models to represent 'supply and demand' models. The intersection between 'supply' and 'demand' came to be known as the equilibrium state, where supply meets demand at a given price and a given quantity.

In financial economics, especially the 'Eugene Fama-Efficient Markets Hypothesis/Theory'-variant aka the EMH, 'price' against 'risk' (however defined), has become (until recently) the only dinner financial economists have learned to eat and get used to.

Within this EMH-world, prices have been set by the all encompassing market, given the measure of (financial) risk, through a process of arbitrage. The market for any security which is traded, so the new-born legend tells us, has come to rest (=equilibrium) given a certain price and an accompanying (measure of) risk, given a specific set of 'known' or market-wide information. Noone in his right mind (so the legend continues) would pay more or less for that given security than this 'equilibrium' price (given the risk).

The current financial crisis has everything to do with the above!

During the nineties and the first decade of the 21st century, real estate (mortgages) and every financial product related to it, has become (and in many cases still IS) the primary security traders within the financial community have favoured. The origin of this 'faith' has always been the historical 'proof' that real estate was a hedge against inflation and a safe way to invest in.

Banks are the primary sellers of mortgages. House owners and owners of commercial real estate have turned to banks for mortgages on their property. In turn banks were very willing to underwrite these loans, because of the 'real' value of real estate (the bricks-have-value religion).

Because of regulatory restrictions banks could only sell so-many mortgages. But they found a trick to circumvent this restriction: they sold their portfolios of real estate mortgages to the market and insured the risk of this portfolio defaulting. In short they sold against cash and could start selling mortgages with this received cash (flow). This procedure -which is called 'securitization' went on numerous times with the same money being invested dozens of times and (re-)insured dozens of times. All went went well for decades.

Remember one thing: although banks (re-)insured their securitized mortgages every time they sold mortgages to the market, the risk for the bank remained. That is: in case the (re-)insurer defaulted, security owners could claim the value of their securities (=shares) at the securitizing bank. This proved to be very important, so take good notice of this!

Given the size of real estate (mortgage) portfolios within the, or any, bank, the resulting situation dramatically tilted the bank towards a very substantial default risk. As more and more money within securitized portfolios was (re-)insured the portfolios of the (re-)insurer also got tilted towards real estate risk.

And then real estate prices did not rise anymore....or even declined..

The home and office owners could not pay their debts (interest and amortization payments) anymore. In short the (re-)insurers went broke, which in turn made the originating banks the owners of these risks (which of course they could not bear), in short the banks also defaulted or at least had to write-off many defaulted loans and or related securities. To their relief, governments stepped in and bailed them out (with different bail out plans per country involved).

The CDO's, the CDS's and all the other financial products related to this real estate drama suddenly had no price anymore. The market, the Heaven of traders, exploded into nothingness. Simply because nobody was interested in them anymore, in fear of defaulting themselves if they would be the responsible party....

I have arrived at the point I wanted to make with this story: Whenever specific securities are dominating the financial community, as was the case with the internet bubble at the turn of the millenium, the market gets out of its 'equilibrium state'. The 'buy-buy-buy' interest that parties show whenever a specific (financial) industry is promising good returns is extremely dangerous. The reason is that the whole market gets focused on this specific industry, by selling securities that do not bear any resemblance to e.g. 'internet' and buying securities that DO! A so-called 'tilting' or 'quantity' effect overwhelmes the market. Everybody wants 'in' and prices rise as a consequence of this. We've seen this numerous times. From the dutch 'tulipmania' via the 'itc-mania' to the 'real estate-mania'. It is all the same.

Finance theory should finally recognize that this lemming behaviour of market parties is an immanent factor they MUST give weight to in their models. If there is anything that can be learned from the current financial crisis, it is the FACT that financial models since Fama, do not pay ANY attention to sheer size, or quantity.

In my view the finance Nobel Prize winners should return their prizes, enter monasteries, never to be heard form again, beginning with Eugene Fama,

for their utter stupidity of forgetting the simplest of economic laws:

prices relate to quantities.

Hope to meet you again tomorrow.