Games & Markets: Rules Matter

As children (or even now as adults) most of us enjoyed games, whether they are sports, video games, board games, whatever. The defining quality in any of these pastimes is the ability to win in direct competition with others. What makes these games enjoyable is that once the rules are learned or agreed to by participants, skill should become evident as the winner emerges. Sure, luck is an element, but a firm strategy and great tactical moves in a game like Risk make a difference. They also allow a player to exhibit his skill. Even in the case of my own childhood, growing up on the streets of NYC, everyone knew and agreed on which buildings were in foul territory for a game of stickball. The same is true in markets.

Today we have entered a period in American financial history where the rules we lived by for so long have vanished. Markets are supposed to determine value as well as winners and losers. If a Firm employs a bad strategy in the game, it becomes evident in the stock price. Investors are rational even in their irrationality. The reason people pull their assets from the market at this point is simple–a fear of losing further, given uncertainty. This uncertainty, which started in mortgages, has now been exacerbated by the uncertainty and inconsistency of both the Fed and Treasury’s intervention into US markets. The Government’s inconsistent actions of choosing who will live or die in the battles of Bear Run, Lehman’s Crossing and AIGs-burg have given investors agita. Increased violations of a prime market rule: either you have moral hazard or you don’t. There is a reason Star Trek captains had a Prime Directive.

Perhaps if Bear Stearns were allowed to go bankrupt as Lehman did, a safety value would have been reached as investors recognized a world they understood. I can tell you that many at Bear wanted to go the bankruptcy route at one point. The pain may have been greater than the one we see now post-stimulus, $700 billion, and possible eventual, inevitable nationalization of banks. But then again it may not have been. I remember clearly when the bail out bill was rejected by the House, many pundits and traders were forecasting a 3,000 point drop in the Dow. We’ve had a slow burn to get to that number in a week after the passage of the current bail out bill, but we did hit it. Even when firms blow up, the good parts of them survive and are acquired or salvaged. It is another market rule. Just take a look at the following story: ‘Vulture’ investors circle the market, ready to swoop in. As one of my twitter buddies @blackhorse pointed out:

Blackhorse @robpas They’ll be competing against Paulson’s $700 biliion “fund of funds” once he gets his asset mgrs in place. Should be fun to watch.

For those of you that thought privatization of Social Security was a horrible idea, congratulations–you now are the proud investors in a $700 billion dollar fund of funds run by US, Inc.

The reason many investors will not put money to work long term (more than a day or two) is uncertainty of future outcomes of Government intervention. Normally, some investors at this point would feel Mr. Market is out of whack and there is a mis-pricing of assets under the new rules set. This is why many of them were fooled with Lehman. The thought process was — Lehman is underpriced, the Government stepped in on Bear because of counter-party risks, Lehman is another huge counter-party, OK I’ll invest. Bango, the rules changed. The Government decided Lehman was allowed to go belly up. The last thing we want right now is investors with capital confused about when to invest.

Barton Biggs, formerly of Morgan Stanley and now running the fund at Traxis Partners, said it best on Bloomberg TV Friday:

“You’ve got to make a bet on whether the financial system and the market system, as we have known it since the end of World War 2, is going to survive.” Full Article

I take that as–will the rules we have known and operated with as investors, survive in the near future? If not, which rules should we be following?

Investors, uncertain of which laws are in effect, are standing by bewildered, especially when a stimulus or bail out is enacted and the desired outcomes, hoped for by the Treasury and the Fed, don’t appear. The economy has become resistant to many of the financial antibiotics prescribed by both Hank Paulson and Ben Bernanke. Either they provide clarity on what the new set of rules are or they allow the older existing set of market rules re-establish themselves. Do not mistake a 900 point run up in the Dow today for victory. The central problem has not been solved yet. And if you think rule writing for markets isn’t going on, then check in with Silvio Berlusconi, the Italian Prime Minister, in a story from Forbes

“The stock markets are currently in the grip of panic and madness,” Italian Prime Minister Silvio Berlusconi told reporters in Naples, adding that world leaders were considering drawing up new rules for global finance.

Ben Bernanke is highly aware of their inconsistent actions, especially with respect to information and investment. From his MIT PhD thesis, some quotes:

“Chapter 1 analyzes the problem of making irreversible investment decisions when there is uncertainty about the true parameters of the stochastic economy. It is shown that increased uncertainty provides an incentive to defer such investments in order to wait for new information. Uncertainty and the volatility of investment demand are connected at the aggregate level.”

“Finally, the higher their prior probability on the occurrence of future states in which they will regret their illiquid investments (i.e., those future states in which desired illiquid stocks are less than those currently planned), the less the agents will invest in illiquid stocks.”

“The example suggests that when information potential is high, there is an incentive for investors to wait for the new information. This leads to a decrease in current investment.”

“Another realistic aspect of this example is the importance of timing of investments. Timing does not enter most theories of investment; usually, agents are theorized either 1) to make an investment, or 2) not to make an investment, according to some set of criteria. The present analysis adds another option for the agent: 3) wait and get new information. Thus there is a decision about when as well as whether to invest.”

Ben–tell Hank, we are all waiting to get new information and action from both the Treasury and Fed on a daily basis now. It is the new rules set that you have provided. No longer are we looking to regular news events and private action that would add to the market picture–we are waiting for events to come from Governments to drive the market. That is not good.

As investors wait for a measure of future certainty about rules we are using to re-enter the market, they are simply choosing not to invest at this point. This includes financial institutions choosing not to lend. Basically we are all a bunch of indecisive Halmets wishing to delay until we see the information tipping point, in this case which rules are we playing by. Until both Ben and Hank figure out the right set of words and actions, we’re stuck. They decided to enter this game, so they need to finish this hand. They need to inform the market of the new rules and apply them consistently–so we can go back to playing our game. The age-old admonishment is in ‘da house, “You break it, you own it” or as that market sage Jeff Spicoli, from the movie Fast Times at Ridgemont High, would say,

“So If We Don’t Get Some Cool Rules Ourselves, Pronto, We’ll Just Be Bogus Too.”

If you’re interested in the future of the markets and how technology plays into that, check out Money:Tech 2009. The theme is “After the Goldrush: Financial Tools for New Times.”