24 September 2008

More on Market Instability

Wall Street as we knew it vanished over the weekend. All the investment banks have been bought by banks, or have become banks. The difference? Banks are more strictly regulated than investments banks. But more importantly, banks can value assets based on expected discounted cash flow. By law, Investment banks must use the fair market price of the asset.

Fair market price sounds reasonable, but it makes for instability. In a rising market, your asset will be over-valued, and you can borrow against that asset to buy more over-valued assets, creating a bubble, which could burst. Then, in a falling market, your assets will be undervalued, forcing you to write them off and possibly go into bankruptcy.

All the while, the real value of your asset remains unchanged. The real value is the discounted cash flow you can expect from the asset. To make it concrete, supposed you owned a rental property. It's real value to you is the value of the rent you are receiving discounted by the inflation rate over the years you plan to own it, minus the money you can expect to pay for maintenance, etc.

The discounted cash flow valuation encourages buy-and-hold market behavior - and the market stability that goes with it.

In the meantime, our regulators (including Congress and the Bush administration, now that they are jumping into the act) are proceeding without a coherent theory of market stability. Let's hope they are not proceeding without a clue.

But what will really be intolerable is if any of these clowns hits the campaign trail without doing anything at all.


VanceH said...

Hi Scooper, Thanks for your comment on asset valuation. The articles I've been reading focused on the change opening up the ability to take customer deposits as the main benefit--which didn't seem like much of a benefit to me. Marked to market vs. discounted cash flow makes a huge difference in the current illiquid env. I bet that makes a huge difference to their asset valuation. Regarding stability, you are probably familiar with Taleb's stuff. I think he is a bit of a blow-hard, but I think he makes good points on how both our intuitions and the typical analytic approaches to risk analysis tend to be very flawed.

Scooper said...

Actually, I'm not familiar with Taleb. I'm new to this finance stuff. Would be glad to know more.

VanceH said...

I can recommend Taleb's "Fooled by Randomness." More recently he has published "The Black Swan", which I have scanned, but might be a rehash of "Fooled..." Neither book is analytical, but Taleb does appear have a solid financial background. I struggled through his first book "Dynamic Hedging: Managing Vanilla and Exotic Options", of which maybe 70% was over my head.

green eggs and ham^^ said...

what do you mean by the wall street has vanished?