Buy on the rumor - sell on the rumor, also

What happened to Société Générale lately fits right in between the Efficient Market Hypothesis and the madness of crowd, in what is still a no-man's land, in spite of all the welcoming push of behavioral finance to take into account human behavior.

The Daily Mail in the U.K. asserted on Sunday on 7 August 2011 that the bank was in a "perilous state and possibly on the brink of disaster".  Needless to say that in the present frantic environment, it triggered a whirlpool of speculation dragging down SocGen stock price. The Daily Mail admitted later the analysis was unfounded and apologized in a public statement.

Zachary Karabell's point is that rumors have a lot more weight when financial sectors lack credibility and no one trust it anymore: 

We have, in short, arrived in Looking Glass world where no one believes anything that anyone in finance-land says. And for that, we have Dick Fuld, Lehman Brothers, and the entire culture of Wall Street, Washington, and European finance over the past five years to thank. They are the inverse of the boy who cried wolf, and no one now believes that the wolf is not at the door.

The return of Political Economy II

The downgrade of US debt by S&P and the commentaries following it took the debate on credit rating agencies (CRAs) added-value to a next level. It is worth reading the S&P's statement and spotting the key paragraph ( if you missed the "political risk" in the title): 

[T]he downgrade reflects our view that the effectiveness, stability, and predictability of American policymaking and political institutions have weakened at a time of ongoing fiscal and economic challenges to a degree more than we envisioned when we assigned a negative outlook to the rating on April 18, 2011....

Compared with previous projections, our revised base case scenario now assumes that the 2001 and 2003 tax cuts, due to expire by the end of 2012, remain in place. We have changed our assumption on this because the majority of Republicans in Congress continue to resist any measure that would raise revenues, a position we believe Congress reinforced by passing the act.

It comes as no surprise that nobody is arguing about the U.S. debt ratios. It is understood that S&P downgrade has to be viewed within the current political context of the U.S. Here's Dan Drezner's rounds up of the initial reax to the downgrade and why he thinks S&P took an unjustified step. Micheal Cohen holds a different view from across the pond.

These arguments show that once in the "political economy" field however, one has to ask whether S&P has the knowledge and expertise to issue statements and ratings that are political in nature, hence subjective. CRAs gained their legitimacy partly due to a process "hardening of information" whereby financial information is quantified. The process is efficient if risks can be expressed numerically in the form of a debt ratios, but become problematic when politics has to be embedded in a three letter code. We might have reached the limits of what "hard information" can tell us.

Photographies of stock markets

Micheal Najjar's The Down Jones, from 1980 to 2009. Najjar drew an analogy between geologic structures and a social one, the stock market. As Mandelbrot have argued for a long time, financial markets movement are wild and cannot be captured by the Bell curve.  The fluctuations of markets, like the irregular shorelines of the English coast, are both better described by fractal geometry, which Mandelbrot invented.

As we have allegedly entered the anthropocene, and although is it a geological concept that signals that humans now shape the earth, is it interesting to note the parallel with financial math that were once extracted from markets, but which is now shaping it in the form of algorithms. For a 15 minutes talk about how algorithms influence our lives, listen to Kevin Slavin at TED.

How to tame the Leviathan ?

In a fantastic personification of the Dodd-Frank Act, John Oliver from the Daily Show exposes the difficult road ahead of financial regulation bills. The Leviathan just f#&{@  it raw in the  a¶#...

The Daily Show
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Credit Rating Agencies and the added value of information

 

The market for credit rating is an oligopoly with the famous big three dominating the entire industry, which is once again under fire, but some are detecting what could be a departure from the status-quo, paving the way for newcomers to enter the market and moving the business model whereby issuers now pay the CRA's to one whereby investors would do it. In essence, one feels that the motivation behind is to lessen CRA's power grounded in the sheer amount of financial markets participant paying attention to them. From the FT:

"The more people paid attention to these ratings the more it skewed the whole system. They take up an importance that is disproportionate to their value,” says Barbara Ridpath of the International Centre for Financial Regulation and former S&P executive.

The fundamental problem is that regulatory authorities and especially the Basel Committee, built their recommendations and rule for capital adequacy requirements on these very ratings some want now to reform. A U-turn is thus very unlikely in the near future.  

Trust and the internet

A report from Pew links the use of internet to trust. Social Networking Sites users are more trusting than others. As it has social implication implications for financial sectors and (see Guiso, 2008 and Zack, 2000), would it be interesting to investigate if SNS users are more inclined to invest in stock markets ?

Back to the future of lending

It sounds lovely. Bhidé is describing a world that once was:

Bank regulation, like lending, was once decentralized and judgment-based. Regulators relied mainly on examination of individual loans rather than capital-to-asset ratios. A typical bank exam would include scrutiny of every single business loan and a large proportion of consumer loans. Capital adequacy was a matter of judgment: examiners would figure out how large a buffer a bank ought to have, taking into account its specific risks.

But is he suggesting we should go back to the good old days of relationship lending ?

Smarter capital requirements – better Basel rules – aren’t the answer. Rigid, top-down uniformity is essential in the specification of weights and measures and the issuance of currency and coin. Bank lending and regulation, by contrast, must incorporate local knowledge, because, in a dynamic, unregimented economy, each borrower, loan, and bank is different (though some general guidelines can help). The seemingly objective top-down approach ignores the idiosyncratic nature of risk and assumes that one mortgage loan is like the next.

How do we ignore the financial revolution that took place supporting the use of "hard" over "soft" information? Incorporating local knowledge requires using soft information and is therefore costly. In contrast, hard information is easier to process. So the trend of information hardening that goes hand in hand with financial innovation and the use of mathematics in financial economics enhanced certain transaction based lending technologies, such as leasing or factoring, which benefited SMEs by raising credit availability. By the same token, this process is the cause of the increase in distance between small firms and their lender in the U.S. Consequently, distance is less an indicator of creditworthiness than before, which means that small firms at distance enjoy now a wider access to credit.

So this is a huge debate, which goes beyond regulatory issues. Too bad  Bidhé is not even mentioning it.