Fear of what is real

Our global markets resident expert who goes by the handle “J_AG” in Filipino Voices has an interesting take on the “present economic crisis ongoing”:

The issue is not one of destroyed housing values or distressed assets. The issue is one of the fear of what the real value of these assets will be.

Quite oxymoronic from a strictly logical sense but, to be fair, I actually agree with both parts of the above statement; specifically because I believe:

:D No real value is actually being destroyed in this “crisis”; and,

:D What is being destroyed in this “crisis” is the value unfairly perceived by the market.

So as J_AG carries on:

Fear has taken over feeding on itself.

This “fear” is coming from a sudden (or, in some cases, creeping) realisation among folk in the once high-flyin’ financial markets community that they have lost track of what is real and what is perceived. The real asset, say a house, is still there. Unfortunately these real assets have come to be represented in the asset portfolios of some businesses by a once benign thing called a financial security, specifically an unstable species of it called a derivative.

Traditionally, what would be sitting in the balance sheets of a conventional bank that lends money to home buyers would be a contract enforcing said bank’s claim over said mortgaged asset (in this case the house and lot) as collateral over the period of the loan. The formula in that arrangement is simple. The debtor defaults on his loan, the creditor takes possession of the property which can then be sold (and the lent funds recouped by said bank). Let’s call a bank’s mortgage holdings in the way it is described above its traditional asset portfolio.

Enter the bright boys.

The bright boys crafted cleverly-engineered derivative financial instruments that allowed banks to turn their traditional asset portfolios into a new type of marketable financial product or instrument that could be sold to investors. A whole new class of “assets” was created — the mortgage-backed security. This process of creating this new class of “assets” has come to be called securitisation.

Businesses that bought these mortgage-backed securities created a new class of asset portfolio consisting entirely of these securities. Let’s call them non-traditional asset portfolios.

[NB: This "crisis" is quite simple, really, as I demonstrate waaay back in this insightful article.]

By now you can probably see the difference between a balance sheet consisting primarily of traditional asset portfolios reported by Company A and a balance sheet consisting primarily of non-traditional asset portfolios reported by Company B. If you were a person given the task of apraising Companies A and B and recommending which one most reliably approximates its real value in the balance sheet it presents, which one would you select?

I’m betting that you’d go for Company A. The trouble with Company B is that its asset portfolios are built upon a sand dune of perceived value. That’s because a derivative security basically reduces the connection between reality and perception to a baffling jumble of contract stipulations (the handywork of “expert” lawyers) and derivation formulas (the handywork of “expert” “financial engineers”).

Thus “securitisation” has made the whole effort of sifting through the morass of real and perceived value a next-to-impossible endeavour. All that people can do now (specifically those who understand these instruments the most) is wait and see. “Experts” being reduced to a wait-and-see position (falling off from a place where their formulas once gave them deterministic power over their destinies) is fundamentally where this fear Mr. J_AG describes is coming from. Those outside this circle of “expertise” for their part quickly work out (much the same way as a dog can “sense” fear) that even the experts are afraid — and off goes the chain reaction of various fears coming from various sources “feeding” on one another, as our man J_AG poetically waxes.

Obviously the brilliant insight in my article Substance Matters in an Economic Crisis which I cited in my FV article How much are you worth dead? simply flew over the heads of even the more brilliant “commentators” in the Pinoy blogosphere.

To refresh your memories (and to cater to younger folk whose comprehension faculties are atrophied by today’s visually-rich information media technologies) it would help to re-visit this diagram:

In my original thesis, the blue region above represents labour-added-value. As a testament to the scalability of “getrealist” thinking, one can replace labour-added-value with the concept of perception-added-value and the above diagram will not only still hold but will also be applicable in illustrating the difference between the hypothetical Companies A and B in my intuitively simple tale above.

So we now come my favourite part where I say this:

It’s simple, really.™

This financial “crisis” which I prefer to call a financial correction (the correctee being the gap between perception and reality) can be explained in one sentence (which in an inescapably Gödelian sense admittedly owes its succinctness to the article you are reading right now):

Companies that were once thought to be the big pillars of 21st Century Finance are failing today because their balance sheets have come to resemble that of Company B.

And that’s all there is to it. :D

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