Naked Economics (22 page)

The same basic idea is now being used to protect against terrorism. The World Football Federation, which governs international soccer, insured the 2006 World Cup against disruption due to terrorism (and other risks) by issuing $260 million in “cancellation bonds.” If the tournament went off without a hitch (as it did), the investors get their capital back along with a handsome profit. If there had been a disruption serious enough to cancel the World Cup, the investors lose some or all of their money, which is used instead to compensate the World Football Federation for the lost revenue. The beauty of these products lies in the way they spread risk. The party selling the bonds avoids ruin by sharing the costs of a natural disaster or a terrorist attack with a broad group of investors, each of whom has a diversified portfolio and will therefore take a relatively small hit even if something truly awful happens.

Indeed, one role of the financial markets is to allow us to spread our eggs around generously. I must recount one of those inane experiences that can happen only in high school. Some expert in adolescent behavior at my high school decided that students would be less likely to become teen parents if they realized how much responsibility it required. The best way to replicate parenthood, the experts reckoned, would be to have each student carry an egg around school. The egg represented a baby and was to be treated as such—handled delicately, never left out of sight, and so on. But this was high school. Eggs were dropped, crushed, left in gym lockers, hurled against the wall by bullies, exposed to secondhand smoke in the bathrooms, etc. The experience taught me nothing about parenthood; it did convince me forever that carrying eggs is a risky proposition.

The financial markets make it cheap and easy to put our eggs into many different baskets. With a $1,000 investment in a mutual fund, you can invest in five hundred or more companies. If you were forced to buy individual stocks from a broker, you could never afford so much diversity with a mere $1,000. For $10,000, you can diversify across a wide range of assets: big stocks, small stocks, international stocks, long-term bonds, short-term bonds, junk bonds, real estate. Some of those assets will perform well at the same time others are doing poorly, protecting you from Wall Street’s equivalent of bullies hurling eggs against the wall. One attraction of catastrophe bonds for investors is that their payout is determined by the frequency of natural disasters, which is not correlated with the performance of stocks, bonds, real estate, or other traditional investments.

Even the much-maligned credit default swaps have a legitimate investment purpose. A credit default swap is really just an insurance policy on whether or not some third party will pay back its debts. Suppose your husband pressures you to loan $25,000 to your ne’er-do-well brother-in-law so that he can finally complete his court-man-dated anger management program and turn his life around. You have grave concerns about whether you will ever see any of this money again. What you need is a credit default swap. You can pay some other party (presumably with a more favorable view of your brother-in-law’s creditworthiness) to enter into a contract with you that promises to pay you $25,000 in the event that your brother-in-law does not pay back the cash. The contract functions as insurance against default. Like any other kind of insurance, you pay for this protection. If your brother-in-law gets his act together and pays back the loan, you will have purchased the credit default swap for nothing (which is how the other party to the transaction, or the counterparty, makes its money). How could something so simple and seemingly useful contribute to the near collapse of the global financial system? Read on.

Speculation.
Of course, once any financial product is created, it fulfills another basic human need: the urge to speculate, or bet on short-term price movements. One can use the futures market to mitigate risk—or one can use the futures market to bet on the price of soybeans next year. One can use the bond market to raise capital—or one can use it to bet on whether or not Ben Bernanke will cut interest rates next month. One can use the stock market to invest in companies and share their future profits—or one can buy a stock at 10:00 a.m. in hopes of making a few bucks by noon. Financial products are to speculation what sporting events are to gambling. They facilitate it, even if that is not their primary purpose.

This is what went wrong with credit default swaps. The curious thing about these contracts is that anyone can get into the action, regardless of whether or not they are a party to the debt that is being guaranteed. Let’s stick with the example of your loser brother-in-law. It makes sense for you to use a credit default swap to protect yourself against loss. However, that same market also allows the rest of us to bet on whether or not your brother-in-law will pay back the loan. That’s not hedging a bet; that’s speculation. So for any single debt, there may be hundreds or thousands of contracts tied to whether or not it gets repaid. Think about what that means if your brother-in-law starts skipping his anger management classes and defaults. At that point, a $25,000 loss gets magnified thousands of times over.

If the parties guaranteeing that debt haven’t done their homework (so they don’t truly understand what a loser your brother-in-law is), or if they don’t care (because they earn big bonuses for making dubious bets with the firm’s capital), then an otherwise small set of economic setbacks can explode into something bigger. That’s what happened when the American economy hit a real-estate-related speed bump in 2007. AIG was the firm at the heart of the credit default debacle because it guaranteed a lot of debt that went bad. In his excellent 2009 assessment of the financial crisis, former chief economist for the International Monetary Fund Simon Johnson writes:

Raising capital. Protecting capital. Hedging risk. Speculating. That’s it. All the frantic activity on Wall Street or LaSalle Street (home of the futures exchanges in Chicago) fits into one or more of those buckets. The world of high finance is often described as a rich man’s version of Las Vegas—risk, glamour, interesting personalities, and lots of money changing hands. Yet the analogy is terribly inappropriate. Everything that happens in Las Vegas is a zero-sum game. If the house wins a hand of blackjack, you lose. And the odds are stacked heavily in favor of the house. If you play blackjack long enough—at least without counting cards—it is a mathematical certainty that you will go broke. Las Vegas provides entertainment, but it does not serve any broader social purpose. Wall Street does. Most of what happens is a positive-sum game. Things get built; companies are launched; individuals and companies manage risk that might otherwise be devastating.

Not every transaction is a winner, of course. Just as individuals make investments they later regret, the capital markets are perfectly capable of squandering huge amounts of capital; choose your favorite failed dot-com and think of that as an example. Billions of dollars of capital flowed into businesses that didn’t work. The real estate bubble and the Wall Street meltdown did the same on an even bigger scale. Adam Smith’s invisible hand has hurled a lot of capital into the ocean, never to be seen again. Meanwhile, some potentially profitable enterprises are starved for capital because they have insufficient collateral. Economists worry, for example, that too little credit is available for poor families who would like to invest in human capital. A college degree is an excellent investment, but it is not something that can be repossessed in the event of default.

Still, the financial markets do for capital what other markets do for everything else: allocate it in a highly productive, albeit imperfect, way. Capital flows to where it can earn the highest return, which is not a bad place to have it flowing (as opposed to, say, into businesses run by top communist officials or friends of the king). As with the rest of the economy, government can be enemy or friend. Government can mess up the capital markets in the same ways it can mess up anything else—with overly burdensome taxes and regulations, by diverting capital into pet projects, by refusing to allow creative destruction to work its harshly efficient ways. Or government can make the financial markets work better: by minimizing fraud, forcing transparency on the system, creating and enforcing a regulatory framework, providing public goods that lower the cost of doing business, and so on. Once again, the wisdom lies in telling the difference.

Obviously the current crisis has presented some teachable moments. The financial regulatory system needs to be patched up, if not completely overhauled. The challenge will be to protect what a modern financial system does best—allocating capital to productive investments and protecting us from risks we can’t afford—while curtailing the excesses—stupid bets that enrich the folks making them before eventually leaving a mess for the rest of us to clean up.

All that is well and good.
But how does one get rich in the markets?
One of my former colleagues at
The Economist
suggested that this book should be called
Are You Rich Enough?
His logic was that most people would answer no and rip the book off the shelves. Sadly, I’m not a big believer in surefire strategies to trade your way to riches. Just as miracle weight-loss programs violate nearly everything we know about health and nutrition, get-rich-quick schemes violate the most basic principles of economics.

Let me begin with an example. Suppose you are shopping for a home in the Lincoln Park neighborhood of Chicago. After many weeks of searching, you find that a three-story single-family brownstone will cost you somewhere in the range of $500,000. Some homes are listed for $450,000 but they need work; others are listed for $600,000 because they have extra amenities. Just when you begin to despair that you will have to spend $500,000 for a home, you find a brownstone listed for $250,000 that meets all of your specifications. When you investigate, you learn that this home is every bit as nice as the ones you’ve been looking at—same location, same size, same structural integrity. Still wary, you ask your real estate agent for her assessment. She assures you that this house is indeed a remarkable bargain and should be selling for $500,000. In her professional opinion, there is no doubt that you could buy this house for $250,000 and sell it only months later for $500,000 or more. Then you see the final piece of evidence. An article on page 3 of
Crain’s Chicago Business
has a screaming headline: “Bargain of the Month: Lincoln Park Brownstone Listed for $250,000.”

So you snap up the house for $250,000. Sure enough, six months later you sell it for $500,000—doubling your money.
^*

How many things are wrong with this story? Quite a few. A reasonable person might begin by asking some of the following questions:

If this house was really worth $500,000, who was the moron selling it for $250,000? Was this person not willing or able to do the three minutes of work necessary to determine that comparable houses in the neighborhood were selling for twice as much? If not, wasn’t there a family member or a real estate agent—whose commission is based on the sale price—willing to point out this enormous discrepancy?


Maybe not. In that case, why hasn’t my real estate agent bought this house for herself? If this house is a “sure thing” to double in price, why is she working for my 3 percent commission when $250,000 is staring her in the face?


Perhaps my real estate agent is a moron, too. In that case, where are all of the other buyers looking for bargains, especially after this house is featured in
Crain’s Chicago Business?
If this brownstone is a tremendous bargain—and has been widely advertised as such—then presumably all kinds of people are going to want to buy it. A bidding war would result, with potential buyers offering larger and larger sums until the price reached its fair market value, which is around $500,000.

In other words, there is virtually no chance that you will find a Lincoln Park brownstone (without some surprise lurking in the basement) for $250,000. Why? Because of the most basic idea in economics. You are trying to maximize your utility—and so is everyone else. In a world in which everyone is looking to make profitable investments, no one is going to leave $250,000 sitting on the table.
Yet people assume the stock market works like this all the time.
We believe that after reading about a “hot stock” in
BusinessWeek,
or reading a Wall Street analyst’s buy recommendation (offered to all the firm’s clients), we can load up on stocks that will trounce the market average. But those supposed “hot stocks” are merely the Lincoln Park brownstone in different clothing. Here’s why:

Let’s start with a stunningly simple but often overlooked point: Every time you buy a stock (or any other asset), someone has to sell it to you. The guy who sells you this “hot stock” has decided that he would rather have cash. He has looked at the current “bargain price” and he wants out—right when you are getting in. Sure, he may need the money for something else, but he is still going to demand a fair market price, just as we would expect someone who has to move out of Lincoln Park to ask $500,000 for a brownstone, not $250,000. The stock market, as the name would suggest, is a market. The price of a stock at any given time is the price at which the number of buyers equals the number of sellers. Half of the investors trading your “hot stock” are trying to get rid of it.