The Problem of Regaining Trust

Eric Falkenstein sums up 2008 through a ratings-agency lens:

I think 2008's problem was mainly because after the rating agencies were exposed as making an error on their AAA and AA ratings, all investors viewed such securities skeptically. What was previously an asset class that did not require much thought, now need re-underwriting: evaluating the credit from the bottom up. This is very difficult, invariably there are many assumptions (especially for derivatives), and you find very quickly that there are lots of unknowns that are potentially dangerous. Usually, these assumptions are benign, but as the mortgage crisis proved, you can't rest on 'usually'.

I very much like the term "re-underwriting"; I think it's a good way to think more generally about what happens after that other buzzword, deleveraging.

Re-underwriting doesn't just happen among institutional investors with exposure to highly-rated structured products. It happens in banks, who are revisiting all of their loan portfolios, deciding who will get their loans rolled over and who won't. It happens in the mortgage market, of course, every time a homeowner tries to take advantage of lower mortgage rates by refinancing. And more conceptually, it happens whenever any investor, even an individual with just a few thousand dollars in an index fund, stops to really wonder, for the first time, exactly why he's taking these risks with his money, and whether the potential upside compensates for the potential downside.

And there's certainly lots of re-underwriting going on in the world of hedge-fund investors, as Falkenstein says:

Anyone doing due diligence needs to do the simple things, like seeing if a 'conversion strike strategy' is remotely plausible in generating promised returns.

It's actually harder than that, because re-underwriting conversion strike strategies is not simple but rather impossible for 99% of the people invested in hedge funds. So those people need to re-underwrite not tractable conversion strike strategies, but rather something much vaguer: the trustworthiness of their investment advisors. And how does one even begin underwriting the trustworthiness of an institution like Fairfield Greenwich?

A well-functioning capitalist system is based on high degrees of trust. Eventually, inevitably, that trust is going to be gamed and taken advantage of. And then you get a crash, which ends in a mire of mistrust and recrimination. How to get out of that mire is the problem facing us all today.

Comments

[User 265729:]

Really hard to trust anyone when the Fed and Treasury and using $trillions without telling the taxpayers where its going.

How can we invest when we have no idea if that blue chip stock is really propped-up bt the government?

Jan 06 08:05 PM

[Nikola:]

All this talk about trust. But you have to remember a couple of things:

1) People WANT to believe.
2) Most people would NOT trust the system if they were told the whole, unadultered truth about the financial system. And I am even talking about the sophisticated, high net worth individuals. They would not trust in part because they would not understand, in part because it is so very complicated for an "average" person to comprehend anyway, and in part because the whole economy is The Ponzi Scheme, based on belief in eternal growth, something most people realize is not physically possible.

Therefore, we have illusions created for us and served us. IMO the bailouts are one such illusion. They are virtual bailouts. It's not like they printed money and threw it out of the helicopters.

Curbs-in, you don't have your trust back, but I know a lot of people who do. And looking at how the Dow is creeping back up, it seems like the believers are a majority.

Is it that easy? You say you will give seventeen gazillion dollars to anybody who asks. Then you "do," but they do nothing (visible) with the money and/or won't report what they did with it. And the Government is fine with that.

It sounds too crazy, but it's working. It's working because people WANT to believe. And frankly... I am glad for it. I could stand here and say The Emperor Has No Clothes. But why? I don't want the end of the world. So I cheer on.

Jan 07 01:32 AM