Saturday, October 11, 2008

Saturday Morning Musings - finance 101 and the global financial crisis

I had intended to write about cats this morning, or really any topic not connected in some way with the current global financial turmoil. However, it is hard to ignore the continuing chaos.

In writing, I seek to understand, then to explain. Some things, the madness of crowds is an example, cannot easily be understood beyond the abstract. Here words like "feeding frenzy" and "lemmings" come to mind.

The Prisoner's dilemma is one of the most famous concepts in game theory. In simplest terms, take two prisoners. If both keep quiet, they get off. The police don't have the evidence. However, if one confesses and incriminates the other, the one who confesses will get a very light sentence, the other a long sentence. If both confess, then they both receive a longish sentence.

What should the prisoners do? The optimum course is to keep quiet, no sentence. However, this carries the risk of the worst individual outcome if one confesses and the other does not .

The share market has been a bit like this.

The optimum course for all players is to limit selling to avoid placing downward pressure on prices. We have seen this in Australia before with house prices, people refrain from selling until prices start to recover. However, if you don't sell and others do, then you maximise your own losses relative to them. This creates pressures to sell.

Over and beyond the sheer excesses within the financial system, the fact that very clever people have been far too clever by half, there are two features of this crisis not present in some past crises.

The first is the role played by the ratings agencies, something I complained about in The international curse of the ratings agencies. The weight placed upon their rulings makes them players, not simply sources of information.

As an aside, I wonder whether the ratings agencies can survive this crash? As a simple example, the British local councils who based their decisions to deposit with Icelandic banks claim that they did so on the basis of the ratings accorded those banks by the ratings agencies. I wonder who will be the first to sue?

The second new feature are the new international accounting rules, something that Kangaroo Valley David referred to in an email to me. Introduced in response to previous corporate excesses such as Enron, they require companies to bring shifts in asset values to account as they occur.

The problem in this time of turmoil is that such crystallised losses reinforce the downward spiral by weakening balance sheets and lowering credit ratings. This actually reinforces the Prisoner dilemma effect.

In thinking about all this, I keep coming back to the real value of assets.

At one level, the value of an asset is what the market will pay for the asset. This, market value, is the conventional measure. However, its is always a short term, immediate measure.

In the longer term, market value for productive assets (I am not talking about gold or art works) depends on the income stream attached to the asset. This is the reason why shares generally out-perform real estate in the longer term.

Companies pay you a dividend and then reinvest the remaining profits in the business. This creates further profits. Companies also borrow to fund investment. So long as the returns on the investment exceed the cost of capital, this adds to profits. So with shares, you get a rising dividend stream plus a rise in asset values. The two are linked.

Finance 101 I know. However, I want to use this simple analysis to make a simple point.

Recently a colleague commented that there was an old-fashioned flavour to some of my management writing. This actually pulled me up. To be seen as old-fashioned can be the kiss of death for a management professional. That said, I have been consciously mounting a case for a return to what I see as management fundamentals. If that's old fashioned, then I will wear the tag.

One of my concerns has been what I see as the growing instability, the shortening of life cycles, in current organisations. In The fallacy of modern management I tried to use simple maths to show that our near universal obsession with above average growth at organisational levels is in fact a recipe for failure.

One company can achieve above average growth. By definition, all companies cannot. When the gap between the total targets and what is in fact achievable becomes too great, then the outcome is instability and rising failure rates.

Consider corporate borrowings. If corporate borrowings are based on the totality of corporate growth targets and those targets are unachievable, then you know that there will be over-borrowing. Normally, credit market rationing limits this effect. However, should this fail because of excessive lending, then problems result.

As a second example, consider PE ratios and dividend yields. These used to be based on historical earnings. You knew where you were and could make your own adjustments. If you change the measure to prospective earnings, and if the totality of those earning cannot in fact be achieved, the ratios become suspect in the extreme.

As I said, finance 101. However, this simple analysis has significant implications. Consider disclosure issues.

If total profit projections cannot be achieved, then why are we requiring companies to provide individual profit projections? If the value of assets is based on long term sustainable profits, why do we require and measure people on quarterly reports?

To my mind, we should consider putting a bullet through the entire current corporate control and reporting system. It does not and cannot work. Instead, we should focus on what we really want to achieve.


I have been meaning to mention for a little while just how much I have enjoyed John Taplin's Blog and especially his comments on economics. I found it through Neil's Shared Items.

Postscript 2

My thanks to Barry Garden for including this post in his What Others are Saying About Global Financial Crisis?, a compendium of posts on the crisis.

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