Comic books taught me about illiquid markets.
As a youth, I was an avid collector. For years, I monitored the value of my “investment” by checking prices in the various guides that purported to offer the going rates. By those accounts, my collection at its peak should have been worth five figures.
The crown jewel, if you’ll indulge me a bit of nerdy braggadocio, was a complete set of the popular new X-Men.
My brother, literally a rocket scientist, would shake his head at my obsession. If comics were so valuable, he’d ask, why didn't someone on Wall Street buy every issue of the X-Men and corner the market?
The answer, which I didn’t understand at the time, was risk. Wall Street doesn't buy comic books because there’s a risk in getting stuck with hard-to-value assets, especially when there’s no common exchange or uniformity to the investments.
Wall Street, however, seemed to have no problem with illiquid markets so long as they had an air of financial wizardry, such as credit-default swaps and collateralized debt obligations (CDO). These markets turned out to be the financial equivalent of Beanie Babies or X-Men comics, and yet Wall Street pumped trillions of dollars into them.
And now we're paying $170 billion (around Rs8.5 trillion) and counting for the AIG bailout alone to unravel them. Last week, treasury secretary Timothy Geithner unveiled a plan that would create a clearing house for derivatives such as swaps and CDOs. He hopes to inject transparency into the market by creating an exchange for these complex financial instruments.
That, in theory, would give investors a better idea of the risk by helping to determine the creditworthiness of trading partners and the value of the securities traded. But just like my old comic pricing guide, it may not mean much.
“There seems to be a lot of wishful thinking about the way clearing works,” said Craig Pirrong, a finance professor at the University of Houston. “It doesn’t make risk go away, it just sort of shifts it around.”
Clearing houses work well in active markets with continuous trading, such as stocks and even options. In markets such as swaps, however, which are far less liquid and where each contract traded is different, valuing the securities will be more difficult, Pirrong said.
Nor will more transparency reveal much about the stability of the biggest participants, most likely banks such as Citigroup Inc. and Bank of America Corp. What lurks on their balance sheets?
“The whole world is grappling with that issue,” Pirrong said.
In other words, even with a clearing house, determining the value of swaps is likely to remain little more than an educated guess, more like valuing a comic book than a stock.
Our financial system can’t afford for Wall Street to have hobbies. In the crescendo to the current crisis, bankers became enamoured of the arcane and of the dark allure of creative finance, and they ploughed money in as if it was just another market.
And we’re about to do it again. The proposed cap-and-trade “market” for carbon emissions is likely to create an illiquid exchange only traders can love.
Transparency is important for markets to function, and nowhere is it needed more than in derivatives. But transparency alone won’t prevent another AIG or Lehman Bros debacle.
My own foray into illiquid markets ended a little better. Soon after I got married, I sold my collection at a convention, though I never reaped a five-figure profit.
The “market” at the time was depressed, and those guide prices I once studied were, to use Pirrong’s term, wishful thinking. With more dealers than buyers, one of my competitors simply bought my entire inventory for a few thousand dollars.
It was enough to help my wife and I get started in our careers, so I have no complaints. But my brother had a point, and so, I’m afraid, does Pirrong.
© 2009/THE NEW YORK TIMES
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