Sunday, August 5, 2012

Dark Knight's a-Rising: An Anti-Archimedean Theorem

How do you lose $756 million in market cap in less than an hour?  How do you go from being a stalwart utility for over $20 billion in trades each day to having 24 to 48 hours to survive without a capital infusion or a buyer?  From flash crashes to Knight Capital's $440 million "computer glitch" this past Wednesday, the Financial Industry Regulator Authority's (FINRA) official statement that the firm was "in compliance" with its capital requirements is not much of a fig leaf when Knight's reported cash-on-hand at the end of the second quarter of 2012 was $365 million.  To the somewhat mathematically inclined reader, this would imply that there's a considerable gap ($75 million) between the actual loss and the firm's capital position to cover it.  Not to worry, clients and the public were to be reassured that FINRA and the Securities and Exchange Commission (SEC) were "monitoring the situation."

Based on analysis that we conducted in the middle of the last decade - an inquiry triggered by the ill-conceived conversations about having individuals replace Social Security with privately managed investment accounts - by 2007 the majority of stock market transaction activity was being performed by algorithms and machine implemented trades.  In short, quantitative machines and their slavish formulas had taken over.  Knight Capital's recent fatal "glitch" is a symptom of an ominous super-bubble that is being ignored at our collective peril.  With the world's GDP dwarfed by the notional monetary 'value' of financial instruments and counter-party trading agreements (including the staggering trillions of dollars of alleged 'value' in sovereign-manipulated capriciously created currencies) our entire financial system is one 'glitch' away from Fukashima-style  'critical'.  We've witnessed MF Global, Facebook's technical NASDAQ flop (I'm not referring to Zuckerberg's seduction of investment bankers who should have injected a bit of adult supervision in the now vacuous social cobweb), Peregrine Financial, and the expanding LIBOR rate-fixing collusion where trillions of dollars of transactions have been a 'glitch' away from creating and destroying the equivalent of the GDPs of countries.  Yet somehow, We the People are supposed to be content with a few anonymous government agencies "monitoring the situation."  These are the same 'regulators' who have become the cast for what should be the next white collar forensic CSI reality TV show - one best suited for a role in Batman:  CSI:Gotham City.  They seem to only show up after the dead body is rotting and do nothing about the perps who are preying on unsuspecting victims in broad daylight.

Recently I had the opportunity to listen to a Private Wealth Management team from one of the world's largest financial institutions make a presentation regarding investment recommendations for a high net worth client.  The client had amassed considerable financial wealth building two corporate enterprises - enterprises that were quite lucrative and were acquired by even larger companies.  The team was quite confident in their proposed asset allocations pointing to quantitative data to assure the client that he was taking on 'acceptable' levels of risk with 'reasonable' expectations for returns.  As I looked at the fine print in the presentation materials, I noticed a correlation between two highly dissimilar asset classes which, by their very nature, should be uncorrelated.  Willing to accept that I may be missing something, I inquired about the anomaly. 

"We used historical data to build these models," was the dismissive reply.

"Then I would like to see the data," I responded.

"We've never had a client ask for the raw data," one of the bank's team said.

Within 24 hours, data in hand, not only did I find the error but I also found that the 'data' wasn’t actual data.  You see, where there was information missing, the same regression that was used to model future performance was used to guess what could have happened in the past.  In other words, they were taking 20-30 years of data and, rather than dealing with the absence of measured observations in the uncomfortable (albeit, transparent) way where confidence has to be lowered, they simply projected their assumptions backward to smooth out the future prognostication.

This particular Private Bank group advises billions of dollars of high net worth client accounts and nobody had ever asked for the data?  I wish I was incredulous but, regrettably, I'm not.  We've become accustomed to a world of 'experts' who must - we think - be paying attention.  We can't understand the symbols, the numbers, the math so, we tell ourselves, it's beyond our capacity to critique. 

Which leads me to an Inverted Alchemy first; an anti-Archimedean theorem:

The rate of acceptance of a financial product is inversely proportional to its transparency while the catastrophic potential of the same is a log function of the number of people who purport to be incapable of understanding the product.

Knight Capital and LIBOR rate rigging are but two of the myriad of proofs of this proposition.

I was contemplating this while winging my way northward across the east coast of Australia.  Courtesy of Qantas' liberal distribution of The Australian, I was inundated with accounts of the grim reality facing a country built on extractive industries.  There was the cover story of the myriad of contractors who are experiencing job losses as BHP and other miners contract their production in the face of a global economic slowdown.  There was the rather brazen article about BHP's CEO Marius Kloppers' decision to voluntarily forego his $4.7 million employment bonus in the face of the firm's nearly $3 billion write-down of U.S. shale gas assets acquired from Chesapeake Energy.  Generosity and leadership, eh?  You cause your firm to spend $4.75 billion and within two years more than half of that money is lost and you generously forego a bonus?!  Oh, and my favorite line in the article: "Mr. Kloppers told The Weekend Australian that he had taken the decision to forgo his bonus because, at the end of the day, there had to be accountability."  WHAT?

So how does Knight Capital, LIBOR rate-fixing, Private Bank derision of client intellect, and BHP's write-down come together to teach us anything other than the complete impunity with which we allow the titans of finance and industry to act with total contempt for humanity and the earth?  Quite simply.  All of these are the end product of a social evolution which is leading to calamity.  We have become enslaved with the terminal product of our digital hegemonic illusion in which 'computers' can 'out-think' the human intellect.  And in so doing, we have also blurred the line between investing and speculative trading and have become intoxicated at the casino of productivity decoupled returns. 

While I'm not a huge fan of most Occidental scientific theories - including the most recent Higgs Particle nonsense that confirms that our understanding of physics holds provided that there's no gravity, friction or any of the other observable forces in nature - there is no question that a bit of thermodynamic constraints would do us some good.  Perpetual growth is not appropriate.  In the body we call it metastatic cancer and it's deadly!  Assuming that we can extract anything at a rate exceeding its replenishment means that someone somewhere is going to have to pay dearly and by pay, I mean certain loss.  And believing that a computer - programmed by humans using binary (yes, the lowest complexity possible) code - is somehow less susceptible to catastrophic error than sentient beings (including algae) is assuredly a recipe for disaster.

"What is an individual to do?", I've been frequently asked by people who struggle through Inverted Alchemy each week.  The answer is really quite simple.  Invest Yourself.  Not in things that are too illusive to understand but in things that make sense.  If farmers, grocers, service providers, utility providers, or businesses in your community are in need to capital to help them sustain and grow their enterprises across normal seasons (actual or business cycle), invest with them and ask for a return that is suitable within the scale of their productivity.  Take the time and effort to understand how the enterprises on which you depend work and provide Integral Accounted assets to support those that you see as valuable.  If your local bank (or even your behemoth bank) lends money to businesses to help them operate successfully, see what programs they have which can link you to others in your community to help originate, sponsor, or sustain local enterprises at rates determined by the enterprise's productivity; not some arbitrary interest rate.  And if you have an appetite for global opportunities, invest your time, resources, and inquisitiveness to diligence the same.  And, most importantly, having done all of this, if you get to a point where what you're seeing doesn't make sense and you're being asked to just "trust an expert", run, don't walk, away. 

For in the end, there's no Batman out there winging his way to our rescue from our own self-inflicted wounds.  If you have a 401(k) or mutual fund, there's a decent chance that some of BHP's missing billions actually came from your account.  But, if you paid no attention to the fact that money paid through you was invested in BHP, than you didn't lose it, you threw it away.  And the same helplessness that leads to the belief that the system's to complicated to understand is setting us up for even greater disruptions.  To be sure, between now and then, we could see governments and corporations create distractions: cyber attacks blamed on Asia; a mine killing and maiming troops deployed with the 5th Fleet in the Persian Gulf and East Africa blamed on Iran; grid failures or electromagnetic interference that brings down computers and systems blamed on our villains du jour.  Some of these could delay the inevitable reconciliation but these deferrals won't fix anything.  We must reclaim our expansive capacity to think and collaborate, deploy it in a scale commensurate with the confident reach of our knowledge, and embrace our own responsibility for a system created poorly in our most profane image.  Do nothing and you're one 'glitch' away from collapse of the matrix which entangles so many.  Be an informed participant and you'll be at liberty - fully alive and devoid of any need of rescue.  Then, who knows, it may be a sunrise instead of a dark night!

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Thank you for your comment. I look forward to considering this in the expanding dialogue. Dave