Column

Still a man hears what he wants to hear. And disregards the rest.
—The Boxer, Paul Simon

“So what are you afraid of, other than cockroaches?” I asked her.
It was around noon, and we had bunked office to spend, as they say, “quality” time together.

“Well, your mood swings for one,” she replied, sipping the new brand of cappuccino she had picked up from the market.

“And?”
“And… red ants, I guess.”

“I see. Have you read More Than You Know - Finding Financial Wisdom in Unconventional Places by Michael Mauboussin? The book offers some interesting insights. “A group of worker ants, which are essentially blind, sometimes separates from the colony. Since no individual ant has any idea how to relocate the rest of the colony, all of the ants rely on a simple decision rule: follow the ant in front of you. If enough individuals follow the strategy, they develop a circular mill, where ants follow each other around in circles until death,” it goes.

“Aah, death. Can’t we talk about something nicer?”

“You missed the point. I was trying to tell you that ants do the rational thing to get back to their colony when they get lost — follow the ant in front — though it doesn’t work at times. In other words, what seems to be a rational thing to do at an individual level becomes irrational behaviour at a collective level.”

“Rational irrationality — that’s a paradox.”

“Yeah, intriguing concept. John Cassidy defines it in How Markets Fail, The Logic of Economic Calamities as “a situation in which the application of rational self-interest in the marketplace leads to an inferior and socially irrational outcome.”

This is at the heart of the boom and bust cycle that economies keep seeing. Now take the current financial crisis. It has its roots in the home loan crisis in the US, where banks and housing finance companies lent out money to people with extremely low credit standards who were never in a position to repay. With the benefit of hindsight, we can say that it was “reckless lending.” But back then, it did not seem like that at all.”

“You are being kind to people who brought on the financial crisis.”

“Call it the white-streak effect if you will, for one does mellow down with age. But there’s a reason to what I say. Let me give you a couple of reasons. The bank or the home finance company giving out the home loan had no plans of holding on to the loans. They were securitising it away, essentially dividing the loan into financial securities and selling it to investors. By selling these securities, they got their money back immediately and this they could use to give out more loans.

Every time a borrower repaid the loan, the bank or housing finance company kept a small cut and passed on the majority to investors. That’s how the bank and investors made their money. But the risk of the borrower defaulting was not with the bank and hence the loose lending policy. If the borrower defaulted, it was the people who invested in the financial securities that lost money, not the bank.

So for the bank or the housing finance company, generating more and more loans was the rational thing to do. Also, even when a bank or housing finance company saw the risk in this kind of lending, it couldn’t help doing what its peers were doing. As Cassidy explained in an article in the New Yorker (‘Rational Irrationality: The real reason that capitalism is so crash-prone’, October 5, 2009).

“Somebody running a big financial institution seldom has the option of sitting it out. What boosts a firm’s stock price, and the boss’s standing, is a rapid expansion in revenues and market share. Privately, he may harbour reservations about a particular business line, such as sub-prime securitisation. But, once his peers have entered the field, and are making money, his firm has little choice except to join them.”

“And then?”

“Charles “Chuck” Prince, former CEO of Citigroup, summarised it best when he said, “When the music stops, in terms of liquidity, things will be complicated… But as long as the music is playing, you’ve got to get up and dance. We’re still dancing.” Of course, the dance did not go on forever and brought the financial system of the world to a brink of collapse. And after the crisis erupted, banks started to be rationally irrational again.

“Each bank was adopting a prudent course by turning away questionable borrowers and holding on to its capital. But the results were mutually ruinous: once credit stopped flowing, many financial firms —- the banks included —- were forced to sell off assets in order to raise cash. This round of selling caused stocks, bonds, and other assets to decline in value, which generated a new round of losses,”

Cassidy wrote. Economist John Maynard Keynes once famously said, “There is no such thing as liquidity of investment for the community as a whole.” Given this rational irrationality, financial system reform will not work beyond a point. A decision that seems “perfectly reasonable” at the individual level, “when aggregated in the marketplace, produces calamity,” said Keynes.”

“So what’s your big prediction?”

“We may see rational irrationality in the commodities market this year and next. As governments the world over continue to keep interest rates low and keep printing more and more money, it makes tremendous sense for investors to park their money in hard physical assets. As Gary Dorsch recently wrote in his investment newsletter (“Commodity Super Cycle” Ready to
Rumble in 2010, www.safehaven.com, January 6, 2010).

“Traders are plowing billions of dollars, euros and yen into commodities and precious metals, betting on the debasement of all paper currencies.” At an individual level, it seems like the rational thing to do.”

“And you feel this rationality can easily lead to a system-level irrationality and a bubble?” she asked.

“Yes.”

“So when does an investor know that it’s a bubble?”

“I wish I knew. To quote Keynes again: “It is, so to speak, a game of Snap, of Old Maid, of Musical Chairs — a pastime in which he is victor who says Snap neither too soon nor too late, who passes the Old Maid to his neighbour before the game is over, who secures a chair for himself when the music stops.”

(The example is hypothetical)