John Lanchester

Sensex @28,500 : Stock Market as a beauty contest

bullfightingVivek Kaul

We never know what we are talking about – Karl Popper

The Sensex closed at 28,499.54 points yesterday (i.e. November 24, 2014). The fund managers are confident that this bull run will last for a while. Or so they said in a round table organised by The Economic Times.
Prashant Jain of HDFC Mutual Fund explained that during the last three bull markets that India had seen, the market had never peaked before reaching a price to earnings ratio of 25 times. The price to earnings ratio currently is 16 times, and hence, we are still at a “reasonable distance” from the peak.
This seems like a fair point. But how many people invest in the stock market on the basis of where the price to earnings ratio is at any point of time? If that were the case most people would have invested in 2008-2009, when the price to earnings ratio of the Sensex through the year stood at 12.68.
By buying stocks at a lower price to earnings ratio, they would have made more money once the stock market started to recover. But stock markets and rationality don’t always go together. Every investor is does not look at fundamentals before investing. “In investing, fundamentals are the underlying realities of business, in terms of sales, costs and profits,” explains John Lanchester in How to Speak Money.
A big bunch of stock market investors like to move with the herd. Let’s call such investors non fundamentals investors.
So when do these investors actually invest in the stock market? In order to understand this we will have to go back to John Maynard Keynes. Keynes equated the stock market to a “beauty contest” which was fairly common during his day.
As Lanchester writes “Keynes gave a famous description of what this kind of non-fundamentals investor does: he is looking at a photo of six girls and trying to pick, not which girl he thinks is the prettiest, and not which he thinks most people will think is the prettiest, but which most people will think most people will think is the prettiest…In other words the non-fundamentals investor isn’t trying to work out what companies he should invest in, or what company most investors will think they should invest in, but which company most investors will think most investors will want to invest in.”
Or as Keynes put it in his magnum opus The General Theory of Employment, Interest and Money“It is not a case of choosing those [faces] that, to the best of one’s judgement, are really the prettiest, nor even those that average opinion genuinely thinks the prettiest. We have reached the third degree where we devote our intelligences to anticipating what average opinion expects the average opinion to be.”
Hence, a large bunch of investors invest on the basis of whether others round them have been investing. That is the beauty contest of today.
Nilesh Shah, MD and CEO of Axis Capital pointed out in The Economic Times round table that nearly Rs 25,000-Rs 30,000 crore of money will come into the stock market through systematic investment plans (SIPs).
Anyone who understands the basics of how SIPs work knows that they are designed to exploit the volatility of the stock market—buy more mutual fund units when the stock market is falling and buy fewer units while it is going up. This helps in averaging the cost of purchase over a period of time, and ensures reasonable returns.
Investors who are getting into SIPs now are not best placed to exploit the SIP design. Nevertheless, they are still investing simply because others around them have been investing. This also explains why the net inflow into equity mutual funds for the first seven months of the this financial year (between April and October 2014) has been at Rs 39,217 crore. This is when the stock market is regularly touching new highs.
And if things go on as they currently are, the year might see the highest inflow into equity mutual funds ever. The year 2007-2008 had seen Rs 40,782 crore being invested into equity mutual funds. This was the year when the stock market was on fire. In early January 2008, the Sensex almost touched 21,000 points. It had started the financial year at around 12,500 points.
So, now its all about the flow or what Keynes said “what average opinion expects the average opinion to be.” And till people see others around them investing in the stock market they will continue to do so. This will happen till the stock market continues to rise. And stock market will continue to rise till foreign investors keep bringing money into India.
No self respecting fund manager can admit to the fact that these are the reasons behind the stock market rallying continuously all through this year. This is simply because all fund managers charge a certain percentage of the money they manage as a management fee.
And how will they justify that management fee, if the stock market is going up simply because it is going up. Nobel prize winning economist Robert Shiller calls such a situation a naturally occurring Ponzi scheme.
As he writes in the first edition of Irrational Exuberance: “Ponzi schemes do arise from time to time without the contrivance of a fraudulent manager. Even if there is no manipulator fabricating false stories and deliberately deceiving investors in the aggregate stock market, tales about the market are everywhere. When prices go up a number of times, investors are rewarded sequentially by price movements in these markets just as they are in Ponzi schemes. There are still many people (indeed, the stock brokerage and mutual fund industries as a whole) who benefit from telling stories that suggest that the markets will go up further. There is no reason for these stories to be fraudulent; they need to only emphasize the positive news and give less emphasis to the negative.”
And that is precisely what fund managers will do in the time to come. In fact, they have already started to do that.
They will tell us stories. One favourite story that they like to offer is that India’s economy is much better placed than a lot of other emerging markets. This is true, but then what does that really tell us? (For a real picture of the Indian economy check out this piece by Swaminathan Aiyar).
Another favourite line you will hear over and over again is that “markets are never wrong”. This phrase can justify anything.
The trick here is to say things with confidence. And that is something some of these fund managers excel at. Nevertheless it is worth remembering what Nassim Nicholas Taleb writes in The Black Swan: “Humans will believe anything you say provided you do not exhibit the smallest shadow of diffidence; like animals, they can detect the smallest crack in your confidence before you express it. The trick is to be smooth as possible in personal manners…It is not what you are telling people, it how you are saying it.”
And this is something worth thinking about.

The article originally appeared on www.equitymaster.com on Nov 25, 2014

Kotak-ING Vysya merger: Why M&As are like Elizabeth Taylor’s marriages

635266189203244874_Kotak Mahindra Bank Elizabeth_Taylor_portraitKotak Mahindra Bank is set to acquire ING Vysya bank. “All ING Vysya branches and employees will become Kotak branches and employees” after the deal is completed,” the banks said in a statement yesterday. “Congratulations @udaykotak on a brilliant merger move. The enormous synergies are obvious,” industrialist Anand Mahindra tweeted after the deal was announced.
Big companies like to acquire other companies and the reason that is often cited is synergy. But things are never very obvious, even though they may seem to be initially. The history of mergers and acquisitions is littered with examples of things going terribly wrong for companies. Nevertheless, the zeal to merge and acquire, and thus grow bigger in the process, doesn’t seem to die down with executives who always remain confident of making it work.
As Paul B Carrol and Chunka Mui write in Billion Dollar Lessons — What You Can Learn from the Most Inexcusable Business Failure of the Last 25 Years “Executives can be like Elizabeth Taylor, who has said that with each of eight marriages, she was convinced that somehow, someway, this marriage would work.”
Usually a merger is justified by harping on a particular synergy. And what exactly is this synergy? It could be something like the scenario that was used to justify Coca Cola buying Columbia Pictures—consumers while watching movies made by Columbia Pictures will drink Coke. Not surprisingly, this did not work out well and Coca Cola had to soon sell Columbia Pictures.
But on a more serious note what exactly is synergy? John Lanchester defines the term in his book How To Speak Money: “Synergy: Mainly BULLSHIT, but when it does mean anything it means merging two companies together and taking the opportunity to sack people.” He then goes on to explain the concept through an example.
As he writes “If two companies that make similar products merge, they will have a similar warehouse and delivery operations, so one of the two sets of employees will lose their jobs. The idea is that this will cut COSTS and increase profits, though that tends not to happen, and it is a proven fact that most mergers end by costing money…When two companies merge, the first thing that ANALYSTS look at when evaluating the deal is how many jobs have been lost: the higher the number, the better. That’s synergy.”
An interesting story here is that of Bank of America stepping into acquire Merrill Lynch around the time the current financial crisis broke out. Michael Lewis writes in Flashboys that Merrill Lynch ended up taking over the equity division of Bank of America and went about firing employees of the bank. Merrill Lynch employees also gave themselves huge bonuses. Lewis quotes John Schwall, who had for Bank of America for nine years, as saying: “It was incredibly unjust. My stock in this company I helped build for nine years goes into the shitter, and these assholes pay themselves record bonuses. It was a fucking crime.”
Also, even in cases of firms which are in the same line of business, things can turn out all wrong, even with all the projected synergy. As an article in a September 1994 edition of The Economist points out “Even complementary firms can have different cultures, which makes melding them tricky. And organising an acquisition can make top managers spread their time too thinly, neglecting their core business and so bringing doom. Too often, however, potential difficulties such as these seem trivial to managers caught up in the thrill of the chase…and eager to grow more powerful.” This is something that Kotak and ING Vysya will have to deal with. Essentially, what might seem like an extremely valuable operating synergy may simply evaporate because of the cultural differences that exist between the two firms.
A good example here is the merger of America Online and Time  Warner. “At the time of the merger in 2000, when the company’s market capitalisation was $280 billion, AOL’s Steve Case and Time  Warner’s Gerald Levin proclaimed that they had done nothing less  than reinvent media by combining an old-line media company with a new age one. They said AOL  would feed customers to Time Warner’s magazines and its cable, movie, music, and book businesses. Time Warner would provide new kinds of content that would help AOL sign up even more customers for its online subscription service,” write Carrol and Mui.
But the synergy that had been thought of before the merger was simply not there. And there was a reason for it. The idea was to combine the “old and new media”. The top management did a lot to get the synergy going. Nevertheless it did not work out. As Carol and Mul put it “But the folks on the Time Warner side, in particular, didn’t make the jump with them. Time, Fortune, Sports Illustrated and scores of other magazines had prospered for decades. They had well-established practices for how they produced their stories and sold their ads.”
And once these so called obvious synergies evaporate, there is trouble ahead. Hence, most mergers and acquisitions do not work out well. As Carrol and Mui point out “A McKinsey study of 124 mergers found that only 30% generated synergies on the revenue side that were even close to what the acquirer had predicted. Results were better on the cost side. Some 60% of the cases met the forecasts on cost synergies. Still, that means two out of five didn’t deliver the cost synergies, and forecasts were sometimes way off — in a quarter of the cases, cost synergies were overestimated by at least 25%.”
There is other similar evidence available. As Jay Niblick writes in an article titled The Problem with Mergers and Acquisitions “According to KPMG and Wharton studies, 83% of mergers and acquisitions failed to produce any benefits – and over half actually ended up reducing the value instead of increasing it. Multiple other studies would agree, finding that the failure rate of most mergers and acquisitions ranges somewhere between 60-80%. It would seem obvious that something is wrong with this industry.”
Niblick goes on to ask “even the average village idiot should be able to notice that something isn’t working here – right?” But that as it turns out is not the case.
Even with a huge amount of evidence that mergers and acquisitions don’t seem to work, the idea of acquiring companies is seductive. This is primarily because “they fill the need for CEOs to make some bold move that will redefine an industry and establish their legacy,” explain Carol and Mui This leads to the acquiring company typically overpaying for the acquired firm and shareholders of the acquired firm lose out in the process. As The Economist points out “Shareholders of acquiring firms seldom do well: on average their share price is roughly unchanged on the news of the deal, and then falls relative to the market. Part of the reason for this is that lovelorn company bosses, intent on conquest, neglect the needs of their existing shareholders.”
To conclude, the top management of Kotak and ING will have to keep these things in mind once they start merging their operations on the ground. And if history is any guide for things, tough times lie ahead for the two financial firms.

The article originally appeared on www.FirstBiz.com on Nov 21, 2014

(Vivek Kaul is the author of the Easy Money trilogy. He tweets @kaul_vivek)

Federal Reserve ends money printing, but the easy money party will continue

yellen_janet_040512_8x10Vivek Kaul

The Federal Open Market Committee(FOMC) which decides on the monetary policy of the United States in a statement released yesterday said “the Committee [has] decided to conclude its asset purchase program this month.”
What the Federal Reserve calls “asset purchase program” is referred to as “quantitative easing” by the economists. In simple English this is just the good old money printing with a twist. Since the start of the financial crisis, the Federal Reserve has printed around $3.6 trillion of new money.
This month the Federal Reserve has printed around around $15 billion. It has pumped this money into the financial system by buying government bonds and mortgage backed securities. From November 2014, the Federal Reserve will no longer print money to buy government and private bonds.
So why is the Federal Reserve bringing money printing to an end? The simple reason is that with so much money being printed and pumped into the financial system, there is always the threat of too much money chasing too few goods, and leading to a massive price rise in the process. Even though something like that has not happened the threat remains.
As John Lanchester writes in How to Speak Money “More generally QE[quantitative easing] taps into the fear that governments printing money always leads to dangerous levels of inflation, and that inflation, like a peat-bog fire, is all the more dangerous when it’s cooking up underground.”
There have been too many instances of money printing by the government leading to massive inflation in the past. And the Federal Reserve couldn’t have kept ignoring it.
Lanchester perhaps describes quantitative easing(QE) in the simplest possible way and what it really stands for by cutting out all the jargon in his new book How to Speak Money. As he writes “QE involves a government buying its own bonds using money which doesn’t actually exist. It’s like borrowing money from somebody and then paying them back with a piece of paper on which you’ve written the word ‘Money’ – and then, magically, it turns out that the piece of paper with ‘Money’ [written] on it is actually real money.”
Lanchester describes QE in another way as well. He compares it to a situation where an individual while looking at his “bank balance online” also has “the additional ability to add to it just by typing numbers on [his] keyboard.” “Ordinary punters can’t do this, obviously, but governments can; then they use this newly created magic money to buy back their own debt. That’s what quantitative easing is,” writes Lanchester.
This has been done in the hope that with all the newly money created being pumped into the financial system, there would be enough money going around and interest rates would continue to remain low. At lower interest rates the hope was people would borrow and spend more, and this in turn would lead to economic growth.
This did not turn out to be the case. What happened instead was that financial institutions borrowed money at very low interest rates and invested that money in financial markets all over the world. This explains to a large extent why stock markets have rallied all over the world in the recent past despite slow economic growth in large parts of the world.
So with the Federal Reserve deciding to stop money printing, will the era of easy money come to an end as well? The answer is no. For “easy money” junkies the party will continue. The Federal Reserve stated yesterday that “The Committee is maintaining its existing policy of reinvesting principal payments from its holdings of agency debt and agency mortgage-backed securities in agency mortgage-backed securities and of rolling over maturing Treasury securities at auction. This policy, by keeping the Committee’s holdings of longer-term securities at sizable levels, should help maintain accommodative financial condition.”
What does this mean in simple English? The Federal Reserve has printed and pumped money into the financial system by buying bonds. It currently holds around more than $4 trillion worth of bonds. Bloomberg points out that this makes up for around 20% of all the bonds issued by the American government as well as mortgage backed securities outstanding. The Federal Reserve holds around $2.46 trillion of US government bonds.
In the days to come as these bonds mature, the Federal Reserve plans to use the money that comes back to it to buy more bonds. In this way it plans to ensure that the money that it has printed and pumped into the financial system, stays in the financial system.
Hence, Federal Reserve will not start sucking out all the money it has printed and pumped into the financial any time soon. And this means that the era of “easy money” will continue for the time being. The Federal Reserve also stated that fit plans keep interest rates low “for a considerable time following the end of its asset purchase program this month.”
By doing this, the Federal Reserve is essentially buying time. Currently, it is very difficult to predict how exactly the financial markets will react if the Fed decides to start sucking out all the money that it has printed and pumped into the financial system.
As Lanchester writes “Nobody quite knows what’s going to happen once QE stops. In fact, the ‘unwinding’ of the QE is on many people’s list as the possible trigger for the next global meltdown.” Further, even though the American economy is doing much better than it was in the past, the recovery at best has been fragile. The US economy grew by 4.6% during the period between July and September 2014, after having contracted by 2.1% during April to June, earlier this year.
The rate of unemployment in the US has been coming down for quite a while now. In September 2014, it stood at 5.9% against 6.1% in August. This rate of unemployment is around the average rate of unemployment of 5.83% between 1948 and 2014. It is also below the 6.5% rate of unemployment that the Federal Reserve is comfortable with.
Nevertheless, even with these reasons, the Federal Reserve is unlikely to start sucking out money and raising interest rates any time soon. This is because the US has become what Lanchester calls a “two-speed economy”. Lanchester defines this as “an economy in which different sectors are performing differently at the same time”. In the American context, it is a matter of Texas and the rest of the country.
The state of Texas has been creating more jobs than any other state in the United States. As Sam Rhines an economist at Chilton Capital Management points out in a recent article in The National Interest “From its peak in January 2008 through today, the United States has created only 750,000 jobs. Texas created over a million jobs during that same period—meaning that the rest of the country (RotC) is still short 300,000 jobs. During the recovery, job creation has been all Texas or—at the very least—disproportionately Texas.”
This has meant that the contribution that Texas has been making to the US economy has increased over the last few years, from 7.7% in 2006, it now stands at 9%. So, if one takes Texas out of the equation, the United States still hasn’t recovered all the jobs it lost since the start of the financial crisis in September 2008. Further, if one takes out the Texas growth out of the equation, the GDP growth also falls considerably. As Rhines writes “From 2007 through the end of 2013, the U.S. economy grew by $702 billion, and Texas grew by $220.5 billion.”
Other than this the broad unemployment numbers hide the fact that the labour force participation rate has been falling over the years. Labour force participation rate is essentially the proportion of population older than 15 years that is economically active. The number for September 2014 stood at 62.7%. This is the lowest number since 1978. The number had stood at more than 65% before the start of the financial crisis. Hence, more and more people are now not looking for jobs and they are no longer counted as unemployed.
Further, a lot of jobs being created are part-time jobs. Also, with jobs being difficult to come by many people looking for full-time jobs have had to take on part time jobs. In August 2014, nearly 7.3 million Americans were involuntarily working part time, compared to 4.6 million in December 2007, before the financial crisis had started. In September 2014, this number dropped to 7.1 million. Even after this fall, the number remains disproportionately high. This underemployment is not reflected in the rate of unemployment number.
Janet Yellen obviously understands this. As she had said in a press conference in September 2014 “There are still too many people who want jobs but cannot find them, too many who are working part-time but would prefer full-time work.”
Taking all these factors into account the Federal Reserve is unlikely to start sucking out all the money it has printed and pumped into the financial system any time soon. Nevertheless, whenever it gets around to doing that there will be trouble ahead.
Lanchester perhaps summarises the situation well when he says: “If a medicine is guaranteed to make you very sick when you stop taking it, and you know that one day you’ll have to stop taking it, then maybe you shouldn’t start taking it in the first place.”
But that at best is a benefit of hindsight. The horse, as they say, has already bolted by now. Alan Greenspan, the former Chairman of the Federal Reserve, recently said that the next phase of Fed’s retreat would not be so smooth and the Fed would not able to avoid turmoil. “I don’t think it’s possible,” Greenspan said.

The column is an updated version of a column that appeared on October 29, 2014. You can read it here.

(Vivek Kaul is the author of the Easy Money trilogy. He tweets @kaul_vivek)

Why the US Fed will not be sucking out all the printed money any time soon

 

Vivek Kaul

The Federal Open Market Committee(FOMC) is scheduled to meet on October 28-29. This is one of the eight regularly scheduled meetings during the year. It is widely expected that the Janet Yellen led Federal Reserve will more or less bring quantitative easing to an end.
Economists like to refer to the good old money printing as “quantitative easing”. The Federal Reserve till date has printed around $4 trillion and pumped it into the financial system. It currently prints around $15 billion per month and pumps this money into the financial system by buying government bonds and mortgage backed securities.
The writer John Lanchester perhaps describes quantitative easing(QE) in the simplest possible way and what it really stands for by cutting out all the jargon in his new book How to Speak Money. As he writes “QE involves a government buying its own BONDS using money which doesn’t actually exist. It’s like borrowing money from somebody and then paying them back with a piece of paper on which you’ve written the word ‘Money’ – and then, magically, it turns out that the piece of paper with ‘Money’ [written] on it is actually real money.”
Lanchester describes QE in another way as well. He compares it to a situation where an individual while looking at his “bank balance online” also has “the additional ability to add to it just by typing numbers on [his] keyboard.” “Ordinary punters can’t do this, obviously, but governments can; then they use this newly created magic money to buy back their own debt. That’s what quantitative easing is,” writes Lanchester.
This has been done in the hope that with all the newly money created being pumped into the financial system, there would be enough money going around and interest rates would continue to remain low. At lower interest rates the hope was people would borrow and spend more, and this in turn would lead to economic growth.
This did not turn out to be the case. What happened instead was that financial institutions borrowed money at very low interest rates and invested that money in financial markets all over the world. This explains to a large extent why stock markets have rallied all over the world in the recent past.
Lanchester believes that instead of going through the QE route the Western governments should have simply handed over this money directly to the people. He makes this comment in the context of the United Kingdom. As he writes “In the UK, the government has spent magic money on QE to the tune of £ 375 billion, an amount equal to 23.8% of…GDP…If they’d just had given the money direct to the public, perhaps in the form of time-limited. UK-only spending vouchers, it would have amounted to just under £ 6,000 for every man, woman and child in the country. Can anyone doubt that the stimulus effect that would have been much bigger?”
A similar argument can be made for the American economy as well. Nevertheless, this is just a counterfactual and something that did not happen.
Now the US Federal Reserve is likely to stop printing money after its meeting over two days. Does that mean there will be trouble ahead? As Lanchester writes “Nobody quite knows what’s going to happen once QE stops. In fact, the ‘unwinding’ of the QE is on many people’s list as the possible trigger for the next global meltdown.”
Once the US Fed stops printing money, new money will stop coming into the market every month. Hence, perpetually increasing liquidity will come to an end, at least in the American context.
So, does that mean interest rates will start to go up? The answer is no. As Mohammed A. El-Erian wrote in a recent column for Bloomberg “They will reiterate their willingness to keep interest rates low, should economic conditions warrant it. In doing all this, Fed officials will again try to buy time — both for the economy to heal and for politicians to step up to their responsibilities — hoping for better times ahead.”
What this means in simple English is that the Federal Reserve will not start sucking out all the money it has printed and pumped into the financial any time soon. And this means that the era of “easy money” will continue for the time being.
The reason for this is fairly straightforward. Even though the American economy is doing much better than it was in the past, the recovery at best has been fragile. The US economy grew by 4.6% during the period between July and September 2014, after having contracted by 2.1% during April to June, earlier this year.
The rate of unemployment in the US has been coming down for quite a while now. In September 2014, it stood at 5.9% against 6.1% in August. This rate of unemployment is around the average rate of unemployment of 5.83% between 1948 and 2014. It is also below the 6.5% rate of unemployment that the Federal Reserve is comfortable with.
Nevertheless, even with these reasons, the Federal Reserve is unlikely to start sucking out money and raising interest rates any time soon. This is because the US has become what Lanchester calls a “two-speed economy”. Lanchester defines this as “an economy in which different sectors are performing differently at the same time”. In the American context, it is a matter of Texas and the rest of the country.
The state of Texas has been creating more jobs than any other state in the United States. As Sam Rhines an economist at Chilton Capital Management points out in a recent article in The National Interest “From its peak in January 2008 through today, the United States has created only 750,000 jobs. Texas created over a million jobs during that same period—meaning that the rest of the country (RotC) is still short 300,000 jobs. During the recovery, job creation has been all Texas or—at the very least—disproportionately Texas.”
This has meant that the contribution that Texas has been making to the US economy has increased over the last few years, from 7.7% in 2006, it now stands at 9%. So, if one takes Texas out of the equation, the United States still hasn’t recovered all the jobs it lost since the start of the financial crisis in September 2008. Further, if one takes out the Texas growth out of the equation, the GDP growth also falls considerably. As Rhines writes “From 2007 through the end of 2013, the U.S. economy grew by $702 billion, and Texas grew by $220.5 billion.”
Other than this the broad unemployment numbers hide the fact that the labour force participation rate has been falling over the years. Labour force participation rate is essentially the proportion of population older than 15 years that is economically active. The number for September 2014 stood at 62.7%. This is the lowest number since 1978. The number had stood at more than 65% before the start of the financial crisis. Hence, more and more people are now not looking for jobs and they are no longer counted as unemployed.
Further, a lot of jobs being created are part-time jobs. Also, with jobs being difficult to come by many people looking for full-time jobs have had to take on part time jobs. In August 2014, nearly 7.3 million Americans were involuntarily working part time, compared to 4.6 million in December 2007, before the financial crisis had started. In September 2014, this number dropped to 7.1 million. Even after this fall, the number remains disproportionately high. This underemployment is not reflected in the rate of unemployment number.
Janet Yellen obviously understands this. As she had said in a press conference in September 2014 “There are still too many people who want jobs but cannot find them, too many who are working part-time but would prefer full-time work.”
Taking all these factors into account the Federal Reserve is unlikely to start sucking out all the money it has printed and pumped into the financial system any time soon. Nevertheless, whenever it gets around to doing that there will be trouble ahead.
Lanchester perhaps summarises the situation well when he says: “If a medicine is guaranteed to make you very sick when you stop taking it, and you know that one day you’ll have to stop taking it, then maybe you shouldn’t start taking it in the first place.”
But that at best is a benefit of hindsight. The horse, as they say, has already bolted by now.

The article originally appeared on www.FirstBiz.com on Oct 29, 2014

(Vivek Kaul is the author of the Easy Money trilogy. He tweets @kaul_vivek)

Reversification: A one-word explanation for what’s wrong with the world of finance

how to speak money

Vivek Kaul

When MTV first came to India in the early 1990s, I was hooked on to the channel in a matter of a few months. Growing up in a small town, the channel was my first “real” exposure to what we called “English” music. Until then my only exposure to English music was “Michael Jackson” and like others of my generation I was more aware of his mannerisms than his songs.
One of the things that got me hooked to MTV was reggae music. And one of the first reggae songs that I heard was Inner Cirlce’s Games People Play. Other than the music of the song which was very peppy, what I liked was that for the first time I was able to make out the lyrics of an English song.
One paragraph of the song went like this:
Oh the games people play now
Every night and evety day now
Never meaning what they say, yeah
Never saying what they mean.
This paragraph has stayed with me since then and I have realized its meaning in various contexts at various points of time over the last two decades. One area where this paragraph particularly applies is finance. The writer John Lanchester in his new book How to Speak Money comes with a new term to explain this . He calls the term “reversification”. He defines reversification as a “process in which words come, through a process of evolution and innovation, to have a meaning that is opposite to, or at least very different from, their initial sense.”
A good example of reversification in finance is the much used term “Chinese wall”. In real life, the Great Wall of China is a very big wall that was built over several centuries to keep the enemies out of China. One of the biggest misconceptions about it is that it is visible from the moon.
So, what does it mean in finance? “Inside the world of money, though, the term ‘Chinese wall’ means an invisible barrier inside a financial institution which is supposed to prevent people from sharing information across it, in order to avert conflict of interests,” writes Lanchester.
Let’s take the example of the Chinese walls that are supposed exist between stock analysts who make investment recommendations to investors (i.e. whether to buy, sell or hold the stock of a company) and the investment banking division, which takes companies public, by getting them listed on a stock exchange.
This wall is regularly broken whenever a profitable investment opportunity comes up. Take the case of the dotcom bubble in the United States in the 1990s.
Even with many internet firms wanting to go public, Wall Street still wasn’t in a bargaining position. The bargaining power was with the 20–30 year olds, who ran most of these new internet companies, or the Silicon Valley venture capitalists (VCs) who had backed them. The youngsters and the VCs did not ask for a cut in Wall Street’s fee. What they wanted instead was an assurance that the Wall Street firm would support the price of the stock after it had been listed on the stock exchange.
And, of course, this had to be done legally. This was important for the Wall Street firms because new companies wanting to come out with their IPOs looked at this parameter before choosing the Wall Street firm which would handle its public offer.
The way Wall Street handled this was very clever. Before going public, the Wall Street firm promised the company that the in-house analyst of the firm would initiate coverage of the stock a few days after it got listed on the stock exchange. No favourable coverage or for that matter, a “buy” rating was promised because that would have been going against the law. It was assumed that the Wall Street firm would have nice things to say about the company it had just taken public. And so the Chinese wall was broken. Even in India, it has been observed that the stock broking division of a financial institution has nice things to say about a company that has just been taken public by the investment banking division of the same financial institution.
The way the financial system has evolved large financial institutions have different businesses which “if the system is to function without conflicts of interest – shouldn’t really be there.” But that is not the case. Hence, as Lanchester puts it “the Chinese walls…were worse than non-existent; they were opportunities for the bank to make money…that’s reversification.”
Another excellent example of reversification is a hedge fund. As Lanchester writes “the word ‘hedge’ began its life in economics as a term for setting limits to a bet, in the same way that a hedge sets a limit to a field…The idea is that by putting a hedge around a bet, you delimit the size of your potential losses.”
But is that the case? Before we get into that let’s try and understand what really is a hedge fund. Legally, there is no term called a “hedge fund,” unlike, say, “mutual fund.” The term “hedge fund” was apparently first used by the Fortune magazine in a 1966 article to describe an investment fund managed by Alfred Jones, a Columbia University sociologist, diplomat and steamboat purser who had turned into a fund manager. The article had a very interesting title. It was headlined “The Jones Nobody Keeps Up With”.
In 1952, Jones wanted to launch an investment fund which would not only buy stocks on which he was bullish on, but also short-sell the stocks (i.e., borrow and sell) which he felt were overpriced and, thus, would fall in price in the days to come. At the same time, he thought that with the expertise he brought to the table, the investors in the fund should be willing to pay him a slice of the profits he made for them.
Jones wanted to buy as well as short-sell stocks. The money that he generated from short-selling stocks would partially fund the buying of stocks which he felt were undervalued. This way, he ensured that the exposure was “market neutral,” or, in a simpler language, he “hedged his bets.”
The strategy of Alfred Jones of buying some stocks and selling some others came to be known as the equity long-short strategy. He outperformed the mutual funds which could only go long, that is, buy stocks. They could not sell them short because it was deemed to be a risky strategy. Jones also used leverage, that is, borrowed money, to spruce up his returns. Jones received 20 percent of the returns he generated for the fund as compensation.
The success of Alfred Jones was copied by many others. “The classic hedge fund technique, as created by Jones, is still in use: funds employ complex mathematical analysis to bet on prices going both up and down in ways which are supposedly guaranteed to produce a positive outcome,” writes Lanchester.
But is that really the case? A majority of the hedge funds fail. As Lanchester points out “90% of all hedge funds that have ever existed have closed down or gone broke. Out of total of about 9,800 hedge funds worldwide, 743 failed or closed in 2010, 775 in 2011, and 873 in 2012 – so in three years, a quarter of all the funds in existence three years earlier disappeared. The overall number did not decrease, because hope springs eternal, and other new hedge funds kept being launched at the same time.”
This is reversification at its best, where the word ‘hedge’ has been turned into exactly opposite of what it originally meant.
Another excellent example of reversification is securitization, which has “nothing to do with making things more secure.” Let’s try and understand this step by step.
A big financial institution sells financial securities and raises money. The money is used to buy home loans or mortgages from banks. These home loans are then pooled together. The people who have taken these home loans pay interest on these loans as well as repay their principal. This money comes into the common pool. From this pool, the financial institution pays interest on the securities it has sold to investors. It also repays the principal out of it. This process is referred to as securitization.
In the days when banking was a boring business, banks lent out the money they had collected from deposits. They also kept the loans on their books till they matured. They made money as long as the interest they paid on their deposits was less than what they charged on their loans,a ssuming that the borrower did not stop repaying.
But with securitization the bank does not maintain the loan on its books any more. It passes on the risk to the investor who buys the securities being issued. As Lanchester puts it “It[i.e. the bank] only takes the RISK of the loan for the amount of time between making the initial house loan, and the moment when it has sold the resulting security – which can be a matter of days. The bank has no real interest in the financial condition of the borrower. The basic premise of banking – that you only lend money to people who can pay it back – has been broken.”
Hence, the bank is more interested in giving out home loans rather than verifying whether the borrower has the capability to repay. This was a major reason behind the current financial crisis which started in September 2008.
Lanchester in coining “reversification” has come up with a term which explains a lot of what is wrong in finance. The examples discussed above clearly show that. As Lanchester writes “These are all examples of how process of innovation, experimentation and progress in the techniques of finance have been brought to bear on language, so that words no longer mean what they once meant.”
And this has created a major problem. “It is not a process intended to deceive…But the effect is much the same: it is excluding and it confines knowledge to within a priesthood – the priesthood of people who can speak money,” concludes Lanchester.

(Vivek Kaul is the author of the Easy Money trilogy. He tweets @kaul_vivek)