The sub-prime mortgage crash of two years ago was not about mortgages and it was not about complexity of derivatives and the cross-betting lunacy of credit default swap insurance voodoo. It was about the simplest thing in economics: price. If you can’t find a price, there is no sale, no market, no value, no money. In that instance, everything seizes up and you see what happened yesterday, for a while, on Wall Street.
Investigators are looking at a possible 16 billion dollar trade out of Chicago that should have been recorded as 16 million. It was this suspected three zero error that bounced around like a wrench thrown through a crowded bus, producing panic and pain until things settled down, and I mean down. With the Dow and S&P plunging 3.2 percent., it was a decline that traders could be overjoyed about compared to the vertical drop of more than 900 points earlier in the day.
What may have been set off in Chicago was something more than simply a regular old bad-news consensus. It went way beyond a typical negative Wall Street day, when the smell of a trend causes investors to grab some profits, sell out and jump off the stock wheel for a while. This was a moment when the idea of price itself vaporized in waves of doubt interconnected by massive computer trades, currency hedges, and defensive fear.
My favorite quote of the day came from an equity trader in New Jersey named Joe Saluzzi. He likes to twitter his intense hatred of computer trading and the so-called “quants.” Quant is the name for the math-gurus with their machine driven strategies that could do no wrong when this market, the dot.com bubble and the sub-prime bubble were all on the way up. Yesterday, Saluzzi told Reuters, “We did not know what a stock was worth today, and that is a serious problem,"
The traders couldn’t find a price. Old reliable Procter and Gamble lost 50 percent of its value at one point before bouncing back. A few stocks flirted with zero. This kind of a free-fall can only happen when the consensus that a price can be found for a security breaks down and, like blinking on a rollercoaster, all of a sudden the whole world is a blurry mess. The sub-prime crisis happened in a blink when suddenly the prices for some complicated securities containing what seemed to be backed by the federal government were actually worthless, and enough investors asked the question: “What if everybody stopped paying these mortgages?” Once this question is posed, the ability to price anything at all with a mortgage vaporized like Lehman Brothers, Bear Sterns and nearly Citibank. Their value, in turn, became incalculable, which meant the risk of lending even on overnight and short terms was too high to even set an interest rate. This shut down the credit markets and scared the White House and much of Wall Street into believing they were hours away from the collapse of the entire global economy.
Okay, accidentally confusing millions for billions in the middle of a trading day ought to produce some jitters. But the apparent math errors in Chicago compounded other serious pricing challenges. The European Central Bank can’t seem to figure out what Greek debt is worth and the streets of Athens reek of tear gas from rioting. The global markets are having the same difficulty settling on a price for Spanish and Portuguese bonds. This is making a price for the Euro hard to calculate, which drives billions into something safer: U.S. Government Treasury Bills.
However, with the U.S. deficit close to 11 percent of U.S. GDP, the global flight to treasuries suddenly looks like a migration of lemmings. How quickly might an inability to price T-bills come about? Last week on our program a Harvard Professor said it would take years before the price of U.S. debt would begin to rise. Yet the mortgage backed securities that set off the last crisis were worth a lot the week before they were worthless. It is certain that any scenario in which pricing of T-bills becomes a problem — like stock prices were for Mr. Saluzzi yesterday — would shut down the entire economy on a scale way beyond the freezing of the credit markets in 2008.
The crisis of pricing yesterday might be a blip based on a mistake exacerbated by machines and those annoying “program traders.” But it’s much more alarming to think that all these crises might also be an early sign that the economy as we understand it now doesn’t scale up well. Securities that travel from New York to China and India in a nanosecond begin to lose their identity. What is this I am buying? Or this, why does a corporate CEO get $43 million dollars, this banker $29 million and this high school teacher $45K? Is the teacher worth really that much less than the banker or the president of CBS? How can we price anything when the comparisons are so hard, the languages so diverse, and the assumptions about where things are headed are based on the idea that a price can, and will, be found.
“We did not know what a stock was worth today, and that is a serious problem," equity trader Joe Saluzzi said about the market. Take out the word stocks and substitute any number of products and services ranging from workers salaries to real estate to T-bills and suddenly you feel that there may be no escape from this uncertainty.
If I can’t see a price for something, I typically avoid it. If the markets blink and investors suddenly lose their belief that price even exists, then everything shuts down.