In this article from The IRS Report in March 2008, Chris Gilchrist discusses the current market situation.……

When the market isn't right

"You can't buck the markets," said Margaret Thatcher. And we're still influenced by all that neo-capitalist rhetoric from the heyday of privatisation, releasing state-owned behemoths from the dead hand of bureaucracy and so forth. But one thing that is obvious from the sub-prime debacle and its malign domino-topple effects is that the market is often wrong. Taking it as the arbiter of values is pure folly with the sub-prime losses being a case in point. There is currently no market in many of the sub-prime securities created by the Wall Street banks. There never was much of a market even when a lot of this stuff was being sold. That is why the banks invented complex "mark to model" systems that said what the value ought to be, using the formulae of the same Nobel prize-winning economists who caused the downfall of hedge fund managers Long Term Capital Management in 2000. They used these formulae to value the stuff in their "Special Purpose Vehicles" and conduits. But once the wheels came off and far more black-box junk returned to their balance sheets, regulators became nervous and banks wrote off as much as the markets say they should, given that they can't sell the stuff at any price.

Is the market right? What market? All you are talking about is opinions. It's not as if billions of transactions were going through the market each day, which is what gives us the confidence that there is a market in BP or HSBC or Treasury 8% 2012 or the £/$ exchange rate. Only a functioning market delivers a reliable message.

Before the investment bankers - surely this term is now an oxymoron? - got to work on sub-prime, the banks would be holding the loans, they would have a reasonable degree of confidence in default rates and they would announce provisions in line with those default rates. Some analysts would grumble that provisions were too optimistic, others would take a different view, but the figures would be in the open and investors could buy bank shares with a pretty clear idea of the risk factors involved.

The toxic nature of sub-prime securitisation is evident on the uncertainty and fear it has created. Nobody has a clue what the "right" values are or how to arrive at a sensible figure. Given where we are now, we can say confidently that the banks' models were faulty. But that doesn't help in determining a "correct" value. Nor does "the market". Only the regulators can create certainty, but they dither and flounder because they implicitly endorsed the faulty valuation models and don't have an alternative.

Now consider the latest outburst of hysteria on accounting for pension liabilities. Does the fact that switching from a top-grade (AAA) corporate bond discount rate to a gilt discount rate increases BT's pension liabilities by £4bn to £43bn make any difference? If you were seduced by the accountants into believing that it makes any sense to put the change in the BT pension deficit through the profit and loss account each year, so that BT's profits can be eliminated or boosted by the effect of stockmarket movements on its pension fund, then you might conclude that BT's shares are worth less that you had previously thought. And the fact that BT shares now trade at about 240p on a yield of 6.8% suggests that this is indeed what many investors have concluded.

So "the market" now values at £18bn a company which had sales of £20bn in the year to March 2007, made pre-tax profits of £2.5bn and is expected to pay dividends of 15p a share for its current financial year. Now suppose we take the accountants' view to an extreme, and imagine that a 30% drop in share prices creates a £7bn additional pension fund deficit, all of which has to go through BT's profit and loss account. BT may not have to put an extra penny into its fund - that depends on the view of the pension regulator, not the accountants - so its cash flow could be unchanged. At worst it might have to top up its fund by a hundred million a year. Yet its accounts would imply near-bankruptcy.

This is the opposite of sub-prime, where we had inadequate disclosure and regulation. With pension liabilities, we have more than adequate disclosure, but we also have regulation that obfuscates reality. Worryingly, there is evidence that the latest academic-led review of the bank capital adequacy rules suffers from a similar reality disconnect. In both cases, though, we can be sure that the market is wrong. Not because it is failing, but because well-judged regulation that is clear in its objectives and methods, the market is bound to get it wrong. Free and fair markets depend to a far greater extent on effective regulation than conventional wisdom is prepared to recognise. That is because the SEC - the US regulator - and the Fed are Wall Street's canaires, and London's "light touch" regulation is, as Northern Rock showed, a tissue of complacency stretched over a black hole.

If Mr Market is especially nervous right now, indeed verging on schizophrenic, then I say it's unfair to blame his mood swings on his irrational genes, as Benjamin Graham's value investing devotees tend to do. I think he's confused by regulatory doublespeak and angel-pin dancing actuaries and accountants, and central bankers who make a virtue out of obscurity. The answer is not to give Mr Market some Prozac, but for the regulaters to get to grips with reality.

You can see all of Chris Gilchrist’s articles at www.TheIRSReport.com.

Chris is the editor of The IRS Report every month.

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