Are we serious?
Total global wealth stands at $125 trillion, more or less. The total world market for financial derivatives stands at $700 trillion. Does anyone else see something terribly wrong with this picture?
I’m hesitant to form a Strongly Held Opinion about complex matters I only dimly understand. So it’s with some trepidation that I ask this question: Is everyone involved in this completely nuts?
Financial derivatives are bets placed on some underlying assets that have actual value, bets placed on other bets, or even bets placed on bets placed on bets. The thing about bets is that at some point in the proceedings, the bettors have to settle accounts.
When they do, the world will be short $575 trillion.
I’m sure the problem is my limited knowledge of economics, and not that the geniuses running the financial sector haven’t thought this through.
Financial derivatives are an example of what Wall Street’s advocates are pleased to describe as “financial innovation,” which in1980 replaced manufacturing as the cornerstone of the U.S. economy, supposedly turbocharging it.
The world’s manufacturing economies are the ones that are thriving, though, probably because they (1) export actual products that have tangible value; and (2) use the profits to create jobs in large numbers that pay reasonably well.
Our economy is Nike writ large. We’ve outsourced everything except financing and brand management to other countries.
Before the feds bailed out GM, its path to success consisted of periodic reorganizations coupled with playing financial games. Its path to selling cars? Rebates and interest-free loans.
If you’re a fan of serious irony, here’s one for you: It’s under federal ownership that its slogan became, “May the best car win.”
“Okay, Bob, get off your soapbox now. What does this have to do with me as a working IT manager?”
Aw, okay. As it happens, this has quite a lot to do with you as a working IT manager. One reason comes from a point made by my friend Chris Potts in his business novel FruITion (Technics Publications, LLC, 2008) — that our current notions of IT governance are, shall we say, suboptimal.
The usual approach is to form some sort of IT steering committee composed of the company’s top executives. They horse-trade political favors (the official description sounds more sophisticated, of course) to decide who gets what.
The CIO’s role is a combination of internal consultant and order-taker. The internal consultant advises on feasibility and cost. The order-taker figures out when IT can schedule projects and how to staff them.
The future CIO role, Chris suggests, is more active, interesting, and strategic in nature. As FruITion is a novel, and providing the rest of the answer would spoil its denouement, I’ll just say he and I agree that CIOs have a more active role to play in developing company strategy, which in turn should be a major determinant of the company’s investments in information technology.
(In my view but not necessarily Chris’s, the politics of horse-trading departmental priorities don’t go away — they’re managed through a different pot of money and effort. But that’s a different topic.)
And so, wearing your business-strategy-setting hat, go back to the GM example. One way of explaining what went wrong at GM was that its executives ignored the difference between their mission and their business model. Well-run companies understand both, the difference, and how they connect.
In case the point isn’t clear to you, a well-known health club chain serves as an excellent example. As a health club, its mission is to help its members become more fit. Its business model is quite different: It sells three-year memberships and offers financing on those memberships. Its profits come from the financing.
Another example: Higher education. For colleges and universities, the mission is some variation on helping students gain important, deep knowledge. Their business model: Graduate students who feel enough affection and loyalty toward the institution that when they become financially successful they’ll donate generously.
A company’s mission describes how it creates social value. When the mission isn’t the direct source of profits, executives may be tempted to “starve the mission” in an attempt to improve margins.
It’s a mistake: As GM eventually discovered, mission failure erodes business success. The erosion is, however, like the Grand Canyon:
It happens slowly enough that the connection between cause and effect is only apparent in hindsight.
And that’s why we know companies are in trouble when they install a bean counter as CEO.
A note on derivatives: the total market for derivatives only really tells you about the ability of the market makers to derive profit. Your hypothetical is that a $1 face derivative goes to zero and that it cost $1. That would make the size of the market equal the float equal the potential liability. These are all different things. If I own a derivative that goes up in value when GM equities go down in value it can probably only go to zero, on the other hand, if GM goes up in value my liability is potentially unlimited. So it may be much worse than you imagine. Also, it is frequently the case that someone will hold two offsetting securities such that their liability is only bounded in a short range, so their liability might be much less than the face value of the securities.
Also, there is a bunch of double and triple counting of the face value as the seller and buyer are separate parties. So, buying a $10 derivative may actually result in $20 or much more market size as the firm that sells it to you hedges their exposure as the price changes.
So while don’t disagree that the market needs more oversight than it has, arguing that it shouldn’t be complex and that it doesn’t add value doesn’t really compute. Making steel, for instance, is pretty complicated, yet inconel has a specific purpose just like nak55… should we just go back to the iron age since we can’t explain materials science to everyone with a short attention span? Would you be ok with the abolition of consumer credit cards (one of the most abused sectors of finance on both sides of the transaction)?
Quoting a scary statistic doesn’t increase the quality of debate.
I knew that we were in trouble ten years ago when AOL with its high stock prices was able to merge with (acquire) Time Warner even though it had less than half the cash flow. And, it must have had fewer physical assets. How can a company with little history of success purchase a company with a much better history? I guess that it is all about the Bengamins.
Our guru Bob wrote:
“I’m hesitant to form a Strongly Held Opinion about complex matters I only dimly understand. So it’s with some trepidation that I ask this question: Is everyone involved in this completely nuts?”
No, they are not nuts. They are in fact highly rational and calculating. As long as these things work out, they makes tons of money. If they go bust, somebody else gets left holding the bag.
Clearly we all know little of the real value of derivatives. After all, Robert Merton and Myron Scholes won a Nobel Prize for their method of determining the value of derivatives. Given such high powered brains, who are we to question the Nobel emperors’ lack of clothes, or to suggest that Nobel Prizes should be recalled when the work for which the prizes are awarded turns out to be published in dust.
But then, we don’t manipulate financial markets for wealth. We believe in products and services creating value. Perhaps we’re heretics, or poor benighted fools.
A professor of economics once told me that he had tracked and traced the path of $ 1.00 investment he had purposedely invested. He tracked the same dollar to 101 times transactions. Meaning that money is exchanged each time and each time the ‘investor’ profits. The professor had reached a point which he was unable to find interested businesses to invest in this dollar. Meaning that although he had reached an end, the opportunities to continue this ‘trading’ abounded.
I heard some years ago, when Toyota was still a very success car company, that the finance arm of Toyota made more money than the one making cars. When I heard that, I knew that it won’t be long before they go the way of GM etc.
Of course they managed to hide the problem until it became too big to hide.