Beware new markets

We’re now in the point-the-finger phase of the present financial crisis. The G7 says its all the banks’ faults, and wants to increase their capital adequacy requirements. The banks say its nobody’s fault, and want governments to bail them out. Many economists say its Alan Greenspan’s fault for cutting rates so low and for so long in 2001-2006. Alan Greenspan says its risk managers’ fault.

Here’s my two-pence-worth, from an amateur market-observer with no economic qualifications: beware new markets.

When you look at the great speculative bubbles of the last 20 years, they almost always occur in new and untested markets, markets that have never gone through a downturn, so there is no investor knowledge of their upper limit, and little regulator awareness of the frauds or legal loopholes that investors can exploit.
Thus the Russian financial crisis of 1998 was, among other things, a new market, in which investors had no experience of a crash. That helped drive the euphoria and risk-appetite of local and foreign investors.

The dotcom bubble in the same period was also a new market, based on ‘new economy’ stocks, which seemed so new that analysts and investors threw away their scepticism and convinced themselves these stocks would only go up and up.

The California power crisis of 2001 was also a new market, created by the deregulation of the power sector in that county. The newness of the market meant regulators had not fully got to grips with how the market worked or how unscrupulous investors could exploit the system. Enron, masters of financial innovation and wizardry, were quick to find the loopholes in the untested regulation, and they made a killing at the expense of California, which faced rolling blackouts as greedy traders took electricity out of the county, then brought it back in at double the price.

And the CDO boom of the last six years is another new and untested market, which neither regulators nor banks’ senior management fully understood. Regulators didn’t understand the risks involved. Bank senior management didn’t want to understand, as long as the traders putting together these deals kept bringing in the money.

The moral is that risk managers, and regulators especially, should be wary of new markets that start to grow exponentially quickly. It probably means that investors have found some way of making money which they think is full-proof, and they’re taking dangerous risks.