Posts Tagged ‘Long Term Capital Management’

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As a species there is one thing we are lousy at. We think we are unique. We come up with an idea to solve a particular problem, and rarely does it occur to us that across the economy others are behaving in much the same way, and have come up with a similar idea.

Collective behaviour can have the effect of nullifying our actions; it can even have the opposite effect to what we had originally intended.

So that’s us. You and me. We are victims of this. It’s like a virus, and it has a name too – it is called the fallacy of composition. It has infected humanity since we came down from the trees. But you would expect more from regulators, wouldn’t you? Alas the regulator of the European pension industry – which goes by the snappy title of the European Insurance and Occupational Pensions Authority – has contracted a nasty dose of the fallacy of composition. It is one of the reasons why the economy can’t get out of the rut it has got itself into.

Back in 1997 it happened with Long Term Capital Management (LTCM). They came up with an algorithm that was a sure fire way to make money. It couldn’t fail, or at least the chances of failure were so minuscule that they were effectively ignored. What LTCM did not factor into account was what would happen if other investors applied a similar approach. The crisis that ensued was like an early preview of 2008, and nearly brought the global economy down to its knees. The IMF made a similar mistake. It congratulated the banking industry on the innovation called mortgage securitisation, and said that as a result of this the chances of banking crisis had reduced. It was a victim of the fallacy of composition. When the majority of mortgages were subjected to securitisation, the result was that –because banks took on more mortgages as a result – risk increased. You know what happened next.

We have an economic cycle for much the same reason. When market research shows demand is greater than supply in an industry, the company which commissioned the research increases output, but they rarely factor in competitors having access to similar research. Output rises, the industry sees boom, but then production exceeds demand and recession follows: companies cut production, demand exceeds supply, until research emerges showing demand is greater than supply.

So that’s the composition of fallacy. Across the economy it applies to savings. In a recession, companies and households reduce risk, save more, and the recession gets deeper as a result.

When banks reduce risk en masse, the result is less lending, the economy stumbles and the very thing banks were supposed to reduce, then rises. The fact is that all banks are insolvent. No bank can survive calls from all of its depositors to withdraw their money. If all banks collectively agreed to increase risk by lending more to wealth creators, the result would be a stronger economy and the chances of a banking crisis would fall.

If all pension funds put less money into ultra-safe, low yielding assets, and invested in infrastructure, and funded company investments by buying equities, the result would be an improving economic outlook, and pension funds would rise in value.

But under solvency II regulations, pension funds are required to reduce risk. So they have no choice but to pump more money into government bonds, and because government bonds pay out such incredibly low yields, they have to buy an awful lot of bonds in order to meet their commitments. That means they have to raise more money, and companies have to pump more profits into pension schemes and less into investment. The economy deteriorates as a result. And pension fund find they have an even bigger deficit.

The EU Commission wants to see European pension funds put money into infrastructure. The European Insurance and Occupational Pensions Authority has considered its request, and given the following statement: “Any preferential treatment of a certain asset class might result in a build-up of risk concentrations in the sector with the associated higher level of systemic risk.” In other words, they’ve said no. The irony in this statement is the use of the two words systemic risk. Actually, the fallacy of composition is the cause of systemic risk.

The National Association of Pension Funds (NAPF) has looked at the implications of forcing UK pension funds to follow solvency II rules and fears a £450 billion pension deficit will follow as a result.

Joanne Segars, chief executive of NAPF, said: “The EU plans for UK pensions come with a clear and unpalatable price tag. Businesses trying to run final salary pensions could be faced with bigger pension bills to plug an astonishing £450 billion funding gap. This would have a highly damaging effect for the retirement prospects of millions of UK workers.” She added: “This project has been conducted at breakneck speed due to the EC’s ludicrously tight timetable. This cannot be the basis for formulating a policy that could undermine the retirement plans of millions of people both in the UK and across Europe.”

She is right, but wrong about the problem. The problem is not that the European regulator is enforcing a “ludicrously tight timetable”, it is that it has fallen victim to the fallacy of composition.

©2013 Investment and Business News.

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