March 25, 2009
The Wisdom of the Market

I know as much about the principles that govern Wall Street gambling as I do about astrophysics. But I’m willing to take George Soros’s word for it; he seems to be that rare combination, somebody who is both smart and rich.

In all the uproar over AIG, the most important lesson has been ignored. AIG failed because it sold large amounts of credit default swaps (CDS) without properly offsetting or covering their positions. What we must take away from this is that CDS are toxic instruments whose use ought to be strictly regulated: Only those who own the underlying bonds ought to be allowed to buy them. Instituting this rule would tame a destructive force and cut the price of the swaps. It would also save the U.S. Treasury a lot of money by reducing the loss on AIG’s outstanding positions without abrogating any contracts…

Up until the crash of 2008, the prevailing view — called the efficient market hypothesis — was that the prices of financial instruments accurately reflect all the available information (i.e. the underlying reality). But this is not true. Financial markets don’t deal with the current reality, but with the future — a matter of anticipation, not knowledge. Thus, we must understand financial markets through a new paradigm which recognizes that they always provide a biased view of the future, and that the distortion of prices in financial markets may affect the underlying reality that those prices are supposed to reflect. (I call this feedback mechanism “reflexivity.”)



Posted by Jerome Doolittle at March 25, 2009 04:33 PM
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Who is the picture of?

Posted by: Mahakal on March 25, 2009 6:39 PM

Anonymous trader. (At least anonymous to me. His mother would likely have a different take on that.)

Posted by: Jerry Doolittle on March 25, 2009 8:58 PM
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