Knowing The Known Unknowns

Knowing The Known Unknowns Of A Possible Market Disaster

By Brian Milner | 26 November 2007

Saturday, November 24, 2007

Satyajit Das is not the sort of person you want to meet after a really bad day in the markets. The renowned derivatives expert has such a gloomy outlook on the state of the world's financial system that you might have to be kept away from sharp objects after he leaves the room.

"I think this crisis has a long way to run," the globetrotting Mr. Das said yesterday from London. "It is an extra-innings baseball game and the national anthem still hasn't finished playing. So we really don't know what the worst is."

Unlike some permabears who see a dark lining to every silver cloud and who have waited vainly for years for what they are convinced will be the mother of all market crashes, Mr. Das backs up his concerns with an impressive track record as a banker, trader, corporate treasurer and risk consultant. No one is better at explaining the opaque world of what he calls "supersized" leverage stemming from the slicing and dicing of risk and the vast expansion of credit derivatives, which now total $516-trillion (U.S.), accounting for an amazing 75 per cent of the world's liquidity. His technical reference work on the subject runs four volumes and more than 4,200 pages.

Mr. Das warns that we are in the midst of a tectonic shift of the sort that occurs only two or three times a century and that all signposts point to extreme caution ahead.

"What I'm saying is we now have a shift in the market which is significant in terms of its long-term impact. I just don't think the future is going to be anything like the past."

Last year, when his latest, most accessible book, Traders Guns & Money, hit the shelves, he gave a series of speeches on the coming credit crash. "People decided that either I had lost my marbles finally or I'd been smoking something awful," he laughed.

Then the subprime market crumbled and people began taking notice of this risk assessor's convictions that the credit bubble was never sustainable.

"A diet of cheap and excessive debt has created a bloated financial system," he wrote in a new report commissioned by Jory Capital, a small Winnipeg investment firm that has scored something of a coup by signing him on as an adviser. The firm has even persuaded him to trek to Winnipeg in February to expound on his views.

In a normal world, a bank keeps $1 of real capital on its balance sheet to support $12.50 worth of loans it has underwritten. That's conservative banking. But today, the credit markets use $1 in real capital to support $30 worth of loans through all sorts of exotic structures.

The resolution of the current credit crisis will take years, not months, and will require "regulatory will and an imposition of market disciplines on errant investors and banks," he writes. "Crash diets rarely work."

It's a story replete with villains and victims, including the investment banks that created and pedalled incredibly complex, poorly understood credit instruments for enormous profit; the central banks that have been their enablers; and the institutional investors that snapped up the stuff in their quest for ever higher yields at seemingly minimal risk.

His report is largely a recap of long-held views of the global risk posed by massive leverage, reinforced by recent market developments, financial sector writedowns and central bank interventions to prop up ailing institutions.

But it comes out at a time when many investors, egged on by cheerleaders in the analytical community, are looking at financial stocks and some classes of debt as veritable bargains, because they have been so beaten up.

Mr. Das is noted for leavening the gloom with humour. In the report, he echoes a now famous description of the Iraq mess by then U.S. defence secretary Donald Rumsfeld. When it comes to the state of the financial system, he says, the "known known" is that there are losses stemming from subprime mortgages and anything related to them.

The "known unknown is that everybody knows that they do not know the full extent of the problem." And the "unknown unknown" is that other problems yet to be identified could be lurking out there.

A market crash might be the sexy Hollywood-style sudden ending that people are waiting for. But not Mr. Das. He forecasts a grindingly slow unravelling of the sort that occurred in the 1970s, when inflation effectively halved portfolio values over a period of five to seven years.

If he's right, investors need to adjust for higher inflation, which means focusing on real assets. This helps explain why commodities remain strong and why blue-chip equities have held up remarkably well.

This is the time to look for companies with real cash flows and good businesses that will be sustainable, Mr. Das said.

"Owning debt of a bank or sovereign debt like U.S. Treasuries— in other words, assets with fixed returns— may not be very bright."