Thursday, 2 February 2012

Event Horizon


E=mc2… this is the most famous and known equation of modernity. But what if it is wrong? Or what if it is right on a small scale of a bigger picture? What if by using it, applying it on Earth on a daily basis in experiments and production, it may cause a ripple effect on our world time line? Suddenly, without any warning, we are TERMINATED! Maybe not finding it and living within Newton’s Laws would have kept us safe and the biblical allegory of the fruit of knowledge is more than that. Maybe… another power up of the Large Hadron Collider and…

Ufff! Back again! What I am mentioning above has little chance to be part of Reality and, if it is, we will never know. For all practical purposes it has no interest to us whatsoever. But it justifies that new formulae create new environments… and that is what happened with the new financial environment created by the Black-Scholes formula. It is used everywhere since its inception and it is the main cause of our financial demise. The Black-Scholes formula leads unavoidably to an accounting Black Hole.

Do you remember thalidomide? It was a marvellous relaxing medicine, hailed as a wonder drug that could be used to make our lives better. And you know something, it could. But there was a flaw in the Science. Albeit tested extensively, it was not tested on an important group of people (pregnant women) simply because you couldn't. You cannot/should not make drug tests on pregnant women for a multitude of reasons. However this group was a potential user of this relaxing drug. And the drug was blindly prescribed, with the devastating effects we all know now.

The financial equivalent of thalidome, still being "blindly "prescribed now, is the Black-Scholes Formula (and others that work on the same environment and created the new world of "financial engineering"). This formula assumes that you can have a price now for a given share or security in the future; but there is a big big flaw... 

I start with an example: Barclays Bank plc shares are, as I type this, quoted at £2.2185 in the London Stock Exchange. If you have 1000 of these you can account them as £2218.50. You can also find a price in the future for these in 5 years time. You apply the Black-Scholes formula and it gives you a price for your 1000 shares… say £2500. You can put a deal on and cash the difference NOW! adding £281.50 in your pocket. This is where the flaw resides. If the formula had given you a price of £1800 and you would have to PAY NOW £418.50 you would had never placed the deal. Deals are only made if there is a positive outcome on its application. In the financial environment no loss deals are ever made, like pregnant women were never taken into consideration with thalidomide because they could not be tested.

This formula and quite a few derivations of it have been in place since the 1970s. At that time most deals were made over the phone, with a maturity of days or weeks. The impact of that formula was minimal and its bias was always diluted with the traditional trades. Now all has changed… you trade in a single day the same amount of deals you used to do in a year in the 70s. The formula became mainstream and instead of short-term usage it is now used as forecast of decades. Investment banks ransacked their long term products from retail, like mortgages and loans, and dealt them to have immediate cash available. If they did not have a retail operation they would just buy them out. Barclays/Woolwich, Abbey National, RBS/Skipton etc, Bank of Scotland/Halifax, Lloyds/Cheltenham & Gloucester and this is only in the UK.
All these were cashed in years ago and on maturity there is no money to pay back the deal. What was once used in less than 1% of deals is now above 50%.

The Financial world has been mortgaged for the next 30 years. Money our children are going to earn has already been spent. The stock exchange indexes are now very high and there is no counterpart to pay them back. They are no longer representative of the world's wealth. The Bank of England has no money to cover all deals made in British Pounds (only 5%) and the Federal Reserve has no money to cover all deals made in US dollars (only 8%). Funnily enough the European Central Bank has more cover to back up deals made in euros, so the euro “crisis” is a mere diverting tactic.

On Black Holes there is a point called event horizon: after you pass a certain threshold you are unable to climb back out of it. The Financial World event horizon happened sometime in 2005!
Black-Scholes... to Black Holes. Phonetic coincidences?

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