Friday, May 02, 2008

Tulips (Just In Time for Spring)

It is April 3rd , the 66th trading day of the year, and we’ve already had 30 days where the markets have been up or down at least 1%. That’s volatility with a Capital “V” my friends. However, it might be comforting to know that we’ve gone through this sort of thing before.

Our current crisis of confidence is all about the perception of value. This manifests itself in a number of ways.

We agree (assume) that the rarer something is, the more valuable it is. Diamonds, postage stamps printed upside down, limited edition cars. It’s not that these things function any better, or at all, for that matter – it’s that there are so damn few of them. Perception. Scarcity = value. For some reason endangered species don’t work this way.

In business, however, this works well…believe me. In my former life (sales), I learned that there was nothing better than a closeout offer. People would line up for used cat litter if it were a limited time offer. The same perceptions move people to sleep overnight, in freezing temperatures, for the latest version of the Xbox. It’s the exclusivity factor. And it’s all perception.

Which brings me to the subject of tulips and Holland. There are similarities to our current value enigma that are worth examining.

At the beginning of the 17th Century, a rare new exotic flower was introduced and soon became popular with the elite of Holland. Why tulips became a fad, I’ll leave that for the tipping point experts. But soon the prices seen for even ordinary tulip bulbs were skyrocketing. It was not unusual for bulbs to range in price from $2,000- $3,000 (today’s dollars). The perception of value had begun working its magic – and before you knew it, you’ve got tulip inflation.

Eventually, the extreme was reached. Bulbs were considered too valuable to plant, but were just displayed – unflowered, certainly unattractive…but still perceived very valuable.

Not surprisingly, bulb trading became the rage. Bulb traders were making (Are you seated?) over 60K per month in today’s dollars.

But these were simpler times. There were no bulb mutual funds. Tulip derivative strategies never came into play. There were no tulip options, or tulip futures ( I could be wrong about this ). No tulip default swaps, and no one developed a tulip volatility index. Things were simpler.

Finally, the bulb bubble burst. All it took was one buyer who didn’t show, and who reneged on the deal. Panic spread, and prices plunged. (There were no bailouts in those days.)

So let’s look at this more closely. Was it really the one buyer? Probably not. We know that the perception of tulip value did change very quickly, though.

Perhaps it was that the Dutch woke up one day and realized a sobering bit of information (a tulip is a flower) and because of that critical change in perceived value, the Dutch financial system very quickly disintegrated, which brought on economic chaos that lasted 100 years. No kidding.

Fortunately, there has never been another instance of flower mania in the 400 plus years since the great Dutch debacle. I’m almost certain that hedge funds have no origin in gardening.

So, there are many kinds of flowers…also diamonds, real estate, and investment banks. Each has a perceived value. We lose sight of the perceived value lesson until Bear Stearns reminds us. If there is no market for its assets, even a leading investment bank can be almost worthless overnight.

As we speak, the White Knights ride to the rescue, in the persons of Chairman Bernanke, and his merry band of Federal Reserve Board Governors. Don’t get me wrong – the Fed response to Bear Stearns’ imminent bankruptcy was completely necessary. The domino effect brought on by a disappearance of investor confidence would have been devastating.

But what is happening now warrants scrutiny. We are seeing a proposal that includes a complete overhaul to the system of checks and balances, a total revision of supervision. The Fed discount window, a source of ready capital to commercial banks, becomes a fallback position to the investment bankers. It is a profound change.

Chairman Bernanke’s testimony on Capital Hill was more like a pitch, missing only a PowerPoint presentation and a laser pointer. The questions from the committee were contentious, from Senator Kennedy, from others. True the Fed Chairman clearly identified his function as independent of any accountability to the American people. Still, I have a hard time envisioning former Chairman Greenspan being cross-examined in this way. Things have clearly changed.

With a sales team that includes Treasury Secretary Paulson, the Fed’s presentation is likely to be well received. The markets may recover, buoyed by additional resources.

This may very well turn out to be our White Knights, digging our economy out of the hole we’re in, or it may ultimately be The Four Horseman of the Apocalypse, preparing a hole suitable for our eventual demise.

Tulips might be nice.

Tulips, Part II to follow


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