The market is in turmoil and BNP is complaining about liquidity issues. I went back to look at an interview from Scholes (author of Black-Scholes pricing) for an opinion on the situation.

As a result, “decision time becomes elongated” and speculators hold back their capital just when their services are most in demand. The lack of liquidity itself then becomes a factor in asset pricing, leading to swift, sharp drops in values.

This seems to be happening right now and he said this in March of this year.

So is the problem liquidity? Or is the problem something else? I think the key problem and one that has gotten me into hot water with an investment bank person is the question of the philosophy of market pricing. At Market Watch the question of marked to market pricing was raised.

Mark to market means the following:

In finance and accounting, mark to market is the act of assigning a value to a position held in a financial instrument based on the current market price for that instrument or similar instruments. For example, the final value of a futures contract that expires in 9 months will not be known until it expires. If it is marked to market, for accounting purposes it is assigned the value that it would fetch in the open market currently.

My opinion is that while it is nice to have paper profits, it don’t matter squat because those are not real and you need to look at the market value. And it is this point that rankled an investment bank person. They said to me that this is a liquidity issue since the products are exotic and thus cannot be priced. 

For those wondering what exotic products are look at the following slide show. On one of the slides it says the following:

What Makes Options Exotic?

* Pricing of such options is not transparent

* Pricing and hedging are often non-trivial

* Aftermarket is non-existent or illiquid

I replied to this person of course there is a price, let’s say 1 dollar. The person replied in a short tempered manner,

“That’s not a price, there is a real market price and right now we don’t know it.”

Well, excuse me, but yes 1 dollar is a price. What 1 dollar as a price means to the other person is a price that they don’t happen to like. 1 dollar represents a price that is a major collapse.

So I want to refresh the memories of a similar situation in 1929. (Trading for a living, pg 44):

I’ll give you the worst case example. In the 1929 crash, Singer stock was selling for a $100 and all of the sudden there’s no bid, no bid, no bid, and somebody comes forth – “I gotta sell, what am I bid?” and one the floor clerks said “one dollar” and he got it. He got the stock.

The problem that we have is that the other market individuals are smelling blood. Just like they smelled blood with LTCM. Just like they smelled blood in 1929. Yes BNP and co might think that the market is being unfair, just like with LTCM, and just like 1929, but in the words of Keynes:

The market can stay irrational longer than you can stay solvent.

This is the core on why I DON’T believe in models, and why people who work as and with quants will call me as lacking experience and not understanding the issue.

With any model there is a blind spot that somebody will execute to see you fail.

This is the heart of the market and what I feel many people fail to remember. It is like running a marathon where cheating, tripping, shoving and so on are all allowed. A runner that trains well, eats well, and believes that they will win can still loose because somebody trips them.

Of course you can avoid tripping, but you have to acknowledge that you could be tripped. You have to acknowledge that tripping is a Black Swan event that happens more often than not.

To close this entry I want to illustrate something that could be construed as a “liquidity” issue. Look at the following real estate entry.

4521 55TH ST #19, SD – San Diego, CA 92115
–03/2006: purchase price of $280,000.
–07/2007: listed on MLS for $189,900, then dropped again within a month to $149,900 ($249/sqft).

Now ask yourself. Could you see the person selling the property saying, “oh we are having liquidity issues.” And could you see the person arguing, “this property is not properly priced, lets wait and see in a month?” This is the core of the exotic options pricing problem. As Steve in Hot Rod show said, “You can’t make chicken soup out of chicken s**t.”

So I ask you the reader is this a “liquidity” problem or a 1 dollar answer?

NOTE: I am still not yet convinced this is a blood bath or bear market. Of course I am not buying either.