Wall Street hides behind complexity, casing too many suckers to buy complex assets that they don’t understand. The sub-prime fiasco offers an excellent example: Very few people understood the instruments they were trading, but no one wanted to look stupid while the good times kept rolling. Now they do after $500 billion in credit write downs, with more to come. Similarly, Freddie and Fannie had exceedingly complicated business models, and both shares now trade below $1.
The Freddie and Fannie news, released over the weekend, is yet another example of unnecessary complexity. Financial bloggers spent the weekend typing away, trying to figure it out. Should the government have used a receivership or a conservatorship? Does this constitute a credit event for credit default swaps? Who owns Fannie and Freddie’s defaults? I don’t know the answers to these questions, and it would probably take weeks, if not months, for the market to wrap its head around the implications.
Legendary investor Warren Buffett said that you shouldn’t buy what you don’t understand. Considering that very few people, myself included, understand the complexity of this bailout, I have to doubt the credibility of any near-term stock market rally. It’s one thing if Wall Street hides behind complexity, but investors have to wonder why regulators use taxpayer money to pile on additional layers of complexity to solve problems that the regulators probably don’t understand themselves.
The bottom line: Asset prices go up and then they go down. Cryptic regulations and absurdly complicated asset structures can’t defy gravity forever. Wall Street’s complexity was leveraged to the hilt during the bull run, and if we are going to restore balance we will need to return to simplicity during a cycle of de-leveraging.
"The evolution of knowledge is toward simplicity, not complexity,” wrote L. Ron Hubbard, the founder of Scientology. I always try to avoid the "stress tests" administered by the Scientology mobs, but maybe Mr. Hubbard is on to something here. Wall Street will have to listen to his advice: To put the credit crisis behind us we need to move towards simplicity, not complexity. As long as Wall Street hides behind complexity, I’m bearish.
Disclaimer: I own SDS and DXD (short U.S. equities)