“A trillion dollar mean reversion”
In part, the current financial crisis - or at least, the hitherto dominant, structured finance part of it - was caused by an unhealthy trust in concepts like mean reversion.
That is, the assumption that over time, fluctuations in price “revert” to a long-term mean average.
Mean reversion was used as a key metric in the modelling of many structured instruments’ default risk or pricing. Too much reliance on mean reversion underplayed the likelihood of a sustained, highly correlated financial crisis.
Ironic then, this, from a note sent out today by Deutsche bank’s Jim Reid:
The chart shows “excess” profits earned by US financials relative to their long-term relationship to US GDP. That is, profits which deviate from the mean projection. In other words, banks profits have not mean reverted - until now.
Here’s another graph, which rather clearly illustrates the cleavage between banks’ profit trajectories and that of regular corporates:
The irony, then, being, that what we are witnessing in the current financial sector could be described - in financial modelling terms - as a rather dramatic mean reversion. In modelling CDOs banks mean reverted too much. In their own performance, they mean reverted too little.
The US Financial sector has made around 1.2 Trillion ($1,200bn) of “excess” profits in the last decade relative to nominal GDP.
So mean reversion would suggest that $1.2 trillion of profits need to be wiped out before the US financial sector can be cleansed of the excesses of the last decade.
Clearly this is too extreme if you believe that the financial sector has seen a sustainable structural change in its business model over the last decade or that it is uniquely positioned to exploit strong Global growth. Sectors do change/grow in importance over time… However, this is the kind of argument that has helped lead to this credit crisis. The financial sector has grown rapidly over the past decade, has embraced high leverage, and we’ve also seen a shadow banking system emerge that didn’t really exist a decade or so ago. Calculating the “natural” appropriate size for the financial sector relative to the rest of the economy is a phenomenally difficult conundrum.
A conundrum we will leave others to solve.
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