Why the winner’s curse could hit complex finance


In financial markets, the more complex the instrument, and the more uncertain the outlook, the greater the likely range of views of common value. More often, trading puts assets in the hands of those who think the assets are more valuable than they really are.

Imagine someone wheeling a trolley of attractively packaged objects down Wall Street and through the City of London. The trolley has three shelves. On top are executive toys designed by rocket scientists. You do not quite know how they work but they are said to relieve stress. Below is the lucky dip. These items have been packaged and repackaged so many times that no one is quite sure what is in them any more, but they are carefully graded A, B and C and priced accordingly. In the bargain basement, banks and other wholesalers offer stock items at what looks like a good price.

All packages are attractively if opaquely wrapped, the sales staff persuasive. Since unsold objects remain intact, they can be kept by the original owner or offered tomorrow in different packaging, which can be customised to fashion and individual taste. Only a few items a day need leave the trolley to establish a profitable business, so you need sell only to those willing to pay too much.

It is hard to make out, far less understand, the labels on the shelves, but they seem to read something like “exotic derivatives”, “collateralised debt obligations” and “credit risk insurance”. To understand why these complex instruments have multiplied, and why that multiplication is dangerous, it is helpful to understand the distinction between private value and common value.

The importance of these concepts emerged when the US government over 30 years ago began to auction offshore oil blocks and bidders fell victim to what became known as the winner’s curse. Each block went to a company whose bid was higher than the valuation made by any of its competitors. So the winners of the auction were typically the people whose geologists had screwed up.

In a private value auction, as at Sotheby’s or Christie’s, different bids are the result of different personal preferences for a painting or piece of furniture of agreed specification. In a common value auction, different bids are the result of uncertainty about the real nature of the object and if everyone had the same information all bids would be the same.

Businesses that participate in auctions, and agencies that design them, have learned about the winner’s curse and adjust their behaviour in the hope of avoiding it. But there is no escaping the underlying problem: an object of uncertain value is more likely to be owned by people who overestimate that value than by people who underestimate it. European mobile phone companies paid too much for their auctioned 3G licences because telecommunications companies are run, and their shares owned, by people excessively optimistic about the future of mobile telephony. Businesses are always managed, and shares are always owned, by people who think these businesses have good prospects.

The fundamental value of a security – the return it will deliver to its holder – does not vary much between potential holders but assessments of that value can vary by a lot. So, in financial markets, differences in judgment of common value dominate differences in private value. The more complex the instrument, and the more uncertain the outlook, the greater the likely range of views of common value. Sometimes trading operates to put assets in the hands of those to whom these assets are really the most valuable. More often, as in the Gulf of Mexico, trading puts assets in the hands of those who think these assets are more valuable than they are.

So as you work your way down the shelves of the trolley, ask yourself these questions. Should I trust my own judgment when my analytic skills as buyer are so much more limited than those of the seller? Do I really want to buy products when it is impossible to specify the underlying risks? And – especially when you reach the bargain basement – ponder why do I want to buy what someone else is so anxious to sell?

It does not matter much if buyers, on average, find their purchases slightly disappointing and it is in the nature of buying from the trolley that this will be so. But recently, some players have mortgaged properties to stock their shops with goods from the trolley. The pain when their customers finally unwrap the goods will be widely felt.

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