Robert Merton gave the opening talk this morning on the subject of sovereign wealth funds…and immediately digressed into talking about the current credit crisis. As with Shiller yesterday, he is advocating more and better financial theory that has learnt from recent problems rather than saying the mathematics is invalid. He was heavily critical of the pricing models used for CDOs and the like (more of which in a later post).

An interesting point was that he reminded the audience that vanilla loans and mortgages contained embedded put options on the assets of the issuer, and that as a result the recent dramatic decrease in value of this kind of instrument is not purely due to ten sigma movements in markets, but rather lower movements in market variables but combined with greatly increased sensitivity (delta) to these inputs as markets decline and become more volatile. Put another way, he does not hold with the fashionable premise of the Black Swan of extreme events explaining all that we have been experiencing.

On sovereign wealth funds, he suggested that they should concentrate on their unique advantages as investors/counterparties in the market, such as credit worthiness and access to liquidity, and focus much less on stock picking and timing to allocate investment (he cited recent investments in US investment banks by CIC as an example). He proposed that sovereign wealth funds should sell that which costs them nothing (e.g. liquidity) and that others needs. He ended his talk by suggesting the sovereign wealth funds may (only may) step in to fill the gap left by the dramatic downturn in hedge fund activity in the market, as he classified both types of institution as “lightly regulated” and able to get around the “institutional rigidities” faced by the banks. So maybe the sovereign wealth funds are not the international bogey-men that the press have been making out recently?…