Saturday, 25 October 2008

Pretenders all of us



By Chan Akya

I am highly inspired by the testimony provided by Alan Greenspan, former chairman of the Fed and formerly the most powerful man in financial markets, to the US House Committee of Government Oversight and Reform on Thursday. Headlines immediately captured the essence of the prepared testimony, namely that "the" Alan, as we can call him in the style of the times, had admitted some shock but hadn't really fessed up to any major mistake on his own part.

Now of course, there is the whole ego, superego and id thing; but the little matter of continuing employment wherein the former chairman derives some tidy income from consulting for the world's major financial companies in sectors such as mutual funds (PIMCO) and banking (Deutsche Bank). Then there is always the matter of book sales [1], which may be adversely affected by any notions of fallibility.

In any event, many commentators have in the past attempted to create a dictionary of what Greenspan means when he uses any particular phrase. His commentaries and numerous testimonies during his tenure were famous (or infamous, depending on how much you actually understood) for the use of code, with specific phrases designed to excite the markets but leave lay people utterly befuddled.

In the same spirit, the following few phrases that appeared in his testimony on Thursday have been translated for the benefit of Asia Times Online readers. I have also added a comment on what a certain fictitious chairman of the Fed (let us call him Paul V) might have said in the same place.

The Alan: "We are in the midst of a once-in-a century credit tsunami. Central banks and governments are being required to take unprecedented measures. You, importantly, represent those on whose behalf economic policy is made, those who are feeling the brunt of the crisis in their workplaces and homes."

What he meant: "I am really glad it's you not me doing the heavy lifting. Furthermore, my opening with the tsunami reference is designed to make this whole mess seem like an unpredictable seismological event rather than the simple effect of various policy mistakes."

What Paul might have said?: "I messed up."

The Alan: "What went wrong with global economic policies that had worked so effectively for nearly four decades? The breakdown has been most apparent in the securitization of home mortgages. The evidence strongly suggests that without the excess demand from securitizers, subprime mortgage originations (undeniably the original source of crisis) would have been far smaller and defaults accordingly far fewer. But subprime mortgages pooled and sold as securities became subject to explosive demand from investors around the world. These mortgage-backed securities being 'subprime' were originally offered at what appeared to be exceptionally high risk-adjusted market interest rates. But with US home prices still rising, delinquency and foreclosure rates were deceptively modest. Losses were minimal. To the most sophisticated investors in the world, they were wrongly viewed as a 'steal'."

What he meant: "Hey don't look at me; all my data said this sort of stuff could never happen. It's the fault of all those poor people who couldn't see that they were supposed to turn away the free money being offered to them, and the fault of all my rich buddies for trusting these poor folks in the first place."

What Paul might have said?: "Firstly, it is not true that economic policies had worked well in the past four decades, as the series of crises in the US and around the world from 1968 to the present would tell us. I should have tightened credit policy and banking supervision when the growth in higher risk mortgages appeared to increase disproportionately to actual income growth in the United States. Furthermore, the billions of dollars flowing into the US should have alerted me to potential bubbles and forced me to hike rates drastically. Or in short, I messed up."

The Alan: "It was the failure to properly price such risky assets that precipitated the crisis. In recent decades, a vast risk management and pricing system has evolved, combining the best insights of mathematicians and finance experts supported by major advances in computer and communications technology. A Nobel Prize was awarded for the discovery of the pricing model that underpins much of the advance in derivatives markets. This modern risk management paradigm held sway for decades. The whole intellectual edifice, however, collapsed in the summer of last year because the data inputted into the risk management models generally covered only the past two decades, a period of euphoria. Had instead the models been fitted more appropriately to historic periods of stress, capital requirements would have been much higher and the financial world would be in far better shape today, in my judgment."

What he meant: "Nobody really knew how to price or trade these things. They even managed to confuse the idiots on the Nobel committee. So don't blame me for believing the balderdash. Also no one told me Nicholas Nassem Taleb was writing a book [2] that would point out all these model fallacies and so sell more copies than my book did."

What Paul might have said: "We had enough experience of other crises, such as the Latin America debt crisis that blew up our banks in the late '80s, to know the effect of false assumptions and poor data on the integrity of our financial system. This should have alerted us to the potential for mispricing and false profit generation; that should have forced us to intervene on the regulatory and accounting side of these transactions to make them less attractive for our banks to do. That was my job as Fed chairman, and I failed. Or in short, I messed up."

Fessing up
Having translated some of the comments for Asia Times Online readers, I will now fess up to my own mistakes in assuming that the end of the Group of Seven leading industrialized countries [3] could be hastened by the emergence of new giants such as Russia and some Asian countries.

In particular, three countries have recently performed a whole lot worse than my expectations, in effect denting any claims they can have in coming years for being considered serious (and independent) investment destinations. These three countries are Russia, South Korea and India: I have left out for now other countries that seem in greater danger of tipping over, such as Indonesia, as they were never considered anything more than exotic destinations. The three above though were talked of in some earnest as breaking their historic moulds but instead may well have been exposed as fraudsters being pulled up by the global economic prosperity.

I show below the performance of the countries' equity indices and their currencies against the US average, and for good measure those of China. While the relative equity performance is nothing to boast about for China (indeed, as equity returns are currency adjusted it means that nominal performance in China was the worst across that column), the trio of Russia, South Korea and India show some eye-popping bad numbers. The most difficult to believe is the significant decline of the Korean won against the US dollar this year; shocking for a country that showed an improving current account balance until the middle of this year.

  YTD Equity
Return %
YTD Currency
Return %
Russia -72 -9.10
Korea -63 -49.62
India -62 -26.34
US -38 NA
China -62 +6.33

This is however not all of the bad news - as the current crisis is very much one rooted in the credit markets, it makes sense to evaluate the relative riskiness of the various governments underpinning the economies. This we can do by looking at sovereign credit default swaps (CDS), that is, the insurance payment being demanded by a market counterparty to cover your risk of that government failing to repay its obligations. These are traditionally shown in basis points or one-hundredth of a percentage point (thus 500 basis points means 5%).

From the CDS value, the implied probability of default being assigned to that sovereign can be worked out provided we can assume a certain "loss given default", (or LGD, which is fixed here at 60%); this is shown in the column after the CDS. Note that the figure below for India pertains to its largest state-owned bank (State Bank of India) because the government itself doesn't have any externally traded obligations.

  Oct 23rd 5yr
CDS spread
Implied Prob
of Default %
Russia 1100 61
Korea 600 41
India 750 48
US 25 2
China 235 15

From the above, it is clear that none of the pretenders and especially not the first three countries can claim to be in a position to overtake the existing global benchmark for risk-free assets, namely the United States. It is shocking and rather amazing that despite holding about US$1 trillion of reserves between them, the three countries average a default probability of 50% within five years. That one-in-two chance of default within the period shows that these countries have never truly learnt the lessons of the past few decades.

Russia
The simple matter of evaporating market confidence has belied Russia's claims to great-power status, resurgence under president and now Prime Minister Vladimir Putin and so on. For a country with more than $500 billion in reserves (itself down around $100 billion from just August this year), market signals are not so much about the government as they are about the overall level of confidence in the economy and its business representatives.

The first point of the market's loss of confidence is the mounting debt maturities of various Russian companies and the country's largest banks, all of which tapped the short-term (one- to two-year) markets to finance their expansion plans. With many of these facilities now coming due for payment, and no prospect that any investor would agree to postpone payments for another couple of years (refinancing), the Russian government has been expected to step up.

The only other alternative for investors in such nominally private companies, namely to convert the debt into equity stakes, doesn't apply in the case of Russia, due to the high-handed behavior of the government. Thus, despite very little in the way of direct obligations, the shadow of the 1998 debt default by Russia along with a string of Kremlin-inspired malfeasance has scared investors and caused a flight from Russia. Many oligarchs are rumored to be urgently stashing away their wealth in destinations far away from Russia, adding to the pressure on the currency - this is even being cited as one reason for private companies to deny payments to foreign creditors as their owners make off with the bank balances.

It is still possible for Russia to take remedial steps that could prevent an escalation of the current crisis into a full-blown economic collapse. After underpinning the viability of Russian banks, it must undertake quick steps to improve investor confidence; for example by avoiding arbitrary closure of its stock markets whenever prices fall [4], avoiding the temptation to indulge in currency intervention and implementing steps to improve bankruptcy procedures, corporate governance and the like which can help create equilibrium much faster.

South Korea
Perhaps the country that shocked me the most by its presence on this list, South Korea has failed to learn the basic lessons of asset-liability and liquidity management from its previous crisis in 1997-98. Most recently, the Korean government has had to unveil a $100 billion guarantee program for the offshore debt of its banks, taking away a rather substantial chunk of the $240 billion or so of foreign exchange reserves that it boasts.

Given the escalating current account deficit and poor prospects for investment inflows, it is possible (albeit very unlikely) for Korea to run out of foreign exchange by the beginning of 2010. This must be problematic for any country, and more so for one with international pretentions, as shown by the abortive global takeovers attempted by South Korean companies such as KDB [5] and Samsung in recent months.

There are numerous culprits here. Most notable is the Bank of Korea, which followed an ill-advised policy of maintaining an onshore US dollar shortage in order to deflect the potential for Korean won appreciation. In so doing, it created the conditions for greater offshore borrowings to fund the economic reliance on the export market rather than domestic consumption. In turn, this left banks and companies with the same mix of short-term liabilities against longer-term assets that marked South Korea's first descent into a balance of payments crisis in the Asian financial crisis of 1997.

Ironically, many equity index managers were finally upgrading Korea from its perch in "emerging markets" to a new "developed markets" level; instead it appears that Korea will have to negotiate to stay afloat in the emerging markets category; its most recent equity, currency and credit performance certainly put it in the same category.

India
To a number of people who bought into the BRIC - Brazil, Russia, India and China - hoopla, India's fall from grace parallels that of Russia. Here again, it is not the external borrowing practices of the sovereign itself that are to blame; funnily enough, neither are the borrowings of local companies in global markets considered to be excessive. In any event, less than $25 billion of Indian corporate and bank debt falls due by the end of next year compared with $275 billion of foreign exchange reserves that the country boasts. Even accounting for zero capital inflows and continued current account deficits, the overall cushion will remain close to $200 billion.

Achilles though still has a heel. The loss of confidence can be traced to the haphazard decision-making of the central bank, which came late to the inflation-fighting party this year in a futile attempt to prevent foreign exchange appreciation, thereby causing policy about-turns that stun even the most adept of investors.

Secondly, political noise in the country has been increasing ahead of next year's elections. This has turned investors naturally cautious, and in turn made crisis management a bit trickier for the government (in which respect there is much in common with the recent US experience).

Thirdly, there is legitimate concern both domestically and offshore about the impact of low infrastructure investments by India over the past two decades. The problems seen in the poorest parts of the country offer a closer view, albeit one that the media have been slower to latch onto compared with the markets.

Recent violence in the state of Orissa between Hindu fundamentalists and Christian missionaries showed not so much the tinderbox of religious intolerance as it did the fairly low "price" that poor Indians assigned to their centuries-old culture and religion. For the destitute and the desperate whose battle for basic sustenance is all-consuming, manna from any source is welcome. Inconveniently enough for the people who believe in an India that can outshine its recent past, the images aptly conveyed the two sub-nations (the upwardly mobile and the downwardly stale) created by communist-inspired governments in the country. [6] As in the case of Russia, the response from investors has been to sell first and ask questions later.

And in closing ...
Perhaps the one quote from Greenspan's testimony that I find myself agreeing with, and especially the last sentence: "There are additional regulatory changes that this breakdown of the central pillar of competitive markets requires in order to return to stability, particularly in the areas of fraud, settlement, and securitization. It is important to remember, however, that whatever regulatory changes are made, they will pale in comparison to the change already evident in today's markets. Those markets for an indefinite future will be far more restrained than would any currently contemplated new regulatory regime."

The fact that a market become overcautious at the drop of a hat (or a few billion dollars) is borne out by the experience of the US subprime mortgage market, as it is for countries such as Russia, South Korea and India. In all these cases, the loss of confidence that has been sparked by a combination of quantitative and qualitative factors will induce substantial behavioral shifts that will take years if not decades of patient reworking for these markets and/or countries to correct. Pretenders, whether they are government officials or market fallacies, will always be exposed.


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