The China Syndrome

Shanghai Stock Exchange Composite Index

The recent stock market sell off owes little if anything to fundamentals, and everything to herd mentality. Nothing we found out when the sell off began was anything we didn't already know. China's economy is slowing, energy supply still exceeds demand and is US interest rates are likely to rise towards the end of the year. We've known all this for months, so why the panic in US markets?

It was a knee-jerk reaction to a sell-off in China. That in turn was a bursting of an equity bubble that had been created after the run-up in property prices stalled and many of China's new-to-the-market fairly naïve investors were looking for the next big opportunity. Many were over-extended and had to sell as market began to turn down, turning a gentle slide into a route. But that was always going to happen - PE ratios were absurdly high and prices had become completely disconnected from the underlying fundamentals. (Even now,they are probably too high - the market is 50% above where it was 18 months ago).

But instead of looking at China's melt-down as just a much needed market correction and not an indicator of any real change to the economy, investors in Europe and the US panicked and rushed for the exits too.

That may be over-stating the case. There are several ways in which the "China Syndrome" might impact US companies. First the Chinese government's response (lowering interest rates and devaluing the Yuan) were hurried and cast doubt on the Party's ability to manage the market economy it is creating. Second, the devaluation and the denting in consumer confidence among China's neauveau riche will hurt consumer technology and luxury goods sales; much of Apple's recent profit growth has come from China.

But the scale of the investors' reaction in the US vastly outweighs the impact of a likely 1% reduction in China's GDP this year (which we already knews was on the cards). If US companies relied exclusively on China for sales and profit, then the drop in US stocks would be in the right ball park - but US exports to China ($123bn in 2014) account for less than 1% of US GDP ($17.4tr). Granted other countries to which the US exports might also themselves export to China so that the effect is larger than just the US' trade with China; but even so the reaction seems quite out of proportion with any reasonable estimate of the impact of  China's slow-down on the US economy.       
    
All of which supports my contention, an observation I made to a finance colleague 20 years ago, that finance is less about pricing of assets and risk than it is a function of rumour, social network and herd behaviour. If expectations of the present value of future cash flows determined asset prices none of last week ups and downs would have happened.  

A Greek settlement?

Although no one emerges from the Greek debt crisis smelling of roses, Alexi Tsipras has perhaps lost more than most; the new deal for Greece he promised the Greek electorate in the run up to his election six months ago is gone; and the one that today he has been forced to accept is worse than the that on which he staked his future when he called a referendum eight days ago.

Several things are clear. First Germany's desire to stick to the rules has trumped France and Italy's desire for the appearance of European Unity. Second, the crisis has exposed flaws in the structure of the common European currency, which looks like it has fallen between the two stools of monetary and fiscal independence and full integration, a position that it turns out is unworkable. Third, it has shown how important are integrity and honesty in negotiations; and that when they are gone things get very difficult very quickly.  And finally, any deal which might have made economic sense has been distorted by the whipping up of public opinion and the resulting transition from the realm of finance to that of politics.    

It would appear that the economic can has again been kicked down the road in that Greece may have been forced to make promises in return for a lifeline that it simply hasn't the capacity to deliver. And even supposing that the numbers did add up, something Paul Krugman disputes, Greece's history of lax implementation of revenue raising policies and its attachment to spending may scupper implementation of key parts of the deal; and that's even assuming that the deal is approved by an parliament that must feel angry at Europe and betrayed by its prime minister. 

One commentator asked a Greek MP this morning whether this was 'Europe trampling on the democratic will of the people'. I understand journalists like to ask provocative questions but this was at the sillier end of the spectrum. Europe has 503 million people, 482 million (97%) of whom were excluded from that referendum; and ultimately they are footing the bill.

If European monetary union is to succeed, the notion that economic under-performance in one region can be solved by labour migration, which replaced currency fluctuation as the purported adjustment mechanism, must be largely discarded. Instead the richer Europe countries will have to come to terms with the fact that direct transfers of wealth may be required semi-permanently to support the less productive parts of the European economy, while the latter must accept that those transfers will come with strings attached: and that effectively means a loss of sovereignty—something the Greeks are just finding out.


  




  

Greece

First a caveat; I don't claim to understand the Greek situation, but for some reason it's bugging me. There is little likelihood that Grexit will have a big impact on the US and we have other things to worry about in California: fire (too frequent) and water (not enough), not to mention gun violence, racism, decaying infrastructure, expensive health care, declining educational standards. But although it's a small country, about the population of Ohio, with a GDP equivalent to 1.7% of the US (roughly equivalent to Louisiana), I am transfixed.

Here's my take. When Greece joined the Euro, its government was able borrow money from private lenders at very low interest rates. They were prepared to lend at rates that didn't reflect the risk of Greek sovereign default in part because the government cooked the books on its tax receipts, and in part, I'm assuming, because they calculated that the EU would not let the Greek government default; that would put lots of European 'too big to fail' institutions in peril.
When Greece's finances began to look shaky, interest rates on Greek debt soared, and default looked likely, the IMF, the ECB and the EU then stepped in, bailed out the private lenders to reduce the risk of contagion (exactly as those lenders predicted) and, in return for lending European tax payers money to the Greek government, asked for a repayment plan, one based on 'austerity' (meaning a drastic cut in government spending and the privatization of state owned enterprises).

It seems that some of this plan was never implemented: the retirement age was not raised, pension reform was neglected, privatization proceeded at a snail's pace, and tax collection wasn't improved. But government downsizing did lead to a severe contraction in economic activity, lowering tax receipts still further and prompting another bailout. With it came more pressure for reforms and government spending cuts, leading ultimately to a soft 'revolt' by the people who, in 2015, elected an anti-austerity government led by Alexi Trsipras. Trsipras' Syriza party came to power promising to undo austerity, something it really had no way of knowing it could deliver.

Over the six months of rancorous negotiation and increasingly hostile rhetoric, Trsipras and Yanis Varoufakis, Greece's finance minister, failed to get the concessions they had promised their voters and in a desperate move, called referendum on the austerity deal which, perhaps not surprisingly, the Greeks rejected, in effect tying Trsipras to the mast of his electoral ship.

By now, private lenders were largely off the hook so 'contagion' in the banking system was mitigated. But that meant that instead, European tax payers in effect were backing Greece through the IMF, the ECB and directly through (I'm assuming) Greek debt purchases made by European governments.

In June an IMF repayment deadline came and went with out visible consequences; in early July and ECB deadline (it had promised not to renew it's prpovision of funds to the Greek banks were a deal not reached) passed and funds continued to be provided. So a big bang (much like the passing of the US debt ceiling) went off with hardly a sound, making all the dire warnings look like posturing and negotiating. What people say they will do and whey they actually do when push comes to shove often seem to differ.

So where now? For one thing, despite the artificially whipped up emotional indignation of "being cast out of Europe" there may be benefits to letting the Greek currency float again. Import substitution should create jobs and the economy, after some period of inevitable chaos, should recover. That may give Greece some breathing space to decide for itself which path it wants to take - reform or economic stagnation and collapse. But at least that won't be a solution imposed on them by outsiders.

Through the looking glass

The Economist had an article last week on the threat to the reinsurance industry from catastrophe bonds. I was struck by the thought that AIG got into trouble by creating a product (credit default swaps) that looked like insurance but for which it didn't have the competences needed to price the risk accurately. Now we have financial firms substituting bonds for reinsurance -- which looks to an outside an awful lot like the same things in reverse.  

Third party rating agencies

DPReview is a website that has been providing reviews of digital camera for 10 years. It is an example of how things can so easily go wrong.
I recently noticed that almost all the cameras they reviewed were "highly recommended". So I looked at all the reviews they have done since 1999 and an interesting trend emerges.

The graph show the average of ratings awarded each year using 5 for "highly recommended" to 1 for "below average". 14 of the 19 cameras reviewed in 2009 were "highly recommended".

This kind of 'grade inflation' is understandable; the site relies on equipment makers loaning them the cameras for (pre)review and doing so early so as to attract eyeballs to the site. Manufacturers are understandably more likely to lend equipment to sites that give them high marks. So getting hold of new cameras is easier if you give the makers better ratings.

However the value to consumers declines as ratings are compressed into the top category. Telling one from another is no longer a case of looking at the bottom line, but now requires making a subjective judgment (often based, in no small measure, on someone else's subjective judgment).

Ratings inflation also compromises the site's brand for integrity and objectivity. If the raters are basing their assessments on something other than their response to the product, namely the desire to get product to review and eye-balls to the site, how much faith can one place in what they write? (And to my eyes, some of what they write bears absolutely no relation top the test images they comparing.)

Of course, this kind of compromised objectivity applies not only to reviewers of digital cameras; the financial instruments that were the building blocks of the "normal accident" (Perrow, 1984) that befell our economic system last fall, were rated by supposedly impartial third parties - and look how well that worked out.

Risk postcript

In reading my prior post, one might interpret my observation as implying that bankers' decisions have less serious consequences than the decision of pilots. Unfortunately, that may not be the case.

Data collected by C. Pritchard (1990) suggests that suicides rise by 1.72 per million for every 1% rise in unemployment*, which has increased by 4.2% from May 2008 to May 2009. This would suggest that the deteriorating economy has contributed to about 1,700 additional deaths in the last year. This may be a conservative estimate since it does not take into account other factors such as home foreclosures. By contrast there were on average only 66** accident related aviation fatalities a year over the period 1989-2008, and only 16 per years between 2002 and 2008***.

However the point of my last post still stands; paying people more money does not seem to make us any safer.

* Panel data regression based on this data available on request.
** Deaths caused by an illegal act are excluded from the calculation.*** 2009 however is turning out to be a bad year - 49 died in the regional air crash in February in Buffalo, NY, the incident that prompted the Senate hearings mentioned below, and 228 perished in the Air France Rio to Paris flight on June 1st. Pilot error may have been a factor in the first; the cause of the second has not been determined.
Pritchard, C. 1990. Suicide, unemployment and gender variations in the Western world 1964–1986. Social Psychiatry and Psychiatric Epidemiology, 25(2): 73-80.

Compensation and risk

In testifying before a hearing of the Senate Subcommittee on Aviation Operations, Safety and Security recently, Roger Cohen, President of the Regional Airline Association asserted that there was no data to suggest any relationship between pilot compensation and the risk accidents due to pilot error.

The same lack of relationship between compensation and risk-taking that puts others in jeopardy seems to exist elsewhere; for example in some large banks and one insurance company. Despite high compensation, the senior managers in the cockpits of some of the nations largest financial institutions were unable to prevent a crash.

We seem unperturbed that those in whose hands we place our lives earn minimum wage, while those who look after the money seem to make more mistakes yet are paid a thousands times better (literally).

Perhaps the banks' shareholders might think about this next time they take a regional flight to a shareholders meeting.

Not quite what they had in mind?

Allan goes on a road trip in his father's car and gets into an accident. He calls his dad who wires him the money to get the car fixed. However, Alan's dad says there will be conditions - he'll have to drive more carefully in the future and he may have to take more driving classes when he get home. Instead of fixing the car, Alan spends half the money on drink, drugs and hookers, and expensive gifts for his friends; with the rest he hires an attorney to prevent his father from forcing him to take additional driving classes when he gets back. The car, unsurprisingly, is not fixed.

Key

Allan	Banks receiving bailout money
Alan's father	Tax payers
Money to get the car fixed	TARP + ...
Road trip	Writing CDSs and buying CDOs
Drink, drugs and hookers	"Performance" related bonus payments
Expensive gifts	Dividends
Attorney	Washington lobbyist
Additional driving classes	Government regulation and oversight

More on AIG

Like many people I am concerned that employees and managers in the Financial Products Division of AIG, the arm of the company that wrote the under-priced CDSs, are receiving large bonuses. It is more all the more irksome because they are now being paid by US tax payers, many of whom are struggling with the fall out of AIG's bad decisions.

However, I am opposed to some of the suggestions being floated in Washington to recover that money, for example that of Charles Schumer, who is advocating new completely ad-hoc tax laws. This is the kind of response that makes people wary, indeed suspicious, of government. Such ad-hocary increases uncertainty and makes the Government look weak and capricious.

The time to argue about bonuses was before the money was handed over, not after the fact. Of course, as was I'm sure clear to many at AIG, they had the government over a barrel and the government would have found it enormously difficult to make the surrendering of bonuses a pre-condition of the bailout.

While AIG took excessive risks that have contributed the crisis, it did so because we (regulators, government and the electorate) allowed them to do so. Blaming a few fat cats is easy - they make wonderful scapegoats, but not all of the blame is theirs.

Stewart vs. Cramer

First let me declare my bias: I enjoy Jon Stewart’s show (sorry Dominie). Having watched it pretty regularly for 8 years, I think he does a better job pointing out inconsistency and illogicality in public figures than 90% of the serious television so called journalists (a reflection on the regrettable state of the broadcast media). And that was really his point last week.

Conspiracy theorists and Fox News junkies may impute to Stewart “a hidden agenda”; in some ways they are probably right - I imagine that his “agenda” includes such subversive ideas as a belief that hypocrisy, and unethical behavior in public figures should be called out. Is he “Fair and Balanced”? Probably not. Is Fox News? Of course not.

But this is all quite irrelevant. To dismiss Stewart because he is a comedian or because he probably votes Democrat is a superficial and misguided heuristic, because his substantive points have not been answered.

Cramer was shown explicitly encouraging ethically dubious market manipulation in his internet show; as an insider was may reasonably assume he had more knowledge than most about CDOs and CDSs; given is background and access to insider information, his advice on Lehman stock seems more to reflect the interests of his industry associates than those of the people his show claims to represent.

Stewart’s understandable outrage stems perhaps from seeing his mother’s 401k fall in value while those whose actions contributed to the collapse take home very large bonuses, something to which he alluded on the show.

Of course, some will argue that the problem was not just on Wall Street and I agree. Politicians of both sides contributed to relaxation of oversight regulation the evisceration of the agencies that should have been carrying out that oversight. And many people (encouraged I’m sure by unscrupulous real estate agents) made very foolish decisions that left them overextended. Yet someone who made a bad decision on their choice of mortgage looses their home; they don’t get a six or seven figure bonus (paid for by us, the tax-payers) as a reward for their poor choices.

AIG

AIG needs more tax payer money. While this seems a little like throwing good money after bad, what happens if we don’t? Here’s my lay-person’s take.

If AIG goes under, presumably it will not make good on its credit default swaps (CDS), the insurance-like products it sold to the banks. These CDSs were bought by the banks to protect the mortgage-backed securities they had written; in the event that the collateral (the properties against which the mortgages were written) turned out to be worth less than the mortgages themselves, their mortgage-backed securities (or collateralized debt obligations, CDOs) still had something behind them. If AIG doesn’t make good on its CDSs commitments, the banks’ CDOs are worth less than they currently and those banks will likely fail their ’stress tests’. Consequently, they will be forced into bankruptcy as well.

Some think this is a good idea (and perhaps in some ways they’re right), yet the cost to many could be horrendous. Without the banks to lend to business and consumers the economy will contract further, more people will loose their jobs, their houses, their 401k savings. Property prices will fall further, personal credit will be more difficult to obtain, consumption will decline, and the recession will deepen.

Of course, though keeping the banks alive may lessen the severity of the recession, we will have preserved the very system that was in no small measure to blame for getting us into the mess in the first place…

Normal accidents

Perrow (1984, “Normal Accidents: Living with High-Risk Technologies”) noted that tightly coupled systems are more prone to accidents.

Population ecologists (Hannan, M. T. and J. Freeman, 1977, “The Population Ecology of Organizations” ) tell us that specialization is a response to the demands for efficiency. Specialization leads to increasing interconnectedness and interdependency; in other words tight coupling.

The near collapse of the world financial system this fall, a crisis brought about by a very small perturbation (only 2% of mortgages are in foreclosure), seems to be a good example of a normal accident.

As firms increasingly outsource and reduce buffers between system elements in the quest for efficiency, are we going to see similar accidents in other sectors I wonder?

A question answered

A few weeks ago, I posed a question: how will the bailout plan simultaneously unfreeze the credit market and ensure that taxpayers are not left with the bill. I think I now have an answer. Nationalizing the banks (taking share in exchange for cash) fixes the weak balance sheets in a way that buying troubled assets at fair market value did not. And it appears that the terms are not that shabby; a guaranteed 5% return with greater upside potential if the banks' shares do well.

In other words, the plan, in its original form was never likely to work without the taxpayer taking a bath. This new approach looks a lot better.

Identification

Identification: a feeling of belonging to something larger than oneself.

When one group is treated differently from other groups, people might be forgiven for adjusting their frame of reference. The larger group to which they once thought they belonged - and owed some allegiance - may be replaced by a smaller more proximate group. The Wall Street bail-out risks creating such a shift. Small business owners may wonder why it is acceptable for them to fail but not for large Wall Street firms. Home owners struggling to pay mortgages, other who have lost their homes.

Arguments about vital interests and the like, while intellectually comprehensible, are hard to swallow in a culture that holds dear the notion that everyone has an equal shot - but by the same token faces the same risks. If care is not taken in how the Emergency Economic Stabilization Act is implemented, fissures may appear in the rather delicate fabric of our society (sorry Lady Thatcher - there is such a thing as society).

Moral Hazard

Allowing those investment banks that found themselves unable to meet their obligations to creditors not to fail creates a moral hazard problem that will haunt not only the financial services industry but all businesses in the US for a generation.

• We have signalled to outside directors that they need not exercise due diligence in oversight of the companies on whose boards they sit.


• We have signalled to managers agents that their risky behaviour has no downside and thus that there is not cost to risky behaviour in the future.


• And we have signalled to owners - shareholders - that they need pay no heed to the actions of those working on their behalf. Their investment is guaranteed.

Everyone - owners and managers alike - how has an incentive to take ever larger risks. If they win fine; if they loose, not a problem, someone will come to their aid. The problem is that those who are being asked to provide that aid is all of us, the US taxpayer. We have created an expectation, not just in the banking sector, but thought the business community that if you are large enough, no harm will be allowed to come to you, if you’re big enough. Small business owners may create half the wealth in this country but they are not equal recipients when it comes to a transfer of wealth from Main Street to Wall Street and beyond.

Help wanted…

Something I do not understand about the TARP: suppose the Treasury buys the troubled assets for what the market thinks they’re worth. How this is to be achieved is still not clear though the Chairman Bernanke mentioned a reverse auction in his testimony to Congress on Wednesday.

But assuming some price discovery is possible, then we acquire them for the market’s best guess as to what they are really worth. The price reflects all the available information about future development in economy and the housing market in particular. In other words, at these prices, the best estimate of their net present value is zero; we will be paying as much for them as the markets expects we will get back. In other words, everyone’s best guess as to their worth means that the taxpayer should expect to neither make nor loose money on the deal.

However, if we pay the market price, the banks still have under-capitalized balance sheets; this, as far as I understand it, is what is preventing other banks from lending them money. So buying the assets at the market price makes no difference to the lack of credit, the problem that is making the impact so much more wide-spread than a problem for just the banks; their balance sheet are still too weak.

If, however, the plan was to buy the assets at their book value, which would certainly shore up the banks’ balance sheets and fix the liquidity problem, the taxpayer is almost guaranteed to loose. Paying anything above the market price for the ‘toxic assets’ represent an expected subsidy to the banks and an expected loss to the taxpayer.

So my question is this: is the above logic wrong? If not how do we avoid getting stuck will the bill if the bail-out works? (Two questions actually).