Tag Archives: money

The Hidden Cost of Credit Ratings

justice

The NY Times’ “The Hidden Cost of Trading Stocks” paints a concise and damning picture of yet another malpractice in financial services.  This has been a recurring theme.   

Another storm may be brewing – this time for the credit ratings industry.  

It is standard practice for issuers to hire ratings agencies to rate their securities.  This practice has lead to incentives to give higher ratings when trying to get business from securities issuers, putting the ratings agencies in the position of representing the issuers when they are given special status to serve and protect investors.  They are not even required to disclose the conflict of interest.  The closest we get to protection is a lawsuit when they explicitly advertise objectivity.

It now looks like 16 states will each get their chance to sue individually.  This may be the beginning of a big and positive change.  If conflicts of interest did influence credit ratings, it would shift capital and damage economic efficiency even when it is not misdirecting pension money into a mortgage bubble.  I wonder if we will see a social media movement to influence reform like we are seeing with network neutrality and “common carrier” status.  I hope so.

 

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More on Money

“The process by which banks create money is so simple that the mind is repelled.”

– John Kenneth Galbraith

“That is what our money system is. If there were no debts in our money system, there wouldn’t be any money.”

– Marriner S. Eccles, Former Chairman of the Federal Reserve Board

“Whoever controls the volume of money in our country is absolute master of all industry and commerce…and when you realize that the entire system is very easily controlled, one way or another, by a few powerful men at the top, you will not have to be told how periods of inflation and depression originate.”

– James A. Garfield, assassinated President of the United States

“The Government should create, issue, and circulate all the currency and credits needed to satisfy the spending power of the Government and the buying power of consumers. By the adoption of these principles, the taxpayers will be saved immense sums of interest. The privilege of creating and issuing money is not only the supreme prerogative of government, but it is the government’s greatest creative opportunity.”

– Abraham Lincoln, assassinated President of the United States

“Until the control of the issue of currency and credit is restored to government and recognized as its most conspicuous and sacred responsibility, all talk of sovereignty of Parliament and of democracy is idle and futile…Once a nation parts with its control of its credit, it matters not who makes the nation’s laws…Usury once in control will wreck any nation.”

– William Lyon Mackenzie King, former Prime Minister of Canada

A cartoon explanation of the banking system:
http://video.google.com/videoplay?docid=-9050474362583451279

The Credit Crunch and the Market

[Download the complete article in PDF format, with charts and better formatting]

The past month has been a roller-coaster in the financial markets.

At the first hints of falling prices in the mortgage backed securities markets, Bear Sterns announced the bankruptcy of two large hedge funds, and 90% losses in a third fund which had $850 million invested in highly rated mortgage-backed securities. In the following weeks, other major funds also announced losses. Goldman Sachs’ Global Alpha hedge fund fell 27% this year through Aug. 13, prompting clients to ask for $1.6 billion in redemptions, investors told Bloomberg. DE Shaw, a pioneer of quantitative investing based on complex mathematical and computer techniques, has been hit hard in August. DE Shaw’s Valence fund is down more than 20% through August 24th, according to a fund of hedge fund manager.

These high-profile losses are prompting redemptions, and as cash flows out of hedge funds, managers must sell. Around the world, leveraged funds anticipate redemptions and are deleveraging (selling).

“When you can’t sell what you want, you sell what you can.”

Because the markets for mortgage-backed securities dried up so completely and so quickly, managers began selling positions that remained liquid and well-priced. In a sense, they had to sell good investments because they couldn’t sell the bad ones. What started as a series of collapsing mortgage strategies has spread into just about every other market that hedge funds touch. Prices fell in investments ranging from emerging market bonds to the price of hogs. In all, more than $1 trillion in value has been lost in US stock markets, alone. Many foreign markets and alternative asset classes suffered worse declines.

The trigger event is a credit tightening: mortgage issuers extended too much credit, were too loose with their lending standards, and may not have adequately communicated their loan terms. In response, lending standards have been increased and credit is tighter. US consumers might slow their spending, which might trigger a broader slowdown in the US economy, which might have implications for global growth. Uncertainty and fear prevail.

We view this fear as primarily psychological, wildly overestimated, and only loosely related to market fundamentals (See Figure 1). But that may not matter.

Contagion

The pricing of risk is driven by psychology. Investors require compensation for the possibility of loss and also for the inconvenience of uncertainty. So rising risk can cause capital to become scarce, lending rates to go up, and spending to slow. In this sense, the psychology can impact the fundamentals in what is sometimes called a “contagion”.

The “Greenspan put” was like a safety net, providing the comfort that credit would be made available on those occasions when it was needed. Bernanke has reiterated this strategy, but it remains to be seen if he has the same appreciation for what Keynes called the “animal spirits” of the market. Contagion is a real phenomenon, generally starting with a crisis in one market or a large fund, then spreading to other asset classes as volatility rises and investors require higher premiums for risky investments.

In our view, the excessive lending in the mortgage industry could trigger a contagion in a variety of ways, such as:

  • Rising rates and tightening lending standards leads to a contraction in home prices, reducing consumer spending and slowing economic growth.
  • A new awareness for the risk of debt investments causes borrowing costs for corporations and governments to rise, reducing investment and slowing economic growth.

These risks can be self-reinforcing, and could change the fundamental characteristics of the economy. These are the type of events that could change our investment strategies if they appear to develop out of control.

So far, these contagions have not caused a significant slowdown in economic activity. Volatility triggered by major hedge fund failures is different; it generally causes sharp declines in recently popular asset classes followed by recovery. These declines can proceed in unexpected ways, and can continue for some time because each price shock runs the risk of triggering another failure. It is surprising how many hedge funds use leverage sufficient to make them incompatible with price shocks. As months pass, however, these shocks can be a blessing because they offer rare value opportunities.

We should all hope that a full-fledged contagion does not develop, and be thankful that the world’s central banks are standing guard.

The Federal Reserve

It is important for the government to intervene if a contagion might damage the economy in fundamental ways, but also important for the government to avoid interfering otherwise. The Federal Reserve and foreign central banks play an important role in managing the stability of economic growth by changing the availability of capital at money-center banks, but interventions can also cause distortions in currency exchange rates, changes in the money supply affect inflation expectations, and reliance upon government intervention can lead investors take excessive risks.

On the 17th, the Federal Reserve followed several foreign central banks (European Central Bank, Australia, Japan, and others) by pumping capital into their nations’ banking systems in response to the recent volatility. This intervention increases the monetary supply, but the psychology of selling is still driving down many market prices as global investors reduce their exposure to risk and shift their portfolios to hold more cash and US Treasury Bonds.

Credit tightening is a reasonable response to excessive lending, but the signal from global central banks is that they are ready to smooth the volatility, even if it means increasing the money supply. This indicates that they may intend to inflate their way out of potential economic pain. As a result, we are less concerned about a recession, but our long-term expectations for inflation have risen. This combination makes stocks and real assets more attractive because they are better hedges against inflation, and reduces the value of fixed income instruments (such as US Treasury Bonds). Meanwhile, the global investor crowd has been doing the opposite. If higher inflation will be the ultimate outcome of this recent roller coaster, then the massive global shift toward cash and fixed income may ultimately be reversed.

The U.S. Penny is worth 1.04¢!

[The following article is part of a larger commentary, available here.]

After monitoring this calculation for a long time, I’m happy to announce this new and unusual arbitrage.

Pennies are composed of 97.6% zinc and 2.4% copper, with a total weight of 2.5 grams. After several years of rapid appreciation, copper prices have been stagnant for about 6 months, but zinc has been rising toward $4,000 per metric ton (or about 4/10 of a cent per gram). That places the value of the zinc at 0.994¢, and the value of the copper at 0.045¢, bringing to total cost of the raw metals to 1.04¢.

So if you collect pennies, melt them down, separate and purify the metals, then sell the metal on the public exchange, you make 4%. This is a new phenomenon, and may not last. I would expect to hear an announcement that the penny will be modified, replacing zinc with aluminum. This would bring the value of the metals down to less than 7/10 of a cent, and gives the government another couple years before they are forced to drop the penny as a unit of currency.

The new aluminum pennies will still be clad in copper, but will feel much lighter. You heard it here first.

Chinese currency policy

The import textile quota expiration may be a catalyst for political pressure on Chinese currency policy. Non-Chinese emerging markets will threaten to devalue or peg their currencies as long as the US is not punishing that type of behavior.

See also: Renminbi Valuation

Buffet: "I don’t see how the dollar avoids going down"

Forbes reports on Warren Buffet’s currency perspective:

Heed the Sage of Omaha. Warren Buffett, whose investment acumen seems unerring, had a caveat for America: Barring “a major change” in policies, the trade deficit will further undermine the U.S. dollar.

The billionaire spoke in a Wednesday interview with CNBC, the cable TV news channel owned by General Electric (nyse: GEnewspeople).

Without shifting current trade policy, “I don’t see how the dollar avoids going down,” he mused, warning of inflation risks posed by an anemic Yankee currency.

The prairie-born genius also confessed he’s having a “hard time” identifying stocks to buy, and isn’t purchasing commodities. His cash swelled to $43 billion in the third quarter, by one account, because he couldn’t find many investment opportunities.

Buffett, 74, is chairman of Berkshire Hathaway (nyse: BRKa
news
people), the immensely successful investment vehicle that acquired a new–and immensely successful–board member in December: Microsoft (nasdaq: MSFTnewspeople) Chairman Bill Gates.

The latter also enjoys a personal friendship with Buffett, and takes part in his bridge games. (see: “Gates: Buffett’s Pal Bill Elected To Berkshire’s Board“)

Renminbi Valuation

The renminbi is pegged to the US Dollar, and has been for a long time, so what would a revaluation of the Chinese currency mean? Without an exchange rate determined by the marketplace, how can we anticipate the magnitude of the difference between the pegged rate and the appropriate market rate?

It is clear that the yuan is cheap relative to the dollar, but by how much? Our economies are different, and these differences lead to different relative pricing, but looking at a variety of prices can give us some sense of purchasing price parity.

Unskilled Labor:

Textile workers in China are paid about 1/30 of the amount paid for equivalent work in the United States. If this ratio were to equalize through currency revaluation, the yuan would increase by 3000%. However this is almost certainly too high, as China has an oversupply of unskilled labor. This number provides the high-end boundary on the scope of the question.

Gold:

Gold can be purchased in yuan At the time of this writing, $442 worth of gold costs 3670 yuan, implying an exchange rate of about 8.303 Yuan/$. If this ratio were reflected in the currency echange rate, the yuan would increase a negligible amount (Because the exchange rate peg is currently 8.27 Yuan/$). However this is almost certainly too low, as it is illegal for chinese citizens to invest in Gold. This number provides an low-end boundary on the scope of the question.

Basket of goods:

Depending on the basket you select, purchasing price parity implies different undervaluation of Yuan. I estimate approximately 40% undervaluation, clearly with different classes of goods and services.

Trading:

Under a fair and open market, I envision a 40% inflation on Cinese imports would greatly imporove the stature of US companies that have been drowning under Chinese import competition. Similarly, Chinese companies that earn their revenues from Chinese will see a US Dollar denominated revenue increase of 40%.

[UPDATE 1/25/2005]

Senator Lindsey Graham, (R) Judiary Committee and

Senator Charles (Chuck) Schumer, (D) Finance Committee

are announcing bill to impose a 27.5% tarif on Chinese imports, implying their view that the Renminbi is near 27.5% discounted against the Dollar.

[END UPDATE]

Let’s speculate that Chinese currency will reflect market forces within 2 years. In this speculative possible environment, investors might benefit from:

underweight Chinese companies with revenues largely based on exports

overweight Chinese companies with revenues largely based in China

underweight US companies who import from China

overweight US companies who compete with Chinese imports

Now let’s speculate that Chinese currency will remain pegged to the US Dollar. In this speculative possible environment, investors might benefit from exactly the opposite positions.

How can the US exploit a currency peg that is clearly an unfair trade practice?

Cut taxes and issue more debt.

This increases the Federal deficit, diminishing the value of the US Dollar, and also increases the after-tax pay rates for US workers.