Friday, August 31, 2007

And another thing...

I want to continue my rant on the New York Times' recent article about how the subprime mess has led some in the "international community" to call for more input into US financial regulation. (See my screed here and the NYT article here.)

Clearly, greater international regulatory cooperation can be a great boon. However, the arguments posited by Peter Bofinger and Professor Dick Bryan in Heather Timmons' and Katrin Bennhold's article are not among the reasons we need this cooperation. International regulatory cooperation exists for two purposes -- so bad guys can't use the international system to undermine national sovereignty (quite the opposite of what Bofinger is suggesting) by permitting regulatory arbitrage; and, second, so the world's regulators don't step on each others' feet so much, to the detriment of global markets.

I'm harping on this point because these academicians really should know better. For example, the article notes:

Their argument is simple: The United States is exporting financial products, but
losses to investors in other countries suggest that American regulators are not properly monitoring the products or alerting investors to the risks. “We need an international approach, and the United States needs to be part of it,” said
Peter Bofinger, a member of the German government’s economics advisory board and a professor at the University of Würzburg.

While regulators in the United States have not been receptive to the idea in the past, analysts said that Europe and Asia had more leverage now. Washington might have to yield if it wants to succeed in imposing bilateral regulations on government-owned investment funds from emerging economies.

“America depends on the rest of the world to finance its debt,” Mr. Bofinger said. “If our institutions stopped buying their financial products, it would hurt.”

Rather than an argument that the US regulators are asleep on the job, isn't this an argument that the European regulators aren't monitoring the risk management practices of their own firms? Were these firms really snookered into believing that the subprime mortgage securities were safer than they are -- particularly when anyone with half a bucket of sense could tell you otherwise?

Likewise, it is certainly true that US regulators have not been keen on engaging foreign governments in determining what US financial regulations should be. Indeed, I suspect that if the US public knew anyone in the United States was even considering it, they would be hanged from the nearest lamp post (which may explain why Basel II is as complicated as it is -- US banking regulators, after all, have such skinny necks). All of that said, I fail to see why US financial regulators would particularly care if foreign investors, in particular, stopped investing in any specific US security. Regulators might care if investors, writ large, started having a problem, but there is nothing magical about foreign investors.

And this, fundamentally, is why these academics' arguments fail. The Fed, the SEC and most other US financial regulators draw no distinctions between US and foreign investors. This is the strength of the US system and why the United States is able to import capital so cheaply, regardless of how many boneheaded statements Congressional leaders might make about foreign capital. What's good for foreign investors is good for American investors, and vice versa. US regulators are unlikely to take advice from foreign regulators who historically have a problem with attracting even domestic investors to their own market.

Thursday, August 30, 2007

NYT: World wants a say in US financial regulation

Yesterday, the New York Times had an article on the subprime mess quoting a number of foreign talking heads demanding more international input into US financial regulation. (See Calls Grow for Foreigners to Have a Say on U.S. Market Rules.)

Yeah, what's new? Actually, that should be the title of the article. What I found most amusing, of course, is the arguments put forward about why there needs to be more of an "international" approach -- whatever that means.

“We need an international approach, and the United States needs to be part of it,” said Peter Bofinger, a member of the German government’s economics advisory board and a professor at the University of Würzburg.

While regulators in the United States have not been receptive to the idea in the past, analysts said that Europe and Asia had more leverage now. Washington might have to yield if it wants to succeed in imposing bilateral regulations on government-owned investment funds from emerging economies.

“America depends on the rest of the world to finance its debt,” Mr. Bofinger said. “If our institutions stopped buying their financial products, it would hurt.”

I believe logicians call that the "we're your customers, therefore we should have a say into how you run things" argument. I suggest you try it with your cell phone carrier some time -- it really does work.

(As for the "we're going to stop buying your products" thought, Mr. Bofinger, you'll stop buying when we stop being so damn profitable, and not a day before--or a day later, for that matter. Do I have to explain everything to you European government types?)

Granted, I expect that kind of thinking from European academicians. (Do you ever stop and wonder what happened between Rene Descartes and today? I mean, seriously. The Europeans actually invented deductive reasoning, and today we get this?) However, the Aussies are in on it, too.

As geographical boundaries are broken down, “a problem in one location is a problem everywhere,” said Dick Bryan, a professor of economics at the University of Sydney.

“There is the need to challenge the sovereignty of national regulators,” he said. “Why should the rules of lending in the U.S. be left to U.S. regulators when the consequences go everywhere?”
There's your problem, Professor Bryan. You are following the lending rules of the United States because you are actually lending in the United States. If you were lending in Australia, the rules might be different. If you don't like it, stop lending to damn ferriners. (Oh, I guess I don't mean you, personally. I mean Australian financial institutions, who, as we all know, are demanding significantly more regulation in the United States...)

Please, everyone. The old saying is don't confuse brains with a bull market. On the flip side, don't confuse conspiracy with a bear market.

You investors and borrowers out there want to know who's to blame for the subprime mess? Look in the mirror.

Tuesday, August 21, 2007

Bernanke's competence on subprime crisis brought into question

After all, nothing will bring into question your competence on an issue than for Sen. Chris Dodd (D-Conn.) to say you "get it." (See Fed ‘Gets It’ on Mortgage Crisis, Senator Dodd Says.)

I'm all for addressing liquidity crises, but there is a very fine line right now between holding off a wider, preventable systemic crisis, and repeating the Fed's past mistakes regarding moral hazards and banking bailouts. (Which, in my opinion, include pretty much every Fed banking crisis intervention in the past.)

Just as an example, has there ever been a more blatant case of begging for corporate welfare than Jim Cramer's beserk attack on Bernanke two weeks ago? (Watch here or here if you're interested).
"Bernanke is being an academic!... [William Poole, St. Louis Fed President] has no idea what its like out there--None! They know nothing! The Fed is asleep! My people have been in this game for 25 years ! They are losing their jobs and these firms are going out business!... This is a different kinda market!"

First, never trust anyone who says this is a different kind of market. For 400 years, it's been the same kind of market.

Second, why should we care if you are losing your jobs over your poor investment decisions? (Some people, particularly those betting against you, have been making a lot of money.)

I could be wrong, but given Congress' involvement in previous market-related matters, I can't help but suspect that Chris Dodd is just a slightly more calm version of Jim Cramer (particularly given the number of hedge funds operating out of Connecticut).

Friday, August 17, 2007

Why the Heritage Foundation is getting its butt kicked by Cato

You don't have to go much farther to understand the ideological break up of the Republican Party than the Heritage Foundation's support for an internal US passport. See Federal ID plan raises privacy concerns. Cato, on the other hand, is right: a national ID card is more about illegal immigration than national security.

And Mr. "Shared Responsibility" Chertoff should be credited for being able to say without smirking that he's part of a Republican administration and that: "This is not a mandate," Chertoff said. "A state doesn't have to do this, but if the state doesn't have -- at the end of the day, at the end of the deadline -- Real ID-compliant licenses then the state cannot expect that those licenses will be accepted for federal purposes." Which, of course, means that those of you living in those 20+ states opposed to this plan will either have to suck it up or start using your US passport to board planes, trains and buses.

Chertoff, of course, assures us that our privacy is guaranteed and that the government would never abuse this information. In other words, he's from the government and he's here to help. (Makes you wonder what Reagan would think of his party these days...)

So I guess this means that if I'm in favor of small government and opposed to unfunded mandates, I'm a Democrat?

Thursday, August 09, 2007

Roel Campos to leave SEC

Democratic Commissioner Roel Campos announced today that he will be leaving the Securities and Exchange Commission by the end of September. The media is making a big deal out of the fact that Campos is the SEC's first Hispanic commissioner and a Democrat in a highly divided Commission. However, Campos is also the "international" commissioner--he represents the SEC before a number of international organizations and is currently the Vice Chairman (and prospective chairman) of the developed markets committee of the International Organization of Securities Commissions. With Campos leaving, SEC Chairman Cox will have to nominate someone new to represent the SEC before the world--though, given Cox's own interest in international matters, I wouldn't be surprised if he takes up this job himself. If he does, we can expect a new emphasis placed on IFRS-US GAAP convergence and mutual recognition.

The conspiracy theorist in me expects Paul Atkins to leave soon as well, in a quid pro quo that will reduce the SEC to three commissioners. The Financial Times has reported that Atkins may be heading over to the Commodity Futures Trading Commission. Even if he does not, his term ends in a year and he may be interested in more remunerative work even before then. As it stands, the 5-member Commission will soon be down to 4 members, only one of whom is a Democrat at precisely the time that some very important decisions are coming due and an upcoming election season.

If Atkins leaves for the CFTC, I expect Bush will leave the SEC with three commissioners for the remainder of his term. This is because, despite all the talk about a shift in the balance of power, the current Commission is ideologically dysfunctional. Previous SEC chairmen (particularly Arthur Levitt) ran the SEC as a corporate chairman--i.e., largely by fiat, with the four other commissioners more or less falling in line. However, starting with Harvey Pitt and his battles with fellow intellectual heavy-weight Harvey Goldschmid, individual commissioners started having their own ideas and pursuing their own political agendas. The media story on current SEC chairman Cox's predecessor, William Donaldson, was that he "sided" with the Democrats and chaired a fractious Commission. However, the same fractures are starting to appear with Cox as well. And the source of these cleavages? Atkins.

Atkins, in particular, is a thorn in any Republican SEC chairman's side, basically because he has yet to see a securities regulation he likes. He is an ardent deregulator, and such views can be particularly unhelpful to more "responsible" (i.e., vulnerable) Republicans during an election season. Cox is no investor-hugging hippie, but he does recognize that an SEC that appears to be in the pocket of industry is not something good for his party. (Hence his vote with the Democrats to petition the Solicitor General to file an amicus brief on behalf of the investors in the Stoneridge case.) Atkins, on the other hand, would rather be ideologically pure than in power. Furthermore, he has a tendency to get the other Republican commissioner (whoever that might be) to get onboard with him.

Reducing the Commission to three members might, then, help Cox pursue his own (and his party's) wider agenda. Under a 2-1 Commission, Cox likely could count on support from his remaining fellow Republican commission Kathleen Casey, and Democrat Annette Nazareth likely would go along to get along.

A nice, quiet SEC for the remainder of George W.'s term. What's not to like?

Wednesday, August 08, 2007

China's "Nuclear" Currency Option

The London Telegraph is reporting that the Chinese government is threatening a massive sell-off of the $1.3 trillion-worth of US dollars it holds if the US Congress passes trade sanctions as a result of China's policy of undervaluing its currency. (See China threatens 'nuclear option' of dollar sales.) What's worse, the Telegraph breathlessly reports this as a threat.

OK, I'm a bit lost here. The US accuses China of hoarding dollars as a way to keep the Chinese yuan artificially low, thereby making Chinese products artificially cheap and flooding the US market with Chinese imports. To protect US consumers from having to pay so little money for these products, Congress is threatening to slap trade sanctions on China if it doesn't stop these currency policies. In response, the Chinese goverment basically says, "Oh, yeah? Well, if you slap sanctions on our companies, you know all those dollars you paid us for everything you buy at Walmart? Well, we're going to give them away for free! That'll show you!"

How am I not exaggerating? The US says stop keeping your currency low or we'll hit you with sanctions, and the Chinese say, if that's how your going to be, then we're going to stop keeping our currency so low! Is that a threat? A negotiating tactic? Who are these people?

The Telegraph goes on to suggest that a massive sell-off of Chinese-held US government debt could "...cause a spike in US bond yields, hammering the US housing market and perhaps tipping the economy into recession." Granted, a firesale of US bonds might cause a spike in US bond yields (and an excellent investment opportunity for the rest of us), but even if that caused a recession, which products are these newly impoverished American consumers most likely to forgo most quickly? You think it might be all those Chinese products that suddenly doubled in price?

And all those poor American consumers, suddenly seeing their property values drop. Do you think they might be able recoup some of the loss with a better-paying job at a US exporter? You know, maybe a company like Boeing, since the prices foreigners have to pay for a new Dreamliner just dropped dramatically with a devalued dollar?

All I'm saying is that I wish these Chinese negotiators would come over to my place sometime for a night of poker. I could use the cash...particularly with a recession coming up.

Sunday, August 05, 2007

Foreign Policy: Five things my economist told me that I'm too dumb to understand

The web issue of Foreign Policy Magazine (which Kids Prefer Cheese calls the People's Magazine of international affairs) has an article called "Five Lies My Economist Told Me". I don't know why some people say ostensibly respectable journals can let their editorial standards go to hell where an Internet edition is involved. In this case, Foreign Policy hits it on the nose. Speakin' the truth, brotha! For example:

1. High productivity and low unemployment make us all better off: Despite six years of sustained growth, with unemployment averaging around 5 percent, the median U.S. worker is not faring well. Since 2001, middle-class Americans have seen their pay drop by 4 percent, although labor productivity went up by 15 percent during the same period.
Now we know this is a lie! It's low productivity and high unemployment that's the secret to success! Bring back stagflation and 10 percent unemployement. Middle class incomes are sure to rise then. And while you're at it, we need to get rid of Tivo. I don't know about you, but my middle class life hasn't improved one wit by fast-forwarding through 40 minutes of TV ads every day. After all, if it's not salary, I don't care.
2. It’s hard to grow without good banks and private property: One word: China. The gross domestic product of this Asian giant has increased sixfold between 1984 and 2004, with a stunning average growth of roughly 9 percent since 2005. Yet only in 2007 did the protection of private property acquire equal footing in Chinese property law. Moreover, experts still deem China’s banking system to be shaky despite a major overhaul that started in 2002.
Good banks and private property are a lie! It's easy to grow if you don't have banks or private property! Which, of course, is why Mao's China was going gangbusters. In fact, China would be growing much faster now that it was in the past if they had just stuck to Mao's glorious policies. After all, why do you need a bank if you don't own any property? Clearly, economic growth has never been linked to a strong financial system or some kind of assurance that you aren't going to be robbed. And any economist who tells you otherwise is just lying to you.
3. Capital must always be let free to flow: The Asian financial crisis. Starting in 1996, overvalued real estate prices collapsed in Thailand, spurring a devaluation of the Thai currency. Soon enough, the contagion spread to nearby Malaysia, Indonesia, and South Korea. Capital flight triggered painful recessions in most of East Asia. Only China and Taiwan, which had maintained tight capital controls, weathered the crisis unscathed. Malaysia split the difference by introducing capital controls in 1998, a last-minute attempt to avoid the worst.
This is completely a lie! After all, if you keep capital out of your economy, clearly it won't flee when the corrupt underpinnings of your market become apparent. Which, of course, is why Zimbabwe is an economic powerhouse, and Western markets, which got rid of their capital controls in the late 1970s, have been in the economic shitter ever since.
4. The euro will never work: In January 2002, the euro made its entrance on the world stage and into the wallets of the citizens of 13 European countries. Five years later, it is still alive and healthy—stronger than the U.S. dollar, in fact. And despite grumbling from countries like Italy, where policymakers wish they could still boost exports by devaluing the old lira, nobody is seriously considering going back to single national currencies.
That's right, you liars! The Euro is stronger than the US dollar! And the only people complaining about the Euro are little whiners like the Italians and all the lower-wage EU markets getting burned by the strong Euro. Because, you know, a strong currency is a sign of economic strength. Just ask the Chinese, and their pathetically devalued Yuan. Not an economic growth sign in sight there. (By the way, why does the FP then go on to say that the critics are right and the Euro is essentially just a political tool divorced from economics? Why back down when you've got such a compelling argument?)
5. Japan—no wait, China—is going to take over the world economy: As of 2007, the United States is still the greatest capitalist economy in the world, with a gross domestic product roughly three times as big as that of Japan, the world’s second largest economy. True, Japan’s car industry is still a rising star: Toyota briefly overtook General Motors a few months ago as the world’s largest automaker. Yet, as Newsweek columnist Fareed Zakaria put it, the Japanese “ran into a brick wall.” After more than 15 years of economic stagnation, repeated currency deflations, and record-high unemployment, the Japanese economy is just now coming out of the doldrums.
Again with the lies! All those lies in the late 1980s by such reknown economists as Clyde Prestowitz, Chalmers Johnson and Robert Reich. OK, so maybe they weren't "economists" in the U.S.-sense of the word. And by that I mean they didn't know anything about economics. And by that, I mean that Paul Krugman, who actually is an economist and knows something about industrial policy, calls them a bunch of policy poseurs (he's such an asshole like that). But somebody once said "economics" and "the Japanese and Chinese are going to crush us" in the same sentence, and if that's good enough for Foreign Policy, it's good enough for me.

Saturday, August 04, 2007

Sub-prime credit rating agencies

Sean Egan, head of boutique rating agency Egan-Jones and co-founder of some lobbying group designed to get his firm recognized by the SEC as a Nationally Recognized Statistical Rating Organization ("NRSROs" as they are known to their friends) wrote an op-ed in last Thursday's Financial Times (see Sobering lessons of the Bear Stearns losses). Given Egan's previous writings to the SEC and other groups, the FT piece is actually pretty good. Which means, of course, that I doubt he really wrote it. (Must have hired a new PR firm recently.) Egan correctly points out that the Basel II accord has basically made the role of credit rating agencies (CRAs) more important than ever, even as recent structured finance deals and the all-to-predictable sub-prime fiasco call into question whether these CRAs really can be trusted to properly rate the component parts that go into a structured finance deal or a collateralized debt obligation (CDO).

Structured financing and CDOs have become an important part of our economy. In "finance for dummies" terms, these are complex arrangements that let banks or others lend money, and then sell off the IOUs from those debts to other investors. Groups of these IOUs are broken into "tranches" according to the risk that the borrowers will default, and then bits of those tranches are sold off as securities. The idea is that the lender can diffuse its risk among a wide range of investors, each with a different risk preference. You want to invest in rock-solid debt? Then you buy securities from the AAA tranche. You want to take your chances, buy low with a very high chance you'll get nothing, but a chance that you'll make a killing? Then you buy into the "junk" (or sub-prime) tranche. You're an idiot and don't want to get paid back at all? I've got securities in the M.D. Fatwa tranche right here!

In an ideal world, this system is great and, according to some economists, is the reason that the last two recessions in the United States were as painless as they were. (You think they weren't? Then you are a punk and obviously can't remember the early 1980s.)

However, in the latest go around, Egan notes:
Investors in two hedge funds managed by US investment bank Bear Stearns were wiped out in June, which was surprising given that the securities in the funds were rated either AAA - the same level of safety as US Treasury bonds - or one notch lower at AA. Within a couple of months, $1.5bn of capital was lost in only two funds. This development is particularly sobering because, from the obvious indicators, the two funds were insubstantially better financial condition than most banks: they had equitymore than twice that of most banks, at 15 per cent of assets compared with only 6 per cent or 7 per cent for the majority of banks. These funds therefore met and exceeded the requirements of debt-to-equity ratios under Basel II. Additionally, the assets of the funds were rated higher than the typical bank's assets.

This event is a reminder of the weak underpinnings of the mortgage financing market. The problem is a shift in the mortgage business to a situation where all the participants have an incentive to complete the transactions; the mortgage brokers, bankers, investment banks and rating firms are paid if and only if a deal is completed.

This structure is significantly different from the markets of yore, in which a local banker would check borrowers' income and grant a loan only if there was an adequate ability to pay. Even if the banker became too aggressive, there were bank regulators to keep the business on the straight and narrow. One could argue that rating firms today are capable of assessing credit quality and halting the flow of garbage by withholding a rating. Unfortunately, in the ratings field, the tough rater is likely to be the underemployed rater. One of the major rating firms, Moody's, announced last week that it lost market share when it became less liberal than its
Egan's point about Moody's is very good. Moody's recently noted that ever since it toughened up its standards for reviewing commercial mortgage bonds, it has been shut out of 70 percent of this market. (See Moody's Shut Out of Rating Commercial Mortgage Bonds.) Moody's is one of the biggest CRAs and if it is being ratings-shopped, it's not hard to imagine that CRAs may be becoming subject to the same types of pressures that undermined securities analysts a few years ago.

However, as cogent an argument as Egan makes, he actually undermines his point (and his own firm) in his op-ed. In particular, as Egan has consistently noted, the big CRAs are all paid by the issuers they rate. A clear conflict of interest. The big guys argue that if they didn't charge issuers, then no one would pay them since email and fax machines mean that once they issue a rating to even one person, news of that rating travels fast (and the more respected their ratings, the faster the news travels). However, Egan-Jones and other small CRAs are paid by subscribers and investors, and not by the issuers they rate. No conflict of interest, right?

But then Egan writes:
...regulators must pay better attention to incentives. If a rating firm receives 90 per cent of its compensation for ratings from sellers of securities, it is difficult to envision that the interests of investors are paramount. This issue of incentives is all the more pressing given the great difference ratings make to a bank's capitalisation requirements. Under the Basel II accords, $100 of AAA securitised assets requires a bank to hold 56 cents of equity to back up the debt. However, if the bank or fund holds $100 of BBB assets, it has to hold $4.80 of equity - a far more onerous proposition. (Last week Standard & Poor's cut the ratings of several securities from AAA to BBB in one day.) This greater burden of holding lower-rated assets increases pressure on ratings firms, which depend on issuers of debt for business.
Wait a minute. Sure, I get your first point -- if a CRA receives 90% of its revenue from issuers (sellers) of securities, it's hard to see how the CRA will make the interests of the investors (buyers) of these securities paramount. But then you say that, under Basel II, the greater burden investors face in holding lower-rated assets increases pressure of the CRAs to up the ratings. But aren't the banks getting screwed by a lower rating the investors you were just talking about? So who's putting the pressure on the CRAs? Sure, I can see an issuer not wanting a low rating on a debt offering, but once that debt is out there, the pressure will be coming from the banks and investors. And aren't those guys the ones paying your bills, Mr. Egan?

So who's conflicted here?

Thursday, August 02, 2007

99 percent of Chinese exports safe

This according to Chinese Commerce Minister Bo Xilai, as reported in the FT. This makes some sense, when you keep in mind that 1 percent of all Chinese exports these days are for the new Mattel Swishy Switchblade (TM) Vodka Bottle Opener and Child Home Defense Kit (now with more lead flavor!) What can I say. It's not China's fault that kids thing this is the hottest thing since the Bat Masterson Derringer Belt Gun.

Risk, of course, is such a fun topic. Basically, Minister Bo is reassuring us that 99 out of every 100 Chinese products we have in our house or that we use are safe. Personally, I'm completely reassured. After all, it's not like we use a lot of Chinese-made goods every day, is it?