Irresistible stuff from David Rosenberg

So let’s get the story correct. We are still in the midst of a credit collapse where there is simply too much debt and debt service globally relative to worldwide income. The fact that we had a year-long respite does not alter this view. It was a respite that was induced by what is now an apparent unsustainable pace of bailout and fiscal stimulus in practically every country on the planet, not just the United States. What has happened was that governments bailed out the banks and massively stimulated the economy but because the revenue cupboard was bare, in part due to the savage effects of the global recession, public sector debt loads exploded at all levels of government, and to varying degrees, in every jurisdiction.

But someone had to buy these government bonds, and who else, but the very same banks that the governments rescued! And, they had a super-steep yield curve to generate profits from this bond-buying activity. Talk about a symbiotic relationship.

Not only that, but because of global bank capital rules, these financial institutions were not compelled to put any new capital into reserve against these government bonds because of their investment-grade status from the ratings agencies, when in fact, very few countries actually deserve the ratings they have when one assesses structural deficit ratios, debt/GDP ratios and interest costs/revenue ratios appropriately. Now, ironically, the governments, having saved the banks, only to then rely on the banks to fund their bloated deficits, are now in a situation where their banks need help again because of the eroding quality of the government debt on these bank balance sheets. Talk about a dangerous game of musical chairs.

Source: ‘Breakfast with Dave’, May 28, 2010, David Rosenberg, Gluskin Sheff, Canada

Democracy at work

A sad, brilliant, devastating commentary on American democracy at work by Michael Lewis (ht: Dr. Vidyasagar) in the form of a letter from a financial sector lobbyist to his clients. Vintage Michael Lewis, of course. To this one-item reading list must be added this short piece from Gretchen Morgenson which talks of negligible progress after 3000 pages whereas Glass-Steagall took all of 34 pages.

Do not miss out on the extremely perceptive speech by Jeffrey Lacker, President of the Federal Reserve Bank of Richmond. Full text here. Key highlights below:

A compelling alternative premise, one that I personally believe is most likely to emerge as the consensus assessment among future scholars, is that the incentives created by the financial safety net were the chief cause of the financial crisis.

future assessments of the official response to the financial crisis will hinge less on the TARP and the large-scale market interventions by the Fed that followed AIG, and more on how the sequence of actions in the year before might have discouraged critical actions that firms could have taken to protect against financial distress.

While regulators have a fairly good record of preventing exact replicas of past crises, it is another matter entirely to foresee the distress that might result from the confluence of innovative financial arrangements and shocks to unanticipated macroeconomic fundamentals.

If, in a crisis, regulators remain focused on alleviating ex post distress, they are likely to err on the side of rescue and further weaken market discipline.

The expansion of the implicit safety net has been driven by the pursuit of ex post efficiency — that is, doing whatever it takes to alleviate the adverse impact of financial distress once it has occurred.11 Future economists may continue to debate whether official interventions in this crisis have achieved significant ex post efficiency gains, but our true goal ought to be ex ante efficiency, not ex post efficiency.

we will not break the cycle of regulation, by-pass, crisis and rescue until we are willing to clarify the limits to government support, and incur the short-term costs of confirming those limits, in the interest of building a stronger and durable foundation for our financial system.

Measured against this gauge, my early assessment is that progress thus far has been negligible.

Negligent homicide

Professor Ross Levine calls the financial crisis in the US a case of ‘negligent homicide’. The steps that eventually led to the homicide have been well documented elsewhere and on this blog too. But, nonetheless, it is good to keep the words of a Brown University Economics Professor handy.

He concludes,

To create a healthy financial system, the authorities need to address the institutional underpinnings of why the financial regulatory system failed so miserably in the decade before the crisis.

What are the institutional underpinnings? I am not so sure that what needs addressing are institutional underpinnings as much as individual and behavioural underpinnings.

First, hubris. American policymakers, in particular,concluded that the ‘great moderation’ was due to their stewardship of monetary and fiscal policy and not just to a coincident combination of lucky and other factors (taming of labour, collapse in oil and other commodity prices, end of cold war, no concern with aging societies, etc.)

Second, belief that risk is not so important because business cycles have been moderated. Therefore, only lip-service and ‘powerpoint service’ were paid to risk management by one and all. Regulators knew it but they thought it did not matter.

Third, mistaken belief that competition and more firms meant dispersion of risk. They failed to reckon with dispersion of returns rather than risk as more firms adopt same practices, own, buy and sell the same financial products.

Fourth, US monetary policy that pulled all others’ rates down in a race to the bottom in 2001-2003, flooded the world with easy money, altered incentives for savings and for borrowings and facilitated easy leverage and leverage-based products (aka ‘financial innovation’).

Have these lessons been learnt? At least, John Hussman does not think so. In a different context, this is what he has to say about Treasury Secretary Tim Geithner:

What could European leaders possibly find more arrogant than to be lectured on bailout policy – not simply by the U.S., but specifically by a one-trick pony bureaucrat whose chief trick is the ability to smoothly talk the language of prudence while simultaneously pillaging the fiscal stability of an entire nation for the benefit of bondholders who made bad loans?

While we are at it, it might make sense to take note of the article on ten most corrupt contemporary Americans (ht: Barry Ritholtz). When I shared this with a few friends, one of them asked why the list was not 11. Guess whom he had in mind.

[p.s: This is a great cartoon]

More on Europe

John Plender says that the US looks a lot better than Europe (true for now and perhaps, true on the dimensions he looks into) and hence US dollar share of global reserves would rise again. He may be right. Or, the share of Gold and Swiss franc might rise faster than that of US dollar even as EUR share falls at least as it stands currently.

The prospect of a split looks less unlikely (sorry for the double negative) than it did before. FT Alphaville covered the escape clauses lenders gave themselves in proposing a financial assistance package for Southern European countries. For the most part, financial markets ignored it. But, we are not sure if Southern European countries would be able to ignore it, eventually. The German Parliament might have approved Germany’s participation in the lending programme but many observers say that German public remained rather displeased. The German Constitutional Court holds the key now that the French have clearly said that they had broken the EU Treaty in coming up with the financial assistance package.

Martin Feldstein says rather quietly that the Eurozone would survive the current crisis but not all of its current members would remain as members a year from now! Is that survival?

The good thing about George Magnus’ piece is that he at least tries to sketch what might help to avoid the grim forecast of, say, Martin Feldstein above. He calls for political imagination that would break the market’s worry over debt restructuring in the southern European countries and the chance of a breakup of the Euro into two halves or many parts.

Among other things, he calls for economic and financial reforms in the Eurozone. One such reform is dealing with bad debts in German and French banks. Wolfgang Muenchau in FT is not so sanguine about it.  He thinks that the Southern European debt in the Northern European banks is of the same quality as the  AAA and AA rated tranches of CDOs of Sub-Prime RMBS. We all know what happened to their valuations subsequently. If so, holders of these debts have to worry now. They would start selling or should start selling. The European Central Bank has to keep buying them. Its balance-sheet would swell and the EURO would keep getting weaker.

That might be a positive. All hopes rest on the weak Euro delivering strong export and overall growth to Northern Europe, muting their criticism and enabling southern Europe to undertake austerity measures without causing social disruptions.

If you believe that this outcome carries a higher probability than the one of either Southern debt restructuring or Eurozone split or a banking crisis in Germany and France or a bit of all of this, then you should be buying European assets on dips.

[Update: this blog has noted Mr. Lorenzo Smaghi’s comments approvingly in recent times. However, intellectual honesty demands that this brilliant counterpoint by FT Alphaville be acknowledged. This is on the same lines of the comments of Kapil Dalal to my post on capital controls in Europe].

‘Bits & Pieces’ on Investment Strategy

The regional sales head for CLSA Damien Kastel prepares an interesting publication called ‘Bits & Pieces’ which is a collection of interesting observations made by several commentators – within CLSA and without. He has his own comments on them. They are hand-written and that lends a personal touch to the comments. One of the comments he had picked up was from the PIMCO Annual Secular forum report by their co-CIO Mohammed-El-Erian. You can find it here.

For a money manager, these implications of their world-view are important and I happen to agree with all of them:

  • The distribution of global outcomes is going through a transformation, both in terms of overall shape (flatter) and tails (fatter);
  • It is a world where several of the old simplifying adages that once brought comfort to investors – such as industrial country governments constitute interest rate risk while emerging economies involve credit risk – require considerable refinement;
  • It is a world that calls for a broader investment universe and guidelines and, for those who use them, revamped benchmarks that better capture the world of today and tomorrow rather than that of yesterday;
  • It is a world of significant country, regional and instrument differentiation when it comes to harvesting equity and credit premiums in high-quality corporates, financials and emerging markets;
  • It is a world where the currencies of the emerging (as opposed to submerging) economies will continue to warrant a greater allocation over time; and
  • It is a world where the safest of carry will come from duration and curve in sovereigns that, due to their economic and financial fundamentals, are truly core countries in the midst of this global paradigm shift.

For asset allocators, another recent note is a useful read. This time it is from James Montier of GMO. He used to be Its central message is captured in these paragraphs:

Clients should liaise with their managers to set a “realistic” real return target (recognizing that available returns are a function of the opportunity set, not a function of the needs of the fund). After all, the aim of investing must surely be “maximum real returns after tax” as Sir John Templeton observed long ago. None but a few very lucky fund managers get to retire on relative performance.

Having defined the target, managers should be given as much discretion as possible to deliver that real return. This avoids the benchmark-hugging behavior that is typically induced by policy portfolios.

Thus, an approach that combines a more sensible view of risk and a concern for valuation makes considerably more sense to me.

Having been in this industry for some time, let me simply state that this does not appear imminent. His observation on why volatility is not a good measure of risk is well-made. Volatility indices were extremely low in 2007 and they were extremely high post-Lehman Brothers bankruptcy in 2008. Which of the two periods were the riskiest for investors? – buying in 2007 or buying in 2008, post-Lehman?

As a final parting note, apparently one of the speakers in the PIMCO Secular Forum in 2010 made this wonderful observation:

The world is on a journey to an unstable destination, through unfamiliar territory, on an uneven road and, critically, having already used its spare tire(s).

There were four speakers: Arminio Fraga, Ian Goldin, Greg Ip and Kenneth Rogoff. My money is on Ken Rogoff to have made that colourful statement. Yours?

Martin Wolf sketches a brilliant tale

A friend had forwarded this to me. I am very sure that this article would be forwarded and circulated a lot. Martin Wolf has used the ants and grasshoppers framework to describe the decisions and choices made by Asian nations – including China and Japan – to lend to America and by Germany to other European countries. Very well-written. In his story, ants lose their savings, eventually. Whether in full or partially is not made clear by Martin Wolf. Perhaps, that is the end-game for the chain of events unleashed by the crisis that originated in America’s sub-prime mortgage sector. In Martin’s tale, some ants starve to death because they do not get back what they had lent to the grasshoppers. How would they react to that prospect? Wars, any one?

Second, if this is the end-game and if it has a reasonable probability, should ants continue to lend to the grasshoppers or stop accumulating reserves to be lent to grasshoppers? Are the ants doing that? Not yet. What are the ants waiting for? Perhaps, they were waiting precisely for a column like this to goad them into action.

Reversible reformers

Bibek Debroy assigns a score of 1.6/10 to the UPA II’s first year based on the specific promises made and fulfilled in the first one year. The government made some specific commitments for the first 100 days .They have apparently delivered on 4 out of the 25 commitments made. As is the case usually, it is a well-written piece. The only thing that is disappointing about this piece is the last paragraph. Perhaps, it is too tongue-in-cheek.

Other than this, what I liked abut this piece was Bibek’s reference to the fact that contemplating the potential of the counterfactual scenario of higher growth with more refoms is an impossible task for the public and for politicians. Well, it is a very difficult task for most humans in most situations. Evaluating a particular course of action/recommendation for its intrinsic merit, costs and consequences should always be done in the light of the alternatives foregone and what they would have entailed in each of these dimensions. IT is easy to praise or to criticize what one sees. It is a lot harder to place such evaluation in the light of the alternative choices forsaken. That is why we repeat errors and that is why we are only occasionally and accidentally rational.

While you are at it, you might also wish to check out Niranjan’s comment on the tale of two Manmohan Singhs . Niranjan is a lot more restrained than he could be. What could have been done with all the monies  spent on the redistributive programmes of the last six years boggles the mind. Who said that India really reformed and that they were irreversible? Mr. Manmohan Singh has reversed himself and that is what Niranjan hints at.

UPA – II completes one year in India

Mr. T. N. Ninan’s understated but damning critique actually, says it all. He says with characteristic understatement that the UPA government has underperformed in the first year. None of the Ministers he takes up for evaluation (barring, to some extent, Mr. Sibal) get overwhelming praise.

The numerical score from the industry is a predictable 6 out of 10. They cannot afford to be seen or heard giving anything lower than that. Worst ministers, according to the industry, occupy Telecom, Civil Aviation and Agriculture. One CEO has had the gall to say that corruption has graduated to a level of extortion under this government.

Surprisingly, Mr. Swaminathan Aiyar gives the government a B+ and he lists some factors that would have happened anyway, without any government involvement. Bibek Debroy is mostly dismissive of this government’s first year. It certainly isn’t a reformist government on economics. Bibek Debroy correctly defines economic reforms as greater reliance on market mechanisms. Chandan Mitra over at ‘Pioneer’ has a similar comment, focusing on inflation and national security and Congress party’s ambivalent stance on the latter. Reading John Elliott over at Financial Times would complete the picture. Or, if you wish, you could round off with this scorching comment from Surjit Bhalla in his Op-Ed on the inclusion of caste in the national census:

If the Congress accepts caste as part of the census, it will prove to all the doubters that it is a valueless party, a party now reaching its nadir. It is a party for sale to the highest bidder. How can they then claim that red blood does not flow in our veins?


Thanks to an email from good friend, Professor Mukul Asher, I discovered a magazine called ‘Inclusion‘. It is a quarterly and the first quarterly issue of 2010 is on the topic of India on a growth turnpike – a phrase first used by Mr. Vijay Kelkar when the NDA under Mr. Vajpayee was in office. I have not read the cover story but the column by Bibek Debroy is a great read. Do not miss it.

Gillian Tett on China

Gillian Tett’s latest piece in FT (ht: Naked Capitalism) is a thoughtful one.

After all, although a vague sense of optimism about China has underpinned the investment debate in the Western world during the last year, the fact is that very few Western investors really know that much about what is – or is not – happening at the grass roots in China now. The pattern is not that different from the US housing market five years ago, when investors had vague assumptions that American property markets always rise, and thus gobbled up mortgage bonds – but ignored the granular details of how subprime loans worked.

Just remember, to requote Goldman Sachs, that China is fourteen times bigger than Greece; and even more opaque.

US Financial Reform bill

For a good read on what has happened and what are the implications, it would do one no harm to start with this news article in Bloomberg. The Volcker rule on proprietary trading gets a soft mention and could be diluted in implementation. The House and the Senate versions of the bill have to be reconciled. There is confusion on whether capital requirements have been successfully raised. Also, see here and here.

These are the two key elements of banking reforms and both of them are not firm and concrete. The financial reform bill (Senate version) does not too badly on consumer protection agency and on reforming credit rating agencies. See a comment here on the latter.

Another important thing – to bring transparency to the derivatives market – is to bring the credit default swaps (contracts that pay out to the owner if an underlying bond defaults on debt or interest payment – it is like an insurance contract against a bond default) market into organized exchanges with more information flow in public and transparency on who owns insurance against which bonds. Read the post here on Lorenzo Smaghi’s comments on this.

The Senate version seems to have survived hectic lobbying by major banks  (see here, for example). But, it might still be diluted in the House-Senate conference committee.

Overall, one would give the reform bill a C or C+ letter grade. Reforms do not happen overnight. But, America is trying even as the industry is fighting and resisting hard.