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
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