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     Oct 25, 2008
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Pretenders all of us
By Chan Akya

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.

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

Continued 1 2  

Too big to fail versus moral hazard
(Sep 23,'08)

The Fed's king of bubbles (Apr 6,'08)

US government throws oil on fire

2. The Bush doctrine in ruins

3. An absent rebellion

4. Details of Iraq pact reveal US debacle

5. Gliding towards nuclear war

6. Big Oil, the big survivor

7. Death stalks the highway to hell

8. Forget Bush's wars and work with Asia

9. Rusal's China hopes drift into the future

10. Tata does ethical u-turn

(24 hours to 11:59pm ET, Oct 23, 2008)



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