lundi 28 février 2011
dimanche 27 février 2011
vendredi 25 février 2011
“There are two superpowers in the world,
the USA and Moody’s bond rating division
and it is sometimes unclear which of them is more powerful”
2- I know, right, model definitely does not capture half the risk
3- We should not be rating it
4- We rate every deal. It could be structured by cows and we would still rate it
Financial journalist Roger Lowestein investigated how Moody’s rated CDOs. To preserve confidentiality, the CDO was given the name “Subprime XYZ”. It was a package of 2939 mortgage loans made in the spring of 2006 at a total value of over $400 million. The bank that engineered the package provided Moody’s with general information about the borrowers but Moody’s did not seek to consult individual files or confirm the data. “We are not loan officers, our expertise is as statistician on an aggregate basis” explained Claire Robinson from Moody’s.
Indeed, Moody’s Modus Operanti is simply to assess the likeliness of default based on average historical data and information about similar products. The structure would be inspected but the underlying assets (the real mortgage loans that made up the package) would never be looked at. Nobody was in charge of assessing the underlying risk, except the loan officers who has little incentive to do so since they knew that the mortgage would be sold and that they wouldn’t have to support the risk.
Bad behaviour supported by bad statistics
In the end, CRAs were just statisticians, and bad ones with that. Their data was outdated at best and misleading at worst. They based their models on the way house prices reacted to the 2002 downturn. But this downturn was unique in that the Fed had pushed interest rates as far as they would go and house prices kept rising.
Furthermore, they were over reliant on opaque statistical models and algorithms derived from the Gauss law. The Gauss law when applied produces the well-known bell curve whereby the number of individuals decreases as we move away from the average. But the Gauss Law (which is the foundation of many of the algorithms and formulas used in the financial world) is flawed in that it over-emphasizes the average and underestimates the probability of extreme events. As we can see on the bell curve, the number of subjects associated to extreme (meaning very far from the average figure) figures is fairly low.
All in all, CRAs underestimated the likelihood how extreme events such as a sharp decline in home prices. They assumed that times would always be good and that home prices could only rise in the foreseeable future.
The CRAs question raises a number of issues that are as much philosophical as they are economic and financial. The regulations surrounding them and the power governments gave to them stem from an insane desire to regulate the behaviour of thousands of investors and to define the indefinable.
Defining risk is impossible. Risk is multiform and in constant evolution. Giving a fixed, official definition of risk will just make investors focus on a certain kind of risk and blind them to new forms that are beyond the scope of the official definition. By forcing investors to refer to notations given by inherently imperfect organizations staffed with normal human being, regulators have highly increased the probability of the current financial disaster.
In the end, it is all about the kind of capitalism we want. Do we want a system in which free and responsible investors do their own research and take a careful look at the solidity of the assets they buy or do we want a system that sees investors stripped of their responsibility by the nanny state being pushed to blindly trust the findings or a handful of government mandated agencies? Had regulators not tried to rigidly define risk in the first place, investors would have had to do their own math, check for themselves the risk associated to certain assets and decide of the appropriate level of capital they had to carry.
CRA were governments’ way of crating a fictitious impression of security and stability. Liberalism is about separating government from business and making it as small as possible. What regulators have done is old fashion dirigism with the connivance of private actors. Strict regulations laying out what you may or may not do, which assets you may or may not hold only exacerbate economic cycles and make investors behave like sheep and follow the herd. While having all investors act the same way because regulators mandates them to (be it via direct intervention or by forcing them to act according to CRAs ratings) might be comforting for politicians and the general public whose understanding of financial market is imperfect at best, it makes crisis all the more serious.
When times are good and the AAA stamp is hot, investors all run after the same assets and trip over each other to get into the same markets. But when things go wrong and the train goes off the tracks, everybody in the market gets clobbered. These repeated attempts to use government intervention to make the system risk proof do nothing but make us more vulnerable to small changes in the market that would otherwise have been quickly absorbed. In the words of John Norberg, “Every attempt at diversification or adaptation has been wiped out by precautionary principles” and investors have come to resemble a sad herd of sheep because of government regulations. Investors should not act the same; this is not what the free market is about, this is not how we will build a stable and efficient financial system.
Government is the problem, not the solution
So what now? Many call for governments to take over the job of CRA and would like to see the creation of an official state run rating agency. But the underlying problem would remain. Companies (especially state owned ones) are prone to mistakes and nothing guarantees that a state run agency would do any better a job than private ones, especially if governments’ interests (for example not having their own grade lowered) come into play. State run companies do not have a good track record of honesty and reliability. The issue is not that agencies have done a bad job. If regulators had not forced investors to subscribe to their ratings the problem would have been much less acute. They would just have lost their credibility, some people would have lost money and life would have gone on. The problem is that giving legal force to CRAs (be them public or private) has simply made investors stupid.
The real solution is to strip CRAs of their legal status and come back to a freer model of capitalism. CRA have a future, just not as government-mandated structures. Their ratings should again become informational and investors should be free to ignore them. Then we will have a capitalism of smart human investors instead of a capitalism of sheep. As Hayek said, “Economics is about showing people how little they know about what they imagine they can control”. Governments and regulators should remember that.
jeudi 24 février 2011
- A compelling story: storytelling is very hip right now. We easily forget names, logos, slogans but what we remember are stories. Stories may be the most powerful and cost effective way to convey a brand message. They are easily memorable, often aspirational or entertaining and encapsulate the brand essence. They are what stays when everything else is forgotten. Most great brands are, to varying degrees, supported by compelling stories: Nike, Apple, Microsoft, Zara, Nespresso, Budweiser etc... Justin Bieber knows that stories speak volumes and is careful to capitalize on his (young boy who started by posting videos of himself singing on YouTube and was later discovered by RnB superstar Usher) as much as possible. Hence his movie "Never say never" (although I can say with absolute certainty that I will NEVER watch it) that is essentially a 1h30 long biography meant to strengthen his brand image. Good move JB!
- A clear target audience: Bieber does not try to give something to everybody. He knows that his music and attitude are unbearable for people over 16 and yet he sticks to his message because he knows who he is talking to. Well done little man!
- Strong symbols: Bieber does not keep his hairstyle because it looks good, he keeps it because it is his logo, the visual representation of the Bieber brand. How many brands do you know who have their logo on other people's heads? 祝贺你小朋友!
- An image that is aspirational without being unattainable: the tittle pretty much says it all. Maintaining an aura of superiority without seeming aloof and out of touch is a fine line to walk. But for now Bieber is walking it just fine. He maintains an image that is perfect enough to create scenes of riot everywhere he goes but he is also careful to stay in contact with his fans (mainly via social networks) and seem "down to earth". To his fans, he is almost like one of them, kind of like the most popular guy/girl in high school: he walks amongst you and yet lives in a different world you hope you could enter but really can't.
mercredi 23 février 2011
- Constant expansion: Napoleon Bonaparte's rule rested on expansion. Military conquest was the regime's essence and raison d'être. Napoleon rose to fame after the first campaign of Italy where the young corsican crushed the mighty Austrian armies at Lodi (amongst other places). He then strengthened his aura during the famous campaign of Egypt during which he defeated the fearsome Mamelukes and from which he came back a hero (despite the fact that his fleet was destroyed by the British at Aboukir and that Napoelon was subsequently effectively trapped inside Egypt). During his reign, military expansion was what made Napoleon's legitimacy. Granted this is as much a personal point of view as it is an historical fact (I recently had a heated debate with a good friend of mine about precisely this question) but I strongly believe that military expansion and the Napoleonic regime were consubstantial. Expansion allowed Napoleon to keep is enemies at bay, secure the necessary support at home to implement his domestic reforms and make people accept the authoritarian aspect of his rule. Like the first empire, communist China depends on expansion, albeit of a different kind to survive. To stay relevant, the party needs growth. Lots of it. Without economic growth, people may be less prone to tolerate corruption and inequalities and without a sense of nationalism generated through a hawkish military and diplomatic stance, the party's popularity could suffer. But this reliance on expansion at all costs could one day cause trouble. For Napoleon, it led to poorly planned campaigns in Spain and Portugal and the downright foolish campaign of Russia. In China, reliance on growth no matter of what kind or at what cost leads to unsustainably high levels of investment as a share of GDP, artificially cheap capital, environmental disasters, high inequalities and bank lending policies that make Ben Bernanke look cautious. Even on the micro level, you can see the consequences of this reliance in the way infrastructure projects are managed (excellent article illustrating my point just here). In the long term, China's hawkish foreign policy could alienate its neighbors and lead them to coalesce against it (just like Napelon's enemies did). In many ways, we are already seeing that happening with South Asian countries (along with the US, South Korea and Japan) implementing what I like to call a "reverse string of pearls" strategy to contain the middle kingdom. Bottom line: regimes that rely on constant expansion encounter difficulties at some point or another.
- The "aura". I struggled to find a term to refer to the second parallel between Napoleonic France and Communist China. "Aura" seems the best one. By aura, I refer to the psychological component of power. In the glory days of the empire, military expansion rested largely on fear. France's enemies' feared Napoleon, the great general turned emperor seemed invincible on the battle field. His military genius gradually became a self fulfilling prophecy. We are seeing the same thing with modern China. To be sure, China's achievements have been absolutely remarkable and I have no doubt that it is destined to be one of the great economies of this century. However, in some respects, China is a Potemkine country. Its growth rates are remarkable but are the fruits of an unsustainable and inefficient investment-fueled economic model. Many of its technological achievements merit our praise but it still has a long way to go towards creating an environment that truly fosters innovation and out of the box thinking. Its political model appears to be working fine for now but still has much to prove. I could go on for hours. The point is that the way we think about China lacks nuance. Because of it's strong aura, everything China does or says is magnified, exaggerated and blown out of proportions. Most recent example: the unveiling of the J-20 stealth fighter. As of today we know that this plane is black, can fly for 15 minutes and that its technology is most likely drawn from parts of a American F-117 that crashed in Kosovo in 1999 (good article on that here). And yet papers are full of grim reports predicting that China will threaten the west's military supremacy. I'm not saying that we should not take this entire affair seriously and maybe the J-20 indeed is a remarkable achievement that deserves our attention. But as far as we know, the J-20 is still a question mark. I also remember reading a very long report a few years ago about China's indigenous TD-SCDMA mobile phone standard. The report predicted that the standard would be a huge success because well... it was China and that it would be exported to western markets within 10 years. China, the report said, was now leading the way and sheer numbers would force the world to adopt its standard. A few years later, TD-SCDMA is a huge (and very expensive) failure. It was so unpopular that the government backtracked and allowed two of the three state owned operators to use other, foreign, standards. But I digress. My point is that China seems great because we do our best to make it look greater than it really is. This is regrettable since it not only leads us to overestimate certain aspects of the Chinese model but also prevents us from seeing potential where it really is. China is indeed a country with a bright future but anybody that takes the time to look at things with a cool head and an objective mind will be forced to nuance his point of view. When Napoleon lost his aura, he lost everything. His enemies ceased to be scared and his reign ended in disgrace. Obviously the chances that modern China will go the same way are virtually non existent but once the facade of our completely unrealistic expectations about the Middle Kingdom starts to show cracks, many people will lose their shirts and the country may be in some some tough times economically speaking.