4 Reasons to be bullish about China

In a previous post, I listed the reasons for which I think that China's economy is due for a slowdown in GDP growth. However, there are plenty of very good reasons to be extremely optimistic about the long term potential of China's economy. Indeed, lots of people are impressed by the mighty Chinese economic powerhouse but for the wrong reasons. They look with admiration at the large scale infrastructure projects, shiny sky scrapers and Louis Vuitton shops which are precisely the most fragile and misleading signs of economic success.

Here is why, despite my belief that China is due for a downturn, I still have great faith in the Chinese economy's long term prospects:

• A sophisticated consumer base: in my post about the risks China faces, I placed particular emphasis on the alarmingly low (30%) share of private consumption in the country's GDP. However, while still worrying, the numbers I used to illustrate my point can be misleading. In truth, the problem is not so much that consumption is atrophied but that investment is on steroids. More importantly, the Chinese consumer is extraordinarily sophisticated, much more than his level of disposable income would suggest. Examples abound to illustrate this phenomenon amongst which the extraordinary speed with which Chinese consumers have integrated the Internet and now mobile networks in their consumption behavior. Chinese consumers are brand sensitive, tech savvy, open to trying out new products and increasingly demanding. Simply selling them tuned down versions of products designed for western markets is no longer enough (it probably never was to begin with). More and more western brands are acknowledging this and are integrating the sophistication of Chinese consumers into their strategies by launching "designed for China" products (notable examples include Hermès and Levi's). Sophisticated consumers are good for the economy since they force local firms to step up their game and stimulate product and process innovation. It also means that once structural obstacles are lifted, the Chinese consumer might well be able to make up for the fall in investment levels.

Carrefour, not Cartier

• Great companies: when western media mention Chinese enterprises, they usually pick state owned giants such as telcos, banks and insurance companies. In my view, these firms have little growth potential beyond Chinese borders and succeed mainly because they operate in ultra-protected markets and benefit from government largesse. But this does not mean that China does not have world class companies. I'm planning on devoting an entire post to the strengths of Chinese companies so I won't give too much away in this paragraph. In short: China has plenty of dynamic firms that have developed innovative products and business processes that answer the specific needs and constraints of emerging market consumers. These companies such as Alibaba, Huawei, Wahaha, Lining and other less well known firms have managed to leverage their cost and scale advantage, capitalize on their first hand knowledge of local environments and exploit market gaps left by large western multinational. They represent the future of China's economy and I'll bet an arm that in a few year's time you will have some of their stuff in your garage/pocket/on your feet.

Take that Nike!

• Shanzhai and incremental innovation: the word Shanzhai (山寨) literally means "Mountain bandit". It originally referred to counterfeiting but its sense has gradually evolved and it has come to signify the practice of incremental innovation. In short, it means outsmarting richer and better equipped competitors by building cheap but reliable products that still integrate advanced technology and focus on features that truly matter to the customer. The best example is smart phones. For the vast majority of Chinese, smart phones remain too expensive. There is no way the average Li can spend $400 on an iPhone, HTC Desire or Motorola Droid. However that does not mean that the average Li does not want a smart phone and is not willing to spend a sizable chunk of his income on one. Many Chinese companies such as Huawei (mentioned above) and Meizu have smelled opportunities at the low end of the market and have rolled out cheap smart phones that start at around $100. These models such as the M9 and the Ideos are reliable, integrate advanced technologies and take advantage of the open Android platform. What you get is a phone that doesn't look half bad, runs Android and allows you to do pretty much the same thing than the 3 times more expensive HTC Desire. This knack many Chinese firms have for delivering great value at a competitive price will prove a tremendous asset for China's economy.

WEI NI HAO APPLE!? THIS IS MEIZU AND I'M GONNA KICK YOUR ASS!

• A pragmatic leadership: this argument may come as a bit of a surprise but I truly believe that most people in Beijing are aware of the challenges they face and have a generally good idea of what needs to be done to rebalance the economy (even if the process proves to be painful). In my view, the problem lies mainly with local authorities who are the main drivers of credit expansion and investment and who are reluctant to take any meaningful action towards making the Chinese model more sustainable and consumption-driven. But if Beijing manages to nudge local officials in the right direction, I see no reason why China should not be able to pull the rebalancing trick off. There will be some painful re-adjustments but in the end, if everybody sings the same tune (and that tune is the right one) China's should be back in the game pretty quickly.

All in all, even though China may have a brief fall from grace, I have no doubt that it has tremendous long term potential, albeit nor necessarily for the reasons that are most often cited.

Why failure matters

Being a libertarian is tough. Often times, people alarmingly ask me what would happen if we pulled the plug on agricultural subsidies, quitted supporting so called "national champions" and let treasury bonds depreciate as they should. They then proceed to answer their own question by saying with an air of great gravity that "failure would be the result. Firms would go bankrupt, people would lose their job and investors would take a shell-shaking". To that I inevitably answer "so what?".

One of the big differences between classic liberalism and other ideologies is that the ideas that we support are not absolute. Failure is a key part of our philosophy, one of the most important drivers of progress. We believe that it is through a constant process of trial and error that man becomes better and finds new, more efficient ways to satisfy his needs and aspirations.

Unfortunately, in modern societies, failure is no longer accepted as an immutable element of daily life and an indispensable component of any sound economic and social system. Prevalent ideologies are what I like to call absolute ideologies. What they implicitly promise is a society and an economy in which state intervention would have completely eliminated failure. Liberalism promises a better world but progressivism is selling us a perfect world in which individuals would be shielded from failure for their entire lives.

Failure is important because without it, there can be no responsibility and without responsibility, liberty is meaningless. Without failure, men have no incentive to be cautious, assess risk and make long term planning (Lehman Brothers anyone?). When the possibility of failure is gone, whether for real or because people are stupid enough to believe it, the human mind becomes corrupt and the longer we wait to let failure happen, the more devastating its consequences.

Most importantly, a system that does not allow for failure to occur can't evolve and become resilient. Failures allows us to learn from the past, they set examples and paves the road for innovation and progress. Without failure, societies become sclerosed, secluded, trapped in denial and focussed on preserving rather than creating.

Painful but necessary

The practical consequences of our aversion for failure should strike us: over-leveraged and under capitalized banks were given the signal that is was ok to take insane risks because in case of a crash, the Greenspan put would come into effect and taxpayer money would be there to cushion their fall. Global finance was trapped into a complicated corpus of regulations that completely wiped out every attempt at diversification and created an insane situation in which castles that were supposed to be invulnerable turned out to be made of sand and everybody had the same Achilles' heal. Inefficient firms that failed to make products that consumers wanted were propped up by governments because they were deemed of "national interest" or simply "too big to fail". Intolerable moral hazards were created and the customer/taxpayer was left to foot the bill. In western countries, people act like spoiled brats when faced with adversity: they closet themselves in denial, look for scapegoats, evade their responsibilities and ask for some outside force to give them what they feel entitled to. The crisis in the west is not economic, it is moral. Everywhere, we have created laws, regulations, subsidies, aid mechanisms and other such stopgap schemes with the aim of making our societies and economies failure free. The result is disastrous.

Bottom line: we need failure. Let banks fail! Let governments fail! Let investors lose money on treasury bonds! Instead of doing everything to prevent people from losing their jobs, focus on making it easy for them to find a new one! Let companies fail when consumers clearly don't want them around anymore! Quit keeping this artificial, unsustainable model alive! Let us try and let us fail because there is no other path towards material, intellectual and moral progress.

The other story about Japan

As eyes are turned towards Japan's nuclear power plants, our thoughts and prayers go to the victims of this terrible tragedy. However I believe that the biggest implications of the disaster that struck Japan a few days ago will be economic.

Let's start by addressing one of the most idiotic statements of the week: that this event, as tragic as it may be, will in the end have positive repercussions and boost the Japanese economy. The misguided idea that destruction is somehow the best way to stimulate economic activity is as old as the econ profession. You would just think that by 2011 it would have gone away... Sadly it has not. To see newspapers around the world channel the moronic claims of such economists as Larry Summers is quite frankly sad. French philosopher and economist Frederic Bastiat brilliantly demonstrated the absurdity of this kind of thinking in his well-known "Parable of the broken window":

Have you ever witnessed the anger of the good shopkeeper, James Goodfellow, when his careless son happened to break a pane of glass? If you have been present at such a scene, you will most assuredly bear witness to the fact that every one of the spectators, were there even thirty of them, by common consent apparently, offered the unfortunate owner this invariable consolation—"It is an ill wind that blows nobody good. Everybody must live, and what would become of the glaziers if panes of glass were never broken?"

Now, this form of condolence contains an entire theory, which it will be well to show up in this simple case, seeing that it is precisely the same as that which, unhappily, regulates the greater part of our economical institutions.

Suppose it cost six francs to repair the damage, and you say that the accident brings six francs to the glazier's trade—that it encourages that trade to the amount of six francs—I grant it; I have not a word to say against it; you reason justly. The glazier comes, performs his task, receives his six francs, rubs his hands, and, in his heart, blesses the careless child. All this is that which is seen.

But if, on the other hand, you come to the conclusion, as is too often the case, that it is a good thing to break windows, that it causes money to circulate, and that the encouragement of industry in general will be the result of it, you will oblige me to call out, "Stop there! Your theory is confined to that which is seen; it takes no account of that which is not seen."

It is not seen that as our shopkeeper has spent six francs

upon one thing, he cannot spend them upon another. It is not seen that if he had not had a window to replace, he would, perhaps, have replaced his old shoes, or added another book to his library. In short, he would have employed his six francs in some way, which this accident has prevented

What Bastiat shows us is that the process of destruction and reconstruction may generate some activity but in no way does it lead to the creation and accumulation of wealth at the micro level, and this is what truly matters when gauging economic activity. When we think about economics, we focus on what we see and forget what we don't see: what we see in Japan are billions that will be spent on re-building but what we don't see are the billions that without this disaster would have been spent on other goods and services and would have contributed to actual wealth creation as opposed to reconstruction. If destruction has such beneficial effects, why wait for nature to cause it? Why not destroy or cities and monuments on a regular basis, why not solve the problem of unemployment by digging ditches only to fill them up again? Oh and FYI, the Kobe quake barely had any effect on Japanese GDP growth.

Then there is the problem of Japan's public finances: the government already has a debt equal to over 220% of its GDP. The debt level is so high that it doesn't even fit on regular charts (see bellow...). Japan manages to pull this of because it's debt is almost entirely held by domestic actors, which allows it to borrow at incredibly low prices: it's 10 year bonds pay a 1,3% coupon vs 2,5% for Germany! But even at such low rates, interests alone already eat up 25% of tax revenues. As the population enters old age and draws money from its retirement accounts, saving rates will plunge and domestic sources of capital will dry up. Japan will be forced to borrow on international markets where it will pay at least 5% on 10 year bonds. This is a disaster waiting to happen. In the words of Société Générale analyst Dylan Grice "It's like the Titanic has already hit the iceberg and you know it's going to sink, you just don't know how long it will take to go down". If Japan had to borrow on international markets, its cost of debt would spiral out of control and default would be inevitable.

The other meltdown

Unfortunately, the quake and tsunami may have accelerated Japan's descent into the fiscal abyss. The BOJ has already injected over $170 billion in the markets to keep them afloat. Add that to the massive spending that will be required to compensate the thousands of people whose houses are either collapsed or under water and what you have is a pretty dire picture of the road ahead...

Why China's economy may be in for tough times

I've always have mixed feelings about China's economy. Long term, I have no doubt that it has tremendous potential and that China will be capable of producing leading corporations and cutting edge business practices. Short term however I believe that China is due for a crisis.

Last year, I wrote an essay about China's economy. In it I exposed my general point of view about the middle kingdom’s economy: that it is a house of cards and that its model is unsustainable and inefficient. In this article, I will come back on what I wrote and try to see if the current situation corroborates the points I made back then (spoiler alert: it does).

Since 2004 china has devoted an average of 40% of its GDP to investment. This figure far exceeds that of South Korea or Taiwan at the height of their investment led development. These investments derive directly from China’s development strategy based on exports and manufacturing. All in all, industrial output accounts for nearly

half of china’s GDP and services for a mere 40%. As of today, if we look at the structure of its economy, China looks more like a communist country than a capitalist one. What’s mor

e, the stimulus plan is likely to raise the share of investment to over 50% of GDP in 2009, thus accentuating the imbalances the government was trying to correct before the crisis started.

(…)

It is troubling to see that household consumption represents a paltry 35% of GDP while this figure is 67% in India. If it is to join the club of advanced economies, China must go beyond industry and exports and evolve into a service-based economy

relying on its domestic market.

Today, consumption still represents barely 36% of China’s GDP! We see there the effects of a stimulus plan that basically consisted in showering large state owned industrial companies with money, launching boondoggle infrastructure projects (example there) and nationalizing entire swaths of the economy. China’s economy is still experiencing artificial short-term growth driven by massive over investment. It may look good on paper, but it will certainly not last.

The government has also addressed the crisis by ordering banks to lend virtually limitless amounts of money to SOEs. Analysts agree that co

nsidering the

number and size of the loans granted, banks cannot have conducted proper risk analysis an

d will most likely find themselves with an increasing share of Non Performing Loans in their portfolios.

Massive lending also fuels investment bubbles. The th

reat

is aggravated by the intrinsic volatility of China’s markets (the Shanghai stock market is often nicknames “the great lottery”). Lack of credible information from companies (especially state owned) and the government (many figures often differ whether you look at central government or local government figures) encourages blind speculation and makes man

y economists fret about the consequences of the investment boom.

I could write dozens of pages about Chinese banks. These things are time bombs and I wouldn’t touch them or their stock with a 10-foot long stick. Fitch Ratings recently put the probability of a Chinese banking crisis before 2013 at over 60%. According to Asianomics Ltd, bad loans could total more than 400 billion. Even more troubling is the fact that the PBOC (China’s central bank) is having a very hard time putting a lid on bank lending. Year after year it kept overshooting its lending quota by so much that it got rid of it altogether. The reason for all this is quite simple: Chinese banks are primarily political tools whose role it is to channel as much money as possible towards industrialists to ensure that whatever growth objective Beijing has set is achieved. When loans are granted based on political criteria, it is hard to have sound banking system and I believe that China will learn this lesson soon.

Furthermore, there is plenty of capital flying around but it’s not going to the right companies. Over regulated and over politicized financial markets make it very difficult for smaller companies to gain access to the capital they need to develop their activity. That’s one of the main reasons why it will be very hard (if not downright impossible) for China to produce the next Facebook or the next Google (please don’t tell me Baidu proves me wrong or I will hunt you down and hit you with a shoe Lybian style).

As of today, the burden of taxation is on consumption while many companies pay little taxes and thus over invest in new production capacities

Things have not changed since I wrote these lines. A fatal combination of generous tax laws, artificially cheap capital and crony capitalism is still leading companies to massively over invest in production capacities. In too many industries, capital expenditures are through the roof despite falling sales and margins. Many investors are starting to smell danger and things will not end well if nobody takes the punch bowl away (very good presentation about this here).

These are only some of the points I raised in the original paper I wrote. But on top of the problems I highlighted now comes that of inflation. Latest figures put year on year inflation at 4,9% but there a reasons to believe that the real figure is higher. Inflation is the logical result of artificially cheap capital, an ever-expanding monetary base (necessary to keep the Yuan for appreciating) and a lack of private property rights in the countryside that prevents the apparition of large, efficient farms capable of producing cheap foodstuff. I believe that stopgap measures such as price control schemes will only make the situation worst by creating shortages.

The real estate bubble is also a major cause for concern. Real estate investment now represents over 10% of Chinese GDP (vs only 6% and 9% for Japan and the US at the height of their investment cycles). There are more than 70 million apartments in China that are unoccupied. Large Chinese companies have poured billions in highly speculative real estate investments (a practice known as Zaiteku), which grossly inflates their balance sheets and increases market volatility. Moreover, with deposit rates so low (the spread between lending and deposit rates is at an astonishing 3,5 percentage points), real estate is also the only investment with a good enough pay-off for ordinary folks. With so many loans directly tied up to the housing market, there is no telling what will happen when the party stops…

So can China change? Yes but it will take some painful readjustments. Premier Wen Jiabao recently declared that the aim of the 12th five-year plan would be to rebalance the economy and “improve people’s livelihood”. That may sound lovely but that has been the government's stated goal for some time and was already at the center of the last 5-year plan. Top officials have been talking about re-balancing for years but so far have little to show for it. The truth is that the Chinese authorities are way too dependent on growth no matter of what kind or at what price. Even if the central government acknowledges the need to cool things down (which I think it does), local authorities still have growth objectives that are way too high to be sustainable on the long term. So this unstable, unsustainable and inefficient (it takes $7 of government spending to generate $1 of output) model stays alive. But beware, the longer China waits, the more painful the rebalancing will be and the more the wider world economy will suffer. One cause for hope is that many in the regime are aware of the dangers they face, the only question now is will they be able to match their words with actions? Only time can tell.

Presentation about over-investment in China

Good article (in French) about the Chinese real estate market

M. Pettis on NPLs in China

M. Pettis on inflation

Excellent article about China’s public finances

10 reasons to be worried about China's economy

Gordon G. Chang about the next 5-year plan

Recovery? What recovery?

If you look at centuries of financial history, one thing in particular should strike you: no country has ever printed its way out of a recession.

And yet the FED is pointing to a surging stock market and misleading employment numbers to claim that its QE program is a huge success. Pinheads...

QE is nothing more than printing money. It may have a complicated name and have given an artificial boost to the stock market but printing money is not the same than creating wealth and prosperity. Instead of letting the markets readjust and reallocate resources, the FED and the Government are keeping the old economic model alive at the expense of the taxpayer and the suffering middle class (I'll take the time to write about that in later articles).

Recent employment numbers paint a grim picture: unemployment still hoovers around 10% while underemployment (that combines unemployed people with those who have a part time job but would like to work full time) is at nearly 20%. All in all, the job market is more or less where it was a year ago... Good thing TARP, QE and stimulus money was supposed to get us out of the ditch...

Just for fun, let's look at the Obama administration's original predictions...

And they dare say that we, the libertarians, wanted to kill the economy...

Credit rating agencies: modern magicians

As I said, I'm trying to make up for the Twilight article. So here is an article I wrote a few months ago about a more serious topic.

“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”

Thomas L. FRIEDMAN

Turning lead into gold. What alchemists sought to do with alembics and test tubes, Credit Rating Agencies (acronym: CRAs) have done with the help of complex algorithms and an exotic approach to risk assessment. These modern time magicians now facing a heavy fire of critics have for years held the key to the magic formula that kept mortgage-based derivatives markets running and money flowing into their coffers. With a stroke of their pen, a combination a 2 or 3 magic letters, these agencies had power of life and death over thousands of financial products. They were the conductor of this great crazy orchestra that suddenly stopped playing one fateful autumn day of 2008.

How did we end there ?

But how did it all come to this? How can thousands of experienced investors and dozens of venerable institutions have all been fooled into blindly trusting the underlying solidity of assets they had little understanding of? How did the mortgage-based derivative disease spread across the financial system like wild fire without anybody ringing the alarm bell before well after it was to late?

As after every major crisis, an army of self proclaimed experts now glorify their egos by subscribing to the easy, populist view: It is all the market’s fault. Liberalism, deregulation and unfettered competition are to blame. Credit Rating Agencies are the ugly child of the free market. Their role should be assumed by the state. They and they only have made possible the crisis we now have to fight with taxpayers’ money.

Unfortunately, these allegations are based on little more than an ideological allergy to free markets that runs deep in the minds of our intellectual elites. The sheer facts and numbers tell a radically different story. This essay will aim at showing how credit rating agencies, despite their flawed methods and incompetence, could only enjoy such importance because of red tape and regulations. It will highlight how banking regulations gave these intrinsically imperfect organizations a completely disproportionate role and how governments are to blame for what many are too happy to attribute to reckless liberal ideology.

Historical look

Before Credit Rating Agencies’ power could rival those of the USA (in the words of Thomas Friedman, quoted above), these actors were somewhat marginal players and enjoyed a reputation of grumpiness, seriousness and honesty. Before regulations came and changed the rules of the game, credit rating agencies got their money from investors who subscribed to their ratings and advices. Their ratings were strictly informational, had no legal force whatsoever and investors were free (and indeed often did) to ignore them. In such a context they only provided markets with what might well be considered their most precious fuel: information. By releasing information about financial products and their issuers, they added transparency and helped investors take informed investment decisions.

And then came government and its foolish aim to put an official stamp on everything. In 1975, the SEC, wanting to control the risk banks and other investors took sought to establish an official definition of risk. To do so, they recognized three official credit rating agencies: Standard and Poor’s, Moody’s and Fitch ratings whose ratings were now to enjoy legal force. Since the enactment of the law, other agencies have joined the club but the “Big three” retain their pre-eminence and now appear as the most powerful actors in the financial system. The consequences of this legislative move are numerous and far reaching.

These regulations created an oligopoly for the selected agencies and guaranteed them a steady stream of revenues. It also created a de facto obligation for issuers of financial products to have said products rated since capital requirements and the structure of investors’ portfolios depended on these ratings. Indeed, the lower the risk of assets on a bank’s portfolio, the less capital it had to carry and the more money it could invest. Holding high rated assets allowed banks to free up capital, which made them seek actively such assets. What’s more, pension funds were barred from holding anything below AA and similar restrictions were placed on the structure of mutual funds and other such investors’ portfolio.

As a result, a product’s worth depended more than ever on its rating and issuers were forced to submit their products to the all-powerful agencies. The consequence was a radical change in these agencies’ business model. Whereas they previously received their money from investors who trusted their ratings, they were now paid directly by the issuers of financial products. In the words of Johan Norberg, “This amounted to buying a house which value had been assessed by an agent paid by the seller”. I strongly doubt whether any sane home-seeker would ever do that…

Many self called financial experts claim that credit rating agencies enjoyed their power and actively pushed governments to expand their influence. In reality, high-ranking executives of these agencies were among the most vocal critics of the above-described regulations. The words of Thomas Mc Guire, Moody’s chief of corporate ratings are eloquent: “ Rating agencies are staffed by ordinary people with families to support and bills to meet and mortgages to pay. Government regulators are inadvertently subjecting those people to improper pressure and share accountability for any scandal which may result ”.

Current role and legal status

Despite the controversy surrounding them, credit rating agencies have an important function: they provide markets with information. They issue ratings of both financial products (assessing the risk associated to them) and issuers of financial products (evaluating their solvency and the likeliness of default).

Their ratings influence the price of financial products. This is especially true for the most complex products for which no liquid market exists (which was the case for many complex derivatives such as CDOs until the creation of the ABX.HE). They also influence investors’ trust in issuers of financial products and thus the cost of borrowing of governments and companies alike. The recent downgrading of Greece and Spain’s ratings, which triggered a sharp rise in both the interest rate of their treasury bonds and corresponding CDS is truth of that.

The ratings issued by CRAs also contribute to shaping the structure of investors’ portfolio. As previously showed, many mutual and pension funds are barred from holding anything below AA or in some cases AAA. The European Central Bank itself cannot hold Treasury bonds rated below BB.

According to the Basel II agreements, capital requirements for banks depend on the risk-weighted composition of their portfolio. The complex formulas used to calculate the appropriate amount of capital banks are to hold used ratings from CRA to assess assets’ risk. The amount of capital banks must hold thus depends on the letter apposed on the assets they own, which makes CRA all the more powerful and influential.

Controversy and role in the financial crisis

Much had been said and written lately about CRA’s chronic failure to properly accomplish the mission they were trusted with. A look at their recent history indeed shows a worrying incapacity to foresee major financial earthquakes and a troubling tendency to react a posteriori. For instance, Enron’s notation remained at investment grade until 4 days before what remains one of the greatest bankruptcies in history. CRA’s also failed to foresee the 97 Asian crisis and the 2001 Argentinean debt crisis. Furthermore, it today appears that CRA were out like bandits stamping AAA CDOs that turned out to be worth nothing.

The incompetence was apparent in the way they attributed notations to CDOs.

CDOs are structured financial products based on financial assets. In their most common form, they are made of mortgages packaged and are then divided into tranches according to the level of risk. It should be noted that no mortgage is actually owned by one investor. Holding the safest tranches does not mean owning the soundest mortgages, it simply means that you will be the last one to be hit if things go awry.

Government's interventions hiding actual risks

The solidity of a CDO thus logically depends on the solidity of the mortgages it is built with. But in reality, things are much more complicated since CDOs are believed to be removed from the actual housing market. Indeed, the mortgages after being granted by companies such as Countrywide were bought by the two government sponsored enterprises Fannie Mae and Freddie Mac (as part of government’s scheme to increase home ownership) who guaranteed to buy virtually any mortgage however bad it was.

The intervention of these two government sponsored enterprises made investors treat anything they touched like treasury bonds (the safest investment in the world) and blinded them to the risk associated to the products they created. Fannie and Freddie then proceeded to create an Asset Backed Security (which they guaranteed) composed of mortgages from all over the country (to diversify risk exposure). This ABS was then divided into tranches much like a CDO and these tranches were bought by investors (mainly banks) who in turn packaged them into a CDO.

Getting rid of the original mortgages allowed mortgage lenders such as countrywide not to have to wait for 10 or 20 years to get their money back. Reselling mortgages allowed them to free up money to grant more loans and thus generate more revenues. The downside was that since Fannie and Freddie guaranteed to buy the loans, lenders paid little attention to the solvability of borrowers and granted loans on incredibly favourable terms to households who didn’t deserve even a credit card. When times were good, households could in many cases take out a loan without even having to provide the lender with such basic information as credit history, detailed household income etc… Lenders often had little clear idea of whom they were lending money to and little did they care. Nor did investors seek to know more about the solidity of the mortgages since the intervention of government sponsored enterprises and the guarantee on the ABS they created made everybody blind to risk.

Mortgage securitization: a cash cow

All this brings us back to our CRAs. When a bank wants to create a CDO, it needs to have it rated by an agency and had better get a good grade if it wants anybody to buy it. Originally, CRAs estimated that no CDO consisting solely of mortgages could be given an investment grade notation because the degree of risk diversification was way too low and the product was too exposed to the fluctuations of a single market. But as CDOs became more and more popular and the government inflated the housing market with its three giant pumps that were the FED, Fannie and Freddie; CRAs came to realize how much money they could make by re defining their grade attribution criteria. The aim was to make customers come to them rather than their competitors and for that, bringing out the AAA stamp was necessary.

Mortgage securitization was a cash cow, and CRAs were milking it as if there were no tomorrow. Even Moody’s, the most conservative of them, abandoned its diversification requirement in 2004. As its CEO explained “it was a slippery slope. What happened in 2004 and 2005 with respect to subordinated tranches (the riskiest tranches of CDOs) is that our competition, Fitch and S&P, went nuts. Everything was investment grade”. The strategy could not be any more profitable, a single rating could generate over $200 000 of revenues and took little more than a day (in some cases a few hours were enough). In 2005, securitization accounted for over 40% of Moody’s sales.

At a hearing at the House of Representative, one document (an internet chat between two S&P analysts) was produced that shows the extent of the CRAs’ foolishness.

1- By the way, that deal is ridiculous

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.

What now?

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.