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Archive for March 2008

Privatizing gains, socializing losses

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Roger Lowenstein, author of When Genius Failed: the rise and fall of Long Term Capital Management, writes cogently about the credit crisis and government intervention in the Times Magazine.

I’d like to hear a believer in efficient markets try to tell the story of Bear Stearns’ demise. One week it was OK for them to be levered 30 to 1, the next week it wasn’t? When the stock was at 65 people were comfortable with their exposure to mortgages, but then suddenly they weren’t? Come on. When the stock was at 65, what was the implied probability of a total collapse, based on out of the money puts? Zero.

Markets are complex dynamical systems that undergo phase transitions. Even sophisticated institutional investors are mostly just following the herd. Prices can disconnect wildly from real value for long periods of time, until suddenly they jump, often overshooting in the other direction. Huge risks, which in hindsight are obvious, build up in plain view while escaping notice from all but a few Cassandras. Robert Rubin, the Chairman of Citigroup, former co-head of Goldman, former Treasury Secretary, doesn’t know what a SIV is until after the crisis has hit. Tens of trillions of dollars in off the books credit default swaps are traded (often recorded on scraps of paper!) before Wall St. CEOs, central bankers and regulators realize the instabilities involved.

More from James Surowiecki in the New Yorker. (I love this month’s cover 🙂

NYTimes: …Government interventions always bring disruptions, but when Washington meddles in financial markets, the potential for the sort of distortion that obscures proper incentives is especially large, due to our markets’ complexities. Even Robert Rubin, the Citigroup executive and former Treasury secretary, has admitted he had never heard of a type of contract responsible for major problems at Citi.

Bear is a far smaller company, and, it would seem, far simpler. But consider that as recently as three weeks ago, it was valued at $65 a share. Then, as it became clear that Bear faced the modern equivalent of a bank run, JPMorgan Chase negotiated a merger with the figure of $10 a share in mind. Alas, at the 11th hour, Morgan’s bankers realized they couldn’t get a handle on what Bear owned — or owed — and got cold feet. Under heavy pressure from the Fed and the Treasury, a deal was struck at the price of a subway ride — $2 a share.

It is safe to say that neither Jamie Dimon, Morgan’s chief executive, nor Ben Bernanke, the Fed chairman who pushed for the deal, know what Bear is really worth. For the record, Bear’s book value per share is $84. As Meredith Whitney, who follows Wall Street for Oppenheimer, remarked, “It’s hard to get a linear progression from 84 to 2.”

Capitalism isn’t supposed to work like this, and before the advent of modern finance, it usually didn’t. Market values fluctuate, but — in the absence of fraud — billion-dollar companies do not evaporate. Yet it’s worth noting that Lehman Brothers’ stock also fell by half and then recovered within a 24-hour span. Once, investors could get a read on financial firms’ assets and risks from their balance sheets; those days are history.

Firms now do much of their business off the balance sheet. The swashbuckling Bear Stearns was a party to $2.5 trillion — no typo — of a derivative instrument known as a credit default swap. Such swaps are off-the-books agreements with third parties to exchange sums of cash according to a motley assortment of other credit indicators. In truth, no outsider could understand what Bear (or Citi, or Lehman) was committed to. The thought that Bear’s counterparties (the firms on the other side of that $2.5 trillion) would call in their chits — and then cancel their trades with Lehman, perhaps with Merrill Lynch and so forth — sent Wall Street into panic mode. Had Bear collapsed, or so asserted a veteran employee, “it would have been the end: pandemonium and global meltdown.”

Perhaps. Or perhaps, after some bad weeks or months, Wall Street would have recovered. What is scary is the degree to which the Fed assimilated the alarmism on the Street: “These guys are so afraid of an economic cycle,” a hedge-fund manager remarked. And without public airing or debate, it stretched the implicit federal safety net under Wall Street.

To question intervention is not to dispute that markets need rules. But for nearly two decades, Washington has trimmed its regulatory sails. The repeal of Glass-Steagall, which once separated banks from securities firms, and the evolution of new instruments that circumvent disclosure rules have loosened the market’s moorings. Huge pools of capital have been permitted to operate virtually unregulated. Mortgages have been written to the flimsiest of credits. Swelling derivative books have made a mockery of disclosure.

The relaxation of oversight has implied an unholy bargain: let markets operate unfettered in good times, confident that the feds will come to the rescue in bad. In 1998, the Fed intervened to cushion the collapsing hedge fund Long-Term Capital Management; dot-com stocks immediately began their dubious ascent. Then, when the tech meltdown led to a recession and the Fed cut rates to 1 percent, adjustable-rate mortgages became as hot as the iPod. One rescue begets the next excess.

It is true that Bear’s shareholders have suffered steep losses. But the Fed went much further than in previous episodes to calm the waters. Notably, it announced it would accept mortgage securities as collateral for loans — enlarging its role as lender of last resort. (Wall Street jesters had it that the Fed would also be accepting “cereal box-tops.”) Then the Fed extended a backstop line of credit to JPMorgan to tide Bear over; finally, it agreed to absorb the ugliest $30 billion of Bear’s assets.

Written by infoproc

March 30, 2008 at 12:56 am

Charlie Munger, Ricardo and finance

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Here is the text of an interesting talk given by Charlie Munger entitled Academic Economics: Strengths and Faults After Considering Interdisciplinary Needs. Among other things, he discusses physics envy, psychology, behavioral economics and efficient markets. Munger, a billionaire, was Warren Buffet’s long time investing partner. He studied briefly at Caltech before attending Harvard Law School, and now lives in Pasadena.

“Charlie is truly the broadest thinker I have ever encountered. From business principles to economic principles to the design of student dormitories to the design of a catamaran he has no equal…” –William H. (Bill) Gates III Microsoft Corporation

…Another example of not thinking through the consequences of the consequences is the standard reaction in economics to Ricardo’s law of comparative advantage giving benefit on both sides of trade. Ricardo came up with a wonderful, non-obvious explanation that was so powerful that people were charmed with it, and they still are, because it’s a very useful idea. Everybody in economics understands that comparative advantage is a big deal, when one considers first order advantages in trade from the Ricardo effect. But suppose you’ve got a very talented ethnic group, like the Chinese, and they’re very poor and backward, and you’re an advanced nation, and you create free trade with China, and it goes on for a long time.

Now let’s follow and second and third order consequences: You are more prosperous than you would have been if you hadn’t traded with China in terms of average well-being in the United States, right? Ricardo proved it. But which nation is going to be growing faster in economic terms? It’s obviously China. They’re absorbing all the modern technology of the world through this great facilitator in free trade, and, like the Asian Tigers have proved, they will get ahead fast. Look at Hong Kong. Look at Taiwan. Look at early Japan. So, you start in a place where you’ve got a weak nation of backward peasants, a billion and a quarter of them, and in the end they’re going to be a much bigger, stronger nation than you are, maybe even having more and better atomic bombs. Well, Ricardo did not prove that that’s a wonderful outcome for the former leading nation. He didn’t try to determine second order and higher order effects.

If you try and talk like this to an economics professor, and I’ve done this three times, they shrink in horror and offense because they don’t like this kind of talk. It really gums up this nice discipline of theirs, which is so much simpler when you ignore second and third order consequences.

The best answer I ever got on that subject – in three tries – was from George Schultz. [Schultz was an MIT economics professor before becoming Secretary of the Treasury and Secretary of State.] He said, “Charlie, the way I figure it is if we stop trading with China, the other advanced nations will do it anyway, and we wouldn’t stop the ascent of China compared to us, and we’d lose the Ricardo- diagnosed advantages of trade.” Which is obviously correct. And I said, “Well George, you’ve just invented a new form of the tragedy of the commons. You’re locked in this system and you can’t fix it. You’re going to go to a tragic hell in a handbasket, if going to hell involves being once the great leader of the world and finally going to the shallows in terms of leadership.” And he said, “Charlie, I do not want to think about this.” I think he’s wise. He’s even older than I am, and maybe I should learn from him.

My favorite Munger quote:

I regard the amount of brainpower going into money management as a national scandal.

We have armies of people with advanced degrees in physics and math in various hedge funds and private-equity funds trying to outsmart the market. A lot of you older people in the room can remember when none of these people existed. There used to be very few people in the business, [and they were not] who were not very intelligent. This was a great help to me.

Now we have armies of very talented people working with great diligence to be the best they can be. I think this is good for the people in it because if you know enough about money management to be good at it, you will know a lot about life. That part is good.

But it’s been carried to an extreme. I see prospectuses for businesses with 40-50 people with PhDs, and they have back tested systems and formulas and they want to raise $100 billion. [Reference to Jim Simons of Renaissance Technologies.] And they will take a very substantial override for providing this wonderful system. The guy who runs it has a wonderful investment record and his system is a lot of high mathematics and algorithms with data from the past.” […]

“At Samsung, their engineers meet at 11pm. Our meetings of engineers (meaning our smartest citizens) are also at 11pm, but they’re working on pricing derivatives. I think it’s crazy to have incentives that drive your most intelligent people into a very sophisticated gaming system.

Written by infoproc

March 29, 2008 at 4:06 pm


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With the current troubles on Wall Street, New York City’s economy is in for a rough patch. Unfortunately, so are the rest of us — the financial sector accounts for over 20% of all S&P earnings 😦

How do New Yorkers feel about the recent misfortunes of the masters of their universe?

NYTimes: … For many of the city’s middle class, especially those in the creative class, who have felt sidelined as the city seemed to become a high-priced playground for Wall Street bankers, the implosion of the brokerage house Bear Stearns raises a tantalizing possibility: participation in an economy they have been largely shut out of.

Few romanticize the nearly bankrupt New York of the 1970s or the recession of the late 1980s. But if the city suffers an economic downturn, as many now predict, there are fantasies of New York returning to a pre-Gilded Age, before the average Manhattan apartment cost $1.4 million, SAT tutors charged $500 an hour and dinner entrees crossed the $40 threshold.

…New York City has always been defined by the yawning gap between its haves and have-nots. But the last 15 years have witnessed the rise of a class of financiers whose salaries and bonuses have reached staggering heights. Over the last five years, the median compensation for a managing director working in investment banking rose from $650,000 to $1.37 million, according to Johnson Associates, a compensation consulting firm.

That is a pittance compared with hedge-fund managers. The highest-paid managers earned at least $240 million a year in 2006, according to the Institutional Investor’s Alpha magazine, nearly double the amount of 2005 (and up from a minimum of $30 million in 2002).

Their pay — and eagerness to spend it — has encouraged the growth of a luxury market in everything from groceries to restaurants to spas to specialty boutiques. Witness the Marc Jacobs-ization of the West Village, the surging average price of a two-bedroom apartment in Harlem to $1.1 million, and the rise of $15 tubs of ice cream in, of all places, the Lower East Side, at Il Laboratorio del Gelato.

In a city where the median household income in 2006 was $46,480, it’s no wonder that many people are bitter.

…Robert H. Frank, an economics professor at Cornell, has written about the phenomenon of Americans who feel impoverished because of the towering wealth of those above them. In New York City, he said, those feelings are compounded by the sense that much of the wealth at the top is derived from financial instruments that merely move money around.

“It’s one thing if people are adding value to society,” Professor Frank said. “But there is skepticism that this is all a shell game and these guys are not adding value, at least to the extent that justifies their salaries.”

34k Wall St. layoffs since last July, and another 20k to come? Read what the locals have to say:

March 25th, 2008 9:22 am

Best and the brightest?! Please! They are the greediest and the selfish. I for one am tickled pink that these bankers are finally coming back to earth a bit. They have ruined the entire East Coast as far as affordability. No one except an investment banker or hedge funder can afford a house in a nice area between NYC and Boston. And you can forget about vacation spots – they’re all ruined by them. The ridiculous monopoly money bonuses these “geniuses” receive every Christmas has made me sick for years so my schadenfreude meter is on high.

— Posted by tomas

Or, as I wrote a couple years ago:

…Yesterday, waiting for a lunch meeting, I met an old friend for coffee. We wandered into the recently renovated MOMA in midtown, with its quiet sculpture garden. His employer, like all the big banks, is a major donor, and his ID card gained us immediate entry. Manhattan is like a big amusement or theme park for financiers. Relative to their compensation, all the rides (taxis, restauarants, everything but real estate) are free! See the drivers in big black sedans dropping off perfectly groomed, uniformed children at their $25k/y private schools, where the headmistress greets each child by name.

Written by infoproc

March 25, 2008 at 4:12 pm

What Created This Monster?

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The mainstream media is finally starting to catch on to the nature of the current credit crisis. One of the key points is that very few of the top people — CEOs, central bankers, regulators — really understood what was going on. Some are even starting to admit it.

See this article in the Sunday Times, and dozens of posts on this blog over the last 3 years… Here’s a post from 2004 in which I noted that Fannie Mae CEO Franklin Raines didn’t seem to understand derivatives accounting.

NYTimes: …LIKE Noah building his ark as thunderheads gathered, Bill Gross has spent the last two years anticipating the flood that swamped Bear Stearns about 10 days ago. As manager of the world’s biggest bond fund and custodian of nearly a trillion dollars in assets, Mr. Gross amassed a cash hoard of $50 billion in case trading partners suddenly demanded payment from his firm, Pimco.

And every day for the last three weeks he has convened meetings in a war room in Pimco’s headquarters in Newport Beach, Calif., “to make sure the ark doesn’t have any leaks,” Mr. Gross said. “We come in every day at 3:30 a.m. and leave at 6 p.m. I’m not used to setting my alarm for 2:45 a.m., but these are extraordinary times.”

Even though Mr. Gross, 63, is a market veteran who has lived through the collapse of other banks and brokerage firms, the 1987 stock market crash, and the near meltdown of the Long-Term Capital Management hedge fund a decade ago, he says the current crisis feels different — in both size and significance.

The Federal Reserve not only taken has action unprecedented since the Great Depression — by lending money directly to major investment banks — but also has put taxpayers on the hook for billions of dollars in questionable trades these same bankers made when the good times were rolling.

“Bear Stearns has made it obvious that things have gone too far,” says Mr. Gross, who plans to use some of his cash to bargain-shop. “The investment community has morphed into something beyond banks and something beyond regulation. We call it the shadow banking system.”

It is the private trading of complex instruments that lurk in the financial shadows that worries regulators and Wall Street and that have created stresses in the broader economy. Economic downturns and panics have occurred before, of course. Few, however, have posed such a serious threat to the entire financial system that regulators have responded as if they were confronting a potential epidemic.

As Congress and Republican and Democratic presidential administrations pushed for financial deregulation over the last decade, the biggest banks and brokerage firms created a dizzying array of innovative products that experts now acknowledge are hard to understand and even harder to value.

On Wall Street, of course, what you don’t see can hurt you. In the past decade, there has been an explosion in complex derivative instruments, such as collateralized debt obligations and credit default swaps, which were intended primarily to transfer risk.

These products are virtually hidden from investors, analysts and regulators, even though they have emerged as one of Wall Street’s most outsized profit engines. They don’t trade openly on public exchanges, and financial services firms disclose few details about them.

…TWO months before he resigned as chief executive of Citigroup last year amid nearly $20 billion in write-downs, Charles O. Prince III sat down in Washington with Representative Barney Frank, the chairman of the House Financial Services Committee. Among the topics they discussed were investment vehicles that allowed Citigroup and other banks to keep billions of dollars in potential liabilities off of their balance sheets — and away from the scrutiny of investors and analysts.

“Why aren’t they on your balance sheet?” asked Mr. Frank, Democrat of Massachusetts. The congressman recalled that Mr. Prince said doing so would have put Citigroup at a disadvantage with Wall Street investment banks that were more loosely regulated and were allowed to take far greater risks. (A spokeswoman for Mr. Prince confirmed the conversation.)

It was at that moment, Mr. Frank says, that he first realized just how much freedom Wall Street firms had, and how lightly regulated they were in comparison with commercial banks, which have to answer to an alphabet soup of government agencies like the Federal Reserve and the comptroller of the currency.

…Wall Street firms rushed into the new frontier of lucrative financial products like derivatives. Students with doctorates in physics and other mathematical disciplines were hired directly out of graduate school to design them, and Wall Street firms increasingly made big bets on derivatives linked to mortgages and other products.

…ONE of the fastest-growing and most lucrative businesses on Wall Street in the past decade has been in derivatives — a sector that boomed after the near collapse of Long-Term Capital.

It is a stealth market that relies on trades conducted by phone between Wall Street dealer desks, away from open securities exchanges. How much changes hands or who holds what is ultimately unknown to analysts, investors and regulators.

Credit rating agencies, which banks paid to grade some of the new products, slapped high ratings on many of them, despite having only a loose familiarity with the quality of the assets behind these instruments.

Even the people running Wall Street firms didn’t really understand what they were buying and selling, says Byron Wien, a 40-year veteran of the stock market who is now the chief investment strategist of Pequot Capital, a hedge fund.

“These are ordinary folks who know a spreadsheet, but they are not steeped in the sophistication of these kind of models,” Mr. Wien says. “You put a lot of equations in front of them with little Greek letters on their sides, and they won’t know what they’re looking at.”

Mr. Blinder, the former Fed vice chairman, holds a doctorate in economics from M.I.T. but says he has only a “modest understanding” of complex derivatives. “I know the basic understanding of how they work,” he said, “but if you presented me with one and asked me to put a market value on it, I’d be guessing.”

…Timothy F. Geithner, a career civil servant who took over as president of the New York Fed in 2003, was trying to solve a variety of global crises while at the Treasury Department. As a Fed president, he tried to get a handle on hedge fund activities and the use of leverage on Wall Street, and he zeroed in on the credit derivatives market.

Mr. Geithner brought together leaders of Wall Street firms in a series of meetings in 2005 and 2006 to discuss credit derivatives, and he pushed many of them to clear and settle derivatives trading electronically, hoping to eliminate a large paper backlog that had clogged the system.

Even so, Mr. Geithner had one hand tied behind his back. While the Fed regulated large commercial banks like Citigroup and JPMorgan, it had no oversight on activities of the investment banks, hedge funds and other participants in the burgeoning derivatives market. And the industry and sympathetic politicians in Washington fought attempts to regulate the products, arguing that it would force the lucrative business overseas.

“Tim has been learning on the job, and he has my sympathy,” said Christopher Whalen, a managing partner of Institutional Risk Analytics, a risk management firm in Torrance, Calif. “But I don’t think he’s enough of a real practitioner to go mano-a-mano with these bankers.”

…In the meantime, analysts say, a broader reconsideration of derivatives and the shadow banking system is also in order. “Not all innovation is good,” says Mr. Whalen of Institutional Risk Analytics. “If it is too complicated for most of us to understand in 10 to 15 minutes, then we probably shouldn’t be doing it.”

Written by infoproc

March 23, 2008 at 9:34 pm

To live long, first prosper

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Or, at least, get a good education so that you can follow progress in health research, and develop enough self-discipline that you can implement the important recommendations. The entire effect may simply be that those capabilities tend to be correlated with income and social status.

NYTimes: …Dr. Singh said last week that federal officials had found “widening socioeconomic inequalities in life expectancy” at birth and at every age level.

He and another researcher, Mohammad Siahpush, a professor at the University of Nebraska Medical Center in Omaha, developed an index to measure social and economic conditions in every county, using census data on education, income, poverty, housing and other factors. Counties were then classified into 10 groups of equal population size.

In 1980-82, Dr. Singh said, people in the most affluent group could expect to live 2.8 years longer than people in the most deprived group (75.8 versus 73 years). By 1998-2000, the difference in life expectancy had increased to 4.5 years (79.2 versus 74.7 years), and it continues to grow, he said.

After 20 years, the lowest socioeconomic group lagged further behind the most affluent, Dr. Singh said, noting that “life expectancy was higher for the most affluent in 1980 than for the most deprived group in 2000.”

“If you look at the extremes in 2000,” Dr. Singh said, “men in the most deprived counties had 10 years’ shorter life expectancy than women in the most affluent counties (71.5 years versus 81.3 years).” The difference between poor black men and affluent white women was more than 14 years (66.9 years vs. 81.1 years).

…Robert E. Moffit, director of the Center for Health Policy Studies at the conservative Heritage Foundation, said one reason for the growing disparities might be “a very significant gap in health literacy” — what people know about diet, exercise and healthy lifestyles. Middle-class and upper-income people have greater access to the huge amounts of health information on the Internet, Mr. Moffit said.

Thomas P. Miller, a health economist at the American Enterprise Institute, agreed.

“People with more education tend to have a longer time horizon,” Mr. Miller said. “They are more likely to look at the long-term consequences of their health behavior. They are more assertive in seeking out treatments and more likely to adhere to treatment advice from physicians.”

A recent study by Ellen R. Meara, a health economist at Harvard Medical School, found that in the 1980s and 1990s, “virtually all gains in life expectancy occurred among highly educated groups.”

Written by infoproc

March 23, 2008 at 12:56 am

Asian decoupling?

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Not yet, but coming soon. More cars, computers and cellphones sold in emerging markets than in the US. The current US recession will still have a big impact in Asia, but much less so than in 2001.

BusinessWeek: Are Asian Economies Decoupling from U.S.?

Morgan Stanley emerging markets guru Jonathan Garner says the days of a U.S.-centric world are fading fast

The debate over whether emerging markets are decoupling from the US continues to rumble on. With the US economy slowing and probably heading into recession, the debate is of particular interest at this time. Here Jonathan Garner, managing director and head of global emerging markets equity strategy with Morgan Stanley, explains why he thinks that emerging markets will weather this slowdown far better than in previous US slowdowns.

What are your main reasons for arguing that decoupling is under way?

The emerging markets are now 30% of the global economy at current exchange rates. They are even larger now than developed Europe and their share of global GDP is steadily rising and will continue to rise, I suspect, for the foreseeable future.

Also emerging markets have demography on their side. The emerging world’s working age population will increase by another one billion people between now and 2050. The developed world’s working age population will shrink by about 120 million—or about one eighth, whereas emerging markets will rise by about 25% from the current level. This and the adoption of the market economy, urbanisation and other profoundly positive trends will keep emerging markets moving forward.

How rapidly is this process moving?

I would say we are exiting the US-centric world pretty quickly. And if we are right about this, emerging markets will contribute over 60% of global growth this year. Last year they contributed about 48%. China alone is contributing more to global growth than the US now and will do so for the foreseeable future. China contributed about 11% last year and will contribute 12% this year. This process is slowly bringing down the global share of US GDP while the share of emerging markets is steadily rising.

The decoupling argument seems to have plenty of sceptics

Decoupling runs against the consensus view. Some people simply don’t buy it and don’t understand the profound change that is underway. And most people still have this view of the US as the core and emerging markets as the periphery. If you go back to the 1990s that was true to some extent—the core drove the periphery—but that was when you had small emerging countries like Hong Kong, Singapore and Thailand that were exporting to the US. It’s very different when you have got really large population emerging market countries adopting a market economy. When that happens their growth really starts to kick in.

How is it different this time?

Some things are happening that don’t usually happen in a US recession. Export growth in emerging market countries is still running at 19.9% year-on-year. Look at the last US recession, which began in Jan 2001: Then Emerging Markets export growth plummeted. The reason for this difference is that the US is gradually becoming less and less important. Since 2001 there has been a huge gain in intra-emerging market trade and a huge decline in the share of exports from the emerging markets to the US. As an end-user market the US now takes less than a fifth of emerging market exports. And the biggest growing element is trade with the emerging markets and after that trade with the EU.

How is this reflected in product categories?

If you look at auto sales for example, in China alone they have grown from two million units in March 2002 to 7.5 million December 2007. Auto sales in the Bric countries (Brazil, Russia, India, China) totalled 14 million units in 2007. That’s 88% the size of the US market and they are growing at 20% year-on-year which means that within a year the Bric counties will have larger auto sales than the US. If you go back to the last US recession in 2001-02, the Bric countries had auto sales that were less than one-third the size of the US. If you look at the auto sales to population densities—this trend definitely won’t stop here.

Are the any other areas where growth has been strong?

It’s also true in areas such as personal computers—not an area where you tend to think about decoupling. Back in 2001 the US was twice the size of the Asian market ex-Japan, while in 1998 it was three times the size. Today it is scarcely larger.

It is happening in even smaller ticket items such as mobile phone handsets. The US and Europe together take less than one-third of global handsets. In the last US recession it was more than a half. The vast majority of handsets these days are sold into the emerging markets.

What about spending on infrastructure development?

Infrastructure is very important. We have tried to estimate infrastructure spend and gross fixed capital formation and then looked at the proportion of that that which goes to infrastructure. We reckon that the 29 emerging markets countries that we have modelled will have about $22 trillion over the next 10 years. So rising from about 2% of global GDP in 2008 to about 3.5% of global GDP in 2017. That’s a very major improvement and it’s a structural driver of global GDP growth as we expect it to be growing faster than overall GDP growth.

How is this spending going to be financed?

It can be funded because the emerging markets countries have got their house in order economically. They are running surpluses and their public sectors are external creditors not debtors. The big debtor is the US. The public sector even in places like Brazil and Mexico is now a creditor. Its gives them huge scope to engage in infrastructure building and at the governmental level almost every emerging markets country has drastic infrastructure spending plans across a whole range of sectors. These include airports, power stations, power stations, property, and railways. It really is a far bigger and probably far longer investment theme than the housing problems in the US right now. People find it hard to get their mind around it right now because it crosses many countries and involves a lot of different sectors.

So do you think a slowdown in the US is going to have much impact on Asia?

Well it will have some—we are expecting a growth deceleration. It would be foolish to argue there would be no effect. But we think it will be quite limited. Much more so than in previous US recessions. Because emerging market countries are no longer just exporting to the US. They are exporting to the EU and to each other to feed their own end-use consumers.

Written by infoproc

March 21, 2008 at 4:18 pm

So long, Bear: fear crushes greed

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Bear Stearns evaporated over the weekend. Its market cap plummeted from $20B a year ago to $3.5B on Friday to essentially zero this weekend, when JP Morgan acquired them for less than the real estate value of their building in Manhattan. Due to Fed guarantees made to JP Morgan, US taxpayers are on the hook for $30B of the most illiquid mortgage backed securities on Bear’s books. The Fed intervened because had Bear been allowed to melt down there would have been chaos in and systemic risk to the financial markets (“too big and interconnected to fail”). The current crisis is much more serious than either the Long Term Capital collapse of 1998 or even the savings and loan crisis of the 1980s.

How do illiquid securities get priced? Ultimately, it’s competition between FEAR and GREED. At the moment FEAR is winning — there are serious mispricings in corporate and municipal bond markets due to gigantic risk premia and a flight to security. Mortgage securities won’t bottom out until GREEDY capital (controlled by investors willing to take a risk today in hopes of future profits) is sufficient. The problem is that price recovery can’t take place until market confidence returns and, additionally, the ultimate value of mortgage securities depends on future projections about the bursting housing bubble, default rates, overall macro trends, etc. It could take a long time for markets to clear, with the Fed (taxpayers!) acting as the buyer of last resort in the interim.

WSJ: …”At the end of the day, what Bear Stearns was looking at was either taking $2 a share or going bust,” said one person involved in the negotiations. “Those were the only options.”

To help facilitate the deal, the Federal Reserve is taking the extraordinary step of providing as much as $30 billion in financing for Bear Stearns’s less-liquid assets, such as mortgage securities that the firm has been unable to sell, in what is believed to be the largest Fed advance on record to a single company. Fed officials wouldn’t describe the exact financing terms or assets involved. But if those assets decline in value, the Fed would bear any loss, not J.P. Morgan.

The sale of Bear Stearns and Sunday night’s move by the Fed to offer loans to other securities dealers mark the latest historic turns in what has become the most pervasive financial crisis in a generation. The issue is no longer whether it will yield a recession — that seems almost certain — but whether the concerted efforts of Wall Street and Washington can head off a recession much deeper and more prolonged than the past two, relatively mild ones.

‘Uncharted Waters’

Former Treasury Secretary Robert Rubin last week described the situation as “uncharted waters,” a view echoed privately by top government officials. Those officials have been scrambling to come up with new tools because the old ones aren’t suited for this 21st-century crisis, in which financial innovation has rendered many institutions not “too big too fail,” but “too interconnected to be allowed to fail suddenly.”

Bear Stearns’s sudden meltdown forced the federal government to come to grips with the potential collapse of a major Wall Street institution for the first time in a decade. In 1998, about a dozen firms, with encouragement from the Federal Reserve Bank of New York, provided a $3.6 billion bailout of Long-Term Capital Management that kept the big hedge fund alive long enough to liquidate its positions. Bear Stearns famously refused to participate in that rescue.

The scale of the financial system’s troubles are even bigger this time around. Since last summer, the Fed has lowered its target for the federal-funds rate, charged on low-risk overnight loans between banks, to 3% from 5.25%, and it is expected to cut the rate again this week. Last week, the Fed said it would lend Wall Street as much as $200 billion in exchange for a roughly equivalent amount of mortgage-backed securities.

But those moves have failed to soothe investors and lenders, who are worried about the true value and default risk of many debt securities or are hoarding cash to meet their own needs. As worries grew that failing to find a buyer for the beleaguered investment bank could cause the crisis of confidence gripping Wall Street to worsen across the financial system, federal regulators pushed Bear Stearns’s board to sell the firm.

Who can forecast or model the future value of a complicated CDO tranche? Only a quant with a PhD. Are the real decision makers and risk takers on Wall Street in the mood to trust those calculations? Certainly not at the moment. Therefore, I predict, for now, very limited bargain hunting by just a few bold investors, and no end to illiquidity.

From a recent Fortune interview with Paul Krugman; he seems to be saying subprime is oversold and there’s money to be made for the steely eyed:

Fortune: …do you think the sense of crisis is turning into a crisis of confidence more than anything else?

I fluctuate on that. I look at the prices on subprime-backed securities. Even the AAA-rated tranche is selling for barely over 50 cents on the dollar, and the rest is essentially worthless, which amounts to a prediction that you’re going to get really very little on this stuff. Even if every subprime borrower walks away from his house and a lot of money is lost in foreclosure, it’s hard to get numbers that bad. So there might be some overselling in these markets. But on the other hand, a lot of the financial system looks like it’s going to shrivel up and have to be rebuilt. And that’s not too good.

The other risk is, of course, a dollar meltdown. As the Fed lowers interest rates and (effectively) prints money to stimulate the economy and prop up banks and securities firms, foreign investors must begin to question the future of the dollar as a store of wealth. The same crisis of confidence that brought down Bear could eventually bring down the US dollar.

Weighted US dollar index (NYBOT:DX):

Written by infoproc

March 17, 2008 at 12:18 pm