Quote of the Day: Agency Problem in the Mutual Fund Industry

From Investment guru David F. Swensen of Yale University

The companies that manage for-profit mutual funds face a fundamental conflict between producing profits for their owners and generating superior returns for their investors. In general, these companies spend lavishly on marketing campaigns, gather copious amounts of assets — and invest poorly. For decades, investors suffered below-market returns even as mutual fund management company owners enjoyed market-beating results. Profits trumped the duty to serve investors…

This churning of investor portfolios hurts investor returns. First, brokers and advisers use the pointless buying and selling to increase and to justify their all-too-rich compensation. Second, the mutual fund industry uses the star-rating system to encourage performance-chasing (selling funds that performed poorly and buying funds that performed well). In other words, investors sell low and buy high.

Read the rest here

This has been a dynamic which I have repeatedly been talking about, see here and here

I agree with Mr. Swensen that EDUCATION has to be in the forefront in the campaign to protect investors against such conflict of interests

But I strongly disagree with the suggestion that the SEC has to play a greater role in regulation and enforcement.

One of the reasons why investors have become vulnerable has been due to the complacency derived from the expectations that the nanny state will do the appropriate due diligence and provide protection in behalf of the investors.

Such smugness reduces individual responsibilities and increases the risk taking appetite. Yet for all the regulations and bureaucracy added over the years, why has Bernard Madoff been able to pull one off over Wall Street and the SEC?

Romanticizing the role of arbitrary regulations and bureaucrats won’t help.

Two, unquestionably putting clients ahead is an ideal goal. But this is more an abstraction in terms of implementation. The ultimate question is always how? The devil is always on the details. Has more regulations led to greater market efficiency or vice versa?

Or to be specific in terms of the industry's literature how should these be designed, should they encourage short term trades or long term investments? How does the regulators determine which is which?

Three, it would be wishful thinking to believe that regulators know better than the participants with regards to the latter’s interest. Yet giving too much power to regulators would translate to even market distortions, more conflict of interests, corruption, regulatory arbitrages and benefiting some sectors at the expense of the rest. For example, the shadow banking industry, which has played a crucial role in the 2008 crash, has been a collective byproduct of myriad regulatory arbitrages.

Lastly, since regulators are people too, conflict of interest with the regulated is also likely to occur. This means that the risk of the agency problem dynamic will not vanish but take shape in a different form; the difference is that conflict of interest will shift from the marketplace to the political realm. This is known as regulatory capture.

Beware Of The Brewing Meralco Bubble!

``As government has destroyed one business opportunity after another, perhaps we should not be surprised that investment money has left domestic production and was diverted to financial markets. Investors want a return, and government agents and the political classes seem determined to destroy free markets — and the opportunities they present for economic growth.”-William L. Anderson, One Cheer for Paul Krugman, or Why the Bubble Economy?

Meralco is in a SEMINAL bubble.

The Case For A Brewing Bubble

The Lopez owned utility firm skyrocketed 40% last week and is 111% up on a year to date basis.

Meralco’s free floated market capitalization share to the Phisix index has leapt to 5.48% as of Friday’s close from less than 1% share late last year and has catapulted to the FOURTH spot among the top weighted issues, following PLDT 34.15%, Bank of the Philippine Island 7.17% and Ayala Corp 5.52%. Previously Meralco wasn’t even in the top 12!

Meralco’s outperformance seen in its soaring share prices coupled with the languid performances of the price values of the traditional heavyweights- such as BPI, AC, Metrobank , SM Investments , SM Primeholdings have expanded MER’s influence on the Phisix.

This means that a sharp reversal of MER’s share price trend would risks placing unnecessary onus on the Philippine benchmark. And this could unduly influence the overall market especially if it unwinds under today’s melancholic global atmosphere.

Moreover, MER’s weekly traded volume in PESO has accounted for a cumulative 53.3% of the entire trade, 48.55% of the trades at the close of February 27^th and 32.37% on the close of February 20^th. Previously Meralco had less than 5% share of total trades.

We recall that the last time we saw bubbles with nearly the same magnitude was in BW Resources (1998-1999) and Philweb (2000) days see figure 5.

Figure 5: Philweb (red), BW Resources (blue) Bubble and Phisix (black) Bear Market

If memory serves me right, the controversial BW Resources (blue line) corralled about 70% of the entire market’s PESO traded volume during its zenith, and in fact, fleetingly displaced San Miguel Corp as the largest listed company based on market cap in the Phisix then.

Incidentally, both bubbles- BW Resources which today is listed under a new management Sun Trust Realty (of the Megaworld group) and Philweb (red line)- occurred during the bear market of 1998-2002.

Although one may argue that the scale of price increases may not be similar YET, where BW (approx 5,000%) and Philweb (estimated 1,200%), whereas MER’s prices has only increased by about 200% (based on June 2008 trough), the common feature of ANY bubble is the transition from a MANIC phase to a BLOW OFF phase characterized by parabolic movements in the underlying share price trend (see figure 6).

Figure 6: Moneyweek.com: Stages of A Bubble

Meralco seems to be in a manic phase. And we hope to see some temperance rather than a progression to the Blow off phase.

As you would notice in the previous chart, both BW and the Philweb boom-bust cycles have the same dynamics as the typical vicious bubble cycle above. To add, in both times the bubbles went bust, the overall markets suffered dearly.

And attempting to “time” bubbles by the ordinary market participants may only lead to more tears and mental anguish.

King Kong Versus Godzilla

Another common feature of the localized bubble is the “takeover” component which rationalizes the market action.

In BW Resources series, it was the hyped tale of a supposed (but aborted) buy-in of the Macao’s gambling magnate Mr. Stanley Ho.

On the other hand, the surge in Philweb share prices came about over the company’s successful takeover of the Cabarrus owned South Seas Oil and Minerals (formerly SSO), which likewise partially piggybacked on the peaking sentiment of the US dot.com boom.

Of course, one may further argue that Meralco is a cash flow rich utility vastly different from “third tier issues”. But NO economic or corporate fundamentals justify such exuberance except for the same “takeover” story.

The apparent action in Meralco has been allegedly due to corporate maneuverings by rival groups in contest for the management prize.

According to the grapevine, the Lopez camp, which is the incumbent managers with substantial ownership of Meralco is allegedly being aided by PLDTs Manny Pangilanan (with speculations of access to the Indonesia’s Salim group), while at the same time reportedly seeking other allies (Henry Sy?), to fortify its position in the utility company by acquiring shares in the market, against a possible hostile takeover attempt by PGMA ally in San Miguel Corp.

If this floated story is anywhere near correct, then MER, which is a regulation instituted monopoly, whose prized possession is being bitterly contested by politically privileged groups signify an engagement between “crony capitalists” representative of the opposite side of the political fence.

It’s like a King Kong versus Godzilla movie, where one monster eventually wins but the rest of the city is devastated.

This means that joining the bandwagon risks a disaster for most of the ordinary market participant. Why? Since it is a high profile corporate struggle, the flow of information is largely asymmetric. Movements of share prices tend to favor insiders and their affiliates who seem to be “gaming” the issue.

Yet even insiders can’t be assured of their newfound paper wealth. If we learn by history, in the BW case, allegedly some insiders or even the BW owner Dante Tan, reportedly lost a fortune in the pointless exercise to buttress a deflating bubble.

In addition, such maneuvers will obviously come to an end, possibly on one or a combination of the following reasons: 1) share price will be high enough to dissuade anyone of the contending parties from further pursuing their agenda, 2) budgets of one of the opposing camps have been drained, 3) political goal accomplished-alliance confirmed and management role retained or successful takeover and or 4) lastly, basic economics-high prices will eventually lure more sellers than buyers.

The Psychology of Bubbles

It is disheartening to see a bubble-like activity emerge anew in an environment resembling a bear market, even when the overall domestic market seems to be on the mend. If history were to rhyme and the MER saga transforms into a full blown bubble which eventually goes bust, then this could extrapolate to additional selling pressures on the local markets anew.

Nonetheless, the vulnerability of the public to get hooked to a bubble is understandable; in a somber environment like today, there is an added desire to squeeze some earnings from momentum driven trades.

Besides, the dearth of trading opportunities in a bear market which have been handicapped by the lack of accessible “short” facilities may have increased participants desire to speculate.

Moreover, negative real interest rates account for as a big incentive to chase yields. When your savings account yields lower returns than the inflation rate, then the temptation to gamble or the appetite to speculate is whetted.

Perhaps these are some of the reasons why a localized bubble coincides with a bear market here.

But unknown to most participants, bubbles operate similar to getting finagled by a Ponzi scheme like the recent Bernard Madoff or Robert Allen Stanford case or the US real estate-securitization cycle.

Such fraudulent conducts or unsustainable trends require exponential acceleration of fresh flow of money from new entrants, whom are seduced with records or appearances of sustainability of past performances-persistent high yields or strong capital returns-even when the underlying business model is questionable or flawed or even non-existent.

In short, most people buy on emotions and not on rationality.

Yet, the more the entrenched the trend, such as the dot.com or US Real Estate, or the more “socially” known people are involved, the greater the attraction to join the bandwagon, such as the Bernard Madoff case.

This is a cognitive bias which humankind in general won’t overcome-the Herd mentality- simply because it is hardwired into our genes. Our ancestors didn’t have the privilege of rationalizing and used intuitions or mental short cuts rather than risks becoming the next meal for carnivorous predators such as tigers and or lions.

But we don’t live in primordial times anymore. We have advanced and will continually do so but our instincts remain.

Worst of all, having a PhD or even an army of highly decorated or awarded professionals does not guarantee protection from fraud. Again as in the Bernard Madoff case, it had among its victims Banks, Insurance companies or hedge funds [see Madoff Ponzi Scam and Boom-Bust cycles].

Yet this world appears to be more fixated with academic and professional credentials whose rich “quantified” trainings or experiences haven’t reduced their ability to read through risks. Thus, the perpetual cycle.

Actually, it is the process ability from emotional intelligence that distinguishes plain academic or technical expertise from being streetsmart or market smart.

Conclusion

The present price actions in Meralco appear headed towards a full blown bubble.

We hope to see the issue make a gradual ascent instead. Moreover we hope that the positive sentiment from its recent activities spillovers to the general market which should reinforce the case of a general market turnaround thereby strengthening the case for MER’s sustained long term uptrend. For a boom to be sustained this requires a recovery in the general market sentiment, especially for the largely underdeveloped liquidity and sentiment sensitive Philippine equity markets.

On the other hand, a bursting bubble, which implies a decline in a similar degree to the preceding upside momentum, will only dampen sentiment as losses are likely to be swift and severe.

In learning from the lessons of history we understand that a bubble bust risks undermining the progress in the local market. This happens even if the bubble is a residual specific risk or is based on a particular company, mainly because the bubble has commanded a substantial share of the market’s attention. Thus, a bubble works like a temptress-they are seductive but fatal.

Unfortunately markets don’t operate on hope.

Applied to the analogy of Dante Alighieri’s who wrote in his classic "Divine Comedy"…

“Before me things create were none, save things

Eternal, and eternal I endure.

All hope abandon ye who enter here."

Therefore my advice, caveat emptor.

What Posttraumatic Stress Disorder (PTSD) Have To Do With Today’s Financial Crisis

``The most popular method of deprecating capitalism is to make it responsible for every condition which is considered unsatisfactory. Tuberculosis and, until a few years ago, syphilis, were called diseases of capitalism. The destitution of scores of millions in countries like India, which did not adopt capitalism, is blamed on capitalism. It is a sad fact that people become debilitated in old age and finally die. But this happens not only to salesmen but also to employers, and it was no less tragic in the precapitalistic ages than it is under capitalism. Prostitution, dipsomania, and drug addiction are all called capitalist vices. Ludwig von Mises Economic Teaching at the Universities

Lessons from Nassim Taleb

There are two important things I’ve learned from my favorite iconoclast Nassim Taleb, the chief proponent of the Black Swan Theory.

One is that he cautions the public to indulge in the study of markets or economies centered upon highly flawed but popular econometric models which are nothing but algorithms designed to operate on sterilized environments similar to classroom or laboratory conditions.

Since these computer models unrealistically operate on the assumption that every factor can be anticipated, examined and evaluated, risks are therefore assumed to be under control. Yet, the complex nature of our world can lead to manifold variables which can’t be read, evaluated or anticipated. The impact of which is known as randomness or the BLACK SWAN, a low probability but HIGH impact event, and is the nemesis of these ‘quant’ models. For instance the humongous losses in today’s financial crisis have been be partially blamed on the failure of quant models to anticipate risks from statistical fat tails.

Second, the other lesson taught by our unorthodox savant is to avoid getting trapped with cognitive biases such as projecting past connections and outcomes into the future.

The Sanctity of Delusion

Today we are told that the world is going to the sewer.

That is because the US, which has functioned as the only major ‘aggregate demand’ of the world, can’t live up to its role as it is undergoing a deep recession. In corollary, these experts further assert that the world won’t be able won’t replace the US as the provider of demand because of its sheer size. In other words, past performance guarantees tomorrow’s outcome.

Based on their economic premise, where supply exists only as a function of demand, then with today’s imploding private sector credit bubble, which has deeply dented the demand equation, must be replaced and absorbed by the government. Therefore, the government’s role MUST be to create artificial demand by printing up as much money in order to sustain the bursting bubble structure.

Tersely said, from the private sector, the credit bubble now is being reconfigured to one known as a government credit bubble. And this seems to be what we are seeing all around the world. From nationalization, “bad bank” or other means of government interventions, the idea is to transfer the leverage and the attendant losses to the government.

The same logic says that if Bernard Madoff was a fraud, and had operated on an unsustainable platform which didn’t last, the government’s insistence of operating on the same an unsustainable platform, but charged to the taxpayers and meant for the “good of the citizenry”, MUST SUCCEED. The difference was that Madoff was a felon, while governments sustaining bubbles for chimerical prosperity, are deemed as legitimate and for a good cause.

Unfortunately for Madoff, he was an individual and not privileged to conduct the same scheme which is equally being thrown to the public by governments. But the underlying principle of both Madoff and the governments is the same: to get something from nothing!

In other words, you resolve the problem of drug addiction by providing more drugs. If you are Madoff you get charged with drug pushing. But if you are the government, you receive plaudits for a fighting for a good cause.

In a reality check, unsustainable trends which can’t last, won’t! NO amount of the printing press nostrums will make illusions a reality.

Reality has finally landed in Zimbabwe. The Mugabe-Gono government finally capitulated to the marketplace realities by allowing the depressed African economy to trade in foreign currencies which in effect jettisoned the local currency, the Zimbabwe dollar. This also means the Mugabe-Gono government will fall soon. And in the same vein, all nationalizations or government guarantees are only as good as the real capital standing behind these.

Does the words of Karl Marx in Das Kapita in 1867…``Owners of capital will stimulate the working class to buy more and more of expensive goods, houses and technology, pushing them to take more and more expensive credits, until their debt becomes unbearable. The unpaid debt will lead to bankruptcy of banks, which will have to be nationalized, and the State will have to take the road which will eventually lead to communism"…ring a bell?

Fairy Tales Cures and Self Righteousness

Yet popular opinion believes in fairytale cures.

To call for market forces to rectify the situation, one risks being labeled as insane, inhuman or bloodless.

Nevertheless just look at level of desperation policymakers are into so as to consider ridiculous ideas to restore an unsustainable structure of economic growth:

-In déjà vu to the hog reduction program of the Great Depression of the 1930s, US policy makers are considering to boosts car sales via a program known as "cash for clunkers". (CNNmoney) Yes, the US government plans to buy and junk old cars so as to motivate its populace to buy new ones. If the policy gets enacted, this is going to be a waste of productive resources.

-Moreover, they are considering “to renegotiate mortgages it owns that might otherwise enter foreclosure” (Washington Post) or allow “bankruptcy judges to modify the mortgages of troubled homeowners” (Washington Post) all at the expense of the property rights of American people.

To add, not content with plans to impose tons of regulations on the national level, the statists have been contemplating on to expand impositions abroad. Signs of protectionism, which had greatly contributed to the Great Depression of the 1929, are surfacing in the political arena. At the confirmation hearing, Treasury Secretary Tim Geither unleashed what he “believes that China is manipulating its currency” (Wall Street Journal). In addition, the stimulus bill which was recently passed by Congress contained a “Buy America” rider (Washington Post).

All these actions seem to agitate for a mutually devastating global trade war.

And why would authorities engage in such potentially calamitous actions? We understand 3 possible things: economic ignorance, messianic complexity or plain political rhetoric.

Realities say that the US doesn’t produce enough, that’s why it incurs trade deficit. And a trade war would mean massive catastrophic shortages. Think oil. The US imports 60% of its oil requirements (CNNmoney). If world trade shuts, the economic implication would be a collapse in the US economy with a geopolitical implication of a possible World War 3.

And also considering that the US is the largest debtor nation in the world, it wouldn’t be far where a trade war would also extrapolate to an equally internecine debt default. And what’s to stop these interventionists fools from inciting a war economy or the misguided belief that only war, after everything else fails, can stimulate the economy?

Now we turn the tables and wonder who is insane, inhuman or bloodless? Does provoking a trade war which has dire consequences similar or worst in scale than the Great Depression a humane and charitable option? How altruistic is it, if the world goes into war out of the desire to stimulate the economy? How does hyperinflation as in the case of Zimbabwe lead to progress? How charitable can it be to live a world of self delusion?

Does the 2008 Global Trade and Production Collapse Signify Posttraumatic Stress Disorder?

If a bubble structure can be characterized by unrestrained credit creation, speculative excess seen in asset inflation and unparalleled concentration of financial wealth and power, then in as much as the massive wage or income disparities or “Shameful bonuses” in Wall Street relative to the average Americans had been a function of a bubble structure, the world’s production-supply chain structure have also been partly been built around the same bubble environment.

And today’s bursting bubble which has prompted for “demand destruction” has been met by more “supply destruction”.

Yet what seems to be remarkable has been the sharp collapse in global production and trade.

Figure 3: IMF World Economic Outlook: Collapse of Global Industrial Production and Merchandise Trade

The chart IMF’s World Economic Outlook demonstrates the seeming peculiarity of the last quarter’s world trade and production activities.

If you are to compare with the dot.com days or the previous bubble bust and its ensuing recession, you’d notice that the same trends went into a steady decline over a period of time (years). But this hasn’t been the case last year. The outright collapse in just ONE MONTH by both economic variables suggests that world suddenly stopped doing anything and merely watched in shock and awe!

And why would the world do that? The obvious answer is the shock emanating from the near meltdown of the US banking system subsequent to the Lehman debacle. This has been prompted for by the institutional bank run in the US banking system as discussed in last October’s Has The Global Banking Stress Been a Manifestation of Declining Confidence In The Paper Money System?

So contrary to mainstream views which ANCHORS upon this collapse as their basis for prediction, we suggest instead that this could be a function of a Posttraumatic stress disorder (PTSD) where according to Wikipedia.org, ``is an anxiety disorder that can develop after exposure to one or more terrifying events that threatened or caused grave physical harm.”

As an example, the 9/11 terrorist attack on the World Trade Center was graphically captured in living color by media. The repeated airing of the deplorable terrorist event heightened the fear of air travel which thereby caused a shift or substitution in some of the public’s traveling patterns.

And the shift emanating from the fear, resulted to more casualties from the higher risk land transportation.

According to a study The Impact of 9/11 on Driving Fatalities: The Other Lives Lost to Terrorism by Garrick Blalock, Vrinda Kadiyali, Daniel H. Simon, ``We find that driving fatalities increased significantly following the terrorist attacks of September 11, 2001, an event which prompted many travelers to substitute less-safe surface transportation for safer air transportation. After controlling for time trends, weather, road conditions, and other factors, we attribute an increase of 242 driving fatalities per month to additional road travel undertaken in response to 9/11. In total, our results suggest that about 1,200 driving deaths are attributable to the effect of 9/11. We also provide evidence that is consistent with the 9/11 effect on driving fatalities weakening over time as drivers return to flying. Our results show that the public response to terrorist threats can create unintended consequences that rival the attacks themselves in severity.”

Why is this so? According to Trevor Butterworth, ``Because fear strengthens memory, catastrophes such as earthquakes, plane crashes, and terrorist incidents completely capture our attention. As a result, we overestimate the odds of dreadful but infrequent events and underestimate how risky ordinary events are. The drama and excitement of improbable events make them appear to be more common.”

So given Mr. Butterworth’s tread, could we be “overestimating the odds of dreadful but infrequent events and underestimating how risky ordinary events are”?

Evidences of PTSD

Some evidences show we are.

One, global barter trade has been picking up. [see Does Growing World Barter Trade Suggests Of Bigger Cracks In Today's Monetary Order?]

According to the Financial Times, ``Officials estimated that they ranged from $5m for smaller contracts to more than $500m for the biggest.” It could be more. There have been accounts of barter since this episode has unraveled.

And the reported cause? ``Failure to secure trade financing as bank lending has dried up.”

The fact that governments have traded OUTSIDE the financial system, means demand and supply seems intact for basic necessities for them to conduct trade. The fundamental problem lies within the traditional means of facilitating payment and settlement via the banking system.

Two possible reasons why governments have been undertaking barter, which is a primitive method of trade:

One, the banking system remains dysfunctional despite the heavy interventions by global governments and

Two, there is a growing distrust for the present medium of exchange. The second finds a voice in Russian Prime Minister Vladimir Putin’s speech in Davos, ``Excessive dependence on a single reserve currency is dangerous for the global economy. Consequently, it would be sensible to encourage the objective process of creating several strong reserve currencies in the future. It is high time we launched a detailed discussion of methods to facilitate a smooth and irreversible switchover to the new model.”

The next evidence could be seen via the surging Baltic Dry Index see figure 4.

Figure 4: stockcharts.com: Rising Baltic Index=Rising Oil and Copper?

The Baltic Dry index according to the wikipedia.org is ``a number issued daily by the London-based Baltic Exchange. The index provides "an assessment of the price of moving the major raw materials by sea. Taking in 26 shipping routes measured on a timecharter and voyage basis, the index covers Handymax, Panamax, and Capesize dry bulk carriers carrying a range of commodities including coal, iron ore and grain.”

Plainly put, the Baltic Index is the cost of freight to move raw materials or basic commodities. It could be seen as a leading indicator.

So far the Baltic Index has risen by 60%, whereas oil and copper appears to be consolidating or “bottoming” even as the US dollar index has been going up. To recall, during the October-November collapse, the US dollar has inversely accompanied the rapid declines of the Baltic index as with the oil and copper.

The seeming divergence could be added signs of the diminishing influences of debt deflation.

Furthermore, even in the US, there are signs that production and inventory or supply destruction have been catching up with its counterpart demand destruction see figure 5.

Figure 5: Danske Bank: Is the US Manufacturing Sector Beginning to Recover?

These observations from the Danske Team (bold emphasis mine),

``First, prior to the recession the US manufacturing industry ran very lean inventories. Second, the liquidity squeeze from the credit crisis has led to an unusually fast alignment of production to demand fundamentals.

``Consequently, the pace of production is now undershooting the slowdown in demand. Hence, it will merely take stabilisation in demand growth to spark an industrial recovery.

The Danske team suggests that the first signs of recovery will be manifested over the ISM index which may stabilize and recover over the coming 3-6 months. In addition, a recovery in the ISM index will most likely add pressure to long US bond yields and signal stabilization in corporate earnings.

While I don’t necessarily share the optimism of the Danske team, the point is that the recent collapse have meaningfully adjusted both the demand and supply equation possibly enough to generate some market based (and not government instituted) revival.

So from growing world barter activities, buttressed by the rising Baltic Dry index, and a potential run down of inventories and similar downside adjustments in the supply side production could mean a semblance of restoration of global trade.

And if indeed the Danske Team is right about their forecast about the manufacturing recovery in the US, then this could signal a potential trough or nearing close of the US recession.

But then again, as a reminder, the cardinal sins in policymaking that could lead to prolonged bear markets: protectionism (nationalism, high tariffs, capital controls), regulatory overkill (high cost from added bureaucracy), monetary policy mistakes (bubble forming policies as negative real rates), excess taxation or war (political instability). Except for the last threat, the 4 seems likely a clear and present danger.

Will An Easing PTSD Lead To A Resurgent Asia?

Nonetheless, if the US supply side has adjusted to counterbalance the sharp fall in demand, then it is likely that the spate of sharp declines in the economic activities in most of Asia can be construed as the same degree of supply/production side adjustments.

Figure 6: DBS Bank: Asia’s Industrial Production Recovered earlier during the .com recession

Like in 2001, Asia’s heavy exposure to the technology sector hit exporters. Today, the sharp decline in US consumer spending has equally affected Asia’s exports as much as it also affected production. However, the sharp drop late last year could likely be explained by the Posttraumatic stress disorder (PTSD) emanating from the distress in the banking system.

But unlike in 2001, which saw Asia as floundering from the nasty side effects of the Asian Crisis, where there essentially had been no domestic demand, this isn’t the case today. Asia has simply grown bigger and more dynamic and with ample shield from its high savings enough to potentially generate its own demand.

The recent DBS bank outlook says it best, ``Asia now generates almost as much new demand every year as the US- and it is that fresh demand that’s the very definition of global growth. The US is still a key driver and will remain so for a long time. But it is not the driver it used to be.” (bold emphasis mine)

And the Economist seems to agree, ``The question is, might domestic demand now take up some of the slack? There are reasons to think so. Falling commodity prices are boosting consumers’ purchasing power, just as they squeezed it last year. More important is the impact of monetary and fiscal expansion…(bold emphasis mine)

And the Economist sings to be singing a tune similar to ours, ``Asia has never before deployed its monetary and fiscal weapons with such force. Every country across the region has cut interest rates and announced a fiscal stimulus. In previous downturns, Asian governments were often constrained by dire public finances or the need to support currencies. But most countries entered this downturn with small budget deficits or even surpluses. All the main Asian emerging economies apart from India have relatively low ratios of public debt to GDP.” (bold emphasis mine)

In our Will “Divergences” Be A Theme for 2009?, we brought up the Austrian economics explanation that ``market rate of interest means different things to different segments of the structure of production.”

In essence we believe that convergent actions by global central banks will ultimately lead to divergent responses based on the capital and production structure of every economy.

Where the same amount of rain is applied to a desert land, forest land or grass land, the output will obviously be different. And to complement the DBS and Economist outlook, we recently said ``this crisis should serve as Asia’s window of opportunity to amass economic, financial and geopolitical clout amidst its staggering competitors. But this will probably come gradually and develop overtime and possibly be manifested initially in the activities of the marketplace.”

So to refrain from overestimating the odds of dreadful but infrequent events and underestimate how risky ordinary events are, we revert to the study of Garrick Blalock, Vrinda Kadiyali, Daniel H. Simon who concludes, ``Although we are unable to identify precisely reasons for either the 9/11 effect or its weakening, the existence of the effect is consistent with theoretical models in behavioral economics and psychology of inaccurate assessment of risks by consumers and exaggerated adjustments to risk assessments. The fortunate weakening of the 9/11 effect may be attributable to consumer learning over time in response to environmental changes. For example, the perceived risk of flying may have declined with the absence of any further terrorist incidents since 9/11, or travelers may have become accustomed to the increased inconvenience of flying.”

No we don’t just read past data and project them to the future like most of the experts. Instead, we try to understand that human action, to quote Ludwig von Mises, is a purposeful behavior!

Cartoon of the Day: The Madoff Model

source indystar.com varvelblog

Madoff Ponzi Scam and Boom-Bust cycles

“At any given time there exists an inventory of undiscovered embezzlement in — or more precisely not in — the country’s business and banks. This inventory — it should perhaps be called the bezzle — amounts at any moment to many millions of dollars. It also varies in size with the business cycle.”- John Kenneth Galbraith, “The Great Crash of 1929”

``Commercial and financial crisis are intimately bound up with transactions that overstep the confines of law and morality shadowy though these confines be. The propensities to swindle and be swindled run parallel to the propensity to speculate during a boom. Crash and panic, with their motto of sauve qui peut induce still more to cheat in order to save themselves. And the signal for panic is often the revelation of some swindle, theft embezzlement or fraud” wrote Charles Kindleberger in Manias, Panics and Crashes.

When people generally feel safe, they take in more risk than is necessary even to the point of dispensing with the necessary appraisal or due diligence.

The recent boom bust cycle underscores this; for instance, institutions that bought into financial assets backed by questionable collateral did so because they put their trust on credit rating agencies, they reached for additional yields, they believed that they can “time” (or exit) the markets, they believed that the boom cycle was in a perpetual motion and most importantly, because everyone else have been doing it (herd mentality). And when the tide did go out, most of them got caught swimming naked, to paraphrase Warren Buffett.

Thus, it is no different when Bernard Madoff bamboozled $50 billion off from the who’s who list which includes top rated financial institutions among them banks, (e.g. BNP Paribas, Banco Santander, Fortis Bank Netherlands, HSBC Holdings, Nomura Holdings, Royal Bank of Scotland and etc.) insurers (CNP Assurances, Clal Insurance, Harel Insurance) and Hedge funds (Tremont Group Holdings, Fairfield Greenwich).

To consider, these institutions account for as supposedly smart money outfits since they are backed by an army of “elite professionals”, e.g. economists, accountants, risk managers, quants etc…). Yet at the end of the day, smart money seemed like everybody else; they got what they deserved because they substituted prudence with fad.

When something turnouts too good to be true they always end up as being a fleeting anomaly or a scam.

Yet markets can’t be blamed for these, in fact, there had been some efforts to expose the Madoff PONZI scheme (a fraudulent scheme which involves paying abnormally high returns to investors out of the money paid in by subsequent investors, rather than from the profit from any real business-wikipedia.org) from the private sector as Aksia, a firm that does due diligence on investment advisers or by trader Harry Markopolos, who in 1999 wrote that "Madoff Securities is the world's largest Ponzi Scheme," in a letter to the SEC (WSJ).

Figure 2 Wall Street Journal: US SEC budget

Unfortunately, the Security and Exchange Commission, as the oversight body with about 3,371 employees (as of 2007) and with a ballooning (almost tripling) of budget (see figure 2) has failed to detect the fraud until the recent bust conditions heightened risk aversion which ultimately forced the unraveling of the grandest fraud.

This only goes to show how bureaucracy almost always lags the social or market dynamics because to quote Ludwig von Mises in Bureaucracy, ``The bureaucrat is not free to aim at improvement. He is bound to obey rules and regulations established by a superior body. He has no right to embark upon innovations if his superiors do not approve of them. His duty and his virtue is to be obedient.”

Another, again it’s that feeling of safety but this time from the comfort of regulations that exposes people to more risk taking. As James Grant recently argued “the commission is worse than useless because not only is it always behind the curve, its very existence gives many investors a false sense of comfort that a big agency is looking after their interests.”

Regardless of boom or bust conditions it is our duty to conduct the necessary due diligence and depend less on government or its bureaucracy to their work for us, otherwise suffer from similar consequences of fools parting with their money as above. We should never keep our guards down because there will always be a prowling Charles Ponzi or Bernard Madoff in different forms.

As the Wall Street Editorial goes, ``There's a lesson here for investors and Congress. Instead of shoveling more money and power to the regulators who already had plenty of both, let's take care not to overregulate the people who actually warned about Mr. Madoff's miracle returns. Law enforcement is useful in punishing wrongdoers after the fact, which will deter some crooks. But expecting the SEC to prevent a determined and crafty con man from separating investors from their money is no more sensible than putting your life savings with a Bernard Madoff.”

Finally today’s environment brings other possible scams to the surface that have not been widely reported as in Colombia’s Ponzi DMG card and Canadian hedge fund run by Otto Spork dealing with glacier investments.

Yet the Madoff Ponzi scandal also reflects on today’s crisis which stemmed from the debacle of the previous credit bubble borne out of Ponzi financing “securitization-derivatives-shadow banking” structures.

As an aside, possible future crisis emanating from similar Ponzi type of operations, but are clothed with legitimacy as the Social Security entitlement program (AEIR, James Quinn) and the Fractional Reserve Standard (JS Kim, Dr. Ellen Brown) should be closely monitored.