Quotes of the Day: How QE ‘Forever’ Represents Regulatory Capture and Crony Capitalism

Both quotes from Randall Holcombe at the Independent Institute

On regulatory capture

The basic logic behind the capture theory of regulation is that while the general public is largely ignorant of the regulator’s activities, those in the regulated industries are well-informed, and pressure regulators for favorable regulation. Furthermore, information about regulated industries is largely under the control of those in the industry, and personal connections between regulators and the regulated also influence regulatory outcomes. The result is that regulatory agencies act as agents for those they regulate, not the general public.

The Federal Reserve Bank’s recent QE3 announcement that they will be buying $40 billion in mortgage-backed securities a month for an indefinite period of time is an excellent example of regulatory capture. Under Chairman Bernanke, the Fed has successfully pushed to increase its regulatory role over the financial industry, and Stigler’s capture theory would predict that the Fed, as a financial regulator, would act to benefit the financial industry it regulates…

Just like the government’s purchase of Chevy Volts, the Fed is creating demand for a product (morgtage-backed securities) that is in weak demand, for the benefit of the industry it regulates.

On Cronyism

The Fed is buying the products of the financial industry—the mortgage-backed securities—just like the Defense Department is buying Volts that are the product of GM. In both cases, the purchases are designed to increase the demand for a product the government wants to support, for the benefit of the producers of the product.

If there are any differences, they are (1) that, as I noted above, the Defense Department may actually have a use for automobiles, but the Fed has no use for mortgage-backed securities, and (2) the scale of the operation. There’s a big difference between a purchase of $60 million in total and on-going purchases of $40 billion a month. So, looking at these two examples, QE3 is much more clearly an example of crony capitalism—designed to benefit cronies in the real estate and financial industries—and QE3 is crony capitalism on a much more massive scale.

In Defense of Insider Trading

From Harvard Professor Jeffrey Miron (Hat tip: Bob Wenzel)

Most policymakers, along with the general public, believe that insider trading should be banned. Yet straightforward economic reasoning suggests the opposite.

The most obvious effect of a ban is delaying the release of relevant information about the fortunes of publicly traded companies. This means slower adjustment of stock prices to relevant information, which inhibits rather than promotes market efficiency.

Imagine, for example, that the CEO of a pharmaceutical company learns that a blockbuster drug causes previously unknown side effects. Absent a ban, the CEO might rush to sell or short his company’s stock. This would have a direct effect on the share price, and it would signal investors that something is amiss. Insider trading thus encourages the market to bid down the shares of this company, which is the efficient outcome if the company’s fortunes have declined.

Under a ban on insider trading, however, the CEO refrains from dumping the stock. Market participants hold the stock at its existing price, believing this is a good investment. That prevents these funds from being invested in more promising activities. Thus the ban on insider trading leads to a less efficient allocation of the economy’s capital.

Whether these efficiency costs are large is an empirical question. Short delays of relevant information are not a big deal, and the information often leaks despite out the rules. Thus, the damage caused by bans is probably modest. But efficiency nevertheless argues against a ban on insider trading, not in favor.

And bans have other negatives. Under a ban, some insiders break the law and trade on inside information anyway, whether by tipping off family and friends, trading related stocks, or using hidden assets and offshore accounts. Thus, bans reward dishonest insiders who break the law and put law-abiding insiders at a competitive disadvantage.

Bans implicitly support the view that individuals should buy and sell individual stocks. In fact, virtually everyone should just buy index funds, since picking winners and losers mainly eats commissions, adds volatility, and rarely improves the average, risk-adjusted return.

Thus, if policy is worried about small investors, it should want them to believe they are at a disadvantage relative to insiders, since this might convince them to buy and hold the market. Bans instead encourage people to engage in stupid behavior by creating the appearance – but not the reality – that everyone has access to the same information.

The ban on insider trading also makes it harder for the market to learn about incompetence or malfeasance by management. Without a ban, honest insiders, and dishonest insiders who want to make a profit, can sell or short a company’s stock as soon bad acts occur. Under a ban, however, these insiders cannot do so legally, so information stays hidden longer.

Thus, bans on insider trading have little justification. They attempt to create a level playing field in the stock market, but they do so badly while inhibiting economic efficiency

Information will always be asymmetric.

People do not read news or even mandated ‘public disclosures’ at the same time or at similar degrees. And people’s interpretation and absorption of information will be always be distinct.

I don’t read the newspaper by choice, so I am at a disadvantage on information or facts disclosed. Also, readers of broadsheets have different preferences, e.g some value the business section, some read sports, some prefer entertainment and so forth…

Yet this deficiency in information does not deprive me of the necessary knowledge required for investing overall. In short, the desire for information is about tradeoffs and preferences. Legal mandates will not equalize information dissemination.

And this applies to insiders as well.

The price channel is always the best medium for information (economic or fundamentals).

Importantly, a ban on insider trading or attempts to equalize information through restrictions of insider knowledge does not attain the political objectives intended, as pointed by Professor Miron. In reality, such regulations tilt the balance to favor transgressors.

Insider trading bans is another example of feel good arbitrary laws which in reality are ambiguous, uneconomical, and repressive, i.e. can be or has been used to intimidate or harass individuals or entities for political goals rather than to attain market efficiency.

Yet the ultimate violators of insider trading are central banks who have been manipulating the financial markets, through various means (QEs, swaps, zero bound rates, subsidies, etc...), all to the benefit of the banking system and other Fed cronies, as well as, regulators who erect walls of protectionism to protect favored political entrepreneurs (cronies) which enhances their company's stocks values.

Insider Trading: What is Legal isn’t Necessarily Moral

Cato’s Walter Olson has a splendid article on the recent controversy over alleged insider trading by some politicians

Mr. Olson writes, (italics original)

Washington has been buzzing for the past 48 hours over revelations that some of Capitol Hill’s best-known lawmakers have been making fortunes speculating in the stocks of companies affected by official actions, typically while in possession of market-moving inside information. Rep. John Boehner (R-OH), Senatorial wife Teresa Kerry and others made bundles trading in health companies’ stocks shortly before Congressional or executive-branch action affecting the companies’ fortunes. After closed-door 2008 meetings in which Fed chairman Ben Bernanke briefed Congress on the gravity of the financial collapse, some lawmakers dumped their own stockholdings or even placed bets that the market would fall. Rep. Nancy Pelosi (D-CA) got access to highly desirable IPO (initial public offering) stock placements, some in companies with business before Congress. And so on. Studies have found that lawmakers as a group reap far above-average returns on their investments—suggesting either that these politicians are among the world’s cleverest investors, or else that they are profiting from inside information. All this has been turned into a front-page issue thanks to Throw Them All Out, a book by Hoover fellow Peter Schweizer, whose findings were showcased the other night on 60 Minutes.

So the question is: is all this legal? While there’s some difference of opinion on the issue among law professors, the proper answer to that question is most likely going to be, “Yes, it’s legal.” As UCLA’s Stephen Bainbridge points out, existing insider trading law, developed by way of a long series of contested cases under the Securities and Exchange Commission’s Rule 10b-5, assigns liability to persons who are not corporate insiders if they are violating a recognized duty of loyalty to those for whom they work. As applied to the investment whizzes of the Hill, this implies that trading on inside information might be a violation if done by Congressional staffers (since they owe a duty of loyalty to higher-ups) but not when done by members of Congress themselves.

First of all, I am not certain about the validity of the alleged statistics. Unless the analysts, who uncovered the controversial wealth derived from supposed insider trading, have been privy to the personal accounts of the aforementioned politicians or entirely trust disclosures as being forthright, these figures should be seen with cynicism.

How do we ascertain if under the table deals (concessions, bribery and etc.) are being passed off or camouflaged as investment gains? In short, what distinguishes money laundering from insider trading?

Second, what is legal isn’t necessarily moral.

Are insider trading laws moral?

As Professor Philosopher Tibor Machan writes, (bold emphasis mine, italics original)

It is conventional wisdom to treat this version of insider trading as morally wrong because it supposed to adversely affect others by being unfair. As one critic has put it, “What causes injury or loss to outsiders is not what the insider knew or did, rather it is what they themselves [the outsiders] did not know. It is their own lack of knowledge which exposes them to risk of loss or denies them an opportunity to make a profit.” By the fact that these others do not know what the insider does know, they are harmed since they are not able to make use of opportunities that are in fact available, knowable to us.

But what kind of causation is it that fails to make a difference when it does not exist? If someone’s knowing a good deal has no impact on what another does, it cannot be said that any harm upon another had been caused by that someone. Certainly, had the other known what the insider knew, he or she could have acted differently. By not acting differently, he or she could easily have failed to reap advantages the insider did reap. But nothing here shows that the insider caused any harm, only that he or she had a better set of opportunities. Unless we assume that valuable information known by one person ought, morally—and perhaps legally—be distributed to all interested parties—something that would beg the most important question—there is no moral fault involved in insider trading nor any causation of harm.

In short, insider trading is fundamentally about asymmetric information or "a situation in which one party in a transaction has more or superior information compared to another" (investopedia.com) and its effect on the marketplace.

I might add that even if there have been symmetry of information, people’s interpretation of information have factually been nuanced or different such that diversity of thoughts leads to variable actions, and thus voluntary exchange. In reality, there will never be symmetry of information because of the variable factors people read or construe information.

So how does one establish “fairness” in information?

Again, Professor Machan, (bold added, italics original)

As this applies to insider trading, if I have a prior obligation to share my information with others, that is, a fiduciary duty to clients or associates, then it is not that the information is “from the inside” but that it is owed to others that makes my dealings morally and possibly legally objectionable. It is only in such cases that fairness is obligatory, as a matter of one’s professional relationship to others, one established by the promise made or contract one has entered into prior to the ensuing duty to be fair. It is only then that one cause injury by refusing to do what one has agreed to do, namely, divulge information prior to using it for oneself. Accordingly, Hetherington’s objection to insider trading is without moral force. What he should have objected to is the breaching of fiduciary duty, which may occur on occasion by means of failing to divulge information (possibly gained “from the inside”) that has been—perhaps even contractually— promised to a client.

Furthermore, if I have stolen the information—spied or bribed for or extorted it—again the moral deficiency comes not from its being inside information but from its having been ill gotten.

If there has been no established fiduciary duty then fairness or unfairness becomes another abstraction used by politicians as pretext to enforce control over the marketplace. Insider trading, thus, becomes subjective and arbitrarily determined by politicians and regulators

This leads us back to Mr. Olson’s conclusion (bold emphasis mine)

It is tempting to approach the new revelations the way an ambitious prosecutor might, trying to stitch together a test-case indictment from, say, the penumbra of the mail and wire fraud statutes bulked up with a bit of newly hypothesized fiduciary duty here and a little “honest services” there. But that’s not how criminal law is supposed to work: for the sake of all of our liberties, prohibited behavior needs to be clearly marked out as prohibited in advance, not afterward once we realize it doesn’t pass a smell test. But we are still free to deplore the hypocrisy of a Congress that has long been content to criminalize for the private sector—often with stiff jail sentences—behavior not much different from what lawmakers are happy to engage in themselves.

My conclusions

It is unclear whether politicians benefited from insider trading or from other shady deals which has been passed off as stock market investments, thus the alleged outpeformance.

Insider trading, as argued from a moral standpoint, without clear parameters of the how the inequitable distribution or the lack of knowledge affects other parties accounts for as an arbitrary law. Hence these can be used by politicians to harass some participants in the marketplace for political or personal goals, and thus can be construed as an immoral law.

Given that politicians have become above the law, this accentuates the unfairness or the unilateral nature of the ethically flawed insider trading law or regulations

Finally, politicization of the marketplace, bailouts, inflationism, green energy and other market manipulation which predominate today’s have been skewing gains in favor of political clients at the expense of society, so where has the prosecution on insider trading been?

Clearly, what is legal may not be moral as the insider trading law reveals.

P.S. The Philippines has seen its popular Insider trading Scandal via the BW Resources.

Don’t blame this on free markets but one of state corporatism or crony capitalism

As the PCIJ writes, (bold emphasis mine)

The machinations surrounding the operation of the BW Resources Corp. and its affiliated BW Gaming and Entertainment Co. were probably the height of presidential recklessness. To begin with, Estrada was Dante Tan's secret partner in BW, confirms Espiritu. That was why BW became the recipient of so many government favors: an online bingo license given in record time by the Philippine Amusement and Gaming Corporation (Pagcor), the state-owned gaming company; a P600-million loan from the Philippine National Bank that was approved even if the collateral was worthless land; and a contract from Pagcor that ensured the transfer of Pagcor operations to a building that BW was constructing in downtown Manila.

Moreover, as various officials attested during the impeachment hearing, Estrada intervened on behalf of Tan when he was being investigated by the Securities and Exchange Commission (SEC) for insider trading and stock price manipulation. The President also ordered Jimenez and ethnic Chinese businessmen Wilson Sy and Willy Ocier, whose speculative play in the market was believed to have caused BW prices to fall precipitously in late 1999, to return the money Tan had lost to shore up BW prices.

"That was the version of Dante Tan when I confronted him about it," says Espiritu. "That version was also confirmed by the brokers at the Philippine Stock Exchange." Face to face with an angry president, Sy and Ocier agreed to reimburse Tan's losses, according to prosecution lawyers in the Estrada impeachment trial. The payoff was supposedly made not in cash but in 650 million shares of Belle Corp. worth P1.5 billion. The shares were turned over not to Tan but to Estrada, who then supposedly sold them to SSS and GSIS at a profit of P800 million.

Such politically driven stock market manipulation has been fated to meet with divine justice.

President Estrada has been impeached (yes I know Mr. Estrada ran and placed second in the 2010 presidential elections), where the scandal had been part of the impeachment proceedings, and BW Resources crashed back to earth, where crony Dante Tan, reportedly lost lots of money and has fled country and reportedly is in Canada even if the courts eventually absolved him--which again reveals of the nebulousness of the law.

BW Resources (blue chart) [from my previous post]

Dealing With Financial Market Information

Ideas and only ideas can light the darkness. These ideas must be brought to the public in such a way that they persuade people. We must convince them that these ideas are the right ideas and not the wrong ones. The great age of the nineteenth century, the great achievements of capitalism, were the result of the ideas of the classical economists, of Adam Smith and David Ricardo, of Bastiat and others. What we need is nothing else than to substitute better ideas for bad ideas-Ludwig von Mises

Markets operate on a pricing system. And prices are manifestations of people’s actions guided and coordinated by information aimed at the efficient allocation of resources.

As the great F. A. Hayek wrote[1],

Fundamentally, in a system in which the knowledge of the relevant facts is dispersed among many people, prices can act to coördinate the separate actions of different people in the same way as subjective values help the individual to coördinate the parts of his plan.

The financial or capital markets (stock markets, bond, currency, derivatives, etc...) function the same way. They are information sensitive since they operate as intermediaries of savings and investments. Perhaps they even could even represent more information sensitivity than the real economy for the following reasons:

-Financial markets today are organized formal markets that are far larger than the economy

According to the table above from McKinsey Quarterly[2], despite the 2008 crisis, financial depth still accounted for 293% of the GDP (Here financial markets include equity, bank deposits, private and government debt)

-Financial markets are more globally integrated have been buttressed by the digital technology

-Financial markets are more liquid and volatile, and have been lubricated by the central banking based monetary system.

Of course not all information are equally useful or relevant.

There are information that are considered as useful or to quote Hayek anew “only the most essential information is passed on and passed on only to those concerned[3]” and that many information are not.

Furthermore information isn’t complete. They are dispersed, localized and account only for a portion of the system, writes author Peter L. Bernstein[4], (bold emphasis mine)

The past or whatever data choose to analyze, is only a fragment of reality. That fragmentary quality is crucial in going from data to a generalization. We never have all the information we need (or can afford to acquire) to achieve the same confidence with which we know, beyond a shadow of a doubt, that a die has six sides, each with a different number, or that a European roulette wheel has 37 slots (American wheels have 38 slots), again each with a different number. Reality is a series of connected events, each dependent on one another, radically different from the games of chance in which the outcome of any single throw has zero influence on the outcome of the next throw. Games of chance reduce everything to a hard number, but in real life we use such measures as “a little”, “a lot” or “not too much please” much more often than we use a precise quantitative measure.

Falsifying Popular Delusions

This brings us to the gist of what supposedly are useful information/ facts/ data sets for the financial markets.

Here is a great example, this isn’t being nostalgic for 2008 crisis but should be a thought provoking exercise

Information/Fact A

According to ABS CBN[5] (bold emphasis mine)

In a statement Sunday, the PSE reported that the combined net income of publicly listed firms dropped to P198.91 billion in 2008 from P281.54 billion in 2007, a banner year...

Lim noted, however, that revenues of listed firms grew 12.8 percent to P2.67 trillion from P2.37 trillion.

The recent data were culled from the latest financial statements submitted by 233 out of 246 listed companies. Of the 233 reporting firms, 159 posted net gains while the remaining 74 posted net losses.

Interpretation: Public listed companies were down from a RECORD highs in 2007 but remained overall positive. To add, 68% of publicly listed posted profits in 2008.

Information/Fact B

The above is the % change of the Philippine economy courtesy of tradingeconomics.com[6]

Interpretation: Like corporate profits, the Philippine economy slowed but did not suffer a recession in 2008.

Information/ Fact C

The Phisix closed at the end of 2007 at 3,621.6 and at the year end of 2008 at 1,872.85

Interpretation: The Phisix fell 48.28% in 2008!

Analysis:

Fact A partly reflected on Fact B because Fact A is part of the computation of Fact B, or corporate profits are part of the computation for the GDP[7]

Where the conventional wisdom is to generalize

Fact A (corporate profits) + Fact B (economic growth) = Fact C (rising stock markets),

then we see that three facts tells us the contrary

A+B ≠C

The conventional wisdom of A+B=C has been demonstrably falsified.

Let me add Fact D

According to Bloomberg at yearend of 2008[8],

The S&P 500 decreased 38.5 percent, the most since the 38.6 percent plunge in 1937, to 903.25 and sank to an 11-year low of 752.44 on Nov. 20. Volatility increased, with the index rising or falling 5 percent in a single day 18 times. The Dow Jones Industrial Average slumped 34 percent to 8,776.39 for the steepest drop since 1931.

Additional analysis: The Phisix did not suffer a recession or a crisis, yet the local stock market endured MORE losses compared to the epicentre or the source of the crisis—the US markets.

In short, there has been no meaningful correlation or even an established causation nexus between corporate profits and the economy relative to the stock market under the local setting.

Asymmetric Risk Taking

Why this matters?

Because any serious or prudent investors would attempt to pursue information or assimilate knowledge that are relevant or one that works, something which Nassim Taleb calls as “positive knowledge[9]”, and presumably ignore those that don’t.

Not every individual engaged in the stockmarket or the financial markets share the same incentives: instead of the primary pursuit for profits or returns, many are there for the adrenalin (thrill or the gambling tic) or to stimulate the dopamine “brain’s pleasure centers” (intellectual or ideological strawman), some are merely active for social purposes (signalling via talking points) or possibly to simply to keep busy.

The deviance from the pursuit of profits makes risk taking activities largely asymmetric.

Thus the demand for workable ‘positive’ knowledge in the financial markets would be proportional to the desire to generate real returns. We increase our profits by dealing with information or knowledge that will give us profits.

The famous Wall Street maxim, ‘bulls and bear make money but pigs get slaughtered’ are representative of market participants who see profits or returns as a secondary priority. Of course, everyone will likely say that they are in for profits but their subsequent actions will reveal of their unstated or subliminal priorities—or that actions should speak louder than words.

The great part in today’s marketplace is that the internet has allowed us vast access to information and on real time basis. This gives us the opportunity to screen information. And this also means that filtering information will tilt one into an information junkie to the risk of an information overload.

Again from Peter Bernstein[10], (bold emphasis mine)

We tend to believe that information is a necessary ingredient to rational decision making and that the more information we have, the better we can manage the risk we face. Yet psychologists report circumstances in which additional information gets in the way and distorts decisions, leading to failures of invariance and offering people in authority to manipulate the kinds of risk that people are willing to take.

In short information or facts can be tainted.

Agency Problem, Again

This brings us to the most sensitive part of information sourcing: the principal-agent or the agency problem

Economic agents or market participants have divergent incentives, and these different incentives may result to conflicting interests.

To show you a good example, let us examine the business relationship between the broker and the client-investor.

The broker derives their income from commissions while the investor’s earning depends on capital appreciation or from trading profits or from dividends. The economic interests of these two agents are distinct.

How do they conflict?

The broker who generates their income from commissions will likely publish literatures that would encourage the investor to churn their accounts or to trade frequently. In short, the literature will be designed to shorten the investor’s time orientation.

Yet unknown to the investor, the shortening of one’s time orientation translates to higher transaction costs (by churning or frequent trading). This essentially reduces the investor’s return prospects and on the other hand increases his risk premium.

How? By diverting the investor’s focus towards frequency (of small gains) rather than the magnitude. Thus, a short term horizon tilts the risk-reward scale towards greater risk.

Nassim Taleb has shown this in the analogy of the Turkey problem[11] as shown in the chart[12] above.

The Turkey is fed from day 1 and so forth, and as a consequence gains weight through the feeding process.

From the Turkey’s point of view such largesse will persist.

However, to the surprise of the Turkey on the 1,001th day or during Thanksgiving Day, the days of glory end: the Turkey ends up on the dinner table. The turkey met the black swan.

The turkey problem is a construct of the folly of reading past performance into the future, and likewise the problem of frequency versus the magnitude, both of which serves as the cornerstone for Black Swan events.

Going back, such conflict of interest may also apply to bankers too. Bankers are likely to publish literatures that goad their clients to use their facilities where the bankers earn from having more fees than focusing on the client’s interests of generating above average returns.

At the end of the day, for both cases the gullible investor ends up holding the proverbial empty bag.

So unless one is aware of such distinction, information embellished by statistics which may be construed as facts can instead represent promotional materials.

It is important to note that conflicts of interests emanating from the agency problem played a significant or crucial role during the bubble days that was also responsible for the last crisis[13].

In addition, the common practise of politicians and their apologists to present statistical facts to promote their interventionist agenda is another example of agency problems.

Most of these facts do not objectively represent the problems in a holistic sense, but instead are selectively chosen facts or data mined statistics that fits into their theories. These proposals are also usually wrapped in logical fallacies.

And most of their so-called solutions are usually framed with noble sounding intentions so that these will easily sell to the vulnerable voters. Little do the hapless voters know that such policies focuses on the short term are booby trapped with unintended consequences.

Conclusion: Ideas Have Consequences

Bottom line:

Ideas have consequences.

And so with ideas forged by false theories.

Prudent investors need to screen, test and falsify ideas and observe their validity rather than simply accepting them without due scrutiny. Failing to do so is to assume the risks of the proverbial Wall Street Pigs that have been the traditional fodder of Bears and Bulls.

Moreover, prudent investors should adapt on ideas that are likely to produce positive results over the long term at the same time reducing the prospects of being swallowed by black swan events.

In short, prudent investors need a critical and constructive mind to examine the usefulness of information as sources for ideas that underpins the subsequent action.

In addition, prudent investors must be vigilant with the source of information as this can reflect more of the interest of the information conveyor than that of the recipient.

---

[1] Hayek, Friedrich von, The Use of Knowledge in Society

[2] McKinsey Global Institute Global Capital Markets Entering a New Era, September 2009

[3] Hayek, Friedrich von ibid

[4] Bernstein, Peter L. Against The Gods: The Remarkable Story of Risk, p 121

[5] Abs-cbnNews.com Listed firms' profits down 29% in 2008, May 31, 2010

[6] Tradingeconomics.com Philippines percent change in GDP at constant prices

[7] Bureau of Economic Analysis, National Economic Accounts

[8] InfiniteUnknown.net U.S. Stocks Post Steepest Yearly Decline Since Great Depression, Bloomberg.com December 31, 2008

[9] Taleb Nassim Nicolas Anti Fragility, How To Live In A World We Don’t Understand, Chapter 5, How (NOT) To Be A Prophet fooledbyrandomenss.com

[10] Bernstein, Peter Op. cit. P.278

[11] Wikipedia.org Black swan theory

[12] Kinsella Stephan, The Turkey Problem

[13] See Agency Problem: Examples, Risks and Lessons, December 25, 2009

Agency Problem: Examples, Risks and Lessons

Here is an example of what we've been referring to as the agency problem or the conflict of interests that may result from different incentives guiding diverse economic actors or as defined by wikipedia.org "treats the difficulties that arise under conditions of incomplete and asymmetric information when a principal hires an agent, such as the problem that the two may not have the same interests, while the principal is, presumably, hiring the agent to pursue the interests of the former".



Gretchen Morgenson and Louise Story of the New York Times brings to spot a possible case, (bold emphasis mine),

``Goldman was not the only firm that peddled these complex securities — known as synthetic collateralized debt obligations, or C.D.O.’s — and then made financial bets against them, called selling short in Wall Street parlance. Others that created similar securities and then bet they would fail, according to Wall Street traders, include Deutsche Bank and Morgan Stanley, as well as smaller firms like Tricadia Inc., an investment company whose parent firm was overseen by Lewis A. Sachs, who this year became a special counselor to Treasury Secretary Timothy F. Geithner.

``How these disastrously performing securities were devised is now the subject of scrutiny by investigators in Congress, at the Securities and Exchange Commission and at the Financial Industry Regulatory Authority, Wall Street’s self-regulatory organization, according to people briefed on the investigations. Those involved with the inquiries declined to comment.

``While the investigations are in the early phases, authorities appear to be looking at whether securities laws or rules of fair dealing were violated by firms that created and sold these mortgage-linked debt instruments and then bet against the clients who purchased them, people briefed on the matter say."

Read the entire article here.

Meanwhile Professor Arnold Kling of econolib.org makes a good explanation (bold emphasis mine),

``One difference is that financial innovation often serves the purpose of regulatory arbitrage--devising an instrument to comply with the letter of regulation while evading its spirit. Another difference is that financial innovation often is used by clever Wall Street bankers to separate less sophisticated investors from their money. In that sense, it is sort of like innovation in stealing credit card information. In the case of bankers outsmarting their clients, you can blame the victims for failing to be wary or to protect themselves."

The obvious lesson is that people's actions are impelled by divergent incentives whether it be motivated by regulatory arbitrage, profits, innovation, reputation and etc...

The second lesson is that divergence could mean conflict of interests; the cost -benefits and risk-reward tradeoffs, aside from information or knowledge can be asymmetric and opposite to the interests of the other party.

Third, while the article's innuendo is one of 'market failure' via misrepresentation, the fact is that regulators themselves have different incentives from the private or non-public economic actors which could lead to myriad forms of conflicts of interest. In other words, trying to forcibly align incentives by means of added regulations will likely lead to more distortions and/or unintended consequences.

The fact that regulatory arbitrage exists, which could be construed as a cat-mouse dynamic, is a manifestation of how private economic actors work to always circumvent current regulations.

Also, the fact that regulatory capture is stereotyped mostly in industries that are heavily regulated implies that many economic actors collude with regulators (or politicians) to "game" the system (example, monopolies, special licensing, private-public partnership and etc...).

Fourth, it is also true that with the growing sophistication of markets, diversified security instruments may be used for hedging, than simply a one-direction trade, often seen in underdeveloped markets. Hence, unless governments opts to bring society, as represented by the markets, back to the medieval ages, the question of conflicts of interest could be contentious and signify as controversial gray area.

Lastly, the ultimate lesson is nailed by Professor Kling, "you can blame the victims for failing to be wary or to protect themselves."

This means that without understanding the incentives driving the source of your information or those whom you do business with, you can increase your risks.

``Risk comes from not knowing what you're doing” warns Mr. Warren Buffett, we'd further improve "risk comes from not knowing the incentives with those whom you are dealing with"

Should Filipinos Invest Abroad?

``No drug, not even alcohol, causes the fundamental ills of society. If we're looking for the source of our troubles, we shouldn't test people for drugs, we should test them for stupidity, ignorance, greed and love of power.”-P.J. O'Rourke, American Political Commentator, Journalist

In a recent discussion, a colleague raised the issue of whether locals should consider investing overseas given today’s financial globalization. My immediate reply was that there is no general answer to these concerns as this would depend on the distinct goals of each individual.

Some could see overseas investing as a way to tap overseas opportunities unavailable to the domestic market, others may contemplate on putting eggs into different markets or for portfolio diversification, some because of perceived higher returns or lower transaction costs, some for tax purposes or “recycling of funds” or some for just plain curiosity or even vanity (the need to feel sophisticated).

Nonetheless, global retail overseas investing has been a growing trend supported by the ongoing integration and the deepening of financial markets, technology advances such as real time online trading platforms, relaxation of capital flow regulations and the lowering of so-called Home Bias.

As an example, we previously mentioned of the metaphorical Mrs. Watanabes of Japan, an embodiment of retail investors who, because of their high savings and nearly zero interest rates, have used the international currency market to enhance returns, which became an important foundation of the global carry trade arbitrages.

According to the Economist, the ``Mr and Mrs Watanabe account for around 30% of the foreign-exchange market in Tokyo by value and volume of transactions, according to currency traders, double the share of a year ago. Meanwhile, the size of the retail market has more than doubled to about $15 billion a day.” (highlight mine)

For those who are contemplating to undertake offshore investments should consider the risk-reward tradeoffs than simply plunging into the pool without appropriately understanding the risks involved. As Warren Buffett cautioned, ``Risk comes from not knowing what you're doing.”

Risks From Direct Investing

Here is a rundown on some of the risks we need to consider when investing abroad:

1. Currency Risk-

As defined by Investopedia.com, ``A form of risk that arises from the change in price of one currency against another. Whenever investors or companies have assets or business operations across national borders, they face currency risk if their positions are not hedged.”

As an example, you may gain 10% from your equity investments abroad but a corresponding 10% loss in the currency from which your equity investments are denominated effectively offsets your gain. A worst case would be to see your equity investments values fall in a currency that is also losing- a double whammy!

The important point is that investing abroad requires the comprehension of the fundamental dynamics of the currency market.

This perhaps is the main reason why the Mr. and Mrs. Watanabes opted for the carry trade arbitrage in the currency market which has now evolved into a $3.2 trillion a day turnover than from equity investments, because currency trading signifies as the simplest route to access offshore opportunities.

In other words, you only have to deal with the currency equation without having to complicate your investing perspective with other risk concerns.

As an aside, this is where home bias has a defined advantage for equity investments, simply because you reduce the risk of currency volatility or your risk spectrum is mostly confined to domestic related influences or variables.

Hence, the optimum goal in investing overseas is to profit from investments on a market that has both an upside potential on the currency and the equity aspects.

2. Beta Risk-

As per Investopedia.com, ``Beta is a measure of a stock's volatility in relation to the market. By definition, the market has a beta of 1.0, and individual stocks are ranked according to how much they deviate from the market. A stock that swings more than the market over time has a beta above 1.0. If a stock moves less than the market, the stock's beta is less than 1.0. High-beta stocks are supposed to be riskier but provide a potential for higher returns; low-beta stocks pose less risk but also lower returns.”

Essentially such risk measure is one of correlation of a market (or a benchmark) among other markets or of individual stock or sectoral benchmark relative to its operating market; see Figure 1 as our example.

Figure 1: Danske Bank: Correlation of EM Markets (left) and Global Equity-Financials (right)

In today’s generally deteriorating equity markets, we see the US markets, despite being the epicenter of the crisis, outperforming Emerging Markets (EM). Of course, the chart’s perspective comes from a one year period and doesn’t show the larger picture. Prior to the crisis EM benchmarks have markedly outperformed the US; where, in spite of the present losses, EM continues to outperform over the past 5 years (remember framing matters).

From here we can deduce that EM markets tend to outperform during better days and underperform during periods of stress. The broad implications to portfolio allocations would be to long EM once the recovery is in the horizon and long US markets when the world tilts to a crisis, although perhaps an alternative proposition would be to long Gold or traditional currency havens as Swiss Franc or Japanese Yen for the latter scenario. This also suggests that in order to distribute or dissipate risk requires the arbitrage of different asset classes in different markets around the world.

Another, the left pane illustrates how Financials stocks have been tightly correlated with the general global equity bellwether. While Financial stocks have suffered more than the bellwether of global ex-financial stocks, the strains of the former has likewise generated a downside trajectory to the latter, the causality of which generally accounts for the function of macroeconomic links (see below).

It doesn’t make sense to invest in a market which is highly correlated to your base market unless your goal is to tap industries that are unavailable to the local market. Therefore, if the objective to invest abroad is to diversify, then the ideal approach would be to deal with markets that have either a low or negative correlation.

3. Macroeconomic risk-

Macroeconomic risk generally deals with the performance, structure, and behavior of a national or regional economy as a whole (wikepidia.org).

Figure 2: wikipedia.org: Macroeconomics Circulation

The fundamental reason why the world has been suffering from a growth slowdown or the financial markets agonizing from heavy losses is due to the fundamental impairment of the financial channels (market and banking) whose transmission mechanism is clearly demonstrated above in figure 2.

The tightening of credit conditions from the US led housing-securitization bubble bust have effectively been raising the cost of capital, eroding corporate profits, decreasing business expenditures, magnifying losses in asset holdings among public and private institutions, prompting for the balance sheet restructuring by reducing leverage in private institutions, contracting consumer demand, raising unemployment, lowering prices of commodities and increasing government intervention in markets. And this weakness has been spilling over to the world.

Thus, the recent liquidity contraction translates to a magnified purview of the financial and economic structure of each nation under present turbulent conditions.

Said differently, the performance of markets in reaction to the gummed or gridlocked credit markets and economic downdraft has probably been a reflection of: one) the depth of interconnectedness of a country to the world via trade/financial/political channel, or two) the overall vulnerability of a country’s economic framework.

In essence, macroeconomic risks deal with the risks of an investment theme relative to economic output, national income, inflation, interest rate, capital formation or savings and investment, consumption, fiscal conditions and international trade and finance.

Thus, investing abroad means understanding how economic, financial and political linkages could impact your portfolio.

3. Taxation and Transactional Cost Risk-

From Reuters financial glossary ``The risk that tax laws relating to dividend income and capital gains on shares might change, making stocks less attractive.”

Whereas transaction cost means ``cost incurred in making an economic exchange” (wikipedia.org) which involves the “search or information” cost (search for availability of goods or securities in a specific market), “contracting” cost (cost of negotiation or bargaining) and “coordination/policying and enforcement” costs (meshing of different products and process aside from cost of enforcing the terms of contract) [wikipedia/wikinomics].

This means that prospective investments in overseas market requires the understanding of risk dynamics from the underlying cost structure of the present taxation regime of the host market, aside from its potential changes.

Taxation is part of the transaction costs that could determine the viability of investing overseas. Lower cost of transactions could function as a critical variable if only to wring out additional profits or returns from an economies of scale standpoint.

4. Liquidity Risk-

As defined by investorwords.com, ``The risk that arises from the difficulty of selling an asset. An investment may sometimes need to be sold quickly. Unfortunately, an insufficient secondary market may prevent the liquidation or limit the funds that can be generated from the asset. Some assets are highly liquid and have low liquidity risk (such as stock of a publicly traded company), while other assets are highly illiquid and have high liquidity risk (such as a house).”

In short, liquidity risk can mean the tradeable-ness of a given security or market.

This is somewhat related to the transaction cost where the more liquid or scalable a market is translates to lesser transactional cost.

Example, the Philippine state pension fund Government Service Insurance System (GSIS) has allotted some $1 billion, which makes up around 12% of GSIS’s total loans and investment portfolio for its global investment programme.

This dynamic can be lucidly seen from the AsianInvestor.net article (highlight mine), ``The GSIS will have a tough time generating returns for its members if it continues to stick with Philippine shares because of limited choices and relatively low volume. Low interest rates and the absence of a strong secondary fixed-income market in the Philippines are also constraints.”

Thus, a prospective overseas investor needs to aware of the liquidity conditions of the market or of the specific issues which one intends to deal with.

5. Political and Regulatory risks-

Political risk is a broad definition which essentially encompasses the changing nature of a country’s political structure. This from investorwords.com ``The risk of loss when investing in a given country caused by changes in a country's political structure or policies, such as tax laws, tariffs, expropriation of assets, or restriction in repatriation of profits. For example, a company may suffer from such loss in the case of expropriation or tightened foreign exchange repatriation rules, or from increased credit risk if the government changes policies to make it difficult for the company to pay creditors.”

Such risks get accentuated when government becomes more adverse to private sector participation or to market oriented economic platforms (e.g. Venezuela and Bolivia) or when government policies run roughshod over its constituents (e.g. Zimbabwe) or with its neighbors (e.g. Russia).

As we have noted in Phisix: Learning From the Lessons of Financial History, trade, current account and fiscal surpluses, high forex reserves, low debt or favorable economic or market conditions can be radically overturned by 5 cardinal sins in policymaking; namely-protectionism (nationalism, 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).

Whereas Regulatory risks are political risks applied more to specific sectors; from investopedia.com, ``The risk that a change in laws and regulations will materially impact a security, business, sector or market. A change in laws or regulations made by the government or a regulatory body can increase the costs of operating a business, reduce the attractiveness of investment and/or change the competitive landscape.”

Hence it is imperative for any overseas aspiring investor to anticipate risks of policy changes that could negatively impact an investing environment.

6. Other Risks

Of course there are other domestic risk issues to deal with such as valuation risks (financial valuation ratios), leverage risks (risks due to debt related exposure) or company specific risks (labor, management, etc.).

Risks From Indirect Investing

Nonetheless one may argue that you can deal with foreign markets through a variety of funds, such as Exchange Traded Funds, ADRs, Hedge funds, mutual funds or trust related funds sold by banks (UITFs) or insurance companies.

But as we previously noted there are issues like:

A. Principal-Agent Problem

This deals with the conflict of interest by investors when dealing with other market participants because of differing goals mostly due to the varied business models. For instance, investors would be mostly concerned about profits or returns on investment (ROI), whereas most brokers would be concerned with the commissions from client transactions while mainstream bankers or fund managers would be interested with the fees generated from the products they sell.

Thus, when bankers, fund managers or brokers issue their inhouse literatures they are mostly designed to sell the products or services they offer than to meet the investor’s objectives.

As Legg Mason’s Michael Maubossin writes in the Sociology of Markets, ``agency theory is relevant because agents now control the market. And, not surprisingly, agents have very different incentives than principals do. And this game is close to zero sum: The more the agents extract, the lower the returns for the principals.”

B. Asymmetric Information

``A situation in which one party in a transaction has more or superior information compared to another. This often happens in transactions where the seller knows more than the buyer, although the reverse can happen as well. Potentially, this could be a harmful situation because one party can take advantage of the other party’s lack of knowledge.” (investopedia.com)

Applied to the financial markets this means that sellers of financial products have more information than the buyer or clients. Thus, clients or investors are likely to submit to the whims of the finance manager, who are usually not invested. In other words, many people have committed their trust and money to fund managers or bankers who don’t even have much stakeholdings in the funds they manage except via fees or profits.

From Chuck Jaffe (marketwatch.com), ``In 46% of the domestic stock funds surveyed, the manager hadn't invested a dime. Other asset classes were far worse with nearly 60% of foreign stock funds reporting no manager ownership, two-thirds of taxable bond funds having no managers with money in the fund, up to 70% of balanced funds having no manager cash and some 78% of muni bond funds having shareholder cash only.”

Besides, investors who bought into funds are subject to information asymmetries on how fund managers or bankers allocate their portfolios. The risk strategies employed by fund managers may not square with the overall risk appetite of the investor or investment managers could be taking in more risks than would be tolerated by their clients.

How Distorted Incentives Contributed To The Mess

How does this relate to investing overseas?

First, no institutions are insuperable. The idea that funds are backed by big institutions should be questioned or scrutinized by every investor here and abroad.

As the lessons from Enron (formerly 7^th largest corporation in America) in 2001, the recent fall of the 158 year old Lehman Bros (formerly 4^th largest investment bank in the US) and American International Group (largest insurance in the US), fund managers and bankers are not immune to cognitive biases of the herd mentality whose agency problem, because of the desire for more share in the fees derived from profits piled into more leverage and momentum despite being aware of the unsustainable trend and compounded by guiding principle of implicit guarantees of government bailouts, helped triggered the colossal overspeculation fueled by monumental overleverage. It’s not their money anyway.

Evidence? Look at the performance of the $1.9 trillion hedge fund industry (Wall Street Journal), ``Nine out of every 10 of the 4,000 hedge funds surveyed globally by data provider Eurekahedge are performing insufficiently well to beat their high-water mark–the level at which they can charge performance fees, equivalent to a fifth of returns.

``All but 3% of funds of hedge funds were under the mark, according to the survey, as were 90.6% of equity long/short funds, 86% of portfolios focusing on market events, 85.4% of those investing in distressed securities, and 82.6% of futures managers. The picture was also bleak for long-only absolute return funds, 96.5% of which were below their high-water mark. The survey used figures compiled for July 31–the most recent available–and are likely to have worsened since then.”

To consider hedge funds have the ability to trade and profit even on when the market moves to the downside, except for the recent ban on short selling on 950 financial stocks which clearly handicapped their strategies.

Moreover, the agency problem and the information asymmetry dynamics had clearly been a functional component in the bubble formation when investment banks turned into the “originate and distribute models”-where they packaged and sold low quality or subprime mortgages or distributed credit risk, in complicity with the seal of goodstanding from credit rating agencies who ironically derive their revenues from the originators (effectively distorting the incentives to be objective appraisers), to equally unthinking clients or institutions worldwide. Thus, when the bubble imploded, the negative externalities caused by failed government policies espoused and profited by institutional oligopolies borne out of the cartelized financial system will once be folded into the arms of the US government whose concentration risks to the remaining institutions have equally been amplified.

Summary and Recommendations

To recap, to invest overseas isn’t the same as to invest locally primarily because of more risks concerns; particularly currency, beta, macroeconomic, taxation and transactional cost, liquidity, political and regulatory risks and other domestic related risks.

In addition, to rely on indirect exposure abroad via institutional products isn’t as risk free as portrayed by some, or impervious to the corrosive effects of principal-agent and the asymmetric information problem as recent events have clearly shown.

Big institutions have failed and will possibly go under the wringer as the world’s financial system adjust from taking up too much debt more than it can afford. The global credit crisis basically is a consequence of global financial institutions not knowing “who holds what” (similar to the Old maid game), thus we can’t really know who among the big financial players will remain standing or “strong” until the fog from the battlefield has lifted. What we understand is that Asian institutions are supposedly the least impacted compared to their counterparts because of the rear view mirror effects from the Asian Crisis.

The lesson for every investor is to increase their financial literacy and do their homework under some of the risk guidelines as presented above.

For beginners, before trying out overseas investment I suggest for you to get your hands dipped into the local market. Vanity won’t do you any good because tuition fees can be very costly and emotionally distressful. Once you gain experience via the learning curve, you can begin to dabble with markets abroad.

Refrain from the assumption that all markets operate similarly, as advocated by many hardcore technicians, because they aren’t. To analogize using George Orwell’s Animal Farm, ``All animals are equal, but some animals are more equal than others.” In addition, the supposition that markets contain all the information isn’t true as the information asymmetry dynamics above suggests.

It would be recommended that you should use the international markets to compliment your overall portfolio strategy by either going for opportunities not accessible in the domestic markets or to diversify to less correlated markets or to hedge your portfolio using intermarket arbitrage.

Finally, be cognizant of the possible conflict of interest when dealing with institutions whose economic model and incentives are different than yours.