Infographic: Dodd Frank-enstein

How burgeoning financial regulations will kill productive enterprises.

For a crispier view of the graphic proceed to Bob Wenzel's EPJ site here

From Amy Payne of the conservative Heritage Morning Bell

There’s a reason the financial regulation law has been called “Dodd-Frankenstein.” This monstrous creation will swell the ranks of regulators by 2,849 new positions, according to the Government Accountability Office. It created yet another new bureaucracy called the Consumer Financial Protection Bureau (CFPB) that has truly unparalleled powers.

This new bureau is supposed to regulate credit and debit cards, mortgages, student loans, savings and checking accounts, and most every other consumer financial product and service. And it’s not even subject to congressional oversight.

Frighteningly, the CFPB’s regulatory authority is just as vague as it is vast. More than half of the regulatory provisions in Dodd–Frank state that agencies “may” issue rules or shall issue rules as they “determine are necessary and appropriate.”…

The results of this haphazard regulation are dire, Katz says, because “consumers will experience tight credit, higher fees, and fewer service innovations. Job creation will suffer.” She adds that “financial firms of all sizes are shelling out hundreds of millions of dollars for regulatory compliance officers and attorneys rather than making loans for new homes and businesses.”

So the law that was supposed to fix the financial sector—and created something called the Consumer Financial Protection Bureau—is hurting consumers rather than “protecting” them. Congress should repeal Dodd-Frank before it can do any more damage.

Dodd Frank is an example of arbitrary statutes that leads to regime uncertainty which adds to the prevailing economic and financial uncertainty.

Regime Uncertainty: Dodd-Frank

Regulations can be a major source of risk and uncertainty. Repressive and arbitrary regulations may diminish the entrepreneurs incentives to invest or allocate capital to productive ventures which in aggregate adds to economic woes.

Peter Klein at the Independent Institute quotes Peter Wallison on the adverse effects of the Dodd Frank law

“The question is why—why did this act have such a dramatic effect on the U.S. economy, essentially stifling the modest recovery that had begun almost a year earlier? The most likely explanation is uncertainty. The Dodd-Frank Act was such a comprehensive piece of legislation—and required so many new regulations before its effects could be fully evaluated—that many financial institutions and firms simply decided to wait for regulatory developments before expanding, hiring new workers, or rehiring workers who had previously been laid off. . . .

Following the precept of the president’s then-chief of staff Rahm Emanuel that “You never want a serious crisis to go to waste,” the law was rushed through Congress only 18 months after the Obama administration took office and 13 months after the first draft of the law was available to Congress and the public. This would have been warp speed for any one of the major provisions in the act. For a law with dozens of complex, radical, and occasionally contradictory provisions, adopting it so quickly and with so little real understanding of its effects verged on dereliction of duty.

Once business firms got a look at the language, they realized that they would have to change their financing arrangements in significant ways, and the costs were largely unknown.

Regime Uncertainty: Assault on Private Property Rights

Professor Robert Higgs explains, (bold emphasis mine)

it has to do with widespread inability to form confident expectations about future private property rights in all of their dimensions. Private property rights specify the property owner’s rights to decide how property will be used, to accrue income from its uses, and to transfer these rights to others in various voluntary arrangements. Because the content of private property rights is complex, threats to such rights can arise from many different sources, including actions by legislators, administrators, prosecutors, judges, juries, and others (e.g., sit-down strikers, mobs).

Because of the great variety of ways in which government officials can threaten private property rights, the security of such rights turns not only on law “on the books,” but also to an important degree on the character of the government officials who administer and enforce the law. An important reason why regime uncertainty arose in the latter half of the 1930s, for example, had to do with the character of the advisers who had the greatest access to President Franklin Roosevelt at that time—people such as Tom Corcoran, Ben Cohen, William O. Douglas, Felix Frankfurter, and others of their ilk. These people were known to hate businessmen and the private enterprise system; they believed in strict, pervasive regulation of the market system by—who would have guessed?—people such as themselves. So, as bad as the National Labor Relations Board was on paper, it was immensely worse (for employers) in practice. And so forth, across the full range of new regulatory powers created by New Deal legislation. In a similar way, the apparatchiki who run the federal regulatory leviathan today can only inspire apprehension on the part of investors and business executives. President Obama’s cadre of crony capitalists, which he drags out to show that “business is being fully considered,” in no way diminishes these worries.

Thus, regime uncertainty is a multifaceted and somewhat nuanced concept. Many economists don’t like it because it cannot be measured and compiled along with other standard macro variables in a convenient data base.

Read the rest here

Every time governments intervene in the marketplace someone’s property rights gets affected. The unintended consequence is risk aversion from heightened atmosphere of uncertainty.

Global Markets Violently Reacts To Signs Of Political Panic

``Obviously the thing to do was to be bullish in a bull market and bearish in a bear market.”-Jesse Livermore

We don’t share the view with the Perma bears that this is the return of the bear market.

A technical trend break in chart trends does NOT automatically translate to a bear market. Besides charts are a menagerie of past information which does not suggest any infallible concept about the future outcomes.

And neither was last week about world credits being repriced nor about the adverse debt developments in the US.

Figure 4: Danske Bank: German short-sell ban rattles markets

To the contrary, sovereign debt papers of the US, Germany and Denmark were chief beneficiaries of last week’s turmoil (see figure 4 right window). So while we are seeing some emerging tensions in money markets via interbank funding rates (left window), they are yet substantially distant from the cataclysmic heights in post Lehman episodes of 2008.

Of course the $64 billion question is, are we headed there? My reply is a likely no.

Why?

Because most of adherents to this school sees markets as being immobilized by debt, which is simply not true.

To quote Murray Rothbard[1], (bold highlights mine)

``What deflationists always overlook is that, even in the unlikely event that banks could not stimulate further loans, they can always use their reserves to purchase securities, and thereby push money out into the economy. The key is whether or not the banks pile up excess reserves, failing to expand credit up to the limit allowed by legal reserves. The crucial point is that never have the banks done so, in 1990 or at any other time, apart from the single exception of the 1930s. (The difference was that not only were we in a severe depression in the 1930s, but that interest rates had been driven down to near zero, so that the banks were virtually losing nothing by not expanding credit up to their maximum limit.) The conclusion must be that the Fed pushes with a stick, not a string.”

UNLESS this time is different I simply can’t see how Zero interest rates combined with suppressed inflation will prompt for catastrophic markets.

Throughout Japan’s lost decade, as we previously discussed[2], we haven’t seen her market’s crash when interest drifts at the zero level.

While it may be true that government actions in solving today’s predicaments may be reaching diminishing returns, zero interest rates and dampened inflation provides government extended leeway to conduct activities as noted by Mr. Rothbard above.

And while Eurozone[3] and the UK[4] have been witnessing accounts of rising consumer price inflation to a 16 and 17 month highs respectively, they haven’t reached levels that could stymie government actions.

Moreover, as previously noted[5], the premise of diminishing returns is exactly the main reason why the scale of rescues have been constantly swelling. Unless we see global governments willing condescend to market forces, and accept the limits of central banking, this isn’t likely to happen yet.

But recent events only prove that this is exactly in the opposite direction.

Germany’s Signs Of Desperation

Just last week, the arrogance of trying to prevent markets from revealing the true nature of balance sheet impairments of subprime Europe prompted Germany’s chancellor, Angela Merkel, to slap a ban on naked short selling on credit derivatives, euro bonds and select financial equities[6].

European authorities similar to Filipino voters have little incentives to learn from past experiences. Never mind that the US tried the same approach in the wake of the Lehman bankruptcy that exacerbated if not helped triggered the October 2008 crash.

And we seem to be seeing the same market response.

According to the Danske Research Team[7], ``The reason for introducing the ban on naked short-selling is that BaFin wants to reduce the extraordinary volatility that has been witnessed but the immediate market reaction suggests that the contrary has been accomplished and the euro has weakened further against the dollar. In the credit market, sovereign CDS tightened dramatically (short covering) whereas the corporate indices widened – the reason probably being the uncertainty that has been created in the playing field.” (bold highlights mine)

So regulatory risks has been exacerbating the market’s meltdown.

To wit, there have been accounts of massive capital flight[8] from Germany to Switzerland, which according to some reports, prompted heavy foreign exchange intervention[9] by the Swiss National Bank (SNB).

Moreover, there have also been emerging signs of political schism in the Eurozone, the surprise ban on short sales, which had purportedly been meant to shore up political support for Germany’s approval of the Euro’s bailout, hasn’t been well received by France[10], while other EU nations remain undecided. The following day the Germany approved of the bailout[11].

Earlier much of EU’s actions have been tilted in favour of France; where Germany argued for Greece to solve her own problems while France favoured a bailout and where Germany was initially in favour of marginal support while France’s Sarkozy wanted a “shock and awe”.

According to Gordon Long[12], ``It's in Sarkozy’s interest to fight for a US-like Keynesian solution with excess money printing. This would "kick the can down the road" and avoid an impossible "austerity cuts" war with French unions and workers.”

Obviously we seem to be witnessing public choice theory at work anew, where political self-interest interests among policymakers continue to trump the markets.

So political risks from the discordant and unilateral policies seem to be worsening the uncertainties in the marketplace. And this has led to last week’s market carnage.

Moreover, one can infer that these actions signify as signs of panic and act of desperation by EU authorities. So while governments in panic can be indicative of a bottom or present itself as buying opportunities, the obverse side is that desperate actions can lead to reckless policies that could backfire. The ban in naked short selling is an example.

But as we have long been pointing out[13], politics will be the order of the day. And to this point we are being validated anew.

So until we see signs of restoration of order and confidence in terms of policymaking, the likelihood is for continued volatility in global markets.

But I’d like to reiterate that that this isn’t the 2008 meltdown, where most of the actions from last week seem to emanate from regulatory risks and from political risks rather than from a seizure in the banking system caused by quasi ‘electronic’ bank runs and the subsequent drying up of trade finance.

In short, the nature of market stress has been entirely a different animal.

Even the Federal Reserve’s swap facilities which it has recently reopened, has had less takers, if not entirely “no new demand”[14]. This hardly implies of credit stress but again most likely from political and regulatory oriented strains.

Furthermore, there is a chasm of a difference between administrative politics and the politics in the financial-economic sphere. The latter is where markets have been greatly influenced as the drama in the Eurozone has exhibited.

Contrasting China And EU’s Predicament

Finally I’d like to point out that there’s a big difference between the developments in China and the Eurozone.

In China, governments have been fighting a brewing bubble by attempting to contain surging asset prices, particularly property prices, from credit expansion. (see figure 5)

Figure 5: US Global[15]/ Danske Bank[16]: Money Supply and Inflation

In Europe, governments have been trying to contain the debt crisis by inflating the system.

In other words, you have two (set of) governments fighting different monsters with slightly opposite measures.

As you can see in the left chart, China’s money supply appears to be shrinking. And this may have prompted for the recent collapse in Shanghai Stock Exchange (SSEC) and a possible easing of her property markets.

And as pointed above, the bubble strains isn’t just being manifested in surging property prices but also in consumer price inflation (right chart).

Hence in my view, the odds of a bust look greater in China than in Europe at the present moment, considering that rising consumer price inflation and asset bubbles are likely to retrain the hand of the authorities. Although markets appear to be saying that both are in a bust now, I wouldn’t bet on it.

As noted above, governments coordinating to pump massive amounts of money into the system will have to go somewhere.

Moreover, austerity measures that should affect economies such as Greece is only a sliver to the economic recovery being seen in most of the Euroland, Spain and Italy included (see figure 6)

Figure 6: Danske Bank[17]: Euroland: Between robust data and political risk

Europe’s manufacturing indices PMI appears to be at an upside momentum while business surveys IFO remain positive, in spite of the unravelling crisis.

So unless you expect the markets to suffer from more convulsions out of concerted shrinking of supply of money, which will be the only way for a coordinated meltdown, possibly through simultaneous collapses in the banking system, I highly doubt this scenario would occur.

Especially not with governments putting implicit, if not explicit guarantees, in the banking system, and especially not with governments frantically throwing money at every known social problem.

Of course, the other major risk would be to severely impede or even restrict movements in the capital markets, but that would be opposing the interests of the banking system from which global governments have toiled so hard to save.

As previously shown, governments can put them to public trial for theatrics, but at the end of the day, they’d scamper to rescue once signs of distress emerge.

The recently passed new financial regulation bill in the US will hardly change the politics of banking cartels and the central banking system.

And as the EU drama shows, rules will be bent for political conveniences.

---

[1] Rothbard, Murray N. Lessons of the Recession Making Economic Sense p.220

[2] See What Has Pavlov’s Dogs And Posttraumatic Stress Got To Do With The Current Market Weakness?

[3] Bloomberg, European Inflation Accelerates, Exports Increase

[4] BBC.co.uk, UK inflation hits 17-month high

[5] See The Euro Bailout And Market Pressures

[6] See Germany Bans Short Selling, Another Scapegoating The Markets

[7] Danske Bank, German ban on short−selling dampens the mood

[8] Pritchard, Ambrose Evans Germany's 'desperate' short ban triggers capital flight to Switzerland

[9] Alloway, Tracy, Swiss franc intervention cost a billion a day in April, FT Alphaville

[10] Wall Street Journal, Taking the Naked Ban to a New Level

[11] BBC.co.uk, Germans approve euro rescue plan

[12] Long, Gordon T., What Will Come of the Euro Experiment?

[13] See Why The Greece Episode Means More Inflationism

[14] Wall Street Journal, Lack Of Demand For Fed Currency Swaps Plus For Markets

[15] US Global Investors, Investor Alert, May 14, 2010

[16] Danske Bank, China: Solid growth and higher inflation clear the way for revaluation

[17] Danske Bank: Euroland: Between robust data and political risk

Germany Bans Short Selling, Another Scapegoating The Markets

Governments almost always believe that market has been the culprit for most of the ills in society. And that when push comes to shove, their instinct is to resort to palliatives: throw money at the problem, regulate or tax.

Since the markets has not stabilized even after the Bazooka or Shock and Awe monster $1 trillion bailout, of the not only of Greece, but the entire Euro Union, last night, Germany banned short selling in European bonds and credit default swap and shares of select industries in the stock market.

This from Bloomberg,

``Germany prohibited naked short- selling and speculating on European government bonds with credit-default swaps in an effort to calm the region’s financial markets, sparking anxiety among investors about increasing government regulation.

``The ban, which took effect at midnight and lasts until March 31, 2011, also applies to the shares of 10 banks and insurers, German financial regulator BaFin said late yesterday in an e-mailed statement. The step was needed because of “exceptional volatility” in euro-area bonds, BaFin said."

The problem is that these bans introduces more risks by not allowing the markets to reflect on the fundamentals via price signals.

Besides, excessive government spending financed by debt coupled with insufficient revenue, which is the source of the Euro's problem, hasn't been caused by the markets but by extant policies.

So the German government is simply looking for another scapegoat.

While the stockmarkets in Europe did react positively, perhaps due to some short covering on the issues affected by the ban, US stocks got slammed and the Euro cratered!

Regulators don't seem to realize that banning naked shorts hardly produces the intended effects and instead creates an aura of heightened uncertainty.

So aside from regulatory risks, these actions may suggests of an act of desperation or act of concealment of problems.

At the near climax of the Lehman episode in 2008, the US government reacted the same way, by instituting a ban on naked short selling in mid September as Lehman filed for bankruptcy.

And instead of the consequences going in the way of the regulators, the US markets collapsed! See below...

The blue arrows mark the time where naked short bans had been imposed.

Japan followed in November of the same year (above window), yet the results were the same...a failure to stem the hemorrhage.

The more governments manipulate the markets, the unstable they will be.

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.