``Fools ignore complexity," said Alan Perlis, the US computer scientist, "Pragmatists suffer it. Some can avoid it. Geniuses remove it." The world's central bankers, who are fretting about the growing complexity of financial markets, are clearly not fools. But unless a genius comes along with a solution, they will have to be pragmatic about complexity, and all of the risks that it entails.”-Financial Times, Where is the Risk?
I had been asked by a client if the recent developments in the US subprime mortgages market could signify as a possible catalyst that could upset the present momentum in the financial markets.
Subprime loans are basically loans to consumers who do not qualify for prime rate loans and have impaired or non-existent credit histories, therefore are classified as a higher risk group likely to default. As such, subprime loans are charged at higher rates compared to the prime loans.
``They made up about a fifth of all new mortgages last year and about 13.5 percent of outstanding home loans, up from about 2.5 percent in 1998, according to the Washington-based Mortgage Bankers Association” notes a Bloomberg report.
Rising incidences of defaults and foreclosures have led to a wave of mortgage lenders going under. Since December of 2006 ``about 20 lenders have gone kaput”, according to Mortgage-Lender-Implode-A-Meter.
Present developments have likewise led to the an increased loan loss provisions by the world’s third largest bank by market value, the HSBC Holdings Plc, aside from suffering from a management shakeout, while US second largest subprime lender New Century Financial Corp said that it probably lost money last year and had to restate earnings for 2006, where its stock prices tumbled 36% last Wednesday.
While of course we remain vigilant over the fact that the latest housing boom in the US has been the biggest since 1890, according to Yale Professor Robert Shiller of the “Irrational Exuberance” fame as shown in Figure 1.
Figure 1: NYT: Largest Housing Boom Since 1890
The consequent fallout could rather be nasty. As we previously quoted Mr. Shiller [see Jan22to 26 Financial Globalization’s Pluses and Minuses] saying that while the present decline in the housing industry had been seen largely in the context of the RATE of change by mainstream analysts, nominal housing prices remain at LOFTY levels. And at such high levels, it would be unusual for a manifestation of a bottom as activities remain vibrant aside from indications that the bulls remain HOPEFUL.
Since ALL markets are essentially psychological, the embellished description by the elaborate Josh Wolfe of Forbes on the US present day housing dilemma seems clear enough, ``But it’s not until you see a middle-class family on the cover of Newsweek with their bags outside of a church that we’ve seen full capitulation. Like a pendulum, when things go to excess they revert.”
Mr. Shiller recently twitted mainstream analysts in his latest commentary at the Wall Street Journal for not being able to predict the occurrence of the recent US housing boom, and as consequently questions them for their ability in finding a bottom, yet he wrote to remind us that the present risks shouldn’t be papered over (emphasis mine),
``We are left with a deeply uncertain situation, but one in which it would seem that a sequence of price declines continuing for many years has some substantial probability of happening. Traditional finance theory has trouble reconciling even a semi-predictable sequence of price declines with basic notions of market efficiency. The situation we are facing is a reminder of the glaring inefficiencies and incompleteness of existing markets for residential real estate, and may be regarded as evidence that institutional changes will be coming in future years to fundamentally change the nature of these markets.”
Let me remind our readers that today’s Globalization has NOT been limited to trade and migratory trends but also to the financial markets.
Figure 2: Stockcharts.com: Global Correlation
Where money flows have been enabled by the click of the mouse, and where global inflationary policies, which have resulted to an ocean of liquidity, have collectively altered the risk environment as evidenced by record low spreads and interest rates, almost simultaneous advances in diversified asset classes, historically low volatility and strong risk-taking appetite; the world’s financial market have shown unprecedented correlativeness.
As evidence, look no further and compare our own Phisix (red-black candle) in Figure 2, with that of the Dow Jones Industrial Averages (black line), and the Ishares MSCI Emerging Market Index (lower panel). Quite simply, world markets appears to have moved as one, which suggests that as much as the present market gains from the dynamics of global interrelatedness, the fundamental risks have been equally shared, as we have explained in our January 8 to 12 edition (see Global Risks Rise Amidst Market Euphoria).
To quote the recent Emerging Market Report by the Institute of International Finance or the world’s only global association of financial institutions (emphasis mine), ``There are a number of risks to the projections. They include: increasing geopolitical tensions with potential effects not only on the real economy but also on market sentiment and risk appetite; uncertainties about the duration and severity of the ongoing housing slump in the United States as well as its impact on the rest of the economy; and the ever-present potential of the huge global current account imbalances igniting a disorderly adjustment, especially in the event of a sharp weakening in U.S. growth. Realization of any of these and other major risks could bring about a sharp adverse turn in the global financial environment now characterized by ample liquidity, low volatility, and strong risk appetite.”
Going back to whether the spate of adverse developments in the US will spillover to its financial markets and spread globally, recent market actions tell us that such effects have been rather benign or subdued, so far.
Figure 3: Stockcharts.com: Dow Jones Mortgage Finance and Philadelphia Bank
In Figure 3, the Dow Jones US Mortgage Finance Index (red-black line), whose components include the Government Sponsored Enterprises (GSE) as Freddie Mac and Fannie Mae, aside from the Philadelphia Bank Index (black line) has apparently shown minimal collateral damage arising from the recent developments.
Considering that the present state of the markets which has been largely overbought and overextended, the recent activities merely reflect profit-taking instead of a PANIC driven strain of action. Put differently, the damage has not been MATERIAL enough to convincingly manifest of a TREND REVERSAL.
There are two important matters to distinguish here; one is a plain correction which simply implies profit taking but a continuation of the underlying general trend and the other is an inflection point which indicates of a general trend reversal. Taking on the necessary action depending on which circumstances emerge is very important in determining your portfolio returns.
Investors who rely mainly on the assumption of fundamentals as drivers to the markets, ignoring market psychology, could get surprised or stumped with losses by the extraordinary resilience of a trend. In the words of market savant billionaire philanthropist George Soros in his book, the Alchemy of Finance, ``Markets are almost always wrong but their bias is validated during both the self-fulfilling and the self-defeating phases of boom/bust sequences. Only at inflection points is the prevailing bias proven wrong.” This goes to show that even if the markets are deemed fundamentally wrong they may remain or stay wrong until a certain point. Or as marquee economist John Maynard Keynes once warned, ``the market can stay irrational longer than you can remain solvent.”
Yes, defying a trend can usually be hazardous to one’s portfolio.
As you know, I have remained skeptical of the present rally on largely the account of a general downshift in the global economy, as shown in Figure 4, whose ramifications are to a large extent unqualified and whose outcome could be uncertain.
Figure 4: IIF: Worldwide Economic Growth Slowdown
Unlike the consensus who believes that today’s financial markets looks insuperable, deservingly risk free and incorporates permanency to present conditions, the inflationary dynamics has, in my view, distorted the way risks have been priced in, in as much as how assets have been valued at.
Further, boom-bust cycles have been determined by massive credit expansions from which today’s marketplace have been structured, in the words of the illustrious Ludwig von Mises, ``The boom can last only as long as the credit expansion progresses at an ever-accelerated pace. The boom comes to an end as soon as additional quantities of fiduciary media are no longer thrown upon the loan market”.
In principle, this makes little difference from what has occurred in the Great Depression in the 1930s to Japan’s recent bout with deflation. Of course, this is in sharp contrast to Milton Friedman-Anna Schwartz’s theory [US Fed Chief Bernanke’s icon] that it was government’s failure to liquefy the system that caused such conditions.
In fact, in terms of the scale and magnitude, today’s money and credit creation has been unprecedented.
I might add too that today’s financial marketplace is undergoing the greatest experiment of all time, the FIAT MONEY Standard or the US dollar “DIGITAL and DERIVATIVES” standard system.
American Jurist Oliver Wendell Holmes Jr. once said that ``A page of history is worth a volume of logic.”
In the John Law 1720 experience, the excesses of fiat money dynamics caused a reversion to the gold standard; it may or may not be the case today. In human history ALL experiments with paper money have been etched in epitaphs.
The great depression led to the US Government’s revocation of the public’s ownership rights of gold and the adoption of protectionist policies.
In addition, while there have been indeed massive changes in today’s economic and financial frontiers such as a combination of deregulation, technology enabled integration, greater participation of nations to trade and the inclusion of a huge pool of labor supply into the world economy, which has contributed to what is known as the era of disinflation, the collective government/central bank’s action has been to sow the seeds of inflation in the financial system.
The public’s perception that inflation remains muted lies on the chicanery of price index manipulation meant to promote and preserve the political power of the ruling class, regardless of the form of government. In Zimbabwe, for example, its national government comically and laughably declared inflation as illegal amidst hyperinflation or inflation gone berserk! Quoting New York Times (emphasis mine), ``For the government, “the big problem about Zimbabwe is that the one thing you can’t rig is the economy,” said one Harare political analyst, who refused to be identified for fear of being persecuted. “When it fails, it fails. And that can have unpredictable effects.” Well, governments can rig anything except for purchasing power.
One must be reminded that these massive changes globally may well just be the initial impacts of the adjustments operating under a greatly expanded economic universe which should translate to rising inflationary pressures overtime as demographic trends and entitlement programs continue to exert pressures on the fiscal state of collective governments.
This is not without precedent, however. Historian Niall Ferguson identifies globalization trends prior to 1914 which ended with the advent of World War I. Operating almost in the same template, the financial markets had been equally complacent then and risk insensitive. Let me quote Mr. Ferguson at length,
``To be sure, structural changes may have served to dampen the bond market’s sensitivity to political risk. Even as the international economy seemed to be converging financially as a result of exchange rate alignment, market integration, and fiscal stabilization, the great powers’ bond markets were growing apart. The rise of private savings banks and post office savings banks may help to explain why bond prices became less responsive to international crises. An investor whose exposure to long-term government bonds was mediated though a savings account might well have overlooked the potential damage a war could do to his net worth, or might well have missed the signs of impending conflict. Yet even to the financially sophisticated, as far as can be judged by the financial press, the First World War came as a surprise. Like an earthquake on a densely populated fault line, its victims had long known that it was a possibility, and how dire its consequences would be; but its timing remained impossible to predict, and therefore beyond the realm of normal risk assessment.”
He warns of the risks that history could repeat itself.
Aside from risks of a long known possibility but whose “timing is impossible to predict” also comes of risks from something beyond what is conventionally known. It is called the Black Swan problem, where swans had been assumed as white until black swans where found in Australia....or risks associated with RANDOMNESS.
To borrow the words of the erudite author Nassim Taleb which he calls as "ludic fallacy" or "the attributes of the uncertainty we face in real life have little connection to the sterilized ones we encounter in exams and games".
The real world is complex, fluid and dynamic. This is in contrast to what is commonly known, or perceived as, or what we know, and could pose as one of the "sterilized" risks probabilities. We maybe overestimating on what we know and underestimating the role of chance. Most of the blowups emanate from unexpected events. Trying to figure or mathematically model all variables is an impossible task; while we try to assimilate risks prospects, the more scenarios we build on, the more questions that comes in mind.
I am not certain if the present ruckus in the subprime markets will diffuse to the general markets. Signs are that the impacts have been minimal; yield spreads in major public and private instruments benchmarks have been little changed, US dollar has even declined, while gold and oil staged strong rebounds. In other words, no relative signs of stress yet.
However if major participants to the subprime mortgage markets find themselves facing a liquidity squeeze enough to provide for a meaningful impact on the Credit and Derivative markets, then there is a likelihood of a contagion to the general financial sphere with systemic repercussions. It would be best to deal with these once the signs of stress or dislocations become more apparent.
Figure 4: BCA Research: Emerging Markets are No longer Homogenous
