Thursday, 30 October 2008

Here Today, Gone Tomorrow

Many investors have been lured into hedge funds since it was sold to them as a "safe haven" or an investment that would not lose money in a bear market - like cash or bonds, but only at better yields.
Yet, as the ripple effect from the global credit crunch continues, it is becoming increasingly clear that many hedge funds will be forced to close due to the interplay of shrinking access to leverage, disappointing investment performance and investor demands for redemption.
George Soros, one of the most renowned hedge fund managers of all times, recently suggested that the industry could shrink by as much as two-thirds. Speaking at the Massachusetts Institute of Technology, the Soros Fund Management chief said: 'The hedge fund industry is going to move through a shakeout. In my estimation, it will be reduced in size by anywhere between half and two-thirds.'
If the hedge fund industry does suffer carnage on anything like this scale, managers will not be the only ones to suffer. New research suggests that US-based hedge funds will cut total IT spending by 40 per cent to USD882m in 2009.
Again, the weeding-out process is reaching out to all areas of the financial world and everyone connected with it.
Quoted from: Hedgeweek Comment, 30 October 2008,

Tuesday, 28 October 2008

Words from The Wise Investor

Charlie Rose, an American TV interviewer and journalist, recently had an exclusive interview on his show with the top investor, Warren Buffett where he asked the questions that most investors are concerned about. How serious is the credit crisis? How will it affect the economy? Will America - by far the leading economy in the world - recover from a deep recession? Are equities still a good long-term investment prospect?
Buffett, in his typical easy-to-understand manner sketched the reasons for his ultimate belief that capitalism will survive the current crisis. Hence, investing in equities will bear fruit in the future and that the current distressed market conditions offer fantastic investing opportunities.
The link below covers the full interview; it is rather lenghty (55 minutes) but definitely worth watching.

Thursday, 23 October 2008

The Fallibility of Statistical Models

Who are the culprits that caused the meltdown of the global financial system which in all probability will lead to a severe global recession? A lot has been said about the sheer greediness of mortgage originators, investment banks and their cosy relationships with rating agencies. Roman Frydman, Michael Goldberg – authors of Imperfect Knowledge Economics – and Edmund Phelps – 2006 winner of the Nobel Prize in Economics – argue in an article published in the Financial Times (October 19) that another major cause is often overlooked, namely "failure to acknowledge that market participants and regulators alike have only imperfect knowledge about the forces and mechanisms driving asset values and the broader economy."
"We rely on markets because we know of no other way to take account of the myriad bundles of knowledge and intuition that individuals use in determining economic values, such as those for financial assets. Asset prices often undergo long swings away from historical benchmark levels, followed by “corrections”, because this is how markets “discover” a sensible range of values."

"Such price reversals are a source of risk that is not recognised by standard risk-management methods. Even more importantly, these methods ignore the very nature of a capitalist economy: it generates new ways of doing things. Hence, economic relationships and patterns that applied in the past are eventually replaced by new ones."

"Many of our regulations are designed to achieve transparency of information. Public companies must make available their financial statements on the theory that investors can then decide how much of an asset to hold. What the crisis has demonstrated is that more than information is required for prudent investment decisions. Financial markets need regulation to bring to light the imperfect knowledge of those who are in the business of providing assessments of financial assets."

"Finance and economics professors devoted their talents to developing abstruse, yet simplistic, models that left out the imperfection of knowledge. Universities have produced two generations of financial engineers who sold the idea that academic models could safely neglect market discovery of risk and prices."

"The ratings agencies used statistical models that projected historical default patterns to continue. These patterns showed very low loss rates, thanks to ever rising prices since 1997. With such low loss rates, triple A ratings appeared to be justified. Brave new models tempted the industry to abandon proven prudential procedures, which combined their own judgment and more formal criteria. To be sure, agencies apply stresses to their current procedures. But these stresses are hidden in ratings reports and, as recent events have painfully demonstrated, are woefully inadequate."
"Had the agencies been required to make explicit how their ratings would have changed under the alternative assumption that house prices would fall back to benchmark levels, the markets would have feared greater loss rates, lowering the demand for mortgage-backed securities. This would have reduced the volume of mortgages originated and thus ultimately the amount of bad paper that banks ended up holding. Requiring the agencies to rate securities under one or more pessimistic scenarios as well as the optimistic one would make it harder for the agencies to deliver rosy ratings in return for business from the investment banks."

The authors propose that agencies should be required to report at least two ratings: one assuming that historical patterns will continue and at least one other assuming reversals in the trends of major variables. No single individual or institution can render a definitive judgment on the riskiness of securities. Only markets have aggregate knowledge that is not given to anyone in its totality.

Tuesday, 21 October 2008

"Put your mouth where your money was"

Warren Buffett, in a recent article - Buy American. I Am - that appeared in the New York Times (October 16), tells the story of a restaurant that opened in an empty bank building and then used the following smart advert: "Put your mouth where your money was." Today, Buffett says that both his money and mouth are saying: 'Buy equities.'
This is a very significant change in Buffett's investment strategy (for his personal account). Until now and besides his stake in Berkshire Hathaway, he owed nothing but US government bonds. We all know that financial markets are in a mess as they are discounting rising unemployment, failing businesses and scary, sensational headlines.
Why is Buffett so optimistic after all? Buffett explains it as follows:

"A simple rule dictates my buying: Be fearful when others are greedy, and be greedy when others are fearful. And most certainly, fear is now widespread, gripping even seasoned investors. To be sure, investors are right to be wary of highly leveraged entities or businesses in weak competitive positions. But fears regarding the long-term prosperity of the nation’s many sound companies make no sense. These businesses will indeed suffer earnings hiccups, as they always have. But most major companies will be setting new profit records 5, 10 and 20 years from now."

"Let me be clear on one point: I can’t predict the short-term movements of the stock market. I haven’t the faintest idea as to whether stocks will be higher or lower a month — or a year — from now. What is likely, however, is that the market will move higher, perhaps substantially so, well before either sentiment or the economy turns up."
"A little history here: During the Depression, the Dow hit its low, 41, on July 8, 1932. Economic conditions, though, kept deteriorating until Franklin D. Roosevelt took office in March 1933. By that time, the market had already advanced 30 percent. Or think back to the early days of World War II, when things were going badly for the United States in Europe and the Pacific. The market hit bottom in April 1942, well before Allied fortunes turned. Again, in the early 1980s, the time to buy stocks was when inflation raged and the economy was in the tank. In short, bad news is an investor’s best friend."

"Over the long term, the stock market news will be good. In the 20th century, the United States endured two world wars and other traumatic and expensive military conflicts; the Depression; a dozen or so recessions and financial panics; oil shocks; a flu epidemic; and the resignation of a disgraced president. Yet the Dow rose from 66 to 11,497."
And now for probably the most important advice from the great man:
"You might think it would have been impossible for an investor to lose money during a century marked by such an extraordinary gain. But some investors did. The hapless ones bought stocks only when they felt comfort in doing so and then proceeded to sell when the headlines made them queasy. Today people who hold cash equivalents feel comfortable. They shouldn’t. They have opted for a terrible long-term asset, one that pays virtually nothing and is certain to depreciate in value. Indeed, the policies that government will follow in its efforts to alleviate the current crisis will probably prove inflationary and therefore accelerate declines in the real value of cash accounts."

"Equities will almost certainly outperform cash over the next decade, probably by a substantial degree. Those investors who cling now to cash are betting they can efficiently time their move away from it later. In waiting for the comfort of good news, they are ignoring Wayne Gretzky’s advice: I skate to where the puck is going to be, not to where it has been.”

Sunday, 19 October 2008

The (Much) Lighter Side of The Financial Crisis

Humor is probably the best medicine to cope with feelings of anxiety amidst the global financial crisis and despair with the material loss of wealth investors suffered due to the growing fears of a major global economic recession. Here are some of the gems I have come across recently:
The definition of optimism? A banker who irons five shirts on a Sunday.
What's the difference between an investment banker and a large pizza? The pizza can still feed a family of four.
What's the difference between an investment banker and a pigeon? The pigeon is still capable of leaving a deposit on a new Ferrari.
What do you say to a hedge fund manager who can't sell anything? A quarter-pounder with fries, please.
"The credit crunch has helped me get back on my feet. The car's been repossessed."
"This credit crunch is worse than a divorce. I've lost half my net worth and I still have a wife."
"The bank returned a cheque to me this morning, stamped: 'Insufficient funds'. Is it them or me?"
"A man asked his bank manager how to start a small business. The manager replied: 'Buy a big one and wait.'
Money talks. Mine knows only one word: ''Goodbye".
What have an Icelandic banker an an Icelandic streaker got in common? They both have frozen assets.
The company director decided to award a prize of $50 for the best idea of saving the company money during the credit crunch. It was won by a bright young man who suggested reducing the price money to $10!
Quoted from Weekend Argus, October 18, 2008

Tuesday, 14 October 2008

A New Geopolitical Order?

The past week will be heralded as one of the worst weeks ever for stock markets around the world. In total, about $6,200bn (R56,000,000,000,000 – about 30 times SA’s GDP!) was wiped off the value of the world’s stock markets as panic and distressed selling were the order of the day.

The credit crisis began in earnest in March with the collapse of Bear Stearns, but until middle September equity markets stood up relatively well. Since then the major markets collapsed fiercely and from its highs last year markets have retracted already more than 40%.

The severity of the 2008 credit crisis is compared with the financial crisis and economic collapse of the 1930s (Great Depression). Back then the S&P 500 lost about 85% of its value within 15 months. Will we experience similar equity losses in today’s crisis? Unlikely, because governments all over the world have reacted quickly to avoid an economic disaster and are standing united to ensure the normal functionality of the financial system, but obviously at a great cost to tax payers.

Philip Stephens, columnist for Financial Times, however reckons that this crisis is unique in two aspects, and thus making it difficult for governments to deal with the crisis: First, the ferocity of the crisis and second, the geography. In the recent past financial crises used to start in Latin America, Asia or Russia – typically developing or emerging economies, and not developed economies. Back then the developed economies used to prescribe to such countries/regions how to transform their economies – market liberalisation, better fiscal control, etc. – as a precondition for financial support from the IMF. This time around the crisis started on Wall Street preceded by the slump in the US housing market. Emerging economies have been the victim, rather than the culprits.

After the Asian currency and credit crisis of 1997-98, Asian countries accumulated foreign currency reserves to defend themselves against future crisis. Today those reserves are worth $4,000bn which basically financed the reckless credit explosion in the USA and Europe. One commentator made the following remark: “America drowned itself in Asian liquidity.”

Today the West’s moral authority has been largely eroded and they cannot expect emerging economies to listen to their lectures about how to run their economies anymore. Yet, the west still assumes political and economical leadership in talks how to redesign the global financial system. To quote Stephens in his recent article – “Crisis marks out new geopolitical order”,, October, 9 – “... the west can no longer assume the global order will be remade in its own image. For more than two centuries, the US and Europe have exercised an effortless economic, political and cultural hegemony. That era is ending.”

Wednesday, 8 October 2008

The Boom-Bust Cycle of an Ideology

Gideon Rachman writes in his latest column for that ideas, similar to the stock market become fashionable and get pushed to their logical conclusion and beyond, leading to “irrational exuberance” and then a crash. The 2008 Credit Crisis is a direct consequence of a 30-year bull run in an ideology that began with the Thatcher-Reagan regimes of the 1980s.
Three central ideas can be identified out of the Reagan-Thatcher era: the promotion of home ownership, financial deregulation and faith in the market mechanism. These ideas worked fantastically for three decades, leading to increased prosperity and freedom. Yet, when the ideas combined were pushed too far it created an enormous disaster.

For example, the subprime mortgages - at the heart of the current financial crisis - personified the dream of home ownership for everyone, even if they could not afford it. In April 2005 Mr Greenspan praised subprime mortgages for helping to widen home ownership. Investment bankers, were allowed to bet their banks on these market segments because regulators and politicians believed firmly in the self-regulating qualities of the market.

Today the intellectual cycle has swung decisively against the right-wing ideas of the Reagan-Thatcher era. Rachman believes regulation and government intervention is bound to overshoot in the other direction. But eventually the joys of government regulation will fade and nostalgia will set in once again for the go-go years on Wall Street and the bracing qualities of neoconservatism.