On Economist.com, two Nobel-prize winners in Economics debate the motion "it would be a mistake to regulate the financial system heavily after the crisis". Professor Myron S. Scholes, the proposition, argues that deregulation since the 1970s have brought staggering increase in wealth and prosperity globally and a heavy-hand regulation will stifle innovations that are key to long-term growth. Professor Joseph Stiglitz, the opposition, counters that financial crises have become more frequent and more severe in the deregulation era. On the innovation point, he highlights that much of the creativity is directed to circumventing regulations and regulatory arbitrage, instead of making the economy more efficient and helping ordinary people. He suggests that inadequate regulation plays a large role in the current crisis.
Scholes argues for a light-hand regulation that would continue to encourage financial innovations. In his point of view, those who propose re-regulation failed to measure the staggering increase in global wealth and income brought to us by financial innovations since deregulation started in 1970s. On the other hand, more regulation would not prevent financial crisis from happening. Banks and broker-dealers have gone bust in countries with heavy regulation on the financial system. Even worse, incorrect regulations often have unintended consequences which add fuels to financial bubbles. Therefore, the matter is not whether to have more or less regulation, but to have better regulation.
The current crisis which sparked off from subprime mortgages deteriorated rapidly because financial institutions have gone leveraging too far and left their capital bases very weak. In light of this, Scholes proposes regulation on requiring that financial institutions meet stricter capital requirements. He is careful to provide detail arguments to weigh the pros and cons of this approach. Citing classical research results in Economics, he points out that although additional equity capital will diminish a firm's expected return on equity, it would not affect the enterprise's value. It is because with additional equity capital, the capital to debt ratio is improved and this, in turn, results in reducing risk of the equity. In other words, expected return on equity is lowered but the return-to-risk tradeoff is unaffected. Scholes concludes that instead of adopting a heavy-hand regulatory approach which almost always does more harm than good, simply requiring banks to boost their capital base is much more efficient and flexible. And flexibility in regulation is necessary for innovations.
After going through Scholes' main arguments, let's have a look at what Stiglitz said.
Professor Stiglitz believed that inadequate regulation is at least as well a reason of the current financial crisis as bad regulation. In particular, he pointed out that the Fed have not employed the full regulatory power it has to keep the financial system healthy until it is too late to remedy. In his words, this is "the unsurprising consequence of appointing as regulators people who only half believe in regulation". He admits that the current regulatory framework is not perfect, but as Paul Volcker once remarked that "even a leaky umbrella can be helpful in a rainstorm", an equally relevant point to inadequate regulation is that current regulators, who ironically doubts regulations, have not made good use of what is already available. Noting that collapses in the financial sector, in addition to doing harm within Wall Steet, always hurts innocent bystanders as the economy plunges into a recession or a depression and they lost their jobs. As a result of this, those whose interest are more unaligned with that of Wall Street should have a larger voice in regulation in the future.
On the benefits of deregulation, Stiglitz remarks that there is no strong evidence in supporting that deregulation since the 1970s led to the increase in global wealth since then. In contrast, what is much more evident is that financial crises have become much more frequent and serious since then, with the largest happening at the moment. He argues that innovations are more often directed at gaming the regulatory system instead of making capital allocations more efficient. Instead of providing valuable services to the economy, Wall street bankers make hard efforts in "predatory lending", taking advantage of the asymmetric information they have against ordinary people, reaping enormous bonuses by lending to those who cannot afford. What happens now is that householders are forced out of their homes, houses are built in nowhere, and capital is massively misallocated and wasted.
Stiglitz argues that inadequate regulation plays a large role in crisis and more regulation is needed to prevent it from happening again. He highlights a regulatory framework which includes corporate governance, accounting methods, incentive structures, speed limits and lending practices. He also proposes setting up a "safety commission" of financial products which would encourage the kind of innovations that make our economy more efficient and discourage those that serve Wall Street in sacrificing Main Street.
He shares commonground with Scholes that the matter is better regulation rather than more of less regulation. However, he believes that much more regulations have to be reformed because they have shown themselves to be too inadequate.
Monday, December 1, 2008
Sunday, October 26, 2008
Absolute return – but only when the market goes up
Hedge fund managers have always claimed that they possess investment skills that can produce absolute returns no matter how the market weather. Investors in hedge funds obviously believed in this when they were willing to be charged several percentage points of the returns as management fees. It is now almost one year after the Dow Jones saw its peak around 14,000 and it has seen fallen by a scaring 40%. Oil is also down more than 50% from its peak and many other commodities have performed even worse. Against the backdrop of global fire-sales of asset, the typical hedge funds seemed to have done not too poorly: it has lost 20% in a year. But it definitely hasn’t lived up to its promise of generating absolute returns.
Why have hedge funds fared so badly? Most of the fund managers point their fingers at the ban on short-selling of financial stocks in recent weeks. Being able to sell short is necessary for hedge funds to hedge away the risks in their portfolios. So when the government abruptly banned short-selling, it prompted a simultaneous fire-sales of suddenly non-hedgeable risky assets. This hurts everybody and particularly hedge funds which employ the “convertible arbitrage” style, the type of hedge fund that lost most, 42%, a year to now. However, although the ban can partly explain why this September was the worst month for hedge funds since statistical data is available, it cannot explain why hedge funds have been constantly losing money in each month since the credit crunch broke out last summer.
The sudden disappearance of cheap money is one obvious cause. Skeptics have long argued that the huge returns of hedge funds come from nothing but leveraging on mediocre returns. When credit stopped flowing and interest rates went up to the roof, hedge funds’ interest costs surged and they had to liquidate some of their positions when re-financing became impossible.
Another plausible suspect, who naturally has not been blamed by fund managers, is their own client. When hedge fund first became popular in the 1990s, most of their assets under management came from super-rich individuals and banks. These are mainly loyal investors who do not ask their money back when times are bad. But as hedge funds become more and more known to the public, the picture is now totally different. Among the $2 trillion assets under management, almost 40% of them came from funds-of-hedge-funds which are the first to leave in the prospect that something bad may happen. The past month alone has seen a worrisome withdrawal of $20 billion from the industry. Most hedge funds employ strategies that require them to stay in the positions long enough to make profits. They are thus indeed hit hard by their own clients.
If the markets bounce back, capital may as well once again flow back to hedge funds. It is thus hard to say the current credit crisis would lead to a debacle of the whole industry. But certainly, as the promise of absolute returns is not realized, their clients would make the business much less profitable by demanding a reduction in performance fees.
Sunday, October 19, 2008
Regulation or Deregulation
Capitalism has never been so challenged since the Great Depression. And state interventions in markets now seem the only way out. Without the American and European governments buying stakes in banks and lending directly to corporates, the credit market would seemed to be clogged forever. And consequently much more businesses would go bankrupt and unemployment would soar and a depression would be certain. Alan Greenspan, the former Fed Chairman, has always claimed that deregulation is a main driver for the past two decades of fast growth in the U.S. How true it is we are not certain. But obviously, many of the root causes of the current crisis come from not regulating the financial system properly. The important question for the future is, how big a role should the government play in the market.
With the scale of the mess seen in past weeks, those in favor of more regulation is quickly gaining ground. It is true to certain extent that regulations can stop financial instutions from taking excessive risks, but they may also have unintended consequences which encourage risk taking. For example, the Basel Accord requires banks to put a portion of capital as reserves to cushion against bad times. This by all means seem an effective method as it restrains banks from putting all its capital at stake. However, what happened was that financial firms come up with innovations to move the risky assets off balance sheets and take advantage of it as far as possible. It is one reason why securitization of mortgages, collateralizated debt obligations and credit default swaps have become so popular in recent years.
So the correct question is not asking how much regulation we need, but how to regulate better. In terms of this, one principle stands out: transparency. The main reason why banks now are not lending to each is the opacity of banks' financial health. Counterpary risk is hard to estimate when toxic assets are held off balance sheets. Therefore, a reform of accouting rules requring disclosure of highly risky assets is necessary. But that is still not enough because these assets are often complexly strctured and hard to price fairly. As models that are accepted industry-wide can only be found in Alice's wonderland, a better and simpler solution is to restrain the exposure of banks to these opaque products.
Without doubt, the regulations can hurt banks' profitability, in short term. But it is now evident that excessive profitability in the short term often is the preclude to going bust in the near term.
With the scale of the mess seen in past weeks, those in favor of more regulation is quickly gaining ground. It is true to certain extent that regulations can stop financial instutions from taking excessive risks, but they may also have unintended consequences which encourage risk taking. For example, the Basel Accord requires banks to put a portion of capital as reserves to cushion against bad times. This by all means seem an effective method as it restrains banks from putting all its capital at stake. However, what happened was that financial firms come up with innovations to move the risky assets off balance sheets and take advantage of it as far as possible. It is one reason why securitization of mortgages, collateralizated debt obligations and credit default swaps have become so popular in recent years.
So the correct question is not asking how much regulation we need, but how to regulate better. In terms of this, one principle stands out: transparency. The main reason why banks now are not lending to each is the opacity of banks' financial health. Counterpary risk is hard to estimate when toxic assets are held off balance sheets. Therefore, a reform of accouting rules requring disclosure of highly risky assets is necessary. But that is still not enough because these assets are often complexly strctured and hard to price fairly. As models that are accepted industry-wide can only be found in Alice's wonderland, a better and simpler solution is to restrain the exposure of banks to these opaque products.
Without doubt, the regulations can hurt banks' profitability, in short term. But it is now evident that excessive profitability in the short term often is the preclude to going bust in the near term.
Monday, October 13, 2008
Unprecedented bailouts in historic times
Governments in both the U.S. and Europe had failed to restore confidence in financial markets until today. Last week, in spite of the co-ordinated half-percentage-point rate cut by the central banks and various aggressive bail-out packages, the costs of overnight interbank borrowing broke record every day and stock markets around the world had slumped by more than 20 percent. The fire sales seemed never-ending.
After the G7 nations gathering last weekend, the governments in the industrialized nations at last found themselves determined to rescue the financial system. The Fed and the European Central Bank pledged to provide unlimited amount of liquidity, in dollars and in euros, respectively, to unclog the credit markets. The European governments in total came up with a bail-out package of more than $2 trillion. Britain will inject capital directly into its ailing banks and guarantee any new debt they issue. Other European countries are likely to follow suit. The Treasury of the U.S. had also started discussion about buying stakes in banks, in contrast to its strong disapproval of it in the past weeks. With all the efforts, the G7 officials announce that they will "use all means to prevent a systematic collapse of the global banking system."
Stockmarkets around the world soared on Monday after the news, with the Dow Jones making the biggest percentage-point gain since the Great Depression. Investors rush back as they see investment values in stocks after the fire-sales last week. However, it is too early to claim that confidence is back. Although the stock market has bounced back strongly, the spreads in the credit markets are still near record highs. Moreover, as housing prices in both continents are unlikely to hit bottom soon, mortgage-related losses will continue to stress the financial system. With thier unprecented moves, the governments may be able to avert a severe global depression. But a global recession is now without doubt.
After the G7 nations gathering last weekend, the governments in the industrialized nations at last found themselves determined to rescue the financial system. The Fed and the European Central Bank pledged to provide unlimited amount of liquidity, in dollars and in euros, respectively, to unclog the credit markets. The European governments in total came up with a bail-out package of more than $2 trillion. Britain will inject capital directly into its ailing banks and guarantee any new debt they issue. Other European countries are likely to follow suit. The Treasury of the U.S. had also started discussion about buying stakes in banks, in contrast to its strong disapproval of it in the past weeks. With all the efforts, the G7 officials announce that they will "use all means to prevent a systematic collapse of the global banking system."
Stockmarkets around the world soared on Monday after the news, with the Dow Jones making the biggest percentage-point gain since the Great Depression. Investors rush back as they see investment values in stocks after the fire-sales last week. However, it is too early to claim that confidence is back. Although the stock market has bounced back strongly, the spreads in the credit markets are still near record highs. Moreover, as housing prices in both continents are unlikely to hit bottom soon, mortgage-related losses will continue to stress the financial system. With thier unprecented moves, the governments may be able to avert a severe global depression. But a global recession is now without doubt.
Sunday, October 5, 2008
Money Market still Frozen
The $700 billion mortgage-rescue plan was unexpected rejected by the House on Monday. The stockmarket then was immediately in panic. The Dow Jones industrial average slumped by more than 400 points in 10 minutes after the result of the vote was shown on TV screens, and eventually plunged by 778 points, its largest point drop ever.
The shock from the House prompted Henry Paulson, the treasury secretary, and Ben Bernanke, the chairman of the Fed, to make more concessions on the bail-out. These include capping executives' pay in rescued institutions and increasing the limit of the Federal Deposit Insurance from $100,000 to $250,000. With these changes and more effortful lobbying, the Senate passed the bill in the middle of the week and the House finally passed it on Friday. However, confidence did not seem to be restored. After the bail-out plan was approved, the DJIA first gave up its 200+ gains and finally ended down more than 150 points.
One big problem to worry about is the money market. In the wake of the collapse of so many financial institutions in such a short period of time, banks are now extremely reluctant to lend money to each other for more than an overnight in fear of counter-party risk. This pushes the spread of LIBOR over the Treasury rates to more than 4 percentage points. Even credityworthy institutions are now paying punitive rates to get their necessary funding.
After seeing collapses of financial institutions all over the continent, the European money market has become even more clogged than the American one. In usual times, banks and investors arrange foreign-exchange swaps to get their needed funds in dollars or euros. But the market is now completely dried up. To help dealing with the problem, the Federal Reserve provided a credit line of $620 billion to its counterpart, the European Central Bank, for lending dollars to European banks. At first glance, it may look like a back-door bailout. However, there is a big difference with respect to the collateral the banks need to put at the central bank. In the American bail-out plan, or the TARP, troubled mortgage-related assets would be accepted as colleteral. In contrast, the European Central Bank would only accept colleteral of much higher quality. Moreover, the Fed in fact is lending directly to the ECB and so there is no real credit risk.
The shock from the House prompted Henry Paulson, the treasury secretary, and Ben Bernanke, the chairman of the Fed, to make more concessions on the bail-out. These include capping executives' pay in rescued institutions and increasing the limit of the Federal Deposit Insurance from $100,000 to $250,000. With these changes and more effortful lobbying, the Senate passed the bill in the middle of the week and the House finally passed it on Friday. However, confidence did not seem to be restored. After the bail-out plan was approved, the DJIA first gave up its 200+ gains and finally ended down more than 150 points.
One big problem to worry about is the money market. In the wake of the collapse of so many financial institutions in such a short period of time, banks are now extremely reluctant to lend money to each other for more than an overnight in fear of counter-party risk. This pushes the spread of LIBOR over the Treasury rates to more than 4 percentage points. Even credityworthy institutions are now paying punitive rates to get their necessary funding.
After seeing collapses of financial institutions all over the continent, the European money market has become even more clogged than the American one. In usual times, banks and investors arrange foreign-exchange swaps to get their needed funds in dollars or euros. But the market is now completely dried up. To help dealing with the problem, the Federal Reserve provided a credit line of $620 billion to its counterpart, the European Central Bank, for lending dollars to European banks. At first glance, it may look like a back-door bailout. However, there is a big difference with respect to the collateral the banks need to put at the central bank. In the American bail-out plan, or the TARP, troubled mortgage-related assets would be accepted as colleteral. In contrast, the European Central Bank would only accept colleteral of much higher quality. Moreover, the Fed in fact is lending directly to the ECB and so there is no real credit risk.
Monday, September 29, 2008
Stocks plummet as the House votes for the bail-out plan
The House is going to vote for the $700b bail-out plan today. In contrast to the 3 page proposal Henry Paulson, the Treasury Secretary, started with, the rescue plan is now 110 pages long, and has added numerous provisions demanded by legislators. The changes include allowing the government to modify the terms of the mortgage payments to protect homeowners from foreclosures, authorizing the Fed to pay interest rates on the reserves maintained by banks and thus the power to pump unlimited cash into the money-market. The Troubled Asset Relief Program, or Tarf, will give Mr. Paulson or his successor enough flexibility to buy trouble mortgage-related assets, and anything else necessary, from ailing financial institutions, to stabilize the financial system. Mr. Paulson now will be given only $250b immediately, $100b more at the President's discretion and $350b upon approval by Congress, instead of a $700b lump-sun he initially proposed.
Along with the going-at-light-speed legislative procedures on Capital Hill, the Federal Reserve, together with centrals banks in Europe, continued to pump billions of capital into the financial system in both Continents in an attempt to firebreak the latest stage of the credit crisis. Last week in America saw the collapse of Washington Mutual, the biggest-ever failure of commercial bank. And in the past weekend, several financial institutions in Europe had been bailed out by governments.
Stock markets around the world had rebounded last week in anticipation of the plan. Now with both the Democrats and the Republicans extracted numerous concessions from the bill, the bail-out plan is expected to pass the House today, and the Senate this week. Nevertheless, as investors are worried by the latest eruptions in the past weekend, stock markets plummet again today.
Along with the going-at-light-speed legislative procedures on Capital Hill, the Federal Reserve, together with centrals banks in Europe, continued to pump billions of capital into the financial system in both Continents in an attempt to firebreak the latest stage of the credit crisis. Last week in America saw the collapse of Washington Mutual, the biggest-ever failure of commercial bank. And in the past weekend, several financial institutions in Europe had been bailed out by governments.
Stock markets around the world had rebounded last week in anticipation of the plan. Now with both the Democrats and the Republicans extracted numerous concessions from the bill, the bail-out plan is expected to pass the House today, and the Senate this week. Nevertheless, as investors are worried by the latest eruptions in the past weekend, stock markets plummet again today.
Saturday, September 27, 2008
21 Sept 08
The theory of decoupling has lost its popularity from the current credit crisis. Along with plummeting stock prices in developmed markets, share prices in emerging markets have plunged even more in the past week. The main bourses in Russia suspending trading for three days in a row after its market fell by a record 26%. The stockmarket in China, India and Brazil has also dropped by double-digit this week. As investors panicked and confidence were lost, governments were quick in their actions. The central bank of India aggressively sold its foriegn-exchange reserve to support the rupee. And soon after Lehman Brother's collapse the China government cut the benchmark lending rate, by 27 basis points, for the first time in six years, to support its financial sector.
Not until recently, equities in emerging market are deemed as one of the best investments. Supported by high growth rate and massive current-account surpluses, share prices in emergeing countries traded at an even higher multiple of earnings than developed countries last year. Trillions of capital has been poured into the emerging markets since 2000 as global growth remains strong. A bull market in commodities has drawn a lot of hot money into resources rich countries like Russia, India and Brazil. However, the trend seems to have reversed this year. $67 billion of capital has flowed out from emerging countries this year, compared with inflows of hundreds of billions of dollars in the previous five years. Stockmarkets of emerging coutries are also the ones that have falled the most so far this year, with many of them now trading at less than half of the peak.
Not until recently, equities in emerging market are deemed as one of the best investments. Supported by high growth rate and massive current-account surpluses, share prices in emergeing countries traded at an even higher multiple of earnings than developed countries last year. Trillions of capital has been poured into the emerging markets since 2000 as global growth remains strong. A bull market in commodities has drawn a lot of hot money into resources rich countries like Russia, India and Brazil. However, the trend seems to have reversed this year. $67 billion of capital has flowed out from emerging countries this year, compared with inflows of hundreds of billions of dollars in the previous five years. Stockmarkets of emerging coutries are also the ones that have falled the most so far this year, with many of them now trading at less than half of the peak.
Subscribe to:
Posts (Atom)