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Money managers under the microscope

Batten down the hatches

May 22, 2009

It’s fashionable now for leading economists and financial wizards to claim that they saw the credit crunch coming and the kind of dislocation it would create. But how many have predicted where the next implosion will occur?

bad-building1Dr Andrew Lo, founder of hedge fund firm AlphaSimplex, and director of the MIT laboratory for financial engineering, has spent his career studying market behaviour, publishing papers examining why quant funds imploded in August 2007, and trying to reconcile behavioural economics with efficient market theory.

He sees the next big meltdown in commercial mortgages, but this time it’s pensions funds that will bear the brunt of the losses rather than banks. Lo points out that commercial mortgages have been packed and sold in the same way as residential mortgages – different levels of risk exposure sliced and diced and wrapped up together in one package with a triple A rating slapped on top.

But commercial mortgage backed securities (CMBS) are facing the same liquidity problems as RMBS following the sub-prime meltdown. When mortgages start to reset at higher rates this year the defaults will pile up and the losses will hit the end-investor – in this case, large pension funds in the US, Europe and Japan, says Lo.

“We are likely to see a number of pension funds having a hard time meeting their liabilities, and the government may have to step in and help out some of these insolvent funds,” he says.

Why pension funds rather than banks, which had the greatest exposure to RMBS?

Lo says that large pension funds expanded their programmes into riskier areas like CMBS to capture additional yield during the low volatility, low return years.

Lo is now trying to develop a way to measure systemic risk, so regulators have an early warning system when the global economy starts nudging critical levels. The idea is to measure the gearing in the economy and how this compares to the level of activity by looking at factors like the notional exposure in the credit markets, public debt as a ratio to GDP, inflation and money supply.

“My hope is that within the next couple of years we will have a way to measure systemic risk and we’ll be able to control it like we can with pollution,” he said. He suggests one way to do this would be to ”tax” investment banks when they start to put the financial system under too much strain, so their behaviour becomes counter-cyclical.

Comments

Hmmm, CMBS would be a problem if they actually start defaulting on their loans, wouldn’t it? I mean in the case of sub-prime, we had mortgages given out to people that couldn’t payback …
I don’t I am having a difficult time absorbing this.

- ludwig

 

So what’s to stop them from switching their programs to some less-risky area now? And wouldn’t that just hurry the “crunch?” And why would taxing anything help prevent the loss of funds? In this case, the tax would trickle down to the investors, and actually take money from the general population and give it to the corporations. Why not just let the market take care of itself? If they are going to go bust, let them. Survival of the fittest.

Posted by Whisper | Report as abusive
 

What happens when all the newly printed (valueless) money runs out and the tiny lift it created runs out? Do we print more? Borrow more?

When an economy is based on juggling the books and manipulating data (a service economy) with no real wealth being created, how does it continue to flourish?

Posted by Ben | Report as abusive
 

RE: “Lo is now trying to develop a way to measure systemic risk, so regulators have an early warning system when the global economy starts nudging critical levels.”

It is rather naive of Andrew Lo to think that the problem of systemic risk is just a quantitative financial engineering problem. You will remember that there was a massive failure by the regulators with regard to systemic risk. I am a former senior bank regulator and I spent many years in the investment banking world involved in risk management, risk reporting and risk technology. There appears to be a failure to recognize that the regulatory process can only work if there are good regulatory people looking at the matters every day. Let me offer the following comments:

1. The bank regulators had the authority to examine any aspect of a bank’s activities. They had the authority to figure out what was going on at the banks and to limit it. The regulators did nothing. So all the new regulations on paper or hiring additional analysts or creating new “early warning statistics” will mean nothing if the regulators cannot or will not do their jobs.

2. Sending a regulator who makes $75,000 dollars a year to examine the activities of sophisticated financial traders who make millions of dollars a year is not a fair battle. And if you have ever worked in a government agency, as I did for many years, you will be intimately familiar with the viciousness of the turf battles among the senior officials. There are dim bulbs and deadwood at the top of the agencies and all of it needs to be cleaned out. A Herculean task if there ever was one.

3. We recently saw the regulators “stress-test” the major banks and compute the additional capital that the banks required to weather the economic turmoil. Then some of the largest banks complained vociferously about the additional capital requirements and the regulators backed off. So much for firm regulation.

Posted by Steve | Report as abusive
 

There is tremendous value in the research and work Dr Lo is doing. Kudos to him! However I believe the punishment to those who “put a strain on the system” should come from the consumers of the product, not top down oversight, and an unconstitutional taxation measure. Instead of giving this tool to regulators, why not market it to the masses? Give them the benefit of “early warning” and let them make up their minds? Excellent development!

Posted by Matthew | Report as abusive
 

I think that a lot of people in the financial system… and perhaps many of those outside of it knew that something big was going to happen. Nobody knew quite what.

Several factors contributed to the “meltdown”. And, these factors will not be easy to resolve.

1. Differing growth/inflation rates.
a. Government inflation rate – 2-3%
b. Fuel Prices – as high as 100% after Katrina then leveling off a bit.
c. Food Price Spikes.
d. Housing – 10%
e. Many “consumables” being artificially kept down by exporting more and more labor. I.E. items made in the USA might be increasing by 10%, while imported items might be keeping stable.

2. Historically everything is based on a population growth model EXCEPT increased scarcity of resources including food and land, forcing us to need to stabilize our population (which the USA sadly fails to do). However, a stable population and increasing number of retired individuals creates a dangerous affect too.

3. The “Ponzi Scheme” nature of the entire stock market, and the Baby Boomers. Many Baby Boomers have been using the stock market for investment growth. And, now it is time to cash it in and buy the Winnebago. As withdrawals increase to potentially exceed deposits, we enter a very dangerous state with the stock market.

4. Americans, considered by some to be the “richest nation in the world” is barely able to pay for 1/3 of our Chinese Imports. As a society, our greatest export has been “green paper”, which has been useful for other countries to trade on the international market, but is only required in finite amounts, and it certainly is not a very stable state of affairs.

5. Debt is also mounting throughout the nation, from individuals to the government. Individuals no longer “own” their houses as they approach retirement. We now have a government that is now borrowing more money than it is bringing in in taxes, and owes more money than the entire annual production of the country. Consider… some people talk about taking a couple of days of a “pay holiday”. If every citizen in the USA took a year long “pay holiday”, then we might be able to get the National Debt under control.

We have so many disjointed parts of the economy that more woes are inevitable. Yet, I believe that there will be some sense of recovery at least in the short-term.

Posted by Clifford | Report as abusive
 

Everyone can predict anything after the fact period. All economists are frauds and all are non scientists. Economics is nothing but the study of buying stuff.

A monkey could predict better than them.

Posted by Edward Phillips | Report as abusive
 

The trend goes beyond just the mortgage crisis of late. For decades,people have been chasing bubbles trying to get money for nothing, and when one collapsed, they jumped on the next one.

After learning the hard way that the “value” of your “investments” are in the end only worth what you get cash in hand on the day you seel them, they cried for tax breaks on stocks they did sell and made gains from, crying foul for being caught up to their ears in greed in midstream, and the gov forgave a ton of taxes owed.

And through it all, the “experts” have done nothing but beat the bull market wardrum and whip investors and funds into a frenzy. The few who cried wolf back then have had a career riddled with ridicule by the very folks who NOW claim they saw ti coming.

If they saw it coming, the bank stocks should have bottomed ahead of the collapse as they ran to the exits before the fire even broke out.

And only now do the pyramid scams surface, but as the old adage goes, you can’t con an honest man. Folks investing with the scams thought their slick inside connections would get them a ton of money (at the expense of others), and that arrogant greed made them perfect targets.

But this routine has been going on for decades, and other both parties, so stop the bumper sticker slogan finger pointing and do like some countries do: prosecute, bankrupt and permanently discredit all who were willing in on the crisis. It has been as much an assault on the security and future of this nation as any terrorist attack.

At least a mindless drone suicide bomber sacrifices himself. These monsters hide behind connections and legal trickery while they make off with the money.

Too bad we all have to go down with them and be stuck with the bill.

Posted by Brian Foulkrod | Report as abusive
 

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