When Ratings Don’t Work

In the wake of the Lehman minibonds debacle a lot has been said. A vicious blame game has begun between the banks and their investors — should investors be blamed for not reading the danger signs, or were they wrongly informed by bank salespeople? Amid the discussion, a common consensus that has emerged though. To prevent such a fiasco from repeating itself, some have suggested some kind of agency be established to rate the safety financial products in the future, so consumers can make better informed decisions about the risk they make. This has been raised in the ST forums, as well as by Andy Ho in yesterday’s column. 

If only life were so simple.

As logical as this sounds, actually creating a successful agency isn’t as simple as it seems. In fact, it’s probably impossible to come up with satisfactory rating system that rates products accurately, like every other thing in Singapore.

The reason for this is the risk linked to financial products is ever-changing and almost impossible to quantify. Andy Ho has compared such financial products to “toys” and “microwaves” lacking proper safety measures, but this is a false comparison. The risk inherent in a microwave exploding is very much unlike the risk inherent in a bond defaulting, for two reasons.  

The first is complex interdependency of financial markets. To borrow George Soros’s theory of reflexivity vaguely, markets are the result of the constant feedback between participants biases and their actual behaviour: thousands of interactions taking place in an instant, affecting each other interdependently. With an infinite number of possible permutations, this makes calculating risk accurately a nearly impossible task. 

Furthermore, the second challenge in calculating risk is the human factor in markets. One of economic’s greatest assumptions — the assumption of rational behaviour — also is one of the subject’s greatest flaws. Hence, while there are so many experts in the field of statistics, econometrics and finance soothsaying about the market, only one Warren Buffett exists. As Keynes rightly pointed out, the market is often governed by emotions and gut feelings (“animal sentiments”) and not rational behaviour assumed in models. So tell me: how do you articulate animal sentiments into a mathetical equation?

The point here is that is almost impossible to gauge an appropriate level of risk. Risk in itself is a constantly changing thing. I often take ratings by agencies like Moody’s with a pinch of salt — witness how many times “AAA” products have turned foul within moments. The logical response is to perhaps factor in the fluctuations arising from market uncertainties, but if this method is used, then only ultra-conservative estimates are likely to result. This would defeat the value of even using ratings in the first place, with all products automatically downgraded.  

Instead of establishing a ratings agency, what should be present are a clear set of laws which prevent abuses of consumers. By abuses, I mean portraying incorrect information, or in some cases, incorrectly portraying correct information. In the first case, for example, I personally know someone who was told by the bank last year that these minibonds were “risk-free”. This is portraying incorrect information, as even the fine print did not guarantee a full return of principal. In the latter case, sometimes financial product sellers only reveal select pieces of information, painting an incomplete picture. This too is considered consumer abuse. Laws need to make sure transaction processes are more transparent, so that both sellers and buyers of these products are properly informed of the products they buy, and in the case of abuse, proper penalties are awarded. Other than this, there’s really little else that can be done. 

-A.S.

Recession In, Environment Out?

Is environmental spending just a luxury good?

How quickly things change within the passage of time. Months ago, global warming and the environment was the talk of the town. The very first article on The Lookout, incidentally, commented about this year’s G8 conference, where leaders convened to discuss on how to tackle environmental issues together. Now, everyone’s suddenly scrambling for their wallets and the environment is forgotten. When the presidential campaign was once about the “healing” of the planet, now its all about how whether you can trust Obama or McCain to put food back on the table. 

In recession no one can hear you scream. Or pollute, for that matter

This is especially so since this crisis affects the lower and middle-income groups the most. Practically speaking, when there are bills to pay and a possible retrenchment to worry about, paying more premiums for goods that “help the environment” suddenly feel like a luxury.

In short: why should I care about rising carbon dioxide levels when I have a family to feed?  

This spells bad news, because it is incidentally these lower to middle income groups that contribute to most of world’s greenhouse gas output. For the households in the developed world, “green goods” like hybrid cars or organic foods no longer affordable. And as primary and secondary industries begin to cut back costs, its clear that environmental standards will be the first to be compromised. 

Moreover, with credit lines contracting, this means alternative energy companies — the heart of the solution — are less able to raise capital to sustain research and development. Banks, looking to cut back on loans, are unlikely to lend as freely as they did before, but not until the whole crisis blows over. Until that happens, researchers like Ron Surdam will have to halt their programmes. 

On the upside, a slowdown in growth will also cause demand for fossil fuels will also fall, reducing emissions for a time. This however, is only a small consolation. This is because the global warming problem needs a sustainable, not a temporary solution: improvements to technology that will allow alternative energy sources to compete with fossil fuels in terms of cost and effeciency. But scientists will tell you there is a long, long way to go before this point is reached, and this was even before the crisis occured. 

A ray of hope though is Obama and his talk of the “Apollo Project“. Unveiling it in his interview with Time, Obama briefly outlined how he would use new energy as a means to drive America’s economy in the coming years, with consumption bubble finally burst. This sounds good in theory, but many challenges await. Firstly, research and development requires years before any dividends are paid. If new energy is to be a part of the US, can the public wait before this breakthrough is reached? Furthermore, old habits die hard. America, the leading producer of greenhouse gases, will certainly not be able to mend its ways overnight. The decision to “go green” requires a deal of commitment – such as a willingness to change spending habits, deal with possible inconveniences – a decision i’m not sure many American households are willing to make. 

Taking a step back, maybe its just a matter of time before global warming returns to the table. Then again, now, not later, is the best time to test the worlds’ leaders resolve about the environment. Based on what happens from here, it will be clear whether they genuinely see global warming as something important, or just another coffee-and-tea item to discuss when times are good.

-A.S.

Obama Must Win

For most, the US Presidential Debate held a few days back revealed nothing new. It presented two sound candidates with their obvious strengths and weaknesses. For McCain, it was his superiority in experience at foreign policy and an extensive political record. For Obama, what struck me was his intelligence, the clarity of his thoughts and his consummate ability to articulate them. In selecting the next president though, the criteria  shouldn’t be simply weighing each candidate against the other like on a balancing scale, but rather, which candiate is better equipped to battle America’s woes. If this criterion is used, then Obama proves far superior. Here is why.

First, let us contextualise America’s current position. Unlike before, America is a country on the decline, not one on the rise. The failure of the Iraq War, the unpopularity of President Bush, Guantanamo Bay, the financial crisis, are events in past years that have undermined America’s credibility and reduced its soft power. Furthermore, the America now is that has to contend with an incredibly amount of certainty — much more than in previous years. Globalisation has acceleated the pace of change, and as the dust of the financial crisis settles, America’s role in the world will inevitably be re-defined. To steer America out of such unclear waters, this requires someone who has broad-mindedness and to a great deal, the ability to improvise.

For these reasons, Obama emerges a superior candidate. Firstly, Obama demonstrates a deep awareness of America’s lost and the urgent need to reclaim it, stressing time and time again the need to “restore America’s standing in the world”. This means he has his first foot on the right position. Moreover, Obama seems well-equipped for this role, ironically because his seeming weakness — his lack of experience, may actually be his trump card. In order to successfully reconcile America to the world again, America needs to have a clean slate. This is something Obama offers.

McCain on the other hand, looks like someone with a lot of baggage. His greatest strength and selling point, his experience, may quickly turn into a weakness if he relies on his past experiences to make new judgements. This was clear in his choice of examples throughout the debate, mentioning historical figures like Reagan, Kissinger, and Vietnam. This worries me as somone who may not be able to to perform the task of re-learning new paradigms, the proverbial dog unable to learn new tricks. Granted, McCain may be superior to Obama in delivering a winning military strategy. However, Obama’s “broader strategic vision” is something that makes far more sense. Soft power is the power of the future and is something America despearately needs back. I don’t want to take away anything from McCain. In a different era, perhaps what he would have made a superior choice. But in this context, he seems very out of place.

Having said this, Obama also huge for failure. Based on the campaign so far, he comes across as one who can be very evasive on issues he lacks the experience about. If this evasiveness swings into indecision, or hesitation, then this can only spell dire consequences. Also, there’s the danger that his McCain rightly pointed out this week Obama lacks the record to match the scale of his promises. But this is a risk Americans must be willing to take, surely a lesser evil to McCain’s flaws.

In final analysis, America can no longer possibly be the America of the past. Trapped in the experiences of the past century, this is fact McCain cannot seem to accept. On the other hand, this is the very fact Obama is banking his whole campaign on, and for that reason, America must vote him as the next leader.

-A.S.

On the Origins (and Manifestations) of Greed and Self-Preservation in Wall Street

SUBMITTED BY CHUE Z.Y.

mrchue@gmail.com

The most basic of all human instinct is that which tends towards survival. When one’s life is in serious jeopardy, there can be no doubt that the inner savage in him will be unleashed, even if the very act of barbarism itself were to perpetuate his life by an insignificant amount. This is in essence the self-preservation motive, a powerful force that compels one to put aside any external prejudices and expectations to ensure his continued existence in the world. 

As one expands beyond the individual to a collective body, we find that this attitude is in no way lost or diminished. Many acts of aggression can in actual fact be considered to be defensive in nature once the self-preservation motive is taken into account, a most famous example being Japan’s expansionist campaign in World War II. For most of history, the body’s survivability assures the survivability of the individual so long as the individual acts in concert with the body’s overall objectives. However, once the body begins to exhibit signs of weakness, humans can be expected to work no longer for the group but themselves, exacerbating the collapse of the group. From an economic viewpoint, true workplace loyalty is thus virtually non-existent amongst the rational part of the population under employment.

For any market to function effectively, it is supposed that all participants base their decisions purely on the advancement of their self-interests. (The argument concerning altruism is considered to be beyond the realm of rational behavior (neither is it irrational) and can be discussed in a further enquiry.) Self-interest here refers to the combination of two aspects, one being the self-preservation motive that has been just discussed, the other being the satisfaction of material needs. It is undeniable that the satisfaction of essential material needs, namely air, food, water, shelter and sex, are required for self-preservation. Yet, as soon as the individual’s survival is guaranteed, his needs expand outwardly in order to fill a psychological void that has just been created; this in effect is the origin of greed. The same can be said for a collective body. Men’s wants are unlimited. There is no definite end to the extent of their greed. It is on this note that we proceed to apply what is being understood to the present economic situation we are faced with.

We are currently in the midst of a credit boom-bust sequence that can be described as such: In a bid to outplay, outwit and outlast one another, bankers trod down a path of excessive risk taking, resulting eventually, and ironically, in their ultimate demise. It is a humorous scene, but sadly inevitable. The survivability of non-niche banks (and all other business entities) is determined not by its profitability, but on its ability to increase its profitability as time passes on. Profit is the key to expansion and innovation, which leads to increased productivity, scale of operations and greater absolute profits, setting a positive feedback loop that is self-reinforcing. In Wall Street, stagnation in growth is strictly unacceptable, and this often leads to changes in leadership of such companies in question. The profit motive (corporate greed) is thus the bank’s only defense against a hostile takeover from another bank.

At the individual level, bankers work not only to ensure the survivability of their bank, but also their survivability within the bank itself. Bankers generating steady single-digit returns  are consistently pressurized by clients who outrageously insist on double-digit and even triple-digit returns. This is consistent with shareholders expectations for banks to deliver record profits after record profit, even with the knowledge that this is unsustainable beyond the short run. The concerted demands by both shareholders and bank clients (a manifestation of men’s greed) set the backdrop for irresponsible leveraging and increasingly complex derivative swaps, leaving the banker with a predicament: either he loses competitiveness and his job immediately, or takes excessive risk with the hope that it will pay off handsomely, ensuring job security – albeit temporarily. Hence, the choice of the banker becomes simple and obvious: in the likely event that the banker’s initial risk-taking severely backfires, he doubles downs in an elaborate “Ponzi” scheme to sustain himself for as long as possible, now at the expense of the bank’s overall survivability.

The residents of Main Street have never ceased to condemn the attitude of corporate greed that is so prevalent within Wall Street, but what they all fail to realize is their responsibility for the savage behavior that abounds inside the (once) hallowed doors of Lehman Brothers, Bear Sterns, AIG and so on. It is perhaps time that we acknowledge that in Wall Street, survivability necessitates greed and other forms of mercenary behavior.