May 15, 2010

The Big Short and Rating Agencies


Michael Lewis' The Big Short is, in my opinion, by far the best book written up until now about the origins of the financial crisis. There are so many nuggets in this book, I have highlighted almost half of it. It is a fantastic tale of incompetence and/or dishonesty and one of the big unanswered questions in the end remains: who was incompetent and who was dishonest? It's a question the multiple lawsuits in the pipeline will only provide a partial answer to.

As the Senate recently approved new rules for credit-rating agencies, it's interesting to note that the rating agencies come out really bad in the book. They were badly gamed by the investment banks:
The pretense that these loans were not all essentially the same, doomed to default en masse the moment house prices stopped rising, had justified the decisions by Moody's and S&P to bestow triple-A ratings on roughly 80 percent of every CDO. (And made the entire CDO business possible.)
Not only that but, since rating CDOs brought in the bulk of their revenues (paid by the very investment banks who designed the CDOs), the credit-rating agencies had every incentive to do exactly as they were told and not dig any deeper than necessary. This is the damning email an S&P managing director sent one of his analysts, who apparently wanted to know a little more about the toxic waste in a CDO he was rating:
Any request for loan-level tapes is TOTALLY UNREASONABLE!! Most originators don't have it and can't provide it. Nevertheless we MUST produce a credit estimate.... It is your responsibility to provide those credit estimates and your responsibility to devise some method to do so.

May 14, 2010

Markets Are Right Only When They Agree With My Thesis


As much as I admire Paul Krugman and agree with most of his writings, I must say his latest New York Times column smacks of bad faith. Why am I saying that? This is what he writes:
Both nations [the U.S. and Greece] have lately been running large budget deficits, roughly comparable as a percentage of G.D.P. Markets, however, treat them very differently: The interest rate on Greek government bonds is more than twice the rate on U.S. bonds, because investors see a high risk that Greece will eventually default on its debt, while seeing virtually no risk that America will do the same.
Everything in this paragraph is true, that's not the issue. The problem is that, in most of his writings, Paul Krugman berates markets when they don't agree with his opinions. I remember quite a few columns in which he wrote words to the effect that "markets don't seem to agree with my way of thinking but we all know markets are stupid and anyway I don't care about markets and neither should you". But in this case, since markets seem to be giving the U.S. a pass lately (who knows for how long), mostly because American finances are a paragon of virtue compared to European finances, and that squares with his opinions, all of a sudden he has newfound respect for them. Better late than never I guess.

Or maybe this is just another example of someone talking his book, which is as close to a universal law as any Wall Street old saw.

May 1, 2010

Remember Inflation?


Mohamed El-Erian, the other genius at PIMCO, has this intriguing thought in the latest Barron's:
Most investors today haven't experienced inflation, and have very little inflation protection in their portfolios. The biggest risk is stagflation and most portfolios have very little protection. The challenge is to use 2010 to build up inflation protection for the medium term.
He sees inflation as inevitable in the medium term for two reasons. One is that governments running large deficits (as is the U.S.) will always be tempted to inflate and even if they don't, investors will expect them to, so that inflationary expectations will go up. The other is that unemployment will stay high for the foreseeable future and the Fed will be hesitant to be too hawkish lest they hurt the economy and worsen the employment situation.

Rising inflation expectations combined with a less than totally committed Fed will most likely result in some serious inflation at some point down the road. As Mr. El-Erian suggests, adding some TIPS to one's portfolio this year would qualify as a prudent move.