Smoke & Mirrors (or What The Pink Panther Can Teach Us About the Market Meltdown)

What a week! Last week began with an almost unprecedented plunge in global stockmarkets that stretched from Hong Kong to Frankfurt (and places in between) that led to the sharpest interest rate cut in the history of the US Federal Reserve (21 - 22 January 2008). The week finished with the venerable French bank, Societe Generale, announcing that it had lost $7.2 billion -- a figure that easily exceeds the GDP of several countries and rivals Harvard's endowment -- because of the actions of a 'rogue trader,' Monsieur Jerome Kerviel. (Aside: The two events may have been related.)

So how do we make sense of these events? For that matter, how do we get our minds around the whole credit crisis and its messy consequences? The answer: Think of the Pink Panther.

For those of you who are not cinephiles (movie lovers), The Pink Panther (the original version and not the one with Steve Martin) was a 1963 movie starring David Niven as the brilliant jewel thief, Sir Charles Lytton, a.k.a. 'the Phantom,' who planned on stealing a rare diamond, named the Pink Panther. His nemesis was one Inspector Jacques Clouseau, played by the late, great British comedic actor Peter Sellers.

Originally, The Pink Panther was suppose to be a star vehicle for David Niven's character, the Phantom. The Phantom was supposed to be the criminal version of James Bond who would have a movie franchise built around his criminal exploits. In reality, what happened was that Peter Sellers' brilliant performance as the bumbling but preternaturally lucky Inspector Clouseau was so popular that subsequent movies in the Pink Panther series was built around his character. Inspector Clouseau -- rather than the Phantom -- became a household name, recognized by people who have never seen the movies, and became a near universal cultural reference.

And that's the problem. The problem that we are having in analyzing what is happening to the markets during this credit crisis and general collapse of confidence in financial markets is that we are focusing in on the Inspector Clouseaus rather than the Phantoms.

People -- especially during the annual meeting of financial, economic, and political 'luvies' at Davos, Switzerland -- have expressed incredulity at how Jerome Kerviel could have lost the equivalent of the GDP of several countries through bad trades and outright fraud. Some of the thoughts that have been expressed from Wall Street and the City (of London) to the ski slopes of Switzerland include: 'He couldn't have acted alone.' 'How much has he socked away?' 'He didn't even attend a Grandes Ecoles!'

My thoughts on these displays of incredulity are this: He probably did act alone. That is not to absolve the guilt of the Mandarins who did attend the Grandes Ecoles and run SocGen and much of France ... they fell asleep at the helm. But Jerome Kerviel probably knew enough about gaming the system from his experience with back-office work with processing and auditing trades to get away with it as long as he did.

I also believe that he didn't gain much financially from his endeavors. After all, if he did stash away billions (or even millions) of Euros from his fraudulent trades, then why didn't he run off to some exotic locale with an ex-model turned chanteusse in the style of another Frenchmen who's been in the news? His motivation was probably to cover up the fact that he made losing bets on the direction of equity futures. It probably had more to do with ego rather than financial gain. (Some insights into this was given by another infamous 'rogue trader,' Nick Leeson -- the man who brought down the venerable British bank, Barings -- during a recent interview with the BBC that was surprisingly candid and detailed.)

As for the final point, it's true that he didn't attend a Grandes Ecoles, but this brings us to what I call the Pink Panther problem. By focusing on the admitedly tantalizing narrative of some 'rogue trader' bumbling away billions of Euros, Pounds, Dollars, etc., we are missing what ought to be far more disturbing aspects of what is happening to us because of the crisis in the financial markets.

No, Jerome Kerviel didn't attend fancy schools and wasn't a member of the power elite. But what is the responsibility of those who have fancy credentials and connections in the current economic mess? It's easy to scapegoat some low-level employee in a trading outfit or some lowly mortgage broker or realtor straight out of Glengarry Glen Ross for the current troubles, but what about the higher-ups who are pocketing huge bonuses and/or severance packages and will land on their feet despite fubar-ing away billions if not trillions of dollars (all the while people are losing jobs and losing their homes)?

What about all of the supposedly non-rogue traders and derivatives salesmen who made decisions that were far more reprehensible and stupid than what Jerome Kerviel allegedly did? Those people aren't being arrested ... no, they're the ones who are running off to exotic locales with trophy wives/mistresses while they leave behind a trail of victims that lost a substantial chunk of what little they had.

What about the sanctimonious cheiftains of investment banks, hedge funds, etc., that ridicule single mothers, the lost youth of the inner cities and the countryside, and others who are less fortunate than they when they sincerely need help all the while these captains of industry are going around panhandling for money from goverment backed investment vehicles?

What about the politicians that looked the other way when all of this was going on? They weren't being wined and dined by the Jerome Kerviels of the world nor were they concerned about what would happen to ordinary Joes and Joannes that voted for them when the supposedly non-rogue, but (in some ways) far more crazy financial dealings of those who were wining and dining officials blew up. No, it was the business-world's equivalents of 'Sir Charles Lytton' that did attend the Grandes Ecoles, the Ivy Leagues, etc., that got our leaders and regulators to look the other way.

And looking the other way is at the heart of our crisis. One of the basic tricks of magicians is to use devices that distract the audiences' attention from what they should be focused in on in order to not get tricked ... smoke and mirrors. A good magician knows that human beings are more likely to be interested in the stumbling and bumbling Inspector Clouseau rather than the coldly calculating Phantom.

The mess that we are in is because we believed in a mirage, a possibility suggested in an excellent article by David Leonhardt of the New York Times. Just as Inspector Clouseau repeatedly escaped death by pure dumb luck, we had managed to escape financial disaster (until now that is) by Clouseau-esque good fortune. Sadly, Peter Sellers is no longer with us, and it is obvious now that the economy is also mortal.

People thought that the "spreading of financial risk, across institutions and around the world, had reduced the odds of a crisis" (from David Leonhardt's article). Quite the contrary, it is the spreading of financial risk that has led to the spreading of the crisis. Just as infectious diseases become more contagious when a virus or a bacteria takes advantage of the network effects of the interlinked relationships between their human hosts, financial contagion can now spread through more channels than in the past.

We were told that financial derivatives is another way of taming risk. Although derivatives can be validly used in risk and investment management, there are those who want to -- in the infamous, quasi-fictional words of Satyajit Das' 'Nero Tulip' -- lever up as much as possible via ever dizzying combinations of options, swaps, futures, special purpose entities, etc. In the recent past, we were lucky on a Clouseau-esque level to not have had all this 'hidden' leverage blow-up on us. Our luck ran out.

Risk can't be tamed. It can't be controled in some simplisitic, mechanstic way. That's the mirage we believed in. We put our faith in the good fortune of Jacques Clouseau all the while missing the thieves getting way with the loot.

Risk can't be waved away with a magic wand nor can we shuffle it off somewhere without it feeding back on us. Scapegoating some low-level flunky misses the point ... although there are plenty of villains (including, allegedly, Mr. Kerviel) ... because the really reprehensible characters will probably get away with it.

We can respect risk. We may be able to understand it on some level (although I doubt we can fully unravel its mysteries). But risk isn't subject to us, we are subject to it.

Finally Waking Up to the Credit Derivatives Mess

Regulars to The Econophysics Blog know that, since day one of the current crises, I've been pointing out the role that credit derivatives have played in creating and worsening the credit/mortgage crises -- a fact that was obscured or under-reported by the mainstream financial press and 'experts.' There is an article in The Economist that basically confirms the case I've been making -- along with some new fears -- about the toxicity of credit derivatives: CDOh no!: With trades scarce and losses mounting, it is going to be a harsh winter (Nov. 8, 2007).

According to the very interesting and comprehensive article, the AAA tranches of CDOs (collaterised-debt obligations: a vehicle used to package credit derivatives) have been substantially downgraded in value (see the chart of the ABX index -- and index of credit derivatives -- below) with fears of more downgrades to come. This would wreak havoc on already shaky financial markets.


There is also the question of accounting for these credit derivatives. The recommended method is to stick it in a category called "Level 3" which assesses "fair value" using "assumptions that market participants would use." But is that a good way to assign "fair value"? This situation is made worse by the fact that Level 3 securities have grown so much that they "now exceed shareholder equity" of many banks. No wonder many investment and commercial banks (as well as insurers, hedge funds, etc.) have been accused of not marking down their credit derivatives sufficiently.

Things can get much worse: AAA rated securities are relied on by a diverse range of investors -- from old age pensioners and municipal goverments to high flying hedge funds and banks. If AAA rated securities take a bigger hit because of their links to credit derivatives -- and/or other type of credit linked instruments (linked to consumer loans, for example) start sliding -- things can get really ugly ... much uglier than it is now.

Twilight of the Quants (or yet another reason for the current financial turmoil)

Over the last few months, I've tried to offer some analysis about the recent market turmoil that I feel has not been fully understood by the financial press and so-called expert commentators (e.g., the role of credit derivatives in the current crisis). It turns out that there is another contributing factor to the recent turmoil in the markets: quantitative hedge funds.

The most recent Buttonwood column in The Economist (25 Oct. 2007), sheds light on how 'quants' have been adding risk to the market because of their strategies. These quant funds are staffed by mathematicians, physicists, etc., that are suppose to come up with ultra-sophisticated models that should, they promise, lead to higher returns. But the problem is that other funds also hire quants that use similar models. This leads to a kind of feeding frenzy (or a vicious cycle) where an increasing number of very smart people are chasing ever shrinking opportunities for genuine arbitrage profits, which causes them to either ratchet up risks and/or try ever more esoteric strategies (which are copied almost as soon as there is any profit to be made), which, in turn, lead them further down the slippery slope.

For that reason, as well as others, these funds -- just as recently foreclosed home owners and their subprime mortgage lenders (who, presumably, didn't do PhDs in maths, physics, or engineering) -- loaded up on leverage (either directly or indirectly via derivatives, etc.). When the markets turned against the quants, they tried to offload their now toxic investments (in credit derivatives, etc.). Of course they couldn't find buyers, so they had to unload more liquid and valuable investments in order to meet margin calls and/or stay in business. But all this did was to cause a stampede among quant funds to get rid of assets that they really shouldn't have gotten rid of but HAD TO because of margin calls, the need to delta hedge their positions, plain desperation, etc.

This is the story of so many financial bubbles bursting -- except on a high tech, post-modern level. This, according to Buttonwood, is what happened during August. It seems that no one on Wall Street or in the City has a memory beyond their last bonus. Didn't we go through this with LTCM? Program trading in October 1987? Yet we are told that ever more sophisticated models or ever faster execution of orders will lead to greater returns. But what these 'geniuses' don't realize is that the world doesn't always fit their 'sophisticated' models. Common sense should have told them that strategies and assets that weren't correlated before will become correlated once everyone else with a PhD in Computational Chemistry decides to sell similar things at the same time! The rules of the game are the same whether you are a down-on-your-luck homeowner or an over-educated quant.

But to be fair, quants shouldn't shoulder all the blame. Yes, it's true that, as the article points out, "instead of providing liquidity in a crisis, the quants added to the instability." But the same could be said for those who participated in the dotcom bubble, tulip-mania, the Roaring 20s, and a whole host of financial fads and fashions that went awry. The problem is not that we are too sophisticated or that we are not sophisticated enough; the problem is arrogance. The problem is being willfully blind to 'Black Swans.' I doubt that any amount of rigorous modelling, algorithmic trading, statistical arbitrage, or improvements in order executions will solve that problem.

More on the Credit Crunch

Hopefully, all of you have read my last blog post -- Credit Derivatives Meltdown & Book Review of 'Traders, Guns & Money' (Aug. 16, 2007). In that blog post (among other things), I outline a major factor in the credit crisis and market fall that is being ignored (or misunderstood) by most commentators -- credit derivatives.

I found several articles in the most recent New York Times that relate to the current crisis in the credit and real estate markets (and their knock-on effects to the financial markets in general). I don't think they get to the heart of the matter (credit derivatives), but they do talk about issues that are nonetheless important to any attempted explanation of what is going on now.

Drop Foreseen in Median Price of U.S. Homes by David Leonhardt and Vikas Bajaj (Aug. 26, 2007) : In the last few years, almost every real estate 'expert' dismissed the idea of a nationwide decline in housing prices across the U.S. Guess what? ... It's happening!

Inside the Countrywide Lending Spree by Gretchen Morgenson (Aug. 26, 2007): With many mortgage banks/lenders at deaths door (either closing down or dramatically reducing their mortgage lending operations), Countrywide's recent bailout from other banks ($11.5 billion credit line had to be drawn down 2 weeks ago and Bank of America recently took a 16% stake in Countrywide for $2 billion) is emblematic of the recent crisis in the credit and real estate markets.

A Psychology Lesson From the Markets by Robert J. Shiller (Aug. 26, 2007): Yale financial economist and author of Irrational Exuberance comments on what is happening in the most recent market crisis.

Will the Credit Crisis End the Activists’ Run? by Andrew Ross Sorkin (Aug. 26, 2007): Speculates that credit crisis will reduce the ammunition needed by activist hedge funds to ply their trade.

Just How Contagious Is That Hedge Fund? by Mark Hulbert (Aug. 26, 2007): Hulbert cites research by 3 financial economists (the most prominent being Rene Stulz of Ohio State University) arguing that hedge fund strategies may be correlated with each other. This is flies in the face of hedge funds' advertised goals of using strategies that are unique and distinct from one another. What this means is that if the strategies of a few hedge funds fail, then there is a good chance that others will fail as well. To some extent, we are seeing some of this with the credit derivatives bets made by some hedge funds.

Credit Derivatives Meltdown & Book Review of 'Traders, Guns & Money'

Regulars to this blog may be familiar with my preference to not comment on contemporaneous events occurring in the markets. The basic reason for this is that I'd prefer to let the dust settle before I say anything about movements in the financial markets (if I have anything to say about it at all). I am making an exception to this general 'rule,' because the credit market meltdown that we are currently experiencing in the global financial markets just happens to coincide with a book review I wanted to write for a long time.

So what is this book I wanted to review that seems ironically (or, perhaps, appropriately) to be the perfect companion to the bursting of the credit/real estate bubble? The book I want to review today is titled Traders, Guns & Money (Knowns and Unknowns in the Dazzling World of Derivatives) written by financial derivatives expert and veteran trader, Satyajit Das.

The most succinct endorsement (obviously, I will give a more detailed endorsement below) I can give to this book is by comparing this book to two of the books -- Fooled By Randomness and The Black Swan -- written by one of my favorite authors, Nassim Nicholas Taleb. In a nutshell, Das' book takes many of the ideas developed and espoused in NNT's books and applies them, in a clinical and detailed (but accessible) way, to the world of financial derivatives.

But a stronger one-line endorsement of this book was given by Frank Partnoy (author of FIASCO: The Inside Story of a Wall Street Trader and Infectious Greed) : "When 'derivatives' and 'f******' appear together on every other page, you know someone has written the truth about financial innovation." (It's worth noting that Partnoy exaggerates the amount of profanity used in the book ... but his basic point is well put.)

In Traders, Guns & Money, Satyajit Das dissects and analyzes almost every aspect of the derivatives industry with the same level of skill and care as an expert crime scene investigator combs through the scene of a crime. No part of the derivatives world escapes the attention of Das. Sell side, buy side, over-the-counter (OTC) derivatives, risk (mis-)management, 'quants,' structured products, equity derivatives, credit derivatives (much more on this later), and even more exotic derivatives (like weather and carbon emission derivatives) are covered in this fascinating book.

Das uses several underlying themes or frameworks throughout this book. One of these themes/frameworks is his use of semi-fictionalized narrative -- presumably, based on his own long career in the derivatives industry -- to highlight the dark side(s) of the derivatives world. This is reminiscent of the style used in NNT's books (Das even has his own 'Nero'; although Das' Nero is more like NNT's Fat Tony ... in fact Das' Nero would make Fat Tony look like a debutante). Das' 'war stories' are salacious, but, more importantly, they serve the purpose of exposing the real world workings of the derivatives industry to naifs.

Another theme/framework Das employs throughout his book is a somewhat Popperian one: 'knowns' and 'unknowns.' Das categorizes the workings of financial derivatives into one of four categories based on permutations of knowns and unknowns. There are the 'known knowns' -- things that we know that we know and, thus, can have a high degree of certainty about. The second category is 'known unknowns' -- things that we don't know but we know that we don't know them; this adds a degree of uncertainty but it is manageable uncertainty (similar to NNT and Benoit Mandelbrot's "mild uncertainty").

The third category is rather fascinating to me when I first heard it: 'unknown knowns.' These are things that we know but we do not realize (or, many times, we don't want to realize) that we know it! This may sound far-fetched, but I think Das is correct to articulate this category. An example that Das cites to illustrate 'unknown knowns' is the idea of greed and fear that underlies the derivatives game. No matter what people may say (and even believe, to some extent) about derivatives as a tool to hedge risk, add liquidity to markets, etc., the almost unsaid truth is that the motivation behind trading derivatives is greed and the fear of missing out on greed. This is an 'unknown' known because the players have incentives to not admit this to others (or even to themselves) because it is, at the very least, impolitic to 'know' this known.

The last category are the 'unknown unknowns' -- the "things that you did not know you did not know" (p. 12). This is the most problematic category because the degree of uncertainty in this category is virtually unbounded. This is like NNT's "Black Swan" (or "wild randomness").

Lest one is tempted to think this is all idle philosophizing, as the book highlights along the way, both the 'unknown knowns' and 'unknown unknowns' seems to pervade the derivatives industry.

One of the 'unknown knowns' that Das book does a great job of exploring is the mythology of financial 'engineering.' Many business schools and economics departments would like to beatify quantitative finance by removing the messy realities of the real world and 'cleaning' (over-simplifying) it up so that it resembles something like civil engineering. Academic and industry naifs would like people to believe that Black-Scholes, Cox-Rubenstein, Miller-Modigliani, etc., turn derivatives valuation into something akin to bridge building (and, as the recent tragedy in Minnesota shows us, even bridge building is a lot messier in the real world than in textbooks).

Das does a lot to explode these myths. Yes, Das would concede, fancy quantitative models can help, but there are serious weaknesses with copulas, implied correlations, dynamic delta hedging, etc. In other words, model risk, basis risk (basically, comparing apples to oranges), marking-to-model or to a market when there is no liquid market for the instrument, liquidity risk and flight-to-quality, etc., will forever doom even the geekiest and 'greekiest' models to getting blind-sided by negative Black Swans.

Along the same lines is how Das' book exposes the dark underbelly of many derivatives contracts. Many (if not all) the textbooks and technical literature on derivatives seem to think that derivatives are created and structured by Mother Theresa's Sisters of Mercy. These other books/papers will describe vanilla call, put, forward/futures, swap contracts but will have next to nothing on 'exotic' derivatives, structured products, special purpose vehicles, credit derivatives, etc. Even books/papers that touch on OTC and exotic products tend to take an unrealistic and unworldly view of things; i.e., they seem to unskeptically accept the propaganda of sell side traders/derivatives salesmen that they are 'client-centric' and that they would 'never' try to hide anything or slip in financial equivalents of ticking time bombs into their derivatives products.

Fortunately, Das -- having been on both the buy and sell side of the business -- doesn't believe that derivatives salesmen and traders have taken a vow of chastity. Das exposes many of the hidden details in real world -- as opposed to the idealized models one sees in textbooks -- derivatives contracts/products. And, not surprisingly, these details show that derivatives aren't the seemingly innocent ways to make markets more 'efficient' as we've been led to believe. There is sketchy accounting, hidden leverage (often massive), outlandish terms, and other ugly and sordid details.

For example, one semi-fictional example of contractual shenanigans that Das gives is almost comical (if you have a mathematical bent) if billions of dollars weren't at stake. One swap contract would have had a near-bankrupt company pay $4 million a month to a dealer in exchange for the investment bank paying the company an amount based on the following formula/algorithm (adapted from pp. 10-11):

Max[0; $600 million * {7 * [(LIBOR^2 * 1/LIBOR) - (LIBOR^4 * LIBOR^-3)]} * days in the month/360]

If you know basic algebra, then you would realize that this term will always equal zero! [Hint: The LIBOR terms.]

There are many other aspects of this book that I can highlight and praise, but the remainder of this post will focus on the intersection between Das' book and the current turbulence in the markets: namely, credit derivatives. The current market meltdown -- as summarized in the current issue of The Economist -- revolves around collateralized debt obligations (CDOs), collateralized loan obligations (CLOs), and mortgage backed securities (MBS) [for the purposes of our discussion, we can consider all three to be virtually interchangeable]. It just so happens that Das' book contains the best overview of credit derivatives that I am aware of.

The problem that credit derivatives products are causing right now in the markets are complex and hard to describe in the limited space of this blog. However, I can very briefly outline the problems below:

(1) Credit derivatives, like CDOs, are causing problems right now, in part (again, it's much more complex than what I can get into at this point), because they are basically untradeable and unhedgeable at this point. Why? Because the assets underlying these credit derivatives -- for the most part real estate mortgages (but there are other kinds of debt, like corporate debt, at play here too) -- have tanked in value because of the rising levels of defaults and the increase in the (subjective) probability of defaults.

(2) That's not the only problem. The other problem is that investments in these credit derivatives vehicles/products are structured into what are called tranches. That is a fancy way of saying that different classes of investors in credit derivatives will get paid in different ways. The 'equity' and 'mezzanine note' holders are taking a bath on this freefall in the CDO 'market' (I use that term loosely, since much of this is OTC) since they had lower priority in cases where some of the holdings in the credit derivatives portfolio defaulted (i.e., they took the risk in return for the rewards, and the chickens have come home to roost). The catch here is that senior note holders who had the highest priority are also taking a beating. This came as a surprise to them (but, according to Das and to my way of thinking, maybe it shouldn't have been) because most of these CDOs are structured so that the senior notes will get the highest possible ratings by credit rating agencies -- AAA. Now, the senior note holders are finding that AAA might as well be FFF.

(3) To make matters even worse -- and this happens in virtually every market crash (bursting of asset pricing bubbles) -- investors, banks, etc., are compelled to sell assets in order to limit losses and/or hedge risk. The problem is that this is either hard to do and/or makes things even worse. Obviously, they want to get rid of non-performing and/or illiquid assets, but they can't right now (if ever) because they're heading toward worthlessness. So they have to sell off 'good' assets, which means that prices of assets that at first blush seems to have little to do with CDOs, MBSs, mortgages, lending, banking, etc., also fall precipitously. I.e., correlations are created when there was little or none before!

(4) To top it all of, there is a LOT of leverage involved (both explicit and implicit). Leverage makes downturns even worse. For example, the need to meet margin calls is what is causing the sell off that I described in point (3).

That's a nutshell description of what is happening now in the financial markets. Like I said, it is much more complicated than that I'm sure, but if you can follow what I just wrote, then you're probably more knowledgeable than the vast majority of the people who bought and sold CDOs over the years.

Getting back to Das and how his book relates to the current tremors in the markets ... Das' book is the only book that I'm aware of that gives an accessible account of the workings and structure of credit derivatives, including both financial and legal issues surrounding them. Chapter 9 of his book -- considering the mess we're in -- is well worth the price of the book in it of itself (although the rest of the book is just as great if not better)! I would go so far as to say that Das essentially predicted the current crisis over a year ago (the book was published last year, 2006).

The intersection between Das' book and the market meltdown brings us back to the theme of knowns and unknowns. Goldman Sachs has admitted that its hedge funds -- keep in mind that hedge funds have been big buyers of credit derivatives -- have been "hit by moves that its models suggested were 25 standard deviations away from normal" (from The Economist article). This is, in terms of standard Gaussian mathematical statistics, akin to saying that it was impossible for these losses to take place. Guess what ... the losses took place!

Apologists for hedge funds, investment banks, credit agencies, and investors may claim that these are what Das might call 'unknown unknowns.' How can anyone think that a (negative) 25 sigma event would take place? How can anyone know that credit rating agencies' grades are not worth the paper they're printed on when you need to count on them the most? Etc.

The problem with this line of argument is that these 'unknown unknowns' were actually known .. we just didn't want to admit that to ourselves. Nassim Nicholas Taleb, Benoit Mandelbrot, and -- as this blog post outlines -- Satyajit Das, have been warning us about these kinds of Black Swans for quite a while. Chance of a 25 sigma event taking place? Impossible from a 'normal,' bell curve perspective. Quite likely, from the Black Swan way of thinking.

The lesson we can learn from the NNTs and Das-es of the world -- those rare individuals who can combine sincere humility with the courage to face and embrace inconvenient truths -- are that the 'unknown unknowns' are really 'unknown knowns.' We actually know that 'impossible' events can take place because we should know that our pretentious models and heuristics are vulnerable to the messiness of the real world. The problem is that we don't know -- or, more accurately, we don't want to know -- that we know. That kind of self-knowledge is too painful to our ego, too inconvenient, and too humbling.

But ask yourself the question: Isn't it better to feed yourself humble pie rather than having it hurled at your head as is happening to so many traders and bankers now?

Greenspan chimes in on Chinese stockmarkets

I've written a couple of posts lately about the possibilities of a stockmarket bubble in China (More signs of a Chinese stockmarket bubble, 5/13/07, and Makings of a Chinese Stockmarket Bubble?, 4/29/07) . According to the New York Times (5/25/07), former Fed Chairman Alan Greenspan has chimed in as well. According to the Time article:

Mr. Greenspan, now 81, struggled to contain the tech stock boom, issuing his famous “irrational exuberance” warning in December 1996 only to watch the American market keep rising and finally collapse in early 2000. He tried his hand at forecasting Chinese stocks on Wednesday, telling an audience in Madrid by satellite that the Chinese market was “clearly unsustainable” and could undergo a “dramatic contraction.”

After setting records on Monday, Tuesday and Wednesday, the A shares, those traded in yuan, fell 0.47 percent in Shanghai and 0.6 percent in Shenzhen on Thursday as investors responded to the warning.

But the warning was not news to Mr. Zhou and other Chinese officials. The central bank, securities regulators and prominent business executives have all been cautioning investors that buying stocks is not a guaranteed path to riches — all with less apparent effect than Mr. Greenspan.

To reiterate my earlier warnings, developments in China can (and has) effects on an increasingly inter-linked, globalized financial markets.

More signs of a Chinese stockmarket bubble

According to the Financial Times [in Bourses in China eclipse all of Asia (May 9, 2007)]: "The value of shares traded on China’s stock markets on Wednesday was greater than the rest of Asia combined – including Japan – helping the benchmark index to breach the 4,000 mark for the first time. Analysts said this was almost certainly the first time that turnover at the Chinese bourses had exceeded that of the rest of Asia." (Although, it should be noted, that the Chinese stockmarkets in Shanghai and Shenzhen are still substantially smaller than the markets in Japan, the UK, and the US, in terms of market capitalisation.)

This is more evidence for some of the comments I made in previous posts on China's financial sector ... the latest post being Makings of a Chinese Stockmarket Bubble? (April 29, 2007). A financial bubble (that bursts ... as they invariably do) in China could have devastating consequences for markets (and economies) of other countries (including the US, the UK, and Europe). It's definitely worth keeping an eye on developments in China.

Makings of a Chinese Stockmarket Bubble?

China is in the midst of a stockmarket frenzy. According to an article in The Economist magazine (April 26, 2007), new accounts at stock brokers are being opened at a rate of more than 200,000 a day (e.g., more than 310,000 on April 24th of this year). Many of these punters are relatively new to the market and are often either unsophisticated or relatively low-income (including, students and old-age pensioners).

What is fueling this madness for stocks? Despite a couple of scares earlier this year (February 27, and April 19), phenomenal returns (for now). E.g., the Shanghai Stock Exchange's composite index rose by about 130% in 2006 (and is still rising). (See the chart below.)


Having seen some newspieces from China Central Television's channel 4 news on the latest stockmarket craze, I can see how much the stockmarket has permeated daily life in China.

It's worth noting that another factor, besides hyperbolic returns, is driving this 'investing' frenzy -- consumer technology. By "consumer technology" I don't mean China's equivalent of tech stocks (although I'm sure they are enjoying a boom). Instead, it is the growing availability of communcation devices like cell phones, instant messaging, and broadband Internet connections that have reinforced and further enabled this stockmarket 'madness of crowds.'

So is this a bubble? It certainly has all of the earmarks of a stockmarket bubble that will eventually burst. The recent past has demonstrated that Chinese stockmarkets (in Shanghai and Shenzhen) are vulnerable to market volatility as well as to macroeconomic shocks and policy changes by the Chinese Communist Party.

One of those Chinese would-be investors, when describing China's stockmarkets, quoted by The Economist summed it up best: "It's like a casino set up by the Communist Party." If the CCP isn't careful, they will find themselves in quandry (which they may already be in). A rising stockmarket keeps the public (especially the growing middle class) mollified and gives the CCP more credibility. On the other hand, a bubble that burst could cause widespread anger toward the CCP. As Western capitalists can attest to, it is rather difficult (if not impossible) to reconcile those two agendas.

Air Out of the Real Estate Bubble?

With each passing day, there seem to be more and more signs that the air is coming out of the real estate bubble in the U.S. News of layoffs at mortgage lenders and investigations of some mortgage lenders seem to be consistent with the popping of a bubble. Most of the economic data and trends related to real estate are also consistent with a downturn in real estate. The Economist magazine has an article (March 22, 2007) analyzing the rise in foreclosures and the downward direction of the real esate market.