Tuesday, April 20, 2010



CNN's financial reporter David Goldman (What's in a Name?) analyzed the AIG case today. AIG lost its clients and itself billions of dollars in financial transactions called credit default swaps. Often in situations in ...which the large insurer acted as final counterparty of transactions like the Goldman collateralized debt obligations (CDO's) that we reported on a few days ago. With the Goldman Abacus CDO leading to prosecution by the US government and fraud charges, many market participants (pension plans, banks, private investors and their representatives) are either looking for a legal case themselves or carefully monitoring how the SEC and the US District Attorney will do in the Goldman case.

With AIG - at that time in September 2008 the world's largest insurer - ending up in a bailout worth USD 182 billion(!) it was clear that people would also carefully follow how prosecutors would fare in a case against AIG and its former derivatives chief Joseph Cassano. The CNN analysis concludes that it will be very difficult to successfully prosecute AIG. And that is kind of shocking in a case where one firm receives bailout money larger than the GDP of approximately 75 percent of the world's countries! One firm being saved with funding equal to what populations of complete nations - with the exception of the top 50 - were earning collectively per annum.

Joe Cassano: AIG's former derivate chief
Negative role model of the financial wiz kid during the Credit Crisis

But the problem is that legally one has to prove that AIG management was deliberately acting against the interest of stakeholders (clients, shareholders, government, society as a whole etc) and should and could have known what would happen. The problem is however that the products that were being created in the casino economy aka financial sector were so complex that it provides anyone always with an argument to say 'How could I know?'. And also: with AIG often being the counterparty in deals similar to the one that Goldman is being prosecuted for, one actually provides AIG with a chance to plea guilty when accusing Goldman (and other institutions with similar products) of fraud.

The Western financial industry went crazy when wizz kids were allowed to create complicated products - often highly leveraged as well - with third party's funds, basically creating playgrounds for poker addicts who were subsidized with other people's money. The problem with financial products in general is that traditional financial products (long only) provide already situations in which theoretically the sky is the limit (positive return possibility of hundreds/thousands of percent) and a minimum (bankruptcy or default) of minus one hundred percent. Psychologically this will always be a tempting situation for 'players', similar to what we see with gamblers.

Another problem is also that what one investor will gain, another will lose. Psychologically winners will talk about their wins and losers will shut up. No one wants to be the loser at a party. With losers being silent and winners talking about and publishing their results, temptations are extrapolated even further.

But we aren't there yet: leverage (playing with borrowed money) makes things even more exciting: suppose you are able to attract USD 100 million in investment funds for a strategy that is expected to generate a return of 10-15 percent per annum. When interest rates are low - and they were low during the last 10-15 years - one could borrow money against an interest rate of let's say 5-7 percent and use the proceeds in our aforementioned strategy. Suppose you borrow USD 900 million based on the collateral of USD 100 million (and markets / market participants were indeed crazy enough to do this, again to a large extent because a) many people really believed that the wizz kids were true magicians; and b) everyone wanted to have a share of this free lunch opportunity) then in the end you can use USD 1 billion in your strategy. When the strategy generates 10-15 percent, the proceeds are USD 100-150 million. Subtract 5-7 percent over USD 900 million, i.e. USD 45-63 million and we are left with a net gain for the strategy's shareholders of USD 55-87 million. And that is on an initial investment of USD 100 million. Fantastic! A return of 55-87 percent. The leverage factor due to borrowing led to a multiplier of 5-6 of results without leverage.

This triggered even more extreme opportunities. And the financial world was full with alleged wizards that made fortunes selling this type of complex products, with the bulk of clients just hoping to become rich as well. And as so often, things go well until they go wrong. And they will go wrong, sooner or later. That is what we experienced during the Great Crisis.

But it is not really surprising what has happened. There are no free lunches and risk management is very important. But too many clients of financial institutions were on the one hand 'convinced' that the successful wiz kids would make them rich too and wasn't it true that the successful wiz kids were the ones to believe and not the cynical consultants or risk specialists like Noble Prize laureate Harry Markowitz who seemed to be telling a boring, negative story? I.e. money talks, bullshit walks....

However, the tower of Babylon collapsed. Why? International market flows and import/export situations across the globe have - in combination with differential economic growth rates in a changing world in which emerging markets are finally receiving their share of the action - led to a situation in which the group of investors ready and willing to participate in the casino economy was relatively more unstable in that disequilibria were now more likely. In the past the world was simple: the US had its savings deficit and Europeans and Japanese had a savings surplus. But markets in those countries were relatively too small compared to the size of the savings surplus. Result: money found its way to the US which had the more developed market with 'sophisticated new products' that could then be sold to make the circle complete. The US the money inflow, generated in excess savings behavior by foreigners.

But Chinese and Middle Eastern investors don't automatically participate in this game. And when they do, like the Chinese, they buy US government bonds and not necessarily complicated equity-like products. Add to this the complexity that Globalization really changed the world and created a situation in which contagion between markets was an inevitable new de-facto status quo that made it more complicated to predict what would happen, and we see what went wrong.

Wiz kids overestimated their qualities in a changing world. They were playing poker together and with their clients (and in almost all cases mainly with the latter's money) without sufficient attention for the changes in the world. We know now that we cannot close our eyes for these changes. AIG might not be prosecuted and it still remains to be seen if Goldman will be convicted, but the bottom-line is clear. What we should learn from all of this is that Emerging Markets will - unless we start to control the financial services industry in the developing countries - gain control over an increasingly large slice of the global economic pie. While we get crazy playing in the casino, they are making so much money that they can buy casinos.

And we all know that in the end, the casino owners are the only ones that make the money. That is what the financial services giants were doing in their old two-block (US versus Europe/Japan) world. But in the new world order - with three blocks (third block: Emerging Markets) - knowledge transfer within the financial industry from Western asset managers, banks, insurers to Emerging nations (compare what is going on in Hong Kong, Singapore, Shanghai, Dubai, Bahrain, Moscow, Sao Paulo etc) will change maybe not the rules of the game but definitely the relative power balance.

The Credit Crisis is more than just a Crisis in which the main poker players in our Western casino's are suffering. The Western casino owners struggle as well, and the Emerging Markets providers enter the stage at a time when they are the ones capable of buying casino's and strong players (financial execs). Result: financial services in Emerging Markets are gaining market share.

We believe that this trend will continue during the next 3-5 years. When eager to invest in the financial services industry, don't concentrate on big, fancy Western names only. Apply the logics of our analysis and do incorporate leading Emerging Markets providers of financial products in your strategy as well.

LMG Emerge follows a spectrum of some 50-75 Emerging Markets (and the number is growing) and quite a few of them are home base to successful, growing banks, asset managers and insurance firm. Do the right thing and diversify into this market segment.

No comments:

Post a Comment