44 thoughts on “Weekend reflections

  1. Hugh White nails the cretinous Afghanistan debacle:

    Any government that is too weak to win a counterinsurgency without massive outside help is too weak to be worth supporting


    I condemn Howard for his craven and spurious invocation of the ANZUS Treaty. And I condemn Rudd and Gillard for their refusal to restore the dignity of Australia by withdrawing support for the West’s folly in Afghanistan.

  2. How can you sue rating agencies when so many buy and hold a diversified portfolio. Investment ratings are superfluous information that stock pickers buy. Passive investors did not rely on the ratings to buy and hold a portfolio that matches the whole market.

  3. Because there are organizations that rely on ratings agencies for what bonds they buy.

    Some can only buy AAA rated debt for example and it was painfully obvious that CDO’s rated AAA by some agencies were not.

    The Leading fund manager I was with at the time (2007/8) wouldn’t touch them with a barge pole.

  4. There’s a grey area between fraud and negligence.

    The US justice system appears to have a category called civil (i.e., non-criminal) fraud. I’m having a little trouble getting my head around that concept.

    Negligence is more straightforward. Undoubtedly much harm was done. Presumably, some investors were motivated to buy certain products based on their ratings. But do the ratings agencies owe a duty of care to these investors? The investors didn’t hire the ratings agencies.

    However, the sellers of the assets rated may have known that the agencies missrated them. Knowing that, the sellers fraudulently, recklessly or negligently used those ratings to help them to misrepresent their products.

    It appears to me that the ratings agencies are an appropriate target in the eyes of the US Justice Department because they are likely to be found not liable.

  5. Katz, On credit ratings agencies, see http://conversableeconomist.blogspot.co.nz/2011/08/where-did-s-get-its-power-federal.html

    • Banks satisfied their regulators by just heeding the ratings of agencies rather than doing their own evaluations of the risks of the bond.

    • Insurance, pension and securities market regulators followed suit in privileging credit ratings agencies in prudential regulation compliance.

    • Active investors want stable ratings to reduce the need for frequent and costly adjustments in portfolios.

    • Passive investors buy a portfolio matching the entire market so credit ratings do not matter.

    Those who criticise the efficient market hypothesis must think that credit rating agencies can potentially add value.

    Under the efficient market hypothesis, credit rating agencies are a form of stock picking. Stock pickers think they can beat the market, but only the top 3% of investment fund managers win a return to just cover the costs and risks of active trading and their research departments

    Eugene Fama argues that stock prices predict changes in ratings better.

    He also said that bonds are simpler to evaluate than stocks because there is a downside risk, but no upside. Bonds have become more complicated because of the securitization but still not that big a deal. there is still only downside to manage.

    Fama’s solution is to increase bank capital requirements to 40-50 percent. They halved from 30% when deposit insurance was introduced in the 1930s.

  6. Jim Rose, those people who promote financial myths (including textbook authors and bloggers), who talk about ‘the market’ and ‘the market portfolio’, might wish to consider what they are doing in the light of the notion of fraud or negligence.

    Are you sure you are not engaging in myths dissemination?

  7. @Jim Rose
    “How can you sue rating agencies when so many buy and hold a diversified portfolio. Investment ratings are superfluous information that stock pickers buy. Passive investors did not rely on the ratings to buy and hold a portfolio that matches the whole market.”

    Jim, you don’t seem to know that the problem with rating agencies concerns debt-like securities and not ‘stock’ (equity)!!!

    I write ‘debt-like’ securities because you don’t seem to know what ‘securitisation’ is about and I want to indicate to you that we are not talking about ‘stock’.

  8. Ernestine Gross, There are also passive investment funds such as Vanguard that buy and hold diversified bond portfolios.

    There is still no upside to analyse in rating the risk of securitised bonds. Like all bonds, the issue is default risk. With shares, both ups and downs must be prophesied.

    Like all stock pickers, rating agencies pretend that they can beat the market in predicting bond defaults and charge a fee less that the value of this new knowledge.

    1. Do you hold a diversified superannuation portfolio? Does it buy and hold to minimise trading and research costs and management fees?

    2. How large a share of funds (shares and bonds) under management is now with the index-link passive funds inspired by the efficient market hypothesis?

    p.s. Fama is director of research of Dimensional Fund Advisors, which had $213.7 billion under management in 2011. It rejects stock-picking and market timing and uses enhanced indexing to design portfolios and limit trading costs.

    see http://www.dfaau.com/firm/research.html

  9. @Jim Rose

    Your questions 1 and 2 are unrelated to securitisation, the role of proverbial Wall Street Banks and rating agencies in the marketing of CDOs and other derivatives and the GFC. That is, my comment @33 is still valid.

    May I ask you to put a question to “Fama”. What data would the Dimensional Fund use to apply its indexing method in a ‘market’ consisting exclusively of index funds? (Hint: If “Fama” provides any answer other than his method would not work, don’t believe anything else he may say.)

  10. @Ernestine Gross to save you looking up the wiki, enhanced indexing comprises:

    1, Enhanced cash – Enhanced cash managers use futures to replicate the index then they take the roughly 95% of the capital left after buying futures (with their inherent 20 to 1 leverage) and purchase fixed income securities. The key to performance in these strategies is that the yield on the fixed income strategies is greater than the yield that is priced into the futures contracts (for the leverage).

    2. Index construction enhancements – Instead of relying on external indexes created by third parties like S&P or Dow Jones, enhanced indexes often use proprietary indexes. Alternatively, they use dynamic rather than static indexes.

    3. Exclusion rules – some enhanced indexes eliminate securities likely to reduce performance (e.g. companies with excessive debt or those in bankruptcy).

    4. Trading enhancements – Utilizing intelligent trading algorithms, some enhanced index funds create value through trading (e.g. by buying illiquid positions at a discount or by selling more patiently than traditional index funds).

    5. Portfolio construction enhancements – Enhanced index funds sometimes implement hold ranges that reduce portfolio turnover by allowing funds to hold positions during buffer periods even after traditional sell signals are triggered.

    6. Tax-managed strategies – manage buys and sells to minimize taxes.

  11. @Jim Rose

    Is the content of your post @ 36 the answer you obtained from “Fama” in response to my question @ 35? If so, I strongly suggest you ignore it (does not answer my question).

  12. @Jim Rose

    A ‘unilateral strategy’ is what you have been playing in a word game. You write as if either I had asked you for information on ‘indexing’ or as if you need to tell me. But neither is true. You just talk your talk. This ‘unilateral strategy’ in word games is effective if it is played by a person who has institutional power; you don’t.

    Your ‘unilateral strategy’ (talking your talk) avoided you answering my question. However, your talking your talk resulted in the remarkable result that an index fund (I can’t be bothered going back to look up its name), associated with “Fama” and inspired by the ‘efficient market hypothesis’ is conditional on ‘market work with zero intelligence traders’. This is priceless.

  13. @Ernestine Gross Re zero intelligence traders,
    how long after the explosion did it take the share market to work out who was the supplier of the faulty parts to the challenger space shuttle in 1986. how much of this learning and discovery took place while share trading was suspended?

  14. Financials are like any business, they will maximise profits when market conditions favour them. Blame central banks for running loose monetary policy.

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