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*EUROPEAN FINANCIAL STABILITY FACILITY MAY BE CUT BY S&P

Old joke about Analysts:

You do not need them in a Bull market, and you do not want them in a Bear market.

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I was thinking about that in light of the S&P’s mass EU downgrade threat.

As always, the Credit Rating Agencies are quite late to the party. And consider that the European Central Bank, whose balance sheets are festooned with bonds from all of these countries, is somehow still AAA.

My bottom line about the rating agencies is they are worthless to investors.

Consider how the market actually reacts to these outlook and ratings downgrades. As an example, think about the downgrade of US debt from AAA to AA+, as the chart below reveals:

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Spot the Down Grade!

click for larger graphic

Source: Stockcharts

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As a reminder, the S&P downgrade was August 5th; US Treasuries have actually rallied since, then, sending rates appreciably lower, and making US borrowing costs less expensive. (Thank you sir, may I have another?)

Equity markets wobbled for a few months, then resumed what they were doing previously (going sideways).  Last I checked, the Euro was practically flat year to date.

Given the various downgrades, they seem to make a lot more heat than light. They do not seem to matter as much as we think to the markets they are actually rating — namely, debt. Its somewhat ironic that a downgrade of debt seems to have more impact in the equity markets.

Which leads us to telling question: Do the ratings agencies matter anymore? Have investors figured out that they are corrupted, conflicted, unable to honestly discharge their duties?

Or is it simply that they suck at what they do? Recall the downgrades of Enron, Worldcom, Lehman, AIG, and many others. It seems the markets force them to act, that Traders are issuing the call long before the analysts at Moody’s or S&P actually  downgrade a corporate or sovereign ratings.

We may not need the judgment of honest analysts in a bull market, or want them in a bear market, but it seems the answer to our headline question: When it comes to the ratings agencies themselves, investors seem to have little if any use for them anytime.

Source:
Over Rated,
Bloomberg Businessweek,
Nov/Dec 2011

There may be no honor among thieves, but there has always been some small measure of dignity — even respectability — amongst the con men of the equity markets.

Apparently, there is no such corresponding code of honor amongst commodity trading firms.

I refer of course to the debacle that is MF Global. How on earth could $633 million in customer accounts simply disappear?

As it turns out, quite legally.

The regulations governing these customer accounts are 25 plus years old, according to a few insiders I spoke with. They gave the firms an ability to hypothecate (lend) client money, so long as it was only used to legally purchase investment grade sovereign debt.

So that was what MF Global did.

As originally conceived, client monies were only supposed to purchase US Treasuries. However, so as to not offend trading partners (and other reasons), the regs were written so as to include any “investment grade sovereign” in the rules. Hence, AA rated European sovereign debt, despite the obvious fact that in 2011 they are obviously not the equivalent of US Treasuries, technically qualify. Whether this violates the obvious spirit and intent of the law will be for a judge to decide.

Of course, this raises another question: If the corrupt and compromised rating agencies had actually done their jobs — downgrade European junk to what it really was — would MF Global been able to empty client accounts? I suspect not.

Regardless, consider the Con Man’s Lament: The past half century of boiler rooms, accounting scandals, pump & dumps, backdated options, corrupted analysts, IPO spinning, derivative debacles, etc., have all come about for this simple reason: Brokerage firms cannot simply reach into client accounts and take the money for firm use.

This wasn’t a face-in-hand moment — Hey, why didn’t we think of that? — amongst equity criminals. Rather, it was a well understood rule that was enforced without question. “Borrow” money from a client account without their knowledge, go to jail for grand theft.

Consider:

• If the weasels at Stratton Oakmont or any other ’90s boiler room thought they could merely empty client accounts, they would have. Instead, they had to concoct enormous Pump & Dump schemes to dupe willing rubes out of the money.

• If Merrill Lynch could have merely grabbed billions from Orange County, rather than create an elaborate derivatives scheme that ultimately bankrupted the county, don’t you think they would have done that?

• Instead of the IPO spinning to capture assets and revenues that most of the major bulge bracket firms did int he boom times of the late 90s, wouldn’t it have been easier to merely leverage up client accounts?  Heads we win, tails you lose?

• Would any of the major accounting firms had to do such absurd audits of firms like WorldCom or Tyco? They worked hand in hand with Wall Street to help capture money. (But steal? Never!)

• Consider the side pockets developed by Enron with the help of McKinsey & Co. If there was a way to simply take client money, why would anyone bother going through all that trouble?

• Even the convoluted Lehman’s Repo 105 was a way to hide $50 billion per quarter from investigators and regulators. Had they been able to tap client monies, who knows how their saga might have ended.

Now, that may not sound like much, but it is worth considering. Neccessity being the mother of invention forced the very worst enterprises on the equity side to engage in all manner of deception and duplicity by morally compromised, ethically challenged bad actors. They had to do this, because they could not merely grab monies from client accounts.

It was a point of pride amongst equity con men that they did not merely steal. They cajoled, wheedled, scammed, and cheated, but they never stole.

Hey, what kind of people do you think we are?

Kiron Sarkar is an investor and advisor in London. Formerly in the M&A dept of N M Rothschild in London, he was head of M&A of Rothschild (Hong Kong) and worked on their international privatisation team. He worked as privatisation adviser to the UK Governments Know How Fund. Most recently, he was European Head of Media, Tech and Telecoms at CIBC World markets. Kiron has acted as a lead adviser in respect of over US$150bn of deals and has worked globally in both developed and emerging markets.

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Moody’s threatens to downgrade ALL Euro zone countries – hey, that includes Germany does it not. Off course it does. I really wonder what officials in the German Finance Ministry think of that – a bit of a shock – well, possibly stronger emotions than that, I suspect. However, why the surprise – in my view Moody’s is just reflecting the reality of the situation.

French newspaper reports (La Tribune) suggest that S&P may downgrade the country’s outlook to negative in the next few weeks – personally, I do not believe that France will be able to maintain it’s AAA rating, so no surprise. French unemployment rose to the highest since December 2009. Looks increasingly as if Sarkozy is “French toast” in next years Presidential elections – no great loss, but the likely winner (a socialist) – who knows what he will be up to. Basically, more
uncertainty – just hope (likely) that the euro zone issues will be sorted out before that – making it more difficult for the potential Socialist candidate to complicate the process.

The far more important point is that Germany is finally recognising that it is not financially immune. The other big issue is whether Germany comes up with a credible solution re the Euro Zone and, by default (maybe not the right word to use, given the current situation) for themselves.

Read the rest of this entry »

You may have missed Simon Potter’s publication on Friday “The Failure to Forecast the Great Recession.”

Potter is not merely a distant observer throwing stones; he is the Executive Vice President and Director of Economic Research of the Federal Reserve Bank of New York.

He breaks down the economists’ collective research failure into three categories:

1. Misunderstanding of the housing boom
2. A lack of analysis of the rapid growth of new forms of mortgage finance.
3. Insufficient weight given to the powerful adverse feedback loops between the financial system and the real economy.

The entire piece is in the Think Tank for your reading pleasure . . .

The Failure to Forecast the Great Recession
Simon Potter
November 25, 2011

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Experience shows that what happens is always the thing against which one has not made provision in advance.
– John Maynard Keynes¹

Our best plan is to plan for constant change and the potential for instability, and to recognize that the threats will constantly be changing in ways we cannot predict or fully understand.
– Timothy Geithner²

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The economics profession has been appropriately criticized for its failure to forecast the large fall in U.S. house prices and the subsequent propagation first into an unprecedented financial crisis and then into the Great Recession. In this post, I examine the performance of the forecasts produced by the economic research staff of the Federal Reserve Bank of New York (New York Fed) over the period 2007-10 and consider some of the reasons why we, like most private sector forecasters, failed to predict the Great Recession. This spreadsheet contains staff forecasts, the outcomes, and a standard measure of private sector forecasts—the Blue Chip consensus. In addition, staff material prepared for bi-annual meetings of the New York Fed Economic Advisory Panel provide some further insights into the evolution of the staff outlook.

The staff forecasts of real activity (unemployment and real GDP growth) for 2008-09 had unusually large forecast errors relative to the forecasts’ historical performance, while the forecasts for inflation were in line with past performance. Moreover, although the risks to the staff outlook were to the downside throughout this period, it wasn’t until fall 2008 that a recession as deep as the Great Recession was given more than 15 percent weight in the staff assessment.

How Bad Were the Forecasts for Real Activity?

Economic forecasters never expect to predict precisely. One way of measuring the accuracy of their forecasts is against previous forecast errors. When judged by forecast error performance metrics from the macroeconomic quiescent period that many economists have labeled the Great Moderation, the New York Fed research staff forecasts, as well as most private sector forecasts for real activity before the Great Recession, look unusually far off the mark.

One source for such metrics is a paper by Reifschneider and Tulip (2007). They analyzed the forecast error performance of a range of public and private forecasters over 1986 to 2006 (that is, roughly the period that most economists associate with the Great Moderation in the United States).

On the basis of their analysis, one could have expected that an October 2007 forecast of real GDP growth for 2008 would be within 1.3 percentage points of the actual outcome 70 percent of the time. The New York Fed staff forecast at that time was for growth of 2.6 percent in 2008. Based on the forecast of 2.6 percent and the size of forecast errors over the Great Moderation period, one would have expected that 70 percent of the time, actual growth would be within the 1.3 to 3.9 percent range. The current estimate of actual growth in 2008 is -3.3 percent, indicating that our forecast was off by 5.9 percentage points.

Using a similar approach to Reifschneider and Tulip but including forecast errors for 2007, one would have expected that 70 percent of the time the unemployment rate in the fourth quarter of 2009 should have been within 0.7 percentage point of a forecast made in April 2008. The actual forecast error was 4.4 percentage points, equivalent to an unexpected increase of over 6 million in the number of unemployed workers. Under the erroneous assumption that the 70 percent projection error band was based on a normal distribution, this would have been a 6 standard deviation error, a very unlikely occurrence indeed.

Did We Calibrate the Risks to the Forecast Appropriately?

Of course, there is much more to forecasting than the point forecasts reported in the spreadsheet. In particular, it is crucial to assess the uncertainty and risks around any point forecast.

Throughout this period, the uncertainty and downside risks assessed around our point forecast were substantial relative to economic fluctuations in the Great Moderation. One way of gauging the appropriate calibration of downside risk is to measure the depth of the implied recession if the risks were realized.

The chart below does this by considering the probability distribution of the four consecutive quarters with the lowest GDP growth in a recession. It presents results based on the staff outlook in April 2008 and November 2008. The depth of the mild recessions shown in the chart was typical of the type of recessions expected during the Great Moderation. The actual depth of the 2007-09 recession as gauged by this metric is currently estimated to be 5 percent. As the chart shows, it was only by November 2008 that the probability of the actual outcome was above 15 percent.

Upon seeing this type of calculation, Robert Barro, a Harvard professor and member of the New York Fed Economic Advisory Panel, noted that the decline in real stock market values in the United States was similar to that observed in countries experiencing depressions. Taking this relationship into account in the calibration of the downside risks produced about a 50/50 chance of the currently observed depth of the Great Recession (see the March 2009 Wall Street Journal op-ed article by Barro for his assessment of the probability of a depression).

Recent Forecast Performance

In contrast, the New York Fed staff forecasts for 2010 made in 2009 and early 2010 are quite accurate (under the assumption of no major revisions to the estimates of GDP growth in 2010). This accuracy, however, has not been sustained through 2011. As widely discussed by a number of Federal Reserve officials, the level of real activity in 2011 has been disappointing relative to expectations. This shortfall is evident in the chart below, which compares forecasts for GDP growth in 2011 and 2012 produced in April and October 2011. However, this chart also depicts the uncertainty and risks around the staff forecast as of April 2011. Given the uncertainty around the April forecast, the subsequent changes to the outlook are not very surprising. On the other hand, near-term downside risks to this forecast were low compared to other forecasts produced in the last four years, so the direction of the change was more surprising.

Why Did We Fail to Forecast the Great Recession?

The quotations from Keynes and Geithner at the start of this post capture the importance of constantly striving to ensure that policy is robust to unexpected events. As explained in much of the recent work of the 2011 Nobel Prize–winning economist Tom Sargent, the unexpected events for which policymakers need to make provision have the characteristic of being the most likely unlikely bad event. The collapse in housing prices and its propagation to the economy certainly fit this description.

A leading example of how effective a robust approach to policymaking can be is the 2009 Supervisory Capital Assessment Program. In this program, large U.S. banks were evaluated against a capital standard under the assumption of a longer and deeper recession than contemplated in the prevailing consensus estimate. The idea was that if banks had sufficient capital to continue performing their intermediation function under this more adverse scenario, the scenario was less likely to occur.

Indeed, in the period leading up to the financial crisis, analysts who were suspicious of the stability of the Great Moderation, such as Nouriel Roubini, offered assessments that proved to be significantly more accurate than the point forecasts of New York Fed research staff or most professional forecasters in gauging the potential for unlikely bad outcomes. On a more positive note, if one compares the downside risk in the New York Fed research staff outlook with that of the Survey of Professional Forecasters (see the chart below from April 2008), there is some evidence that we had a more sober assessment of the risk of a severe downturn than did private sector forecasters.

Looking through our briefing materials and other sources such as New York Fed staff reports reveals that the Bank’s economic research staff, like most other economists, were behind the curve as the financial crisis developed, even though many of our economists made important contributions to the understanding of the crisis. Three main failures in our real-time forecasting stand out:

1. Misunderstanding of the housing boom. Staff analysis of the increase in house prices did not find convincing evidence of overvaluation (see, for example, McCarthy and Peach [2004] and Himmelberg, Mayer, and Sinai [2005]). Thus, we downplayed the risk of a substantial fall in house prices. A robust approach would have put the bar much lower than convincing evidence.
2. A lack of analysis of the rapid growth of new forms of mortgage finance. Here the reliance on the assumption of efficient markets appears to have dulled our awareness of many of the risks building in financial markets in 2005-07. However, a March 2008 New York Fed staff report by Ashcraft and Schuermann provided a detailed analysis of how incentives were misaligned throughout the securitization process of subprime mortgages—meaning that the market was not functioning efficiently.
3. Insufficient weight given to the powerful adverse feedback loops between the financial system and the real economy. Despite a good understanding of the risk of a financial crisis from mid-2007 onward, we were unable to fully connect the dots to real activity until 2008. Eventually, by building on the insights of Adrian and Shin (2008), we gained a better grasp of the power of these feedback loops.

However, the biggest failure was the complacency resulting from the apparent ease of maintaining financial and economic stability during the Great Moderation. Perhaps most important, as noted by some analysts as early as the 1990s, these adverse consequences of the Great Moderation were most likely to arise from the actions, judgments, and decisions of financial market participants:

Longer stretches of economic growth imply greater leverage and complacency and thus, greater financial problems when recessions do occur.
–William Dudley and Edward McKelvey³

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¹Letter to Jacob Viner, June 9, 1943, Collected Writings of John Maynard Keynes, ed. Donald Moggridge, vol. 25. London: Macmillan, 1980.

²Letter from the Chair, Financial Stability Oversight Council Annual Report.

³The Brave New Business Cycle: No Recession in Sight, Goldman Sachs Economic Research Group, January 1997.

Interesting quote from Laszlo Birinyi on Wall Street research:

“One of the dark secrets of the market is we don’t really do much research on Wall Street. I started off on the trading desk. I worked at my job. There were a lot of people who really hadn’t done the work, and what they were saying was very compelling and saleable, but it wasn’t right.”
-Laszlo Birinyi

Things have improved, but not all that much.

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Stock investors may take days to distinguish real news from noise, according to Federal Reserve Bank of New York.

This is especially true these days, given false announcements of bailouts, Fed interventions and rescues. They tend to cause fake short squeezes that temporarily spike markets, only to see them ultimately head lower.

To get a closer look of noise on markets, the FFRBNY studied how UAL’s stock moved in September 2008. At the time, a “six-year-old report on the company’s bankruptcy filing appeared online and was treated as a new story.”

David Wilson of Bloomberg has the details:

“UAL, which later became United Continental Holdings Inc., plunged as much as 76 percent on Sept. 8, 2008, in response to the error. While UAL’s loss narrowed to 11 percent by the close of trading, the shares fell the next two days before rebounding.

“Residual effects attributable to the false news shock” lasted for seven trading days, the researchers wrote this week in a blog posting on the New York Fed’s website. The effect is at odds with the efficient-market hypothesis, which holds that share prices reflect all publicly available data on a company.

To identify the time period, they estimated where UAL’s shares would have traded if the outdated report hadn’t surfaced. The projection was derived from the performance of the Standard & Poor’s 500 Index, the Bloomberg World Airlines Index and crude oil during the period. The posting by economists Carlos Carvalho, Nicholas Klagge and Emanuel Moench was based on a report they published in May 2009 and revised in June. Carvalho, who teaches economics at the Pontifical Catholic University of Rio de Janeiro, worked at the New York Fed when the research was originally done. His two co- authors are still there.

Given every twitch of the market over tales of EU/ECB action, German banks bailing out Italy, or anything related to Greece, it is interesting to see how traders behave relative to false announcements.

Morgan Stanley Research channels our prior discussion on earnings during recessions:

“We have heard investors suggest $80 in EPS was a fair bear case for 2012. We decided to look at history as a guide in assessing the bear case EPS. The 2001 recession saw a 13% revenue decline and a 57% EPS drawdown. The 2008 recession saw a 14% revenue decline and a 51% EPS hit, peak-to-trough. For 2012, bottom-up estimates (excluding financials) embed a 5% revenue INCREASE and just over 10% year-over-year EPS growth. If prior recessions prove relevant to next year’s economy, $54 to $68 in EPS in 2012 would be a more likely range than the $112 that the bottom-up consensus estimates currently embed.”

What should SPX prices be? Depends upon how much earnings fall during the coming slow down/recession. If we get a pre-2000 recession drop of 15%, then we are priced fairly. A 2001-recession like drop of 25% means more downside. Of course, the 2008 outlier — earnings plummeted 44% during the credit crisis  — well, that means a whole lot more downside work in equities . . .

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Hat tip Sam Ro

Previously:
The investor’s dilemma: Earnings, valuations and what to do next (September 11th, 2011)

Is the S&P500 Cheap? (August 29th, 2011)

McKinsey: Equity Analysts Are Still Too Bullish (June 2nd, 2010)