The Smalrus Web Site

Yet again, I’m managing to neglect my blog here – everything from whether or not the economy is in a recession (and if so, for how long), to my absentee vote for John Edwards being mailed on the day he drops out of the race, to the New York Giants (a team I cared about when I was about 10 years old) winning the Super Bowl, to “le Rogue Trader,” Jérôme Kerviel, of Société Generale, or even to wedding plans (which I’m going to have to have Judi start putting some updates on that part of the site)…

But instead, I’m somehow managing to update on Chinese news.  In an effort to better educate myself to globalisation, I recently started to sporadically read the English version of Xinhua online (Xinhua being the official news agency of the People’s Republic of China).  Now, when you consider the fact that the site is the government’s “mouthpiece,” it’s easy to read it with the proverbial grain of salt. But that also presents an interesting conundrum.

See, I’m looking at two different stories from three different news sources here:

1.  ”In China, many greet New Year in dark” – from CNN.com
2. “Snow-hit China welcomes New Year” -from BBC.co.uk
3. “Chinese leaders visit disaster-hit regions on holiday eve” – from Chinaview.cn (Xinhuanet)

What is interesting is how these three major news stations are reporting the breaking events in the snowstorm in Asia. The first two articles assess the actual picture of health caused by the snowstorms, often times interspersing human interest stories to demonstrate the severity of the situation.  The third article plays into the morale boosting by President Hu Jintao and Premier Wen Jiabao, replete with photo ops of Mr Hu and Mr Wen meeting with “ordinary Chinese on Lunar New Year’s Eve.”  Accompanying pictures in a photo gallery show the urban city of Hangzhou looking much like Boston, Massachusetts might during a Nor’easter.

Thus, the same story is really represented two different ways.  Yet due to government censorship of some foreign media, its leaders still come out ahead.  With the proliferation of the internet to all aspects of the world however, this changes the way we view events as well as history.  Propaganda is not new, nor is it necessarily exclusive to Communist countries.  Yet the outsider is more sensitized to these differences in stories (if not the inaccuracies themselves), even when the stories are apolitical.  So the question still remains, which messenger of the news does one trust?

A few years back, I read the book, Ponzi’s Scheme: The True Story of a Financial Legend, by Mitchell Zuckoff. The book detailed the life of the ubiquitous Charles Ponzi, inventor of the first successful pyramid scheme. This scheme enabled Mr. Ponzi to get rich quick through what would be tantamount today to currency arbitrage. The crux of the scheme involved buying and selling International Postal Coupons (IPC) at a low price in Italy, taking the coupons to the U.S., selling them in the U.S. for a greater price, and re-investing in more of these coupons.

Ponzi attracted these investors by promising them 50% return on investment in 45 days or double their money in 90 days. In order to get even more people involved in the scheme (thus creating higher payouts for himself), Ponzi ended up buying so many IPCs that the object itself became devalued. As people became self-aware of the relative uselessness of so many IPCs, they demanded their money back. Unfortunately, the outpacing moneyback demand caused the base of the pyramid to crumble and eventually collapse. Ponzi’s complex scheme of arbitrage created an atmosphere of trading that was so euphoric, it lost its grounding.

Ever since I read this book and started to read more about the global financial marketplace and stock markets, I’ve been trying to pose a theory of my own: the financial system is nothing less than a Ponzi scheme that we’re all buying into. This past week, the subprime mortgage crisis seemed to validate my theory. Replete with a breakdown of my basic understanding of financial markets, here’s how I see it:

When I was in London, I started to broach the idea to my Ruskin roommate, Charles (not Ponzi). His response was that the marketplace is filled with such complex financial instruments that it would be difficult for one industry to bring down the market. This complexity meant that risk was spread out even farther with less direct impact on markets as a whole. What would happen in one industry would be less likely to touch another industry. Even though this conversation was only three months ago, it was an answer I was willing to buy into, since it was the only one that seemed to show that my theory wasn’t entirely developed. However, the past week seemed to disprove his answer, instead highlighting the poignancy of my own theory.

Subprime mortgages are mortgages that are offered with introductory interest rates that are lower than the prime rate — usually 300 basis points above the Federal Reserve rate. Typically after the first six months to a year (depending on the terms of mortgage), the interest rate skyrockets to exorbitant percentages that are often variable and much larger than to those offered to regular borrowers. But who would be taken advantage of like this?

Some subprime mortgages can often be described as a type of ninja loan (No Income, No Job, no Assets). After all, we all need some place to live, no?  Typically, the subprime borrower has a lower credit rating and is given a “second chance” by the lending bank.  In the eyes of the bank, there is a trade off by lending to people with unverifiable income or poor credit: the high-yield interest return on the lending risk.

What happens though, when even some of these borrowers can’t afford to pay when the interest rates rise to well above prime?  As the chart shows, with almost $600bn of subprime loans (35% of total mortgages) originated in the U.S. last year alone — when the mortgages aren’t paid and they go into default, the bank gets left with a house and no return.

Let’s switch tracks for a second and introduce another financial concept here: the idea of Asset-Backed Securities (ABS) or Mortgage-Backed Securities (MBS). For a financial institution, debt is viewed as an asset. Not only is it getting back the principal investment, but it is also getting a return on investment (interest). When a bank loans money for a mortgage, it knows that it will be receiving these monies back or else, based on the stipulations of the mortgage agreement, the homeowner will foreclose on the house. Rather than keep these mortgages on the balance sheets, the Financial Institutions repackage all the mortgages into MBS, where these securities can be freely traded on the open market. It’s a simple, yet very complex financial instrument that, once traded, starts to make the mortgages themselves seem useless.

The problem is, the mortgages are not useless. Much like with Ponzi’s IPCs, there has to be some sort of value underneath the derivative. If people cannot pay these subprime mortgages (or any mortgages, for that matter), there is no true backing to the instrument. Thus, unless paid for, the hedge funds and banks that trade MBS are really trading something without much value. When it is admitted that there is no actual money backing the securities – no liquidity – everything starts to catch up and the pyramid falls.

This became most obvious last week when several hedge funds – including some from large investment banks such as BNP Paribas, Bear Stearns, and Goldman Sachs – admitted to large losses stemming from the subprime mortgage crisis. The liquidity backing these securities just wasn’t there. The complex scheme of ABS and MBS created an atmosphere of trading that was so euphoric, it lost its grounding. The trading of billions of dollars of these securities even infiltrated other market exchanges.

Unlike the Ponzi investors however, the Federal Reserve Board (as well as Bank of Japan, Bank of England, and European Central Bank) was able to attempt loss-stabilisation by directly injecting this “lost” liquidity into the market. However, with an interest in maintaining interest-rates and inflation targeting, the Fed’s choice to flood the market with billions of dollars of liquidity raises the question of What happens next? Government didn’t offer bailouts to Ponzi investors.

So… is the financial system just a Ponzi scheme that we’re all buying into?

I’m not a financial analyst, but my critical analysis would seem to suggest that it is. The level of complexity that financial instruments starts to devalue liquidity, however it is liquidity that drives the entire world markets. Inability to back assets with liquidity makes them even more susceptible to risk. Risk isn’t merely spread out because of complexity, but is ultimately intertwined with everything else that drives the markets (lower overall investor confidence, for instance). When everyone wants their money doubled in 90 days and finds the money isn’t there, everyone gets burnt. I don’t think there’s anything complex about it: if my theory is even partially correct, when the full extent of damage is revealed, this whole crisis could be bigger than we all thought. They might as well have been selling IPCs.

The battle is over, Rupert Murdoch has won.  Not only has Mr Murdoch won, he has also done it with little effort.  His efforts to buy the revered American financial newspaper, the Wall Street Journal have ended with a family realizing its destiny and mismanagement of its own firm.  As Louis Ureneck was quoted in yesterday’s Financial Times, “The irony of The Wall Street Journal is that it’s such a great journalistic institution and yet it’s been so poorly managed.  The double irony is that it’s a newspaper about business.”

Now I must admit that I am biased, as I read the Financial Times on a daily basis, and find the conservative leanings of the WSJ editorial board too much for my tastes.  However, I can only see two logically possible outcomes from the $5 billion takeover of Dow Jones by News Corporation:

The first outcome would be that Mr Murdoch ignores the agreement with Dow Jones’ Bancroft family and injects his meddlesome influence beyond into just operations but into the editorial content as well.  As anyone who knows media has already written, Mr Murdoch is known for his conservative touch on all his media outlets, from Sky Television to Fox News.  His tabloid sensationalism and penchant for selling product often comes with an ideological slant.  Were this to be the case, Mr Murdoch could alienate a large portion of his financial readers and convert them to subscribing to rival newspapers such as the global leader, Financial Times.

This gives me reason to believe that the second possible outcome would be more likely:  Rupert Murdoch would rather enhance his competitive stance and win people into switching to his paper.  By tampering with the current format, Mr Murdoch has nothing to gain from purchasing the Journal, particularly at the 65% price premium offered.  It is true that buying the newspaper will serve News Corporation’s agenda in promoting a Fox financial channel to rival CNBC.  But if Mr Murdoch doesn’t stay on the mark, the newspaper’s reputation gets cut on the spot.  Though my ideologies differ from Mr Murdoch, I recognize that changing the format makes little business sense.  If you buy a broken valuable and it ain’t fixed, don’t keep breaking it.

Ultimately, businesspeople are looking for accurate, balanced, and in-depth information.  Afterall, the markets depend entirely on information.  By skewing the news agenda and information of the Wall Street Journal and by creating a sense of distrust amongst its readers, Rupert Murdoch will lose out.  Smart business dictates Murdoch won’t choose to lose out.

Before I get into the main subject of this posting, I just wanted to recap the French debate. The New York Times put it best, it was the kind of “vivid confrontation that has disappeared from the American scene, where the candidates avoid each other as much as possible.” The post-debate polls ended up split, and even the political analysts couldn’t make heads or tales on who actually “won” the debate. Both actually played off their opponents’ strengths, so for that matter, they each had pros as to who might have won. From a neutral standpoint, I’m also of the mind that it was a draw, however it is obviously the votes that count. On a personal level, it was nice to see Ms. Royal finally shed some of her charm and fight with some intensity against the usually hard-headed Sarkozy. She might not have had all of her facts right (those who aren’t privy usually find it more difficult to be right), but at least she shows that she could possibly have the cojones to run the country.

On a different subject, there was an interesting column by Jonathan Guthrie in the Financial Times today about carbon footprints. After reading it, I came away with a sharp check on my thoughts about Pigovian taxes. For those who don’t know, Pigovian taxes is an economic term that describes taxes that are levied as a way of reducing economic externalities (the effect a person/company has on another person/company, either directly or indirectly). In some instances, these taxes are called sin (or more formally, sumptuary) taxes.

Here’s the thing with Pigovian taxes. Taxes are a financial charge that are raised by the state. In the case of Pigovian taxes, the money raised would be used to offset the negative externality (in this case, carbon emissions). But what happens if we take a cynical look at Pigovian taxes?

Let’s pretend that Company X was emitting 200 tons of carbon a year. Let’s say there was no tax. That means that the company is taking normal income at face cost. The government derives no tax benefits of Company X’s pollution and no finances to actually offset the problem and the Company has no incentive to stop polluting.

Now, let’s say that there was a tax of $2m per ton of carbon. The company takes in normal income at face cost. Thus, the government now derives $400m in tax benefits off Company X’s pollution and has some finances to offset the problem, while the Company has some incentive to stop polluting: If it cuts its emissions by 50 tons, it only pays $300m in taxes.

This method of cutting carbon emissions seems like a great way to save the environment. And in fact, its one of the most feasible (and common) options that government can step in to reduce externalities. However, there are two reasons to be cynical here. The first is that we must assume that the taxes levied on the externalities are actually being put to use for carbon emissions. Here in America, we can’t even actually be sure that taxes aren’t being pooled together to fund the Iraq War instead of subsidising businesses that are researching environmental issues.

President Bush actually recently met with Angela Merkel and Jose Manuel Barroso and shrugged off the suggestion that the US get involved with the Kyoto treaty as to entice China and India to reduce their carbon emissions. His stance was to invest in new technologies and pass them off. This is a great suggestion, but it only works when the government’s budget and financing actually plows the Pigovian tax proceeds back into research.

The second problem I’m finding with Pigovian taxes is, as Mr Guthrie writes, the means by which they become nothing more than the indulgences the Catholic Church used to sell in the Middle Ages. Sure, this is why Pigovian taxes are often called ‘sin taxes,’ but now that the wealth in the world is massively disproportionate and the reach of the problems are truly global, the actual viability of these indulgences is actually unrealistic to me. And I’ll tell you why.

I have a friend who is very much the type of person who subscribes to this “pay to make it go away” mentality.  If Mayor Mike Bloomberg’s Congestion Tax ever makes its way to New York, I could see her being the type to pay $8 to bring her car into lower Manhattan.  There are companies that have the same approach: if they can afford to pay the $400m and it means they don’t have to spend any money on researching how to reduce carbon emissions, why not pay the $400m and call it a day?  Throwing money at problems solves them, doesn’t it?

Well that comes back to the previous premise.  In economics, there is an assumption that firms are profit-maximizers and that they will act rationally in order to achieve this goal.  The fact of the matter is, this is farther from the case.  Firms are actually more inclined to behave as people, with the same behavioural patterns (and one might even suggest, psychoses) that individual persons have.  Governments are the same way.  So while the Pigovian tax proposed by Mr Bloomberg might fund the planting of 1 million trees in New York City, Mr Bush may never put the money to R&D of these technologies (this coming from the man whose 2003 State of the Union suggested that hydrogen cars we’re not that far off but lost all ground to the Japanese in carmaking).

Throwing money at problems doesn’t solve anything unless you use money for problems.  Just as paying to rid oneself of sin is a ridiculous idea, so is paying to use tons of carbon just because the money is available.   So it is with low gas mileage SUVs where people say “If I can afford to pay for the gas, why shouldn’t I get one,” it is with carbon emissions.  “Affording it” doesn’t solve problems, reducing it does.

Thanks to WordPress, I get to use firestats to see just where visitors to my website are coming from. The only thing is, a whois trace ends up ending at RIPE.NET, the portal to Europe’s internet link. Given the vast amount of “junk” websites out there, I’m wondering who in Russia and in Germany are using my site as the springboard for another junk site. On another stats provider through PowWeb, I’ve been seeing a lot of referral sites that are junk sites with no actual links to my site. Also, given the fact that the homepage for my site was hacked about 10 months ago, I’m questioning whether my hosting provider – PowWeb – can truly assure security of my site.

If anyone knows where those visitors to my website are coming from and would like to share, please let me know. Otherwise I might be .htaccess-ing those IP addresses from accessing the site. Not ideally that I’d like to need to moderate my site, but I’m finding the site hits to be really odd (especially since the 4th most visiting hostname is ‘webmaster2.firstvds.ru‘ and I have no idea what that is).

In other news, I might be offering some thoughts later on the French presidential election and the recent rise of Bayrou in relation to Segolene Royal. It’s going to be an interesting race and I’ve been following it rather closely. If Royal can nip Nicolas Sarkozy in the bud, she has the potential of stemming the Bayrou tide. And Bayrou has the potential of stemming the Le Pen tide. However, she really needs to spend her time attacking Sarko’s record, his policies, and his right-wing extremism. Based on my past readings of Sarkozy, he definitely seems to be a moderate version of Jean-Marie Le Pen. And that’s good for no Frenchmen, especially since most National Front supporters tend to hold their tongues on their votes, deflating poll numbers on the extreme-right.

Now in some respects, all the candidates aren’t really of high-calibre candidacy. Sarkozy is too right wing, Le Pen is way too right, Royal has no real stance on anything and might mismanage the treasury, Bayrou is a poseur for the right as well (but capitalising well on the anti-establishmentarianism against the main contenders). I’m not sure who should come in for any run-off of substance other than maybe Jose Bove, the altermondialization activist. However, Bove is an extreme long shot who barely mustered the signatures to qualify as a candidate.

I believe I had more to say about the election, but for the time being, I suppose its time for some shut-eye. Keep reading…