Transparency of risk, complexity, Overseas investing

[free4now]

The biggest shock for me in the recent financial crisis is realizing how little transparency we really have into the risks being taken by the businesses that form our stock markets.

It's becoming clear that the source of this crisis was that the lending industry was taking on more risk than they were being paid to take on. Every layer of the food chain (bond rating agencies, CDS writers, MBS packagers, loan officers, home appraisers) tended to sweep the default risks under the rug while taking their fees for supposedly protecting against those risks.

In the past the word transparency meant knowing that all cash flows were accounted for, that there was no cash leaking out via corruption. I'm sensing that now transparency has to mean something more; there needs to not only be transparency of cashflow but also transparency of risk and complexity.

With the immense scale of today's big corporations, with global markets and instant computerized money transfers, it's becoming clear that just knowing the exact account balances at the end of the quarter isn't enough.

The new way of stealing money is in plain sight, using complexity. Make a legal wrapper (such as MBS or CDS) that is so complicated and novel that nobody else has the time or inclination to unravel what is underneath, and you effectively have cover to do whatever greedy or morally bankrupt activities you want. Because the waste product, increased risk, doesn't show up on the balance sheet immediately, it builds up unseen until a leak springs.

It's almost like using public key cryptography; the person who built the wrapper has the key so they can see inside, and theoretically anyone with a sufficiently powerful computer can crack it from the outside. But in practice it's sufficient for most people to hide most anything successfully.

I'm worried that these "complexity wrappers" will be more and more common in the future, as computerized systems and globalization make them easier to construct and work with.

I don't invest internationally precisely because of corruption. There may be great economic opportunities overseas, but it seems to me the people on the ground and inside the deals are the ones who will sop that up in the form of bribes to the governments, warlords, mafias, insiders, and so forth. Rarely do the people in charge on the ground have motivation to make sure foreign shareholders are compensated for their investments; the banana republics and warlords tend to have very short term orientations, not caring if their reputations with overseas investors are soured by corruption. You can say lots of bad things about the US financial system, but you can't say we don't care about our reputation. US treasuries are still considered one of the safest places to stash money.

If I were investing internationally, I might be concerned by revelations of the recent financial crisis; I might decide that I want more transparency than I can get overseas, and that for all the US flaws at least we're the ones that first found and first started fixing this global problem. And I might be concerned that overseas investments are sinking right along with the US; the supposed diversification advantage of overseas is not helping much now.

But I do have the contrarian in me saying maybe now is a good time to diversify into overseas indexes just because they are down and I'm not in them.

I'm curious to hear from others on whether the financial crisis revelations have changed your appraisal of overseas investing, especially as it relates to transparency and corruption. Are you increasing, or decreasing your international allocation these days and why?

 

[DblDoc]

But I do have the contrarian in me saying maybe now is a good time to diversify into overseas indexes just because they are down and I'm not in them.

Certainly alot better time to get into them then say a year ago!

I think some of your arguments are why international are more volatile (and hence greater returns) but not by as much as one would think if you diversify across all international and/or all emerging markets.

DD

 

[Animorph]

I do my foreign investing via mutual funds instead of directly in stocks, but that's the only concession to foreign-specific risks I've made. Diversity is your friend here, along with someone controlling the fund who supposedly knows what they are doing.

 

[Gone4Good]

I have a bit of a different view on what happened. I'm not of the opinion that complexity was used to hide corruption or deliberate wrongdoing. Instead, I think complex innovations were misunderstood and the full extent of their risks were not appreciated. This happens from time to time. The original automobiles were far less safe then those of today. Similarly the financial innovations that helped cause the credit crisis will be refined and improved and better controlled. And in the end, they will help our financial system the way they were originally intended.

 

[free4now]

I see the corruption of overseas investments as sort of a fee, a certain percentage that gets lost due to friction in the company's normal business activities. I don't know what the amount of this corruption fee is... I'm guessing more than 1% but probably less than 10% per annum on average across wide indexes. When you add that onto the 1-2% fees that most overseas funds have, you're looking at funds that have 2% or much more drag right off the bat. Lets assume 3% to be charitable. I just don't see any evidence that overseas funds will have anywhere near 3% better results than US stocks over any long period of time. In fact most studies show they drag behind US indexes.

If they were seriously decorrelated enough to reduce the overall volatility of my portfolio under Modern Portfolio Theory then okay, but I'm still waiting to see evidence that they can even do that.

 

[free4now]

I have a bit of a different view on what happened. I'm not of the opinion that complexity was used to hide corruption or deliberate wrongdoing. Instead, I think complex innovations were misunderstood and the full extent of their risks were not appreciated. This happens from time to time. The original automobiles were far less safe then those of today. Similarly the financial innovations that helped cause the credit crisis will be refined and improved and better controlled. And in the end, they will help our financial system the way they were originally intended.

Even cars are different overseas. When I was in Southeast Asia recently the taxis were mostly 10-15 year-old Toyota Corrollas without any of the modern safety features. Some didn't even have seatbelts. Even the new vehicles sold over there typically don't have ABS, traction control, airbags, or any of the safety advances we have over here; the market won't bear the incremental cost. Life is simply cheaper in developing countries; people are more expendable. Sure at some point they will get the safety features we will have had a decade or two ago. And I am sure that the investment protections from the US will also eventually come to the emerging markets, as they are demanded. But why put up with that when we've already got the protections here in the US.

 

[FIREd]

I think that the superior returns of international equity funds in the past 5 years can be attributed in large part to the weakening dollar. I think that this trend may very well have started to reverse and therefore I expect most international equity funds (especially developed markets) to underperform their US counterparts for the next few years. So for the time being I am contributing less to my international funds and more to my domestic equity funds. But if you are bearish on the dollar, then I think that foreign equities would still be a worthy diversifier.

 

[ERD50]

The biggest shock for me in the recent financial crisis is realizing how little transparency we really have into the risks being taken by the businesses that form our stock markets.

I agree completely. I'd extend that to lack of transparency in many other things - the govt, and heck - maybe even things we don't know about?

-ERD50

 

[chinaco]

There will be a sweeping regulatory overhaul within 12 months. Part of the problem is that the financial services industry is innovating and the regulators do not want to stop the innovation (throw the baby out with the bath water)... but they do not want a few bad eggs that take huge risks to ruin it.

If America wants to be the capital leader, they need to ensure that our securities markets and our companies are trustworthy... otherwise we will lose the lead in that valuable industry.

We need to bear in mind that the vast majority of companies did not do anything wrong... but it shows how a few large entities and wreck the entire system.

I am hoping that Dennis Kozlowski has some extra people to keep him company in prison soon.

 

[Gone4Good]

There will be a sweeping regulatory overhaul within 12 months. Part of the problem is that the financial services industry is innovating and the regulators do not want to stop the innovation (throw the baby out with the bath water)... but they do not want a few bad eggs that take huge risks to ruin it.

This is a difficult, dare I say impossible, balance that we must try to forge. Financial innovation is unlike any other. There is no laboratory where we can do clinical trials to determine the safety and efficacy of a new financial product before it is loosed upon the world. Our only available financial petri dish is the market itself. And only after a product blows up (e.g. Drexel Burnham's junk bonds, LTCM's highly leveraged, model driven, arbitrage strategy, "Portfolio Insurance", etc.) do we learn its limitations and its weaknesses.

So in the extremes, we can choose not to innovate and accept stagnation, or we can push forward with new financial technologies with the understanding that we'll have an occasional mess to clean up. As is almost always the case after a disaster, we'll now likely lean more heavily in favor of limiting innovation and accepting stagnation as a consequence. At least for a while.

 

[ERD50]

So in the extremes, we can choose not to innovate and accept stagnation, or we can push forward with new financial technologies with the understanding that we'll have an occasional mess to clean up. As is almost always the case after a disaster, we'll now likely lean more heavily in favor of limiting innovation and accepting stagnation as a consequence. At least for a while.

I agree, and IMO, transparency will do a better job of limiting problems, w/o limiting true innovation than regulation will.

-ERD50

 

[bamsphd]

I'm curious to hear from others on whether the financial crisis revelations have changed your appraisal of overseas investing, especially as it relates to transparency and corruption. Are you increasing, or decreasing your international allocation these days and why?

No, it has not changed my appraisal of overseas investing.

I've been moving additional money into Vanguard's Pacific, European, and Emerging Markets index funds during the recent volatility, because I had let my portfolio diverge from its ideal because of tax issues. Ideally, I would like to have a roughly 50/50 split between my US and foreign equities, though I'll grant most people consider that extreme, and it is vulnerable to a breakdown in the free flow of world capital. However, the argument for it is basically the Japan example. A Japanese investor who was 50/50 Japanese/Foreign recovered a lot faster after their crash than a Japanese investor who's portfolio was 100% Japanese stocks. In my own experience, my foreign holdings helped my portfolio recover after the .COM crash.

If you define "corruption" broadly, to include not just Enron style events, but also "perfectly legal" things like issuing large numbers of extremely dilutive options, then I'm not convinced that US corporations are the safest deals in the world for stock investors. Certainly many European countries have very low "corruption" by any international standard. Though there are also certainly countries like Russia where I fear to invest.

By using an index approach, I think I minimize the transparency and higher transaction cost issues present in some foreign markets. Remember that most of the time stock and bond prices tend to reflect issues like a lack of transparency. Buying 10 US blue chip stocks with an average PE of 20 may not be a better deal than investing the same amount of money in 100 international stocks with an average PE of 5. As always, good companies make nice investments, but good deals make even better investments. It all depends on the current prices.

 

[chinaco]

This is a difficult, dare I say impossible, balance that we must try to forge. Financial innovation is unlike any other. There is no laboratory where we can do clinical trials to determine the safety and efficacy of a new financial product before it is loosed upon the world. Our only available financial petri dish is the market itself. And only after a product blows up (e.g. Drexel Burnham's junk bonds, LTCM's highly leveraged, model driven, arbitrage strategy, "Portfolio Insurance", etc.) do we learn its limitations and its weaknesses.

So in the extremes, we can choose not to innovate and accept stagnation, or we can push forward with new financial technologies with the understanding that we'll have an occasional mess to clean up. As is almost always the case after a disaster, we'll now likely lean more heavily in favor of limiting innovation and accepting stagnation as a consequence. At least for a while.

As long as the products are legit (e.g., not a pyramid scheme), the market will sort out which products are useful.

From the perspective of corporations that might carry these derivatives and non-traditional securities on their books... FASB, the SEC, the Fed, etc must pass regs that require a reasonable risk based capital management approach to investments. For individuals... it is caveat emptor. But investors and other stakeholders should not be exposed to unkown risks.

Updated accounting rules will go a long way toward solving the problem.

If things work out the way they should, some rating agency would rate a companies risk based on thier normal business exposure and any investments they have made in derivative. Same goes for insurance companies and banks that sell those things.

 

[Free To Canoe]

I don't invest internationally precisely because of corruption. There may be great economic opportunities overseas, but it seems to me the people on the ground and inside the deals are the ones who will sop that up in the form of bribes to the governments, warlords, mafias, insiders, and so forth.

A fellow from India once observed that the US also has corruption, only they are more sophisticated about it. I believe that there is some truth to this statement.

Free to Canoe