Tuesday 1 November 2011

The ABCs of GFC jargon


Are you scared of Dutch disease? And would a haircut help? Barbara Drury wonders if even self-described experts know what they're talking about.
Financial markets are home to some of the worst abuses of the English language and some of the greatest creativity. The language of the street, from Wall Street to Bond and Collins Street, also tells us a lot about the world we live in.
When financial markets are falling and the outlook is uncertain, the temptation is to gild the lily, obfuscate or engage in self-denial.
Financial adviser and Money contributor Noel Whittaker is fed up with industry insiders who refuse to call a spade a spade.
A protester holds stones during violent protests around Syntagma square in Athens.
Off the hook ... a bailout means Greece has no incentives to change its ways. Photo: Reuters
He says a loss is no longer called a loss but a ''negative return''.
Similarly, ''negative growth'' is a recession by another name, says Satyajit Das, author of Extreme Money: The Masters of the Universe and the Cult of Risk. Das likes to quote US cowboy and commentator Will Rogers, who once said you can't say civilisation doesn't advance when in every war they kill you in a new way.
"Financial markets find more ways of losing money every time," Das says.
One way to keep your head, and your savings, while everyone around you is losing theirs is to cut through the jargon, hype and obfuscation to reveal what lies beneath. The following is just a small sample of the current argot.
QUANTITATIVE EASING (QE)
QEI and QEII are not stately ocean liners but successive attempts at economic shock therapy administered by America's central bank, the US Federal Reserve (the Fed).
The only thing quantitative easing has in common with a royal barge is that they are both very big and difficult to manoeuvre in a tight spot.
The chief economist at AMP Capital Investors, Shane Oliver, explains: "In traditional economics you try and change the price of money [by raising or lowering interest rates], but when interest rates are already zero you try and change the quantity of money to boost growth."
This is how it works.
Quantitative easing is a policy that aims to increase the supply of money circulating in the economy to boost economic activity and avoid a recession.
Central banks do this by printing money and buying bonds from high-street banks such as Bank of America.
If all goes well, the banks lend this money to businesses and individuals to spend on goods and services. That's the theory. Unfortunately, it hasn't worked.
Oliver says American consumers are so concerned about job security and their future economic prospects that they are reluctant to borrow, even when interest rates are close to zero, for fear they won't be able to repay their loans.
So all that freshly minted money is trapped in bank accounts with the Federal Reserve while the US economy limps on without the shot of financial adrenalin it needs.
Oliver calls this a classic ''liquidity trap'' - but that's another story.
DUTCH DISEASE
Not to be confused with Dutch-elm disease, a fungus that is deadly to elm trees, although Dutch disease is potentially as lethal to branches of the economy. The term Dutch disease was first used to describe the situation in the Netherlands in the 1960s when the discovery of North Sea natural gas deposits resulted in a resources boom and rising currency at the expense of manufacturing exports. Sound familiar?
In Australia's case, a rise in the price of commodities has fuelled a mining boom, pushing up the value of the Australian dollar as well as wages.
Not only do local manufacturers face rising wage costs in the competition for workers but the rising dollar makes it difficult to compete with cheaper overseas goods and services.
Despite the similarities, Oliver argues that Australia faces structural problems that were not around in the '60s. "In Australia, it is not just Dutch disease we are facing but an increase in competition from emerging economies,'' Oliver says. ''Chinese workers get paid a fraction of what our workers get paid."
MIS-SELLING STOCKS
Das argues that many expressions used by financial advisers are an attempt to defend bad advice. Cheekily, he puts ''buying the dip'', ''averaging in'' and ''buy and hold'' into this category.
"If you believe that shares only go one way, which is up, then every time they go down, it's a buying opportunity,'' he says. ''If a stock was good value at $10 then it must be cheap at $9 and a bargain at $8. People forget that the lowest it can go is zero."
Averaging-in, or dollar-cost-averaging, is a strategy designed to avoid trying to time the market and investing all your money at the wrong time.
The idea is that by investing small amounts regularly you buy more when prices are low and less when prices are high. Left to their own devices, most people do the opposite.
This works well in a rising market but when prices are falling you simply throw good money after bad and keep fund managers in business.
"The only way out of a hole is to stop digging," Das says.
The buy-and-hold strategy is based on the premise that if you hold a stock long enough it will make money.
This may be true for good quality stocks some of the time but it is not an excuse to nod off at the wheel. Some stocks are lemons and there are times when it pays to reduce your overall exposure to shares and invest in something that provides a better return.
"People forget that after the 1929 crash it took 25 years to recover,'' Das says. ''The Japanese market has never regained its high of 1989."
THE 2/20 RULE
To an outsider, the world of hedge funds makes as much sense as the lyrics of a Beatles song from their acid-tripping days. They use strategies with names that shed little light on their activities, such as market neutral, short bias, quantitative directional and discretionary thematic.
The main reason for these patently silly names is to convince investors that hedge fund managers are very clever chaps who can miraculously make money in both rising and falling markets.
Some hedge fund managers are undoubtedly skilled but many others used the long-market boom to cash in on humanity's relentless and fruitless quest to turn lead into gold.
"My view is that they will lose money in all seasons," Das says. Many have done just that.
Das points out that hedge fund managers have an expression for the premium they charge for their supposedly superior skills - the 2/20 rule.
That is, they charge a management fee of 2 per cent of the money you invest with them and take 20 per cent of your investment gains (it goes without saying that they don't refund 20 per cent of losses).
A traditional fund manager generally charges about 1 per cent of funds under management. The only difference between the two managers is often their name. The most important thing with hedge funds is not the label but the ingredients.
Hedge funds use a variety of strategies, the most important being:
❏ Short-selling: the practice of selling securities you do not own in the hope or expectation of buying them back at a lower price for a profit (see below).
❏ Leverage: the use of borrowing to increase potential profits but at the risk of increasing potential losses.
❏ Hedging: the use of short-selling as insurance against loss in another part of the portfolio, rather than as pure speculation.
In the past decade, these strategies have gone mainstream. Many traditional fund managers use them, as do the new investment products that were responsible for some of the worst losses of the global financial crisis such as the ones following.
CDOs IN THE GFC
''Structured product'' is code for risk, even though they claim to do the opposite and offer protection against market risk.
"You can't have a product that says 'I will rip you off and give you more risk', so product providers say 'we will give you a structured product'," Das says.
The term ''structured product'' has a ''safely engineered'' ring to it. Unfortunately, when faced with a product that is potentially hazardous to wealth, the temptation is to give it a name so mind-numbingly bland and meaningless that investors will be lulled into complacency. Like ''collateralised debt obligations'', or CDOs.
In 2007, veteran commentator Ian Kerr dubbed them ''Chernobyl death obligations'' after the Russian nuclear disaster. And toxic they were.
The CDOs offered to investors before the global financial crisis bundled together thousands of mortgages to spread the risk of any one mortgage-holder defaulting. The mortgage pool was divided into several ''tranches'', or slices, with varying degrees of risk so they could be sold to investors with different risk tolerances.
Das likens the structure to buying an apartment in a flood-prone area. Buying an apartment on the eighth floor might seem risk-free when the high water mark reaches only the second floor. But a severe flood weakens the foundations and makes the whole building unsafe. That's what happened to investors who thought they were protected by the ''safe'' CDO structure when the GFC tidal wave of mortgage defaults hit.
To make matters worse, CDOs were what is referred to in the trade as derivatives or synthetic instruments. In other words, they were designed to look and feel like a mortgage-backed investment but they weren't the real thing. Instead, they invested in things that mimicked the performance of mortgage-backed securities.
If you are still confused, take heart. Most of the guys who sold the things either didn't know, or didn't want to know, how they worked either.
The GFC has not cured financial markets of their taste for derivatives.
A new rash of financial products based on derivatives is entering the market, promising to inoculate investors against further market falls.
The only protection against investment losses is common sense, education and discrimination - and they are free of charge for anyone with the discipline and patience to develop them.
Shave and a haircut
There is a difference between obfuscation and verbal shorthand that is designed to put a smile on your dial. Like the fashion for haircuts.
Commentators are predicting European banks that have lent money to Greece will have to ''take a haircut''. That is, they may be forced to forgive part of their debt repayments or risk Greece defaulting on its loans.
Eureka Report's Alan Kohler describes a haircut as losing part of your money but not all of it.
''It can be just a bit off the top and sides,'' he says. ''If a Greek default is averted, you could call it a close shave.
''We have all had a close shave in the turmoil and aftermath of the financial crisis. By learning to decipher financial market code we might avoid being scalped in future.''

Put a price on morals

Forget Greeks bearing gifts, now we are warned to beware of Greeks acting immorally - in the fiscal, not biblical, sense.
The European Central Bank and the puritanical Germans are prevaricating about whether they should write off Greek government debt. A bailout would allow Greece to avoid bankruptcy and the rest of Europe to avoid an even bigger debt crisis. But the ECB worries that by letting Greece off the hook, it would not have any incentive to reduce spending and get its financial house in order.
In other words, Greece would be exposed to moral hazard.
Moral hazard first became a talking point after the failure of Lehman Brothers and the run on British bank Northern Rock.
Governments in Britain, Australia and elsewhere responded with guarantees for bank deposits to restore confidence in the banking system.
But critics said this would encourage banks to continue to engage in risky lending practices and stop depositors punishing banks by withdrawing their funds.
It is interesting that moral hazard troubles the market only in times of crisis. When markets are booming, morality and the hazards of risky behaviour are the last things on people's minds.


Read more: http://www.smh.com.au/money/the-abcs-of-gfc-jargon-20111025-1mgsb.html#ixzz1cStP3N63

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