The straight talk on talent shortage

I loved this quote in the WSJ today:

“When executives talk about a talent shortage in their ranks, they’re really talking about a commitment shortage,” which stems partly from pay inequality, says Rakesh Khurana, an associate professor at Harvard Business School. “The greater the inequality, the less willing employees are to learn specific company ways of doing things that aren’t going to be useful to their next employer.”

He says less than one-third of M.B.A. graduates from elite business schools are pursuing corporate management jobs, compared with two-thirds in 1970.

WSJ Link

Unbelievably true. I’ve seen this in every damn company in Singapore and Asia. As Chief Exec of a corporate, you’ve gotta hold down costs, meaning the compensation of the people who work for you, while keeping your staff.  Keep em happy enough to stay with you, but pay them as little as possible…

The second point, that less than one third of elite b school grads head to corporate jobs, is absolutely true. WSJ surveys of b schools for example, which are somewhat different from other surveys because they ask corporate recruiters which b schools they like, show HBS and GSB at the bottom, because students there have many other options than the typical corporate training program. Notably consulting, private equity, hedge funds and investment banking.

Kevin Hassett’s misguided Regulation FD rant

This is probably the most idiotic article I’ve ever come across on Bloomberg. Kevin Hassett mouths off about Reg FD in such a convoluted misguided way that it makes me wonder… If he’s a adviser to John McCain, then the US is going to be headed for some real economic trouble if McCain wins.

In the old days, if you were a big customer and heard speculation that a firm such as Bear was in trouble, you might call up the boss and ask him about it. If the rumor was that the firm was flat broke, then he might invite you to his office and show you his list of assets to calm you down.

Alternatively, if a chief executive received a number of troubling phone calls, he might summon a highly respected analyst to his office and open up his filing cabinets. If things checked out, the analyst would then issue a report saying that the bad rumors were unfounded. If he tried to get cute and profit personally from the opportunity, then insider-trading laws would apply.

Such a common-sense response to false rumors is now a crime. The law makes innuendo-based attacks far too easy.

Well, why can’t you just publish your news on Bloomberg? Tell everyone that you are OK, instead of just sharing it with one or two people? The law certainly makes widespread publishing OK.

What Mr. Hassett is really saying is that there are reasons why a company should not disclose information in the full public domain. Those reasons include legal liabilities that the information must be true (ie the company cannot spread counter-rumors). In effect, Mr. Hassett says that short sellers can use rumors to drive prices down, but the company cannot now use rumors (ie assertions not completely evidenced) to counter.  And he blames Regulation FD.

Oh boo hoo. First and foremost, there is absolutely no damn reason that any company should not be able to announce anything it wants to the broader market under FD. Just beware, no favoring privileged insiders.If that affects disclosure standards by companies, tough. If you really want to make them disclose more, just modify accounting standards or laws. Anything they disclose on their own is optional anyway, and you are dependent on an illusory faith in good governance.

A second stupid part of this article

A study by economists Armando Gomes, Gary Gorton, and Leonardo Madureira of the Wharton School at the University of Pennsylvania found that earnings-forecast errors for small companies skyrocketed after Reg FD was passed, suggesting that it is mucking up information transmission even in normal times.

Yeah no shit. But Mr. Hassett assumes that information transmission is of the utmost importance. This is patently untrue. If information transmission was the only factor in market design, one would actually allow insider trading. Insiders would be able to transmit their knowledge most efficiently by trading on the stock. The stock price would then reflect all information, both public and private. Efficient market hypothesis, strong flavored.

He of course does not discuss why information transmission could be secondary to fairness.

I can’t believe this guy is a director of anything.

Dismal long term view from the Roach

Insight: Watch out for aftershocks
By Stephen Roach

Published: April 14 2008 17:15 | Last updated: April 14 2008 17:15

The author is chairman of Morgan Stanley Asia

But do not confuse that possibility with an all-clear sign for the real economy, stock markets or the political cycle. As the US slips into recession, a chain of increasingly powerful feedback effects is likely to follow. The after-shocks of this crisis will shape the landscape for years to come.

Financial markets have breathed a sigh of relief that the worst may now be over. Maybe that is the case for the crisis, itself.

Every financial crisis is different, but at some point, they all end. It is hard to know if the end of this one is at hand, but there are grounds to believe the worst of the fire-storm may be burning itself out.

Among the reasons: liquidity injections by central banks, especially the US Federal Reserve, have erred on the side of overkill. Moreover, some of the actions have been unconventional, especially the opening of the Fed’s discount window to investment banks for the first time since the 1930s.

And the failure of Bear Stearns is reminiscent of similar catharses that have marked the bottom of earlier crises, from the failure of Herstadt Bank in 1974 to the demise of Long-Term Capital Management in 1998.

However, there is far more to the macro end-game. This crisis has been big enough to have triggered a host of feedback effects that should endure long after financial markets begin to heal.

First and foremost, there is the impact on the real economy. This is particularly true of the US, where income-deficient, housing-dependent consumers are caught in a vice between a cyclical erosion of labour income and the bursting of housing and credit bubbles. Add to that a steep recession of homebuilding activity, and risks have tipped decidedly to the downside for fully 78 per cent of the US economy. As a result, corporate profits should fall well below expectations, especially for the non-financial component of the S&P 500. As indicated by the recent earnings shortfall at General Electric, such optimism, in the face of recession, points to especially painful feedback effects for the stock market.

Second, there are lagged impacts on the broader global economy. In an era of globalisation, the world economy has become tightly linked through cross-border flows of trade, financial capital, information and labour. Export-led developing Asia has been a big beneficiary of the surge in global demand and world trade over the past five-and-a-half years. Now that the global business cycle has turned, Asia will have a very hard time decoupling itself from a consolidation of the US consumer.

Third, it seems quite likely that bruised and battered financial institutions will have to contend with an additional round of pressures. Until now, financial intermediaries have been hit mainly by crisis-related disruptions on the credit front. But as is typically the case with erosion on the demand side of the real economy, a cyclical deterioration in loan quality for households and businesses is coming.

Fourth, feedback effects could also hit commodity markets – the sole surviving bubble in an increasingly bubble-prone world. By now, most are convinced that commodities are in a permanent “super cycle”, with the limited expansion of supply failing to keep up with a growing appetite on the demand side of the equation sparked by commodity-intensive economies such as China and India. However, with global GDP growth in 2008-09 likely to fall well short of the near 5 per cent average pace of the past five years, a cyclical correction in the prices of oil, base metals and other non-food commodities seems likely.

Fifth, a political backlash to this crisis is likely to lead to a new wave of re-regulation. Just as the bursting of the dot-com bubble and an outbreak of corporate accounting scandals led to passage of Sarbanes-Oxley Act of 2002, US politicians now seem equally committed to a recasting of the regulatory framework governing financial markets. The US Treasury has already fired an opening salvo in what is likely to be an intense and drawn-out debate. As an added twist, look for the US Congress to rewrite the Fed’s policy mandate to make the central bank more accountable for avoiding destabilising asset bubbles in the future.

ADM Capital: What happened last year?

Asia Debt Management, one of the oldest Asian distressed debt funds, seems to have had a rather bad year last year. From what I can tell, the fund missed its 15% hurdle, and had a few senior people leave.  It seems like the top dogs stayed on, but the thirty somethings, the core of the fund business, seem to have evaporated.

Justin Ferrier ends up in Myo capital, Mary Schroeder joins Och Ziff. That leaves you with the just the 4 principals of the fund. I’m not sure which deals blew up on them, but they did some darn innovative work along the way, one of the first Indian restructurings led by a foreign party, and all sizes of stuff all over South East Asia.

Mary Schroeder

Mary Schroeder is a corporate recovery consultant with substantial experience implementing debt restructuring plans and performing forensic accounting of financially distressed companies in the U.S. and in Hong Kong. Prior to joining ADM, Mary worked for KPMG’s Corporate Turnaround Department for five years, where she was involved in the refinancing of a PRC oil refinery, liquidation of an U.S. auto parts manufacturer, and the asset sales program of a Hong Kong construction company. Prior to joining this group, she worked in KPMG’s Assurance Services Department as an auditor. Mary is a graduate of the University of Notre Dame, where she obtained double degrees in Business Administration and Chinese Studies.

Mr Christopher Botsford,

Co-founder and CEO, ADM Capital

Christopher Botsford is a co-founder of ADM Capital, CEO of ADM Capital and a member of ADM Capital’s Investment Committee. Before establishing ADM Capital, Chris ran the Asia-Pacific regional debt and derivatives operation for Republic National Bank of New York. In 1995, he was a founding board member of the Asian arm of the International Swaps and Derivatives Association, the self-governing body for the derivatives industry. Chris holds an MA and BA from Cambridge University.

Hong Kong-based hedge fund firm Myo Capital is gearing up to launch an Asian-focused fund that will focus on undervalued credit strategies.

The Myo Capital Master Fund is set to debut on April 1 with $50 million in assets under management, according to Asian Investor.  The new Asian-focused (ex-Japan) vehicle will have four sub-strategies including high-yield credit, distressed, special situations and event driven.

The new fund is being headed up by Justin Ferrier, a former director at hedge fund shop ADM Capital.

“For example, if we are looking at a distressed credit, our Thai or Indonesian analyst will provide local intelligence, while Alfred, our trader, provides the market pricing and can source the credit from a large number of participants,” Ferrier told Asian Investor.

Other principals in the fund include Geoff Lee, who previously worked with Ferrier at Peregrine Capital and will run the special situations portfolio for the new fund; and Alfred Miu, formerly with UBS’s global credit strategies group, who will run the high-yield portion of the fund. In all, there will be 12 members of the team.

The fund is targeting returns of 13-15% net, with a volatility of 7% and a Sharpe ratio of 1.5-2. To start, it will not use leverage, but add use up to 150% as time goes on. The fund has a target close of $500 million.

Merrill Lynch will serve as prime broker for the new Myo fund; Maples and Calder and Simmons & Simmons will serve as lawyers; and HSBC will be the administrator.

What does sustained high energy prices mean for the world?

Oil hits a record US$112 a barrel today or thereabouts. It’s now at its inflation adjusted high. And Goldman thinks its on track to hit U$200 barrel within two years.

What does this really mean for the world. Sure more expensive gasoline, higher air ticket prices, but how is the face of the world going to change?

The ten biggest changes are probably going to be:

1. The death of suburbia: The high cost of fuel is going to force consumers to relook allocations of monthly budgets. As the fuel bill becomes larger, long run consumer choices are going to be skewed towards shorter daily commutes, living nearer the office. Bigger cities will expand dramatically. This should be the death knell of small town middle america as high transportation costs reduce the viability of communities.

2.  The resurgence of local manufacturing for some goods. The cost of trade overall is going to increase, and fewer low value goods are going to be exported over time. Value density of exported goods will increase. Some manufacturers of low value goods are going to site them closer to their consumers.

3. A drastic increase in fuel efficiency of vehicles. Within 5 years, what the US Senate has been unable to legislate for the last 20 will occur. Consumers will naturally prefer high fuel efficiency cars. This should be the last stand of the SUV.

4. An increase in the power of oil producers: No brainer. But this is also going to lead to a world which needs to be much more sensitive to the needs of Muslim communities over all.

5. Big infrastructure projects that reduce travel time and cost which depends on oil. The Kra Canal, the Silk Road rail project, perhaps even an Artic Route from Russia to the US. Spending US$100 billion on the Kra would not seem that much if were compared to the 7-14 days saved by every ship through the Straits of Malacca for the next 100 years.

6. Increases in food prices to levels never before seen. There is going to be a tight coupling of the world’s food, energy and arable land markets. Tough choices are going to have to be made by governments and consumers on what kind of crops and for what purpose is to be planted. Food is going to take up a much larger chunk of income.

7. Decrease in disposable income, and increase in poverty. Or at least a moderation of the current trends if not a reversal. If poverty be defined as lacking access to basic necessities of food, shelter and water, then high oil prices are going to push people into poverty as the basic necessities are going to cost more.

8. Resource arbitrage. Should you use a barrel of oil of energy to produce 100 gallons of drinking water from the sea? Or to produce fertilizer. Skewed incentives on the part of governments may make one activity more profitable than the other.

Indian Distressed Opportunities

MUMBAI: India is becoming a hot destination for ‘scavenging’. Cash-rich private equity distress funds are hovering atop the $35-billion distressed asset market in the country sighting enormous wealth-creation opportunities.

According to experts, 2006 has been an eventful year for distress funds as estimated investments in non-performing assets have grown from around $1 billion in 2005 to over $1.7 billion. It has been a safer bet for private equity (PE) players investing in distressed assets as many have fair potentials of recovery and are largely secured against tangible assets including high value real estate.

“The trend kicked-off with Asian Development Bank (through its Asian Development Management Fund) investing close to $100 million in India Cements in mid-2005. We have seen a handful of sizeable deals in sectors like cement, pharma and textiles in 2006,” said Arun Natarajan of Venture Intelligence.

Year 2006 witnessed the UK-based international fund Spinnaker Capital investing Rs 125 crore in IG Petrochemicals (IGPL). According to sources, the debt of the company was around Rs 640 crore at the time of buyout. The Hyderabad-based Pennar Industries also received an aid of Rs 120 crore from Spinnaker Capital and Eight Capital in July 2006.

As per the agreement, the funds will together pick up a 27% stake in the company after 18 months, something that Spinnaker is also doing in IG Petrochemicals, where it will pick up a 14.83% stake within a year. Sanghi Cement (GE-led foreign consortium investment of $160 million), Binani Cement (JP Morgan’s investment of $57 million), Kopran (Clearwater Capital Partners Investment of $20 million) and Shetron (Citigroup investment of $10 million) were the other major PE investments in stressed assets in 2006.

Despite the restrictions, funds continue to be active, especially, on the single-credit front, where some 15 to 20 of them are said to be operational at the moment in the country. “PE players have evinced tremendous interest on distressed assets over the past two years. There is still enough space for quite a lot number of players in the sector. The sector will be more interesting to watch once private asset reconstruction companies give more opportunities to existing lenders to recoup some part of their losses,” said Siby Antony, executive trustee, Stressed Asset Stabilisation Fund, a subsidiary of IDBI Bank.

According to experts, high debt burden of takeover assets (as a result of the recession in 1990s), rise in valuation of distress assets, multiplicity of lenders while taking over and unknown and unclear liabilities of takeover assets are the challenges faced by the investors.

Gautam V Patel, vice-president, Deutsche Bank AG, said, “The initiatives taken by regulators to empower lenders with SARFAESI (Securitisation and Reconstruction of Financial Assets and Enforcement of Security Interest Act) and CDR (corporate debt restructuring) system have been successful by far. But a lot more has to be done. The regulators should also allow change of management under the SARFAESI Act. We should initiate changes in the judicial process to weed out hassles of unclear liabilities and other legal wrangles.”

India – Securitisation and Reconstruction of Financial Assets and Enforcement of Security Interest Act 2002 – SARFAESI Act

ARCIL

Stocks: Malaysia: Pantech

 Found this on the Edge: Looks interesting if it is legit. Need to investigate a little more.

Pantech Group Holdings (RM1.87) offers investors a relatively cheap exposure to the booming oil & gas as well as palm oil industries.

The company is one of the largest one-stop distributors of pipes, fittings and flow controls (PFF) products in the region. That is, Pantech provides its customers a complete solution for the transmission of fluids and gases from point A to point B.

Double-digit growth over foreseeable future
Pantech is expected to grow at a rapid clip, bolstered by increased activities in the buoyant oil & gas and palm oil sectors.

The company’s sales expanded at a compounded growth rate of nearly 66% annually in the past three years, from RM53.5 million in FYFeb04 to RM243 million in FY07. Sales are on track to hit RM310.7 million for FYFeb08, or equivalent to about 28% year-on-year (y-o-y) growth.

Similarly, earnings have also expanded by leaps and bounds over the same period. Net profit rose from just RM2.3 million in FY04 to RM26.8 million in FY07. We estimate earnings to grow by 27% to RM33.9 million in FY08. Looking further ahead, net profit is expected to grow by another 18% and 23% in FY09-FY10, respectively.

On the other hand, Pantech’s shares are still trading at very attractive valuations — relative to the company’s projected double-digit growth rates. The stock is priced at only 7.2 and 5.9 times our annualised 2008-2009 estimated earnings, respectively.

From humble beginnings…
Pantech has its humble beginnings as a trading company catering to the domestic market back in 1988. The company successfully capitalised on the growing market for high pressure, seamless and specialised steel pipes, fittings, flanges, valves and other related products — right at the time when Malaysia’s petrochemical and oil & gas industries were taking off.

Its customer list soon grew to include major players such as Gas Malaysia, Malaysia Marine and Heavy Engineering (a subsidiary of MISC), Kencana HL, Petronas Carigali, Sime Engineering, KL Kepong and Mewah Oils.

In 2000, Pantech expanded into the manufacturing of butt-welded carbon steel fittings such as elbows, tees, reducers, end-caps and high frequency induction long bends. Since then, the manufacturing arm has grown from strength to strength, and now accounts for over one-fifth of total sales.

… to one of the largest PFF distributors in the region
Today, over 80% of Pantech’s manufactured products are exported to countries all over the world, including the US, Mexico, Iran, Singapore, India and Brunei.

The company’s products are highly specialised — its PFF products are mainly used in high pressure, corrosive or extreme temperature conditions across a broad swath of industries.

The oil & gas sector is its biggest customer, accounting for some 53% of total sales, while palm oil and refineries contribute to about 15% of sales.

Both sectors are expected to growth at a rapid pace with activities spurred by prevailing high crude oil and crude palm oil prices.

Pantech has warehouses and storage yards located at key industrial hubs in Malaysia — in Pasir Gudang, Shah Alam, Kuantan and the Free Trade Zone in West Port — and Singapore.

The company has also recently opened a sales office in Vietnam, to capitalise on the country’s fast-growing oil & gas sector. Total storage space has more than doubled to over 78,000 square metres currently, from just 29,341 square metres two years back.

Note: This report is brought to you by Asia Analytica Sdn Bhd, a licensed investment adviser. Please exercise your own judgment or seek professional advice for your specific investment needs. We are not responsible for your investment decisions. Our shareholders, directors and employees may have positions in any of the stocks mentioned.

Singapore’s problems

Minister for Foreign Affairs George Yeo on the SPG culture

Minister for Foreign Affairs George Yeo’s Interview with Astro Awani Television on 4 February 2008

Q: Of course. So what are your comments then on generally people coming into Singapore? As you said it’s a city-state, you have got limited resources and then you are going to have this sporting event that will bring thousands and thousands and thousands of people. I mean it’s great for business but will Singapore be able to cope with it?

Minister: That’s a problem that we have got to solve. This is not a theme park, this is home for us. [] And Singaporeans sometimes get upset by this because prices go up or foreigners have habits which we are not familiar with, they make friends with our girls, I mean so there are all kinds of problems which we face because we are opening up even more than before. [] You open the windows, the flies come in, and of course you also get fresh air and the sunshine.

Full text

Misnomers: Hedge Fund and Private Equity

The terms hedge fund and private equity are probably the most mistakenly used in the finance vocabulary today. The industry has grown much faster than the public’s capacity to understand it, and not a day goes by without a newspaper columnist, layperson or well-meaning friend makes remarks that make me cringe at the generalizations made of an enormously complex industry.

Private Equity: Traditional private equity was precisely that, all it meant was investing in the shares of non-publicly traded companies. It relied on fundamental equity analysis to identify companies which were not large enough to be listed, but had great prospects. However, over time, a number of strategies began to emerge as the market outperformers during some cycles. These included

LBOs: Where a minimal amount of equity is used to take an inefficient public company private, using a large amount of debt. The idea is really that the public company has a baseline of cash flow even when it is inefficient, and this can support the debt. Any improvement in the company’s prospects is upside to the equity, the PE sponsor.

VC: Venture capital, another mangled term, means one of two things. The first, which is commonly associated with the VC term is really funding of early and middle stage technology companies. Exits are usually based on strategic sales or IPOs and these firms take on very little debt, as the tech companies usually do not have cash flows to support it. The lesser known use of VC, is really traditional seed funding of businesses, such starting up a hotel, a small manufacturing company, etc. But most people tend to ignore this aspect of VC, even though it is the far larger market for funding.

Hedge Funds: The traditional use of the hedge fund term would probably apply to strategies which have been around as long as a stock market existed. The initial, essential idea was that a money manager could short one security, while being long another, and this would help him make money regardless of where the market ended up going. In contrast a long only manager is a slave to the vagaries of the market. Even if you made a good bet, a market downturn would put you in the red. Over time of course, many strategies sprang up around this concept of long/short:

Risk Arbitrage: Legalized insider trading. Wait till a merger is announced. The price of the target moves close to offer price, the price of the buyer moves lower due to dilution concerns. The HF will start calling up his buddies in banking, accounting, law firms, brokerage desks to see whether the merger has a good chance of happening. After getting all the market rumors, from whether the shareholders of both firms are keen to whether the bankers are able to fund the deal, the HF decided whether or not the acquisition will go through. If so buy target, short buyer. If not, the converse.

Convertible Arbitrage: One of the most successful strategies, and has produced some of the big names of our times including Och-Ziff, Fortress and Citadel. A convertible is essentially a bond which can be converted to equity at a certain stock price. You’re protected on the down side by the bond like features, and get the equity upside if things go well. There are a number of mathematical trading strategies to realize profits over short periods of time due to the volatility of the stock. Plus margin leverage at up to 10:1 with some brokers.

Distressed Debt: Buy up the debt of a company in distress or unable to pay its loans. Pay40 cents on the dollar. Short the stock at the same time if you think company is heading into bankruptcy. Used the legalized insider trading and market rumor system to make short term profits over the bankruptcy process. Alternatively, propose a restructuring plan which rewards you with 80,90,100 cents on the dollar while the shareholders get wiped out. This strategy has been inconsistent over time. Similar to risk arbitrage. Just as you need a bull market for mergers to occur, you need a bear market for distressed.

Credit Trading:  Perhaps the most technical off all the HF strategies. It’s all about exploiting different values of fixed income instruments based on risk perceptions, maturity, spread, duration and currency. Complicated, and usually depends on leverage from prime brokers to amplify small price differences. Think Long Term Capital Management.

Quantitative Trading: Engineer builds computers. Puts in all the data in the world. Computer crunches historical numbers, tell Engineer what to buy and sell. Essentially  something like “Buy gold when Japan yen bonds yield x”. Requires liquid markets, lots of fast computerized trading. This strategy ran into trouble recently because all the Engineers read the same books and went to the same schools.

Commodity Trading: What started out as a system for mid western farmers to lock in profits by agreeing to sell their crop three months in advance is now a multi billion dollar HF industry. Guys trade options and forwards as well as physicals (I will ship 100m barrels of oil to you in Hamburg by next week). Names like Glencore, Ospraie, Olam, Philipps Brothers, Red Kite Metals

Welcome to a new world

And that’s just the beginning. What most laypeople fail to understand when they lump hedge funds together is the world of difference between what the various strategies do and who these people are.

An Australian Glencore trader who goes to a coal mine in Newcastle, buys 1m tonnes of coal, and then ships it to China where a power plant in Shenzhen would be forced to shutdown and create a blackout if it didn’t get coal on time.

is very different from

An equity long/short guy who sits at a Bloomberg terminal in a dingy building in Hong Kong, listening to endless company calls for these small mainland Chinese companies, buying stock in them while being short the market.

The skill sets, the risk-return, the value to society, the actual people, personalities, are all completely different.  The difficulties of the job, the people they communicate with, whether they build a business or just do some trades.

So hedge funds as a whole are never going to go away, and are never going to implode. Individual funds, certain strategies, at certain times, will perform badly. Like in any other industry, there will be some instances of fraud. But the only consistent thing about the industry is allowing a small number of people to play with large amounts of money and get paid like stars.

George Soros: False ideology at the heart of the financial crisis

Great article from George Soros about the current state of affairs. Seems like he believes the 6% gain in my portfolio from mid March is a true dead cat bounce. I think another 6 months is going to bring us to the proper brink of the crisis. We’ll see.

The proposal from Hank Paulson, US Treasury secretary, for reorganising government regulation of financial institutions misses the point. We need new thinking, not a reshuffling of regulatory agencies. The Federal Reserve has long had authority to issue rules for the mortgage industry but failed to exercise it. For the past 25 years or so the financial authorities and institutions they regulate have been guided by market fundamentalism: the belief that markets tend towards equilibrium and that deviations from it occur in a random manner. All the innovations – risk management, trading techniques, the alphabet soup of derivatives and synthetic financial instruments – were based on that belief. The innovations remained unregulated because authorities believe markets are self-correcting.

Regulators ought to have known better because it was their intervention that prevented the financial system from unravelling on several occasions. Their success has reinforced the misconception that markets are self-correcting. That in turn allowed a bubble of excessive credit to develop, which extended through the entire financial system. When the subprime mortgage crisis erupted it revealed all the weak points. Authorities, caught unawares, responded to each new disruption only after it occurred. They lacked the ability to foresee them because they were in the thrall of the market fundamentalist fallacy. They need a new paradigm. Market participants cannot base their decisions on knowledge, or what economists call rational expectations. There is a two-way, reflexive interaction between the participants’ biased views and misconceptions and the real state of affairs. Instead of random deviations, reflexivity may give rise to initially self-reinforcing but eventually self-defeating boom-bust sequences or bubbles.

Instead of reshuffling regulatory agencies, the authorities ought to prepare for the next shoes to drop. I shall mention only two. There is an esoteric financial instrument called credit default swaps. The notional amount of CDS contracts outstanding is roughly $45,000bn. To put it into perspective, that is about equal to half the total US household wealth and about five times the national debt. The market is totally unregulated and those who hold the contracts do not know whether their counterparties have adequately protected themselves. If and when defaults occur, some of the counterparties are likely to prove unable to fulfil their obligations. This prospect hangs over the financial markets like a sword of Damocles that is bound to fall, but only after some defaults have occurred. That must have played a role in the Fed’s decision not to allow Bear Stearns to fail. One possible solution is to establish a clearing house or exchange with a sound capital structure and strict margin requirements to which all existing and future contracts would have to be submitted. That would do more good in clearing the air than a grand regulatory reorganisation.

The other issue is rising foreclosures. About 40 per cent of the 6m subprime loans outstanding will default in the next two years. The defaults of option-adjustable-rate mortgages and other mortgages subject to rate reset will be of the same order of magnitude but occur over a longer period. With single family home sales running at an annual rate of 600,000, foreclosures will overwhelm the market and cause prices to overshoot on the downside. This will swell the number of homeowners with negative equity who may be tempted to turn in their keys. The fall in house prices will become practically bottomless until the government intervenes. Cutting foreclosures should be a priority but the measures so far are public relations exercises.

The Bush administration has resisted using taxpayers’ money because of its market fundamentalist ideology. Apart from a bipartisan fiscal stimulus, it has left the conduct of policy largely to the Fed. Yet taxpayers’ money will be needed to reduce foreclosures. Two proposals by Democrats in Congress strike a balance between the right to foreclosure and discouraging the exercise of that right. One would modify the bankruptcy laws allowing judges to modify the terms of mortgages on principal residences. Another would provide Federal Housing Administration guarantees that would enable mortgage holders to be paid off at 85 per cent of the current appraised value. These proposals will not solve the housing crisis, but go to the heart of the issue. They should be given serious consideration.

The writer’s book, The New Paradigm for Financial Markets: The Credit Crisis of 2008 and What It Means, is released as an e-book by PublicAffairs on Thursday

Copyright The Financial Times Limited 2008