Subject: The Age of Political Risk (Financial markets) - New Yorker _ May 24, 2010
From: "Michael Andrews" <[email-masked]>
To: "Eric Schwerin" <[email-masked]>, "Hunter Biden" <[email-masked]>
Date: Fri, 21 May 2010 10:04:32 -0400

I think this piece nails why we can be successful in partnering our  
resources to assess political risk since political risk now dominates  
the market sentiment.

Michael

 From the current issue of the New Yorker:

The Financial Page

The Age of Political Risk

by James Surowiecki May 24, 2010

It seems crazy: the German state of North Rhine-Westphalia holds an  
election, and Americans’ 401(k)s go haywire. But that’s not a bad  
shorthand description of what’s happened to the stock market over the  
past few weeks. What links the two is the Greek debt crisis and the  
actions of Germany’s Prime Minister, Angela Merkel, the villain of  
the story. When the scale of Greece’s problems first became clear,  
she grudgingly agreed to help with a bailout. But in the spring  
Germans started to ask why they should pay for Greek fecklessness and,  
as elections loomed, Merkel began taking a harder line in her public  
comments. The tougher she talked, the more skittish markets got. On  
April 26th, Merkel gave a speech in which she said, “Germany will  
help if the appropriate conditions are met,” making it sound as if  
that help were far from a sure thing. The yield on Greek debt  
immediately soared, and within days a rout was on. It may well have  
been the most expensive “if” in history.
The European Union did eventually come through with a rescue package  
for Greece and other beleaguered members, like Portugal, but the  
markets didn’t calm down, rallying on Monday only to nosedive again  
at the end of the week. The fact is, this kind of volatility isn’t  
going away, because we now live in an environment dominated by what  
economists call “political risk”—the uncertainty that businesses  
face as a result of government actions. Of course, government actions  
always affect the economy, but usually in an undramatic way: an  
interest-rate cut here, a new regulation there. The economic downturn  
and the debt crisis have given us instead a world where governments  
are among the most important players in markets—injecting money into  
economies on a colossal scale and routinely propping up, or even  
nationalizing, troubled companies.

As a result, investors have a vast range of new things to worry about,  
like voter sentiment in Westphalia. They have to try to figure out  
whether policymakers will do things they shouldn’t, like slash  
spending during a downturn, and not do what they should, which is to  
intervene promptly when systemic crises appear. Unfortunately, this  
sort of thing is inherently harder to predict than, say, how Procter &  
Gamble is going to do over the next few years. Last week, Mohamed El- 
Erian, the C.E.O. of the bond giant Pimco, sent a letter to investors  
saying that “the new normal” is a world in which “the public  
sector plays a much more influential role.” That’s a more uncertain  
world and therefore one in which markets will be more volatile.

Political risk is hard to manage because so much comes down to the  
personal choices of policymakers, whether prime ministers or heads of  
central banks. And those choices aren’t always going to be  
economically rational—witness  Merkel’s recent tergiversations.  
Similarly, the U.S. government’s failure to bail out Lehman Brothers  
in 2008 seems to have been in part the result of Treasury Secretary  
Henry Paulson’s desire not to be seen as Mr. Bailout. Investors,  
then, are being forced to read the minds of policymakers—not  
something they’re good at. Markets work best when there’s lots of  
information available and a historical track record to go on; they  
excel at predicting things like horse races, election outcomes, and  
box-office results. But they’re bad at predicting things like who  
will be the next Supreme Court nominee, as that depends on the whim of  
the President.Also injecting uncertainty is the fact that, even when  
politicians do the right thing, timing is all. Take the TARP bailout  
plan. Congress rejected it the first time around, in the fall of 2008,  
and the Dow fell nearly eight hundred points in a day. TARP passed on  
a second attempt, but by then the damage was done: fear and risk  
aversion had spread, and the stock market tumbled fifteen per cent  
more in a week. The bill for the Greek bailout has ballooned as a  
result of similar delay. In March, people were talking about a  
commitment of twenty-two billion euros. By early May, the E.U. and the  
I.M.F. planned to come up with a hundred and ten billion euros. Now  
more countries need bailouts and the total cost is seven hundred and  
fifty billion. The initial estimates were certainly too low, but, had  
Merkel acted sooner, the bill could have been a lot cheaper.

Politicians do sometimes do the right thing at the right time, but  
that’s no easier to foresee. In 1995, with Mexico teetering on the  
edge of default and threatening to take down much of Latin America  
with it, the Clinton Administration conjured up a back-door twenty- 
billion-dollar loan bailout that stabilized the Mexican economy. In  
1998, when Hong Kong came under attack from speculators who believed  
that its currency and stock market were overvalued, the government  
daringly put enough money into the stock market to send the hedge  
funds packing. And, just last year, the Obama Administration’s  
decision to stress-test the country’s biggest banks and require them  
to raise capital from private investors, rather than simply  
nationalize them, was instrumental in stabilizing a falling market.  
But in each case it was far from clear that the action would really  
happen—all three decisions were subject to vituperative criticism— 
so unpredictability still reigned.

Political risk adds new complexity to markets, and, as Nassim Taleb,  
the author of “The Black Swan,” recently said to me, “As the  
system gets more complex, it becomes harder to forecast.” Claire  
Hill, a law professor at the University of Minnesota, argues that  
investors trying to manage political risk have historically moved  
between extremes of “optimism and skittishness,” which sounds a lot  
like the current situation. That doesn’t mean you should put your  
money in gold; over time, even volatile markets can rise. But it  
won’t be a smooth ride. ♦

Read more: http://www.newyorker.com/talk/financial/2010/05/24/100524ta_talk_surowiecki#ixzz0oYr8DyD4