http://www.wilmott.com/blogs/satyajitdas/index.cfm Knowns & Unknowns In Derivatives/ Financial Products en-us Sat, 25 May 2013 11:27:28 --0100 Wed, 27 Feb 2013 05:05:00 --0100 BlogCFC http://blogs.law.harvard.edu/tech/rss blogs@wilmott.com blogs@wilmott.com http://www.wilmott.com/blogs/satyajitdas/index.cfm/2013/2/27/The-Setting-Sun--Japans-Coming-Debt-Crisis Japan?s Nikkei 225 stock average rose by around 23% in 2012 and has continued to rise in early 2013. Much of the increase was since the announcement of the election in late 2012, when the index rose by around 20%, outperforming 92 of 94 equity benchmarks around the world. Foreigners increased holding of Japanese equities by a net US$21 billion in the six weeks before Christmas. The increase reflects faith in the reflation strategy of second time Prime Minster Shinzo Abe to increase growth through an additional US$120 billion of public spending and create inflation to reduce the debt to GDP ratio. In the post war period, Japan enjoyed decades of strong economic growth ? around 9.5% per annum between 1955 and 1970 and around 3.8% per annum between1971 and 1990. Since the collapse of the Japanese debt bubble in 1990, Japanese growth has been sluggish, averaging around 0.8% per annum. Nominal gross domestic product (?GDP?) has been largely stagnant since 1992. Japan?s economy operates far below capacity, with the difference between actual and potential GDP being 5- 7%. The Japanese stock market is around 70-80% below its highs at the end of 1989. The Nikkei Index fell from its peak of 38,957.44 at the end of 1989 to a low of 7,607.88 in 2003. It now trades around 8,000-12,000. Japanese real estate prices are at the same levels as 1981. Short term interest rates are around zero, under the Bank of Japan?s (?BoJ?) Zero Interest Rate (?ZIRP?). 10 year Japanese government bonds yield around 1.00% per annum. Since 1990, public finances have deteriorated significantly. Government spending to stimulate economic activity has outstripped tax revenues, resulting in a sharp increase in government debt. Japan?s total tax revenue is at a 24 year low. Corporate tax receipts have fallen to 50 year lows. Japan spends more than 200 Yen for every 100 Yen of tax revenue received. Japanese government gross debt is now around 240% of GDP. Net debt (which excludes debt held by the government itself for monetary, pension and other reasons) is about 135%. Total gross debt (government, non financial corporation and consumer) is over 450% of GDP. Japan?s large pool of savings, low interest rates and a large current account surplus has allowed the build-up of this large government debt. Japan has a large pool of savings globally, estimated at around US$19 trillion. In recent years, household savings were complemented by strong corporate savings, around 8% of GDP. Around 90% of all Japanese Government Bonds (?JGBs?) are held domestically. Low interest rates make servicing the high levels of debt manageable. If Japan continues to run large budget deficits, as is likely, then the falling saving rate and reversal in its current account will make it more difficult for the government to borrow, at least at current low rates. Japanese household savings rates have declined from between 15% and 25% in the 1980s and 1990s to under 3%, reflecting decreasing income and the aging population. As more Japanese retire, inflows into JGBs will decrease making domestic funding of the deficit more difficult. Insurance companies and pension funds are increasingly selling their holdings or reducing purchases to fund the increase in payouts to people eligible for retirement benefits. Since 2007, the Japanese trade account surplus has fallen sharply, turning into a deficit in 2012 due to an appreciating Yen, slower global growth and higher cost of energy imports. But Japan?s large portfolio of foreign assets (US$4 trillion, including US Treasury bonds of US$1 trillion) will cushion the effects for a time. But even if net income from foreign assets stays constant, Japan?s overall current account may move into deficit as soon as 2015. As the drawdown on financial assets to finance retirement accelerates, Japan will initially run down its overseas investments, losing its net foreign asset position. Unless public finances improve, Japan ultimately will be forced to finance its budget deficit by borrowing overseas. Where the marginal buyers of JGBs are foreign investors rather than domestic Japanese investors, interest rates may increase, perhaps significantly. Even at current low interest rates, Japan spends around 25-30% of its tax revenues on interest payments. At borrowing costs of 2.50% to 3.50% per annum, two to three times current rates, Japan?s interest payments will be an unsustainable proportion of tax receipts. Higher borrowing costs will also trigger problems for Japanese banks, Japanese pension funds and insurance companies, which also have large holdings of JGBs. To avoid the identified chain of events, Japan must address the core problems. Reductions in the budget deficit are difficult. Spending on social security accounts and interest expense now totals a major part of government spending. An aging population and shrinking workforce will continue to drive slower growth and lower tax revenues. Tax increases are politically unpopular. Reductions in the budget deficit are likely to reduce already weak economic activity, compounding the problems. Japanese policy makers can maintain its zero rate policy and monetise debt to finance the government. Japan can try to inflate away their debt. But ultimately, Japan may have no option other than a de facto domestic default or restructuring to reduce its debt levels. Investors and traders have repeatedly bet on a Japanese crisis, usually by short selling JGBs to benefit from higher rates. But the bet has failed each time, giving the strategy its name ? the widow maker. Economist Rudiger Dornbush once observed: ?The crisis takes a much longer time coming than you think, and then it happens much faster than you would have thought?. Japan?s toxic combination of weak economic performance, large budget deficits, high and increasing levels of government debt, declining household savings and looming current account deficits is increasingly unsustainable. © 2013 Satyajit Das Satyajit Das is a former banker and author of Extreme Money and Traders Guns & Money Global Sovereign Debt Crisis Wed, 27 Feb 2013 05:05:00 --0100 http://www.wilmott.com/blogs/satyajitdas/index.cfm/2013/2/27/The-Setting-Sun--Japans-Coming-Debt-Crisis http://www.wilmott.com/blogs/satyajitdas/index.cfm/2013/2/9/Perceptions-of-Beauty--Stock-Valuations The American comedian Will Rogers provided sage advice about investing: "Don't gamble; take all your savings and buy some good stock and hold it till it goes up, then sell it. If it don't go up, don't buy it". Changes in the economic environment and a world of low growth make following Rogers' method more difficult than ever. Stock spruikers argue that equities are ?undervalued?. But changes in the economic environment may make quaint measures such as price-earning (?PE?) ratios misleading. In a world of low growth, the dynamics of corporate earnings, which ultimately underlie stock prices, have become more complex. Profit margins and cash flow improve, perversely, in a period of low growth. Initially, companies cut costs improving profitability. As revenues are stagnant, companies have no need to invest in expanding capacity or working capital, releasing cash flow. Reduction in depreciation charges and the ability to use cash flow to reduce debt reduces interest expenses. In the present cycle, sharp decreases in interest rates, though not necessarily interest margins, have also improved profit margins. These effects are short term. In effect, they misstate earnings. As English Economist John Hicks argued true income must to allow for sustained productive capacity, which is the amount that can be withdrawn or paid out without diminishing the ability to produce the same next year. Plant must eventually be replaced. Cost cutting, productivity improvements and restructuring cannot be repeated endlessly. In the long run, increases in profitability require revenue growth. But lower growth translates into lower demand slowing revenue increases. Lower demand and also over capacity in many industries have reduced corporate pricing power decreasing profitability. A striking feature of recent corporate history has been low and poor quality revenue growth. Earnings have increased more than revenues. Where companies or sectors experience revenue growth, the causes are interesting. Beneficiaries of government spending targeted at increasing demand have benefitted. Artificially low interest costs have encouraged substitution of technology and mechanised equipment for human resources boosting revenues of technology and industrial equipment manufacturers. Commodity producers? revenues have benefitted from rises in volumes (driven by emerging market demand) and higher prices. Banks and financial institutions? earning have benefitted from central bank activity to create artificially low interest rates and provide near unlimited funding. Policy measures have provided additional ?carry? income, allowing banks to borrow at near zero rates to invest in government bonds or higher yielding assets. These investors have also profited from capital gains as central banks have intervened aggressively to bring down asset yields. Low rates have also reduced loan losses allowing weak borrowers to continue to service crippling debt. In the US, specific actions targeted at the housing market have boosted returns for mortgage lenders. Unsurprisingly, bank earnings and stock prices have performed well. Some firms have increased revenue by cannibalising competitors and adjacent industries. RIM and Nokia have lost market share to i-Phones. Sony?s Walkman and other makers of mobile entertainment devices have lost market share to i-Pods. Makers of personal digital assistants ? Palm Pilots and Handsprings- were superseded by smart phones. Tablets have increased market share at the expense of desktop and notebook computers. Picking the winners and losers in this game is difficult. The build-up of cash on corporate balance sheets is frequently cited as a sign of corporate health. In the US, since 2008 companies have been net lenders rather than borrowers and now hold around US$1 trillion in cash. Japanese companies hold liquid assets of US$2.8 trillion. European companies too hold large cash balances. Mark Carney, the newly appointed Bank of England governor, referred to the $300 billion of cash held by companies in his native Canada as ?dead money?. He urged vainly for firms to ?put money to work and if they can?t think of what to do with it, they should give it back to their shareholders?. The high cash balances reflect uncertainty about future financing conditions and the willingness of banks to lend. But it primarily reflects the lack of investment opportunities. The cash balances are a drag on corporate earnings, given the near zero interest rates in most developed markets. But cash surpluses have influenced stock prices and returns. Following Mark Carney?s advice, many companies have returned capital, through stock buybacks and higher or special dividends. In late 2012, fear of US tax changes prompted such actions. But investors are now faced with the problem of where to deploy the cash. Other companies have used surplus cash to purchase competitors, businesses or assets. Given the indifferent results of many mergers and acquisitions (many acquisitions by technology firms and resource companies come to mind), it is unclear that this will benefit anyone other than shareholders of the acquired company and investment bankers. Equity valuations increasingly will reflect changes in the market environment. Changing demographics affect stocks. Investors approaching retirement may switch to more defensive asset and seek steady income, favouring bonds and cash. Low and declining returns over time has also undermined demand for equities. The reduction is evident in outflows from equity funds into other assets. But a major factor is increasing distrust of the market itself. Government policies especially zero interest rate policies, quantitative easing and other forms of financial repression, now exert a significant effect on stocks. Low holding costs have driven stock prices. Dividend paying stocks have benefitted from the attention of investors seeking income. With limited policy options and central bank desire to boost asset prices to protect financial institutions and increase consumption, further intervention, including direct purchases of stocks, cannot be ruled out. The Bank of Japan has purchased risky assets including corporate bonds and stocks. During the 1997/1998 Asian monetary crisis, the Hong Kong Monetary Authority purchased stocks. Algorithmic trading now dominates stock markets, making up between 30% and 70% of all activity. While necessary to facilitate execution, computerised trading may increase volatility. Holding periods now average a few seconds. Computer generated market failures, such as the Flash Crash and the problems of Knight Capital, reduce confidence in the integrity of the market. Average investment periods for traditional investors have fallen from 7 years in 1940, 5 years in 1960s, 2 years in the 1980s to 7 months currently. Short term trading feeds volatility and may distort values. Responding to shorter investment holding periods, the European Union have proposed a quixotic investor loyalty plan (rather like a mileage scheme offered by airlines!). Under the plan (which faces significant opposition), loyal shareholders in European companies would benefit from extra voting rights and higher dividends. This would be a significant change to the ?one-share one-vote? principle of corporate structures. Despite the increase in computer driven trading, overall trading volumes have declined by 15-30%. The reduced liquidity affects stock valuations. Revelations of insider trading reduce and expert networks designed to secure preferential access to tips has emerged. As Robert Khuzami, director of enforcement SEC put it in his successful prosecution of Galleon: ?Raj Rajaratnam is not a master of the universe, but rather a master of the Rolodex?. Institutionalised wrong doing further undermines investment interest, especially from retail investors. Equity market analyst Laszlo Birinyi may have been right when he observed that ?the relationship between the stock market and the economy is tangential, not causal?. But in the longer term, the disjunction between fundamentals of real earnings or cash flow and stock prices as well as changes in the structure of the market undermines investor interest in and demand for stocks. John Maynard Keynes famously likened the stock market to a beauty contest, where success depended on anticipating the views of the judges rather than an investor?s own perspectives on pulchritude. Stocks may or may not be undervalued. But fundamental changes in the drivers of stocks and trading in equities now make Keynes views on investing success more important than ever. © 2013 Satyajit Das Satyajit Das is a former banker and author of Extreme Money and Traders Guns & Money Investment Management Sat, 09 Feb 2013 19:08:00 --0100 http://www.wilmott.com/blogs/satyajitdas/index.cfm/2013/2/9/Perceptions-of-Beauty--Stock-Valuations http://www.wilmott.com/blogs/satyajitdas/index.cfm/2012/8/9/Tilting-at-Windmills Richard Duncan (2012) The New Depression: The Breakdown of the Paper Money Economy; John Wiley, Singapore Simon Lack (2012) The Hedge Fund Mirage: The Illusion of Big Money and Why It?s Too Good to be True; John Wiley & Sons, Inc, Hoboken NJ In Miguel de Cervantes? Don Quixote the hero seeks to fight windmills that in his imagination are giants, despite the warning of his servant Sancho Panza. In English, the phrase ?tilting at windmills? has come to be associated with attacking imaginary adversaries, based on a heroic, romantic and ultimately incorrect logic. Both The New Depression and The Hedge Fund Mirage share something of the Knight of La Mancha?s mis-placed idealism. Richard Duncan is a practitioner, who has over three books ? The Dollar Crisis, The Corruption of Capitalism and his new work The New Depression ? sought to diagnose the ailments of the global economy. Mr. Duncan?s consistent and oft repeated argument throughout his trilogy is that the problems are caused by the over-extension of credit. Mr. Duncan is, of course, not the first or alone in this pre-occupation. The rapid expansion of credit presaged both the Great Depression and 2007-2008 economic problems. Between the mid 1920s and 1929-30, debt as a percentage of US GDP increased from about 160% to 260%. In the run-up to the current crisis, debt to GDP reached over 350%. Mr. Duncan attributes the credit growth to the demise of the gold standard. The end of the Bretton Woods system of fixed exchange rates and the de facto gold standard via the dollar?s link to gold, Mr. Duncan argues led to a rapid build up in debt and global imbalances, exemplified by persistent current-account deficits. The explanation may well be broadly correct. However, it is inconsistent with the fact that a large expansion in credit took place in the 1920s when most currencies were linked to gold. Mr. Duncan?s analysis relies on an extension of Irving Fischer?s theorem on the relationship of money supply and prices: MV=PT or money supply times the velocity of circulation equals the price level times the number of transactions. Mr. Duncan replaces ?M? with ?C? the total credit in the economy with V becoming the turnover of credit. Mr. Duncan argues that the increase in C and some increase in V led to a steep rise in asset prices that led to the current problems. Mr. Duncan identifies the process whereby banks lent money against the collateral of overvalued asset prices, reinforcing prices rises, until the game of musical chairs ended. Few would disagree with the proposition. It lies at the heart of the now fashionable Minsky analysis of the financial processes underlying boom and bust cycles. Like Irving Fisher?s equation, Mr. Duncan?s revised formulation is a self evident truth; the amount of money spent equals the value of goods and services purchased. At the ?crisis attribution? level (all books on the crisis need a pantomime villain), Mr. Duncan blames policymakers who presided over this rapid growth of credit. The thesis is one that has been well argued before elsewhere, perhaps more persuasively. In this slim volume, Mr. Duncan does not delve beyond the surface of the argument and his imaginary enemies. The reality may be more nuanced. Western economic systems require continued growth. The period of stagnation in the 1970s following the oil price shocks promoted a major policy shift including deregulation of crucial industries such as banking and hence credit creation. Credit became a way of driving growth, in conjunction with more market based economies. Increased debt in small doses may be useful in promoting growth. But over reliance on credit is more dangerous, even if it is inevitable if economic history is any guide. The global monetary system is remarkably ad hoc, underpinned by economic theorems that are conjectural and unproven. As identified by Belgian-American economist Robert Triffin in the 1960s, the use of the dollar as the global reserve and trade currency required the US to run large trade deficits to meet the world?s demand for foreign exchange. As a self serving President Johnson argued: ?The world supply of gold is insufficient to make the present system workable?particularly as the use of the dollar as a reserve currency is essential to create the required international liquidity to sustain world trade and growth?. The complexity of the international finance may make it difficult to manage completely or successfully. Arguably, like the gold standard that preceded it, the Bretton Woods system was flawed at the outset as well as in its abandonment. Mr. Duncan?s conclusions are problematic. In The Dollar Crisis? published in 2002, he predicted a dollar implosion, as a result of a huge global imbalances and the credit bubble. The dollar remains in relative good health, despite the efforts of policy makers. Mr. Duncan?s prognosis is romantic, although he eschews an idealistic call for a return to the gold standard. Seeing no realistic prospect of private consumption or investment driving real growth, he urges continued fiscal stimulus. Rather than encouraging private consumption or public spending, Mr. Duncan proposes an American solar energy initiative to create a new era of growth and prosperity. This is keeping with a previous suggestion of a $3trillion US government investment in unspecified ?21st century technologies over 10 years?. The New Depression proposed program would cost perhaps $1 trillion over ten years, and reduce the cost of energy by 90%. Mr. Duncan?s approach is based on his view that conventional stimulus policies will create hyper inflation (which ignores the very low creation of credit and its lower velocity), depression or both. It is difficult to assess whether the proposal is realistic. An obvious query is whether Mr. Duncan, a financial market professional, has the right disciplinary credentials for promoting such renewable energy initiatives to boost growth potential. In any case, like the authors? earlier recommendations of a rising minimum global wage, which has perhaps more to commend it, the chance of adoption is low. The chance of a reversal of the monetary policies of recent years to restore financial integrity is also unlikely. Politicians of every persuasion like the illusion of control that power over money gives. While abandoning this power may be sound policy, it is unlikely that policy makers will willingly embrace it. As conservative politician William Buckley Jnr. knew: ?Idealism is fine, but as it approaches reality, the costs become prohibitive?. A different idealism permeates The Hedge Fund Mirage. Simon Lack, a former hedge fund profession, provides an insightful, if not original, critique of the industry. Mr. Lack?s thesis is simple, if distressing for investors ? hedge fund returns are not all they are cracked up to be. He presents his claim provocatively: ?if all the money that?s ever been invested in hedge funds had been put in Treasury bills instead, the results would have been twice as good?. Mr. Lack?s argument is that hedge fund returns are grossly overstated. A typical hedge fund makes most of its larger percentage return early in its history when it is small. This means that a small percentage loss in later life when it is much larger can lead to a loss in dollar terms than gains to that date. The dollar gain or loss argument is important although it has been made before. Author Richard Bookstaber in A Demon of Our Own Making argued that percentage returns can be misleading. In its first 18 years, Julian Roberston?s Tiger Fund generated returns of 30 percent per annum. In its last two years, the fund made losses of 50 percent. Taking the losses into account, Tiger returned 25 percent per annum over its life. Starting life in 1980 with $10 million, it had $22 billion under management by 1998. The fund?s highest percentage returns were on a small dollar base. The losses came from a larger base (a 50 percent loss on $22 billion is a loss of $11 billion). Tiger may have lost more dollars than it made over its life. Mr. Lack outlines familiar arguments. Historical returns exclude funds that fail or no longer accept new investment -survivorship bias. Only funds with a successful track record report performance?backfill bias. The difference between the best and worst performing funds is large, placing a premium on fund selection. Funds of funds add cost which detracts from return. Most really good hedge funds are closed to outside investors. Controversially, The Hedge Fund Mirage claims hedge fund managers have taken the largest share of the investment profits (over 80%). Mr. Lack indulges in some sensational hyperbole (essential these days to gain media attention and sell even a modest number of books earning the author less than the minimum legal wage in Sudan). But for the most part, the book reaches sensible if unremarkable conclusions, highlighting the importance of fund selection, avoiding indexes and averages, the importance of risk management and avoiding any invitation from Mr. Madoff and his ilk to invest. For investors seeking alpha, high average returns are meaningless, like a comfortable average ambient temperature where your feet are in the oven and your head is in the refrigerator. Unlike Mr. Duncan, whose prescriptions have not budged the needle on the Richter scale, The Hedge Fund Mirage has extracted a predictable, earth shaking response from the hedge fund industry, through its lobby group -Alternative Investment Management Industry (?AIMA?). In a series of opinion pieces, articles, a 24 page ?research paper? and ?commissioned? academic research, the AIMA has sought to highlight methodological, mathematical and factual errors. Mr. Lack probably can?t believe his luck as the AIMA?s rabid attacks have provided that most useful fuel for book sales ? controversy. Financial Times journalist Paul Murphy drew the analogy to Mel Gibson?s The Passion of Christ, whose success at the box office was guaranteed by the fact that the film managed to upset every Christian group who took up arms against the work. The AIMA criticism is also framed in ancient Aramaic, borrowing from The Passion of Christ. The central controversy is based on the appropriate measure of returns - dollar weighted or time weighted. The AIMA have resorted to that great modern invention - global best practice standards, which advocate time-weighted data for assessing hedge fund performance but dollar-weighted return for private equity assets. The detailed data used by Mr. Lack is not explicitly outlined making it difficult to independently assess the competing claims. Both sides to this arcane controversy have sought the idealistic high ground. It is useful to remember writer Aldous Huxley?s observation that ?idealism is the noble toga that political gentlemen drape over their will to power?. Whilst amusing, the exchange, which may have to do with livelihoods (hedge fund managers and Mr. Lack?s advisory business), does not advance greatly the debate regarding hedge funds, their performance and role in financial markets. A confluence of events may have boosted hedge fund returns. Initially, small funds and state managers may have benefited from regulated inefficient market. Macro funds high returns have been the result of the growth of emerging economies, the end of communism in Eastern Europe, world trade and deregulation of financial markets. Some hedge fund managers are undoubtedly exceptionally skilful. Soros, Tudor Jones, and James Simons, an ex-mathematics professor and former code breaker, have outstanding records. Others undoubtedly boost performance using investment Viagra, leverage and investment in illiquid or complex securities. Some managers have sought an information edge, testing the boundary of insider trading and market abuse. In reality, hedge funds occupy an artificial evolutionary niche in financial markets. Their existence is heavily reliant on the restrictions placed on normal investment vehicles. The ability to short, use leverage and focus on absolute returns defines hedge funds. But increasingly, their existence has also become a way of charging higher fees. As one manager candidly admitted: ?a hedge fund is just an excuse to charge two and twenty; they do not do anything else very different?. The Hedge Fund Mirage does not address these issues. It also does not explore the issue of the feasible size of hedge funds and their broader influence on financial markets. Whatever the truth or dare of these arguments, The Hedge Fund Mirage provides a welcome and wry antidote to the hilarious and excessively serious hagiographies about hedge funds and hedge fund managers ? see Sebastian Mallaby?s More Money Than God and Maneet Ahuja?s The Alpha Masters. Most authors and journalists behave like pre-pubescent girls in the presence of Justin Bieber when near these Lords of Money. They suffer from a phenomenon first diagnosed by John Kenneth Galbraith: ?Nothing so gives the illusion of intelligence as personal association with large sums of money. It is also alas an illusion?. Perhaps in a concession to his American ancestry, the Singapore resident Mr. Duncan is more earnest, believing that he can influence policy. True to his British heritage, Mr. Lack recognises that most hedge-fund books are written by ?proponents?. He recognises that the industry won?t change any time soon. The books are examples of a new emerging sub-genre in financial literature - Quixotic Tracts. The primary characteristic is an impractical idealism, lofty and romantic ideas and belief in extravagantly chivalrous standards of behaviour. The ideas in both books ? sensible economic management and efficient investment behaviour- are probably beyond the human race in its current stage of evolution. © 2012 Satyajit Das Satyajit Das is a former banker and author of Extreme Money and Traders Guns & Money Book Reviews Thu, 09 Aug 2012 07:59:00 --0100 http://www.wilmott.com/blogs/satyajitdas/index.cfm/2012/8/9/Tilting-at-Windmills http://www.wilmott.com/blogs/satyajitdas/index.cfm/2012/8/7/Personal-versus-Personalities Jonathan Fenby (2012) Tiger Head, Snake Tails: China Today, How It Got There and Where It is Heading Robert Frank (2011) Who Repo?d My Jet: the manic millionaires, and why they?ll lead us to the next boom and bust John Coates (2012) The Hour Between Dog and Wolf: Risk Taking, Gut Feelings and the Biology of Boom and Bust Personal ? relating to an individual or what serves the interest of that individual. Personality ? distinctive assemblage of qualities which defines an individual, frequently in modern life conflated with celebrity. These three books deal with the ?personal? and ?personality? in the financial world. In an increasingly crowded list of books purporting to explain China, Jonathan Fenby?s Tiger Head, Snake Tails is a standout, providing very personal insights into the Middle Kingdom rarely found elsewhere. Mr. Fenby is in an excellent position to write about the subject, having been the Editor of the South China Morning Post in HK for many years. His resistance to the newspaper following an overt pro-China line as demanded by the owner may have been a factor in his contract not being renewed. He continues to be closely involved with China, heading a team at the research service ? Trusted Sources. His direct knowledge and immediate experience provides the substance that defines the work. Most books on China are polemical tracts, rooted in Sino-philia or Sino-phobia, sometimes both simultaneously. Sino-philia believes in the Chinese ?model?. For example, The Economist asserts that: [Chinese leaders make] ?rational decisions that balance the needs of all citizens over the long term?. Francis Fukuyama and Nancy Birdsell believe that ?China can avoid the delays of ?a messy democratic process? because the bureaucracy at its upper levels is capable of managing and coordinating sophisticated policies?. Sino-phobes fear that China is hell-bent on conquering the world, capturing its resources and enslaving its peoples. They hold China accountable for everything, including the unsolved death of Marilyn Monroe and the mysterious forces behind the assassination of an American president in Dallas. The discussion and binary opinions are driven by the fact that economically and politically China is being called upon to play a central role in the world. The debate is focused on what the world requires rather than what China sees as its own interests and a realistic assessment of its abilities. Treading a nuanced path, Tiger Head, Snake Tails develops the thesis of an emerging country, seeking to deal with complex problems of economic development, social structure, political system and the unshakeable legacy of its history. Nothing illustrates this better than Chinese income levels. Despite its status as the world?s second largest economy, China ranks 98 out of 181 nations in the World Bank?s ranking of GDP per capita. Based on forecasts, wealth per capita in 2016 will be only equivalent to US$13,700 against $57,300 for the US and US$48,000 for Germany. This does not take into account the massive income inequalities in China, where a large portion of the population lives on less than US$1.25 a day. Mr. Fenby outlines China?s challenges, giving detailed examples and evidence. For example, to test the sustainability of its debt fuelled investment model, Mr. Fenby examines the Chinese Railway system, now one of the most extensive in the world. The Ministry of Railways employs 2 million people, has its own 70,000 strong police force and a court system employing 7,000 staff which includes judges with no legal training. It leader ?Liu Zhijun- was a cadre, whose major qualification was that he was Deng Xiaping?s bridge partner. The very fast trains are based on design by Kawasaki of Japan. The Chinese have ?indigenously re-innovated? the technology and now compete with Kawasaki to build high speed trains throughout the world. The route structure is erratic. The first super-fast train route puzzlingly connected Guangzhou and Wuhan (where Liu hailed from) rather than one in the more obvious North East. The trains were found to be faulty and their speed (rated at 300 KPH) has been throttled back in the interest of safety. A large number of faults have been discovered, including bridges built of gravel and garbage rather than cement. Liu himself and his deputy were dismissed for corruption and bribery. During this period, Chinese Railways debt tripled to around US$300 billion. The example is not isolated. Mr. Fenby painstakingly documents the endemic inefficiency, environmental abuse, lack of intellectual property rights, weak economic and managerial foundations of the economy, lack of rule of law, absence of rights, injustice, corruption and social problems. Mr. Fenby?s analysis highlight that any view of China through the prism of Western constructs is flawed. Central to China is the role of the Chinese Communist Party (?CCP?), which Mr. Fenby compares to the secretive, insular world of imperial rule that dominated China throughout much of its history. As Richard McGregor documented in his work The Party, the CCP plays a vital part in every aspect of Chinese life. CCP cells make most important decisions in all enterprises, even those that are publicly owned and have significant foreign shareholders. China?s economic, social and political systems are the product of its own history, as interpreted by the CCP. The central belief is that the fate of the CCP and China are intrinsically the same. Fear of instability and uncertainty form the background to every decision of a leadership that despite its outward appearance is deeply insecure. Comprehensive and provocative, some readers may find the organisation of the book idiosyncratic. Some may find its density challenging. But the book?s detail and richness is its strength, eschewing pat simplistic explanations. The text will reward carefully reading and re-reading. Tiger Head, Snake Tails is an antidote to the shallow narratives about China found in airport shops, which frequently form the basis of policy debates at least on TV chat shows and in business circles. Robert Frank, a journalist for the Wall Street Journal and author of the Richistan, takes the personality route. Who Repo?d My Jet is a slim volume of stories about people who belong to the nouveau rich whose wealth ?mansions, cars, private jets etc- was eviscerated by the events of 2008. Mr. Frank has compiled a well written, breezy set of tales whose dominant theme seems to be: got rich, mainly through luck and a generous dose of borrowed money, mistook the source of success as genius, spent too much money on various toys mainly to impress who knows whom, became overextended in business, investments, personal lifestyle or all of the above, then the bank called the loans in causing the entire pack of cards to collapse. While diverting and at time entertaining (the description of Aspen?s annual Gatsby Party and phrases like seasonal homes which are ?cruise ships on land?), Who Repo?d My Jet suffers from the shallowness of its analysis, paralleling the people portrayed. Mr. Frank?s attempt to develop an over-arching theme ?that the rich are important because they manically create wealth, booms and busts- is not convincing and the evidence he relies on does not support the conclusions. The book lacks the power of the apocryphal short exchange between F. Scott Fitzgerald and Ernest Hemingway. Included in The Crack-Up, compiled by Edmund Wilson. as entries from his notebooks, Fitzgerald is quoted as saying: ?The rich are different from you and me?; to which, Hemingway responds: ?Yes, they have more money.? Who Repo?d My Jet is Schadenfreude stretched thin. The Hour Between Dog and Wolf is about explaining the trader?s personality via his biology. It wades into the ?nurture versus nature? debate, trying to relate risk taking behaviour in financial markets to neurobiology, in particular to testosterone levels of traders. The author John Coates is a former trader at Goldman Sachs, Merrill Lynch, and Deutsche Bank who has earned a doctorate in neuroscience from the University of Cambridge. His thesis is simple. Male traders perform better when they have elevated testosterone levels. As prices increase and decrease, traders experience chemical changes. Euphoria caused by boosted testosterone levels from successful trades drives higher risk taking. Losses or reversals increase levels of the defensive steroid cortisol leading to risk-aversion. While a provocative and well argued thesis, Dr. Coates? arguments are thin as the experimental data relied on is limited at this stage. Dr. Coates also draws a distinction between the masculine world of risk-taking traders and the more feminised world of asset managers. The evidence presented is less than convincing. Most importantly, the analysis disregards environmental and cultural factors, documented by ethnographers such as Dr. Karen Ho in Liquidated. This includes matters such as incentive structures, risk control systems and peer performance pressures. Dr. Coates? thesis is not all encompassing. For example, cautious investors and traders also make and lose money, suggesting that biology cannot be the only driver. John Maynard Keynes?s ?animal spirits? may not be so easily reduced to a series of simple chemicals and their effects on humans. The book proposes positive steps that banks and fund managers can take to manage risk. Some of the proposals are well known - changing bonus systems and implementing mandatory cooling-off periods. Dr. Coates proposed hiring more women and older men. But Dr. Coates is coy about the potential for artificially manipulating the biology of traders and investment managers to improve performance. It is not hard to imagine a future where traders will need to have their supplements ?uppers and downers (in the old parlance)- at hand to improve trading, similar to the experience of competitive sports where drugs have become relatively commonplace to improve performance. It is also not hard to imagine internal risk mangers and regulators insisting on regular monitoring of hormone levels as part of the compliance regime, with attendant cheating. This is not far fetched. Already, organisations are adopting unusual initiatives to gain a critical edge. A trader at Steve Cohen?s SAC Capital was allegedly forced by his boss to take female hormones and wear articles of women?s clothing at work, leading to a sexual relationship between the men, one of whom was married. The bizarre behaviour was to eliminate the trader?s aggressive male attitude, making him a more obedient and detail-oriented trader. One suspects that neurobiology of the business cycle and all things financial and economic will become a burgeoning field. Like Freakonomics, the quack application of a discipline or cognitive construct to everything and everybody may be entertaining but it may be too simple to provide a complete explanation. However, it does offer a convincing excuse to losses akin to the dog ate my homework ? ?it was beyond my control, it was my hormone levels!? Whether personal or personality driven, these books share complicated titles. Tiger Head, Snake Tails refers to a Chinese saying with complex multiple meanings. The ?tiger head? is the popular views of China but the ?snake tail? details of how the country operates on the ground, which will shape its future. The Hour Between Dog and Wolf refers to a French expression that denotes twilight: ?entre chien et loup?. It is an ambiguous light, in which it is difficult to distinguish between a dog and a wolf. In Dr. Coates? interpretation, it is the time when it is difficult to distinguish whether a trader has become over confident and is taking unreasonable risks. At least, Who Repo?d My Jet does not need any explanation. © 2012 Satyajit Das All Rights reserved. Satyajit Das is author of Traders, Guns & Money and Extreme Money. Book Reviews Tue, 07 Aug 2012 08:16:00 --0100 http://www.wilmott.com/blogs/satyajitdas/index.cfm/2012/8/7/Personal-versus-Personalities http://www.wilmott.com/blogs/satyajitdas/index.cfm/2012/3/19/Pravda-on-Financial-Innovation In the old Soviet Union, Pravda, the official news agency, set the standard for ?truth? in reporting. Discriminating readers needed to be adroit in sifting the words to discern the facts that lay beneath. Readers of The Economist?s Special Report on Financial Innovation (published on 23 February 2012) would do well to equip themselves with similar skills in disambiguation. Faith Based ... The Economist sees financial innovation as good; regarding it in the same sense as charity and goodwill to one?s fellow creatures. The reader is told that: ?Finance has a very good record of solving big problems, from enabling people to realise the value of future income through products like mortgages to protecting borrowers from the risk of interest-rate fluctuations.? The definition of the ?big problems? of our time is obviously subjective. The Report lacks doubt: ?The evidence of this special report suggests that the market does a brilliant job of nurturing and refining instruments that people want.? A closer review of the evidence suggests that the authors of the Report have followed Adlai Stevenson, the Democratic candidate for president in the 1952 and 1956 elections: "Here is the conclusion on which I base my facts." The approach is puzzling as the Report repeatedly admits the difficult of actually measuring the benefits of financial innovation: ?... quantifying the benefits of innovation is almost impossible? and ?To sift through the arguments on both sides is to confront a basic problem with any financial innovation: the difficulty of measuring its benefits.? The Economist quotes a 2011 NBER paper by Josh Lerner and Peter Tufano which argues the impossibility of quantifying the impact of a financial innovation because finance involves many (often unintended) externalities. Instead the paper proposes a ?thought experiment?, imagining what the world would look like without a particular innovation. The Report undertakes this thought experiment, without the requisite imagination and with a pre-disposition to the self evident benefits of finance. In David Hare?s play The Power of Yes, Adair Turner, head of the English FSA, is asked whether the fact that nobody understood what was going on was an issue. Turner responds that no, it wasn?t a problem as, for people like Alan Greenspan, it was just a matter of faith. The Economist follows their mentor?s modus operandi. Finance is as finance does.... Arguably, the function of finance is to match borrowers and savers, provide safe and secure payment mechanisms and also provide efficient tools for risk management. But the Report lacks a discernible working thesis as to what finance should do and how specific financial instruments, new and old, either do or do not further these objectives. Finance?s primacy is held by The Economist as another self evident truth. Despite a self conscious mention of innovations in ?microfinance products aimed at the very poor, social impact bonds, and all manner of whizzy payment technologies?, the focus is on ?wholesale products and techniques?. This is because ?they are less obviously useful than retail innovations and because they were more heavily implicated in the financial crisis?. The Report outlines the case for securitisation, credit default swaps (as an example of derivatives), exchange traded funds (?ETFs?) and high frequency trading (?HTF?). The thesis is that all financial innovations are prima facie useful. Occasionally people push them too far and things go wrong. It is Alan Greenspan?s ?irrational exuberance?. Excesses are the work of out-of-control ?rogue traders?. The sub-text is that the products and system are fundamentally sound. Occasionally unavoidable accidents are always an acceptable cost of progress ? collateral damage for greater good. In 2008, defending deregulated markets, Greenspan stated: ?You can have huge amounts of regulation and I will guarantee nothing will go wrong, but nothing will go right either.? This is the central premise of The Economist?s analysis. Transference... Techniques of risk transfer ? securitisation (collateralised debt obligations (?CDOs?) and credit default swaps (?CDS?) ? are good: ?... even now it is hard to find fault with the concept [of the CDO], as opposed to the practical application, of many of the most demonised products.? The defence of securitisation is: ?[a CDO] is really just a capital structure in miniature?. In addition, ?securitisation?which worked well for decades?allows banks to free up capital, enabling them to extend more credit, and helps diversification of portfolios as banks shed concentrations of risks and investors buy exposures that suit them?. Europe?s ill-fated and discredited adoption of CDO technology for its bailout fund (the European Financial Stability Fund) is the proof of concept, at least for The Economist. While securitisation is not without benefits, the extension of the technique, for example, into re-securitisations (CDO2) created problems ? as the Report readily accepts. However, the Report does not fully understand the true role and effects of securitisation. While a CDO might be like a bank (a capital structure in miniature), it is unregulated. Securitisation for the last 15-20 years entailed shifting assets from banks to structure which reduced the amount of capital required, arbitraging regulatory capital requirements. If a bank already held a loan funded with deposits, then in aggregate by selling the loan to the same depositors does not increase the supply of credit. The increase in credit is a function of the several things: (1) shifting risk into the shadow banking system; (2) alchemy (tranching) to create highly rated securities (AAA or AA) which acts as collateral to allow further re-leveraging; and (3) the ability to re-hypothecate the collateral over and over again, such as in re-securitisation. The process increased leverage (crudely the capital against risk in reduced), model risk, liquidity risk, complexity and linkages via counterparty risk. It also moves risk from somewhere where it is highly visible to where it is less visible. In cutting and dicing risk, it encourages mis-pricing. It also creates difficulties in resolving problems ? a delinquent loan is difficult to restructure when it no longer exists in its original form and different slices of the cash flows are held by different investors. The case for securitisation also misses that banks sell off risk and then re-acquire it either directly through linkages with the shadow banking system or indirectly by financing investors secured against the securitised bonds created. Instead of actually assisting diversification, the entire process concentrates risk while simultaneously lowering the amount of capital and liquidity reserves held against the loans. Recent research and enquiries have presented considerable evidence that CDOs were a direct contributing factor for the toxic phase of the asset bubble in US housing, commercial real estate and private equity market. But if The Economist is aware of these problems, then they are not covered in any detail. The only problem with CDOs apparently was that ?they were stuffed full of subprime loans but treated by banks, ratings agencies and investors as though they were gold-plated?. Given that sub-prime mortgages were only a part of the much larger CDO market, the wider fall in value of securitised debt and the losses must have been a collective hallucination. Giving Credit... After the expected Oxbridge cross Channel sneer at ?choking Europeans?, the Report concludes that CDS contracts are ?sound?. Sovereign CDS contracts perform ?a useful signalling function?. The only problem apparently is that banks sometimes sell protection on their own governments increasing their exposures to the sovereign. Given large banks dependence on the sovereign for their own existence, the absurdity of a bank insuring the nation?s risk collateralised by government debt is ignored. CDS, if it is used as a pure hedge, can be useful. Over time, the market, led by dealers keen to make credit a tradeable commodity, has evolved differently. The major drivers of the market are the ability to short credit and take leveraged positions on bonds. In addition, the fact that CDS contracts are not limited by the availability of underlying bonds or credit assets (at the peak the CDS market was around 4/5 times the available underlying assets) has encouraged the growth of the market. Standardisation of the contract to facilitate trading has created significant ?basis risks? for hedgers. The recent restructuring of Greek debt, designed to specifically, avoid triggering CDS contracts, highlights the problems. A number of episodes over the last 4 years have highlighted documentary issues ? trigger events and loss payouts ? which cast serious doubts as to the utility of the contract. Curiously, The Economist cites that fact that ?conservative? India has recently given permission for CDS contracts to commence trading as proof of the utility of the product. The Report neglects to mention that approval was highly conditional, being designed to ensure that the only contracts traded were pure hedges of underlying positions. In the film Casablanca, Rick (Humphrey Bogart) tells Captain Renault (Claude Rains) that he came to the city ?for the waters? because of his health. Informed that they are in the desert, Rick ironically rejoinders that he was ?misinformed?. The Economist as well as investors and banks, including those who purchased Greek sovereign CDS to protect themselves against the risk of default, may have been similarly misinformed. ETF.... Exchange Traded Funds (?ETF?) are a hoary old chestnut, a listed and tradeable version of an index fund; hardly a revolutionary ?innovation?. As the Supplement notes the absolute size of the ETF market is also relatively modest compared with estimated global assets under the control of fund managers. Vanguard founder John Bogle might take justifiable issue with the statement that ETFs ?allow retail investors access to diversified portfolios of assets that had previously been the sole preserve of institutional investors?. Mr. Bogle founded the Vanguard 500 Index Fund as the first index mutual fund available to the general public in 1975, more than a decade before ETFs. Argument and analysis is replaced by over energetic prose ? ?finance?s infectious creativity?; ?vibrancy looks like a victory for the investor over the fund manager?; ?It is in the nature of finance that experimentation never stops.? ETFs are ?good?, reducing transaction costs and increasing efficiency. The Report notes criticism of ETFs ? counterparty risk to delaers where funds use derivatives to replicate exposure to the underlying assets. Closer reading of the IMF report on ETFs suggest deeper concerns that do not merit mention ? the market impact of simultaneous trend following trading by ETFs and ?innovations?, such as leveraged and other versions. There is no discussion of a key underlying issue ? the idea of diversification. The Economist argues that ?the dotcom bust had underscored the importance of diversification?. Diversification to reduce risk is not without problems. As equity indexes are weighted typically by market capitalisation, as an individual share price rises it becomes a larger part of the index and therefore the ETF. During manic market phases, such as the dot com and now the AGF (Apple Google Facebook) boom, ETF investors may inadvertently find them heavily exposed to such stocks. In asset classes such as debt, the idea of indexation is more problematic. As the indexes are weighted by the amount of bonds on issue, as an issuer borrows more it becomes a larger part of the ETF, irrespective of its ability to make repayments. As Worldcom and more recently European sovereign debt shows, the results are not pretty. While successfully managing the portfolios of an insurance company and the King?s College endowment, Keynes insisted that diversification was flawed: ?To suppose that safety?consists in having a small gamble in a large number of different [stocks] where I have no information?as compared with a substantial stake in a company where one?s information is adequate, strikes me as a travesty of investment?. Mark Twain?s Pudd?nhead Wilson would have agreed: ?Put all your eggs in one basket, and watch that basket.? HFT.... The Economist sides with the high frequency trading (?HFT?) practitioners who are ?frustrated by what they perceive as an unfair onslaught?. The Report resorts to tried and tested rhetoric - HFT is difficult to define; there is not enough data. But these factors present no barrier to the conclusion reached that ?high-frequency traders provide liquidity and ?knit? together our increasingly fragmented marketplace, resulting in tighter spreads that benefit all investors? (citing testimony delivered to the Securities and Exchange Commission in 2010 by George Sauter of Vanguard, a big fund manager). Liquidity and lower transaction costs only benefits an investor when they trade. High liquidity and tight bid-offer spreads are only available, as all practitioners know, when it is not needed, becoming the first casualties of market downturns and volatility. Market-making needs adequate compensation for the risk assumed. Forcing return below sustainable levels encourages dealers to boost revenue from proprietary trading (often using the information gained from client activity) and trading structured products, creating different risks. The Report ignores the real problems of HFT ? the problems of potential market manipulation, insider trading, front running client flows and increased market volatility often at critical times. The Economist cannot imagine a world without HFT which is ?an ?outcrop? of the market structure?. High trading volumes are regarded as normal and desirable. In the zero sum game of trading, the presence of super fast computers copulating with other super fast machines provides uncertain benefits in financial intermediation. Average investment periods for shares have shortened from around 7 years to 7 months since 1940. HFT now accounts for over 60% of equity trading, with an average holding period of around 11 seconds. High levels of trading may create excessive ?noise? preventing prices from reflecting true value, ultimately leading to a loss of confidence in certain markets discouraging investment. HFT may damage the process of long term capital accumulation and allocation. Collateral damage ... The Report believes that collateral is problematic ?the whirring of financiers? minds ... spells trouble? but confusingly sees it is as also breeding innovation. The discussion may remind the reader of an observation of Groucho Marx: ?A child of five would understand this. Send someone to fetch a child of five?. The use of collateral contributed significantly to the financial crisis. Secured lending, collateralised by securities, including high quality bonds especially created through securitisation, contributed to the increase in debt. It allowed a shift of focus from repayment ability based on income and cash flow to the value of the asset securing the borrowing. As debt fuelled a virtuous cycle of price appreciation it allowed the level of debt to increase rapidly. The process relies on a steady and unending rise of debt and prices ? a Ponzi scheme, in effect. It also relies on the ability to trade and the liquidity of markets. Unfortunately, the virtuous cycle turns vicious when the supply of debt ceases and prices fall. The system creates exposure to short term price fluctuations as the amount of collateral required varies. It effectively amplifies the broader financial problems of funding short and lending long. Collateral also facilitates access to derivative markets for less credit worthy counterparties. The problems of Bear Stearns? hedge funds, AIG and Lehman all can be traced, in different degrees, to the system of collateral. Unfortunately, those unlikely to be able to meet demands for payment are unlikely to be able to meet collateral calls ? a fact which financial institutions and their regulators failed to understand. At a broader level, collateral underlies the entire shadow banking system, which proved so problematic during the crisis. Left Unsaid... Mistakes of commission are compounded with errors of omissions. The Report notes that risk transfer may encourage excessive risk taking and lending. It identifies that the illusion of stability may cause instability, an idea first put forward by economist Hyman Minsky (who does not gain a mention). The systemic side effects of financial innovation are barely recognised. Financial innovation played a crucial role in allowing the increase in debt levels and leverage. It created complex linkages between financial participants increasing systemic risk and informational failures. The appropriate size of some markets, such as for over-the-counter derivative, is not considered. The Economist points to interest-rate swaps ?which are used to bet on and hedge against future changes in interest rates, as an example of a huge, well-functioning and useful innovation of the modern financial era?. Interest rate derivatives (including interest rate swaps) are about 70% of total derivative outstanding on $600 trillion, which equates to over $400 trillion roughly 6 or 7 times global GDP and a significant multiple of all financial assets in existence. Daily currency turnover is between 30 and 50 times trade flows. Derivative volumes are inconsistent with pure risk transfer. The necessity for or utility of such high trading volumes does not figure in the discussion. A quaint economic concept ? cost benefit analysis -. weighs the benefits of any actions against the costs. Unable to identify the benefits accurately by their own admission, the Report decides to ignore costs arguing: ?Even bad ideas are not a problem when they first arise. If only a few people get burned by a duff product, the wider world need not care?. Given the high cost of failure of financial innovations as evidenced by the significant and ongoing costs of global financial crisis, the case for financial innovation, at least of many of the products cited, may fail on cost-benefit grounds. Defenders of financial innovation have a high burden of proof to overcome. Super Smarts... The Economist fails to understand the real motivations of financial innovation. They believe that: ?Products ... mutate constantly, in part because patenting is not common?. Citing Franklin Allen of the Wharton School at the University of Pennsylvania and Glenn Yago of the Milken Institute, wholesale financial innovation, they argue, is the creation of new capital structures that align the interests of lots of different parties. In practice, the major alignment of interests relates to getting a deal done to enable the bankers to receive substantial bonuses based on mark-to-market values of the product. The profit frequently does not fully recognise the long term consequences or risks to either the client or the financial institution. Confusing bankers with saintly figures in line for beatification, the Report approvingly cites Goldman Sach?s Martin Chavez who explains that innovation is in response to the ?clients call?... We can?t tell them ?no thanks?.? This, undoubtedly, is ?doing God?s work?, which the head of the firm once stated was its primary mission. It is difficult to reconcile this position with statements by another Goldman Sachs? employee Fabrice Tourre, who sold the Abacus deals to unwitting ?widows and orphans?. Among tender emails to his girlfriend Serres, the self-styled ?Fabulous Fab? observed in January 2007: ?More and more leverage in the system. The whole building is about to collapse anytime now?.?.?.? Only potential survivor, the fabulous Fab[rice Tourre] standing in the middle of all these complex, highly leveraged, exotic trades he created without necessarily understanding all of the implications of those monstrosities!!!? Tourre stated that Abacus was ?pure intellectual masturbation?, ?a ?thing? which has no purpose, which is absolutely conceptual and highly theoretical and which nobody knows how to price?. But Tourre was not assailed by self-doubt: ?Anyway, not feeling too guilty about this, the real purpose of my job is to make capital markets more efficient and ultimately provide the U.S. consumer with more efficient ways to leverage and finance himself, so there is a humble, noble, and ethical reason for my job :) amazing how good I am in convincing myself!!!? Stéphane Mattatia, Société Générale?s global head of equity flow engineering and advisory, told The Economist of a hedge based on the Euro falling and gold rising for a client worried about French CDSs. Of course, SG managed to lose Euro 5.9 billion through its inability to hedge its own risk on positions taken by rogue trader Jerome Kerviel. If the client was concerned about positions in French CDS, wouldn?t it have been just easier to close out its existing position rather than enter into a complex, potentially expensive and illiquid instrument? There is no acknowledgement that much of what is called financial innovation is economic rent extraction, exploiting lack of transparency as well as information and knowledge asymmetries. There is no discussion of the destructive bonus culture which encourages certain behaviours in financial institutions. Thomas Philippon and Ariel Reshef have estimated that around 30-50% of the extra pay bankers received compared to similar professionals is attributable to economic rents. In a January 2009 speech, Lord Adair Turner, chairman of UK?s Financial Services Authority, observed that: ?Much of the structuring and trading activity involved in the complex version of securitized credit was not required to deliver credit intermediation efficiently, but achieved an economic rent extraction made possible by the opacity of margins and the asymmetry of information and knowledge between?users of financial services and producers?financial innovation which delivers no fundamental economic benefit, can for a time flourish and earn for the individuals and institutions which innovated very large returns.? The unpalatable reality that few, self interested industry participants and their cheerleaders are prepared to admit is that much of what passes for financial innovation is specifically designed to conceal risk, obfuscate investors and reduce transparency. The process is entirely deliberate. Efficiency and transparency is not consistent with the high profit margins on Wall Street and the City. Financial products need to be opaque and priced inefficiently to produce excessive profits. The Report does not canvas this issue. Fixing It .... The Report makes prescriptions for strengthening financial innovation ? protection of investors, more capital, improved operational procedures and stronger regulators. The solutions are familiar dictums which have been tried before with limited success. As former New York Federal Reserve President Gerald Corrigan told policy-makers and financiers on 16 May, 2007: ?Anyone who thinks they understand this stuff is living in lala land.? The problem of protecting investors arises because of the difficult in ?judging the sophistication of a client?. Not only retail investors, it seems, need protection. The Report approvingly quotes a regulator: ?A German Landesbank should be treated like a child?. The risk management problems of ?sophisticated? firms (Citibank, UBS, Lehman, Bear Stearns, Merrill Lynch and Long Term Capital Management (whose numbers included Myron Scholes and Robert Merton as well a large number of highly trained financiers)) suggest that most of the industry have not reached pimply adolescence let alone sage maturity. Given a tendency to self harm, most industry participants need protection from each other and themselves. Regulatory initiatives may need to encompass preventive detention for all parties. In the last 20 years, capital held by banks and brokers against loss fell, increasing leverage. The definition of capital was expanded to include hybrid capital, debt ranking below deposits and senior borrowings. Cheaper than normal equity, hybrids avoided dilution of existing shareholders. Increases in debt and leverage reflected ?improved financial flexibility?the results of massive improvements in technology and infrastructure?, according to regulators. Banks? liquidity reserves, designed to cover withdrawal of deposits, were reduced, freeing up money for lending. The risks were ignored. Alan Greenspan argued: ?The lack of a spare tire is of no concern if you do not get a flat.? The prescription for higher capital and liquidity reserves has been tried before. Each capital regime promises more stringent control, but is ruthlessly arbitraged. This time around a fragile global economy means the willingness to compromise the integrity of the financial system for greater credit fuelled growth will be difficult to avoid. In his review of the global banking crisis, Lord Adair Turner noted that: ?An underlying assumption of financial regulation in the U.S., the UK and across the world has been that financial innovation is by definition beneficial, since market discipline will winnow out any unnecessary or value destructive innovations. As a result, regulators have not considered it their role to judge the value of different financial products, and they have in general avoided direct products regulation, certainly in wholesale markets with sophisticated investors.? Regulators may always lag markets and financial institutions in knowledge, experience and pay. Regulatory capture ensures over time the loss of oversight and control. History suggests that the next time will not be different. Realpolitik... Given its reputation, the weaknesses of The Economist?s Special Report are disappointing. Information on the issues is all in the public domain. There are a plethora of reports, such as Financial Crisis Inquiry Commission Report, the Turner Report etc, which explore financial innovation and the financial crisis. There is also, I understand, a relatively new innovative Internet-based tool ? the ?search engine? - with could have been used by The Economist to check and research such facts. In recent stories and reports, The Economist has presented an increasingly strident defence of bankers and their ?City? as well as resistance to regulation of the financial system. Professor Simon Johnson has pointed repeatedly to one cause of the financial crisis - the political economy of the financial system and the lobbying power of financial institutions. If the press becomes part of this political economy, consciously or subliminally, then the problems are exacerbated. Advertising and sponsorship revenues as well as control over access to information and key decision makers, deemed news worthy, are essential commercial links which make newspapers and media susceptible to being influenced. Zdener Urbanek, the dissident Czech novelist, observed that assumptions about what was written are dangerous: ?In dictatorships?. We believe nothing of what we read in the newspapers and nothing of what we watch on television, because we know it?s propaganda and lies. Unlike you in the West. We?ve learned to look behind the propaganda and to read between the lines and, unlike you, we know that the real truth is always subversive.? There is an important and necessary debate about financial innovation but it is not to be found in The Economist?s Special Report on the subject. © 2012 Satyajit Das All Rights reserved. Satyajit Das is a risk consultant and author of Extreme Money: The Masters of the Universe and the Cult of Risk (2011) and Traders, Guns & Money: Knowns and Unknowns in the Dazzling World of Derivatives (2006 and 2010) Quantitative Finance Mon, 19 Mar 2012 20:22:00 --0100 http://www.wilmott.com/blogs/satyajitdas/index.cfm/2012/3/19/Pravda-on-Financial-Innovation http://www.wilmott.com/blogs/satyajitdas/index.cfm/2012/2/28/Greece-Lives-To-Default-Another-Day Following protracted negotiations, the Greek government has agreed on a new Greek austerity package. The bond exchange is likely to proceed with bond holders? suffering losses of over 70-75%. The Troika ? the European Union (?EU?), European Central Bank (?ECB?), the International Monetary Fund (?IMF?) - needs to reduce the level of Greek debt to a ?sustainable? 120% of gross domestic product (?GDP?) by 2020. The bond deal and the latest budget cuts are designed to achieve this paving the way for a second financing package for Greece to enabling Greece to repay a Euro 14.5 billion bond on 20 March 2012. Deterioration in Greece?s finances required the bigger writedowns and greater budget cuts. But even the greater austerity and larger losses to lenders will probably leave Greek debt above the target level, requiring delicate financial engineering to at least cosmetically reach the target. In the end, even with a dollop of wishful thinking and economic gymnastics, the projected debt figure came in at 120.5% in 2020. The 120% level is largely meaningless, being a political construct designed to avoid drawing unwelcome attention to Italy whose debt levels are around this level. There is no certainty that the agreement reached can be implemented. The IIF represents around 50% of banks and investors. The deeper losses will increase resistance to the deal, especially from hedge funds who may prefer to take their chances in a default. One option is to unilaterally insert collective action clauses (?CACs?) into existing bond contracts, allowing a supermajority of lenders to bind the minority. A complicating factor is the ECB?s refusal to take losses. With direct holdings of Greek bonds of Euro 40 billion as well as additional loans to banks secured over Greek bonds, the ECB?s capital of Euro 5 billion (scheduled to increase to Euro 10 billion) is insufficient to absorb losses. As the CAC would force the ECB to share in losses, a special arrangement will exempt them from the effects of any CAC to the further detriment of already resistant private lenders. Any agreement is also likely to face legal challenges from lenders, which would complicate proceedings. Another complication is the extremely tight timetable that must be followed to ensure the arrangements are implemented in time. Greece must undertake certain actions to qualify for the funding. Parliaments in Euro-Zone members must approve the package. The European Financial Stability Facility (?EFSF?), the current main European bailout facility, must raise around Euro 70 billion to finance the bond exchange. Of course, the EFSF is guaranteed around 30% by Spain and Italy! There is little margin for error. This agreement is unlikely to be the definitive resolution everyone seeks. Greece has consistently failed to meet economic forecasts. Despite measures by the Greek government, debt continues to increase. According to the EU statistics office, Greece's debt reached 159.1% of GDP in the third quarter of 2011, up from 138.8% a year earlier and 154.7% in the previous quarter. Greece may get through the March 2012 maturity but the arbitrary 120% debt to GDP ratio, the best case under the plan, is unsustainable, even in the unlikely case that it is met. The Greek economy, which has been in recession for years, shrank by 7% in later part of 2011. Budget revenues for January 2012 fell 7% from the same time last year, a fall of Euro 1 billion. This compares to a budget target for an 8.9% annual increase. Value-added tax receipts decreased by 18.7% in the same period compared to January 2011. Greece?s financial position will deteriorate and it will miss key milestones ? debt levels, budget deficits, asset sales and structural reforms. In the end, Greece may live to default another day. History suggests that a write-down of debt for distressed borrowers is frequently followed by others. With Greece increasingly doomed, the real significance of the negotiations is that they provide a template for future European sovereign restructurings. No one buys the oft-stated European leaders? position that Greece?s position is unique or exceptional. Portugal is first in the line of fire, with the Irish, Spanish and Italians watching anxiously. © 2012 Satyajit Das All Rights reserved. Satyajit Das is the author of Extreme Money: The Masters of the Universe and the Cult of Risk (2011) Global Sovereign Debt Crisis Tue, 28 Feb 2012 18:21:00 --0100 http://www.wilmott.com/blogs/satyajitdas/index.cfm/2012/2/28/Greece-Lives-To-Default-Another-Day http://www.wilmott.com/blogs/satyajitdas/index.cfm/2011/12/14/School-for-Economists Nicholas Wapshott (2011) ?Keynes/ Hayek: The Clash That Defined Modern Economics?; Scribe Melbourne John Mauldin and Jonathan Tepper (2011) Endgame: The Debt Supercycle and How It Changes Everything; John Wiley, New York To borrow from David Letterman, there might be no business like show business, but there are many businesses like economics. There is Classical Economics, Neo-Classical Economics, Keynesian Economics, Austrian Economics, Monetarist Economics etc There are also different types of economists ? academic economists, professional economists (generally policymakers like central bankers), market economists. No wonder economist John Kenneth Galbraith observed that: ?economics is extremely useful as a form of employment for economists?. Economics, one is tempted to add, also provides periodically useful fodder for journalists and business authors. These two books provide interesting perspectives on the profession as much as on the subject of economics. Journalist Nicholas Wapshott previously authored ?Ronald Reagan and Margaret Thatcher: a Political Marriage?. Using the same basic conceit, he posits a conflict between the ideas of John Maynard Keynes and Frederich Hayek around the time of the Great Depression. The present demand for solutions to the Great Recession, Mr. Wapshott argues, gives this debate contemporary relevance. Solid and engagingly written, ?Keynes/ Hayek? suffers from a basic problem ? the major protagonists rarely engaged with each other. Hayek?s puzzling failure to debate Keynes on the subject matter of ?The General Theory? deprives the book of the central conflict and drama that the book?s subtitle claims. Economics seeks to understand how production and financial systems work or should work. It evolved out of political science and philosophy and its social agendas and value systems. One of economic theory?s preoccupations was the business cycle, especially painful and disruptive boom and busts. Capitalism created wealth and progress but at high social cost. Classical economists tried to understand how economies periodically purged excesses in recessions. The 1929 stock market crash was the final phase of the long boom of the jazz age. Led by the U.S., the World?s dominant economy, there were sharp increases in economic activity and the prices of stocks, commodities and other assets. Global trade collapsed. The recession progressively got worse turning into the Great Depression from which the world would not emerge until after the Second World War. Existing economic thought dictated that the fall in values and elimination of bad loans or unsound investments would lead to recovery. It was tough love - the disease simply had to run its course. Keynes argued for government spending to stimulate demand by supporting income and spending power. He broadened the remit of governments to manage the economy to avoid the social consequences of the Depression. Hayek was one critic. A prominent member of the Austrian School, originally founded by Carl Menger in the nineteenth century and extended by Ludwig von Mises, Hayek opposed any interference in markets. Downturns were essential to allow capitalism and markets to purge and renew themselves. The debate was less about economics than differing political ideologies. Keynes? views were shaped by the magnitude of the problem threatened to overwhelm societies and political systems. Hayek?s views were influenced by the epic collapse of the Austro-Hungarian in World War 1. Successive generations have re-interpreted the writings of both men extensively. Milton Friedman, for example, admired Keynes?s economics, which his own work draws on. In contrast, Friedman found Hayek?s economics to be largely incomprehensible. But Friedman was attracted to Hayek?s quest was idealistic renewal. Keynes?s complex bohemian life, including his bi-sexuality and acceptance of short-term political expediency, were not to everyone?s taste. Los Cee-Ca-Go Boys certainly preferred Hayek?s Central European sensibility, captured by John Kenneth Galbraith: ?pessimism is a mark of superior intellect.? Mr. Wapshott does not offer much new, which is understandable because the material has been covered before in greater detail in Robert Skidelsky?s 3 volume biography of Keynes and several biographies of Hayek. Other books on the history of economics have also covered some of the same territory. The attempt to relate the clash to modern developments is strained. In practice, political economy is politics conducted with the language but without the substance of economics. The effort to fit modern policy into the corsets of Keynesian and Hayek-ian thinking is tricky. Profound differences in the structure of economies and financial markets also make any comparison difficult. Commenting on State Socialism, Keynes provided a guide to the relevance of past theories: ?little better than a dusty survival of a plan to meet the problems of fifty years ago, based on misunderstanding of what someone said a hundred years ago?. John Mauldin is described as ?a renowned financial expert and a multiple New York Times best selling author?. He writes an investor newsletter and is an economics commentator and investment adviser. Co-author Jonathan Tepper is founder of a macro-economic research group advising high net worth investors. They are ?market economists?. Keynes and Hayek were pre-occupied with public policy concerns. They would have agreed with Paul Samuelson: ?I don?t care who writes a nation?s laws if I can write its economics textbooks.? In contrast, good market economists concentrate on assessing short-term effects of economic developments on market prices. They have no grand economic scheme. They are like David St. Hubbins in the satiric film This is Spinal Tap: ?Before I met Jeanine?my life was cosmologically a shambles. I would use bit and pieces of whatever Eastern philosophy would drift through my transom.? Less concerned with economic theory, ?Endgame? tries to provide an accessible introduction to the world?s current economic plight. The central theme is that the world has too much debt and will need to reduce this debt with important effects for the global economy. The book is split into two parts ? the first looks at the problems of debt and the second looks at different countries and their unique problems. The central thesis is undeniable. Recent economic growth and the wealth created relied substantially on borrowed money. Since 2001, borrowing against the rising value of houses contributed to around half the recorded economic growth in the US. By 2008, $4 to $5 of debt was required to create $1 of growth. China now needs $6 to $8 of credit to generate $1 of growth; an increase from around $1 to $2 of credit for every $1 of growth. Global trade is built on a financing model where sellers of goods and services, such as China, Japan and Germany, indirectly finance the purchase by lending foreign exchange reserves to countries like the US. The ability to maintain high rates of economic growth through additional debt is now questionable. Mr. Mauldin and Mr. Tepper outline how the system will adjust ? they are ?inflationists? (maybe) but they are also deflationists (first). Irrespective of their position on price levels, the authors are incorrigible ?optimists? ? there will be fabulous innovations, new markets, the population of the earth will continue to grow and the ?human spirit? will triumph. ?Endgame? reads like a series of loosely linked newsletters or excerpts from speeches. The book cites extensively from the author?s collection of famous and brilliant experts (the obvious comparison is with the children of Lake Woebegone who are all above average). One Chapter, for example, restates the analysis of Carmen Reinhart and Kenneth Rogoff?s ?This Time is Different?. The book features many graphs often tangentially connected with the text and argument. Mr. Mauldin and Mr. Tepper?s work poses a fascinating question, perhaps unintentionally. What would Keynes and Hayek be doing and saying if they were alive today? Hayek would probably be at a conservative think tank, railing about government involvement in the economy. Keynes? He would be writing newsletters and policy tracts while quietly making money through his astute investment skills. But on the big issues both would be cautious aware that ?for every complex problem there is a simple solution that is wrong?. © 2011 Satyajit Das All Rights reserved. Satyajit Das is author of Extreme Money: The Masters of the Universe and the Cult of Risk and Traders, Guns & Money: Knowns and Unknowns in the Dazzling World of Derivatives Book Reviews Wed, 14 Dec 2011 02:36:00 --0100 http://www.wilmott.com/blogs/satyajitdas/index.cfm/2011/12/14/School-for-Economists http://www.wilmott.com/blogs/satyajitdas/index.cfm/2011/11/27/Europes-Seemingly-Inevitable-Slide-Towards-Financial-Disaster At best, European plans to resolve the continent?s debt crisis have been to provide funds to tide over the immediate funding problems of weaker Euro-zone members. It does little to deal with the euro-zone?s structural problems. There is still the risk that Europe enters a prolonged period of low growth or recession. There has been no attempt to address the economic divergences that exist within the Euro-zone or ease the painful adjustment processes that weaker members will still have to undergo within the constraints of the single currency. A crucial element of the plan is the ability of Spain and Italy to take action to improve their finances and maintain access to funding at reasonable cost. The EU communique specifically refers to the need for actions by these two members at some length. There is considerable doubt as to whether this will occur. Spain?s economy is weak, with low growth, low productivity and high reliance on debt. As the country has sought to bring its finances under control, Spain?s growth has slowed with an increase in the unemployment rate to 21% and youth unemployment above 40%. Spain?s banking sector remains heavily heavily exposed to the real estate with the likelihood of further losses. It is difficult to see Italy, weakened by internal political strife, making rapid progress to making required structural changes to its economy and cutting public debt. The austerity and balanced budget measures, reinforced and reiterated in the plan, cannot deal with the primary problem - the deflation of the debt-fuelled bubble. Strict enforcement of limits on deficits and level of debt would prevent counter cyclical spending by Governments undermining economic recovery and lock the Euro-zone into a death spiral of budget deficits, further budget cuts and low growth. The problem is compounded by the competitiveness gap between Northern and Southern countries, estimated at 30% difference in costs. For many of the weaker countries, the best option would be to devalue its currency in the same way that the US and Britain are debasing dollars and sterling respectively. The EU?s refusal to contemplate a break-up or restructuring of the Euro makes dealing with this problem difficult. Unable to devalue or control interest rates, these weaker countries are trapped in a vicious and ultimately self-defeating cycle of cost reduction. An additional problem is the internal imbalances exemplified by Germany?s large intra-Euro-Zone trade surplus at the expense of deficit states, especially the Club Med countries like Greece, Portugal, Spain and Italy. German reluctance to boosting spending and imports makes any chance of resolving the crisis even more remote. German banks lent money to many countries to finance exports, which benefited Germany. Germany also gained export competitiveness from a weaker. Reluctance to confront these problems makes a comprehensive resolution of the crisis difficult. The latest plan has bought time, though far less than generally assumed. The European debt endgame remains the same: fiscal union (greater integration of finances where Germany and the stronger economies subsidise the weaker economies); debt monetisation (the ECB prints money); or sovereign defaults. The key element of the 27 October Plan was the unwillingness or inability of Germany and France to increase the size of their commitments. Germany is increasingly unwilling to increase its commitments. It is restricted by the German Constitutional Court?s decision, which makes it difficult to increase support for bailouts without a new constitution. For the moment, Germany cannot or will not go above Euro 211 billion in guarantees for the bailout funds already committed ?about 7% of its GDP. Fiscal integration would have a higher cost than Germany is willing to pay or can sustain without affecting the country?s creditworthiness. France is at the limit of its financial capacity. France?s GDP is around US$2 trillion and its debt to GDP around 82%. Following the assumption of the liabilities of the failed Franco-Belgium financier Dexia, the rating agencies have indicated that France faces a rating downgrade. Netherlands, Finland and Luxembourg are too small to make much difference. Fragile coalition governments in Netherlands and Finland are increasingly reluctant to increase its commitments to the bailout process. The ECB is not allowed and seemingly unwilling to print money. Theoretically, it would need a change in European Treaties although the ECB has stretched its operational limits. Germany?s Bundesbank opposes debt monetisation. There would be deep-seated unease about printing money in Germany, which is still haunted by the memory of hyperinflation in the Weimar period. The accepted view is that, in the final analysis, Germany will embrace fiscal integration or allow printing money. This assumes that a cost-benefit analysis indicate that this would be less costly than a disorderly break-up of the Euro-zone and an integrated European monetary system. This ignores a deep-seated German mistrust of modern finance as well as a strong belief in a hard currency and stable money. Based on their own history, Germans believe that this is essential to economic and social stability. It would be unsurprising to see Germany refuse the type of monetary accommodation and open-ended commitment necessary to resolve the crisis by either fiscal union or debt monetisation. Unless restructuring of the Euro, fiscal union or debt monetisation can be considered, sovereign defaults may be the only option available. © 2011 Satyajit Das All Rights Reserved. Satyajit Das is author of Extreme Money: The Masters of the Universe and the Cult of Risk (November 2011) Global Sovereign Debt Crisis Sun, 27 Nov 2011 11:03:00 --0100 http://www.wilmott.com/blogs/satyajitdas/index.cfm/2011/11/27/Europes-Seemingly-Inevitable-Slide-Towards-Financial-Disaster http://www.wilmott.com/blogs/satyajitdas/index.cfm/2011/11/23/Europes-Plan-to-Have-A-Plan-to-Have-A-Plan-etc The most recent EU plan was too little, too late and involves too much wishful thinking. Even if the plan could be implemented then there?s no reason to believe that it would work. This summit will not be the last and the prospects for a resolution remain slim, with Italy and Spain and increasingly France and other stronger core countries looking increasingly vulnerable. Countries like Greece need to restructure its debt to reduce the amount owed ? an euphemism for default. Banks suffering large losses as a result of these debt write-downs need to be stabilised by injecting new capital and ensuring access to funding to avoid insolvency. A firewall needs to be erected to quarantine Spain and Italy as well as, increasingly, Belgium, France and Germany from the further spread of the debt crisis. Steps must be taken to return Europe to sustainable growth as soon as possible. On 27 October 2011, banks and investors holding Greek bonds, agreed to a 50% haircut. At best, the reduction of Euro 100 billion is less than 30% of outstanding debt, as only private investors were covered. A leaked assessment by the ?Troika? (The European Union (?EU?), ECB and International Monetary Fund (?IMF?)) indicated that a 50% haircut reduces debt to 120% of GDP and funding requirements to Euro 114 billion through 2020. While the write-downs were needed, it is unclear whether the quantum is sufficient and whether Greece?s residual debt burden is sustainable. The EU, to date, has carefully confined discussions about debt restructuring to Greece. The attention of financial markets will inevitably turn to Ireland and Portugal. The Greek write-downs may create speculation for Ireland and Portugal to follow suit, especially if economic condition deteriorate. The EU plans calls for Euro 106 billion in recapitalisation of European banks, primarily to cover losses on holdings of sovereign debt such as Greece, by June 2012. The amount is at the low end of what is required. The amount of recapitalisation focuses on losses from holding of Greek bonds. Taking into account possible losses on Irish, Portuguese, Spanish and Italians bonds, the required recapitalisation is around Euro 200-250 billion. The write-offs, covering the cost of recapitalisation and the general de-leveraging (reduction in debt) is likely to reduce economic growth resulting in increasing credit losses that must also be covered. It is not clear where the additional capital is coming from. Banks must try to raise the capital privately through equity raising or restructuring and conversion of existing instruments into equity. Banks should also reduce dividends and bonus payments to improve their capital position. If this is insufficient or unsuccessful, national governments are required to provide support. Recapitalisation funded via a loan from the European Financial Stability Fund (?EFSF?), the European bailout fund, is the last resort. An enhanced EFSF is the cornerstone of efforts to quarantine Spain and Italy as well as, increasingly, Belgium, France and Germany from the further spread of the debt crisis. The EFSF will provide loans to or purchase bonds in order to support market access for Euro-Zone Member States faced with market pressures and to ensure that their cost of borrowing does not rise to levels that threatens solvency. With available resources of only around Euro 250 billion, the EFSF does not have adequate resources to perform its functions. The amount available can be compared to the financing requirements of beleaguered European countries. Over the next 3 years, Spain and Italy will need to find around Euro 1 trillion to meet their financing requirements. After accounting for existing commitments to Greece, Ireland and Portugal, the fund?s available capacity is around Euro 200-250 billion. In order to enhance the capacity of the EFSF, the EU proposes to leverage the fund. In the absence of details, it is widely assumed that this will entail the EFSF guaranteeing against losses on bond holdings, up to an unconfirmed amount of around 20%. It is unlikely that the insurance scheme will achieve its intended objectives to support market access for and the lowering of borrowing costs of countries like Spain and Italy. A second option proposed is to enhance the EFSF using resources from private and public financial institutions and investors through Special Purpose Vehicles (?SPV?). The idea seems to be to raise money from emerging nations with large foreign exchange reserves, such as China, or sovereign wealth funds. Support for the idea amongst potential investors is uncertain. The Chinese position to date has been that Europe must get its house in order first and then China will assist. The current European position is different ? China must give money to Europe to get its house in order. China has considerable ?skin in this game?. Europe is China?s biggest trading partner. China has around US$800-1,000 billion invested in Euros and European government bonds. Continuation of the European debt problems will have serious effects on China?s economy and its investments. It is not clear that the EU proposal has sufficient chances of success to encourage China increasing its exposure to Europe, especially as relatively wealthy European countries, like Germany and France, are unwilling to put up more money and are seeking to limit their exposure. More worryingly the EFSF?s attempts to raise money to meet existing commitments has run into problems, meeting lack lustre support and a sharp increase in costs. Increasingly, the EFSF looks irrelevant. Time will determine whether the plan creates ?confidence? or is just a ?con?. But the early signs are not promising. © 2011 Satyajit Das All Rights Reserved. Satyajit Das is author of Extreme Money: The Masters of the Universe and the Cult of Risk (November 2011) Global Sovereign Debt Crisis Wed, 23 Nov 2011 00:58:00 --0100 http://www.wilmott.com/blogs/satyajitdas/index.cfm/2011/11/23/Europes-Plan-to-Have-A-Plan-to-Have-A-Plan-etc http://www.wilmott.com/blogs/satyajitdas/index.cfm/2011/10/24/EuroZones-Leveraged-Solution-to-Leverage If as Albert Einstein observed insanity is ?doing the same thing over and over again and expecting different results?, then the latest proposals for resolving the Euro-zone debt crisis requires psychiatric rather than financial assessment. The sketchy plan entails Greece restructuring its debt with writedowns around 50% and recapitalisation of the affected banks. The European Financial Stability Funds (?EFSF?) would increase its size to a proposed Euro 2-3 billion from its current Euro 440 billion. This would enable the fund to inject capital into banks and also support Spain and Italy?s financing needs to reduce further contagion risks. On proposal under consideration entails the EFSF using leverage to increase its size and enhance its ability to intervene effectively. Attributed to US Treasury Secretary Tim Geithner, the proposal is similar to the 2007 Master Liquidity Enhancement Conduit (?MLEC?) super conduit which was ultimately abandoned. The EFSF would apparently bear the first 20% of losses on sovereign bonds and perhaps its investment in banks. This resembles the equity tranche in a CDO (Collateralised Debt Obligations), which assumes the risk of the initial losses on loans or bond portfolios. Assuming the EFSF contributes Euro 400 billion, the total bailout resources would be around Euro 2,000 billion. Higher leverage, a lower first loss piece, say 10%, would increase available funds to Euro 4 trillion. The European Central Bank (?ECB?) would supply the ?protected? debt component to leverage the EFSF?s contribution, bearing losses only above the first loss piece size. The proposal has a number of problems. The EFSF does not have Euro 440 billion. After existing commitments to Greece, Ireland and Portugal, its theoretical resources are at best around Euro 250 billion, assuming that the increase to Euro 440 billion is ratified by European parliaments. The EFSF must borrow money from the markets, relying on its own CDO like structure, backed by a cash first loss cushion and guarantees from Euro-zone countries. In fact, some investors actually value and analyse EFSF bonds as a type of highly rated CDO security known as a super senior tranche. This means that the new arrangement has features of a CDO of a CDO (CDO2), a highly leveraged security which proved toxic in 2007/ 2008. The ECB, the provider of protected debt, has capital of about Euro 5 billion (to be raised to Euro 10 billion), supporting around Euro 140 billion in bonds issued by beleaguered Euro-zone nations, purchased as part of market operations to reduce their borrowing cost. The ECB has also lent substantial sums (market estimates suggest more than Euro 400 billion) to European banks without access to money markets at acceptable cost, secured over similar bonds. While the Euro-zone central banking system has capital of around Euro 80 billion that could be available to support the ECB?s operations, this adds to the incremental leverage of the arrangements. The 20% first loss position may be too low. Unlike typical diversified CDO portfolios, the highly concentrated nature of the underlying investments (distressed sovereign debt and equity in distressed banks exposed to the very same sovereigns) and the high default correlation (reflecting the interrelated nature of the exposures) means potential losses could be much higher. Actual losses in sovereign debt restructuring are also variable and could be as high as 75% of the face value of bonds. The circular nature of the scheme is surreal. Highly leveraged vehicles, in part backed by weakened nations like Spain and Italy, are to undertake the ?rescue? of the same countries and their banks. Levering the EFSF merely highlights circularity in the entire European strategy of bailouts, drawing attention to the correlated default risks between the guarantor pool and the asset portfolio of the bailout fund. This is akin to an entity selling insurance against its own default. This only works if all commitments are fully backed by real cash and savings, which of course nobody actually has, requiring resort to familiar ?confidence tricks?. The proposal assumes that it will not need to be used, avoiding exposing its technical shortcomings. The EFSF too was never meant to be used, relying on the ?shock and awe? of the proposal, especially its size and government backing, to resolve the crisis. The proposal is driven, in reality, by political imperatives - avoiding seeking national parliamentary approval at a time when sentiment is against further bailouts and lack of support for an increase in the size and scope of the EFSF. It is also designed to reduce the increasing risk to the credit ratings of France and Germany. This last factor is increasingly important given concerns raised by rating agencies about the quantum of contingent liabilities being assumed by these countries. For example, after the increase in the size of the EFSF to Euro 440 billion, Germany?s commitment to the EFSF is over Euro 200 billion. The scheme may also facilitate the ECB covertly monetising debt, ?printing money?; to generate the protected debt to leverage the structure and also to cover the losses on its own exposures to distressed sovereign debt. It is simply another means of allowing the imply another way of requesting that the ECB to expands its balance sheet to absorb increased credit risk. It now looks like the proposal to leverage the EFSF via the ECB are unlikely to be pursued - but as this is Europe nothing should be discounted. Instead, different forms of leverage are under consideration - EFSF to enter into credit default swaps to protect holders of bonds issued by weak European sovereign borrowers; EFSF to guarantee the first 10% or 20% or 40% of losses to bondholders; EFSF to act as bond re-insurer. Unfortunately, all these new schemes like previous proposals are unlikely to succeed. The unpalatable fact remains that Europe may not have the capacity to rescue everybody that now seems to need rescuing without imperilling the financial health and ratings of stronger countries such as France and Germany. As Sigmund Freud?s observed: ?Illusions commend themselves to us because they save us pain and allow us to enjoy pleasure instead. We must therefore accept it without complaint when they sometimes collide with a bit of reality against which they are dashed to pieces.? © Satyajit Das 2011 Satyajit Das is author of Extreme Money: The Masters of the Universe and the Cult of Risk (2011) A shorter version of this article was first published in the Financial Times Global Sovereign Debt Crisis Mon, 24 Oct 2011 05:10:00 --0100 http://www.wilmott.com/blogs/satyajitdas/index.cfm/2011/10/24/EuroZones-Leveraged-Solution-to-Leverage http://www.wilmott.com/blogs/satyajitdas/index.cfm/2011/9/18/The-Financial-Compass Roddy Boyd (2011) Fatal Risk: A Cautionary Tale of AIG?s Corporate Suicide; John Wiley & Sons Inc, New Jersey Justin Cartwright (2010) Other People?s Money; Bloomsbury, London Nicholas Dunbar (2011) The Devil?s Derivatives: The Untold Story of the Slick Traders and Hapless Regulators Who Almost Blew Up Wall Street?And Are Ready To Do It Again; Harvard Business Press, Boston, Massachusetts Barry Eichengreen (2011) Exorbitant Privilege: The Rise and Fall of the Dollar; Oxford University Press, Oxford Diana B. Henriques (2011) The Wizard of Lies: Bernie Madoff and the Death of Trust; Times Books/ Henry Holt & Company & Scribe Publications, Melbourne Graeme Maxton (2011) The End of Progress: How Modern Economics Has Failed Us; John Wiley, Singapore In his novel, Justin Cartwright writes that: ?There are beginning and there are ends, and there are also many ways of telling the same story.? The problem is that the great 2007 financial crisis shows no signs of ending. Far from ending, the crisis has shown a virus? capacity to reconstitute itself. Given the literary difficulty of an uncertain end, publishers and editors have improvised in telling the story - a multiple points of the compass approach to ?credit lit?. South is the narrative focused on a supposedly pivotal or at least newsworthy event ? Too Big To Fail and In Fed We Trust are examples of this approach, taking as their point of departure the collapse of Lehman Brothers. The relative calm of the last 18-24 months has meant there has been few additions to this list. As the crisis re-intensifies, there will be other Lehman weekends and books about it. East is titles trying to draw more general points from an individual aspect of the crisis, such as the history of an individual organisation or type of instrument, derivatives and securitisation feature prominently. Fatal Risk, Devil?s Derivatives and The Wizard of Lies are examples of this genre. West is the professional economist?s analysis of the crisis or aspects thereof. Exorbitant Privilege belongs to this class of book. North is the solution manual ? the 10-point plan to solve the problems, delivered with polemic gusto. End of Progress comes closest to that type of book. Then there is the centre ? fiction. Untroubled by facts, the author proceeds to use the power of literary rendition to describe the issues. The publicity of Other People?s Money claims that it is a novel about the financial crisis. In Fatal Risk, Roddy Boyd, an investigative reporter (an endangered creature soon to be listed on the CITES list), provides a solid history of AIG and its problems. Based largely on his own reporting for the NY Post and interviews, Mr. Boyd provides an accurate chronology of events leading up to the implosion, requiring a government bailout in September 2008. Fatal Risk struggles to explain the insurance deals that were used to hide losses and the financial instruments within AIG?s Financial Products operations that were responsible for the problems. The omitted technical details are critical. It was a failure to understand the structure and risk of these contracts, at least at senior levels of AIG, which brought about their downfall. There is also a lack of explanation of the rationale for AIG?s expansion into non-insurance business ? the desire to monetise its ?AAA? rating, balance the volatility of its re-insurance operations and also over confidence about it capabilities in risk assessment. Mr. Boyd largely accepts that Hank Greenburg, the driving force behind AIG growth and expansion into financial derivatives, was a superb risk manager, who personally oversaw the exposures of the company. Implicit in this argument is the suggestion that had Greenburg not been ousted as a result of Elliott Spitzer?s investigations, the problems may not have occurred. Writing about the Battle of Borodino, Tolstoy observed that: ?It was not Napoleon who directed the course of the battle, for none of his orders was carried out and during the battle he did not know what was going on.? The same might be true of AIG. An alternative view might be that AIG was too large, ruled by fear of an autocratic CEO and lacked rudimentary controls that its non-insurance businesses required. Given that Greenburg presided over this state of affairs, the cautionary tale of the book?s sub-title might just be an older and more familiar one - avoid powerful and dominant chief executives and entry into businesses which existing management is not experienced in. A career as a trained physicist who turned to financial journalism at Risk Magazine provided Nicholas Dunbar with a unique vantage point to the comings and goings in the market. Mr. Dunbar turned this insight into his first book Investing Money, which examined the demise of Long Term Capital Management. The Devil?s Derivative focuses on the role played by derivatives in the current crisis with an emphasis on the Collaterallised Debt Obligations (?CDOs?) and other manifestations of structured finance. Well-researched and knowledgeable, The Devil?s Derivative has some problems. The experienced practitioner will find little knew here but the inexperienced will struggle to come to terms with the material as it assumes some basic knowledge. Mr. Dunbar?s desire to titillate, perhaps to appeal to a wider readership, frequently distracts. Tales of men in expensive Italian suits in Knightsbridge night clubs drinking £400 bottles of Belvedere Vodka and cavorting with eastern European blondes might confirm the reader?s suspicions but are not integral to the story. The subject matter of The Devil?s Derivative has also been covered before and better by the Financial Times? Gillian Tett in Fool?s Gold. Oddly, The Devil?s Derivative?s very long sub-title (24 words and 100 characters) ? ?The Untold Story of the Slick Traders and Hapless regulators Who Almost Blew Up Wall Street? ?. And Are Ready to Do it Again? - unconsciously competes with that of Fool?s Gold (13 words and 82 characters) ? ?How Unrestrained Greed Corrupted A Dream, Shattered Global Markets and Unleashed A Catastrophe?. Marshall McLuhan?s famous aphorism ? ?the medium is the message? ? has now been replaced by the lengthy sub-title which obviates the need to read the book. Diana B. Henriques, a senior writer for the NY Times (are there ?junior? writers?), covered the Madoff Affair. The Wizard of Lies is her book of the newspaper articles, collating the history of the life and times of Bernard Madoff, grandee of finance, feted investment manager and finally convicted master Ponzi scammer. The thorough and (perhaps excessively) detailed biography is ?long? on personal details (houses, clothing, charities, holidays, parties, friendships and personal behaviour) but ?short? on real insight (the motivations and most importantly the why?s). Madoff emerges as a curiously dull figure, especially relative to the scale of the fraud he was able to perpetrate. A central figure as insipid as Madoff rather robs the narrative of drama. In the absence of the charismatic villain, Ms Henriques unfortunately miss the opportunity to delve into two interesting issues to the extent warranted. The first is the efforts of the eccentric Harry Markopolos to draw the attention of regulators to the fraud. The SEC?s damning post-mortem contrasts with Ms. Henriques excuses for their failure and criticism of Mr. Markopolos for alienating regulators over their ignorance of derivatives. Curiously, Ms. Henriques assertions that Markopolos? questions were irrelevant because no derivatives are required for a Ponzi scheme conflicts with Madoff?s claims that his investment strategy depended critically upon derivatives. The second issue is the complicity of feeders fund, which channelled investors into the Madoff Fund, and wealthy investors in their own destruction. There is a little analysis or coverage of how much they knew and why they continued their involvement. Answers to both these questions would have shed greater light on Madoff but also perhaps the prevailing culture. Madoff was possible because everyone believed in his or her constitutional right to get rich. Investors ignored what they suspected was a Ponzi Scheme or even investigate the source of the returns, in the belief that they would always be able to get out before it collapsed. Everyone, including regulators, believed in this, ultimately to their own detriment. Exorbitant Privilege is a readable short history of the US dollar and how it came to dominate global trade and financial transaction. The title pays homage to the description of the benefits to America of the dollar?s reserve status, attributed to Valéry Giscard d?Estaing, France?s finance minister in the 1960s. Barry Eichengreen, an international monetary historian, who in his 1992 book, Golden Fetters argued that the inflexibility of the gold standard exacerbated the Great Depression, tells the story of the dollar?s ascent. The history is solid and factually reliable demonstrating how the international monetary system based on the dollar evolved, allowing America the capacity to borrow more cheaply and more aggressively than might otherwise have been feasible. Professor Eichengreen glosses over the geo-political basis of this power. America?s military and industrial strength at the time of the Bretton Woods meetings as well as the economic and military weakness of Britain and France battered by two world wars underpinned the rise of the dollar. Exorbitant Privilege sees the dollar?s continued dominance as mainly the effects of incumbency and the absence of a viable alternative. Professor Eichengreen seems to not fully recognise the role that the dollar?s dominance together with trade imbalances played in the current global crisis. He also underplays the backlash against the dollar, primarily from major holders of US government bonds such as China. The chapter on the financial crisis is highly derivative and unsatisfying. In the end, the author cannot find any alternative to a continuation of the existing system because there is really no alternative to the dollar. Economist, author and presenter Graeme Maxton?s End of Progress is a damning attack on the underlying drivers of economic growth ? financialisation, pollution and poor allocation of scarce resources, like oil and water. The book is a powerful polemic highlighting some of the key challenges facing mankind, although they only infrequently trouble policymakers or citizens, busy acquiring the latest must-haves. Mr. Maxton hits the mark in identifying the problems. His attempt to blame all this on modern economic thinking is less convincing, attributing perhaps too much power and importance to the ?dismal science? and its practitioners. Economics is the outcome of a tacit societal accord where economic growth at all costs is the consensus. The sociology of crowds, greed and DNA of homo sapiens were arguably more important than economists in setting the stage for the present crisis. In the final chapter, perhaps at his publisher?s urging, Mr. Maxton sets out a check list of ?solutions?. The prescriptions are predictable ? lower population; better distribution of resources; and reformation of economics ? fair profits; better pricing of the world?s resources. Unfortunately, as Scottish philosopher David Hume observed: ?All plans of government, which suppose great reformation in the manners of mankind, are plainly imaginary.? Mr. Maxton?s short book (probably no more than 50,000 words) ranges widely if thinly over its key pre-occupations. The evidence is not always complete, but there is no doubting the message. Mr. Maxton raises critical issues that should be on the top of the policy agenda. Asked about the difference between non-fiction and fiction, a writer who migrated from the second to the first responded: ?There is no need to do any research; nor do facts matter.? He could just as easily be talking about modern fiction, which has no end and no beginning. This does not prevent the story being told in many ways. Justin Cartwright?s Other People?s Money is acclaimed as a ?brilliant? and ?beautiful? novel about the crisis. The critics and reviewers quoted extensively on the cover were clearly reading a different book. Mr. Cartwright?s well written and cleverly crafted work is at heart an old fashioned tale of the rise and fall (well almost) of the monied classes of England that readers of Dickens and Thackeray would recognise. Borrowing its title from Nomi Prin?s book about corporate America and the eponymous film featuring Danni De Vito and Gregory Peck, Other People?s Money has little to do with finance. Mr. Cartwright?s grasp of banking is rudimentary and painfully second hand. Fortunately, it is irrelevant to an old tale of the scions of families destroying the family business. The characters are cliched and often border on caricature - the English merchant banker resembling Colonel Blimp, his second wife with acting ambition, a slavishly devoted assistant who is secretly in love with her boss, a self indulgent son who travels the world on his trust money seeking experiences, a conscientious son who becomes an unhappy banker with a Californication wife devoted to urban organic farming, a sundry affair with a hirsute South African rugby player, a despotic American banker etc. The characters that dot the book are shallow and unconvincing. The real people who populate Michael Lewis? The Big Short are far more interesting and better drawn than Mr. Cartwright?s cast. The one exception is the auteur Artair MacCleod with his wild dreams of bringing the works of Flann O?Brien to the stage with Daniel Day-Lewis. Bumbling MacCleod with his dependence on the rich to realise his flaky artistic dreams points to the uneasy compact between those who have money and those who have dreams in modern society. Other People?s Money?s ending is also too contrived and too trite to be credible. But Mr. Cartwright does understand something of the role that ordinary people play in the world of money. One character expresses it accurately: ?The rest of us are just the extras, without speaking parts, just fill in the blank spaces in the frame.? It is sad that there wasn?t more of such sharp observations in Other People?s Money. © 2011 Satyajit Das All Rights Reserved. Satyajit Das is author of Extreme Money: The Masters of the Universe and the Cult of Risk (August 2011) Book Reviews Sun, 18 Sep 2011 04:46:00 --0100 http://www.wilmott.com/blogs/satyajitdas/index.cfm/2011/9/18/The-Financial-Compass http://www.wilmott.com/blogs/satyajitdas/index.cfm/2011/9/6/Nowhere-to-Run-Nowhere-to-Hide The crisis threatening to engulf world financial markets has been brewing since 2008. Until recently, markets were Dancing in the Streets. Increasingly, another Holland-Dozier-Holland standard also made famous by Martha and the Vandellas is relevant: ?Nowhere to run to, baby/ Nowhere to hide.? The recovery from the first phase of the crisis was based on ?botox economics?. Clostridium botulinum ? ?botox?- is commonly used to improve a person?s appearance, but its effects are temporary with toxic side effects. ?Financial botox?, money from central banks and governments to prop up demand, temporarily covered up deep-seated problems, rather than resolving the real issues. As chastened individuals and companies reduced debt, governments increased their borrowing to limit the effects of the crisis on the broader economy. The new phase of the crisis is different to 2008 and the ?Lehman moment?. Then, governments had the financial capacity to backstop the private sector, especially affected financial institutions, and support the wider economy. The crisis now involves entire nations and the ability of sovereigns to finance themselves is in question. Ultimately, there is no one to backstop the governments themselves. Contagion from sovereign debt crisis is especially pernicious and very different to that of 2008. Europe?s debt problems provide an insight into the problem. While smaller nations can be bailed out by other stronger nations, the financial commitment required weaken the saviours and threatens their own survival. Saving Greece, Ireland, Portugal, Spain and Italy would probably require a facility of at least Euro 3.0 trillion with an effective lending capacity of around Euro 2 trillion dictated by the fact that maximum lending capacity is limited by the guarantee commitments of AAA rated countries. As more countries need support, the burden of the guarantees becomes concentrated on stronger Euro-zone members - German, France and the Netherlands. In effect, the creditor nations rapidly become debtors themselves, ultimately affecting their credit ratings, cost of funds and causing financial problems if the contingent liabilities are triggered. International Monetary Fund (?IMF?) support may spread the potential contagion to other countries. In effect, rather then containing risk, support for weaker nations spreads the crisis to the stronger countries. Government bonds are traditionally safe-havens as well as the preferred form of collateral used very widely to secure borrowing and other obligations. If the quality of stronger government issuers were to be contaminated, then this would lead to far reaching effects on financial activities. Most banks have substantial holdings of government bonds, which have increased since 2008 as they have increased levels of liquidity. Any fall in the value of these holdings would affect the solvency of the affected banks. For some European banks, lack of access to commercial funding has forced reliance on money from their central banks and the European Central Bank (?ECB?), generally against government bond collateral. Credit rating downgrades or fall in the value of government bonds would create liquidity problems, as banks are unable to finance themselves. If the banks need government support, then this further weakens the government. If individual national governments require external support, then this weakens the ultimate guarantors. Falls in the value of government bonds or a loss of confidence in their value as surety would lead initially to a global ?margin call?, as the value of the collateral is marked down setting off a ?dash for cash?. In an extreme case, where governments bonds are not accepted as collateral, it would lead to a contraction of liquidity and financial activity generally. Central banks, sovereign wealth funds, pension funds and insurers have significant investment in government bonds. A significant proportion of China?s substantial foreign exchange reserves (over $3 trillion) are invested in US and European government bonds. A loss in value in these holdings would reduce China?s wealth and financial flexibility, ultimately affecting its economic performance. In reality, the crisis has returned to its starting point ?debt levels and the reliance of the global economy on borrowing to fuel growth. The level of debt depends on the value of the assets or investment that supports it and the income or cash flows available to service the interest and principal. Many nations have debt that is above the level that can be sustained in a lower growth world ? the ?new normal?. The new crisis is part of the de-leveraging with governments now joining individuals and companies in being forced to reduce levels of debt. But if not managed properly, sovereign debt problems may escalate rapidly with the risk of a major disruption in financial markets. In his pamphlet Gravity ? Our Enemy Number One, investment analyst Roger Babson, who anticipated the 1929 stock market crash, argued that gravity was an evil force. In the credit boom, prices rose, defying gravity. At the commencement of the crisis, governments flooded the system with money to the keep the game going for a little longer. Now, financial gravity is reasserting its malevolent power. An earlier version was published in the Financial Times Satyajit Das is author of Extreme Money: The Masters of the Universe and the Cult of Risk (published in August/ September 2011) Global Sovereign Debt Crisis Tue, 06 Sep 2011 14:27:00 --0100 http://www.wilmott.com/blogs/satyajitdas/index.cfm/2011/9/6/Nowhere-to-Run-Nowhere-to-Hide http://www.wilmott.com/blogs/satyajitdas/index.cfm/2011/8/11/Still-Stressed-After-All-These-Tests For the second time in two years, the European Banking Authority (?EBA?) completed tests on European banks to demonstrate their ?solvency? under conditions of ?stress?. The results have been over shadowed by other momentous events - the announcement by the European Union (?EU?) of a range of measures to deal with the European debt crisis. The tests remain highly relevant as the EU measures are unlikely to ?resolve? the debt problems and European banks remain heavily exposed to losses. The risk of a European banking crisis remains. Last year?s debut test was openly derided as the equivalent of conducting a crash test on a motor vehicle assuming that the car could never crash. Within months of the stress test, several Irish banks that had passed needed rescue by the EU and International Monetary Fund (?IMF?). Another major casualty was the credibility of European Banking regulators. For the record, only 8 out of 90 European banks tested ?failed? the 2011 test, meaning that they did not have the required 5% level of capital in a stressed scenario. Their capital needs were estimated at around Euro 2.5 billion. Another 16 banks were deemed vulnerable, being within 1% of the minimum required capital level. The numbers are eerily similar to that in the first stress test, which passed all but seven of the 91 banks tested identifying an aggregate capital shortfall of only Euro 3.5 billion. In another similarity to the original stress tests, all those who ?failed? were small banks. The 2011 tests did show that some large banks, including Deutsche Bank in Germany, UniCredit in Italy and Société Générale in France, had capital reserves close to the minimum level where they would have formally been required to raise more capital or reduce risk. Highly stage managed and contrived, the latest stress test has done little to build confidence, instead exacerbating uncertainty and doubt. The coverage of the stress tests is not comprehensive covering around 60-70% of the European banking sector, with many small banks being excluded. After the 2011 test, two small Danish banks, who had not been tested, failed. While their assets were minor, the ability of a small bank failure to affect other larger banks in a chain reaction remains a concern. During the 2011, one bank - Helaba ? withdrew, taking issue with the definition of capital. The level of coverage reduces the utility of the test and the value of the information disclosed. The test focused on the effects of weaker economic growth, falls in stock and property prices, increases in funding costs and, most topically, losses on sovereign debt holdings. A well recognised problem is that the tests were really not ?stressful? enough. The most significant deficiency was in relation to bank holdings of sovereign debt. Where sovereign bonds were held in the banks? ?banking books? (generally long term, non traded investments), a credit rating downgrade of the issuer was specified ? 4 notches for a country rated BBB, or lower, 2 notches for a country rated AA/A. For Greek bonds, this translated into a stress scenario of 15% loss. This was below the actual market losses of 50-60% implied by current market prices for Greek bonds or the 21% loss where banks roll over Greek debt under the new bailout package proposed. Similar problems exist with the Irish and Portuguese bonds where market prices imply losses around 30-40%. Unlike the previous stress test, sovereign bonds held for sale in the bank?s ?trading books? were included. The test implied losses from widening credit margins of around 20-30% for Greek bonds, with lower losses for Ireland and Portugal. For Spanish and Italian bonds, the losses were more modest, below the levels seen in recent trading. The test results may significantly underestimate losses if Greece, Ireland and Portugal default and the Spain and Italy experience serious financial pressure. Traders joked that they would have ?mark-to-market? profits if the stress test standards were used to revalue their holdings. Other stress elements, while less controversial, were also insufficiently testing. The modest drop in growth and rise in unemployment contrasts with the sharp contraction in economic activity and employment seen in the peripheral European economies. Given the stated desire of the EU to bring public finances and budget deficits in line with guidelines, the risk of a long period of stagnation ? low growth and high unemployment ? and its effect on loan losses cannot be discounted. The use of consistent parameters across Europe is questionable. Country-by-country credit data disclosed by the stress test reveals the fragility of some economies. For example, in Spain, British banks disclosed default rates of 8-9% on their credit portfolios. In Ireland, one British bank suffered defaults totalling Euro 13 billion on a total credit portfolio of Euro 64 billion ? a rate of loss of around 20%. Standard stress conditions unadjusted for specific national conditions are analogous to achieving an acceptable average ambient temperature by placing one?s feet in the oven and head in the refrigerator. The assumption of a 15% fall in stock prices may understate potential volatility. The 10-17% fall in property prices looks benign. For example, Spanish property prices remain elevated, well above trend. The overvaluation is exacerbated by unwillingness on the part of lenders to take possession of and sell assets securing loans, which would realise losses. The interaction of the individual stress factors, the so-called ?knock on effects?, are crucial. In the first phase of the global financial crisis, major problems were caused by negative feedback loops starting with loan losses, distressed banks, freezing up of money markets, cessation of lending and macro-economic effects (reduced growth, higher employment, slowdown in trade) which then set off new cycles of instability. The non-incorporation of ?second order effects? is a serious deficiency. A more egregious problem is that it was perhaps the wrong kind of testing on the wrong parties and issues. Financial systems rely on the implicit support of national banking systems by the sovereign. As highlighted by the global financial crisis (?GFC?), financial institutions are ?too big too fail.? This assumes the ability of sovereigns to support their banks, should it become necessary. The financial distress of many Euro-zone countries is well documented. These sovereigns are in no position to support their banks. A stress test of European banks is meaningless without a parallel assessment of the ability of the sovereign to support the bank. This affects the access of banks to capital or liquidity. The stress tests merely identify the need for capital. Banks must raise capital from the capital market or governments, as was necessary during the first phase of the GFC. Given that a troubled bank may face difficulty accessing capital from investors, the ability of the governments to supply the necessary capital is crucial. No one seriously believes that European banks need a mere Euro 3.5 billion of additional capital. Rating agency Standard & Poor?s estimates that European banks need around Euro 250 billion of additional capital to withstand a sharp economic downturn. Using a stricter 7% capital target and adjusting for losses on sovereign debt in banking book, JP Morgan research analysts believe that around 20 banks would need to raise capital. UK banks would have tor raise around Euro 25 billion, French banks Euro 20 billion and German banks Euros 14 billion. The ability of national governments to provide banks with the required additional capital remains unknown. The stress tests also focused on the banks? assets. The trigger for bank problems is usually the inability to finance themselves in the money markets ? the ?run on the bank?. The funding difficulties of certain European banks are well known. Greek, Irish, Portuguese, Spanish, smaller Italian and smaller German banks currently have limited access to international money markets. Covered bond issues, a traditionally reliable means of raising funds, have had to be cancelled. Some European banks have abandoned financing plans in the US and Asia in the face of nervousness in money markets. Many banks, especially in the troubled peripheral sovereigns, are now dependent on funding from their own central bank or the European Central Bank (?ECB?). According to market estimates, the ECB has provided up to Euro 400-450 billion in financing, including Euro 240-250 billion to the bailout nations. Much of this financing is against collateral of uncertain value, being government bonds including those issued by the beleaguered sovereign. Some stronger national central banks, according to some studies, may have also advanced Euro 450 billion to other central banks within the Euro-zone to assist with financing banks with liquidity problems. The Bundesbank?s share of this financing is over Euro 300 billion. The stress tests did not assess the banks? ability to withstand continued funding pressures. The EBA glibly noted that it was ?aware of the funding liquidity challenges in the current environment and national authorities are taking steps to extend maturities, increase buffers and develop contingency plans.? Facing criticism about the rigour of the tests, the EBA pointed to the disclosure of financial information which enables banking analysts to conduct their own review. The volume of data is impressive - 91 banks; 3,200 data points per bank; 10 pages of disclosures per bank. Unfortunately, the information provided is filled with anomalies, mainly relating to aggregation of data and omissions. For example, one British bank only disclosed the European credit exposures in its UK operation, omitting exposures held through other entities below the 5% EBA disclosure threshold. One Italian bank did not separately disclose Eastern European exposures, as they were held via their subsidiary in Austria. The stress tests are revealing about EU and European banking sensibilities. The design of the sovereign bond tests highlights the underlying politics and semantics. The use of the rating agency methodology (4 notch downgrade) allowed the EBA avoided the use of the ?banned? terms - ?default? or ?haircut? on sovereign bonds. Europe seems unable to grasp the seriousness of the situation and deal honestly with its financial problems. There are media suggestions that the EBA preferred a stronger stress test but was constrained by political and banking pressures. There were even suggestions that national central banks failed to provide EBA with accurate data. The UK Telegraph quoted the EBA Chairman saying that: ?figures given by the banks in some cases ?materially? changed after being challenged?. Bankers resisted disclosure arguing that given the uncertainty in money markets, release of detailed information would exacerbate the crisis. The answer, argued bankers, was to reduce the level of detail significantly. The stress test?s objectives were laudable: (1) to strengthen the financial system by forcing banks to hold adequate equity, and (2) to convince markets about the solvency of European banks. Unfortunately, the deep flaws of the stress test mean that they failed both objectives. The market?s judgement was quickly evident. Straight after the release of the test results, Italy?s Intesa Sanpaolo and Spain?s BBVA, who emerged from the stress test with core tier one capital of more than 8% - a top rated ?pass?, saw their shares fall sharply. When the expected European sovereign debt restructurings occur and the effects on the real economy become evident, European banks and regulators will still need to pass the only test that really matters. Whatever the stress tests say, the real test still lies ahead. Given events of recent days - perhaps sooner than most people think. © 2011 Satyajit Das All Rights Reserved. Satyajit Das is author of Extreme Money: The Masters of the Universe and the Cult of Risk (due to be published in August 2011) Regulation Thu, 11 Aug 2011 12:55:00 --0100 http://www.wilmott.com/blogs/satyajitdas/index.cfm/2011/8/11/Still-Stressed-After-All-These-Tests http://www.wilmott.com/blogs/satyajitdas/index.cfm/2011/7/23/French-Connections--The-Greek-Bond-Exchange The proposal in July 2011 for the extension of the maturity of Greek bonds emanating from the Élysée Palace reflects French strengths first identified by Napoleon III: ?We do not make reforms in France; we make revolution.? Structured to meet a German requirement that private creditors contribute to the Greek bailout, the proposal falls short of what is actually required. After initial rejection, the proposal miraculously re-appeared in the European Union's "Grand Plan" to resolve the debt problems of some Euro-zone countries. The analysis below shows that neither the original plan nor its cousin now being contemplated are likely to be viable. Under the original sketchy proposal, for every Euro 100 of maturing bonds, the banks will subscribe to new 30 year securities, but only equal to Euro 70 (70%). Of the Euro 70, the banks, in turn, will only give Greece Euro 50 (50%) and invest the other Euro 20 (20%) in 30 year high quality zero coupon bonds (via a special purpose vehicle) to secure repayment of the new bonds. The new 30 year Greek debt will carry an interest rate of 5.5% per annum with a bonus element linked to Greek growth of up to an additional 2.5% per annum. Of the Euro 340 billion in outstanding Greek bonds, banks hold 27%, institutional and retail investors hold 43% and the International Monetary Fund (?IMF?) and the European Central Bank (?ECB?) hold 30%. It is not clear whether non-bank investors are willing to participate in the arrangements. As not all Greek debt trades at the same price in the secondary market, if all bonds maturing are not rolled over, then banks could arbitrage the offer exchanging bonds trading at a deep discount, holding on to those trading at better prices. The Euro 20 invested in high quality collateral will need to earn around 4.26% per annum to accrete in value to Euro 70 to cover the principal of the new 30 year bonds. German 30 year bunds currently yield around 3.75% per annum, less than the required rate. Other AAA rated bonds, such as the European Financial Stability Fund (?EFSF?) bonds, might be used to provide the extra return. Given that the EFSF is backed by guarantees from countries with questionable long-term credit quality, the security afforded by such a guarantee is unproven. Greece must find Euro 50 for every Euro 100 debt exchanged under the proposal. Given it has no access to commercial funding, this would have to come from the EU, IMF, EFSF or ECB. Greece?s cost would be between 7.7% and 11.20% per annum, as it only receives Euro 50 of the Euro 70 face value of the new bonds. Assuming the remaining funding is at 6%, then Greece?s blended rate for every Euro 100 of finance would 6.85-8.60% per annum, compared to the 7-8% per annum considered sustainable by markets. The new EU proposal does at least address this and lowers the cost to the bailout receipients. Most importantly, the overall level of debt, considered unsustainable, of Greece would remain unchanged. Almost all of the issues identified are present, to different degrees, in the latest version of the debt exchange now being contemplated. The exchange scheme seems designed primarily to allow banks to avoid or minimise recognising losses on holdings of Greek bond. Even if the principal of the 30 year bonds is ?risk free?, the interest on the bonds remains dependent on Greece?s ability to pay. Valued at a rate of 12 % per annum for 30 year Greek risk (a not unreasonable estimate), this would mean that the new bonds are only worth around 64% of face value, equivalent to a mark-to-market loss of around 36%. The new proposals sugegst a lower of loss of 21%. It is not clear if the authorities will require the true loss to be recognised. Other proposed alternatives -an exchange of maturing bonds for new longer dated bonds- is even worse as it defers the problem for an even shorter period of time. Thankfully, the proposed tax on all banks to raise Euro 30 billion over 3 years to provide the pretence of private participation has been abandonded for now. Why banks which have no exposure to Greece should bear the cost is not clear? How this helps Greece is also far from obvious? A more logical solution would be either a full debt restructuring where Greek, Irish and Potuguese debt is written down by 25-50%, acknowledging the reality that the current debt burden is simple unsustainable. Alternatively, Greece can repurchase some its outstanding debt at current market prices, well below the face value of the bonds. The deby buyback is not without its problems. Both proposals would reduce Greece?s debt level. It would also result in the bank?s sustaining losses. According to the Bank for International Settlements, French banks have exposures to Greece, including of around Euros 50-60 billion. German banks have exposures of around Euro 30-35 billion. These banks might result require new capital to absorb the writedowns. If necessary, then the French and German governments would need to provide this capital. In effect, rather than lending to Greece, it would have to use the funds to recapitalise its own institutions. This would, in the final analysis, be more sensible than continuing with the farce that Greece is solvent and the bank?s holding of Greek debt are worth the face value of the securities. It would be the first logical step in addressing the problem of over indebted European nations. History records that in August 2001, the IMF oversaw a debt exchange for Argentina in an unsuccessful, last ditch effort to avoid default. Indecisive and confused action by European authorities seems doomed to ensure that this restructuring, if it eventuates, will be followed by others and an eventual messy, disorderly and expensive default. The French proposal perpetuates the lack of acknowledgment that Greece has a ?solvency? rather than a ?liquidity? problem. Like the EFSF whose structure has been criticised as nothing more than a collateralised debt obligation (?CDO?), it uses financial engineering techniques to defer or disguise losses in an unending game of ?extend and pretend?. © 2011 Satyajit Das Satyajit Das is author of Extreme Money: The Masters of the Universe and the Cult of Risk (FT Press, forthcoming August 2011). Global Sovereign Debt Crisis Sat, 23 Jul 2011 00:48:00 --0100 http://www.wilmott.com/blogs/satyajitdas/index.cfm/2011/7/23/French-Connections--The-Greek-Bond-Exchange http://www.wilmott.com/blogs/satyajitdas/index.cfm/2011/7/12/Why-The-French-Greek-Bank-Debt-Exchange-Proposal-Wont-Work The proposal to extend the maturity of Greek bonds emanating from the Élysée Palace reflects French strengths first identified by Napoleon III: ?We do not make reforms in France; we make revolution.? Structured to meet a German requirement that private creditors contribute to the Greek bailout, the proposal falls short of what is actually required. Under the sketchy proposal, for every Euro 100 of maturing bonds, banks will subscribe to new 30 year securities, but only equal to Euro 70 (70%) effectively repaying themselves. for maturing debt that Greece cannot otherwise repay or refinance. Of the Euro 70, the banks will keep Euro 50 (50%) and invest the other Euro 20 (20%) in 30 year high quality zero coupon bonds (via a special purpose vehicle) to secure repayment of the new bonds. The new 30 year Greek debt will carry an interest rate of 5.5% per annum with a bonus element linked to Greek growth of up to an additional 2.5% per annum, making the maximum interest rate 8 % per annum. Of the Euro 340 billion in outstanding Greek bonds, banks hold 27%, institutional and retail investors hold 43% and the International Monetary Fund (?IMF?) and the European Central Bank (?ECB?) hold 30%. It is not clear whether non-bank investors are willing to participate in the arrangements. The ECB has previously resisted any debt restructuring, including maturity extension. The French plan assumes holders of bonds would agree to roll over 50% of their holdings to provide Greece net funding of Euro 30 billion. But under the French banking federation?s own figures, this would if impossible unless all the Euro 60.5 billion (excluding central bank holdings) maturing by mid-2014 is rolled over. This is also inconsistent with the proposal?s assumption of investor acceptance of 80%. The plan assumes that the ?voluntary? exchange will not be treated as a ?selective or restrictive? default by rating agencies or trigger credit insurance contracts on Greece. Fitch Ratings and S&P have indicated that the French plan will ?very likely? be deemed a default, albetit for an unspecified ?temporary? period, as it constitutes a distressed debt restructuring. The Euro 20 invested in high quality collateral will need to earn around 4.26% per annum to accrete in value to Euro 70 to cover the principal of the new 30 year bonds. German 30-year bunds currently yield around 3.75% per annum, less than the required rate. Other AAA rated bonds, such as the European Financial Stability Fund (?EFSF?) bonds, might be used to provide the extra return. Given that the EFSF is backed by guarantees from countries with questionable long-term credit quality and who may need a future bailout, the security afforded by such a guarantee is unproven. Greece must find Euro 50 for every Euro 100 debt exchanged under the proposal. Given it has no access to commercial funding, this would have to come from the EU, IMF, EFSF or ECB. Greece?s cost would be between 7.7% and 11.20% per annum, as it only receives Euro 50 of the Euro 70 face value of the new bonds. Assuming the remaining funding is at 6%, then Greece?s blended rate for every Euro 100 of finance would 6.85-8.60% per annum, well above that considered sustainable by markets and economists. Most importantly, the overall level of debt, considered unsustainable, of Greece would remain unchanged. The exchange scheme seems designed primarily to allow banks to avoid recognising losses on holdings of Greek bond. But even if the principal of the 30-year bonds is considered ?risk free?, the interest remains dependent on Greece?s ability to pay. Valued at a rate of 12 % per annum for 30 year Greek risk (a not unreasonable estimate), this would mean that the new bonds are only worth around 64% of face value, equivalent to a mark-to-market loss of around 36%. It is not clear if the authorities will require this loss to be recognised. The French proposal has lost momentum in recent days as its flaws have become obvious. One alternative under consideration, an exchange of maturing bonds for new 5 year (French proposal) or 7 year (German) bonds is even worse as it defers the problem for an even shorter period of time. A more logical solution would be that suggested reluctantly by the Institute of International Finance. Under this proposal, Greece would repurchase some its outstanding debt at current market prices, well below the face value of the bonds. This would reduce Greece?s debt level. It would also result in the bank?s sustaining losses. According to the Bank for International Settlements, French banks have exposures to Greece, including of around Euros 50-60 billion. German banks have exposures of around Euro 30-35 billion. These banks might result require new capital to absorb the writedowns. If necessary, then the French and German governments would need to provide this capital. In effect, rather than lending to Greece, it would have to use the funds to recapitalise its own institutions. This would, in the final analysis, be more sensible than continuing with the farce that Greece is solvent and the bank?s holding of Greek debt are worth the face value of the securities. It would be the first logical step in addressing the problem of over indebted European nations. History records that in August 2001, the IMF oversaw a debt exchange for Argentina in an unsuccessful, last ditch effort to avoid default. Indecisive and confused action by European authorities seems doomed to ensure that this restructuring, if it eventuates, will be followed by others and an eventual messy, disorderly and expensive default. The French proposal perpetuates the lack of acknowledgment that Greece has a ?solvency? rather than a ?liquidity? problem. Like the EFSF whose structure has been criticised as nothing more than a collateralised debt obligation (?CDO?), it uses financial engineering techniques to defer or disguise losses in an unending game of ?extend and pretend?. © 2011 Satyajit Das Satyajit Das is author of Extreme Money: The Masters of the Universe and the Cult of Risk (FT Press, forthcoming August 2011). Global Financial Crisis Tue, 12 Jul 2011 12:02:00 --0100 http://www.wilmott.com/blogs/satyajitdas/index.cfm/2011/7/12/Why-The-French-Greek-Bank-Debt-Exchange-Proposal-Wont-Work