Satyajit Das is author of Traders, Guns and Money: Knowns and unknowns in the dazzling world of derivatives (August 2006) and Extreme Money: The Masters of the Universe and the Cult of Risk (August 2011)
~~~
In Crosstown Traffic, Jimi Hendrix sang: “can’t you see my signals turn from green to red / And with you I can see a traffic jam straight up ahead.” In global financial markets, the signals have changed from green to red. But rather than a simple traffic jam, a full scale credit crash may be ahead.
In financial markets, facts never matter until they do but there are worrying indications.
Fact 1 – The European debt crisis has taken a turn for the worse.
There is a serious risk that even the half-baked bailout plan announced on 21 July 2011 cannot be implemented.
The sticking point is a demand for collateral for the second bailout package. Finland demanded and got Euro 500 million in cash as security against their Euro 1,400 million share of the second bailout package. Hearing of the ill-advised side deal between Greece and Finland, Austria, the Netherlands and Slovakia also are now demanding collateral, arguing that their banks were less exposed to Greece than their counterparts in Germany and France entitling them to special treatment. At least, one German parliamentarian has also asked the logical question, why Germany is not receiving similar collateral.
Of course, Greece, which does not have two Euros to rub together, doesn’t have this collateral and would need to borrow it.
Compounding the problem is Greece’s fall in Gross Domestic Production (“GDP”) was worse than forecast, even before the latest austerity measures become effective. The Greek economy has shrunk by around 15% since the crisis began. 2-year borrowing costs for Greece are now over 40%, pawnbroker levels. The next installment of Greece’s first bailout package is due to be released as at end September. Some members of the International Monetary Fund (“IMF”) are already expressing deep misgivings about further assistance to Greece, in the light of the seeming inability of the country to meet its end of the bargain.
A disorderly unwind of the Greek debt problem cannot be ruled out. Ireland and Portugal remain in difficulty. Spain and Italy also remain embattled with only European Central Bank (“ECB”) purchases of their bonds keeping their interest rates down. Concern about the effect of these bailouts on France and Germany is also intensifying.
Concerns about US and Japanese government debt are also increasing.
Official forecasts show that America’s national debt will increase by $3.5 trillion from its existing $14.5 trillion over the next decade. These forecasts are unlikely to be met unless the political deadlock over the budget is overcome and economic growth recovers. Japan was downgraded to AA- and its longer-term economic prognosis continues to be poor.
Facts 2 – Problems with banks have re-emerged.
Banks globally, especially European banks, are seen as increasingly vulnerable to European debt problems. The total exposure of the global banking system to Greece, Ireland, Portugal, Spain and Italy is over $2 trillion. French and Germany banks have very large exposures.
If there are defaults, then these banks will need capital, most likely from their sovereigns. As they are increasingly themselves under pressure, their ability to support the banking system is unclear. The pressure is evident in the share prices of French banks; Societe Generale’s share price has fallen by nearly 50% in a relatively short period of time.
In the US, concerns about Bank of America (“BA”) have emerged, with analysts suggesting that the bank requires significant infusions of capital. The major concerns relate to BA’s investment in US mortgage originator Countrywide including continuing litigation losses, exposure to European banks, loans to commercial real estate and the quality of other assets, such as mortgage servicing rights and goodwill resulting from its acquisition of Merrill Lynch.
BA claims that its exposure of $17 billion to European sovereigns was hedged. As the world discovered in 2008, it wasn’t whether you were hedged but who you were hedged with and whether they were financially able to perform that was the issue.
BA shares have fallen by roughly 40% price over the past month, compared to a 15% decline in the S&P 500. The cost of credit insurance on BA risk has also increased sharply.
BA decision to issue $5 billion in preference shares to Warren Buffett’s Berkshire Hathaway, now confirmed as the market’s lender of last resort, at distressed prices was not a statement of strength but weakness. BA needs more capital in any case and Buffett is betting on both BA and if things go wrong that the US taxpayer will bail him out as they did with his investment in Goldman Sachs.
BA’s woes confirm that problems in the banking system exist globally, not only in Europe.
Fact 3 – Money markets are seizing up
Banks and financial institutions are finding it increasingly difficult to raise funds. Costs have risen sharply.
Spanish and Italian banks have limited access to international commercial funding. Like Greek, Irish and Portuguese banks, they are heavily reliant on funding from local investors and central banks, including the ECB.
American money market funds, which manage around $1.6 trillion, historically invested around 40-45% ($600-700 billion) with European financial institutions. Over the last few months, the money market funds have reduced their exposure to European entities, especially Spanish and Italian banks. The funds have also decreased the term of their loans to the European entities that they are willing deal with to as little as 7 days at a time, in an effort to limit risk.
European banks are having to pay higher interest rates, if they can attract funds. The problems are not confined to European financial institutions. Despite limited known direct exposure to European sovereigns and their relatively strong financial positions, Australian banks’ credit costs in international money markets have increased by more than 1.00% in less than 3 months.
As a result, non-financial institutions are finding finance less readily available and more expensive. Anecdotal evidence suggest that businesses are having difficulty financing normal commercial transactions, recalling the credit problems of late 2008/ early 2009.
Banks are increasingly following Tennessee Williams’ advice for survival: “We have to distrust each other. It is our only defense against betrayal.”
Fact 4 – The broader economic environment is deteriorating.
The global economic recovery is stalling. The risk of a recession or minimal growth is significant.
The favourable stock market reaction to the latest report of growth in orders for durable goods in America misses an essential point. At around $200 billion an month, it is still around 20% below its peak in 2007 and only at 2000 levels.
Germany and emerging market economies, like China and India, which have contributed the bulk of global growth since 2008, are showing signs of slowing. The effects of the excessive credit expansion in China and India are showing up in bank bad debts.
Then there are pernicious feedback loops. Tighter money market conditions feed into lower growth, increasing the problems of government finances. Falling tax revenues and rising expenditures push up budget deficits, requiring greater borrowing. Lower growth feeds into greater business failures that increase bank bad debts, feeding further tightening in lending conditions and the cost of finance.
The rapid and marked deterioration in economic and financial conditions means that the risk of a serious disruption is now significant.
If market seize up again, then “this time it will be different“. There might just not be enough money to bail out everyone and every country that may need rescuing.
Government policy options are severely restricted. Government support is restricted because of excessive debt levels and the reluctance of investors to finance indebted sovereigns. Interest rates in most developed countries are low or zero, restricting the ability to stimulate the economy by cutting borrowing cost. Unconventional monetary strategies – namely printing money or quantitative easing – have been tried with limited success. Further doses, while eagerly anticipated by market participants, may not be effective.
The global economy may muddle through, but a second credit crash is now distinctly possible. But the trigger and timing is unknown. As John Maynard Keynes remarked: “The expected never happens; it is the unexpected always.”
~~~
-Satyajit Das
August 27, 2011
http://www.ritholtz.com/blog/2011/08/from-green-to-red-–-is-credit-%20crunch-2-0-imminent/
Showing posts with label Satyajit Das. Show all posts
Showing posts with label Satyajit Das. Show all posts
30 August 2011
12 December 2009
Value and Rules ~ Satyajit Das
Wall Street Revalued: Imperfect Markets and Inept Central Bankers by Andrew Smithers (2009)
The Road to Financial Reformation: Warnings, Consequences, Reforms by Henry Kaufman (2009)
A book review...
In a sense, this crisis is about values (the prices paid for many assets) and the rules (regulations governing financial markets). It is also about rules (rigid model based formulations of price) and values (ethics or the lack thereof). These two books provide different perspectives on the issues.
In Wall Street Revalued, Andrew Smithers, an experienced practitioner (in fund management and now as a consultant), explores the value of stocks. This is a theme that Mr.Smithers has written about before, most notably in his 2000 book Valuing Wall Street which together with the Robert Shiller’s better known Irrational Exuberance presciently highlighted the overvaluation of new economy Internet stocks.
Wall Street Revalued argues that assets can be objectively valued and managing asset prices should be one of the central functions of central bankers. Mr. Smithers’ asserts that denial of these fundamental principles lay at the heart of the global financial crisis. On valuation, Wall Street Revalued favours the “q” ratio (the replacement cost of a company’s assets) and cyclically adjusted price-earnings ratio over the previous ten years (a measure also adopted by Professor Shiller).
Eloquent and persuasive, Mr. Smithers make his case well with the advantages of brevity and an abundance of charts and Tables. But some problems remain.
It is not clear how earnings or accurate replacement values can be forecast. This is particularly so at inflection points in economic history – I am sure horse and buggy makers were “cheap” on replacement cost and PE measures after the advent of non-equine modes of transportation. The ability of obscurantist accountants and derivative professionals to affect company earnings and cash flows has become increasingly important. The effect of leverage (both obvious and disguised) also affects these numbers perhaps more that Mr. Smithers acknowledges. How are these to be dealt with at an acceptable level of certainty?
If precise valuation were possible then surely the entire idea would have enabled computers loaded with Mr. Smithers’ data and insight to generate significant excess returns. Markets may deviate from fair value for varying, sometimes lengthy, periods. Echoing Minsky’s famous formulation – “conditionally coherent”, Mr. Smithers argues that markets are “imperfectly efficient”, fluctuating around their fair value.
The question then is over what time horizon will be the true value be achieved? As Keynes stated: “…this long run is a misleading guide to current affairs. In the long run we are all dead.”
As every sensible trader knows, the price you pay is always wrong. If you sell then by definition you are lowest price in the market. If you buy, then your bid is the highest. They also know price is what you pay while value is what you hope and pray for. The mysteries of value remain.
Before Nouriel Roubini, Marc Faber and the others, there was Henry Kaufman – the original ‘Dr. Doom’. He too saw the crisis coming (this disease is clearly infectious!). The text contains an entire section on his prophetic and neglected early warnings.
Road to Financial Reformation provides a personal (at times) and insightful overview of the global financial crisis and brims with suggestions for reform to avoid a future recurrence. Intended for financiers and regulators involved in the industry, the book is a thoughtful analysis of the main issues.
Dr. Kaufman’s major concern is the blind faith in models and questionable innovations. He is critical of the rapid increase in size and concentration of financial institutions. He identifies how securitisation of bank loans “created the illusion that credit risk could be reduced if the instruments became marketable” and led to a decline in the credit quality of debt. He also shrewdly identifies how the idea of liquidity altered from assets (what you could sell) to one centered on liabilities (what you could borrow).
His solutions are unsurprising. He advocates a single regulator and increased regulation. Amusingly, he urges that “amid the blizzard of quantitative, technical offerings…courses in economic and financial history should be required for all business degrees.” As Marx warned history has a tendency to repeat first as tragedy and then as farce. It is not entirely clear why the simple study of it would prevent this.
The reliance on central bankers, on the part of both Mr. Smithers and Dr. Kaufman, to prick asset bubbles and take responsibility for regulating the financial system is brave.
Recently, Ben Bernanke, President of the Federal Reserve, confessed: “I did not anticipate a crisis of this magnitude.” Mr. Bernanke further acknowledged shortcomings in a more traditional area of central bank expertise – ensuring the adequate capitalisation of banks. It is far from clear that central bankers would be capable of identifying mis-valuation and acting on it. Most tellingly, traders and investors did not prove particularly able at this task. And they were better paid than central bankers.
Regulation and governance generally rely on enforcement and strict compliance. Dr. Kaufman conveniently neglects mention of the fact that he had a seat on Lehman Brothers’ board and a member of its finance and risk committee.
The octogenarian Dr. Kaufman was joined on this committee by a Broadway producer, a former officer of US Navy, founder of Spanish-language TV station and a former chairman of IBM (from some 13 years ago). The 5 directors had been on Lehman's board for a collective 55 years. It appears that there were two meetings of finance and risk committee in 2006 and 2007. The composition of the committee is especially puzzling as there was no inkling that the investment bank was contemplating ownership of warships or producing musicals or programs for Spanish language TV.
Whatever the book’s other considerable insights, Road to Financial Reformation does not make the case for the capabilities of central bankers and other worthies oversighting either the markets or individual institutions. It may ultimately be a case of values rather than rules.
© 2009 Satyajit Das All Rights reserved.
Satyajit Das is a risk consultant and author of Traders, Guns & Money: Knowns and Unknowns in the Dazzling World of Derivatives (2006, FT-Prentice Hall).
The Road to Financial Reformation: Warnings, Consequences, Reforms by Henry Kaufman (2009)
A book review...
In a sense, this crisis is about values (the prices paid for many assets) and the rules (regulations governing financial markets). It is also about rules (rigid model based formulations of price) and values (ethics or the lack thereof). These two books provide different perspectives on the issues.
In Wall Street Revalued, Andrew Smithers, an experienced practitioner (in fund management and now as a consultant), explores the value of stocks. This is a theme that Mr.Smithers has written about before, most notably in his 2000 book Valuing Wall Street which together with the Robert Shiller’s better known Irrational Exuberance presciently highlighted the overvaluation of new economy Internet stocks.
Wall Street Revalued argues that assets can be objectively valued and managing asset prices should be one of the central functions of central bankers. Mr. Smithers’ asserts that denial of these fundamental principles lay at the heart of the global financial crisis. On valuation, Wall Street Revalued favours the “q” ratio (the replacement cost of a company’s assets) and cyclically adjusted price-earnings ratio over the previous ten years (a measure also adopted by Professor Shiller).
Eloquent and persuasive, Mr. Smithers make his case well with the advantages of brevity and an abundance of charts and Tables. But some problems remain.
It is not clear how earnings or accurate replacement values can be forecast. This is particularly so at inflection points in economic history – I am sure horse and buggy makers were “cheap” on replacement cost and PE measures after the advent of non-equine modes of transportation. The ability of obscurantist accountants and derivative professionals to affect company earnings and cash flows has become increasingly important. The effect of leverage (both obvious and disguised) also affects these numbers perhaps more that Mr. Smithers acknowledges. How are these to be dealt with at an acceptable level of certainty?
If precise valuation were possible then surely the entire idea would have enabled computers loaded with Mr. Smithers’ data and insight to generate significant excess returns. Markets may deviate from fair value for varying, sometimes lengthy, periods. Echoing Minsky’s famous formulation – “conditionally coherent”, Mr. Smithers argues that markets are “imperfectly efficient”, fluctuating around their fair value.
The question then is over what time horizon will be the true value be achieved? As Keynes stated: “…this long run is a misleading guide to current affairs. In the long run we are all dead.”
As every sensible trader knows, the price you pay is always wrong. If you sell then by definition you are lowest price in the market. If you buy, then your bid is the highest. They also know price is what you pay while value is what you hope and pray for. The mysteries of value remain.
Before Nouriel Roubini, Marc Faber and the others, there was Henry Kaufman – the original ‘Dr. Doom’. He too saw the crisis coming (this disease is clearly infectious!). The text contains an entire section on his prophetic and neglected early warnings.
Road to Financial Reformation provides a personal (at times) and insightful overview of the global financial crisis and brims with suggestions for reform to avoid a future recurrence. Intended for financiers and regulators involved in the industry, the book is a thoughtful analysis of the main issues.
Dr. Kaufman’s major concern is the blind faith in models and questionable innovations. He is critical of the rapid increase in size and concentration of financial institutions. He identifies how securitisation of bank loans “created the illusion that credit risk could be reduced if the instruments became marketable” and led to a decline in the credit quality of debt. He also shrewdly identifies how the idea of liquidity altered from assets (what you could sell) to one centered on liabilities (what you could borrow).
His solutions are unsurprising. He advocates a single regulator and increased regulation. Amusingly, he urges that “amid the blizzard of quantitative, technical offerings…courses in economic and financial history should be required for all business degrees.” As Marx warned history has a tendency to repeat first as tragedy and then as farce. It is not entirely clear why the simple study of it would prevent this.
The reliance on central bankers, on the part of both Mr. Smithers and Dr. Kaufman, to prick asset bubbles and take responsibility for regulating the financial system is brave.
Recently, Ben Bernanke, President of the Federal Reserve, confessed: “I did not anticipate a crisis of this magnitude.” Mr. Bernanke further acknowledged shortcomings in a more traditional area of central bank expertise – ensuring the adequate capitalisation of banks. It is far from clear that central bankers would be capable of identifying mis-valuation and acting on it. Most tellingly, traders and investors did not prove particularly able at this task. And they were better paid than central bankers.
Regulation and governance generally rely on enforcement and strict compliance. Dr. Kaufman conveniently neglects mention of the fact that he had a seat on Lehman Brothers’ board and a member of its finance and risk committee.
The octogenarian Dr. Kaufman was joined on this committee by a Broadway producer, a former officer of US Navy, founder of Spanish-language TV station and a former chairman of IBM (from some 13 years ago). The 5 directors had been on Lehman's board for a collective 55 years. It appears that there were two meetings of finance and risk committee in 2006 and 2007. The composition of the committee is especially puzzling as there was no inkling that the investment bank was contemplating ownership of warships or producing musicals or programs for Spanish language TV.
Whatever the book’s other considerable insights, Road to Financial Reformation does not make the case for the capabilities of central bankers and other worthies oversighting either the markets or individual institutions. It may ultimately be a case of values rather than rules.
© 2009 Satyajit Das All Rights reserved.
Satyajit Das is a risk consultant and author of Traders, Guns & Money: Knowns and Unknowns in the Dazzling World of Derivatives (2006, FT-Prentice Hall).
5 October 2009
Dr. Jekyll and Mr. Hyde Finance ~ Satyajit Das,
About one year ago, AIG was brought to the brink of bankruptcy as a result its exposure under credit default swaps (“CDS”) (a form of credit insurance). Asset backed securities and Collateralised Debt Obligations (“CDOs”), which lived up to its cheery nickname Chernobyl Death Obligation, brought the financial system to the edge of collapse.
Volatile equity and currency markets caused problems with exotic option “accumulators” (known to traders as “I-will-kill-you-later”). Numerous investors and corporations are bunkered down with their lawyers hoping to litigate their way out of significant losses on “hedges” pleading familiar defenses – “I did not understand the risks” or “I was misled about the risks by the bank”.
If you assumed that these events meant that wild beast of derivatives would be tamed, then you would be wrong. History tells us that there will be cosmetic changes to the functioning of the market but business as usual will resume in the not too distant future. Problems with derivative problems of portfolio insurance in 1987 and Long Term Capital Management (“LTCM”) in 1998 did not lead to fundamental changes in the operation of derivatives markets.
Tried and faied initiatives (based on particular religious convictions) will be prompted including improving disclosure, increasing capital and implementing a new centralised counterparty (“CCP”) to attemnpt to reduce the risk of a major dealer failing. Fundamental issues - the use for derivative for speculation, mis-selling of instruments to less sophisticated market participants, complexity, valuation problems - will not be substantively addressed.
The industry and its key lobby group (ISDA – International Swaps & Derivatives Association) are well practiced in the art of regulatory skullduggery.
Derivatives, it will be argued, are 'soooo' complicated that only derivative traders themselves can properly “regulate” them. If this fails then there will be more subtle rhetorical thrusts.
The new CCP is only for “standardised” derivatives. Already, there are impassioned semantic debates about what is meant by “standard derivatives” and whether they can actually be cleared through the CCP.
On 17 September 2009, Robert Pickel, ISDA’s CEO, argued before the U.S. House Agriculture Committee: “Not all standardized contracts can be cleared.” He argued that that even if they have standardized economic terms many derivatives contracts will be “difficult if not impossible to clear” because the CCP depends on such factors as liquidity, trading volume and daily pricing. This would, Pickel argued, make “it difficult for a clearinghouse to calculate collateral requirements consistent with prudent risk management.”
Dan Budofsky, a partner at Davis Polk & Wardwell LLP, who testified on behalf of the Securities Industry and Financial Markets Association, agreed that “it may be more appropriate for products that trade less frequently to trade over-the-counter.”
The industry will argue for self-regulation, which bears the same relationship to regulation that self importance does to importance.
The reasons for policy inaction are complex. As undoubtedly numerous professors from well-known universities will testify, derivatives do perform important risk transfer functions within modern capital markets – the Dr.Jekyll side of derivatives. ISDA’s Pickel laid out this argument with eloquent panache arguing against standardisation and the CCP as it “would undercut their very purpose: the ability to tailor custom risk-management solutions to meet the needs of end-users.”
Derivatives by their inherent nature are also have a Mr.Hyde side. The ability to use derivatives to speculate, create off-balance sheet positions, increase leverage, arbitrage regulatory and tax rules and manufacture exotic risk cocktails will continue to be a major factor in derivative activity.
The reality is that hedging and risk management is secondary to the other uses. For companies, the ability to use derivative trading to supplement traditional earnings, which are under increased pressure, is irresistible. For institutional and retail investors, the use of derivatives to improve returns through leverage and access to different risks is now a vital part of the investment process.
For banks, the Dr.Jekyll of derivative trading is the revenues that can be generated. The Dr. Hyde is the risks in derivative trading that are generally deferred into a Panglossian future “neverland” using complex models, based on arcane mathematics and confidence that only ignorance can support.
The complexity of modern derivatives has little to do with risk transfer and everything to do with profits. As new products are immediately copied by competitors, traders must “innovate” to maintain revenue by increasing volumes or creating new structures. Complexity delays competition, prevents clients from unbundling products and generally reduces transparency. Frequently, the models used to price, hedge and determine the profitability also manage to confuse managers and controllers within banks themselves allowing traders to book large fictitious “profits” that their bonuses are based on.
The sheer importance and size of derivative profits means that it will continue to attract the best and the brightest who will continue to play these time honoured games.
Warren Buffet once described bankers in the following terms: “Wall Street never voluntarily abandons a highly profitable field. Years ago… a fellow down on Wall Street…was talking about the evils of drugs…he ranted on for 15 or 20 minutes to a small crowd…then…he said: “Do you have any questions?” One bright investment banking type said to him: “yeah, who makes the needles?
Derivatives and debt are the needles of finance and bankers will continue to supply them to all the Dr. Jekyll’s and Mr. Hyde’s alike for the foreseeable future as long as there is a buck to be made in the trade.
© 2009 Satyajit Das All Rights reserved.
Satyajit Das is a risk consultant and author of Traders, Guns & Money: Knowns and Unknowns in the Dazzling World of Derivatives (2006, FT-Prentice Hall).
http://www.wilmott.com/blogs/satyajitdas/
Volatile equity and currency markets caused problems with exotic option “accumulators” (known to traders as “I-will-kill-you-later”). Numerous investors and corporations are bunkered down with their lawyers hoping to litigate their way out of significant losses on “hedges” pleading familiar defenses – “I did not understand the risks” or “I was misled about the risks by the bank”.
If you assumed that these events meant that wild beast of derivatives would be tamed, then you would be wrong. History tells us that there will be cosmetic changes to the functioning of the market but business as usual will resume in the not too distant future. Problems with derivative problems of portfolio insurance in 1987 and Long Term Capital Management (“LTCM”) in 1998 did not lead to fundamental changes in the operation of derivatives markets.
Tried and faied initiatives (based on particular religious convictions) will be prompted including improving disclosure, increasing capital and implementing a new centralised counterparty (“CCP”) to attemnpt to reduce the risk of a major dealer failing. Fundamental issues - the use for derivative for speculation, mis-selling of instruments to less sophisticated market participants, complexity, valuation problems - will not be substantively addressed.
The industry and its key lobby group (ISDA – International Swaps & Derivatives Association) are well practiced in the art of regulatory skullduggery.
Derivatives, it will be argued, are 'soooo' complicated that only derivative traders themselves can properly “regulate” them. If this fails then there will be more subtle rhetorical thrusts.
The new CCP is only for “standardised” derivatives. Already, there are impassioned semantic debates about what is meant by “standard derivatives” and whether they can actually be cleared through the CCP.
On 17 September 2009, Robert Pickel, ISDA’s CEO, argued before the U.S. House Agriculture Committee: “Not all standardized contracts can be cleared.” He argued that that even if they have standardized economic terms many derivatives contracts will be “difficult if not impossible to clear” because the CCP depends on such factors as liquidity, trading volume and daily pricing. This would, Pickel argued, make “it difficult for a clearinghouse to calculate collateral requirements consistent with prudent risk management.”
Dan Budofsky, a partner at Davis Polk & Wardwell LLP, who testified on behalf of the Securities Industry and Financial Markets Association, agreed that “it may be more appropriate for products that trade less frequently to trade over-the-counter.”
The industry will argue for self-regulation, which bears the same relationship to regulation that self importance does to importance.
The reasons for policy inaction are complex. As undoubtedly numerous professors from well-known universities will testify, derivatives do perform important risk transfer functions within modern capital markets – the Dr.Jekyll side of derivatives. ISDA’s Pickel laid out this argument with eloquent panache arguing against standardisation and the CCP as it “would undercut their very purpose: the ability to tailor custom risk-management solutions to meet the needs of end-users.”
Derivatives by their inherent nature are also have a Mr.Hyde side. The ability to use derivatives to speculate, create off-balance sheet positions, increase leverage, arbitrage regulatory and tax rules and manufacture exotic risk cocktails will continue to be a major factor in derivative activity.
The reality is that hedging and risk management is secondary to the other uses. For companies, the ability to use derivative trading to supplement traditional earnings, which are under increased pressure, is irresistible. For institutional and retail investors, the use of derivatives to improve returns through leverage and access to different risks is now a vital part of the investment process.
For banks, the Dr.Jekyll of derivative trading is the revenues that can be generated. The Dr. Hyde is the risks in derivative trading that are generally deferred into a Panglossian future “neverland” using complex models, based on arcane mathematics and confidence that only ignorance can support.
The complexity of modern derivatives has little to do with risk transfer and everything to do with profits. As new products are immediately copied by competitors, traders must “innovate” to maintain revenue by increasing volumes or creating new structures. Complexity delays competition, prevents clients from unbundling products and generally reduces transparency. Frequently, the models used to price, hedge and determine the profitability also manage to confuse managers and controllers within banks themselves allowing traders to book large fictitious “profits” that their bonuses are based on.
The sheer importance and size of derivative profits means that it will continue to attract the best and the brightest who will continue to play these time honoured games.
Warren Buffet once described bankers in the following terms: “Wall Street never voluntarily abandons a highly profitable field. Years ago… a fellow down on Wall Street…was talking about the evils of drugs…he ranted on for 15 or 20 minutes to a small crowd…then…he said: “Do you have any questions?” One bright investment banking type said to him: “yeah, who makes the needles?
Derivatives and debt are the needles of finance and bankers will continue to supply them to all the Dr. Jekyll’s and Mr. Hyde’s alike for the foreseeable future as long as there is a buck to be made in the trade.
© 2009 Satyajit Das All Rights reserved.
Satyajit Das is a risk consultant and author of Traders, Guns & Money: Knowns and Unknowns in the Dazzling World of Derivatives (2006, FT-Prentice Hall).
http://www.wilmott.com/blogs/satyajitdas/
Still The Masters of the Universe ~ Satyajit Das
Tom Wolfe writing in Bonfire of the Vanities created the term – ‘Masters of the Universe’: “He considered himself part of the new era and the new breed, a Wall Street egalitarian, a Master of the Universe, who was only a respecter of performance.” Wall Street bond trader Sherman McCoy, the original Master of the Universe, came to personify the avariciousness and self-aggrandisement of financiers.
Human history is a sequence of “ations” – civilisation, industrialisation, urbanisation, globalisation interspersed with actual or threatened “annihilation”. The most recent “ation” is “financialisation” - the conversion of everything into monetary form (also known as another “ation” – “monetisation”).
New paper economies emerged directly from the demise of the gold standard that removed restrictions on the ability to create money, especially debt. Finance inexorably displaced industry with trading and speculation becoming major activities as financial engineering replaced real engineering. In an earlier age, Heinrich Heine, the German poet, too had identified the change: “Money is the God of our time….” The rise of financiers is intimately linked to this financialisation of the global economy.
Financial innovations such as securitisation (the packaging up and sale of loans) and derivatives (effectively risk insurance) enabled banks to extend more credit. Banks could literally by increasing throughput, making more loans and selling them off to eager investors, magically increase returns to their investors. Bankers had invented a ‘money machine’.
Bank also began to trade more actively with their shareholders money, following the advice of Fear of Flying author Erica Jong: “If you don’t risk anything then you risk even more”.
All of this, of course, meant increased earnings for the bank and its star performers. As people who work in financial institutions know, it is primarily an enterprise that is run for the employees with an afterthought for shareholders.
Sherman McCoy could with a single phone call make $50,000 and, even better, a share of that was his and his alone. At the height of the boom, top hedge fund and private managers could make more in 10 minutes than the average worker earned in an entire year. In 2007, James Simons of Renaissance Technologies earned $1.5 billion and David Rubinstein of The Carlyle Group earned $260 million in the ethereal “economic stratosphere.” In Australia, Macquarie Bank employees rejoiced in the sobriquet – the ‘Millionaires factory”.
The ability to earn high rewards only becomes a problem where the promise of a share of profits encourages excessive risk taking and a focus on short-term earnings. It also becomes a problem where the basic measure of performance is ambiguous and can be systematically manipulated. Unfortunately, ‘earnings’ proved to be the result of wildly inaccurate models, accounting tricks and risks that had not been accurately captured.
Finance is also problematic when it comes to dominate the economy. In the U.S.A., financial services’ share of total corporate profits increased from 10% in the early 1980s to 40% in 2007. The combined stock market value of these firms grew from 6% to 23% over the same period.
It is now conventional wisdom to accept the central role of financial services. Gordon Brown, the Chancellor of the Exchequer under Tony Blair and then Prime Minister, harboured secret dreams of a Scandinavian-style social welfare state with low taxes funded by the growth of the City. In 2007, he told bankers: “What you have achieved for the financial services we … now aspire to achieve for the whole of the British economy.” Alistair Darling, Gordon Brown successor as Chancellor, was no less loquacious describing financial services as “absolutely critical” to the economy.
The golden age seemed to come to an end with the GFC. Initially, the world viewed the destruction of storied financial institutions in Global Financial Crisis as an entertaining blood sport.
Some bankers lost their jobs by the thousands. Others lived with the psychological fear of firing by text message.
In New York, bankers confessed it was hard to live on less than $500,000 – after all, the children’s private school fees, the maid, the Pilates lessons etc all cost money. They economised by buying cheaper cuts of meat. In London, families deferred moves to more expensive suburbs. The latest Gordon Ramsay restaurant was no longer a must have.
The effects of belt-tightening were seen in a fall in bookings at luxury hotels, holiday resorts and sales of super yachts – some of the plutocrats were down to their last billion. Once rich hedge fund managers were back in court trying to renegotiate the terms of their divorce pleading ‘poverty’.
For some women, the aphrodisiac quality of a young unattached male purring “I’m an investment banker” in a certain type of bar lost its allure. Some professions – personal trainers, dog walkers, personal dressers, children's party organisers – were in danger of extinction.
There was a sense of Schadenfreude as the Masters of the Universe received their comeuppance. Unfortunately, the “financial” crisis quickly spread to the “real” economy – jobs, consumption, and investment- becoming everybody’s problem. “Too large to fail” financial institutions had to be bailed out by governments, that is the ordinary taxpayer. In a perverse piece of income redistribution, the less fortunate now were subsidising the masters of universe because it was in their best interest.
Commentators briefly dared hope that the power and influences of finance and financiers would be reduced. Finance would revert to being a facilitator rather than the central driver of the economy.
The Economist wrote: “Over the past 35 years it has seemed as if everyone in finance has wanted to be someone else. Hedge funds and private equity wanted to be as cool as a dot.com. Goldman Sachs wanted to be as smart as a hedge fund. The other investment banks wanted to be as profitable as Goldman Sachs. America's retail banks wanted to be as cutting-edge as investment banks. And European banks wanted to be as aggressive as American banks. They all ended up wishing they could be back precisely where they started.”
Unfortunately, those hopes are misplaced. Low or zero interest rates, heavily managed markets, reduced competition and state underwriting of solvency has helped surviving banks prosper.
Bank risk levels have increased to and in some cases beyond pre-crisis levels. The higher levels of risk taking reflect increasing comfort in central bank support of financial institution’s liquidity and their ability and willingness to intervene to limit price risks.
In 2008 in Canary Wharf, the financial district in London’s docklands, I meet two affable recruiters from the English Teachers Union who explained that there was “a bit of financial crisis”. Well-educated and highly motivated bankers who were losing their jobs by the thousands might like to consider a new career teaching. I questioned the adjustment in salaries that the change in careers would necessitate. One recruiter’s responded: “If you haven’t got a job then it’s not relevant is it? It was never real money and it wasn’t going to ever last was it?”
Over the last 30 years, talent has increasingly been lured from productive profession into finance and the speculative economy. The rewards available mean that the brain drain into these professions is unlikely to stop. The excesses of the financial economy are also unlikely to be easily tamed.
The Masters of the Universe that survived the carnage are back to their old tricks. The ‘fight for talent’ means that bonuses and remuneration guarantees for new employees are all back in vogue.
Government attempts to deal with the problems of the financial system, especially in the U.S.A., Great Britain and other countries, illustrate Mancur Olson’s thesis - small distributional coalitions tend to form over time in developed nations and influence policies in their favor through intensive, well funded lobbying. The resulting policies benefit the coalitions and its members but large costs borne by the rest of population.
The “finance government complex” (dubbed “Government Sachs” by its critics) and financiers have proved exquisite masters of the game of privatisation of profits and socialisation of losses. Many countries now practice Chinese socialism with Western characteristics.
A year after the collapse of Lehman, the near collapse of AIG and the grande mal seizure in financial markets, the Masters of the Universe are still firmly in charge. As Giuseppe di Lampedusa, author of The Leopard knew: “everything must change so that everything can stay the same.”
© 2009 Satyajit Das All Rights reserved.
Satyajit Das is a risk consultant and author of Traders, Guns & Money: Knowns and Unknowns in the Dazzling World of Derivatives (2006, FT-Prentice Hall).
http://www.wilmott.com/blogs/satyajitdas/
Human history is a sequence of “ations” – civilisation, industrialisation, urbanisation, globalisation interspersed with actual or threatened “annihilation”. The most recent “ation” is “financialisation” - the conversion of everything into monetary form (also known as another “ation” – “monetisation”).
New paper economies emerged directly from the demise of the gold standard that removed restrictions on the ability to create money, especially debt. Finance inexorably displaced industry with trading and speculation becoming major activities as financial engineering replaced real engineering. In an earlier age, Heinrich Heine, the German poet, too had identified the change: “Money is the God of our time….” The rise of financiers is intimately linked to this financialisation of the global economy.
Financial innovations such as securitisation (the packaging up and sale of loans) and derivatives (effectively risk insurance) enabled banks to extend more credit. Banks could literally by increasing throughput, making more loans and selling them off to eager investors, magically increase returns to their investors. Bankers had invented a ‘money machine’.
Bank also began to trade more actively with their shareholders money, following the advice of Fear of Flying author Erica Jong: “If you don’t risk anything then you risk even more”.
All of this, of course, meant increased earnings for the bank and its star performers. As people who work in financial institutions know, it is primarily an enterprise that is run for the employees with an afterthought for shareholders.
Sherman McCoy could with a single phone call make $50,000 and, even better, a share of that was his and his alone. At the height of the boom, top hedge fund and private managers could make more in 10 minutes than the average worker earned in an entire year. In 2007, James Simons of Renaissance Technologies earned $1.5 billion and David Rubinstein of The Carlyle Group earned $260 million in the ethereal “economic stratosphere.” In Australia, Macquarie Bank employees rejoiced in the sobriquet – the ‘Millionaires factory”.
The ability to earn high rewards only becomes a problem where the promise of a share of profits encourages excessive risk taking and a focus on short-term earnings. It also becomes a problem where the basic measure of performance is ambiguous and can be systematically manipulated. Unfortunately, ‘earnings’ proved to be the result of wildly inaccurate models, accounting tricks and risks that had not been accurately captured.
Finance is also problematic when it comes to dominate the economy. In the U.S.A., financial services’ share of total corporate profits increased from 10% in the early 1980s to 40% in 2007. The combined stock market value of these firms grew from 6% to 23% over the same period.
It is now conventional wisdom to accept the central role of financial services. Gordon Brown, the Chancellor of the Exchequer under Tony Blair and then Prime Minister, harboured secret dreams of a Scandinavian-style social welfare state with low taxes funded by the growth of the City. In 2007, he told bankers: “What you have achieved for the financial services we … now aspire to achieve for the whole of the British economy.” Alistair Darling, Gordon Brown successor as Chancellor, was no less loquacious describing financial services as “absolutely critical” to the economy.
The golden age seemed to come to an end with the GFC. Initially, the world viewed the destruction of storied financial institutions in Global Financial Crisis as an entertaining blood sport.
Some bankers lost their jobs by the thousands. Others lived with the psychological fear of firing by text message.
In New York, bankers confessed it was hard to live on less than $500,000 – after all, the children’s private school fees, the maid, the Pilates lessons etc all cost money. They economised by buying cheaper cuts of meat. In London, families deferred moves to more expensive suburbs. The latest Gordon Ramsay restaurant was no longer a must have.
The effects of belt-tightening were seen in a fall in bookings at luxury hotels, holiday resorts and sales of super yachts – some of the plutocrats were down to their last billion. Once rich hedge fund managers were back in court trying to renegotiate the terms of their divorce pleading ‘poverty’.
For some women, the aphrodisiac quality of a young unattached male purring “I’m an investment banker” in a certain type of bar lost its allure. Some professions – personal trainers, dog walkers, personal dressers, children's party organisers – were in danger of extinction.
There was a sense of Schadenfreude as the Masters of the Universe received their comeuppance. Unfortunately, the “financial” crisis quickly spread to the “real” economy – jobs, consumption, and investment- becoming everybody’s problem. “Too large to fail” financial institutions had to be bailed out by governments, that is the ordinary taxpayer. In a perverse piece of income redistribution, the less fortunate now were subsidising the masters of universe because it was in their best interest.
Commentators briefly dared hope that the power and influences of finance and financiers would be reduced. Finance would revert to being a facilitator rather than the central driver of the economy.
The Economist wrote: “Over the past 35 years it has seemed as if everyone in finance has wanted to be someone else. Hedge funds and private equity wanted to be as cool as a dot.com. Goldman Sachs wanted to be as smart as a hedge fund. The other investment banks wanted to be as profitable as Goldman Sachs. America's retail banks wanted to be as cutting-edge as investment banks. And European banks wanted to be as aggressive as American banks. They all ended up wishing they could be back precisely where they started.”
Unfortunately, those hopes are misplaced. Low or zero interest rates, heavily managed markets, reduced competition and state underwriting of solvency has helped surviving banks prosper.
Bank risk levels have increased to and in some cases beyond pre-crisis levels. The higher levels of risk taking reflect increasing comfort in central bank support of financial institution’s liquidity and their ability and willingness to intervene to limit price risks.
In 2008 in Canary Wharf, the financial district in London’s docklands, I meet two affable recruiters from the English Teachers Union who explained that there was “a bit of financial crisis”. Well-educated and highly motivated bankers who were losing their jobs by the thousands might like to consider a new career teaching. I questioned the adjustment in salaries that the change in careers would necessitate. One recruiter’s responded: “If you haven’t got a job then it’s not relevant is it? It was never real money and it wasn’t going to ever last was it?”
Over the last 30 years, talent has increasingly been lured from productive profession into finance and the speculative economy. The rewards available mean that the brain drain into these professions is unlikely to stop. The excesses of the financial economy are also unlikely to be easily tamed.
The Masters of the Universe that survived the carnage are back to their old tricks. The ‘fight for talent’ means that bonuses and remuneration guarantees for new employees are all back in vogue.
Government attempts to deal with the problems of the financial system, especially in the U.S.A., Great Britain and other countries, illustrate Mancur Olson’s thesis - small distributional coalitions tend to form over time in developed nations and influence policies in their favor through intensive, well funded lobbying. The resulting policies benefit the coalitions and its members but large costs borne by the rest of population.
The “finance government complex” (dubbed “Government Sachs” by its critics) and financiers have proved exquisite masters of the game of privatisation of profits and socialisation of losses. Many countries now practice Chinese socialism with Western characteristics.
A year after the collapse of Lehman, the near collapse of AIG and the grande mal seizure in financial markets, the Masters of the Universe are still firmly in charge. As Giuseppe di Lampedusa, author of The Leopard knew: “everything must change so that everything can stay the same.”
© 2009 Satyajit Das All Rights reserved.
Satyajit Das is a risk consultant and author of Traders, Guns & Money: Knowns and Unknowns in the Dazzling World of Derivatives (2006, FT-Prentice Hall).
http://www.wilmott.com/blogs/satyajitdas/
27 August 2009
Satyajit Das - China Syndrome ~ LNL audio
LNL's financial crisis analyst explains how the Chinese economic growth model developed under Deng Xiaoping, and the way China used its export income to invest in US dollars and US Treasury bonds. This meant that by the beginning of the 21st century China was effectively providing the funds for Americans to purchase Chinese products.
http://mpegmedia.abc.net.au/rn/podcast/2009/08/lnl_20090826_2205.mp3
http://mpegmedia.abc.net.au/rn/podcast/2009/08/lnl_20090826_2205.mp3
24 August 2009
Greed & The Other Seven Deadly Sins ~ Satyajit Das
The Das nails it again. Anyone with brains isn't hot on ideologies, dig. Hat tip, Jesse..
Greed & The Other Seven Deadly Sins!
Greed is back already, perhaps it never went away. On the back of revived earnings, compensation for star bankers is looking up. Even signing and guaranteed bonuses are stirring.
Excessive executive remuneration is widely viewed as a symptom of ‘greed’, one of the seven deadly sins.
For some, excessive pay contravenes ideas of ‘equality’. Bankers should be paid the same as a nurse who should be paid the same as a doctor.
This misunderstands the concept of equality. Anatole France observed: “The law, in its majestic equality, forbids the rich as well as the poor to sleep under bridges, to beg in the streets, and to steal bread.” It challenges concepts of motivating achievement through reward. Objective assessment of different contributions is also likely to prove difficult.
Concern about excessive pay also focuses on ‘allocation’; ‘who’ gets ‘what’. Mark Twain once admitted: “I am opposed to millionaires, but it would be dangerous to offer me the position.”
For others, the issue is ‘proportionality’; a chief executive’s reward is disproportionate to his or her contribution.
Tight, in-bred circles of directors and consultants determine senior executive salaries. ‘Benchmarking’ exercises merely reinforce the ‘norm’ with packages being justified as ‘needing to buy the best talent’ or ‘meeting the demands of a competitive market’. Results are also easily manipulated to meet specified performance hurdles for bonuses. Recent severance payments highlight that failure is better rewarded than success.
John Kenneth Galbraith identified this pattern long ago: “The salary of the chief executive of the large corporation is not a market award for achievement. It is frequently in the nature of a warm personal gesture by the individual to himself.”
But who is responsible? Many people are now shareholders, directly or through superannuation schemes. Critics ironically acquiesce in the award of generous senior executive packages. They either actively vote in favour of these contracts or fail to challenge the arrangements, as is their right.
There may be a double standard. Critics were willing to hand executive generous pay packets so those talented managers would make them richer. Many turned a blind eye to excesses when they became richer through higher share prices and dividends. George Orwell reminds us: “People sleep peaceably in their beds at night only because rough men stand ready to do violence on their behalf.”
Criticism of excessive remuneration packages ironically necessitates committing the other six deadly sins. Critics secretly perhaps ‘lust’ after the same riches that they are now censure. Their desire for increased wealth to fuel excess consumption – the sin of ‘gluttony’ – drives greed.
Critics are guilty of ‘sloth’ in their laziness in not exercising their power as shareholders to rein in compensation excesses. Critics may be guilty also of the sin of ‘wrath’ as they now indulge their righteous anger. They commit the sin of ‘envy’ as their stand may be merely resentment at those in the world who have done better.
Finally, critics are almost certainly guilty of ‘pride’, being conscious of their superiority in making their principled stand against greed.
In truth, critics are looking for scapegoats and simple answers to the losses suffered as a result of the Global Financial Crisis. This is evident in the return of large paydays as share prices have rebounded. John Stuart Mill cautioned: “Panics do not destroy capital; they merely reveal the extent to which it has been previously destroyed by its betrayal into hopelessly unproductive works”.
Excessive executive remuneration is not a simple matter of ‘greed’ but symptomatic of deeply flawed economic and social systems. In their classic 1933 book – The Modern Corporation and Private Property – Adolf Berle and Gardiner Means argued that companies were akin to feudal kingdoms run by “princes of industry” consistent with their own interests. Half a century later, directors and managers (with modest shareholdings) in conjunction with, for the most part, benign investment managers still run enterprises in a manner not always consistent with the interest of ‘absentee’ shareholders.
John Maynard Keynes was aware of this: “Capitalism is the astounding belief that the most wickedest of men will do the most wickedest of things for the greatest good of everyone.”
All systems are flawed. The real issue is their effectiveness. Unfortunately, as Keynes wrote: “The decadent international but individualistic capitalism in the hands of which we found ourselves …. is not a success. It is not intelligent. It is not beautiful. It is not just. It is not virtuous. And it doesn't deliver the goods.”
Genuine reform of executive remuneration requires understanding of the true problems and reforming the economic system rather than merely treating one of the symptoms.
© 2009 Satyajit Das
Satyajit Das is the author of ‘Traders, Guns & Money: Knowns and Unknowns in the Dazzling World of Derivative’. This article is based on a contribution to the Adelaide Festival of Ideas.
Greed & The Other Seven Deadly Sins!
Greed is back already, perhaps it never went away. On the back of revived earnings, compensation for star bankers is looking up. Even signing and guaranteed bonuses are stirring.
Excessive executive remuneration is widely viewed as a symptom of ‘greed’, one of the seven deadly sins.
For some, excessive pay contravenes ideas of ‘equality’. Bankers should be paid the same as a nurse who should be paid the same as a doctor.
This misunderstands the concept of equality. Anatole France observed: “The law, in its majestic equality, forbids the rich as well as the poor to sleep under bridges, to beg in the streets, and to steal bread.” It challenges concepts of motivating achievement through reward. Objective assessment of different contributions is also likely to prove difficult.
Concern about excessive pay also focuses on ‘allocation’; ‘who’ gets ‘what’. Mark Twain once admitted: “I am opposed to millionaires, but it would be dangerous to offer me the position.”
For others, the issue is ‘proportionality’; a chief executive’s reward is disproportionate to his or her contribution.
Tight, in-bred circles of directors and consultants determine senior executive salaries. ‘Benchmarking’ exercises merely reinforce the ‘norm’ with packages being justified as ‘needing to buy the best talent’ or ‘meeting the demands of a competitive market’. Results are also easily manipulated to meet specified performance hurdles for bonuses. Recent severance payments highlight that failure is better rewarded than success.
John Kenneth Galbraith identified this pattern long ago: “The salary of the chief executive of the large corporation is not a market award for achievement. It is frequently in the nature of a warm personal gesture by the individual to himself.”
But who is responsible? Many people are now shareholders, directly or through superannuation schemes. Critics ironically acquiesce in the award of generous senior executive packages. They either actively vote in favour of these contracts or fail to challenge the arrangements, as is their right.
There may be a double standard. Critics were willing to hand executive generous pay packets so those talented managers would make them richer. Many turned a blind eye to excesses when they became richer through higher share prices and dividends. George Orwell reminds us: “People sleep peaceably in their beds at night only because rough men stand ready to do violence on their behalf.”
Criticism of excessive remuneration packages ironically necessitates committing the other six deadly sins. Critics secretly perhaps ‘lust’ after the same riches that they are now censure. Their desire for increased wealth to fuel excess consumption – the sin of ‘gluttony’ – drives greed.
Critics are guilty of ‘sloth’ in their laziness in not exercising their power as shareholders to rein in compensation excesses. Critics may be guilty also of the sin of ‘wrath’ as they now indulge their righteous anger. They commit the sin of ‘envy’ as their stand may be merely resentment at those in the world who have done better.
Finally, critics are almost certainly guilty of ‘pride’, being conscious of their superiority in making their principled stand against greed.
In truth, critics are looking for scapegoats and simple answers to the losses suffered as a result of the Global Financial Crisis. This is evident in the return of large paydays as share prices have rebounded. John Stuart Mill cautioned: “Panics do not destroy capital; they merely reveal the extent to which it has been previously destroyed by its betrayal into hopelessly unproductive works”.
Excessive executive remuneration is not a simple matter of ‘greed’ but symptomatic of deeply flawed economic and social systems. In their classic 1933 book – The Modern Corporation and Private Property – Adolf Berle and Gardiner Means argued that companies were akin to feudal kingdoms run by “princes of industry” consistent with their own interests. Half a century later, directors and managers (with modest shareholdings) in conjunction with, for the most part, benign investment managers still run enterprises in a manner not always consistent with the interest of ‘absentee’ shareholders.
John Maynard Keynes was aware of this: “Capitalism is the astounding belief that the most wickedest of men will do the most wickedest of things for the greatest good of everyone.”
All systems are flawed. The real issue is their effectiveness. Unfortunately, as Keynes wrote: “The decadent international but individualistic capitalism in the hands of which we found ourselves …. is not a success. It is not intelligent. It is not beautiful. It is not just. It is not virtuous. And it doesn't deliver the goods.”
Genuine reform of executive remuneration requires understanding of the true problems and reforming the economic system rather than merely treating one of the symptoms.
© 2009 Satyajit Das
Satyajit Das is the author of ‘Traders, Guns & Money: Knowns and Unknowns in the Dazzling World of Derivative’. This article is based on a contribution to the Adelaide Festival of Ideas.
31 July 2009
GFC Cures – Placebo Effects ~ Satyajit Das
GFC Cures – Placebo Effects
PrintShare
Satyajit Das | Jul 29, 2009
Mixed Metaphors…
Botanical commentators are finding ‘green shoots’. The astronomically minded have seen ‘glimmers’. The meteorologically minded have spoken about the storms ‘abating’. Strong rallies in equity and debt markets have confirmed the recovery for the ‘true believers’. The Global Financial Crisis ("GFC") crisis is over!
It is useful to remember Winston Churchill’s observation after the British expeditionary force’s escape from Dunkirk: "[Britain] must be very careful not to assign to this deliverance the attributes of a victory". There may be confusion between ‘stabilisation’ and ‘recovery’.
The ‘green shoots’ theory is based on a slowdown in the rate of decline in key economic indicators, improvements in the financial system, unprecedented government support for the banking system, near-zero interest rates and large fiscal stimulus packages. The recovery of emerging markets and a renewed belief in Decoupling (Release 2.0) also underpin hopes of a swift return to growth.
Receiving the Messengers…
The puzzling thing is that real economy indicators continue to be poor. GDP forecasts for 2009 have steadily deteriorated with world growth expected to be negative 2.00 to 3.00% with especially poor prospects for Japan and the Euro Zone. Industrial output, employment, consumption, investment and global trade continue to be weak. Even China expected to grow between 6% and 8% in 2009 experienced a fall in exports of over 20% over the last year.
The ‘wealth effects’ of the GFC on economic activity are unclear. In the U.S. alone $30 trillion of value has been destroyed. Pension funds have lost anywhere between 20% and 50% of their value. Combined with declines in housing prices and reduced dividends and investment income, the sharp decline in wealth may not be yet to fully flow through into consumption.
The financial system has stabilised but not returned to the ‘rude good health’ that current executive compensation demands within banks would suggest.
Good results for Goldman Sachs and J.P.Morgan are offset by less impressive performances by Bank of America, CitiGroup and Morgan Stanley. The problems at CIT also highlight the problems for the financial system and the threat to availability of credit to small and medium sized businesses.
Profitability is patchy and reliant on risky trading income and large underwriting revenues from capital raisings by financial institutions and companies who are de-leveraging aggressively. Asset quality remains vulnerable to more bad debts from the normal recessionary credit cycle that is working through the economy.
Bank risk levels have increased to and in some cases beyond pre-crisis levels. Goldman Sach Q2 earnings showed an increase in risk levels as measured by Value-at-Risk ("VAR"). The increase in risk is probably understated as it takes into account diversification benefits that may be overstated under conditions of market stress. It is probably also understated because of assumption of trading liquidity that may be optimistic given recent experience. The higher levels of risk taking reflect increasing comfort in central bank support of financial institution’s liquidity and their ability and willingness to intervene to limit price risks
Capital remains scarce and bank balance sheets are at best not growing and at worst shrinking. Some estimates suggest that the bank capital shortfall could be in range of $1 to $2 trillion, equivalent to a credit contraction of around 20-30% from previous levels. Proposed bank regulations, primarily the increased levels of capital and lower permitted leverage, will also affect the ability of the financial system to extend credit.
The link between debt and economic growth is well established. The global economy probably needs around $4 to $5 of debt to create $1 of GDP growth. IMF researchers Tamin Bayoumi and Ola Melander, in a study of the economic impacts of an adverse shock to bank capital ((2008) "Credit Matters:Empirical Evidence on U.S. Macro-Financial Linkages" IMF Working Paper 08/169) found that in the U.S. a 1% point fall in Tier 1 risk-weighted capital ratios reduces real GDP by 1.5%. This means that global bank capital shortage may restrain credit creation thereby reducing economic activity and sustainable growth levels.
The impact of fiscal stimulus packages has been variable. In some jurisdictions, the payments have been saved or applied towards debt reduction rather than consumption. Targeted measures, such as the ‘cash for clunkers’ deals (cleverly packaged as ‘green’ environmental initiatives) have boosted immediate demand for cars but the long-term demand effects are unclear.
The multiplier effect of the fiscal initiatives is likely to be low. Major infrastructure initiatives will take time to implement. Few projects are ‘shovel ready’. The rate of return on government spending programs, some of which are politically motivated, is unclear. Government spending increasing capacity is likely to create problems in a world where many industries are operating with surplus capacity. Government bailout packages for various industries, such as the auto and housing industries, however well intentioned, are delaying much needed capacity adjustments and risk prolonging the problems.
The phoenix-like recovery in emerging markets is primarily driven by panicked government spending and loose monetary policies increasing available credit. Estimates suggest that around 6% of China’s growth of around 8% is attributable to government spending and increased bank lending.
The extraordinary increase in lending in China is fuelling unsustainable growth. In the first half of 2009, new loans totalled over $1 trillion. This compares to total loans for the full 2008 year of around $600 billion. Current lending is running at around three times 2008 levels and at a staggering 25% of China’s GDP. The combination of government spending and bank loans has resulted in sharp increases in fixed asset investments (over 30% up on 2008). Government incentives, in the form of rebates for purchases of high value durables such as cars and white goods, have also increased consumption (up 15% on 2008). Even Chinese government officials have admitted that the recovery is "unbalanced".
The increase in industrial production in the absence of real end demand for products could result in a rapid build up in inventory. The availability of credit is also fuelling rampant speculation in stocks, property and commodities. Estimates suggest that around 20-30% of new bank lending is finding it way into the stock market, in part driving up values.
The price rise in emerging market shares, debt and currencies also reflects a blind belief that anywhere must be safer and more promising than the U.S., Japan or Europe. This misses the point that these markets have a strong trading and export orientation or are external capital dependent. While some have bright long-term futures, they will need to make difficult and slow adjustments to their growth models to return to trend growth.
The recovery in emerging markets has, in turn, underpinned the recovery in commodity prices and economies dependent on natural resources. A significant part of this is inventory restocking but there is a speculative element. Availability of abundant and low cost bank finance combined with a deep seated fear of the long term prospects of U.S. Treasury bonds and the dollar has encouraged speculative stockpiling of certain commodities artificially boosting demand.
In reality, the global economy has, in all probability, entered a period of stability after a fairly big decline. Market sentiment seems to be shaped less by facts than the Doors’ song: "I've been down for so long, it feels like up to me."
Government Largesse…
A key risk remains the ability of governments to finance their burgeoning government deficits. A wretched combination of declining tax revenues, increased government spending to cushion the economy from recession and bailout packages for banks and other ‘worthies’ means that many countries face large and continuing budget deficits.
Even countries with relatively healthy ‘balance sheets’ such as Australia do not anticipate balancing their books for many years. If the problems of an aging population and unfunded liabilities such as public sector pensions, healthcare and social security arrangements are included, then the budgetary position looks considerably worse.
In 2009, total sovereign debt issues are expected to total over $5 trillion of which the U.S. alone will need to finance around $3 trillion. The increases in sovereign debt issuance are astonishing – U.S. around 300%, U.K. over 400%, Euro Zone around 50%. Government debt-to-GDP ratios for many developed countries are projected to reach and remain at levels in excess of 100%.
Overall government deficits in major economies through the recession are estimated to total around $10 trillion (around 27% of GDP of these economies). The work of economists Kenneth Rogoff and Carmen Reinhart on previous recessions suggests that the deficit estimates are conservative and the amount that will need to be financed will be between $15 trillion (40% of GDP) and $33 trillion (86% of GDP).
As a comparison, the total amount of global investment assets under management, according to one estimate is around $120 trillion. This provides some idea of the funding task ahead.
To date, sovereign debt issuance programs have been successful. There have been some auction problems (in Germany, U.K. and U.S.) but these have been manageable.
Long-term interest rates have risen sharply reflecting supply pressures. The U.S. 30 year rate has increased by around 1.50% p.a. since the start of 2009. Maturities have also shortened increasing the re-financing challenges ahead. Participation of central banks in the U.S. and the U.K. bonds, under their quantitative easing mandates, has helped keep interest rate rises down creating a somewhat artificial market.
A key issue over the coming months is the continued demand for increased sovereign debt issues. China, Japan and Europe historically have been major buyers of U.S. Treasury bonds. As their own fiscal position changes and their current account surplus shrinks, the ability of these investors to absorb the increased supply is unclear. China’s foreign exchange reserves are growing more slowly than before. China has continued to purchase U.S. Treasury bonds but some purchases represents a switch from U.S. Agency paper. As the U.S. has increased its issuance program, China’s purchases are now a smaller portion of the total.
In the best case the government debt issuance programs is accommodated but squeezes out other borrowers. In the worst case, governments find themselves unable to finance their deficits setting off a new stage of the GFC.
The markets ability to avoid consideration of these issues reflects Mark Twain’s observation that: "Ignorance more frequently begets confidence than does knowledge".
Withdrawal Method…
Given the size of the intervention, a key question is the timing of withdrawal of government support for the economy. Like the eponymous technique of contraception, it will need to be carefully timed.
The current apparent health of the financial system owes everything to wide-ranging government support. The ability of the banks to raise equity and debt is substantially underwritten by the "too-big-to-fail" doctrine. Profitability is supported by low and, in some cases, zero cost of deposits and a sharply upward sloping yield curve that creates significant earnings from borrowing short and lending long. Withdrawal of support may expose deep-seated and unresolved problems in the financial system.
Substantial quantities of structured securities are now held by central banks either as collateral for funding arrangements or through other innovative market support mechanisms. This has substantially increased the size of central bank balance sheets in the U.S., U.K and Europe.
It is not clear how and when these ‘temporary’ positions will be unwound. Attempts to create structures for repackaging these securities, such as the frequently touted but still to be implemented Public Private Investment Partnership ("PPIP") program, have enjoyed limited success. Untimely attempts by governments to liquidate these portfolios may be disruptive to fragile markets.
These securities may have to be held to maturity (sometimes over 10 years in the case of some Asset Backed Securities ("ABS")) and allowed to self liquidate from the underlying cash flows. The bloated central bank balance sheets may restrict policy flexibility significantly.
Government spending has been substituted for private consumption and investment. The deficits will ultimately necessitate a combination of increased taxation and reduced spending to correct this position.
Assume a country has government equal to 100% of its GDP. Assuming an interest rate of 5% p.a. and a GDP growth rate of 4% p.a., a 1% budget surplus is required to maintain debt at current levels. If the gap between interest rates and growth is greater, then the size of the required surplus is commensurately larger. In effect, it is unlikely that the present expansionary fiscal position can be sustained over a long period. The fiscal position of major economies may restrain growth.
Central bankers have tried to sooth markets about the timing and method of withdrawing life support. The cast consists of the same individuals who failed to identify or take actions to prevent the problems arising in the first place. The risk of policy errors cannot be discounted. Untimely or misjudged withdrawal of support may easily result in recovery interruptus.
Fundamental Truths…
Belief in the recovery story and sharp financial market rallies fail to recognise that little has actually changed since the GFC began. Fundamental failures have not been fully addressed. Writing in 1937 in Prosperity and Depression, Gotfried Haberler observed that: "The length and severity of depressions depend partly on the magnitude of the 'real' maladjustments, which developed during the preceding boom and partly on the aggravating monetary and credit conditions."
The required reduction in debt levels has not been completed. Increases in government debt have substantially offset reductions in private sector debt.
Instead of dealing with the problem of leverage, the debt has also merely been rolled forward through a variety of clever warehousing structures and the manipulation of accounting rules.
In a system that has excessive leverage, there are only two adjustment mechanisms. The value of assets supporting the debt and income available to service the borrowing can be increased, usually by inflation. The value of the debt can be reduced through writing it down to the real value of the assets.
Governments and central banks have gambled on inflation despite its social and economic costs. In reality, inflationary pressures in the global economy are not apparent. The rebound in energy and food costs has prevented deflation. The absence of demand, excess capacity, reduced credit creation and low velocity of money circulation may mean that it is dis-inflation or deflation that is the problem going forward.
There is now faith-based reliance on Governments’ ability to rescue the economy. Intervention has helped stabilise economic activity and the financial system but it improbable that government actions alone can prevent the necessary adjustment in debt levels and growth rates.
Government’s share of most developed economies is around 25-40% of GDP. It role in liberal democracies is limited by the fact that is fundamentally an intermediary, not dissimilar to a bank. It derives its resources through taxation from certain sectors of the economy and redirects it to other sectors. This means that its ability to control an economy has limits in the absence of nationalisation of all productive activity.
In the short run, governments can borrow or print money to augment its resources. Like all debt it borrows from tomorrow to pay for today. Quantitative easing (the now respectable name for ‘printing money’) also has limits unless governments are willing to risk hyper-inflation and the social dissolution of the Weimar Republic or Zimbabwe. While governments can influence an economy, they cannot completely reverse inevitable adjustments dictated by market forces.
Governments may also be impeding necessary adjustments. Rising government investment is increasing capacity in a world with stagnant demand and over-capacity in many sectors.
China’s current growth is being driven by government investment that is increasing capacity, which in the absence of sufficient domestic demand may be directed to exports increasing the global supply glut. Politically and socially motivated bailouts of national champions and strategic industries mean the necessary reductions in capacity through bankruptcy and corporate failure have not been allowed to happen.
There are even signs that the financial sector is rediscovering old habits. The government and taxpayer paid for return to profitability of major financial institutions and the return of remuneration levels to pre-crisis levels raises fundamental questions about whether any change has occurred. After the strong Q2 2009 earning report for the firm, David Viniar, Goldman Sach's chief financial officer told Bloomberg News that "Our model really never changed, we’ve said very consistently that our business model remained the same." Despite the egregious excesses, governments seem collectively to lack the will to reform the financial system to avoid the problems of the past.
In 2007, when the U.S. housing bubble collapsed, the satirical magazine The Onion demanded that the American people be given another bubble to speculate in. Their wish now appears to have granted.
Actions to stabilise the global economy seem only to have created ‘new’ bubbles – in government debt and emerging markets. Government actions seem to be primarily designed to ensuring continuation of the ponzi game. The only lesson learned is that no ponzi game can ever be allowed to stop.
As one anonymous saying states: "Never in the history of the world has there been a situation so bad that the government can't make it worse."
Global Questions
There is broad agreement that a key component of the GFC was the problem of global capital imbalances. A central feature was debt funded consumption by the U.S. that allowed 5% of the global population to constitute 25% of its GDP, 15% of consumption and 48% of global current account deficit. Japan, China, Germany and the other savers funded the consumption. At its peak, the U.S. was absorbing about 85% of total global capital flows to fund its government and private debt.
Any lasting solution to the GFC requires this imbalance to be dealt with. The glib solution requires the U.S. to save more and consume less and the savers to save less and consume more. The problems in implementing the solution are considerable.
Timothy Geithner’s recent discussion with Chinese officials, to assure his hosts of the safety of their investments in dollars and U.S. Treasury Bonds, reveals the dilemma. On the one hand, America needs the Chinese to continue and increase their purchase of U.S. Government debt to finance its fiscal stimulus and bailouts. On the other hand, America needs China to cut the size of its current account surplus, boost government spending, encourage personal consumption and reduce savings. All this should also occur ideally without any major decline in the value of the dollar or U.S. Treasury bonds or the need for China to liberalise it currency and open its capital account allowing internationalisation of the Renminbi!
A cursory look at the respective economies highlights the magnitude of the task. Consumption’s contribution to GDP in the U.S. is 71% while in China it is 37%. Given that the GDP of China is around $4-5 trillion versus $15 trillion for the U.S. and average income in China is around 10-15% of U.S. earnings, the difficulty of using Chinese consumption to drive the global economy becomes apparent.
Additionally, over the last 25 years, Chinese consumption has declined from around 50% to it current levels of 37%. During that same period, Chinese savings have risen and exports have been the engine for growth. Given that a significant portion of exports is driven ultimately by American buyer, lower U.S. growth and declining consumption creates significant challenges for China.
Dealing with these global imbalances has not been a high priority in the various summits, symposiums and talkfests that global leaders have shuttled to and from. The focus has been ‘NATO’ – no action talk only. Half-hearted and unworkable proposals, such as the use of the S.D.R as reserve currency, have emerged.
Bounding Mines….
Reliance on Chinese foreign currency reserves is probably misplaced. Chinese reserves, a large proportion denominated in dollars, may have limited value. They cannot be effectively liquidated or mobilised without massive losses. Increasingly strident Chinese rhetoric about the safety of their dollar assets reflects increasing ‘panic’.
The Middle Kingdom finds itself in a trap from which it probably cannot extricate itself easily. China’s position is like that of an unfortunate who has stepped on a type of anti-personnel mine known as a ‘bounding mine’. The mine does not explode when you step on it. Instead, it trips when you step off it as a small charge propels the body of the mine into the air where the explosive charge bursts and sprays fragmentation at a height of around 3 to 4 feet (1 to 1.3 metres).
China, in building and investing its massive foreign exchange reserves in dollars and U.S. Treasury Bonds, has stepped onto the mine and it cannot step off without serious damage! China’s position is akin to that of a soldier in the Balkan conflict who finds himself in precisely this position in the film No Man’s Land. Initially, he is the centre of attempts, including some by international bodies to free him but ultimately, he is abandoned to his fate.
In reality, China is trying desperately to switch its reserves into real assets – commodity or resource producers where foreign countries will allow. In the meantime, China continues to purchase more dollars and U.S. Treasury bond to preserve the value of existing holdings in a surreal logic. On the other side, the U.S. continues to seek to preserve the status of the dollar as the sole reserve currency (backed no longer by gold but by the 86th Airborne Division) in order to enable itself to finance itself. The intractable nature of this problem is evident in the frequently contradictory statements from various Chinese spokesman regarding the official position on the dollar.
In July 2009, at the G8 Summit in the earthquake damaged town of L'Aquila in Italy, Dai Bingguo, Chinese state councillor, was openly critical of the dominant role of the U.S. dollar as a global reserve currency: "We should have a better system for reserve currency issuance and regulation, so that we can maintain relative stability of major reserve currencies exchange rates and promote a diversified and rational international reserve currency system,"
Western leaders expressed concerns about even raising the issue fearing that discussion of long-term currency issues could undermine the recovery in markets and economies. Gordon Brown, Britain's prime minister, spoke on behalf of the West: "We don't want to give the impression that big change is around the corner and the present arrangements will be destabilised."
No sustainable global recovery is likely without addressing the fundamental global imbalances that lie at the heart of the GFC.
Placebo Effects
On 14 June 2009, Wolfgang Münchau writing in the Financial Times ("Optimism is not enough for a global recovery") eloquently summed up developments: "Instead of solving the problems to generate a recovery, the political strategies have consisted of waiting for a recovery to solve the problem. The Europeans are relying on the Americans to generate growth. The Americans are relying on the Chinese, who in turn are waiting for the rest of the world."
The placebo effect is a pervasive phenomenon in medicine. A sham medical intervention may cause the patient to believe that the treatment will change his or her condition sometime causing the actual condition to improve. Conditioning, expectations and motivation all can play a role in placebo effect.
In recent times, investors, markets and governments have all come to believe in the ‘recovery’ sometimes by selective interpretation of facts to support the conclusion that they need. Given reluctance or inability to deal with the real problems, it is not entirely clear whether the GFC cures are real or inert treatments. It is also not clear whether current improvements in market and economic conditions are sustainable or merely a short-term placebo effect.
© 2009 Satyajit Das All Rights reserved.
Satyajit Das is a risk consultant and author of Traders, Guns & Money: Knowns and Unknowns in the Dazzling World of Derivatives (2006, FT-Prentice Hall).
http://www.rgemonitor.com/globalmacro-monitor/257383/gfc_cures__placebo_effects
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Satyajit Das | Jul 29, 2009
Mixed Metaphors…
Botanical commentators are finding ‘green shoots’. The astronomically minded have seen ‘glimmers’. The meteorologically minded have spoken about the storms ‘abating’. Strong rallies in equity and debt markets have confirmed the recovery for the ‘true believers’. The Global Financial Crisis ("GFC") crisis is over!
It is useful to remember Winston Churchill’s observation after the British expeditionary force’s escape from Dunkirk: "[Britain] must be very careful not to assign to this deliverance the attributes of a victory". There may be confusion between ‘stabilisation’ and ‘recovery’.
The ‘green shoots’ theory is based on a slowdown in the rate of decline in key economic indicators, improvements in the financial system, unprecedented government support for the banking system, near-zero interest rates and large fiscal stimulus packages. The recovery of emerging markets and a renewed belief in Decoupling (Release 2.0) also underpin hopes of a swift return to growth.
Receiving the Messengers…
The puzzling thing is that real economy indicators continue to be poor. GDP forecasts for 2009 have steadily deteriorated with world growth expected to be negative 2.00 to 3.00% with especially poor prospects for Japan and the Euro Zone. Industrial output, employment, consumption, investment and global trade continue to be weak. Even China expected to grow between 6% and 8% in 2009 experienced a fall in exports of over 20% over the last year.
The ‘wealth effects’ of the GFC on economic activity are unclear. In the U.S. alone $30 trillion of value has been destroyed. Pension funds have lost anywhere between 20% and 50% of their value. Combined with declines in housing prices and reduced dividends and investment income, the sharp decline in wealth may not be yet to fully flow through into consumption.
The financial system has stabilised but not returned to the ‘rude good health’ that current executive compensation demands within banks would suggest.
Good results for Goldman Sachs and J.P.Morgan are offset by less impressive performances by Bank of America, CitiGroup and Morgan Stanley. The problems at CIT also highlight the problems for the financial system and the threat to availability of credit to small and medium sized businesses.
Profitability is patchy and reliant on risky trading income and large underwriting revenues from capital raisings by financial institutions and companies who are de-leveraging aggressively. Asset quality remains vulnerable to more bad debts from the normal recessionary credit cycle that is working through the economy.
Bank risk levels have increased to and in some cases beyond pre-crisis levels. Goldman Sach Q2 earnings showed an increase in risk levels as measured by Value-at-Risk ("VAR"). The increase in risk is probably understated as it takes into account diversification benefits that may be overstated under conditions of market stress. It is probably also understated because of assumption of trading liquidity that may be optimistic given recent experience. The higher levels of risk taking reflect increasing comfort in central bank support of financial institution’s liquidity and their ability and willingness to intervene to limit price risks
Capital remains scarce and bank balance sheets are at best not growing and at worst shrinking. Some estimates suggest that the bank capital shortfall could be in range of $1 to $2 trillion, equivalent to a credit contraction of around 20-30% from previous levels. Proposed bank regulations, primarily the increased levels of capital and lower permitted leverage, will also affect the ability of the financial system to extend credit.
The link between debt and economic growth is well established. The global economy probably needs around $4 to $5 of debt to create $1 of GDP growth. IMF researchers Tamin Bayoumi and Ola Melander, in a study of the economic impacts of an adverse shock to bank capital ((2008) "Credit Matters:Empirical Evidence on U.S. Macro-Financial Linkages" IMF Working Paper 08/169) found that in the U.S. a 1% point fall in Tier 1 risk-weighted capital ratios reduces real GDP by 1.5%. This means that global bank capital shortage may restrain credit creation thereby reducing economic activity and sustainable growth levels.
The impact of fiscal stimulus packages has been variable. In some jurisdictions, the payments have been saved or applied towards debt reduction rather than consumption. Targeted measures, such as the ‘cash for clunkers’ deals (cleverly packaged as ‘green’ environmental initiatives) have boosted immediate demand for cars but the long-term demand effects are unclear.
The multiplier effect of the fiscal initiatives is likely to be low. Major infrastructure initiatives will take time to implement. Few projects are ‘shovel ready’. The rate of return on government spending programs, some of which are politically motivated, is unclear. Government spending increasing capacity is likely to create problems in a world where many industries are operating with surplus capacity. Government bailout packages for various industries, such as the auto and housing industries, however well intentioned, are delaying much needed capacity adjustments and risk prolonging the problems.
The phoenix-like recovery in emerging markets is primarily driven by panicked government spending and loose monetary policies increasing available credit. Estimates suggest that around 6% of China’s growth of around 8% is attributable to government spending and increased bank lending.
The extraordinary increase in lending in China is fuelling unsustainable growth. In the first half of 2009, new loans totalled over $1 trillion. This compares to total loans for the full 2008 year of around $600 billion. Current lending is running at around three times 2008 levels and at a staggering 25% of China’s GDP. The combination of government spending and bank loans has resulted in sharp increases in fixed asset investments (over 30% up on 2008). Government incentives, in the form of rebates for purchases of high value durables such as cars and white goods, have also increased consumption (up 15% on 2008). Even Chinese government officials have admitted that the recovery is "unbalanced".
The increase in industrial production in the absence of real end demand for products could result in a rapid build up in inventory. The availability of credit is also fuelling rampant speculation in stocks, property and commodities. Estimates suggest that around 20-30% of new bank lending is finding it way into the stock market, in part driving up values.
The price rise in emerging market shares, debt and currencies also reflects a blind belief that anywhere must be safer and more promising than the U.S., Japan or Europe. This misses the point that these markets have a strong trading and export orientation or are external capital dependent. While some have bright long-term futures, they will need to make difficult and slow adjustments to their growth models to return to trend growth.
The recovery in emerging markets has, in turn, underpinned the recovery in commodity prices and economies dependent on natural resources. A significant part of this is inventory restocking but there is a speculative element. Availability of abundant and low cost bank finance combined with a deep seated fear of the long term prospects of U.S. Treasury bonds and the dollar has encouraged speculative stockpiling of certain commodities artificially boosting demand.
In reality, the global economy has, in all probability, entered a period of stability after a fairly big decline. Market sentiment seems to be shaped less by facts than the Doors’ song: "I've been down for so long, it feels like up to me."
Government Largesse…
A key risk remains the ability of governments to finance their burgeoning government deficits. A wretched combination of declining tax revenues, increased government spending to cushion the economy from recession and bailout packages for banks and other ‘worthies’ means that many countries face large and continuing budget deficits.
Even countries with relatively healthy ‘balance sheets’ such as Australia do not anticipate balancing their books for many years. If the problems of an aging population and unfunded liabilities such as public sector pensions, healthcare and social security arrangements are included, then the budgetary position looks considerably worse.
In 2009, total sovereign debt issues are expected to total over $5 trillion of which the U.S. alone will need to finance around $3 trillion. The increases in sovereign debt issuance are astonishing – U.S. around 300%, U.K. over 400%, Euro Zone around 50%. Government debt-to-GDP ratios for many developed countries are projected to reach and remain at levels in excess of 100%.
Overall government deficits in major economies through the recession are estimated to total around $10 trillion (around 27% of GDP of these economies). The work of economists Kenneth Rogoff and Carmen Reinhart on previous recessions suggests that the deficit estimates are conservative and the amount that will need to be financed will be between $15 trillion (40% of GDP) and $33 trillion (86% of GDP).
As a comparison, the total amount of global investment assets under management, according to one estimate is around $120 trillion. This provides some idea of the funding task ahead.
To date, sovereign debt issuance programs have been successful. There have been some auction problems (in Germany, U.K. and U.S.) but these have been manageable.
Long-term interest rates have risen sharply reflecting supply pressures. The U.S. 30 year rate has increased by around 1.50% p.a. since the start of 2009. Maturities have also shortened increasing the re-financing challenges ahead. Participation of central banks in the U.S. and the U.K. bonds, under their quantitative easing mandates, has helped keep interest rate rises down creating a somewhat artificial market.
A key issue over the coming months is the continued demand for increased sovereign debt issues. China, Japan and Europe historically have been major buyers of U.S. Treasury bonds. As their own fiscal position changes and their current account surplus shrinks, the ability of these investors to absorb the increased supply is unclear. China’s foreign exchange reserves are growing more slowly than before. China has continued to purchase U.S. Treasury bonds but some purchases represents a switch from U.S. Agency paper. As the U.S. has increased its issuance program, China’s purchases are now a smaller portion of the total.
In the best case the government debt issuance programs is accommodated but squeezes out other borrowers. In the worst case, governments find themselves unable to finance their deficits setting off a new stage of the GFC.
The markets ability to avoid consideration of these issues reflects Mark Twain’s observation that: "Ignorance more frequently begets confidence than does knowledge".
Withdrawal Method…
Given the size of the intervention, a key question is the timing of withdrawal of government support for the economy. Like the eponymous technique of contraception, it will need to be carefully timed.
The current apparent health of the financial system owes everything to wide-ranging government support. The ability of the banks to raise equity and debt is substantially underwritten by the "too-big-to-fail" doctrine. Profitability is supported by low and, in some cases, zero cost of deposits and a sharply upward sloping yield curve that creates significant earnings from borrowing short and lending long. Withdrawal of support may expose deep-seated and unresolved problems in the financial system.
Substantial quantities of structured securities are now held by central banks either as collateral for funding arrangements or through other innovative market support mechanisms. This has substantially increased the size of central bank balance sheets in the U.S., U.K and Europe.
It is not clear how and when these ‘temporary’ positions will be unwound. Attempts to create structures for repackaging these securities, such as the frequently touted but still to be implemented Public Private Investment Partnership ("PPIP") program, have enjoyed limited success. Untimely attempts by governments to liquidate these portfolios may be disruptive to fragile markets.
These securities may have to be held to maturity (sometimes over 10 years in the case of some Asset Backed Securities ("ABS")) and allowed to self liquidate from the underlying cash flows. The bloated central bank balance sheets may restrict policy flexibility significantly.
Government spending has been substituted for private consumption and investment. The deficits will ultimately necessitate a combination of increased taxation and reduced spending to correct this position.
Assume a country has government equal to 100% of its GDP. Assuming an interest rate of 5% p.a. and a GDP growth rate of 4% p.a., a 1% budget surplus is required to maintain debt at current levels. If the gap between interest rates and growth is greater, then the size of the required surplus is commensurately larger. In effect, it is unlikely that the present expansionary fiscal position can be sustained over a long period. The fiscal position of major economies may restrain growth.
Central bankers have tried to sooth markets about the timing and method of withdrawing life support. The cast consists of the same individuals who failed to identify or take actions to prevent the problems arising in the first place. The risk of policy errors cannot be discounted. Untimely or misjudged withdrawal of support may easily result in recovery interruptus.
Fundamental Truths…
Belief in the recovery story and sharp financial market rallies fail to recognise that little has actually changed since the GFC began. Fundamental failures have not been fully addressed. Writing in 1937 in Prosperity and Depression, Gotfried Haberler observed that: "The length and severity of depressions depend partly on the magnitude of the 'real' maladjustments, which developed during the preceding boom and partly on the aggravating monetary and credit conditions."
The required reduction in debt levels has not been completed. Increases in government debt have substantially offset reductions in private sector debt.
Instead of dealing with the problem of leverage, the debt has also merely been rolled forward through a variety of clever warehousing structures and the manipulation of accounting rules.
In a system that has excessive leverage, there are only two adjustment mechanisms. The value of assets supporting the debt and income available to service the borrowing can be increased, usually by inflation. The value of the debt can be reduced through writing it down to the real value of the assets.
Governments and central banks have gambled on inflation despite its social and economic costs. In reality, inflationary pressures in the global economy are not apparent. The rebound in energy and food costs has prevented deflation. The absence of demand, excess capacity, reduced credit creation and low velocity of money circulation may mean that it is dis-inflation or deflation that is the problem going forward.
There is now faith-based reliance on Governments’ ability to rescue the economy. Intervention has helped stabilise economic activity and the financial system but it improbable that government actions alone can prevent the necessary adjustment in debt levels and growth rates.
Government’s share of most developed economies is around 25-40% of GDP. It role in liberal democracies is limited by the fact that is fundamentally an intermediary, not dissimilar to a bank. It derives its resources through taxation from certain sectors of the economy and redirects it to other sectors. This means that its ability to control an economy has limits in the absence of nationalisation of all productive activity.
In the short run, governments can borrow or print money to augment its resources. Like all debt it borrows from tomorrow to pay for today. Quantitative easing (the now respectable name for ‘printing money’) also has limits unless governments are willing to risk hyper-inflation and the social dissolution of the Weimar Republic or Zimbabwe. While governments can influence an economy, they cannot completely reverse inevitable adjustments dictated by market forces.
Governments may also be impeding necessary adjustments. Rising government investment is increasing capacity in a world with stagnant demand and over-capacity in many sectors.
China’s current growth is being driven by government investment that is increasing capacity, which in the absence of sufficient domestic demand may be directed to exports increasing the global supply glut. Politically and socially motivated bailouts of national champions and strategic industries mean the necessary reductions in capacity through bankruptcy and corporate failure have not been allowed to happen.
There are even signs that the financial sector is rediscovering old habits. The government and taxpayer paid for return to profitability of major financial institutions and the return of remuneration levels to pre-crisis levels raises fundamental questions about whether any change has occurred. After the strong Q2 2009 earning report for the firm, David Viniar, Goldman Sach's chief financial officer told Bloomberg News that "Our model really never changed, we’ve said very consistently that our business model remained the same." Despite the egregious excesses, governments seem collectively to lack the will to reform the financial system to avoid the problems of the past.
In 2007, when the U.S. housing bubble collapsed, the satirical magazine The Onion demanded that the American people be given another bubble to speculate in. Their wish now appears to have granted.
Actions to stabilise the global economy seem only to have created ‘new’ bubbles – in government debt and emerging markets. Government actions seem to be primarily designed to ensuring continuation of the ponzi game. The only lesson learned is that no ponzi game can ever be allowed to stop.
As one anonymous saying states: "Never in the history of the world has there been a situation so bad that the government can't make it worse."
Global Questions
There is broad agreement that a key component of the GFC was the problem of global capital imbalances. A central feature was debt funded consumption by the U.S. that allowed 5% of the global population to constitute 25% of its GDP, 15% of consumption and 48% of global current account deficit. Japan, China, Germany and the other savers funded the consumption. At its peak, the U.S. was absorbing about 85% of total global capital flows to fund its government and private debt.
Any lasting solution to the GFC requires this imbalance to be dealt with. The glib solution requires the U.S. to save more and consume less and the savers to save less and consume more. The problems in implementing the solution are considerable.
Timothy Geithner’s recent discussion with Chinese officials, to assure his hosts of the safety of their investments in dollars and U.S. Treasury Bonds, reveals the dilemma. On the one hand, America needs the Chinese to continue and increase their purchase of U.S. Government debt to finance its fiscal stimulus and bailouts. On the other hand, America needs China to cut the size of its current account surplus, boost government spending, encourage personal consumption and reduce savings. All this should also occur ideally without any major decline in the value of the dollar or U.S. Treasury bonds or the need for China to liberalise it currency and open its capital account allowing internationalisation of the Renminbi!
A cursory look at the respective economies highlights the magnitude of the task. Consumption’s contribution to GDP in the U.S. is 71% while in China it is 37%. Given that the GDP of China is around $4-5 trillion versus $15 trillion for the U.S. and average income in China is around 10-15% of U.S. earnings, the difficulty of using Chinese consumption to drive the global economy becomes apparent.
Additionally, over the last 25 years, Chinese consumption has declined from around 50% to it current levels of 37%. During that same period, Chinese savings have risen and exports have been the engine for growth. Given that a significant portion of exports is driven ultimately by American buyer, lower U.S. growth and declining consumption creates significant challenges for China.
Dealing with these global imbalances has not been a high priority in the various summits, symposiums and talkfests that global leaders have shuttled to and from. The focus has been ‘NATO’ – no action talk only. Half-hearted and unworkable proposals, such as the use of the S.D.R as reserve currency, have emerged.
Bounding Mines….
Reliance on Chinese foreign currency reserves is probably misplaced. Chinese reserves, a large proportion denominated in dollars, may have limited value. They cannot be effectively liquidated or mobilised without massive losses. Increasingly strident Chinese rhetoric about the safety of their dollar assets reflects increasing ‘panic’.
The Middle Kingdom finds itself in a trap from which it probably cannot extricate itself easily. China’s position is like that of an unfortunate who has stepped on a type of anti-personnel mine known as a ‘bounding mine’. The mine does not explode when you step on it. Instead, it trips when you step off it as a small charge propels the body of the mine into the air where the explosive charge bursts and sprays fragmentation at a height of around 3 to 4 feet (1 to 1.3 metres).
China, in building and investing its massive foreign exchange reserves in dollars and U.S. Treasury Bonds, has stepped onto the mine and it cannot step off without serious damage! China’s position is akin to that of a soldier in the Balkan conflict who finds himself in precisely this position in the film No Man’s Land. Initially, he is the centre of attempts, including some by international bodies to free him but ultimately, he is abandoned to his fate.
In reality, China is trying desperately to switch its reserves into real assets – commodity or resource producers where foreign countries will allow. In the meantime, China continues to purchase more dollars and U.S. Treasury bond to preserve the value of existing holdings in a surreal logic. On the other side, the U.S. continues to seek to preserve the status of the dollar as the sole reserve currency (backed no longer by gold but by the 86th Airborne Division) in order to enable itself to finance itself. The intractable nature of this problem is evident in the frequently contradictory statements from various Chinese spokesman regarding the official position on the dollar.
In July 2009, at the G8 Summit in the earthquake damaged town of L'Aquila in Italy, Dai Bingguo, Chinese state councillor, was openly critical of the dominant role of the U.S. dollar as a global reserve currency: "We should have a better system for reserve currency issuance and regulation, so that we can maintain relative stability of major reserve currencies exchange rates and promote a diversified and rational international reserve currency system,"
Western leaders expressed concerns about even raising the issue fearing that discussion of long-term currency issues could undermine the recovery in markets and economies. Gordon Brown, Britain's prime minister, spoke on behalf of the West: "We don't want to give the impression that big change is around the corner and the present arrangements will be destabilised."
No sustainable global recovery is likely without addressing the fundamental global imbalances that lie at the heart of the GFC.
Placebo Effects
On 14 June 2009, Wolfgang Münchau writing in the Financial Times ("Optimism is not enough for a global recovery") eloquently summed up developments: "Instead of solving the problems to generate a recovery, the political strategies have consisted of waiting for a recovery to solve the problem. The Europeans are relying on the Americans to generate growth. The Americans are relying on the Chinese, who in turn are waiting for the rest of the world."
The placebo effect is a pervasive phenomenon in medicine. A sham medical intervention may cause the patient to believe that the treatment will change his or her condition sometime causing the actual condition to improve. Conditioning, expectations and motivation all can play a role in placebo effect.
In recent times, investors, markets and governments have all come to believe in the ‘recovery’ sometimes by selective interpretation of facts to support the conclusion that they need. Given reluctance or inability to deal with the real problems, it is not entirely clear whether the GFC cures are real or inert treatments. It is also not clear whether current improvements in market and economic conditions are sustainable or merely a short-term placebo effect.
© 2009 Satyajit Das All Rights reserved.
Satyajit Das is a risk consultant and author of Traders, Guns & Money: Knowns and Unknowns in the Dazzling World of Derivatives (2006, FT-Prentice Hall).
http://www.rgemonitor.com/globalmacro-monitor/257383/gfc_cures__placebo_effects
5 July 2009
GFC Plot Lines! ~ Satyajit Das
One is tired of the conventional blame finding and finger pointing from the likes of Puplava, Andros and others who rant in upper case about the evil of socialism and excessive intervention, which in the context of global dollar hegemony is kinda like aquarium fish saying that instead of the owner picking winners, they should compete fairly for the food flakes. That is; talking about the ideology of schooling forgetting that the tank and heaters are what really sustained the ecology and context in which they debate the largely mythological rationales for their preferred order...when thermodynamics might be a better bet.
I got interested in the subject and somehow acquired in five years of research the courage to come to grips with who and what I was and the tools to find that secure center from which all right action can flow and take it from me, that was hard.
By finding your authentic self first your less likely to be misdirected.
Humour, humility and some understanding of the complexities are likely to be a more fruitfull base for any success. I've wandered away from my point which is that Das has the light touch I like.
The number of books on the Global Financial Crisis (GFC) has reached pandemic proportions - the World Health Organisation (WHO) is investigating. With the decorum of vultures at a carcass, publishers are cashing in on the transitory interest of the masses (normally obsessed with war, scandal or reality TV shows) in the arcane minutiae of financial matters.
Authors, the slave labour in the system, have to “innovate” to differentiate their work from those of others. Upon being asked for the nth time about his latest work, an exasperated playwright is supposed to have barked: “Of the 32 possible plots in drama, this is number 19!” In the case of the GFC, all 32 plots have been featured, sometimes in the same work, or even more worryingly in the title.
In Greek mythology, Apollo gives the beautiful Cassandra the gift of prophecy. Later, the spurned Apollo, “Cass”, it seems, did not return his advances, cursed her so that no one would ever believe her predictions. Kevin Phillips’ “Bad Money: Reckless Finance, Failed Politics and the Global Crisis of American Capitalism” and Barry Ritholtz’s “Bailout Nation: How Greed and Easy Money Corrupted Wall Street and Shook the World Economy” are “Cassandra books”.
There has been “bad dreams”, “bad love” so why not “bad money” – shorthand for excessive dependence on mega-finance to drive economies. Veteran commentator Kevin Phillips warns of the consequences of U.S. economic policy, addiction to debt and its dependence on imported oil. Published prior to the onset of the crisis, Mr. Phillips presciently anticipates some of the key issues in the GFC. “Bad Money” does not further the case that the author made in his previous works such as “American Theocracy” but repeats and updates the argument. Cassandra too seemed to frequently repeat her warnings to no avail.
Barry Ritholtz is the epitome of new financial renaissance. A prolific blogger, his site, www.ritholtz.com, is hugely popular (at least, that’s what the site says!). Multi-talented, he is also the CEO and Director of Equity Research at FusionIQ and obligatory media star, appearing frequently on the money channels. One of the editorial reviews of “Bailout Nation” states that it anticipated the great credit crash of 2008. While Mr. Ritholtz may have seen it coming, the book suffers from the disadvantage that it was published in 2009, someway into the GFC.
Notwithstanding any timing issues, “Bailout Nation” (the title is a self conscious reference to “Prozac Nation”) provides a series of well practised rants about the transition of the U.S. from free markets to a form of socialism where the government bails out troubled firms. At times entertaining and never less than forthright in its opinions, the book makes similar arguments as Mr. Phillips and also identifies the familiar list of the “evil villains” responsible for this tragedy - from financial regulators to politicians. “Bailout Nation” provides an interesting history of U.S. Government intervention in the free markets commencing with Lockheed in the 1970s, in banking in the early 1990s, and eventually the entire market in 2000/ 2001 and in 2008.
The polemic arguments of “Bad Money” and “Bailout Nations” themselves are perhaps not as clear as they might appear at first glance. Surely, government have a role in modern economies. Debt also has utility if used sensibly. The build up of debt in the U.S., especially government debt, may seem egregious but Japan’s level of government debt relative to GDP far exceeds that of the US. In addition, the world, especially emerging markets, has relied on U.S. growth to pull itself up from previous recessions and as the basis of economic development. In the final analysis, it may be that the fate that the authors are trying to avoid is the final evolution of all dominant economic powers, a fact borne out by a study of a longer stretch of history than the last 20 years.
Vast generalised overviews of the GFC suitable to the soapbox or pulpit run the risk of simplifying a complex, highly nuanced problem where there are no real heroes or villains just pervasive societal fallibility. As Woody Allen once observed in “My Speech to the Graduates”: “More than any other time in history, mankind faces a crossroads. One path leads to despair and utter hopelessness. The other, to total extinction. Let us pray we have the wisdom to choose correctly.”
Amusingly, the number of people who anticipated the crisis seems to be increasing in direct proportion to the gravity of the crisis. Undoubtedly, Messrs. Philipps and Ritholz “saw it coming” as their publicity says frequently. The question is what did they see and the precision of their prognostications. Cassandra did foresee trouble in Troy focused around a horse. Given the prevalence of equine forms of transport this did not, without further information, prove to be of much use.
Other books have resorted to Pointillism, a style of painting where small distinct dots of colour are used to create the impression of other colours and the depicted image. Several books tackle specific stories relating to the crisis, using the specific to draw inferences about the broader issues.
“House of Cards: How Wall Street’s Gamblers Broke Capitalism” tackles the demise of Bear Stearns. The author, William Cohan, who wrote the prize winning and acclaimed “The Last Tycoons” (the history of Lazard Freres), was big news with the financial deal for this book (as the jacket reminds us).
“House of Cards” is a well written and detailed history of Bear Stearns built around its dominant chief executive Jimmy Cayne. Ironically, “The Lost Tycoons” too was constructed around Lazards famous “big men” – Andre Meyer and Felix Rohatyn. The story is told meticulously and fairly. The book provides some interesting insights into the goings on in major investment banks in the 1990s.
In “Fools” Gold: How Unstrained Greed Corrupted A Dream, Shattered Global Markets and Unleashed A Catastrophe”, Gillian Tett, award winning Financial Times journalist and author of “SavingThe Sun” (a best selling history of the demise of Long Tern Credit Bank of Japan), writes about J.P.Morgan’s role in creating credit derivatives.
Given the role of derivatives generally, and credit derivatives specifically, the subject is immediately relevant. Ms. Tett’s admirable history records the process by which these innovations emerged and how the attempt to disperse credit risk by banks to investors ended up making the financial system more not less dangerous. Ms. Tett, whose journalistic offensives are both legendary and much feared, uses her anthropology training to focus on the human dimension of the story.
Many books on the GFC have sought to identify “heroes” and “villains” – a process that is fraught with problems. Amey Stone and Mike Brewster’s “King of Capital: Sandy Weill and the Making of CitGroup” amply illustrates this risk. In this solid and through book published earlier this decade, the authors focus on Weill the powerful dealer maker in the process of building Citi. Unfortunately, the rather hagiographic view proved unsustainable as the GFC humbled the once dominant institution. Time it seems makes chumps out of all of us in some way or another.
The previous three books are based on extensive interviews with the protagonists. This also creates a minor problem in that it is unclear as to whose version of history we are being presented. As Sir Winston Churchill noted: “History will be kind to me for I intend to write it.”
Charles Morris’ previous book “The Two Trillion Dollar Loss” remains amongst the most successful books on the GFC (both commercially and critically). In “The Sages: Warren Buffett, George Soros, Paul Volcker, and the Maelstrom of Markets”, Mr. Morris focuses on the heroes of the crisis. He chooses Buffett, Soros and Volcker, three quite different individuals whose scepticism of the norm and crowd behaviour has served them well.
Buffet is shown as a canny stock selector with a clear reluctance to be herd driven. Soros is portrayed as mercurial - both a creature and questioner of markets. Volcker is seen as the self-sacrificing but shrewd regulator with a deep sense of public service. Perhaps, these three have the fairest claim to having been the Cassandras that foresaw the GFC. Certainly, Soros made a lot of money of it.
Mr. Morris’ analysis of the records of all three is fair and interesting. A worrying aspect of being elected a sage is the likely after effect. In Australia, recipients of a business award have inevitable encountered trouble shortly after being awarded the prize. Some of been fired, some have gone bankrupt and a few have ended up in Her Majesty’s prison.
There is, of course, always the grand history, for example. Thucydides’ History of the Peloponnesian Wars. In “Chasing Alpha: How Reckless Growth and Unchecked Ambition Ruined The City’s Golden Decade”, Philip Augar delivers the third instalment in his remarkable history of U.K. investment banking that started with “The Death of Gentlemanly Capitalism” and continued with “The Greed Merchants: How the Investment Banks Played the Free Market”.
A trained historian who stumbled into stockbroking simply because he was unable to find work in his expertise, Mr. Augar writes brilliantly about what he knows – the evolution of the equity, corporate finance and investment banking business in the City of London from the 1980s to the present day. Drawing on his intimate knowledge of the firms and personalities (he was one of them), Mr. Augar paints an extraordinarily detailed picture of the factors that drove the changes in the business – specifically the demise of the U.K. Merchant banks, the rise of the U.S. integrated investment banking model and the road to the GFC. As an ultimate insider, he provides insights and analysis rarely ever found in the public domain.
“House of Cards”, “Fool’s Gold”, “King of Capital”, “The Sages” and “Chasing Alpha” despite their absurdly elongated sub titles (the subtitle is now, it seems, the message) are valuable historical records that will be useful to those who ultimately attempt more comprehensive analysis of the GFC.
© 2009 Satyajit Das
Satyajit Das is a risk consultant and author of Traders, Guns & Money: Knowns and Unknowns in the Dazzling World of Derivatives (2006, FT-Prentice Hall).
http://www.wilmott.com/blogs/satyajitdas/
I got interested in the subject and somehow acquired in five years of research the courage to come to grips with who and what I was and the tools to find that secure center from which all right action can flow and take it from me, that was hard.
By finding your authentic self first your less likely to be misdirected.
Humour, humility and some understanding of the complexities are likely to be a more fruitfull base for any success. I've wandered away from my point which is that Das has the light touch I like.
The number of books on the Global Financial Crisis (GFC) has reached pandemic proportions - the World Health Organisation (WHO) is investigating. With the decorum of vultures at a carcass, publishers are cashing in on the transitory interest of the masses (normally obsessed with war, scandal or reality TV shows) in the arcane minutiae of financial matters.
Authors, the slave labour in the system, have to “innovate” to differentiate their work from those of others. Upon being asked for the nth time about his latest work, an exasperated playwright is supposed to have barked: “Of the 32 possible plots in drama, this is number 19!” In the case of the GFC, all 32 plots have been featured, sometimes in the same work, or even more worryingly in the title.
In Greek mythology, Apollo gives the beautiful Cassandra the gift of prophecy. Later, the spurned Apollo, “Cass”, it seems, did not return his advances, cursed her so that no one would ever believe her predictions. Kevin Phillips’ “Bad Money: Reckless Finance, Failed Politics and the Global Crisis of American Capitalism” and Barry Ritholtz’s “Bailout Nation: How Greed and Easy Money Corrupted Wall Street and Shook the World Economy” are “Cassandra books”.
There has been “bad dreams”, “bad love” so why not “bad money” – shorthand for excessive dependence on mega-finance to drive economies. Veteran commentator Kevin Phillips warns of the consequences of U.S. economic policy, addiction to debt and its dependence on imported oil. Published prior to the onset of the crisis, Mr. Phillips presciently anticipates some of the key issues in the GFC. “Bad Money” does not further the case that the author made in his previous works such as “American Theocracy” but repeats and updates the argument. Cassandra too seemed to frequently repeat her warnings to no avail.
Barry Ritholtz is the epitome of new financial renaissance. A prolific blogger, his site, www.ritholtz.com, is hugely popular (at least, that’s what the site says!). Multi-talented, he is also the CEO and Director of Equity Research at FusionIQ and obligatory media star, appearing frequently on the money channels. One of the editorial reviews of “Bailout Nation” states that it anticipated the great credit crash of 2008. While Mr. Ritholtz may have seen it coming, the book suffers from the disadvantage that it was published in 2009, someway into the GFC.
Notwithstanding any timing issues, “Bailout Nation” (the title is a self conscious reference to “Prozac Nation”) provides a series of well practised rants about the transition of the U.S. from free markets to a form of socialism where the government bails out troubled firms. At times entertaining and never less than forthright in its opinions, the book makes similar arguments as Mr. Phillips and also identifies the familiar list of the “evil villains” responsible for this tragedy - from financial regulators to politicians. “Bailout Nation” provides an interesting history of U.S. Government intervention in the free markets commencing with Lockheed in the 1970s, in banking in the early 1990s, and eventually the entire market in 2000/ 2001 and in 2008.
The polemic arguments of “Bad Money” and “Bailout Nations” themselves are perhaps not as clear as they might appear at first glance. Surely, government have a role in modern economies. Debt also has utility if used sensibly. The build up of debt in the U.S., especially government debt, may seem egregious but Japan’s level of government debt relative to GDP far exceeds that of the US. In addition, the world, especially emerging markets, has relied on U.S. growth to pull itself up from previous recessions and as the basis of economic development. In the final analysis, it may be that the fate that the authors are trying to avoid is the final evolution of all dominant economic powers, a fact borne out by a study of a longer stretch of history than the last 20 years.
Vast generalised overviews of the GFC suitable to the soapbox or pulpit run the risk of simplifying a complex, highly nuanced problem where there are no real heroes or villains just pervasive societal fallibility. As Woody Allen once observed in “My Speech to the Graduates”: “More than any other time in history, mankind faces a crossroads. One path leads to despair and utter hopelessness. The other, to total extinction. Let us pray we have the wisdom to choose correctly.”
Amusingly, the number of people who anticipated the crisis seems to be increasing in direct proportion to the gravity of the crisis. Undoubtedly, Messrs. Philipps and Ritholz “saw it coming” as their publicity says frequently. The question is what did they see and the precision of their prognostications. Cassandra did foresee trouble in Troy focused around a horse. Given the prevalence of equine forms of transport this did not, without further information, prove to be of much use.
Other books have resorted to Pointillism, a style of painting where small distinct dots of colour are used to create the impression of other colours and the depicted image. Several books tackle specific stories relating to the crisis, using the specific to draw inferences about the broader issues.
“House of Cards: How Wall Street’s Gamblers Broke Capitalism” tackles the demise of Bear Stearns. The author, William Cohan, who wrote the prize winning and acclaimed “The Last Tycoons” (the history of Lazard Freres), was big news with the financial deal for this book (as the jacket reminds us).
“House of Cards” is a well written and detailed history of Bear Stearns built around its dominant chief executive Jimmy Cayne. Ironically, “The Lost Tycoons” too was constructed around Lazards famous “big men” – Andre Meyer and Felix Rohatyn. The story is told meticulously and fairly. The book provides some interesting insights into the goings on in major investment banks in the 1990s.
In “Fools” Gold: How Unstrained Greed Corrupted A Dream, Shattered Global Markets and Unleashed A Catastrophe”, Gillian Tett, award winning Financial Times journalist and author of “SavingThe Sun” (a best selling history of the demise of Long Tern Credit Bank of Japan), writes about J.P.Morgan’s role in creating credit derivatives.
Given the role of derivatives generally, and credit derivatives specifically, the subject is immediately relevant. Ms. Tett’s admirable history records the process by which these innovations emerged and how the attempt to disperse credit risk by banks to investors ended up making the financial system more not less dangerous. Ms. Tett, whose journalistic offensives are both legendary and much feared, uses her anthropology training to focus on the human dimension of the story.
Many books on the GFC have sought to identify “heroes” and “villains” – a process that is fraught with problems. Amey Stone and Mike Brewster’s “King of Capital: Sandy Weill and the Making of CitGroup” amply illustrates this risk. In this solid and through book published earlier this decade, the authors focus on Weill the powerful dealer maker in the process of building Citi. Unfortunately, the rather hagiographic view proved unsustainable as the GFC humbled the once dominant institution. Time it seems makes chumps out of all of us in some way or another.
The previous three books are based on extensive interviews with the protagonists. This also creates a minor problem in that it is unclear as to whose version of history we are being presented. As Sir Winston Churchill noted: “History will be kind to me for I intend to write it.”
Charles Morris’ previous book “The Two Trillion Dollar Loss” remains amongst the most successful books on the GFC (both commercially and critically). In “The Sages: Warren Buffett, George Soros, Paul Volcker, and the Maelstrom of Markets”, Mr. Morris focuses on the heroes of the crisis. He chooses Buffett, Soros and Volcker, three quite different individuals whose scepticism of the norm and crowd behaviour has served them well.
Buffet is shown as a canny stock selector with a clear reluctance to be herd driven. Soros is portrayed as mercurial - both a creature and questioner of markets. Volcker is seen as the self-sacrificing but shrewd regulator with a deep sense of public service. Perhaps, these three have the fairest claim to having been the Cassandras that foresaw the GFC. Certainly, Soros made a lot of money of it.
Mr. Morris’ analysis of the records of all three is fair and interesting. A worrying aspect of being elected a sage is the likely after effect. In Australia, recipients of a business award have inevitable encountered trouble shortly after being awarded the prize. Some of been fired, some have gone bankrupt and a few have ended up in Her Majesty’s prison.
There is, of course, always the grand history, for example. Thucydides’ History of the Peloponnesian Wars. In “Chasing Alpha: How Reckless Growth and Unchecked Ambition Ruined The City’s Golden Decade”, Philip Augar delivers the third instalment in his remarkable history of U.K. investment banking that started with “The Death of Gentlemanly Capitalism” and continued with “The Greed Merchants: How the Investment Banks Played the Free Market”.
A trained historian who stumbled into stockbroking simply because he was unable to find work in his expertise, Mr. Augar writes brilliantly about what he knows – the evolution of the equity, corporate finance and investment banking business in the City of London from the 1980s to the present day. Drawing on his intimate knowledge of the firms and personalities (he was one of them), Mr. Augar paints an extraordinarily detailed picture of the factors that drove the changes in the business – specifically the demise of the U.K. Merchant banks, the rise of the U.S. integrated investment banking model and the road to the GFC. As an ultimate insider, he provides insights and analysis rarely ever found in the public domain.
“House of Cards”, “Fool’s Gold”, “King of Capital”, “The Sages” and “Chasing Alpha” despite their absurdly elongated sub titles (the subtitle is now, it seems, the message) are valuable historical records that will be useful to those who ultimately attempt more comprehensive analysis of the GFC.
© 2009 Satyajit Das
Satyajit Das is a risk consultant and author of Traders, Guns & Money: Knowns and Unknowns in the Dazzling World of Derivatives (2006, FT-Prentice Hall).
http://www.wilmott.com/blogs/satyajitdas/
1 June 2009
The Finance-Government Complex & The End of U.S. Economic Dominance ~ Satyajit Das
Satyajit Das is a bright lucid star amid dim professional optimists....
Banks remain in the ICU (intensive care unit). Even after around $900 billion in new capital, the global banking system remains short of capital by around $1-2 trillion. This translates into an effective reduction in available credit of around 20-30% from previous levels.
Recent excitement about the "stress tests" of U.S. banks misses an essential point. At best if you accept the premises of the test, the risk of failure of these institutions is much reduced. But the banks’ ability to support lending levels that prevailed in say 2007 has not been restored. In short, the "credit crunch" or shortage of borrowing will continue for a prolonged period.
The financial system will need continued government support for some time to come. The performance of governments trying to rehabilitate the financial system has been problematic. Increasingly, government officials have become focused on “reassuring” the public and maintaining “confidence”. The “political spin” has dominated substance. Many government proposals are “stillborn”; for example, progress on the famed Public Private Investment Partnership (“PPIP”) has been painfully slow.
In April 2009, Elizabeth Warren, Chairperson of the TARP Oversight Panel Report questioned the very approach to resolving the problems of the financial system: “Six months into the existence of TARP, evidence of success or failure is mixed. One key assumption that underlies Treasury’s [PPIP] approach is its belief that the system-wide deleveraging resulting from the decline in asset values, leading to an accompanying drop in net wealth across the country, is in large part the product of temporary liquidity constraints resulting from non-functioning markets for troubled assets. On the other hand, it is possible that Treasury’s approach fails to acknowledge the depth of the current downturn and the degree to which the low valuation of troubled assets accurately reflects their worth.”
Richard Neiman (New York State Superintendent of Banks) and John Sununu (former New Hampshire Senator), two other panel members, issued dissenting findings noting: “We are concerned that the prominence of alternate approaches presented in the report, particularly reorganization through nationalization, could incorrectly imply both that the banking system is insolvent and that the new administration does not have a workable plan.” Many would question the selection of the words “incorrectly imply”.
Constant changes do not suggest a consistent and well thought out strategy in dealing with the problems. Less than rigorous stress tests, using taxpayers monies in different guises provide lopsided subsidies for private investors to buy distressed assets with minimal risk or converting preferred stock into shares to avoid having to seek additional congressional mandates suggest a highly politicised and ideological approach. One online commentator noted the intersection between Wall Street, Constitution Avenue and Main Street was best named: “Confusion Corner”.
Suggestions of political influence and a palpable lack of transparency are emerging. There are allegations that the Henry Paulson, the previous U.S. Treasury Secretary, may have “pushed” Bank of America to consummate its controversial acquisition of Merrill Lynch when it sought to withdraw after additional losses came to light. Certainly, the purchase of Merrill Lynch does not fit comfortably with Ken Lewis’ (Bank of America’s Chairman) earlier statement that “he had just about as much fun in investment banking as he could take”.
The Treasury secretary is alleged to have suggested that Bank of America’s management and board could be removed if it did not proceed. There are also suggestions that both the Treasury and Bank of America decided to avoid public disclosure of these events.
The appointment of Timothy Giethner and Larry Summers initially was viewed favourably. The feeling was that “they knew where the bodies were buried”. Critics pointed out that this was because they may have put them there! The “closeness” between banks and government officials and regulators that is being exposed daily is increasingly part of the problem in dealing with the real issues.
Mancur Olson, the American economist, in his books (The Logic of Collective Action and The Rise and Decline of Nations), speculated that small distributional coalitions tend to form over time in developed nations and influence policies in their favor through intensive, well funded lobbying. The policies result in benefits for the coalitions and its members but large costs borne by the rest of population. Over time, the incentive structure means that more distributional coalitions accumulate burdening and ultimately paralysing the economic system causing inevitable and irretrievable economic decline.
Government attempts to deal with the problems of the financial system, especially in the U.S.A., Great Britain and other countries, may illustrate Olson’s thesis. Active well funded lobbying efforts and “regulatory capture” is impeding necessary actions to make needed changes in the financial system. For example, the Centre of Public Integrity reported that the expenditure on lobbying and political contribution of the top 25 sub-prime mortgage originators, most linked to large U.S. banks, was around $380 million (the Economist (9 May 2009).
Larry Summers, an uncompromising advocate of deregulation and liberalization blamed the Asian crisis, in part, on “crony capitalism”. Increasingly, government actions to rescue and re-regulate the financial system display many of the characteristics of the policies that Summers once criticised.
The phrase - “military industrial complex” - described the complex inter-relationships and influences that shaped America in the post-war era. The “finance government complex” (dubbed “Government Sachs” by its critics) replaced the original arrangement in the late twentieth century and may well prove to be the undoing of American economic dominance.
© 2009 Satyajit Das All Rights reserved.
Satyajit Das is a risk consultant and author of Traders, Guns & Money: Knowns and Unknowns in the Dazzling World of Derivatives (2006, FT-Prentice Hall).
Banks remain in the ICU (intensive care unit). Even after around $900 billion in new capital, the global banking system remains short of capital by around $1-2 trillion. This translates into an effective reduction in available credit of around 20-30% from previous levels.
Recent excitement about the "stress tests" of U.S. banks misses an essential point. At best if you accept the premises of the test, the risk of failure of these institutions is much reduced. But the banks’ ability to support lending levels that prevailed in say 2007 has not been restored. In short, the "credit crunch" or shortage of borrowing will continue for a prolonged period.
The financial system will need continued government support for some time to come. The performance of governments trying to rehabilitate the financial system has been problematic. Increasingly, government officials have become focused on “reassuring” the public and maintaining “confidence”. The “political spin” has dominated substance. Many government proposals are “stillborn”; for example, progress on the famed Public Private Investment Partnership (“PPIP”) has been painfully slow.
In April 2009, Elizabeth Warren, Chairperson of the TARP Oversight Panel Report questioned the very approach to resolving the problems of the financial system: “Six months into the existence of TARP, evidence of success or failure is mixed. One key assumption that underlies Treasury’s [PPIP] approach is its belief that the system-wide deleveraging resulting from the decline in asset values, leading to an accompanying drop in net wealth across the country, is in large part the product of temporary liquidity constraints resulting from non-functioning markets for troubled assets. On the other hand, it is possible that Treasury’s approach fails to acknowledge the depth of the current downturn and the degree to which the low valuation of troubled assets accurately reflects their worth.”
Richard Neiman (New York State Superintendent of Banks) and John Sununu (former New Hampshire Senator), two other panel members, issued dissenting findings noting: “We are concerned that the prominence of alternate approaches presented in the report, particularly reorganization through nationalization, could incorrectly imply both that the banking system is insolvent and that the new administration does not have a workable plan.” Many would question the selection of the words “incorrectly imply”.
Constant changes do not suggest a consistent and well thought out strategy in dealing with the problems. Less than rigorous stress tests, using taxpayers monies in different guises provide lopsided subsidies for private investors to buy distressed assets with minimal risk or converting preferred stock into shares to avoid having to seek additional congressional mandates suggest a highly politicised and ideological approach. One online commentator noted the intersection between Wall Street, Constitution Avenue and Main Street was best named: “Confusion Corner”.
Suggestions of political influence and a palpable lack of transparency are emerging. There are allegations that the Henry Paulson, the previous U.S. Treasury Secretary, may have “pushed” Bank of America to consummate its controversial acquisition of Merrill Lynch when it sought to withdraw after additional losses came to light. Certainly, the purchase of Merrill Lynch does not fit comfortably with Ken Lewis’ (Bank of America’s Chairman) earlier statement that “he had just about as much fun in investment banking as he could take”.
The Treasury secretary is alleged to have suggested that Bank of America’s management and board could be removed if it did not proceed. There are also suggestions that both the Treasury and Bank of America decided to avoid public disclosure of these events.
The appointment of Timothy Giethner and Larry Summers initially was viewed favourably. The feeling was that “they knew where the bodies were buried”. Critics pointed out that this was because they may have put them there! The “closeness” between banks and government officials and regulators that is being exposed daily is increasingly part of the problem in dealing with the real issues.
Mancur Olson, the American economist, in his books (The Logic of Collective Action and The Rise and Decline of Nations), speculated that small distributional coalitions tend to form over time in developed nations and influence policies in their favor through intensive, well funded lobbying. The policies result in benefits for the coalitions and its members but large costs borne by the rest of population. Over time, the incentive structure means that more distributional coalitions accumulate burdening and ultimately paralysing the economic system causing inevitable and irretrievable economic decline.
Government attempts to deal with the problems of the financial system, especially in the U.S.A., Great Britain and other countries, may illustrate Olson’s thesis. Active well funded lobbying efforts and “regulatory capture” is impeding necessary actions to make needed changes in the financial system. For example, the Centre of Public Integrity reported that the expenditure on lobbying and political contribution of the top 25 sub-prime mortgage originators, most linked to large U.S. banks, was around $380 million (the Economist (9 May 2009).
Larry Summers, an uncompromising advocate of deregulation and liberalization blamed the Asian crisis, in part, on “crony capitalism”. Increasingly, government actions to rescue and re-regulate the financial system display many of the characteristics of the policies that Summers once criticised.
The phrase - “military industrial complex” - described the complex inter-relationships and influences that shaped America in the post-war era. The “finance government complex” (dubbed “Government Sachs” by its critics) replaced the original arrangement in the late twentieth century and may well prove to be the undoing of American economic dominance.
© 2009 Satyajit Das All Rights reserved.
Satyajit Das is a risk consultant and author of Traders, Guns & Money: Knowns and Unknowns in the Dazzling World of Derivatives (2006, FT-Prentice Hall).
19 May 2009
Catastrophic to Awful! - The Banking Spin Cycle ~ Satyajit Das
The recent rally in equity markets – the largest for decades – was predicated, in part, on the improving fortune of banks.
Banks reported better than expected profits. U.S. banks seem likely to pass the "stress" test. Repayment of taxpayers' funds by some institutions, at least, seemed imminent. Scrutiny suggests that the episode reflected Adlai Stevenson's logic: "These are conclusions on which I base my facts."
Banks beat "well managed" low-ball expectations. In the last quarter of 2008, publicly traded banks lost $52 billion. Despite a return to profitability for some institutions, in the first quarter of 2009, banks are still expected to lose around $34 billion. For example, UBS and Morgan Stanley recorded losses.
The quality of earnings was questionable. Core businesses declined 20% to 30%. Trading revenue, especially fixed income, rose sharply at most big banks, reflecting high volumes of bond issuance, especially investment grade corporate issues and government guaranteed bank debt.
Corporate issuance was the result of the continued tightening in credit availability as banks reduced balance sheet. The issuance of government guaranteed bank debt provided underwriters with a "double subsidy" – the government guaranteed the debt but then allowed the banks to earn generous fees from underwriting government guaranteed debt.
High volatility generated strong trading revenues. Key factors were increased client flows and increases in bid-offer spreads (by up to 300% in some products). High trading revenues also reflect principal position taking and trading. It will be interesting to see if trading revenues are sustainable.
Questions remain about the impact of payments by AIG to major banks including Goldman Sachs ($12.9 billion), Merrill Lynch ($6.8 billion), Bank of America ($5.2 billion), Citigroup ($2.3 billion) and Wachovia ($1.5 billion). Non-U.S. banks also received substantial payments including Société Générale ($12 billion), Deutsche Bank ($12 billion), Barclays ($8.5 billion) and UBS ($5 billion). Conspiracy theories notwithstanding, it seems likely that these were collateral amounts due to the counterparty or settlement of positions that were terminated. At a minimum, the banks benefited from a one-time increase in trading volume and, reflecting the distressed condition of AIG, larger than normal bid-offer spreads on these closeouts.
The banks also benefited from revaluing their own debt where credit spreads widened. The theory is that the bank could currently purchase the debt at a value lower than face values and retire it to recognize the gain. Unfortunately, banks are not in position to realize this "paper" gain and ultimately if the debt is repaid at maturity, then the "gain" disappears.
Earning also were helped by a series of one-time factors. Bank of America realized a large gain on the sale of its stake in China Construction Bank and also revalued some acquired assets as part of the closing of its Merrill Lynch acquisition. Goldman Sachs changed it balance date, reporting results to the end of March rather than February. Given that its last financials were for the year to the end of November 2008, Goldman separately reported a loss for December 2008. It is not clear how much Goldmans Sachs profit benefited from the change in the reporting dates.
Barclays Bank recently sold its iShares unit (a profitable unit which contributed around 50% of the earnings of Barclays Global Investors) to a private equity firm for $4.2 billion, allowing the bank to book a gain of $2.2 billion that boosted capital ratios. CVC Capital only paid $1.05 billion with the rest ($3.1 billion) being borrowed from Barclays itself. The loan was for five years and Barclays is required to keep the majority of the debt on balance sheet for at least five years. In effect, the gain and capital increase is lower than the cash received (in effect, Barclays is treating part of its loan as profit and capital!). In addition, senior executives of Barclays received substantial gains from the sale under a compensation scheme where Barclays Global employees received shares and options up to 10.3 % of the division's equity.
Effects of changes in mark-to-market accounting standards, which arguably reflected political and industry pressure, are also not clear. New guidance permits banks to exclude losses deemed "temporary" and also allows significant subjectivity in valuing positions. This may improve the financial position and overstate both earnings and capital. Some commentators believe that the changes could increase earnings by up to 10% to 15% and capital by up to 20%.
The market ignored continuing increases in bad debts and provisions. After all, "that's so yesterday!" Further losses are likely in consumer lending (e.g. mortgages, credit cards and auto loans), corporate and commercial lending.
In recent years, it has become an article of accepted faith that corporate debt levels have fallen. In aggregate, that is perfectly true. However, the debt has become concentrated in a number of sectors – commercial property, merger financing, private equity/ leveraged finance and infrastructure and resource financing.
The overall quality of debt has deteriorated significantly. In 2008, more than 70% of all rated debt was non-investment grade ("junk"). This is an increase from less than 30% in 1980 and around 50% in 1990. The debt is also heavily reliant on collateral; the loans are secured against financial assets (shares and property). Reduced ability to service the debt and falling collateral values may prove problematic. For example, the recent distressed sale of the John Hancock Tower produced about half the value paid a few years earlier.
In April 2009, the International Monetary Fund (IMF) estimated that banks and other financial institutions face aggregate losses of $4.1 trillion, an increase from $2.2 trillion in January 2009, and $1.4 trillion in October, 2008. Around $2.7 trillion of the losses are expected to be borne by banks. The IMF estimated that in the United States, banks had reported $510 billion in write-downs to date and face additional write-downs of $550 billion. Eurozone banks had reported $154 billion in write-downs and face a further $750 billion in losses. British banks had written down $110 billion and face an additional $200 billion in write-offs.
Banks may not be properly provisioned for these further write-downs. Recent accounting standards made it difficult for banks to dynamically provision, whereby banks provided in low-loss years for any eventual increase in loan losses when the economic cycle turns. Criticisms regarding income smoothing led to this practice being discontinued. Increasing bad debt will flow directly into bank earnings as credit losses increase as the real economy slows.
Banks may also face write-downs in intangible assets (goodwill or surplus on acquisition) and future income tax benefits. The values of businesses purchased in a more favorable environment will need to be progressively reassessed. The tax benefits of losses can only be carried as an asset where there is a reasonable prospect of utilization in the near future.
In one of his raves on TV, James Cramer, the notorious American commentator, referred to bank accounts as "fiction." He referred to them as the work of Somerset Maugham, William Faulkner or Joseph Conrad. In reality, they are the works of lesser writers – "pulp fiction" or "romantic potboilers.''
The stress tests do not provide comfort regarding the health of the banks. As Nouriel Roubini, chairperson of RGE Monitor, has pointed out, the likely macro-economic environment is likely to be significantly worse than the adverse scenarios used. The Federal Reserve hinted that banks – even banks that passed the "stress test" – would be required to hold extra capital. This is puzzling as surely a bank is appropriately capitalized or it is not. Given that the test is the basis for setting solvency capital requirements, this is hardly reassuring or a guarantee that further taxpayer funded recapitalization of the banking system is not going to be needed.
The proposal floated by some banks to return taxpayer capital misses an essential point. The banks did not offer to waive the government/ FDIC guarantees, which have allowed them to fund in the capital markets. The suspicion is that the proposal had more to do with avoiding close public scrutiny of compensation and hiring practices. Goldman's compensation costs increased 18% in the first quarter while employee numbers were down around 7%, translating into a 27% increase in employee costs.
The reality is that the global economic system is deleveraging and levels of debt must be reduced. As result, asset values are declining and sustainable growth levels have fallen significantly. In this environment, banks are likely to continue to suffer losses on assets (bad debts and further write-offs) and earnings will remain sluggish (lower loan demand and lower levels of financial transactions). Higher funding costs and the need to raise capital compound the difficulties. For the banks currently: "On the liability side, some things aren't right and on the asset side, nothing's left."
Many major global bank shares are still, on average, trading at levels 70% to 90% below their highs. Following the collapse of the "bubble" economy, Japanese banks staged a number of significant recoveries in share price before falling sharply, necessitating government intervention to recapitalize and consolidate the banking system.
Analysis of recent financial performance does not also take into account the underlying favorable current dynamics of the banking industry. Banks are currently beneficiaries of very low and, in some cases, zero cost of deposits. Banks also benefit from a sharply upward sloping yield curve that allows them to generate significant earnings from borrowing short and lending long. Banks have also benefited from subsidies and support from governments; favorable changes in the fair value accounting treatment of securities; and sharply lower competition in most market segments. Adjusting for these factors, it is surprising that banks haven't actually performed better.
The truth is that banks remain in the ICU (intensive care unit). Even after around $900 billion in new capital, the global banking system remains short of capital by $1 trillion to $2 trillion. This translates into an effective reduction in available credit of around 20% to 30% from previous levels. Bank earnings and balance sheets remain under pressure.
The financial system will need continued government support for some time to come, even though the performance of governments trying to rehabilitate the financial system has been problematic. In April 2009, Elizabeth Warren, chairperson of the Troubled Asset Relief Program (TARP) Oversight Panel, questioned the very approach to resolving the problems of the financial system: "Six months into the existence of TARP, evidence of success or failure is mixed. One key assumption that underlies Treasury's Public-Private Investment Program (PPIP) approach is its belief that the system-wide deleveraging resulting from the decline in asset values'' – thus leading to an accompanying drop in net wealth across the country – "is in large part the product of temporary liquidity constraints [that are a consequence of] non-functioning markets for troubled assets. On the other hand, it is possible that Treasury's approach fails to acknowledge the depth of the current downturn and the degree to which the low valuation of troubled assets accurately reflects their worth.''
Two other panel members, New York State Superintendent of Banks Richard Neiman and former New Hampshire Sen. John Sununun, issued dissenting findings, noting: "We are concerned that the prominence of alternate approaches presented in the report, particularly reorganization through nationalization, could incorrectly imply both that the banking system is insolvent and that the new administration does not have a workable plan." Many would question the selection of the words "incorrectly imply."
Constant changes in tack in the dealing with financial system problems do not suggest a consistent and well thought out strategy in dealing with the problem. Less than rigorous stress tests, using the PPIP to leverage FDIC funding into a lopsided subsidy for private investors or converting the preferred stock into shares to avoid having to seek additional congressional mandates also suggest political constraints in resolving the issues.
Evidence of political influence and a palpable lack of transparency in dealing with the problems are emerging. There are allegations that the Treasury may have "pushed" Bank of America to consummate its controversial acquisition of Merrill Lynch when it sought to withdraw after additional losses came to light. The Treasury secretary at the time, Henry Paulson, is alleged to have suggested that Bank of America's management and board could be removed if it did not proceed. There are also suggestions that both the Treasury and Bank of America decided to avoid public disclosure of these events.
In his books "The Logic of Collective Action" and "The Rise and Decline of Nations," American economist Mancur Olson speculated that small distributional coalitions tend to form over time in developed nations and influence policies in their favor through intensive, well-funded lobbying. The policies result in benefits for the coalitions and its members but large costs borne by the rest of population. Over time, the incentive structure means that more distributional coalitions accumulate, burdening and ultimately paralyzing the economic system, causing inevitable and irretrievable economic decline.
Government attempts to deal with the problems of the financial system, especially in the U.S., Great Britain and other countries, illustrates Olson's thesis. Active well-funded lobbying efforts and "regulatory capture" is impeding necessary actions to make needed changes in the financial system. Urgent steps are necessary to accurately recognize losses on assets, remove toxic assets from balance sheets, recapitalize the banks and allow normal financial transactions to resume. If such actions are not taken then the broader economy and sustainable growth levels will be adversely affected. There seems to be a patent unwillingness to admit to and confront the problems facing the industry. Recognition of the problem is generally a prerequisite to working towards a solution.
Amusingly, Peter Hahn, a former managing director of CitiGroup and now a fellow at London's Cass Business School, was reported by Bloomberg as saying: "When you look at the income numbers that have been put out by banks recently, they contain so much fudge and financial manipulation. You could say that the automobile industry has a clearer future at the moment."
Banks have gone from catastrophic to just awful. By most standards, that condition does not constitute a necessary and sufficient condition for a recovery in the global economy.
Satyajit Das is a risk consultant and author of "Traders, Guns & Money: Knowns and Unknowns in the Dazzling World of Derivatives" (2006, FT-Prentice Hall)
Views are as of May 15, 2009, and are subject to change based on market conditions and other factors. These views should not be construed as a recommendation for any specific security.
Federated Equity Management Company of Pennsylvania.
http://www.prudentbear.com/index.php/guestcommentaryview?art_id=10228
Banks reported better than expected profits. U.S. banks seem likely to pass the "stress" test. Repayment of taxpayers' funds by some institutions, at least, seemed imminent. Scrutiny suggests that the episode reflected Adlai Stevenson's logic: "These are conclusions on which I base my facts."
Banks beat "well managed" low-ball expectations. In the last quarter of 2008, publicly traded banks lost $52 billion. Despite a return to profitability for some institutions, in the first quarter of 2009, banks are still expected to lose around $34 billion. For example, UBS and Morgan Stanley recorded losses.
The quality of earnings was questionable. Core businesses declined 20% to 30%. Trading revenue, especially fixed income, rose sharply at most big banks, reflecting high volumes of bond issuance, especially investment grade corporate issues and government guaranteed bank debt.
Corporate issuance was the result of the continued tightening in credit availability as banks reduced balance sheet. The issuance of government guaranteed bank debt provided underwriters with a "double subsidy" – the government guaranteed the debt but then allowed the banks to earn generous fees from underwriting government guaranteed debt.
High volatility generated strong trading revenues. Key factors were increased client flows and increases in bid-offer spreads (by up to 300% in some products). High trading revenues also reflect principal position taking and trading. It will be interesting to see if trading revenues are sustainable.
Questions remain about the impact of payments by AIG to major banks including Goldman Sachs ($12.9 billion), Merrill Lynch ($6.8 billion), Bank of America ($5.2 billion), Citigroup ($2.3 billion) and Wachovia ($1.5 billion). Non-U.S. banks also received substantial payments including Société Générale ($12 billion), Deutsche Bank ($12 billion), Barclays ($8.5 billion) and UBS ($5 billion). Conspiracy theories notwithstanding, it seems likely that these were collateral amounts due to the counterparty or settlement of positions that were terminated. At a minimum, the banks benefited from a one-time increase in trading volume and, reflecting the distressed condition of AIG, larger than normal bid-offer spreads on these closeouts.
The banks also benefited from revaluing their own debt where credit spreads widened. The theory is that the bank could currently purchase the debt at a value lower than face values and retire it to recognize the gain. Unfortunately, banks are not in position to realize this "paper" gain and ultimately if the debt is repaid at maturity, then the "gain" disappears.
Earning also were helped by a series of one-time factors. Bank of America realized a large gain on the sale of its stake in China Construction Bank and also revalued some acquired assets as part of the closing of its Merrill Lynch acquisition. Goldman Sachs changed it balance date, reporting results to the end of March rather than February. Given that its last financials were for the year to the end of November 2008, Goldman separately reported a loss for December 2008. It is not clear how much Goldmans Sachs profit benefited from the change in the reporting dates.
Barclays Bank recently sold its iShares unit (a profitable unit which contributed around 50% of the earnings of Barclays Global Investors) to a private equity firm for $4.2 billion, allowing the bank to book a gain of $2.2 billion that boosted capital ratios. CVC Capital only paid $1.05 billion with the rest ($3.1 billion) being borrowed from Barclays itself. The loan was for five years and Barclays is required to keep the majority of the debt on balance sheet for at least five years. In effect, the gain and capital increase is lower than the cash received (in effect, Barclays is treating part of its loan as profit and capital!). In addition, senior executives of Barclays received substantial gains from the sale under a compensation scheme where Barclays Global employees received shares and options up to 10.3 % of the division's equity.
Effects of changes in mark-to-market accounting standards, which arguably reflected political and industry pressure, are also not clear. New guidance permits banks to exclude losses deemed "temporary" and also allows significant subjectivity in valuing positions. This may improve the financial position and overstate both earnings and capital. Some commentators believe that the changes could increase earnings by up to 10% to 15% and capital by up to 20%.
The market ignored continuing increases in bad debts and provisions. After all, "that's so yesterday!" Further losses are likely in consumer lending (e.g. mortgages, credit cards and auto loans), corporate and commercial lending.
In recent years, it has become an article of accepted faith that corporate debt levels have fallen. In aggregate, that is perfectly true. However, the debt has become concentrated in a number of sectors – commercial property, merger financing, private equity/ leveraged finance and infrastructure and resource financing.
The overall quality of debt has deteriorated significantly. In 2008, more than 70% of all rated debt was non-investment grade ("junk"). This is an increase from less than 30% in 1980 and around 50% in 1990. The debt is also heavily reliant on collateral; the loans are secured against financial assets (shares and property). Reduced ability to service the debt and falling collateral values may prove problematic. For example, the recent distressed sale of the John Hancock Tower produced about half the value paid a few years earlier.
In April 2009, the International Monetary Fund (IMF) estimated that banks and other financial institutions face aggregate losses of $4.1 trillion, an increase from $2.2 trillion in January 2009, and $1.4 trillion in October, 2008. Around $2.7 trillion of the losses are expected to be borne by banks. The IMF estimated that in the United States, banks had reported $510 billion in write-downs to date and face additional write-downs of $550 billion. Eurozone banks had reported $154 billion in write-downs and face a further $750 billion in losses. British banks had written down $110 billion and face an additional $200 billion in write-offs.
Banks may not be properly provisioned for these further write-downs. Recent accounting standards made it difficult for banks to dynamically provision, whereby banks provided in low-loss years for any eventual increase in loan losses when the economic cycle turns. Criticisms regarding income smoothing led to this practice being discontinued. Increasing bad debt will flow directly into bank earnings as credit losses increase as the real economy slows.
Banks may also face write-downs in intangible assets (goodwill or surplus on acquisition) and future income tax benefits. The values of businesses purchased in a more favorable environment will need to be progressively reassessed. The tax benefits of losses can only be carried as an asset where there is a reasonable prospect of utilization in the near future.
In one of his raves on TV, James Cramer, the notorious American commentator, referred to bank accounts as "fiction." He referred to them as the work of Somerset Maugham, William Faulkner or Joseph Conrad. In reality, they are the works of lesser writers – "pulp fiction" or "romantic potboilers.''
The stress tests do not provide comfort regarding the health of the banks. As Nouriel Roubini, chairperson of RGE Monitor, has pointed out, the likely macro-economic environment is likely to be significantly worse than the adverse scenarios used. The Federal Reserve hinted that banks – even banks that passed the "stress test" – would be required to hold extra capital. This is puzzling as surely a bank is appropriately capitalized or it is not. Given that the test is the basis for setting solvency capital requirements, this is hardly reassuring or a guarantee that further taxpayer funded recapitalization of the banking system is not going to be needed.
The proposal floated by some banks to return taxpayer capital misses an essential point. The banks did not offer to waive the government/ FDIC guarantees, which have allowed them to fund in the capital markets. The suspicion is that the proposal had more to do with avoiding close public scrutiny of compensation and hiring practices. Goldman's compensation costs increased 18% in the first quarter while employee numbers were down around 7%, translating into a 27% increase in employee costs.
The reality is that the global economic system is deleveraging and levels of debt must be reduced. As result, asset values are declining and sustainable growth levels have fallen significantly. In this environment, banks are likely to continue to suffer losses on assets (bad debts and further write-offs) and earnings will remain sluggish (lower loan demand and lower levels of financial transactions). Higher funding costs and the need to raise capital compound the difficulties. For the banks currently: "On the liability side, some things aren't right and on the asset side, nothing's left."
Many major global bank shares are still, on average, trading at levels 70% to 90% below their highs. Following the collapse of the "bubble" economy, Japanese banks staged a number of significant recoveries in share price before falling sharply, necessitating government intervention to recapitalize and consolidate the banking system.
Analysis of recent financial performance does not also take into account the underlying favorable current dynamics of the banking industry. Banks are currently beneficiaries of very low and, in some cases, zero cost of deposits. Banks also benefit from a sharply upward sloping yield curve that allows them to generate significant earnings from borrowing short and lending long. Banks have also benefited from subsidies and support from governments; favorable changes in the fair value accounting treatment of securities; and sharply lower competition in most market segments. Adjusting for these factors, it is surprising that banks haven't actually performed better.
The truth is that banks remain in the ICU (intensive care unit). Even after around $900 billion in new capital, the global banking system remains short of capital by $1 trillion to $2 trillion. This translates into an effective reduction in available credit of around 20% to 30% from previous levels. Bank earnings and balance sheets remain under pressure.
The financial system will need continued government support for some time to come, even though the performance of governments trying to rehabilitate the financial system has been problematic. In April 2009, Elizabeth Warren, chairperson of the Troubled Asset Relief Program (TARP) Oversight Panel, questioned the very approach to resolving the problems of the financial system: "Six months into the existence of TARP, evidence of success or failure is mixed. One key assumption that underlies Treasury's Public-Private Investment Program (PPIP) approach is its belief that the system-wide deleveraging resulting from the decline in asset values'' – thus leading to an accompanying drop in net wealth across the country – "is in large part the product of temporary liquidity constraints [that are a consequence of] non-functioning markets for troubled assets. On the other hand, it is possible that Treasury's approach fails to acknowledge the depth of the current downturn and the degree to which the low valuation of troubled assets accurately reflects their worth.''
Two other panel members, New York State Superintendent of Banks Richard Neiman and former New Hampshire Sen. John Sununun, issued dissenting findings, noting: "We are concerned that the prominence of alternate approaches presented in the report, particularly reorganization through nationalization, could incorrectly imply both that the banking system is insolvent and that the new administration does not have a workable plan." Many would question the selection of the words "incorrectly imply."
Constant changes in tack in the dealing with financial system problems do not suggest a consistent and well thought out strategy in dealing with the problem. Less than rigorous stress tests, using the PPIP to leverage FDIC funding into a lopsided subsidy for private investors or converting the preferred stock into shares to avoid having to seek additional congressional mandates also suggest political constraints in resolving the issues.
Evidence of political influence and a palpable lack of transparency in dealing with the problems are emerging. There are allegations that the Treasury may have "pushed" Bank of America to consummate its controversial acquisition of Merrill Lynch when it sought to withdraw after additional losses came to light. The Treasury secretary at the time, Henry Paulson, is alleged to have suggested that Bank of America's management and board could be removed if it did not proceed. There are also suggestions that both the Treasury and Bank of America decided to avoid public disclosure of these events.
In his books "The Logic of Collective Action" and "The Rise and Decline of Nations," American economist Mancur Olson speculated that small distributional coalitions tend to form over time in developed nations and influence policies in their favor through intensive, well-funded lobbying. The policies result in benefits for the coalitions and its members but large costs borne by the rest of population. Over time, the incentive structure means that more distributional coalitions accumulate, burdening and ultimately paralyzing the economic system, causing inevitable and irretrievable economic decline.
Government attempts to deal with the problems of the financial system, especially in the U.S., Great Britain and other countries, illustrates Olson's thesis. Active well-funded lobbying efforts and "regulatory capture" is impeding necessary actions to make needed changes in the financial system. Urgent steps are necessary to accurately recognize losses on assets, remove toxic assets from balance sheets, recapitalize the banks and allow normal financial transactions to resume. If such actions are not taken then the broader economy and sustainable growth levels will be adversely affected. There seems to be a patent unwillingness to admit to and confront the problems facing the industry. Recognition of the problem is generally a prerequisite to working towards a solution.
Amusingly, Peter Hahn, a former managing director of CitiGroup and now a fellow at London's Cass Business School, was reported by Bloomberg as saying: "When you look at the income numbers that have been put out by banks recently, they contain so much fudge and financial manipulation. You could say that the automobile industry has a clearer future at the moment."
Banks have gone from catastrophic to just awful. By most standards, that condition does not constitute a necessary and sufficient condition for a recovery in the global economy.
Satyajit Das is a risk consultant and author of "Traders, Guns & Money: Knowns and Unknowns in the Dazzling World of Derivatives" (2006, FT-Prentice Hall)
Views are as of May 15, 2009, and are subject to change based on market conditions and other factors. These views should not be construed as a recommendation for any specific security.
Federated Equity Management Company of Pennsylvania.
http://www.prudentbear.com/index.php/guestcommentaryview?art_id=10228
5 May 2009
Satyajit Das audio 5th May 2009 Late Night Live
Satyajit Das talks about the other side of the globalisation story - the consequences of financial market cross-infection, swine 'flu pandemic panic, and the rapid international transmission of unemployment.
Download to Listen
Download to Listen
4 May 2009
The End of Ponzi Prosperity ~ Satyajit Das
04.05.2009
Lessons of the Global Financial Crisis: 1. The End of Ponzi Prosperity
By: Satyajit Das
We Are All Keynesians Now!
In January 1971, Richard Nixon recanted years of opposition to budget deficits declaring: "Now, I am a Keynesian." Nixon had borrowed the line from Milton Friedman who had used it in 1965. Then, we embraced Monetarism and flirted with "supply side" economics, christened "voodoo economics" by President George Bush Senior. Now, in the wake of the Global Financial Crisis ("GFC"), it seems that we are all Keynesians again.
The GFC is really a "Minsky moment". In Stabilizing an Unstable Economy (1986), Hyman Minsky outlined a hypotheses that excessive risk taking, driven in part by stability lead to market breakdowns - stability is itself destablising.
The current crisis is financial, economic, social and increasingly ideological. Nikolas Sarkozy, President of France, has pronounced the death of laissez-faire capitalism: "c’est fini". World leaders have penned fevered attacks on neo-liberalism. Even religious leaders have spoken out.
Dead economists have been resurrected in support of political positions. As Keynes himself observed: "The ideas of economists and political philosophers, both when they are right and when they are wrong, are more powerful than is commonly understood. Indeed the world is ruled by little else. Practical men, who believe themselves to be exempt from any intellectual influences, are usually the slaves of some defunct economist. Madmen in authority, who hear voices in the air, are distilling their frenzy from some academic scribbler of a few years back."
No "pure" economic model has been implemented in living memory, except perhaps in North Korea. The theories themselves rarely work. John Kenneth Galbraith is reported as saying: "Milton’s [Friedman’s] misfortune is that his policies have been tried."
Criticisms of the ancien regime are substantive and deserved. There have been undoubtedly egregious market failures, management excesses and errors in the lead up to the GFC. But the key lessons of the crisis may be subtler than first evident.
Growth has been driven by cheap and abundant debt and uncosted carbon emissions and other forms of pollution. The reality is that this period of growth may be coming to an end.
All brands of politics and economics have been informed by assumptions about the sustainability of high levels of economic growth and the belief that governments and central bankers can exert a substantial degree of control over the economy. Harry Johnson, the famed Chicago economist, writing about England in the 1970s with his wife Elizabeth in (1978) The Shadow of Keynes provides a vivid description of this pre-occupation: "…faster economic growth is the pancea for all..economic and for all that matter political problems and that faster growth can be easily achieved by a combination of inflationary demand-managementpolocies and poltically appealing fiscal gimmickry."
Goldilocks Economy
P.J.O’Rourke writing in Eat The Rich (1998) observed that: "Economics is an entire scientific discipline of not knowing what you’re talking about."
Recent global prosperity derived from a fortunate confluence of low inflation and low interest rates. In the 1980s, brutally high interest rates and recessions squeezed inflation out of the economy facilitating lower interest rates. Low energy prices, following the first Gulf War, helped keep inflation low and fuelled growth.
The fall of the Berlin Wall in 1989 and the reintegration of the command economies of Eastern Europe, China and India into global trade provided low cost labour helping maintain the supply of cheap goods and services. Emerging economies provided substantial new markets for products and capital driven by the very high levels of savings in these countries.
Deregulation of key industries, such as banking and telecommunications, fostered growth by increasing access to finance and improved essential infrastructure. Adoption of new technologies, such as information technology and the Internet, improved productivity and assisted growth, though the extent is disputed.
Many countries switched from employer or government pension schemes to private retirement saving arrangements underwritten by generous tax incentives. Rapid growth in this pool of investment capital was also a factor in growth.
Governments, irrespective of political persuasion, benefited from the favourable economic environment. The ability of governments and central banks to control and "fine tune" the economy with a judicial mixture of monetary and fiscal policy became an article of accepted faith. Voters were lulled into false confidence by a mixture of rising wealth, improved living standards and stability.
Elegant theories about the "Great Moderation" or "Goldilocks Economy", with the benefit of hindsight, seem to be little more than narrative fallacies where a convincing but meaningless story is shaped to fit unconnected facts and coincidence is confused with causality.
Ponzi Prosperity
Growth, in reality, was founded on a series of elegant Ponzi schemes.
Consumption rather than investment drove growth, particularly in the developed world. Debt fuelled consumption became the norm. In the new economy, there were three kinds of people – "the haves", "the have-nots", and "the have-not-paid-for-what-they-haves".
The consumption was financed by borrowings supplied by a deregulated financial system. Many workers’ earnings fell in inflation adjusted terms as a result of global competition and associated outsourcing and off shoring practices. The ability to borrow against the appreciation in owner occupied houses and other financial assets underpinned consumption.
Investors, central banks with large reserves, pension funds and asset managers channeling privatised retirement savings, eagerly purchased the debt. Borrowing fueled higher asset prices allowing even greater levels of borrowing against the value of the asset. This virtuous cycle – a "positive feedback loop" – fueled the "doctor feel good" economy of recent years.
"Financial engineering" replaced "real engineering" in many countries. Entire cities (London and New York) and economies (Iceland) become dominated by the rapidly growing financial services industry. In the US, financial services’ share of total corporate profits increased from 10% in the early 1980s to 40% in 2007. The stockmarket value of financial services firms increased from 6% in the early 1980s to 23% in 2007.
The reliance on financial innovation proved disastrous. In A Short History of Financial Euphoria (1994), John Kenneth Galbraith noted that: "Financial operations do not lend themselves to innovation. What is recurrently so described and celebrated is, without exception, a small variation on an established design . . . The world of finance hails the invention of the wheel over and over again, often in a slightly more unstable version."
Financially engineered growth extended into international trade flows. Since the 1990s, there has been a substantial build-up of foreign reserves in central banks of emerging markets and developing countries that became the foundation for a trade finance scheme.
Many global currencies were pegged to the dollar at an artificially low rate, like the Chinese Renminbi, to maintain export competitiveness. This created an outflow of dollars (via the trade deficit driven by excess US demand for imports based on an overvalued dollar). Foreign central bankers purchased US debt with dollars to mitigate upward pressure on their domestic currency. The recycled dollars flowed back to the US to finance the spending on imports.
The process relied on the historically unimpeachable credit quality of the USA and large, liquid markets in dollars and dollar investments capable of accommodating the very large investment requirements. This merry-go-round kept US interest rates and cost of capital low encouraging further borrowing to finance consumption and imports to keep the cycle going.
Foreign central banks holding reserves were lending the funds used to purchase goods from the country. The exporting nations never got paid at least until the loan to the buyer (the vendor finance) was paid off. Essentially, growth in global trade was also debt fuelled.
Moderate debt levels are sustainable provided the value of the asset supporting the borrowing is stable and significantly higher than the amount of the loan. The borrower or the collateral for the loan must generate sufficient income to service and repay the borrowing. In the frenzied market environment of low interest rates and ever rising asset prices, the level of collateral cover and ability to service the loans deteriorated sharply. In 2005, rising interest rates and a cooling in the US housing market set the stage for the GFC.
Sigmund Freud once remarked that: "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." The GFC was the reality on which the fake pleasure of the Great Moderation and Goldilocks economy was smashed.
Taking the Cure
There is currently confusion between the disease and the cure. The "disease" is the excessive debt and leverage in the financial system, especially in the US, Great Britain, Spain and Australia. The "cure" is the reduction of the level of debt that is now underway (the great "de-leveraging").
The initial phase of the cure is the reduction in debt within the financial system. Some of the debt created during the Ponzi prosperity years will not be repaid. Non-repayment of this debt, in turn, has caused the failure of financial institutions. The process destroys both existing debt and also limits the capacity for further credit creation by financial institutions.
Total losses from the GFC to financial institutions, according the latest estimates, will be in excess of US$ 2 trillion. Banks need additional capital to cover assets that were parked in the "shadow banking system" (the complex of off-balance sheet special purpose vehicles) but are now returning to the mother ship’s balance sheet. The global banking system, in aggregate, is close to technically insolvent.
Commercial sources for recapitalisation are limited as losses mount and the outlook for the financial services industry has deteriorated. Government ownership or de facto nationalisation is the only option to maintain a viable banking system in many countries.
Even after recapitalisation the capital shortfall in the global banking system is likely to be around US$ 1-3 trillion. This equates to a forced contraction in global credit of around 20-30% from existing levels.
The second phase of the cure is the effect on the real economy. The problems of the financial sector have increased the cost and reduced availability of debt to borrowers for legitimate business purposes. The scarcity of capital means that banks must reduce their balance sheets by reducing their stock of loans. Normal financing and loans are now being effectively rationed in global markets.
This forces corporations to reduce leverage by cutting costs, selling assets, reducing investment and raising equity. This also forces consumers to reduce debt by selling assets (where available) and reducing consumption.
"Negative feedback loops" mean reduction in investment and consumption lowers economic activity, placing stresses on corporations and individuals setting off bankruptcies that trigger losses for the financial system that further reduces lending capacity. De-leveraging continues through these iterations until overall levels of debt reach a sustainable level determined by lower asset prices and cash flows available to service the debt.
Within the financial sector, de-leveraging is well advanced. In the real economy it is in the early stages. The process echoes Joseph Schumpter’s famous maxim of "creative destruction".
© 2009 Satyajit Das All Rights reserved.
Satyajit Das is a risk consultant and author of Traders, Guns & Money: Knowns and Unknowns in the Dazzling World of Derivatives (2006, FT-Prentice Hall).
This article draws on the ideas first published in Satyajit Das "Built to Fail" in The Monthly (April 2009) 8-13
http://www.eurointelligence.com/article.581+M553774d2c37.0.html
Lessons of the Global Financial Crisis: 1. The End of Ponzi Prosperity
By: Satyajit Das
We Are All Keynesians Now!
In January 1971, Richard Nixon recanted years of opposition to budget deficits declaring: "Now, I am a Keynesian." Nixon had borrowed the line from Milton Friedman who had used it in 1965. Then, we embraced Monetarism and flirted with "supply side" economics, christened "voodoo economics" by President George Bush Senior. Now, in the wake of the Global Financial Crisis ("GFC"), it seems that we are all Keynesians again.
The GFC is really a "Minsky moment". In Stabilizing an Unstable Economy (1986), Hyman Minsky outlined a hypotheses that excessive risk taking, driven in part by stability lead to market breakdowns - stability is itself destablising.
The current crisis is financial, economic, social and increasingly ideological. Nikolas Sarkozy, President of France, has pronounced the death of laissez-faire capitalism: "c’est fini". World leaders have penned fevered attacks on neo-liberalism. Even religious leaders have spoken out.
Dead economists have been resurrected in support of political positions. As Keynes himself observed: "The ideas of economists and political philosophers, both when they are right and when they are wrong, are more powerful than is commonly understood. Indeed the world is ruled by little else. Practical men, who believe themselves to be exempt from any intellectual influences, are usually the slaves of some defunct economist. Madmen in authority, who hear voices in the air, are distilling their frenzy from some academic scribbler of a few years back."
No "pure" economic model has been implemented in living memory, except perhaps in North Korea. The theories themselves rarely work. John Kenneth Galbraith is reported as saying: "Milton’s [Friedman’s] misfortune is that his policies have been tried."
Criticisms of the ancien regime are substantive and deserved. There have been undoubtedly egregious market failures, management excesses and errors in the lead up to the GFC. But the key lessons of the crisis may be subtler than first evident.
Growth has been driven by cheap and abundant debt and uncosted carbon emissions and other forms of pollution. The reality is that this period of growth may be coming to an end.
All brands of politics and economics have been informed by assumptions about the sustainability of high levels of economic growth and the belief that governments and central bankers can exert a substantial degree of control over the economy. Harry Johnson, the famed Chicago economist, writing about England in the 1970s with his wife Elizabeth in (1978) The Shadow of Keynes provides a vivid description of this pre-occupation: "…faster economic growth is the pancea for all..economic and for all that matter political problems and that faster growth can be easily achieved by a combination of inflationary demand-managementpolocies and poltically appealing fiscal gimmickry."
Goldilocks Economy
P.J.O’Rourke writing in Eat The Rich (1998) observed that: "Economics is an entire scientific discipline of not knowing what you’re talking about."
Recent global prosperity derived from a fortunate confluence of low inflation and low interest rates. In the 1980s, brutally high interest rates and recessions squeezed inflation out of the economy facilitating lower interest rates. Low energy prices, following the first Gulf War, helped keep inflation low and fuelled growth.
The fall of the Berlin Wall in 1989 and the reintegration of the command economies of Eastern Europe, China and India into global trade provided low cost labour helping maintain the supply of cheap goods and services. Emerging economies provided substantial new markets for products and capital driven by the very high levels of savings in these countries.
Deregulation of key industries, such as banking and telecommunications, fostered growth by increasing access to finance and improved essential infrastructure. Adoption of new technologies, such as information technology and the Internet, improved productivity and assisted growth, though the extent is disputed.
Many countries switched from employer or government pension schemes to private retirement saving arrangements underwritten by generous tax incentives. Rapid growth in this pool of investment capital was also a factor in growth.
Governments, irrespective of political persuasion, benefited from the favourable economic environment. The ability of governments and central banks to control and "fine tune" the economy with a judicial mixture of monetary and fiscal policy became an article of accepted faith. Voters were lulled into false confidence by a mixture of rising wealth, improved living standards and stability.
Elegant theories about the "Great Moderation" or "Goldilocks Economy", with the benefit of hindsight, seem to be little more than narrative fallacies where a convincing but meaningless story is shaped to fit unconnected facts and coincidence is confused with causality.
Ponzi Prosperity
Growth, in reality, was founded on a series of elegant Ponzi schemes.
Consumption rather than investment drove growth, particularly in the developed world. Debt fuelled consumption became the norm. In the new economy, there were three kinds of people – "the haves", "the have-nots", and "the have-not-paid-for-what-they-haves".
The consumption was financed by borrowings supplied by a deregulated financial system. Many workers’ earnings fell in inflation adjusted terms as a result of global competition and associated outsourcing and off shoring practices. The ability to borrow against the appreciation in owner occupied houses and other financial assets underpinned consumption.
Investors, central banks with large reserves, pension funds and asset managers channeling privatised retirement savings, eagerly purchased the debt. Borrowing fueled higher asset prices allowing even greater levels of borrowing against the value of the asset. This virtuous cycle – a "positive feedback loop" – fueled the "doctor feel good" economy of recent years.
"Financial engineering" replaced "real engineering" in many countries. Entire cities (London and New York) and economies (Iceland) become dominated by the rapidly growing financial services industry. In the US, financial services’ share of total corporate profits increased from 10% in the early 1980s to 40% in 2007. The stockmarket value of financial services firms increased from 6% in the early 1980s to 23% in 2007.
The reliance on financial innovation proved disastrous. In A Short History of Financial Euphoria (1994), John Kenneth Galbraith noted that: "Financial operations do not lend themselves to innovation. What is recurrently so described and celebrated is, without exception, a small variation on an established design . . . The world of finance hails the invention of the wheel over and over again, often in a slightly more unstable version."
Financially engineered growth extended into international trade flows. Since the 1990s, there has been a substantial build-up of foreign reserves in central banks of emerging markets and developing countries that became the foundation for a trade finance scheme.
Many global currencies were pegged to the dollar at an artificially low rate, like the Chinese Renminbi, to maintain export competitiveness. This created an outflow of dollars (via the trade deficit driven by excess US demand for imports based on an overvalued dollar). Foreign central bankers purchased US debt with dollars to mitigate upward pressure on their domestic currency. The recycled dollars flowed back to the US to finance the spending on imports.
The process relied on the historically unimpeachable credit quality of the USA and large, liquid markets in dollars and dollar investments capable of accommodating the very large investment requirements. This merry-go-round kept US interest rates and cost of capital low encouraging further borrowing to finance consumption and imports to keep the cycle going.
Foreign central banks holding reserves were lending the funds used to purchase goods from the country. The exporting nations never got paid at least until the loan to the buyer (the vendor finance) was paid off. Essentially, growth in global trade was also debt fuelled.
Moderate debt levels are sustainable provided the value of the asset supporting the borrowing is stable and significantly higher than the amount of the loan. The borrower or the collateral for the loan must generate sufficient income to service and repay the borrowing. In the frenzied market environment of low interest rates and ever rising asset prices, the level of collateral cover and ability to service the loans deteriorated sharply. In 2005, rising interest rates and a cooling in the US housing market set the stage for the GFC.
Sigmund Freud once remarked that: "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." The GFC was the reality on which the fake pleasure of the Great Moderation and Goldilocks economy was smashed.
Taking the Cure
There is currently confusion between the disease and the cure. The "disease" is the excessive debt and leverage in the financial system, especially in the US, Great Britain, Spain and Australia. The "cure" is the reduction of the level of debt that is now underway (the great "de-leveraging").
The initial phase of the cure is the reduction in debt within the financial system. Some of the debt created during the Ponzi prosperity years will not be repaid. Non-repayment of this debt, in turn, has caused the failure of financial institutions. The process destroys both existing debt and also limits the capacity for further credit creation by financial institutions.
Total losses from the GFC to financial institutions, according the latest estimates, will be in excess of US$ 2 trillion. Banks need additional capital to cover assets that were parked in the "shadow banking system" (the complex of off-balance sheet special purpose vehicles) but are now returning to the mother ship’s balance sheet. The global banking system, in aggregate, is close to technically insolvent.
Commercial sources for recapitalisation are limited as losses mount and the outlook for the financial services industry has deteriorated. Government ownership or de facto nationalisation is the only option to maintain a viable banking system in many countries.
Even after recapitalisation the capital shortfall in the global banking system is likely to be around US$ 1-3 trillion. This equates to a forced contraction in global credit of around 20-30% from existing levels.
The second phase of the cure is the effect on the real economy. The problems of the financial sector have increased the cost and reduced availability of debt to borrowers for legitimate business purposes. The scarcity of capital means that banks must reduce their balance sheets by reducing their stock of loans. Normal financing and loans are now being effectively rationed in global markets.
This forces corporations to reduce leverage by cutting costs, selling assets, reducing investment and raising equity. This also forces consumers to reduce debt by selling assets (where available) and reducing consumption.
"Negative feedback loops" mean reduction in investment and consumption lowers economic activity, placing stresses on corporations and individuals setting off bankruptcies that trigger losses for the financial system that further reduces lending capacity. De-leveraging continues through these iterations until overall levels of debt reach a sustainable level determined by lower asset prices and cash flows available to service the debt.
Within the financial sector, de-leveraging is well advanced. In the real economy it is in the early stages. The process echoes Joseph Schumpter’s famous maxim of "creative destruction".
© 2009 Satyajit Das All Rights reserved.
Satyajit Das is a risk consultant and author of Traders, Guns & Money: Knowns and Unknowns in the Dazzling World of Derivatives (2006, FT-Prentice Hall).
This article draws on the ideas first published in Satyajit Das "Built to Fail" in The Monthly (April 2009) 8-13
http://www.eurointelligence.com/article.581+M553774d2c37.0.html
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