24/6/2013: The Great (Credit) Wall of China

China is now in the anteroom of the 'This Time is Different' sauna... hot seat awaiting:
http://blog.foreignpolicy.com/posts/2013/06/21/say_hello_to_chinas_brewing_financial_crisis

Keep in mind, in China total credit increased from USD9 trillion in 2008 to USD23 trillion now. Credit to GDP ratio went up ca 95% and now stands at 221% of GDP. In the US, in 2002-2007 period, credit/GDP ratio grew by 40 percentage points. And we have no real idea just how deep the real rabbit hole goes: http://www.economist.com/news/finance-and-economics/21578668-growth-wealth-management-products-reflects-deeper-financial-distortions

Here's the contagion trigger: once China gets seated on the hot bench in the TTisD sauna, Chinese purchases of US and euro area bonds will evaporate. With this, yields will be going up even if current QE is retained by the Fed. And what the cost? BIS estimated last 1 trillion. And with yields rising across the board, 15-35 percent of GDP can go up in smoke in France, Italy, the UK and Japan.

Meanwhile, the euro area banks are sitting on a massive pile of dodgy assets (http://trueeconomics.blogspot.ie/2013/06/1862013-size-of-eurotanics-bad-assets.html) backed by funding secured against... right... the aforementioned government bonds.

In this blog parlance, the Impossible Monetary Dilemma will then hit the Great Wall of China. And there are no airbags...

26/5/2013: FTT v Sovereigns' Addiction to Debt

FT.com reports (http://www.ft.com/intl/cms/s/0/c3121802-c480-11e2-9ac0-00144feab7de.html?ftcamp=published_links%2Frss%2Fhome_us%2Ffeed%2F%2Fproduct#axzz2UQE68h14) that 

"The European Central Bank has offered to help the EU redesign its financial transactions tax to avoid any ‘negative impact’ on market stability, highlighting official fears about the implementation of the levy."

So far so good, as FTT indeed is likely to cut liquidity in the markets, reducing markets efficiency, and potentially increasing volatility, rather thane educing it.

Of course, the original idea the EU came up involved levying tax on trading in bonds, equities and derivatives. So one would expect the following prioritisation from the ECB concerned with markets impacts:
1) Not to distinguish between bonds and equities in tax application and rates, as the two instruments are de facto long-only instruments in either corporate (real) economy, banks (financial economy) and sovereigns (for bonds - which somewhat qualifies as a real economy as well).
2) Levy tax primarily on derivative instruments (although here, tax can be avoided much easier)
3) Recognise that in the restricted competition environment and with legacy subsidies from the crisis period still in place for incumbent financial institutions, any FTT will be at least in part passed onto retail investors and savers, and in more extreme cases - e.g. duopoly model of banking in Ireland - onto all retail users of banking services)
4) Real economy - incomes, investment, entrepreneurship, unemployment, etc - will be most impacted by the FTT levied on real assets - equities and some (not all) bonds and this effect will be stronger the stronger is the banking and investment banking sector concentration in the economy.

Alas, as is clear from the FT.com article, the ECB is not concerned with (3) and (4) whatsoever, and it is unconcerned with (1) either. It also seems to be aware of (2) pitfalls. Aside from that, ECB is concerned with the perennial task faced by all European Government - the obsession of raising as much tax revenue as possible while incentivising more debt pumped into sovereign bond markets.


Per FT.com: "The ECB believes markets should efficiently “transmit” changes in interest rates to the real economy." You might think that this means transmitting higher (lower) ECB rates into higher (lower) (a) Government bond yields and (b) higher/lower cost of private credit. Err… you would be wrong.

Per FT.com there are rumours that "…the ECB would prefer to have a limited UK-style stamp duty on equities". What can possibly go wrong, then?

ECB concern is clearly to grease the wheels of sovereign bond markets. The fact that FTT will reduce markets liquidity in real instruments & will cost retail investors in the end - well, that is hardly ECB's concern at all. ECB like the EU Governments is only worried about own coffers & give no attention to the economy.  

Equity markets volatility (FTT original raison d'être is to reduce volatility) had NOTHING to do with the current crises. The ECB focus on 'UK-styled stamp duty on equities', if confirmed, thus exposes FTT as a pure scam to raise more tax revenues, not a measure to deal with 'markets instability'. 

As FT.com quotes one of the market participants: "bond markets were a “phenomenally attractive” way of channelling savings into investment." Alas, it is not - corporate bonds are debt. Shoving more debt while disincentivising equity investment is not a great idea for long term sustainable funding.

In Europe, lending money to Governments, including to fund dodgy unfunded pensions and white elephant projects, is tax-wise deemed to be more laudable than to invest in equity of real enterprises. By corollary, lending to companies is also deemed to be more preferential than funding them via equity. One of the outcomes of this decades-long preferential treatment of debt is the current crisis: over-bloated and under-funded public spending coupled with too much private debt (including banking debt) against too little equity (the latter imbalance drove the bailouts of banks in euro area periphery).

With this in mind, talking about 'Robin Hood' taxes on Financial Services in EU is equivalent to believing in Santa's Magic raindeer as a viable alternative for public transport.

3/5/2013: Basel 2.5 can lead to increased liquidity & contagion risks

Banca d'Italia research paper No. 159, "Basel 2.5: potential benefits and unintended consequences" (April 2013) by Giovanni Pepe looks at the Basel III framework from the risk-weighting perspective. Under previous Basel rules, since 1996, "…the Basel risk-weighting regime has been based on the distinction between the trading and the
banking book. For a long time credit items have been weighted less strictly if held in the trading book, on the assumption that they are easy to hedge or sell."

Alas, the assumption of lower liquidity risks associated with assets held on trading book proved to be rather faulty. "The Great Financial Crisis made evident that banks declared a trading intent on positions that proved difficult or impossible to sell quickly. The Basel 2.5 package was developed in 2009 to better align trading and banking books’ capital treatments." Yet, the question remains as to whether the Basel 2.5 response is adequate to properly realign risk pricing for liquidity risk, relating to assets held on trading book.

"Working on a number of hypothetical portfolios [the study shows] that the new rules fell short of reaching their target and instead merely reversed the incentives. A model bank can now achieve a material capital saving by allocating its credit securities to the banking book [as opposed to the trading book], irrespective of its real intention or capability of holding them until maturity. The advantage of doing so is particularly pronounced when the incremental investment increases the concentration profile of the trading book, as usually happens for exposures towards banks’ home government. Moreover, in these cases trading book requirements are exposed to powerful cliff-edge
effects triggered by rating changes."

In the nutshell, Basel 2.5 fails to get the poor quality assets risks properly priced and instead created incentives for the banks to shift such assets to the different section of the balance sheet. The impact of this is to superficially inflate values of sovereign debt (by reducing risk-weighted capital requirements on these assets). Added effect of this is that Basel 2.5 inadvertently increases the risk of sovereign-bank-sovereign contagion cycle.

The paper is available at: http://www.bancaditalia.it/pubblicazioni/econo/quest_ecofin_2/qef159/QEF_159.pdf

28/2/2013: Risk-free assets getting thin on the ground

Neat summary of the problem with the 'risk-free' asset class via ECR:

Excluding Germany and the US - both with Negative or Stable/Negative outlook, there isn't much of liquid AAA-rated bonds out there... And Canada and Australia are the only somewhat liquid issuers with Stable AAA ratings (for now). Which, of course, means we are in a zero-beta CAPM territory, implying indeterminate market equilibrium and strong propensity to shift market portfolio on foot of behavioural triggers... ouchy...

14/2/2013: New Compensation Model for Rating Agencies

I wrote yesterday about two studies on the effectiveness of the rating agencies (link here). Another interesting study on the agencies and their performance was published in Spring 2012 issue of the Journal of Structured Finance (vol 81 number 1, pages 71-75). Authored by Malesh Kotecha, Sharon Ryan, Roy Weinberger and Michael DiGiacomo and titled Proposed Reform of the Rating Agency Compensation Model, the study looks at the current model of rating agencies compensation - the so-called issuer-pay model whereby issuer of securities being rated paying for the rating delivery - in light of the apparent conflicts of interest implicit in the model. The authors propose an alternative model based on fee levied on new issues and secondary markets trade. Fees would be deposited in a dedicated fund which will pay these out to the rating agencies. The agencies will be rotated on a performance basis, taking into account accuracy of their ratings over time.

The criticism of such an approach to compensation model - as noted by the authors - stems from 

-- the disincentive to rating agencies under the proposed changed model to innovate in ratings models development (higher potential errors etc)

-- the fact that the US bonds market is global in coverage and thus requires competitive pricing systems, 

-- difficulty of devising a merit-based rotating system and setting appropriate levels of fees; and

-- the new model introducing a transactions tax.

Overall, the weakest point of this proposal is undoubtedly its failure to consider the US markets role as global issuance platform with any transaction tax eroding cost competitiveness and the failure in recognising that global scope of rating agencies and the US markets also implies severe limits on new compensation model ability to capture the activities of these agencies.

13/2/2013: Rating Agencies Role & Effectiveness: 2 recent studies

In light of all the cases being filed against the rating agencies and in light of the general controversy surrounding them, here are two recent papers dealing with the topic of rating agencies performance and the links between their ratings and investors' decisions.

One interesting paper was published in the Journal of Banking & Finance )vol 36, number 5, May 2012, pages 1478-1491) by Thomas Mahlmann titled "Did Investors Outsource Their Risk Analysis to Rating Agencies? Evidence from ABS-CDOs".

The paper looks at the floating-rate tranches from collateralised debt obligations (CDO) backed by asset-backed securities to test whether yield spreads at the point of issuance (origination) act as good predictors of future performance. The paper found that, once we control for rating at issuance and other deal-specific data, yield spreads do indeed indicate future performance. However, this result is primarily due to tranches that were initially rated below AAA.

The study concludes that at the issuance / origination, investors did not rely only on ratings, when pricing the CDOs studied. The study econometric evidence also indicates that ratings were inadequate for CDOs because these instruments are much riskier than corporate bonds.

Another paper, published in the International Journal of Finance and Economics (March 2012) by Eduardo Cavallo, Andrew Powell and Roberto Rigobon, titled "Do Credit Rating Agencies Add Value? Evidence from the Sovereign Rating Business" look at the credit downgrades made during and after the financial crises asking whether rating agencies opinions provide any incremental information to the market.

The answer to the question is yes. Rating agencies opinions on sovereign risks do explain a portion of variation in three macroeconomic variables, relevant to the market: exchange rates, stock market indices and future sovereign bond spreads, once the authors control for observed bond spreads.

The study also found that rating agencies upgrades (downgrades) are correlated with:

1. decreases (increases) in the spreads one day forward;
2. increases (decreases) in the stock market;
3. nominal exchange rate appreciation (depreciation) relative to the USD.

Top level conclusion: the ratings do contain information about specific credit and the rating's informational content is in addition to other publicly available market data, such as credit spreads.