It is now (almost) official: q1 dollar reserve growth exceeded the US current account deficit …
The BIS reported data on central banks’ accumulation of dollars in the international banking system today (Table 5c). Central banks added $24.5b to their dollar holdings – but also repaid $53.5b in loans from the world’s banks. That works out to a $78b increase in central bank’s net dollar position – which rose from $534.5b to $612.5b. When a central bank pays back a loan from a commercial bank, the commercial bank is able to lend those funds out – increasing the “liquidity” available to private borrowers. Not all these dollars flowed to the US either. But the availability of dollar financing in offshore financing centers certainly makes it easier for a range of financial players to buy US securities.
The same BIS data shows a $50.7b increase in central banks net euro position in q1 ($47b in flow terms) and a $10.7b fall in central banks net pound position (-10.3b in flow terms).
In ball park terms, net dollar deposits ($78b) grew almost twice as fast as net euro and pound deposits ($40b). That doesn’t suggest much of a shift away from the dollar. I wouldn’t put too much faith in this data though. It covers a small subset of total central bank claims, and I suspect that central banks ran down the pound deposits to buy other pound assets, not to buy dollars or euros.
The BIS data can be combined with the US data to get an estimate of the total increase in central banks dollar holdings. The US BEA reported $147.8b in net official inflows to the US in q1. Most of that came from the purchase of US securities, but there was also a $29.4b increase in (“onshore”) bank deposits. To get an estimate of reported dollar reserve growth that avoid double counting, I need to subtract the increase in onshore deposits from the US total and then add in the overall increase in dollar deposits reported by the BIS. That produces a $196.4b increase in central banks “known” net dollar holdings.
The q1 2007 US current account deficit was $192.6b.
Even if not all central bank offshore dollar deposits flowed directly to the US, it doesn’t take a genius to figure out who is currently financing most of the US deficit.
The US data doesn't pick up all offshore dollar deposits. And the US data also likely underestimates official purchases of US securities. The BEA data always gets revised up after the survey of foreign portfolio holdings. And we know that the increase in the FRBNY’s custodial holdings in q1 ($127.6b) was $21.3b larger than the purchases of Treasuries and Agencies reported in the US data. Add that $21.3b to $192.6b, and there was a $213.9b increase in (net) official dollar holdings in the first quarter.
If that isn’t a record, it has to be close –
A backward looking data point is admittedly a strange thing to calculate on a day when the broad market is selling off. But I suspect it also provides a bit of insight into some of the underlying reasons for recent market moves.
The original idea behind all of my efforts to track reserve growth was to get some advance notice if central banks ever decided to turn away from US assets. That hasn't happened; all available data suggests record official demand for US assets. But I don’t think my efforts have been a total waste. Data on central bank reserves helped, for example, to understand what likely drove the Treasury sell-off in June (that sure seems a long-time ago; Treasuries are back well under 5%).
But it certainly doesn’t help to explain the current sell-off in risk assets. The “official” bid for risk assets is rising – though perhaps a few big buyers are having second thoughts about diversifying into “private” mortgage-backed securities. And the latest FRBNY custodial data shows a $27.8b increase in official holdings of treasuries and agencies over the last four weeks. The FRBNY data doesn’t capture all central bank related flows – it is a floor, not a ceiling. For all that attention generated by sovereign wealth funds, a lot more money is still flowing into traditional reserve assets.
The markets haven’t seized up because central banks stopped buying dollars, or stopped buying dollar-denominated bonds.
Rather, they have seized up because a lot of private investors who had reached for yield over the past few years, in part because central banks drove down the yields on “safe” assets as well as contributing to a fall in market volatility, seem to have reached a bit too far. They lent a lot of money to folks trying to afford to buy a house. And they snapped up CLOs stuffed with LBO related debt, financing the buyout boom that drove up equity markets. As a result, until recently, “even the riskiest companies could obtain credit cheaply.”
Mohammed El-Erian puts it well. For a while,
“individual investors' performance was essentially a function of the degree of their exposure to the most illiquid and leveraged asset classes.”
That naturally created pressure to take on more leverage to buy more illiquid assets.
Things now have changed. Lots of subprime mortgages were bundled into mortgage backed securities and various tranches of different mortgage backed securities in turn were bundled together in often illiquid CDOs. Some of those CDOs were bought with borrowed money. That turned into a problem when folks with limited income started defaulting on their mortgage debt as housing prices turned.
More recently demand for LBO debt disappeared, in part because of concerns that some companies may be taking on more debt than they could service. The IMF has a nice chart showing the rise in leverage in private equity deals (p.3) – along with some interesting graphs on subprime default rates in various “vintages” (p.2) in their recent market overview. Throw in concerns that triple AAA rated structures might have somewhat more risk than the ratings agencies initially thought, and, to quote PIMCO's Bill Gross, the market resembles a constipated owl.
“To be blunt, they seem to be thinking that if Moody’s and Standard & Poor’s have done such a lousy job of rating subprime structures, how can the market have confidence that they’re not repeating the same structural, formulaic, mistake with CLOs and CDOs? That growing lack of confidence – more so than the defaults of two Bear Stearns hedge funds and the threat of more to come – has frozen future lending and backed up the market for high yield new issues such that it resembles a constipated owl: absolutely nothing is moving.”
Felix notes that the fact that a lot of the new instruments that emerged to satisfy investors demand for yield back are untested isn’t evidence that they are unsafe. All new instruments by definition haven’t been tested.
But it still seems to me that the market for a lot of instruments that hadn’t been tested by a downturn got really big really fast. Right now that worries me more than the risk that central banks will suddenly lose their appetite for all dollar assets.
>>Felix notes that the fact that a lot of the new >>instruments that emerged to satisfy investors demand >>for yield back are untested isn’t evidence that they >>are unsafe. All new instruments by definition >>haven’t been tested
Weren’t they backtested ? Did anybody bother to understand how the backtesting ( test sets, validation sets ) was carried out ?
Secondly, from a logic perspective, seems to me that inductive logic, scientific logic dictates that the usual meaning of safe is that there is data, necessarily historical, backing that the particular practice delivers the predicted result.
An untested new instrument would be, err, untested, NOT shown to be safe. What would happen if you used it ? Well, who knows ? it would be gamble wouldn’t it ? Would you use it with your money ? Would you be meeting your fiduciary responsibilities if you were in that position with OTHER PEOPLE’S MONEY ?
Altogether, Felix’s argument is worthy of the touts, reporters(sic!), anchors that appear on CNBC..
-K
I don’t buy this argument:
[risk asset markets] “have seized up because a lot of private investors who had reached for yield over the past few years, in part because central banks drove down the yields on “safe” assets….seem to have reached a bit far”
Surely the displacement effect of central banks buying safe assets would be to widen credit spreads, not narrow them. Anyway, the previous high point for spread product was in 1998, which followed a period of Asian central bank reserves sales in 1997.
I think that the real reason for the boom in spread product is decadence. People, especially in Anglo Saxon countries, have been hoping that high returns rather than foregone consumption can make them rich, are too lazy or cool to research potential investments carefully, and expect any misfortune that befalls them to be made good by either the courts or the Fed/government.
What we are seeing in recent days is another of the periodic falls to the safety net held by the Fed. I hope that this time they hold it sufficiently low for investors to sustain enough bruises to persuade them to lower the trapeze before they break something.
Who, or what, holds controlling interest in the derivatives?
“…Total world stock market capitalization was about… $51.225 trillion in March 2007… total nominal value of derivatives… grew to $415 trillion at the end of 2006. Here’s what that looks like on a standard bar chart… the $ value of derivatives [is] about 8 times larger than stocks now, whereas in 1990 stocks were 6.5 times larger than derivatives…”
http://www.blackswantrading.com/files/d6cc2ef7a2ce22c/bsccc072707.pdf
OK, I see now I’ve not begun to study this area. Still, for what it’s worth, I’ve just updated a chart following Reuter’s Thursday reports on estimated foreign central bank net buys of treasuries and agencies. Last week’s results appeared to be a radical departure from recent experience.
http://housingdoom.com/2007/07/27/us-obligations-trend/
guest — please explain how your query about derivatives links to the themes of this post. thanks
“Investors are abandoning Irish stocks as rising interest rates hurt western Europe’s fastest-growing economy of the past decade. The country’s ISEQ Overall Index, a third of which is made up of Ireland’s three biggest mortgage lenders, has slumped 9.9% in 2007. It’s the worst performer among equity benchmarks for the 13 nations sharing the euro, and the only one besides Italy’s and Belgium’s that has fallen this year. An index for local banking stocks… has slid 18%… Irish house prices are dropping for the first time in five years, and the European Central Bank has signaled it’s not done raising rates…” http://www.bloomberg.com/apps/news?pid=20601109&sid=aEeoHfOx2tkQ&refer=home
From London Financial Times, Serious conflicts of interest in Wall Street ratings of US Corporations.
http://www.ft.com/cms/s/64fa3b00-3ba6-11dc-8002-0000779fd2ac.html
US executives have been able to secure more favourable research ratings for their companies from investment banks by bestowing professional favours on Wall Street analysts, according to new academic research to be published on Friday.
The study found that by offering analysts favours, ranging from recommending them for a job to agreeing to speak to their clients, executives sharply reduced the chances of a downgrade in the aftermath of poor results or a controversial deal.
“Favour-rendering to analysts is evidently widespread and . . . it seems to be compromising the value of the guidance these experts provide to investors,” said Michael Clement of University of Texas, who co-authored the study with James Westphal of University of Michigan.
Analysts’ representatives said that accepting favours such as those described in the study - which also include putting analysts in touch with executives at other companies and advising on personal matters - was unethical.
But, according to the study, conducted between 2001 and 2003 and to be presented to next month’s annual meeting of the US Academy of Management, nearly four out of six Wall Street analysts admitted receiving favours from company executives.
Hi Brad - can you email me at jungle dot np at gmail dot com. I have a JPM piece on reserves to send you, and I lost your email address.
2007-07-27 08:09:30 - try asking 2007-07-27 08:23:01
well, one thing’s clear: the era of (indiscriminately) leveraging cash flows is over… implications?
Dr. S
Once upon a time we looked at the basic balance, not just the current account. Some years ago, it occurred to me that America needed foreign capital to fund the current-account defict plus foreign investment, including real assets as well as portfolio investments and bank lending. What I’m getting at is that we have to be grateful that the capital inflow is greater than the current-account deficit.
That said, I have found your work very insightful.
2007-07-27 11:20:35 - are you sure it’s been indiscriminant - or that its over?
the basic balance is indeed useful. there was a net fdi outflow in q1, a quite significant one really. so US financing to cover CAD + net FDI outflow was close to $250b.
one thing has never been clear to me — what is the accepted way of calculating the basic balance? Some market guys include portfolio equity, some don’t. some include private portfolio debt, some don’t …
the non-interest current account deficit (analogue to the primary surplus) is also useful, but for most purposes, trade and transfers works as a decent proxy …
Study on analyst favors may be a bit dated. There was a major crackdown on this after the 2002 Global Settlements. Analysts in IB’s are told nowadays to accept absolutely nothing from clients, and it isn’t accept nothing *wink* *wink*, it’s accept nothing or you are fired.
Also, mortgage backed securities are set up so that the buyer of the security doesn’t lose payment if the mortgagee defaults. This means that the issuer of the MBS has to cover the loss in case of default, but the buyer of the security is not out of money.
In the case of CDO’s, most CDO’s are sold for risk mitigation, so I don’t see any problems there. Risk gets transfered from people who don’t want it to people who do.
One final thing, hedge funds collapse all the time.
most CDOs though are bought for yield enhancement …
i was hoping for a bit more discussion of the points raised in the first comment, about back testing. naked capitalism would know much better, but i am sure that a lot of new instruments were backtested.
the problem is that that backtesting itself has some problems - if you have an unprecedented runup in housing prices for example, the risk of a fall larger than what has showed up in the backtested data may be quite large. and the development of new markets and new instruments itself can change the way the market operates. More leverage + more embedded leverage in some CDOs = greater returns more risk of liquidity troubles leading to forced sales and the like –
and any CDO requires making some assumptions about correlation among credits (as i understand it), and over time, those correlations may change as economic relationships change.
models cannot (almost by definition) capture unforeseen circumstances that inevitably occur. how s&p/moody’s/fitch (on issuer-provided data) had the confidence to rate structured products based on models is beyond me (well, for the money o’course); their imprimatur, rather than a mark of assurance, is probably feeling more like a cattle brand at this point!
[q]the problem is that that backtesting itself has some problems - if you have an unprecedented runup in housing prices for example, the risk of a fall larger than what has showed up in the backtested data may be quite large.[/q]
But people do think about these sorts of things, and people do run scenarios against extreme cases, and hedge against them. One problem with the financial media is that every small dip becomes this breathless crisis, and it becomes hard to answer the question “how bad is bad.” There is a difference between “cause some hedge funds to go under bad” and “cause the end of civilization bad” and I haven’t seen anything that would suggest that the sub-prime blowup is any more than a small annoyance.
Sorry, Brad, but your last post is disappointing.
Why?
When you talk about backtesting, you have the doctor’s gloves on. No infection!
I think that you are as a balanced man as to cope with the more stressed test about neutrality and equality! Let’s say things clear! OK!
But human beings are malicious sometimes, aren’t they or we?
If lenders invented “ninja” loans (no income, no job, loans); Where they really worried about something else than making business (earn fees and let’s see what happens)?
What have we learned from the market-to-model or market-to-market and rating agencies?
Was it a backtesting problem or a very carefully plan to a new to richness?
Isn’t the MBS business in mortgage market, very similar to LBO and CLO markets?
Rebel Economist talks about decadence. I totally agree with him. But in south europe were are not anglo saxon and we’re braking warriors in speculation.
Today, PEMEX said they will run out of petrol in seven years:
http://www.plenglish.com/article.asp?ID=%7BF1F8B8FE-DA99-4717-8FBD-2B3C4F90FBA3%7D%29&language=EN
The most clear explanation of financial mess explains by a banker:
http://www.dailykos.com/story/2007/7/26/175633/277
Let’s go to the heart of the matter, as P. Krugman wrote it:
“Anyway, now reality is settling in. And there’s one more thing worth mentioning: the economic expansion that began in 2001, while it has been great for corporate profits, has yet to produce any significant gains for ordinary working Americans. And now it looks as if it never will.”
Thanks for your hard-work,
Best Regards
re: “how s&p/moody’s/fitch had the confidence”
FASB 140?
Felix says rating agencies need not be concerned with market risk.
That’s a very dubious view.
Risk modeling errors all amount to pretty much the same thing - and it is the thing that brought down LTCM.
It is the reliance on risk bounds that are determined by statistical analysis - i.e. bounds expressed in terms of historic standard deviations, whether actual or backtested.
The failure is always to consider specific scenarios that significantly pierce those formulaic risk bounds, including correlation assumptions.
A classic expression of this type of human error is Mandelbrot’s definition of the iconic ‘value at risk’ (Var) measure of market risk:
” A theory of ocean waves whose swells are forbidden to exceed six feet. ”
That’s basically the mentality that brought down LTCM.
In that case, it was genius and hubris operating in a vacuum of common sense.
The nature of the error made in risk/default analysis applied in this case is in the same category, whether or not it is the rating agencies that are ultimately responsible.
“…Caja Madrid… boasts half a million immigrants as customers, who account for almost 20 per cent of the savings bank’s mortgage portfolio. Other banks have followed suit, opening branches staffed with Moroccans, Chinese and Latin Americans in immigrant neighbourhoods and tailoring mortgages to the special needs of migrants… Some banks offer loans for buying houses in their customers’ home countries… a property developers’ association, estimates that one in three new homes was sold to an immigrant last year. But because immigrants earn less than Spaniards, their debt burden is greater…” http://www.ft.com/cms/s/0059c4d0-d752-11db-b9d7-000b5df10621,dwp_uuid=d355f29c-d238-11db-a7c0-000b5df10621.html
“…if you look at the highest tranches of CDOs, especially synthetic CDOs, they often default only in extreme economic circumstances, when a lot of companies all default at once. Which is exactly the kind of circumstance when you want your triple-A paper not to default. For this reason, such CDOs really do resemble “economic catastrophe bonds,” which pay out a steady coupon unless and until catastrophe hits, at which point they tend to lose all their value… The interesting thing is that if you want an economic catastrophe bond, you can construct one just as easily by writing something known as a “deep out-of-the-money put spread” on the S&P 500… An investor willing to assume the economic risks inherent in senior CDO tranches can, with equivalent economic exposure, earn roughly 3 times more compensation by writing out-of-the-money put spreads on the market…”
http://www.portfolio.com/views/blogs/market-movers/2007/07/17/why-highly-rated-cdo-tranches-are-a-bad-bet
A bill that would open the way for punishing Beijing over its currency policy passed the Senate Finance Committee 20-1, in a possible indication of how anti-China legislation could fare in the overall Senate.
The U.S. is concerned a surge in Chinese sales of military technologies to Iran could complicate efforts to enforce nuclear compliance.
Brad raises back testing. The problem with such checks is motivation. They are generally done by agents who do well out of the production and distribution of “alternative investments”, while their exposure to investment losses is limited. It is just not in their interest to make such conservative assumptions about poorly known information that such products cannot survive. So the aim (albeit perhaps tacitly, unconsciously so) is to be sufficiently rigorous to screen out imminent blow-ups and to satisfy the regulators, but no more. The investment banks are in the business of taking some cheap (and if necessary, hedgeable) building blocks and making something seductive that can be sold at a large markup. The rating agencies are in a symbiotic relationship with the investment banks. The fund managers want beta dressed up as alpha, since beta is cheap to obtain and alpha is hard, and extreme negative skew investments fit the bill nicely. Ultimately, it is up to the end-investor to exercise caution. Above all, “don’t buy what you don’t understand”!
For a readable account of the motivation (plus a dash of vanity and stupidity) of investment banks and fund managers, I recommend the book F.I.A.S.C.O. by Frank Partnoy.
I wonder if we are too concerned about the risks to the financial business here, and not enough about the end-investor. There seems to be an assumption being made that risk dispersal is a good thing. What if this is true at the institutional level, but macroeconomically irrelevant?
Right now, the conservative nature of central bank and SWF investment policies is looking rather wise. I wonder whether Larry Summers is reconsidering his advice to them to take more risk.
“Holidaymakers heading to the US in the coming weeks may be better off buying their dollars sooner rather than later after the pound fell… against the greenback… Sterling, which at the start of the week set fresh 26-year highs against the dollar of $2.0655, fell to as low as $2.0277 during trading today as investors dumped risky assets…” - ‘Dollar back in favour as safe haven’ http://business.guardian.co.uk/story/0,,2136322,00.html
“…high levels of non-performing loans are a concern… Any economic downturn could lead to the ratios rising from already elevated levels in a number of economies”.
Big discrepancies remain. Last year, the percentage of non-performing loans was 7% in both mainland China and Indonesia versus just 0.8% in South Korea and 1.1% in Hong Kong…” http://www.ft.com/cms/s/461f0b9a-3b4f-11dc-8002-0000779fd2ac.html
“Japan’s first property derivative deal has been announced, marking a milestone for the young but rapidly growing global market. Grosvenor, the British property company, has agreed “a small test trade”… Other companies may use derivatives to hedge their exposure to Japan. Rental yields have fallen, largely because the rapid development of real estate investment trusts has created huge demand for a limited number of properties…” http://www.ft.com/cms/s/f8a76154-3ba4-11dc-8002-0000779fd2ac.html
“…Benchmark bond yields yesterday fell to the lowest in eight weeks on speculation a U.S. housing slump will slow growth in the biggest market for Japanese exporters, making it harder for the [BoJ] to justify raising interest rates…” http://www.bloomberg.com/apps/news?pid=20601087&sid=aravgpCDpYQY&refer=home
2007-07-28 04:16:26
Why were the fund managers so ignorant of the shortcomings of the rating agency methodologies when they bought the paper?
Where was the due dilligence on the substance and quality of the rating agency service then?
Why did they need to wait until now to become experts at rating the rating agencies?
2007-07-28 04:16:26
… The rating agencies are in a symbiotic relationship with the investment banks …
Could you elaborate? What are the natural conflicts between the relationship of these two actors and the buyer?
” Data on central bank reserves helped, for example, to understand what likely drove the Treasury sell-off in June (that sure seems a long-time ago ”
Does the recent plunge in yields mean they’re back in buying?
Or does it mean factors other than central banks explain bond yields?
If the latter, who knows which factor is at work, and when?
“…”Deals continue to get launched in the market,” said Matthew Fuller, associate director at Standard & Poor’s Leveraged Commentary and Data. “The G.E. plastics deal is 7 ½ times levered, it’s $2.8 billion of high yield bonds, and it’s roadshowing internationally…” http://www.nytimes.com/2007/07/27/business/27deals.html?em&ex=1185768000&en=bc63053f50a7fc61&ei=5087%0A
RebelEconomist: The problem with such checks is motivation. They are generally done by agents who do well out of the production and distribution of “alternative investments”, while their exposure to investment losses is limited.
That’s not true (and I know this from first hand observation). The motivation to do back testing is to avoid causing the bank to go bankrupt. The people who do the modeling and back-testing are kept very separate from the marketing people, and in any competently run bank, the risk managers can kill any deal they think will put the bank in danger. There are also people in the bank that are not allowed to talk to each other, and a large compliance bureaucracy to make sure that they don’t talk to each other without a chaperone present (literally).
The other thing is that there is a lot of interaction with academia and regulators. The Fed monitors the banks for risk, and most of the models have input from academia.
[q]It is just not in their interest to make such conservative assumptions about poorly known information that such products cannot survive.[/q]
The possibility of bankruptcy and a wholesale crash of the financial system is a lot of motivation.
[q]For a readable account of the motivation (plus a dash of vanity and stupidity) of investment banks and fund managers, I recommend the book F.I.A.S.C.O. by Frank Partnoy.[/q]
People do learn from their mistakes, and institutions that make lots of mistakes tend not so survive. Reading about the factors that causes major disasters in the past is useful, but assuming that those factors have not been fixed is not.
[q]models cannot (almost by definition) capture unforeseen circumstances that inevitably occur.[/q]
Yes they can. You assume that someone waves a magic wand and interest rates rise to 20% and see what happens. The neat thing about money is that it changes things so that you don’t have to worry about the details. Something happens that causes you to lose $5000, what happens. You don’t have to think about what causes the loss, you just assume it happens.
And just to clarify something. If a mortgagee defaults on a sub-prime MBS, the securities are generally set up so that the issuer of the security eats the loss rather than the holder of the security.
“I think that the real reason for the boom in spread product is decadence. People, especially in Anglo Saxon countries, have been hoping that high returns rather than foregone consumption can make them rich, are too lazy or cool to research potential investments carefully, and expect any misfortune that befalls them to be made good by either the courts or the Fed/government.”
that’s true. but decadence is often followed by panic. panic can be defined as ‘instant prudence.’ instant prudence is then followed by deep regret, and the sound of stable doors being slammed on absent equines. this time there may be a new element. some of the anglo saxons will fear a chinese buying spree - others will hope for chinese investment as the plunge protection team of last resort.
many years ago i suggested that the time to panic was when the president went on television to say that the economy was fundamentally sound. has that moment arrived ? it is the only sure indicator.
“Mutual fund assets worldwide increased 7.6% to $21.76 trillion at the end of the fourth quarter of 2006. For the year as a whole, assets grew 22.5%, the strongest growth since 2003 …Net inflows to bond funds in the [US] accounted for nearly the entire fourth-quarter flow worldwide as, outside of the [US], net outflows from bond funds in South America and Europe largely offset net inflows elsewhere…”
http://www.ici.org/stats/latest/ww_12_06.html#TopOfPage
“…ICI members include 8,579 open-end investment companies or “mutual funds,” 653 closed-end funds, 162 exchange-traded funds and 5 sponsors of unit investment trusts. Mutual fund members of the ICI have total assets of approximately $9.1 trillion, representing 98 percent of all assets of U.S. mutual funds. These funds serve approximately 89.5 million shareholders in more than 52.6 million households… Mutual funds and fund shareholders have a significant stake in the soundness and integrity of the credit rating system. I therefore commend the Committee for holding this hearing to examine the current oversight and operation of credit rating agencies…” http://www.ici.org/statements/tmny/06_sen_credit_tmny.html#TopOfPage
“…”I want the American people to take a good look at this economy of ours,” said President Bush in a “media availability” appearance Friday morning… Bush says the economy is strong. In a 351-word statement, he said “strong” seven times, sometimes twice in the same sentence, in case we missed it the first time around…” http://www.salon.com/tech/htww/2007/07/27/bush_economy/print.html
“…Already the most expensive place in the world to buy a luxury property, this city is expected to set a new price record… In particular, buyers from Asia, India and Russia have been drawn to the London market by an attractive tax structure, which allows them to claim residence in another country and pay no tax on all money kept there…” http://www.iht.com/articles/2006/12/01/news/london.php
“…Rather than buy an imitation out of a suitcase on a Hong Kong street corner, the Chinese financial adviser went two blocks away to check out genuine Piaget Polo watches… Piaget Polo gold watches have a recommended retail price of more than 15,000 euros…” http://www.bloomberg.com/apps/news?pid=20601109&sid=a939fKjsoLVc&refer=home
re: F.I.A.S.C.O. - “…this is no more than you’d expect from a junior associate who’d been on the derivatives desk for a very short period of time… ” http://www.amazon.com/Fiasco-Inside-Story-Street-Trader/dp/0140278796
‘gilles/2007-07-28 17:01:46′ - if you can provide your own definition of ’strong’ and name an economy that is ’stronger’ than the U.S.? Don’t leaders of all nations generally advocate their economy’s strengths? - unless, of course, they are seeking development aid:
“Some German politicians are urging the government to halt development aid worth millions of euros to China, saying the country’s surging economy and thriving exports no longer justify the generous handouts…” http://www.dw-world.de/dw/article/0,2144,2709222,00.html
“…Whether promising to overhaul China’s regulatory regime… will be enough to tame what some view as the Wild, Wild East of capitalism is unclear… because some of the problems are so deeply rooted… 20% of its consumer goods and 14% of the truck tires made here failed safety inspections…” http://www.nytimes.com/2007/07/29/world/asia/29safety.html?hp
Twofish,
Admittedly, it is a few years since I was involved in wholesale financial markets, but I would be surprised if human nature had been controlled that much better since. Perhaps the fact that traders and structurers generally get paid more than risk managers reveals where investment banks’ priority lies.
The quote from the Amazon reviews of FIASCO above is selective - there were many positive reviews too. Actually, I think the book’s marketing publicity is misleading - to me, the buy side seemed to be as guilty as the sell side. Unfortunately, the mutual fund market timing scandal emerged after the book was written. I do believe that the buy side has become more sophisticated in recent years, and I doubt that they buy products that they do not qualitatively understand, but a quantitative understanding good enough to know value is a different matter, as the unfolding CDO story evinces.
A symbiotic relationship is a mutually beneficial relationship between two different species - the classic case is ants and aphids. Since I cannot remember a reference to quote, I will say that “I have read that” the structurers of credit derivatives work with the rating agencies to do just enough to get their target rating. The rating agencies get highly paid for such specialised work. It is also alleged that, as a result of this contact, the smartest rating agency quants get poached by the investment banks. The buy side is likely to get a bad deal, but note the agency problem. If an investment satisfies the plan sponsor’s rules, and yields more than the alternatives, then many fund managers will buy it without looking too closely, especially if they get 20% of the upside and none of the downside.
http://www.fullermoney.com/x/default.html?cotd=y&id=7521
“Hi FM keep up the good work - its long-winded but I’ve practically written an essay for a recent grad-friend based on CDO’s, mortgages and leverage [as a response to his question below]
“OK, there are a few sources, types of leverage:
“1) Corporates take on huge loans (issuing bonds that take their ratings lower) to buy back shares, this is not exactly a useful use of cash because co.’s should borrow for ‘real’ investment, in this sense, corporates ‘leverage up’ to increase shareholder returns but its very short-sighted in my opinion. One of the reasons they do this is hedge funds buy into companies with low levels of debt, and then force the management board to borrow money and pay extra dividends, do buybacks etc. Companies with low levels of debt do this just to avoid an LBO.
“2) Similarly… Private Equity buyers make a bid on a company (LBO)… i.e. a co. with EBITDA of $500m per year, and they pay say 10x EBITDA, i.e. $5bn. Then they put in 20% of the funds themselves (e.g. $1bn). The investment banks make them a short-term “bridge” loan for the other 80% e.g. $4bn. The idea being that they then have 18m (the normal length of a bridge loan) to issue the junk bonds from the company itself once they own it, and repay the inv. bank loan…. now think about it’s crazy, you offer to buy a company but don’t have much money, so when you own the company, the company takes an enormous loan to pay for itself, its nuts! So investment grade companies, often AA rated become B rated ‘junk’ firms overnight. The problem from here is two-fold…
“a) highly levered firms, paying 6.25% on their junk bonds (e.g. $500m over $8bn) just survive, but if rates go up to 8.25%, that company now needs $660m to pay its interest, but is doesn’t earn enough so gets into financial troubles, so companies which had LBO’s two-three years ago and now need to reissue their bonds are screwed, and a few will go bust in H2 now because they cant replace/re-issue bonds; no-one will buy them because they realise they can’t repay the interest.
“b) Investment Banks are said to hold $300bn of bridging loans on their books, now in this turgid market they can’t issue the bonds on behalf of the firms and get rid of the debt, so they’re stuck with it. This is a really inefficient use of capital for Inv. Banks, whose business is based upon churning stuff over, & now JPM et al, is a loan company to ‘junk’ bond corporates, who can’t repay their debts, suddenly it looks on slightly more shaky ground.
“… It’s interesting because investment banks only do bridging loans to win investment banking advisory fees and capital markets business, “bridges” are practically a loss-leader. After the 1930’s depression the Glass-Steagal Act prohibited investment banks from doing loans precisely to stop this sh1t from happening (yep its happened before- after all, the G.Dep. was caused by never-ending withdrawal of liquidity despite the fed’s best attempts - I don’t think they had helicopters to drop money from then!?), and investment banks were forced to separate from their lending businesses (e.g. Morgan Stanley use to be part of JPM). It was only after lobbying from Citibank in 1999ish that the G.S. Act was repealed and cross-lending allowed, now look what’s happened!!!
“So really, leveraged debt is Private Equity firms buying corporations using borrowed money, which is ultimately borrowed from the firms themselves. In theory it can work well i.e. Philip green bought BHS for £200m when he was only worth £50m. But when stock market valuations are already at their peak price/cashflow ratios it’s hard to sell the company on for more money. One of the signs the bubble was at its peak, was Leveraged firms selling companies to other leveraged firms who put more leverage into it in order to buy it!
“3) CDO’s….for example, this is when 100 companies are put into a portfolio e.g. with an average yield of 5%, and the portfolio is ‘tranched’.
“Normally, if 1 firm went bust the investors collectively would lose 1%… But with this it’s different, instead one investor would take on the first tranche, they might earn 10%yield, but if a firm goes bust they lose the whole amount… often they take the first 3 defaults, therefore 1 bust and the high risk investors lose 33% of their investment! But they are at the bottom of the structure earning 10%. the others further up are safe, losing nothing but earning lower yields, so it’s OK for them right?
“So you can model using Monte Carlo, e.g. someone who is 10 defaults up the structure earning 4% yield, statistically they might be 2 std deviations away from experiencing the 11th default etc etc. So the very high-rated investors at AA etc, …towards the top of the structure should be really safe.
“But… Who takes the first-order high-risk part? The investment banks do, because they’re the ones with the PhD’s writing the models for the CDO’s. And they say they can hedge for the first few defaults (much in the way you’d use Black-Scholes hedge-ratio for equities). In a sense it’s also a loss-leader, because they take the high-risk part in order to sell-off the other ’safer’ parts.
“Now it gets more complicated, because what are the actual entities in the portfolio? Imagine they are mortgage bonds. Now a mortgage bond works the same way, it’s tranched. So the first defaults destroy the money of the B rated investors. The next defaults destroy the money of the BB investors and so on. Now, many CDO portfolios seemed vary safe to investors who only wanted to buy the AA rated tranche, filled with AA rated mortgage bonds!… but mortgage bonds are also structured the same way as CDO’s in effect…. Suddenly, if mortgage defaults are twice what we had modelled, then those std deviation bands used for the Monte Carlo were totally wrong. What people thought was a AA mortgage bond is really a BB mortgage bond. And what people thought was a AA CDO tranche was really B (because the CDO uses leverage). Leverage in CDO’s was seen as safe because there is(was) very little mark-to-market volatility in AAA mortgage bonds, so you could take on loads of borrowed leverage and never receive a margin call - this is how Bear Stearns fund’s were caught out last month-end. This means many more things!
“a) Defaults will be much higher (exponentially) than expected/modelled for in mortgages and CDO’s
“b) Some CDO’s were a mixture of AAA mortgages and BB leveraged corporate bonds, to achieve an ‘average’ of AA etc. So lending for corporates will dry-up as the CDO’s get downgraded - as many investors never directly bought B/BB bonds they were bought indirectly through CDOs hence the fact that leverage borrowing for LBO’s got bigger and went on longer than expected. Now if a mortgage bond default causes a CDO to be liquidated, the corporate bonds also have to be sold (or in our case the CDS insurance) sending spreads wider, bearing in mind standard leverage is 8-12x in a CDO.
“c) Banks have to withdraw lending. the reason is this, AA stuff requires 20% capital (i.e. cash to be put down (and the rest is borrowed from the repo market)), but if it is BB it requires 100% (I think! Not a Basle II expert). So most (I believe) CDO investors and banks will have to sell assets to raise the cash… so there will be a global withdrawal of liquidity.
“The trigger for all of this is the fact that the 2006 ‘vintage’ of mortgage bonds was very rubbish. Mortgage brokers never bothered to check if people had jobs, so some mortgages defaulted on the 1st payment!!!
“Even worse, there are CDO’s where the entities inside them are other CDO’s!
“…. So why are stocks up this morning!! ? I think that equities don’t realise what’s happening, it is a new and complex market. At month end all the CDO firms have to revalue their portfolios, so whopping downgrades often come at the end of the month, so expect more ’shock horror’ / ‘hedge fund blows up’ stories through the next 10 days. This is definitely worse than LTCM so I’ve been told by the oldies here.
“I just thank the lord we don’t have ‘06 vintage!”
cf. http://www.housingwire.com/2007/07/10/an-inside-view-managing-a-cdo-and-why-the-rating-agencies-matter/
RebelEconomist: Perhaps the fact that traders and structurers generally get paid more than risk managers reveals where investment banks’ priority lies.
On the other hand, risk managers work sane hours, and there is much less volatility in risk managers income (i.e. a risk manager is less likely to get fired if things go bad). Curiously this fits into people’s personalities. People who have gambler personalities tend to be traders, and people who aren’t tend to be risk managers.
So at the end of the day, what is the loss? Is it “some rich people lose their money” bad or “blood in the streets bad”? My guess is that it will be former.
Guest: the G.Dep. was caused by never-ending withdrawal of liquidity despite the fed’s best attempts
Actually, during great depression, the fed was making the problem worse by not adding liquidity.
Personally, I don’t think it will be that bad, because some people lost a huge amount of money, but some other people made a huge amount of money off the sub-prime mess. The nice thing about derivatives is that they allow you to make bets off other people’s stupidity, and I have reason to believe that some people on Wall Street saw the mess coming, took positions that would pay off when the mess happened, and are walking to the bank with lots of money. The net result of this is that I strongly suspect that derivatives are adding stability into the financial system rather than reducing it.
Agree that, no matter how ‘bad’, many will get rich from credit market crunches. But those who are adversely affected will be spread across an entire spectrum of the economy.
“Short-seller Jim Chanos predicted that many student loan companies will face serious legal issues in coming months… Chanos said investigators will uncover “many tens of billions of dollars in fraud” at loan companies. “We’re short broadly speaking all of them… The real fraud they will find is the herding of middle- and lower-income kids into all kinds of degree schools, and they come out with $40,000 to $50,000 in loans…” http://www.reuters.com/article/GlobalHedgeFundandPrivateEquity07/idUSN1122964920070412
Not that Chanos is above reproach: “…Fairfax Financial… has added James Chanos to the list of defendants in its private lawsuit against short-sellers…” http://www.controlledgreed.com/2007/06/fairfax-financi.html
And Chanos was the guy Skilling called an asshole for asking for a cashflow statement..
Brad, what other sterling assets do you think central banks have been converting their sterling forex holdings into? UK gilts, or something else?
Trend:
Many chief risk officers are former traders who have been put in the penalty box.
former traders who have been put in the penalty box also go into related teaching positions.
wasn’t aware of the second category so much
but the first is a club they don’t want to belong to, a la Groucho, (and traders being what they are), and typically don’t last/stay long
2nd category might stay longer as they watch so many of their students crash and burn. Only speaking from personal experience as that seemed to be the case with my futures and options course instructor, later my boss, as I found so many mistakes in the courses. Did I progress from education to the trading floor? Absolutely not, as I watched so many of our students crash and burn. Perhaps in part due to inadequacies of the education and the type of person that tends to be attracted to the profession, who generally doesn’t want to spend a whole lot of time on courses. In our case, another problem was that one major source of revenue was fines. Headlines about traders in the penalty box also helped sell our retail investor education courses - which catered to retail investors’ fears of corrupt and incompetent brokers. Traders in the penalty box were worth as much or more to the entity that funded us than traders who actually survived and thrived. Education economics is an interesting thing…