Gathering complacency

The Big Picture draws attention the item in The Washington Post that reports on the first moves by AIG into the CDS market. The first steps appear to be rather mundane and cautious. However, it is likely that each subsequent step, supported by the lack of collapse in the previous period, just adds (no multiplies) the level of risk that is being taken.

Noise-trader risk

A return to noise trader risk with a look at experiments in trading.

Here is the experiment.

Currncy returns

Richard Levich and Valerio Poti assess 'Predictability and 'Good Deals' in Currency Markets'

The abstract

This paper studies predictability of currency returns over the period
1971-2006. To assess the economic significance of currency
predictability, we construct an upper bound on the explanatory power
of predictive regressions. The upper bound is motivated by "no
good-deal" restrictions that rule out unduly attractive investment
opportunities. We find evidence that predictability often exceeds
this bound. Excess-predictability is highest in the 1970s and tends
to decrease over time, but it is still present in the final part of
the sample period. Moreover, periods of high and low predictability
tend to alternate. These stylized facts pose a challenge to Fama's
(1970) Efficient Market Hypothesis but are consistent with Lo's
(2004) Adaptive Market Hypothesis, coupled with slow convergence
towards efficient markets. Strategies that attempt to exploit daily
excess-predictability are very sensitive to transaction costs but
those that exploit monthly predictability remain attractive even
after realistic levels of transaction costs are taken into account
and are not spanned by either the Fama and French (1993) equity-based
factors or the AFX Currency Management Index

.

Price discrimination

Here is a story from Crooked Timber about Amazon and price discrimination.

Using order flow

It is usually the case that if it looks too good to be true, then it probably is....However, in the Madoff case, there was a clear explanation for his reported returns. The FT reports on the explanation that Union Bancaire Privee gave to its clients.

“We were assured that he had some visibility as to the momentum of the markets...due to his significant volume size as a broker/dealer,” the UBP letter said.

“The perceived edge was Madoff’s ability to gather and process market-order flow information and use this information to time the implementation of the split-strike options strategy.”

This is also the base for accusations that were made at Madoff that he was front-running (dealing before a large order that he had on the books).

More intielligent soldiers die

Interesting research that shows that the more intelligent soldiers appear to have greater risk of death than their less intelligent colleagues.

Being dumb has its benefits. Scottish soldiers who survived the second world war were less intelligent than men who gave their lives defeating the Third Reich, a new study of British government records concludes.

The 491 Scots who died and had taken IQ tests at age 11 achieved an average IQ score of 100.8. Several thousand survivors who had taken the same test - which was administered to all Scottish children born in 1921 – averaged 97.4.

The unprecedented demands of the second world war – fought more with brains than with brawn compared with previous wars - might account for the skew, says Ian Deary, a psychologist at the University of Edinburgh, who led the study. Dozens of other studies have shown that smart people normally live longer than their less intelligent peers.

"We wonder whether more skilled men were required at the front line, as warfare became more technical," Dear says.

Journal reference: Intelligence (DOI: 10.1016/j.intell.2008.11.003)

Elasticity

NBER research on the elasticity of fleet fuel economy to oil prices.

The authors estimate that a 10 percent increase in gasoline prices from 2005 levels will generate a 0.22 percent increase in fleet fuel economy in the short run and a 2.04 percent increase in the long run - ten times the short-run effect. The $4 per gallon gasoline prices observed in early 2008 could result in a sizable increase in fleet fuel economy - that is, an increase in average fleet miles per gallon, or MPG - of 3.27, or 14 percent, relative to 2005. There also would be a large accompanying reduction in gasoline consumption if these high prices were to remain permanent

Spanish regulation

The FT reports on Spanish banks and finds two important regulations that have insulated them from some of the problems that have hit other banks.

But Spain’s bankers agree that they were kept virtuous largely by the stern regulators at the Bank of Spain. The central bank achieved this in two ways. It made it so expensive for financial institutions to establish off-balance sheet vehicles – of the sort that subsequently sunk banks elsewhere – that few Spanish banks bothered. It also demanded in the good years that banks set aside “generic” bad loan provisions in addition to provisions for specific risks, a sensibly counter-cyclical regime that has been much remarked on abroad since the crisis began. Santander, for example, has built up more than €6bn of generic loan loss provisions.

These are regulations that are likely to be adopted in other countries.

The music business

The Guardian looks at the music business. Major changes in the business model.

Twenty-eight years ago, those west London desperadoes the Clash released an exhausting triple album called Sandinista!. It included Hitsville UK, a tribute to a new breed of cottage industry record labels which blithely bypassed the fact that the Clash were signed to CBS and mapped out a new, non-corporate utopia. In the world to come, they claimed, there would be "no expense accounts, or lunch discounts, or hyping up the charts" - nor any need for "slimy deals with smarmy eels".

This brings together new technology, 2 and 3 way business models and the nature of the consumer.

A silver lining

The FT reports on the opportunities for pension funds in the convertible bond market.

Convertible bonds were hurt more than other markets because hedge funds were the main buyers, owning the bonds as a way of arbitraging the value of the implied option to convert them into equity. But as banks cut back their leverage – from 5.5 times a year ago to virtually nothing now – and investors tried to withdraw money, hedge funds became forced sellers. As a result many investors believe that there is an opportunity to make relatively low-risk double-digit returns without needing to use leverage or complex hedging strategies.

Though hedge funds were forced sellers, this opens the way for other funds to cover some of their losses in other markets.

Illiquid assets

The FT looks at the weight of illiquid assets that can not be sold and are hard to value.

Already, level-three assets are many times bigger than the market cap of the banks. The US Treasury had planned to buy these using the $700bn troubled asset relief programme but changed tack and has used some funds for capital injections.

Greenspan

Brad DeLong provides the balanced view of Greenspan: it is not just free market; it is also a strong belief in the power of the central bank to correct mistakes.

Fundamentally, the Greenspanist combination of massive skepticism of government intervention with overwhelming confidence in the power of the all-knowing and benevolent masters of monetary policy seems strange and unsustainable. But it is, of course, easier to sustain if you yourself are the central planner.

Importance of FX flexibility

Amidst increased talk that the UK will be forced to join the EMU, it is important to note that the last time there was a similar international economic dislocation, exchange rate flexibility was a certain advantage.

As Bernanke says in 'Essays on the Great Depression',

Second, for reasons that were largely historical, political, and philosophical rather than purely economic, some governments responded to the crises of the early 1930s by quickly abandoning the gold standard, while others chose to remain on gold despite adverse conditions. Countries that left gold were able to reflate their money supplies and price levels, and did so after some delay; countries remaining on gold were forced into further deflation. To an overwhelming degree, the evidence shows that countries that left the gold standard recovered from the Depression more quickly than countries that remained on gold. Indeed, no country exhibited significant economic recovery while remaining on the gold standard. The strong dependence of the rate of recovery on the choice of exchange-rate regime is further, powerful evidence for the importance of monetary factors.

This raises the question of whether the mechanism was just a relaxation of the constraint on monetary expansion or something that came from changes in relative prices.

Where does alpha come from?

Alpha comes from maximising winners and minimising losers, according to research carried out by Inalytics (reported in PIonline.com.

“The typical manager, however, compensates for a mediocre hit rate by generating good gains from the winners,” according to the report. The win/loss ratio — defined as the alpha generated from good decisions compared to the alpha lost from wrong decisions — averages 102%. This translates to an average alpha of two percentage points.

Active equity managers also obtain more alpha in their overweight decisions than their underweight choices. Managers made the correct decisions to overweight a stock relative to its appropriate index about 48.5% of the time. But the win/loss ratio was 113.9%, meaning alpha averaged 13.9 percentage points.

Importance of feedback effects

Raghuram Rajan looks at the crisis. One interesting focus is the effect of feedback loops. This is a common theme. Buying leads to capital appreciation and additional buying. This just drives the price further away from fundamental value and increases the risk.

Buffett

The FT looks at Buffett and those 'weapons of mass destruction'

Roman Credit Crunch

From Tacitus, a credit crunch in Rome (ht tired fools).

Meanwhile a powerful host of accusers fell with sudden fury on the class which systematically increased its wealth by usury in defiance of a law passed by Caesar the Dictator defining the terms of lending money and of holding estates in Italy, a law long obsolete because the public good is sacrificed to private interest. The curse of usury was indeed of old standing in Rome and a most frequent cause of sedition and discord, and it was therefore repressed even in the early days of a less corrupt morality. First, the Twelve Tables prohibited any one from exacting more than 10 per cent., when, previously, the rate had depended on the caprice of the wealthy. Subsequently, by a bill brought in by the tribunes, interest was reduced to half that amount, and finally compound interest was wholly forbidden. A check too was put by several enactments of the people on evasions which, though continually put down, still, through strange artifices, reappeared. On this occasion, however, Gracchus, the praetor, to whose jurisdiction the inquiry had fallen, felt himself compelled by the number of persons endangered to refer the matter to the Senate. In their dismay the senators, not one of whom was free from similar guilt, threw themselves on the emperor's indulgence. He yielded, and a year and six months were granted, within which every one was to settle his private accounts conformably to the requirements of the law.

Hence followed a scarcity of money, a great shock being given to all credit, the current coin too, in consequence of the conviction of so many persons and the sale of their property, being locked up in the imperial treasury or the public exchequer. To meet this, the Senate had directed that every creditor should have two-thirds his capital secured on estates in Italy. Creditors however were suing for payment in full, and it was not respectable for persons when sued to break faith. So, at first, there were clamorous meetings and importunate entreaties; then noisy applications to the praetor's court. And the very device intended as a remedy, the sale and purchase of estates, proved the contrary, as the usurers had hoarded up all their money for buying land. The facilities for selling were followed by a fall of prices, and the deeper a man was in debt, the more reluctantly did he part with his property, and many were utterly ruined. The destruction of private wealth precipitated the fall of rank and reputation, till at last the emperor interposed his aid by distributing throughout the banks a hundred million sesterces, and allowing freedom to borrow without interest for three years, provided the borrower gave security to the State in land to double the amount. Credit was thus restored, and gradually private lenders were found. The purchase too of estates was not carried out according to the letter of the Senate's decree, rigour at the outset, as usual with such matters, becoming negligence in the end.

Global supply chain and credit crisis

The FT looks at the effect of the credit crisis on the global supply chain:

The message from Paul Lester, chief executive, was stark: “If you get into financial difficulties, don’t delay but come and talk to us. You are probably better talking to us than banks, because banks aren’t really doing their jobs right now and we can help.”

Possibilities for help include paying suppliers in cash earlier, giving them longer orders or even lending them workers, says Mr Lester. At Safran, Mr Dessemond says his company could put capital into its suppliers, help them obtain aid from government agencies or change payment terms – but all only in “exceptional cases”.

The usual issues banking problems of checking amidst informational asymmetries, monitoring and compliance will arise. Partnerships are possible. At some point it becomes better to take control of the whole company.

Skew and tails everywhere

More insight into the way that there was skew and long-tails throughout the industry.

Yale and Princeton universities have 70% of assets in alternatives, while Harvard University's allocation is 57%. These holdings have helped them generate strong returns over the past decade, but have been unable to offer diversification and liquidity.

Harvard, Yale and Princeton have declined to disclose their recent returns, but it is estimated that that each may be down 25% or more since June 30.

More scope for unwind and fire sale of assets.

Asian toxic assets

The FT has coverage of the risky assets that now pollute Asian financial institutions' balance sheets.

While US bankers were securitising everything in sight, their Asian peers were busy stitching together financing for unlisted mid-cap companies. These deals ticked all the right boxes: fat income streams for bankers, cash for riskier borrowers who lacked track records, and high-yielding assets for hedge funds to snaffle up. As importantly for Asia’s privacy-fixated tycoons, the deals flew below the public radar. Bankers’ guestimates of the dealflow are around the $10-20bn mark.

Yet, as with subprime, these structured loans no longer look so smart. Many of the biggest users of these pre-IPO convertibles were in sectors that are now reeling, particularly Asian real estate. Essentially debt with equity upside, they were predicated on initial public offerings at bloated 2007-style multiples, upwards of 30 times projected earnings. Many deals were written at the top of the market when participation was more important than analysis. In the worst cases, term sheets barely covered an A4 sheet of paper and due diligence was often cursory. Now that the IPO exit is effectively shuttered, hedge funds and other investors find themselves loaded up with illiquid paper they have no way of marking to market. Sound familiar?

When we add this to the widespread appreciation of risky assets it is becoming more clear that this less a problem of regulation (though regulations can limit the greatest excess) or bad people, but more an issue of too much money. It had to go somewhere.

Overconfidence

Eliezer Yudkowsky looks at an experiment with known probability that produces behavioural bias. This would be a very good one to use in the class.

"Many psychological experiments were conducted in the late 1950s and early 1960s in which subjects were asked to predict the outcome of an event that had a random component but yet had base-rate predictability - for example, subjects were asked to predict whether the next card the experiment turned over would be red or blue in a context in which 70% of the cards were blue, but in which the sequence of red and blue cards was totally random.

In such a situation, the strategy that will yield the highest proportion of success is to predict the more common event. For example, if 70% of the cards are blue, then predicting blue on every trial yields a 70% success rate.

What subjects tended to do instead, however, was match probabilities - that is, predict the more probable event with the relative frequency with which it occurred. For example, subjects tended to predict 70% of the time that the blue card would occur and 30% of the time that the red card would occur. Such a strategy yields a 58% success rate, because the subjects are correct 70% of the time when the blue card occurs (which happens with probability .70) and 30% of the time when the red card occurs (which happens with probability .30); .70 * .70 + .30 * .30 = .58".

Can this make people believe that they are over-confident?

Risky assets

Brad Setser looks at the way that investment banks built up the level of risky securitised issues on their balance sheet.

Her article — which included the Winters quote — didn’t just look at Merrill though. She noted that Wall Street was a big buyer of mortgages for its “private label” mortgage backed securities at the peak of the housing boom. Morgenson reports that the Street issued $178 billion of mortgage and asset backed CDOS in 2005 – and an incredible $316 billion in 2006. 2006 was when the quest for yield was at its most intense. Short-term interest rates had been raised. That should have squeezed profits. The fact that it didn’t should have been a warning sign.

I would like to relate this to Setser's other interest - the purhcase of safe treasury bonds and agencies from the US and the shape of the US yield curve.

Insider coup

A great story about incorporation of information and insider trading from Ray Fisman at Slate.

Icelandic banks

Willem Buiter and Anne Sibert at VoxEU report on the Icelandic banking system

With most of the banking system’s assets and liabilities denominated in foreign currency, and with a large amount of short-maturity foreign-currency liabilities, Iceland needed a foreign currency lender of last resort and market maker of last resort to prevent funding illiquidity or market illiquidity from bringing down the banking system. Without an effective lender of last resort and market maker of last resort – one capable of providing sufficient liquidity in the currency in which it is needed, even fundamentally solvent banking systems can be brought down through either conventional bank runs by depositors and other creditors (funding liquidity crises) or through illiquidity in the markets for its assets (market liquidity crises).

Two points: the foreign currency nature of banks' assets and liabilities; the categorisation of new sources of pressure for lender of last resort activity.

Fancy Financing

Just to show that financial games are not the sole preserve of anglo-saxon investment banks, the FT looks at the Porsche take-over of VW.

VW’s share price was squeezed to such heights that it became the 11th biggest company in the world, worth more than other European and US carmakers combined. Absurd. Even more absurd is that this false market is legal in Germany. Stranger still is that Porsche and its managers – even though VW’s share price has fallen – may well have made money from it all. Last year, the company earned €3.6bn from option operations – some three times as much as from cars – profits that will help it buy VW. Porsche used to be the emblem of a go-go City trader. Now it has become one.

Fancy financing and outsmarting the hedge funds!

Banks and capital

John Kay

Banks would normally be wary of lending to someone whose liabilities were 50 times their net assets, but they happily lent to each other on that basis – until, one day, they stopped. If you want a one sentence explanation of the present crisis, that is it.

Governance

Paper on governance in finance.

This is also a theory of the financial crisis. As long as the Wall Street investment banks were partnerships, the young guys who looked forward to becoming high-paid seniors disciplined the firm: they did not want it to blow up before they had their turn in the cushy chairs with the soft cushions. But once you go public, the juniors no longer care so much about the survival of the firm--and the seniors have nobody checking to make sure they are not selling lots of out-of-the-money puts and calling it alpha.

http://www.blogger.com/img/gl.link.gif

Sell at the low

The FT reports that a record $65bn was pulled out of US mutual funds in the week to Friday 10th October as the panic over banking reached its peak.

A Carry Trade?

UK local councils have exposure to Icelandic banks. Why? High interest rates. Why?

The Telegraph

However they are also encouraged to look for banks promising high interest rates, which is why nearly £1billion has been trapped in the Icelandic banks

.

Icelandic banks were presumably prepared to pay more for UK deposits because they could convert it to ISK and lend it out for a much higher rate. This is the money that fueled the purchase of UK assets like....West Ham United (now frozen?).

Liquidity

Vernon Smith in the WSJ

- A "liquidity crisis." In every market, there is ultimately only one source of liquidity: buyers. And this is what central bankers hope to see return when they speak euphemistically of "restoring confidence."

Smith, who has done a lot of work on the design of markets, says that the government expertise is in selling homogeneous assets (tbills and bonds) to multiple buyers, rather than being the buyer of heterogeneous assets (where the sellers have much more information about quality than does the buyer).

German banks

Lex
The practice of borrowing short and lending long has a suitably ugly term in German: Fristentransformation. Mr Funke will probably rue the day he embraced it.

Apple

The Guardian looks at the problems at Wolfson where the failure to win an order from Apple for the latest iPod touch and iPod nano devices.

Wolfson had already embarked on cost-cutting measures in response to an earlier downturn in business, shedding 22 jobs. Among those who left in September was Dave Shrigley, the chief executive, who was replaced by Mike Hickey from Motorola. Shrigley said that he was leaving for family reasons.

Wolfson designs and develops semiconductor products which are then made by third parties in Taiwan and China. It specialises in performance mixed-signal integrated circuits which are used to convert analogue signals into digital for storing and processing information. Wolfson will report its interim financial figures later this month.

Contrast this to the on-going Chinese attempt to prevent iron-ore producers getting more market share and News International buying the set top box operations of Amstrad.

Covered bonds

Covered bonds explained

Covered bonds are secured on a pool of mortgages but crucially also carry a guarantee from the issuing bank to protect investors if the mortgages turn bad. In the UK, this guarantee counts as a senior unsecured liability that should rank equally with other senior unsecured debt. Meanwhile, shareholders emphasised that the bank was solvent and that they should see some residual value.

CDS exchange

The FT looks at the conflicts involved in the creation of a central clearing facility for CDS.

Mark Yallop, chief operating officer of Icap (a shareholder in TCC), says: “The dealers have a choice about where they clear their OTC credit default swaps. But it probably isn’t in their longer-term interests for these to be cleared on an exchange-owned clearing platform because that exchange could, potentially, use the open interest thereby created in its clearing house associated with the dealers’ OTC contracts as a basis for launching exchange-traded CDS contracts. Such a development would undermine dealers’ OTC franchises.

Barriers

The FT reports on the manouvering of the LSE to prevent new upstart exchanges trying to use its liquidity and depth to support their activities.

Nasdaq OMX Europe has hired Citi to provide an “order routing” service that takes any orders that cannot be fulfilled on Nasdaq OMX Europe’s order book and seeks out a market where they are more likely to find matches – including the LSE and other alternative platforms.

In response, the LSE now plans to introduce a way of distinguishing between orders that come straight through to the exchange and those that arrive through order routing from competing platforms. It will then charge a different tariff for orders that arrive from a competing platform.

Rising cost of borrowing

The FT looks at the way that the disruption to bank funding costs is increasing the cost of borrowing for large firms.

“The lenders invoked the market disruption clause,” said Edmund Ding, Hon Hai spokesman. “This happened because global interbank lending rates spiked following Lehman’s breakdown just as our loans were being rolled over.” Mr Ding said the uncertainties were likely to force companies to adjust the way they borrow.

Most loan financings carry a “market disruption clause”, which allows lenders to switch the rate at which they lend to a company from a Libor-based price to a level that represents their true cost of funds. Depending on the deal, it requires the approval of at least a third of the syndicate and also requires banks to disclose what they believe their own cost of funding to be – something they have hitherto been reluctant to do.

A potential headache for banks is that many such facilities will have been agreed before the recent worsening in credit conditions at a fixed rate over Libor – a rate that may now be lower than a bank’s all-in cost of funding that facility. Before triggering such clauses banks have to weigh the risk of upsetting clients that may take business elsewhere.

Buffett on leverage

William Buffett on de-deverage (ht Paul Kedrosky).

What you have, Joe {Kernen], you have all the major institutions in the world trying to deleverage. And we want them to deleverage, but they're trying to deleverage at the same time. Well, if huge institutions are trying to deleverage, you need someone in the world that's willing to leverage up. And there's no one that can leverage up except the United States government. And what they're talking about is leveraging up to the tune of 700 billion, to in effect, offset the deleveraging that's going on through all the financial institutions. And I might add, if they do it right, and I think they will do it reasonably right, they won't do it perfectly right, I think they'll make a lot of money.

Bias

The availability heuristic, giving undue weight to evidence that is easily available, makes it more likely that people focus on what has happened recently. This can be added to the technical things like 'noise trader risk' to explain some of the short term bubble creation.

Peter McCluskey

People who carefully looked for and evaluated as much relevant evidence as they could saw some chance of the current panic happening, regardless of whether they used intuition or fancy statistical models. Some of them warned of the risk. But it was hard for most people to worry about warnings that had been consistently wrong under all the conditions that were fresh in their minds.

Resisting peer pressure isn't pleasant. The banker who insisted on a 20% down payment for all mortgages got less business during the bubble and was seen by his colleagues as a burden on the bank and an obstacle to helping customers. The regulator who insisted on a 20% down payment for all mortgages was seen as denying the poor the good investments that were available to the rest of the country, and as an obstacle to home ownership (sometimes better described as home borrowing)(governments think home ownership ought to be encouraged, in spite of (or because of?) its tendency to increase unemployment).

Credit crunch

John Jansen highlights the increase in the cost of borrowing for Caterpillar.

In early August Caterpillar brought a 5 year bond to market, the 4.90 of August 2013. That bond priced 175 basis points cheap to the benchmark 5 year Treasury note. With the turmoil in the credit markets the last several weeks, the issue has widened on spread and this morning it was quoted 225/ 210.

The talk on the new issue is T + 325 basis points. That is fully 100 basis points cheap to the outstanding issue and 150 basis points above where the same maturity was priced six weeks ago.

This is very disturbing because Caterpillar is an industrial company, unsullied by association with the credit crunch. If it takes that much concession to sell a solid stable industrial, what might the outcome be when a large financial seeks to tap the market.

This does suggest some ugly contraction to come.

Short-selling

Alex in the Telegraph.

Risk-adjusted returns

The FT

The message delivered to shocked Lehman Brothers staff on Monday was simple and direct. “It’s over,” announced Christian Meissner to a morning staff gathering just a week after being appointed to run Lehman’s Europe business. He told the staff to look for new work and “move on”. In Lehman’s offices around the globe, staff had little choice but to follow suit as they came to terms with the collapse of the 158-year-old institution, leaving workplaces with belongings hastily collected and their savings depleted. The mantra of Lehman Brothers was to pay its staff in stock – some 30% of the bank’s equity was held by employees and many bonuses were paid in shares. Now those holdings are all but worthless. Some staff were also told not to expect this month’s paycheck and that they might even be liable for expenses on their corporate credit cards. Others said they had been banned from sending emails and that BlackBerrys and mobile phones no longer worked. Some of Lehman’s senior bankers are expected to set up independent advisory boutiques in the near future.

OIS

Willem Buiter looks at the endgame in the banking system.

[i] The OIS rate is the fixed leg of a swap whose variable counterpart is the daily compounded return of some safe or secured benchmark rate on overnight transactions. Typically, the overnight benchmark is the weighted average of the central bank rate. In the US this would be the Federal Funds Effective rate. In the UK it is SONIA, in the euro area EONIA. Libor is the benchmark rate supposed to representative of the interest rates at which banks offer to lend unsecured funds to each other in the London wholesale money market (or interbank market).

Income elasticity of demand

The slowdown is having some impact on the demand for organic produce. The FT notes that households are trading down.

According to TNS sales data, sales of organic fruit and vegetables increased just 2 per cent in the year to August - a dramatic slowdown from the double-digit increases previously enjoyed. Sales of organic eggs have declined every month this year and now account for 4.7 per cent of the market, against 7.4 per cent at its peak.

Exchange rate forecasing

Jian Wang at Voxeu looks at the asset-price approach to exchange rate forecasting. This essentially says that exchange rates are based on forecasts of future fundamentals. Present fundamentals have a minor role. Future fundamentals are unknown. Therefore, they may not be any use in forecasting, but they would allow for some relationship between fundamentals and exchange rates.

This can also be related to the idea that portfolio flows respond to future fundamentals.

Engel and West (2005) argue that the exchange rate disconnect is consistent with exchange rates being determined by fundamental variables. They show that existing exchange rate models can be written in a present-value asset-pricing format. In these models, exchange rates are determined not only by current fundamentals but also by expectations of what the fundamentals will be in the future. Current fundamentals receive very little weight in determining the exchange rate. Not surprisingly, they aren’t useful in forecasting.

Under the Engel-West explanation, judging exchange rate models by their ability to forecast is too harsh a standard: If exchange rates are determined by fundamentals in the same way as other asset prices, current fundamentals can’t forecast exchange rates better than a random walk, even if the asset-pricing model correctly captures the relation between economic fundamentals and exchange rates. In this case, fundamental-based models are still appropriate for economic analysis, such as exchange rate and trade policy analysis – they are just useless in forecasting.

How do we know the asset-pricing model is applicable? Are there other ways to test fundamental-based exchange rate models if beating the random walk in forecasting exchange rates is too harsh? While the asset-pricing approach doesn’t allow us to predict short-term exchange rates, it does lead to an interesting implication. If the exchange rate is determined by expected future fundamentals, today’s currency values should contain information about tomorrow’s fundamentals.

Fund strategy

One of ideas of corporate strategy is to position the firm and make sure all the components of the business are pushing in the same direction. A simplified version of this says that the firm should seek high price and high value or low price and relatively low value.

The FT look at research from Morgan Stanley that suggests that the asset management business is becoming increasingly polarised into tracker funds and hedge funds.

So it’s “cheap or spicy” - and the main driver continues to be performance versus cost.

Huw van Steenis and his team at Morgan Stanley this week published an 80 page update on the European asset management industry, noting the continuing deterioration in the outlook for traditional managers and at the same time an accelerating rationalisation of alternative managers as winners and losers in the hedge space diverge.

The top 100 hedge funds now represent 69 per cent of total hedge fund assets, up from 56 per cent in 2006, according to Mr van Steenis. The analyst sees “massive” rotation between winners and losers in the sector after the years of plenty.

The evolution of European exchanges

The FT has an excellent overview of the competition for market share in the European equity arena. New regulations and a shift in the business plan are creating opportunities.

Estelle Cantillon and Pai-Ling Yin look at the migration of the bund future from LIFFE to the DTB and assess the risk of new financial tipping points.

UK SME financing

The University of Cambridge Centre for Business Research has a survey of UK SME financing for 2007.

The survey of businesses with less than 250 employees was carried out in the autumn of 2007, but is unlikely to have captured the full consequences of the credit crunch and slowing economy. It shows that there has been a decline in the use of external finance from 81% of firms in 2004 to 69% in 2007. However, the majority of firms said that there had been no change in the ease of obtaining finance and 71% of those seeking new finance received all that they sought. The report examines these headline figures across firm sizes, regions and industrial sectors. It also includes special chapters on key topics such as female-led businesses, start-up businesses, super growth businesses and those in deprived areas.

Real appreciation

Karolina Ekholm, Andreas Moxnes and Karen-Helene Ullveit-Moe look at the effect of the 17% real appreciation of the Norwegian Krone in the 2000 to 2001 period. Using micro data of the performance of Nowegian firms, they find three things:

First, the real exchange rate shock was associated with substantial employment losses. One-seventh of the total decline in manufacturing employment over the period under study can be attributed to the real appreciation.

Second, the shock led to productivity gains at the firm level, indicating that the most exposed firms were able to improve efficiency in a period of tougher foreign market conditions. One-fifth of the productivity improvement over the same time span can also be attributed to the real appreciation. Somewhat surprisingly, we do not find evidence of market reallocation effects; the real appreciation does not seem to have been associated with a reallocation of resources from low-productivity to high-productivity firms.

Third, firms responded to the real appreciation by offshoring (Ekholm and Ulltveit-Moe 2007), thereby purchasing a larger share of their intermediate inputs from abroad. For the manufacturing industry as a whole, the real appreciation increased the import share of intermediates by about 1.5%

This gives some insight into the costs of the Dutch disease.

Michael Veseth looks at the affect of US dollar depreciation on the US wine industry.

Asymmetric risk

The FT reports Merrill Lynch having lost a quarter of its profits for the 36 year period as a listed company in the space of 18 months.

This is a similar performance to that of hedge funds that find a skewed distribution for their returns. There are steady profits in return for taking asymmetric risk. This is also linked to the short-term nature of governance and incentives.

Diamonds are forever

The Atlantic looks at the history of the diamond. The main focus is marketing and the preparation of the market. However, there is also a lot of interesting information about the control of pricing even in the face of adversity.

Here are some diamond prices from Swivel, an end of 2007 cross section rather than time series.

New technology

How do business deal with new technology that threatens to provide an alternative product?

Economic Principals looks at the way that the newspaper industry has to adapt.

Those enormous rolls of newsprint, tank-cars of ink, long lines of presses and fleets of delivery vans are the newspaper industry’s best friends. Among business strategists, they are known as barriers to entry. The capacity to print and deliver the paper product from cities around the world is what makes newspapers different from everything and everyone else in this media-sodden world. Precisely from all this impedimenta – and the paper product it produces – does the authority of newspapers’ increasingly extensive Web-based operations derive.

The example of the radio and television can provide some insight. Radio has its own strength. It is particularly powerful when you cannot watch a picture because you are doing something else. The strength of the newspaper is that it can be passed around. In some ways it is much easier to find things. The newspapers have the advantage of having good, clear links to the sources of information. That have reputation.

More on the commons

More on the tragedy of the commons and how it is being use today to tackle problems.

Soft skills

Richard Reeves looks at the importance of soft skills in the labour market and the way that they contribute to inequality.

Recent claims about social mobility in Britain grinding to a halt are exaggerated. But it does seem that the likelihood of a person being upwardly mobile is increasingly influenced by personal qualities such as confidence and self-control. Julia Margo, associate director of the Institute for Public Policy Research, has assembled an impressive body of evidence linking character to life chances. Her work, which draws on that by Leon Feinstein at the Institute of Education, shows that measured levels of "application"—defined as dedication and a capacity for concentration—at the age of ten have a bigger impact on earnings by the age of 30 than ability in maths. Similarly, what psychologists call an "internal locus of control"—a sense of personal agency—at the age of ten has a bigger impact than reading ability on earnings.

There is also a BBC Analysis programe here.

This fits well with the argument from Chris Dillow that self-esteem is associated with higher earnings. It is also consistent with his idea that we can see the world as a zero-sum or positive sum. If our circumstances, lack of resources and limited opportunity reinforce the zero-sum view of the world, this would tend to undermine our ability to get a better job; if our circumstances support a positive-sum view of the world with benefits from co-operation, trust and thrift, this will encourage this the behaviour that is more rewarded in regualar society - particularly the labour market.

Valuation

The Economist looks at valuation and returns on asset classes in the long-run.

This is roughly how GMO goes about the process: it looks at the relationship between valuations and long-term returns. The return from equities, for example, is equal to the existing dividend yield, plus future dividend growth, plus or minus changes in valuations. Ten years ago, the dividend yield on the American market was low while valuations were high. The likely long-term return looked low, and so it has proved.

Using similar reasoning, GMO has a very gloomy outlook for the American and British housing markets at the moment. By using the ratio of the median house price to the median family income, GMO reckons that prices in America need to fall by 17% instantly or stay flat for four years to return value. In Britain, prices need to fall by 38% or stay flat for seven years. And of course, there is no guarantee they will stay at fair value; in the mid-1990s, they dropped well below it.

The end of an era

The FT reports.

We’re observing the end of an era in two very specific areas. First is the uncontrolled deregulation of global financial markets ... The second point is, the mindless commitment of human and financial resources to securitisation has reached its peak and now will contract for the indefinite future.

This is a trader's comment after the 1987 crash. It may be significant that this are the words of a trader. What is heard more often today are the words of Joe Public and the government. However, as the report points out, the fear of computerised trading has dissipated since 1987. Futures markets, which were used for Portfolio Insurance, are now mundane.

Risk management

A great overview from The Economist

Last but not least, change the perception and standing of risk departments by giving them more prominence. The best way would be to encourage more traders to become risk managers. Unfortunately the trend has been in reverse; good risk managers end up in the front-line and good traders and bankers, once in the front-line, very rarely go the other way. Risk managers need to be perceived like good goalkeepers: always in the game and occasionally absolutely at the heart of it, like in a penalty shoot-out.

Good coverage of some of the institutional issues as well as the limbo position of credit derivatives, standing somewhere between the trading desk and the credit desk and never gaining full attention.

There is a a reaffirmation of the way that banks sold the lower tranches and maintained the higher tranches for themselves, The position gradually increased as it thought inconceivable that these 'safe' assets could lose much value because of credit or market changes.

Fans vs professionals

From the Guardian an analysis of odds offered by bookmakers for football in the last three years shows that betting on the top 10 in the league makes money while betting on the bottom 10 loses money. Do the gamblers and fans need to be enticed to bet for winners while fans will bet for their underdog losers even if the odds fail to provide compensation for the risk?

The Carry Trade

Gillian Tett

Most notably, because super-senior debt carried the triple-A tag, banks were only required to post a wafer-thin sliver of capital against these assets - even though this debt has typically offered a spread of about 10 basis points over risk-free funds. Thus, banks such as UBS and Merrill have been cramming their books with tens of billions of super-senior debt - and then booking the spread as a seemingly never-ending source of easy profit. It is not just the CDO desks that have been playing this game; treasury departments have been playing along. So have many hedge funds, including those financed by . . . er . . . the major investment banks.

Swimming naked...

A reminder from Lex that there are opportunities in a downturn.

The number of companies under offer, as reported by the Takeover Panel, is up 20% on the same period last year.

US overseas income

Returning to US overseas income. Alexander Hijzen looks at FDI and the effect on local wages.

Do foreign multinationals pay higher wages than domestic firms? Simple comparisons suggest they do. Moreover, wage differences between MNEs and local firms tend to be larger in developing countries, presumably reflecting the larger productivity advantage MNEs over local firms in those countries. Simple comparisons between MNEs and local firms, however, overstate the contribution of FDI to improving pay, because FDI is typically concentrated in the most advanced sectors and largest firms in the host economy, which would pay above-average wages even if they were locally owned. Even after correcting for this bias, it is still the case that MNEs offer better pay than domestic firms, particularly in developing countries where their productivity advantage is greatest.

It is probably the case that the full productivity is not reflected in wages. The pull from low level of local wages probably ensure that some of the productivity improvement is taken by the (possibly US-owned) MNE. However, it is much harder to achieve this in the competitive US market.

Tragedy of the commons

A very good overview of the issues from The Economist

It is not simply that three-quarters of those living on less than $2 a day still depend in some way on commonly held resources. The concept of the commons is also spreading to new areas. Their essential feature is that they share one characteristic with private property and one with public goods. Like public goods, they are not “excludable”: the common resource is too extensive to keep people out very easily. But they are also “subtractable” (or “rivalrous”), like private property: if one person uses them, another’s access is diminished. (With a classic public good, such as street lighting, one person’s usage does not affect anyone else.) Many things other than rainforests or drylands share these attributes.

The important point for new areas like climate change is that tragedy is not innevitable.

Overseas income

There is a lot of information about the financing of the US external deficit. AS part of this is clearly due to financing in low yield reserve currency which is in demand because of its liquidity. However, as Gournichas and Rey show in From World Banker to World Venture Capitalist: US External Adjustment and the Exhorbitant Priveledge this is also about the returns that are achieved on the same assets. US FDI returns are much in excess of the returns that foreigners achieve in the US. HBS Working Knowledge suggest that this is partly because of the tough condtions that exist in the US. There is no low hanging fruit.

Another reason that financing the US deficit may be easier than had been feared is that sovereign wealth funds should probably not be seen as 'smart money'. These, after all, are government departments. Jory, Perry and Hemphill find that SWF investments announcements have not noticable effect on the price of the stock that they have bought and that, in the long run (for what it is worth in these cases) they have under=performed the overall stocks and the financial sector.

Viscious cycle

Yves Smith looks at the downward momentum that builds as a a firesale of assets leads to additional deterioration of balance sheet of other financial institutions.

NAB and the Australian stockmarkets were directly affected by the Merrills move, which reflects the US banker's desperate desire to quit as much of its toxic subprime mortgage related investments as it can, without regard to the flow on impact to other banks and markets.

In effect Merrill's move to sell these holdings of CDOs to a distressed debt fund investor, forced the NAB to write-down the value of its holding in the CDOs, a move which triggered a huge sell-off of Australian bank shares Friday and yesterday. Yesterday the ANZ revealed a completely unrelated set of write-offs and provisions, butr these had more to do with the slowing Australian economy.

Behavioural finance

Scientific American looks at at decision-making and the interaction between intuition and reason.

Selling Louisiana back to the EU

MacroMan discusses selling Louisiana back to the EU.

The first port of call is to take profit on a number of 18th century transactions conducted by the US Government. Top of the list is the Louisiana Purchase, which was consummated in 1803 for the princely sum of $23,213,568. To derive a current marketable value, Macro Man calculates an annual cash flow by multiplying state GDPs by 18% (the proportion of US nominal GDP that the Federal government receives in tax revenue) and assigns a modest P/E multiple of 8 to the result. Perhaps some banks or Donald Trump would assign a higher multiple to these one-of-a-kind assets, but Macro Man prefers to dwell in the realm of reality.

Dublin

Some comments in the FT about Dublin as a financial center.

Dublin has effectively come from nowhere to become a strong challenger to Luxembourg as Europe’s biggest asset servicing centre. It has done this by becoming the home of choice for many Ucits funds, Europe’s leading domicile for money market funds and the largest administration centre for exchange traded funds in Europe. According to the Global Financial Centre’s Index published by the City of London, Dublin is the world’s 13th best financial centre and 10th for fund management

So how has this been achieved in the 21 years of the IFSC’s existence? A number of positive factors have fuelled Dublin’s growth, notably Ireland’s position as a member of both the European Union and the eurozone, its use of English, the strong supply of well-educated graduates (at least until recently) and the country’s legal framework.

However, regulation and tax were probably more critical to the IFSC’s success than anything. The financial regulator, the Irish Financial Services Regulatory Authority, is seen as combining robustness with responsiveness, and industry players welcome the efficiency of the regulatory approval process. The IFSRA can afford to be accommodating and attuned to innovations partly because of the lack of a significant indigenous fund management sector. Mr Slattery says: “Here in Ireland we understand the benefit of having an appropriately pitched regulatory regime.”

Low taxes have also played a big part in Dublin’s success. From the IFSC’s launch in 1987 until 2004-05, firms based there paid corporation tax at just 10 per cent. Although this has now risen to the standard 12.5 per cent, it still compares favourably with the 28 per cent levied in the UK and the EU average of 33 per cent

Supply and demand on land prices

FT.com / In depth - US builders forced to sell off holdings: The FT looks at the combined effect of oil and food price increase on the demand for land.

"The result is that farmland close to cities that has often been the seedbed for new housing developments is becoming less valuable to builders, at the same time as farmers want more of it."

Brad DeLong on Greenspan

Back in the second half of the 1990s, various people went into Alan Greenspan's office. "Raise interest rates!" they said. "Let unemployment go up! The Phillips curve can't have shifted in this far! The natural rate of unemployment can't have fallen so far so fast! These stock market valuations can't be rational! We are headed for a big crash, or a big inflationary spiral--unless you change course now!"

Alan Greenspan responded that there was no sign of overly-tight labor demand, no sign of accelerating demand-pull or wage-push inflation that would warrant interest rate increases. People were indeed investing enthusiastically in high-tech start-ups and those buying stocks at outsized price-earnings ratios. But the people doing the buying and investing were relatively well-off, and were grownups. If it turned out to be a serious bubble, and if the unwinding of the bubble triggered a financial panic and threatened to produce a high-unemployment recession, then would be the moment for the Federal Reserve to step in and clean up the mess. In the meanwhile, it would be a shame to destroy millions of jobs and wreck a period of 4%+ economic growth just because the Federal Reserve thought that it knew better than grownup investors what prices they should be paying for stocks and shares in high-tech startups, and feared that there might be trouble in the future.

Similarly, in the middle years of the decade of the 2000s, various people went into Alan Greenspan's office. "Raise interest rates!" they said. "Let unemployment go up! Long-term interest rates cannot stay this low for long! The sustainable pace of construction can't have risen so far so fast! These real estate valuations can't be rational! We are headed for a big crash, or a big inflationary spiral--unless you change course now!"

Alan Greenspan responded that there was no sign of overly-tight labor demand, no sign of accelerating demand-pull or wage-push inflation that would warrant interest rate increases. People were indeed building houses and buying mortgages and taking out home-equity loans enthusiastically at outsized price-rental and mortgage-value income ratios. But the people doing the buying and investing were relatively well-off, and were grownups. If it turned out to be a serious bubble, and if the unwinding of the bubble triggered a financial panic and threatened to produce a high-unemployment recession, then would be the moment for the Federal Reserve to step in and clean up the mess. In the meanwhile, it would be a shame to destroy millions of jobs and wreck a period of 3%+ economic growth just because the Federal Reserve thought that it knew better than grownup investors what prices they should be paying for mortgages and houses, and feared that there might be trouble in the future.

The unwinding of the dot-com bubble in 2000-2002 went remarkably well: no significant macroeconomic distress, and less financial panic and distress than I believed possible. The unwinding of the real estate bubble in 2007-2009 is so far not going well. There is, by contrast, more financial distress than I believed possible. Who thought that quantitatively sophisticated hedge funds would have enormous unhedged exposure to subprime risk? Who would have thought that highly-leveraged investment banks with an originat-and-sell business model would keep lots of the securities they had originated in their own portfolios--and kept them because they were high yield for their rating, i.e., because the market did not believe they were as low risk as the investment banks had bamboozled the ratings agencies into claiming? Who would have thought that those buying subprime mortgage securities from the likes of Countrywide had done no investigation into how Countrywide was screening out borrowers?

But so far--look: In the dot-com boom of the 1990s we were the winners. The rich investors of America built out a huge amount of fiber-optic cables and conducted an enormous amount of experimentation in business models from which we all benefit. In the real-estate boom of 2000s the rich investors of America and the world built an extra four million houses and loaned the rest of us money at remarkably low interest rates for five years. Those who moved into newly-built houses with teaser-rate mortgages wish those teaser rates would continue--but they won't, and in the meantime they got to live in a nice house for quite a low rent. Those of us who took out big home equity loans wish the low interest rates would continue--but they won't. And those of us who felt rich because our house values have appreciated wish we still could think of ourselves as sleeping on a pile of gold--but we can't.

The dot-com bubble and the real-estate bubble were bad news for the investors in Webvan, WorldCom, Countrywide, FNMA, and securitized subprime mortgages. But they were, by and large, good news for the rest of us. And investors are supposed to take care of themselves.

Now we are not yet out of the woods. If the tide of financial distress sweeps the Fed and the Treasury away--if we find ourselves in a financial-meltdown world where unemployment or inflation kisses 10%--then I will unhappily concede, and say that Greenspanism was a mistake. But so far the real economy in which people make stuff and other people buy it has been remarkably well insulated from panic at 57th and Park and on Canary Wharf.

Link

Fannie Mae and the limits of public obligation

Fannie Mae and the limits of public obligation:

"The problem is that the difference between government powers and government responsibility can be addressed by increasing the powers or reducing the responsibility. We should do the latter."

John Kay looks at the regulation of the financial services industry. Despite his plea, it looks much more likely that it will be the former rather than the latter.

The Peso Problem

Alex Tabarrok points us to an overview of the classic Peso Problem

Milton Friedman stated that the interest differential between the two countries may have been due to the market expecting the peso to be devalued against the US dollar. And sure enough, in 1976, the market expectation actually came true as the peso was allowed to ``float'' against the dollar.

Tabarrok also considers this to be a feature of the spread between GSE bond rates and that of other mortgage-backed securities.

More here.

Speculation

There are no onion futures but volatility remains high.

The onion conundrum: no futures market, high volatility - Jun. 27, 2008:

"And yet even with no traders to blame, the volatility in onion prices makes the swings in oil and corn look tame, reinforcing academics' belief that futures trading diminishes extreme price swings. Since 2006, oil prices have risen 100%, and corn is up 300%. But onion prices soared 400% between October 2006 and April 2007, when weather reduced crops, according to the U.S. Department of Agriculture, only to crash 96% by March 2008 on overproduction and then rebound 300% by this past April"

Thanks to Marginal Revolution.

American imports

From Freakonomics, import genius records all the container imports into the US. Scroll to the bottom of the page to watch imports in real time.

Efficient market

Wired in a more general look at data, uncovers a way to make more accurate predictions of crop growth. Here is a small case study in the increased efficiency of information assimilation.

Farmer's Almanac is finally obsolete. Last October, agricultural consultancy Lanworth not only correctly projected that the US Department of Agriculture had overestimated the nation's corn crop, it nailed the margin: roughly 200 million bushels. That's just 1.5 percent fewer kernels but still a significant shortfall for tight markets, causing a 13 percent price hike and jitters in the emerging ethanol industry.

Apple and profit

Oren Hurvitz looks at Apple and the effect of paying engineers less than the competition.






As one of the commentators says

Working conditions at the newspaper are fine: Co-workers are pleasant, the supervisors treat me well, and I believe that both respect me. This means that my total benefits — some I certainly provided to myself — work into the equation to produce the sum total of benefits. I am conscious that I am taking advantage of them and appreciate them. I am currently satisfied with the quality and quantity that makes up the sum total. Perhaps for similar practical and intrinsic reasons, Apple employees are satisfied at Apple.

iPhone and price discrimination

The Telegraph looks at the iPhone and emphasises the low price of the latest model. This is another reminder of the way that Apple has successfully managed to satisfy two major segments of the market.

"Apple seems to have realised it needs to drive volumes beyond gadget-happy geeks who would pay enormous amounts to have this piece of gadget bling."

How Thinking Costs You

Michael S Rosenwald gives an overview of behavioural bias as he looks at how Thinking Costs You:

"Like most things human, it depends on which one you ask. Odean said he saw two options: Be dumb and let others make money off you, or just buy a no-load index mutual fund and stop focusing on beating the market. Kahneman said there was no one-size-fits-all advice, but he liked the idea of having one sure thing and one long shot. The personal finance planners say investors should stick with them -- they get paid to understand this stuff, and to win. Of course, they are humans too, which means they could be prone to the same problematic behaviors"

Collective price discrimination

The FT looks at the possible competition case against banks charging for loan protection.

One banker said: “Personal loan rates have been uneconomic for a while. Rates are likely to go up if PPI is sold separately.”

Bankers expect the commission to argue in its provisional investigation findings – due to be published early next month – that PPI is uncompetitive because customers typically buy it only from the bank where they took out the loan.

Despite industry lobbying, the commission will stick close to its provisional conclusion this year that banks selling the insurance are earning as much as £1.5bn a year above a reasonable rate of return by selling to buyers who are in effect a captive market.

The market for PPI – which covers loan-holders if they become ill or lose their jobs – is worth about £5.5bn a year. The Office of Fair Trading said last year that banks were loading cheap loans with expensive insurance policies.

One competition lawyer who acts for a bank said the commission had concluded that banks were in effect “getting people through the door, quoting them a very low price [for a loan] then selling them something else”.

Looks like a case of price discrimination. Those that will stand up to the hard-sale ("what if you lose your job?" etc) will get the cheap loan, others pay up.

American Idol

Freakonomics: look at the ways that voting on American Idol can be predicted. There is a lot here about information and the way that it can be used in trading.

"But there are many other ways to predict who would win. TiVo has experimented with using data from 20,000 random anonymous subscribers to find out when viewers fast-forward or re-watch particular contestants. Neat idea, but so far they have had a much lower success rate than DialIdol.Instead of looking at phone and television behavior, you can also try to make predictions from Internet behavior. Apple might look at iTunes downloads of the contestant songs. Or you could use Google Trends to see which contestant name has been searched more often. David Cook rules by this method as well:"

Scarcity of safe assets

Richard Kline looks at the way that the scarcity of safe assets (with US budget surplus and demand for Treasuries from China) contributed to the increased securitisation of debt.

Thus an unheard of budget surplus together with major new Treasury buyers indicated that the asset basis for large-volume transactions in the US was going to contract sharply, putting pressure on top tier banks and bank-like entities to find the next best alternative, and fast. These were . . . securitized GSE instruments. Which as slightly less favorable assets carried slightly more charming rates. It was this experience which in many ways set the feet of large US financials on the slippery slope of asset backed security speculation. Thus an event structurally possible within the US financial system, but of very low probability (hadn't happened since your grandfather was younger than your children are now, and wasn't intended to happen at all), refocused major capital flows at the top of the system. With disastrous near term results as we now see. That the budget surplus appears to have been largely generated by capital gains thrown off by the dot.com equities bubble, and so not sustainable not to say illusory, is secondary since the effect of the surplus on the system as a whole was real at the time.

This is one aspect of financial crisis that has not been much remarked upon. If there is scarcity, the price will rise and the financial system will seek to provide an alternative or substitute.

China in Africa

Edward Miguel looks at developments in Africa. One part is the increased presence of Chinese firms. He says.

"Why have Chinese individuals and firms dived in when European and U.S. investors have largely shied away? In discussions with Chinese investors, it seems the key motive is simple: profit. Africa provides bountiful profit opportunities across multiple economic sectors for Chinese firms flush with cash from their boundless growth at home. Chinese investors also have a major advantage over their Western counterparts in that they know how to make money in a developing–country business environment where the rule of law is optional, corruption and bribery are the norm, and infrastructure is patchy. Their experiences at home give them a big leg up on the competition."

Creative destruction

Michael Perelman looks at Schumpeter and Stolper.

I did find that one of these economists, David A. Wells, a name well known at Harvard, did clearly anticipate the theory of creative destruction (see Perelman 1995, p. 192). For Wells, the measure of success of an invention is the extent to which it can destroy capital values. He offered as an example “[t]he notable destruction or great impairment in the value of ships consequent upon the opening of the [Suez] Canal” (Wells 1889, p. 30). Wells asserted that each generation of ships becomes obsolete in a decade. From here, he concluded, “nothing marks more clearly the rate of material progress than the rapidity with which that which is old and has been considered wealth is destroyed by the results of new inventions and discoveries” (Ibid., p. 31).

Peak Whale

The Oil Drum looks at the price response to the over-Whaling of 19th Century.

Emotion and trading

Via Yves Smith some new research on investments and emotions, suggesting that people get too close to their investments.

Visiting Professor David Tuckett, UCL Psychoanalysis Unit, says: “Feelings and unconscious ‘phantasies’ are important; it is not simply a question of being rational when trading. The market is dominated by rational and intelligent professionals, but the most attractive investments involve guesses about an uncertain future and uncertainty creates feelings. When there are exciting new investments whose outcome is unsure, the most professional investors can get caught up in the ‘everybody else is doing it, so should I’ wave which leads first to underestimating, and then after panic and the burst of a bubble, to overestimating the risks of an investment.

It appears that bubbles are caused by people acting like they do when they are first in love. They concentate on the good things and completely ignore the bad things. When the bubble bursts, there is the opposite taking place

Reputation

The British Bankers' Association struggles with the recent hit to their reputation. As Arthur Anderson, LIFFE, Enron and Bear Stearns found, vital support can swiftly disappear. The FT reports.

Leverage

Some indication of the scale and effect of leverage comes from this Report in the FT highlighting the problems at a bond trading hedge fund EMF.

In the US Treasuries market banks are usually willing to lend money to investors with zero “haircut”, meaning they will lend the full purchase price, because of the safety of the US government and typically tiny daily price moves. But last month banks began to demand borrowers put up a margin, albeit a small one, in an indication of their desperation to reduce lending, the same problem that took down Bear.

The scale of borrowing on Treasuries is eye-popping: EMF, for example, started the year with leverage of 37 times its then assets of $294m, almost $11bn, not unusual for a Treasuries book. By the end of March it had reduced this to 25 times assets, according to a letter to investors.

The de-leverage selling of assets continues to unsettle markets.

Regulation of finance

Avinash Persaud looks at some ways to improve the regulation of finance.

The alternative model rests on three pillars. The first recognises that the biggest source of market and systemic failure is the economic cycle and so regulation cannot be blind and deaf to the cycle – it must put it close to the centre. Charles Goodhart and I have proposed contra-cyclical charges – capital charges that rise as the market price of risk falls as measured by financial market prices – and a good starting point for implementation of such charges is the Spanish system of dynamic provisioning (Goodhart and Persaud 2008).

The second pillar focuses regulation on systemically important distinctions, such as maturity mismatches and leverage, and not on out-dated distinctions between banks and non-banks. Institutions without leverage or mismatch should be lightly regulated – if at all – and in particular would not be required to adhere to short term rules such as mark-to-market accounting or market-price risk sensitivity that contribute to market dislocation. Bankers will argue against this, saying that it creates an unlevel playing field, but financial markets are based on diversity, not homogeneity. Incentivising long-term investors to behave long-term will mean that there will be more buyers when banks are forced to sell.

The price of petrol

Business Week looks at signs that petrol use may be responding to the increase in prices.
For 20 years now, county workers in Palm Beach County, Fla., have been counting cars with sensors at strategic points along its 4,000 miles of roads. Nearly every year traffic volume has climbed at least 2%. But in 2007 there was a slight decline in the number of vehicles on the roads. This year traffic is down 7.5% through March. "We're seeing a very significant change," says county engineer George Webb. "We're having a good time speculating why."

It's not just Palm Beach. Traffic levels are trending downward nationwide. Preliminary figures from the Federal Highway Administration show it falling 1.4% last year. Now, with nationwide gasoline prices having passed the inflation-adjusted record of $3.40 a gallon set back in 1981, the U.S. Energy Information Administration is predicting that gasoline consumption will actually fall 0.3% this year. That would be the first annual decline since 1991. Others believe the falloff in consumption is steeper than the government's numbers show. "Our canaries out there tell us they are seeing demand drop much more considerably than the fraction the EIA is talking about," says Tom Kloza, chief oil analyst at Oil Price Information Service, a Gaithersburg (Md.) market research firm.

Of course, it is unclear at this stage how much of this is a response to higher prices and how much is a response to weaker economic activity.

Negative equity

The FT looks at the risk of a rise in negative equity and concludes that because of the relatively modest offerings by banks and the lower proportion of first time borrowers, there will be less negative equity than there was in 1990.

This may come as a surprise, given the problems that banks have encountered following their profligacy at the height of the housing boom. But the reason is simple. Unlike in the late 1980s, they have sought to gain a competitive advantage by offering low mortgage rates, rather than by seeking to out-do each other by offering ever bigger mortgages as a proportion of a home's value.

Bank of England figures last published in 2005 show that in the late 1980s more than 40 per cent of all mortgages - for house purchase and remortgaging - had loan-to-value ratios of more than 90 per cent. In recent years that number has halved to about 20 per cent.

House purchases by first-time buyers, the group that tends to have by far the highest loan-to-value ratios, were also much lower. There were 750,000 in 2006 and 2007, compared with 1.04m in 1988 and 1989. Working out the strength of every mortgage in the UK is difficult.

There are no data on the exact number of mortgages outstanding, the initial price paid and the subsequent movement in house prices. But the FT estimates that 350,000, or 2.8 per cent, of people owning their own homes would succumb to negative equity if prices were to fall 10 per cent.

If prices fell 15 per cent, the FT's estimate is still that only 5 per cent of mortgagors - 2 per cent of all households - would be in negative equity.

Kate Barker, a member of the Bank's monetary policy committee, arrived at the same figure in a speech in February that was based on a Bank survey.

They are also in line with the figures published by some lenders in their annual accounts. HBOS, the country's largest mortgage lender, says only 4 per cent of its stock of loans has a loan-to-value ratio greater than 90 per cent, while Nationwide, another of the country's big four mortgage lenders, has only 1 per cent of its mortgage book in this category.

Gary Styles, strategy, risk and economics director of Hometrack, says that many scare stories about negative equity use figures that are "very inaccurate and far too high".

"Most of the largest lenders in the UK have very few customers with less than 10 per cent equity in their properties and several of the biggest players have only around 2 per cent of their existing mortgage customers with less than 10 per cent equity," he said.

De-leverage

The FT provides a good overview of the way that the de-leveraging in the banking system spreads out through the rest of the financial sector.

The most leveraged funds are now borrowing no more than five times their asset base, compared with 10 times their asset base just six months ago, according to fund of hedge fund managers. The move comes as banks withdraw from risk-taking to repair tattered balance sheets, and places strains on formally lucrative hedge fund relationships.

This will reduce returns (and risk).

Mergers and market power

Do mergers increase prices and allow the new combination to gain market power? A new study suggests that they do. Looking at some extreme cases where makers of substitute products got together, Orley Ashenfelter and Danniel Hosken report an increase of prices of between 3% and 7%. This does not look at long-term cost improvements that may be apparent or the effect of the development of new products. However, given the large-scale industries that are represented, it does suggest a substantial transfer from consumers to producers.

Buffett talks

Warren Buffett talks to students about EMH and regulation amongest othere topics.

The answer is you don't want investors to think that what they read today is important in terms of their investment strategy. Their investment strategy should factor in that (a) if you knew what was going to happen in the economy, you still wouldn't necessarily know what was going to happen in the stock market. And (b) they can't pick stocks that are better than average. Stocks are a good thing to own over time. There's only two things you can do wrong: You can buy the wrong ones, and you can buy or sell them at the wrong time. And the truth is you never need to sell them, basically. But they could buy a cross section of American industry, and if a cross section of American industry doesn't work, certainly trying to pick the little beauties here and there isn't going to work either. Then they just have to worry about getting greedy. You know, I always say you should get greedy when others are fearful and fearful when others are greedy. But that's too much to expect. Of course, you shouldn't get greedy when others get greedy and fearful when others get fearful. At a minimum, try to stay away from that.

Exchanges and Silos

The FT looks at the LSE model which uses the market and external settlement. The contrast is the virticle silo that is favoured by Deutsche Bourse. Though the EU Commission appears to be in favour of competition, there are some signs that sentiment in the US is switching towards the integrated model. Those exchanges that are integrated, appear to enjoy higher valuations.

And around, and around....

Macro Man with an excellent look at the way financial crisis comes around again.

LTCM

The carry trade

Markus Brunnermeier, Stefan Nagel, Lasse Pedersen look at the carry trade.

Our findings...show theoretically that securities that speculators invest in have a positive average return and a negative skewness. The positive return is a premium for providing liquidity and the negative skewness arrises from an asymmetric response to fundamental shocks: shocks that lead to speculator losses are amplified when speculators hit funding constraints and unwind their positions, further depresing prices, increasing the funding problems, volatility, and margins, and so on. Conversely, shocks that lead to speculator gains are not amplified.

John Jansen looks at the TSLF and finds some evidence that the pressure may not be as great as feared.

Another cause of concern was the result of the first TSLF operation conducted by the Federal Reserve to sop up unloved and difficult to finance collateral. The Fed offered the street $75 billion of Treasury collateral and took a similar amount of toxic paper from the street in return. The so called stop out rate was 0.33 .Here is what I think that means:According to the footnote on the Fed website the stop out rate is approximately equivalent to the spread between the Treasury general collateral rate and the general collateral rate for the pledged security over the life of the loan. That means that the person who got financed at 33 basis points received finacing for this unloved stuff at only 33 basis points over Tresury collateral. That seems to indicate a lower level of stress in the system than some had expected. Additionaly the level of interest in the new facility os light as only $86 billion of bids were received for $75 billion of Treasury collateral.

Liquid assets

The FT reports,

The Bank is preparing to swap illiquid mortgages, mortgage securities and other asset-backed securities on banks’ books for liquid assets it will provide, so long as commercial banks carry the can if the loans go sour.

“The banks neither need nor want the taxpayer to insure them against these losses,” Mr King insisted.

The Bank is now discussing with big UK banks how best this should be done. The options range widely.

At one extreme, perhaps the cleanest solution is for the Bank to purchase mortgages at a price close to face value, with the banks promising to insure the central bank fully for any loans that go bad. Taxpayers would take a hit only if the banks themselves went under while the banks would get cash, providing a welcome increase in tier one capital in return for illiquid assets.

Alternative mechanisms could include banks issuing covered bonds for the Bank to buy which are backed not only by the assets but also by the issuer. Or the central bank could buy mortgage-related assets at a big discount to face value to give taxpayers a high probability of coming out making a profit.

What were once liquid assets are no more.

William Painter's presentation on globalisation and education

glumbert - Shift Happens

Front page of the Economist

Let's see if it works. S&P 500 is currently at 1352.99.

Markowitz on line

Markowitz on line.

Reputation and liquidity

The Economist amidst a look at the Skilling evidence, makes the connection between Enron and the recent liquidity crisis for investment banks.

"For many people, the mere fact of Enron’s collapse is evidence that Mr Skilling and his old mentor and boss, Ken Lay, who died between his conviction and sentencing, presided over a fraudulent house of cards. Yet Mr Skilling has always argued that Enron’s collapse largely resulted from a loss of trust in the firm by its financial-market counterparties, who engaged in the equivalent of a bank run. Certainly, the amounts of money involved in the specific frauds identified at Enron were small compared to the amount of shareholder value that was ultimately destroyed when it plunged into bankruptcy."

This is a point made by, amongest others, Malcolm Gladwell. Gladwell asserts that it was the loss of reputation and the drying up of business (as was also seen at Arthur Anderson, that destroyed Enron rather than the fraud. Gladwell also suggests that Enron SIV 'practices' were not that unusual.

Football and globalisation

Dan Rodrik looks at European football to draw some lessons about globallisation

"But the most important lesson revealed by the Africa Cup is that successful nations are those that combine globalisation’s opportunities with strong domestic foundations. For the winner of the cup was not Cameroon or Cô te d’Ivoire or any of the other African teams loaded with star players from European leagues, but Egypt, which fielded only four players (out of 23) who play in Europe.
By contrast, Cameroon, which Egypt defeated in the final, featured just a single player from a domestic club, and 20 from European clubs. Few Egyptian players would have been familiar to Europeans who watched that game, but Egypt played much better and deserved to win"

Bear Stearns

Here are a number of comments on Bear

The WSJ.

Felix Salmon.

Steve Waldman.

New York Times on the financial crisis.

Crisis!

The FT's Lex provides a good summary of the questions that are being asked of European banks:

Investors are screening banks on three main criteria. Those failing even just one are seeing their share prices head south. First, does a bank have enough liquidity to stay solvent? That means looking at its funding mix, in particular its reliance on wholesale markets, and trying to work out whether mortal damage would be done to earnings if this source of capital dried up. This is where Bear tripped up, as did Northern Rock in the UK. It is also why Lehman Brothers and the Icelandic banks are under pressure.

But even banks that appear well capitalised are being marked down because of the third screen: asset quality. This fear of further writedowns is pervasive and poor disclosure has only added to the problem. Swiss bank UBS, despite a strong capital position and a raft of profitable businesses, is the highest profile victim of such distrust

Trader at the top

Mark Thoma look at the report of the Senior Supervisors Group on practices at major financial institutions in the run up to the current credit crisis.

"The senior management teams at some of the firms that felt most comfortable with the risks they faced and that generally avoided significant unexpected losses ... had prior experience in capital markets. Consequently, the nature of market-related events over the summer of 2007 played to their experience and strength in assessing and responding to rapidly changing market developments and issues such as uncertainty in valuations. As risk issues were identified and brought to the attention of senior managers, executives in many of the firms that avoided significant losses championed robust and timely risk mitigation efforts, including executing hedges, deciding to write down exposures, and enhancing management information systems."

The Laws of Anime

The Laws of Anime

Wikipedia

Wikipedia and everything that you ever wanted to know. NYRB.

Bubbles and Mammoth

Paul Krugman on the reason for momentum in equity prices.

And those instincts can be self-reinforcing, at least for a while. After all, whereas an increase in the number of people acting like Cave Bulls tended to mean fewer mammoths per hunter, an increase in the number of modern bulls tends to produce even bigger capital gains - as long as the run lasts. Any broker can tell you that in the last few months the market has been rising, despite mediocre earnings news, because of fresh purchases by ever more people distraught about having missed out on previous gains and desperate to get in on the action. Sooner or later the supply of such people will run out; then what?