Thursday, December 31, 2009

Composition of international capital flows

A survey of international capital flows. The abstract.
In an integrated world capital market with perfect information, all forms of capital flows are indistinguishable. Information frictions and incomplete risk sharing are important elements that needed to differentiate between equity and debt flows, and between different types of equities. This survey put together models of debt, FDI, Fpi flows to help explain the composition of capital flows.

With information asymmetry between foreign and domestic investors, a country which finances its domestic investment through foreign debt or foreign equity portfolio issue, will inadequately augment its capital stock. Foreign direct investment flows, however, have the potential of generating an efficient level of domestic investment.

In the presence of asymmetric information between sellers and buyers in the capital market, foreign direct investment is associated with higher liquidation costs due to the adverse selection. Thus, the exposure to liquidity shocks determines the volume of foreign direct investment flows relative to portfolio investment flows. In particular, the information-liquidity trade-off helps explain the composition of equity flows between developed and emerging countries, as well as the patterns of FDI flows during financial crises.

The asymmetric information between domestic investors (as borrowers) and foreign investors (as lenders) with respect to investment allocation leads to moral hazard and thus generate an inadequate amount of borrowings. The moral hazard problem, coupled with limited enforcement, can explain why countries experience debt outflows in low income periods; in contrast to the predictions of the complete-market paradigm.

Finally, we analyze a risk-diversification model, where bond holdings hedge real exchange rate risks, while equities hedge non-financial income fluctuations. An equity home bias emerges as a calibratable equilibrium outcome.

Wednesday, December 30, 2009

Type 1 and type 2 errors

Amidst a fantastic discussion of the trade off between different types of error, Cosma Shalizi quotes this section from James:
There are two ways of looking at our duty in the matter of opinion, — ways entirely different, and yet ways about whose difference the theory of knowledge seems hitherto to have shown very little concern. We must know the truth; and we must avoid error, — these are our first and great commandments as would-be knowers; but they are not two ways of stating an identical commandment, they are two separable laws. Although it may indeed happen that when we believe the truth A, we escape as an incidental consequence from believing the falsehood B, it hardly ever happens that by merely disbelieving B we necessarily believe A. We may in escaping B fall into believing other falsehoods, C or D, just as bad as B; or we may escape B by not believing anything at all, not even A.
Believe truth! Shun error! — these, we see, are two materially different laws; and by choosing between them we may end by coloring differently our whole intellectual life. We may regard the chase for truth as paramount, and the avoidance of error as secondary; or we may, on the other hand, treat the avoidance of error as more imperative, and let truth take its chance. Clifford ... exhorts us to the latter course. Believe nothing, he tells us, keep your mind in suspense forever, rather than by closing it on insufficient evidence incur the awful risk of believing lies. You, on the other hand, may think that the risk of being in error is a very small matter when compared with the blessings of real knowledge, and be ready to be duped many times in your investigation rather than postpone indefinitely the chance of guessing true. I myself find it impossible to go with Clifford. We must remember that these feelings of our duty about either truth or error are in any case only expressions of our passional life. Biologically considered, our minds are as ready to grind out falsehood as veracity, and he who says, "Better go without belief forever than believe a lie!" merely shows his own preponderant private horror of becoming a dupe. He may be critical of many of his desires and fears, but this fear he slavishly obeys. He cannot imagine any one questioning its binding force. For my own part, I have also a horror of being duped; but I can believe tbat worse things tban being doped may happen to a man in this world: so Clifford's exhortation has to my ears a thoroughly fantastic sound. It is like a general informing his soldiers that it is better to keep out of battle forever than to risk a single wound. Not so are victories either over enemies or over nature gained. Our errors are surely not such awfully solemn things. In a world where we are so certain to incur them in spite of all our caution, a certain lightness of heart seems healthier than this excessive nervousness on their behalf. At any rate, it seems the fittest thing for the empiricist philosopher.

This seems to resonate with the idea that over-confidence is at the heart of entrepreneurial development and the creation of new ideas. Without the failure, there is not likely to be success.

Wednesday, December 23, 2009

Bank barriers

Amidst an interesting look at new entrants to the banking industry the FT notes:
Analysts say that one of the biggest challenges for smaller banks is the onerous capital and liquidity requirements. Holding more high-quality capital – which yields low rates of interest – lifts costs, which are harder for smaller institutions to absorb, and constrains the business they can do. And new banks will have to meet these requirements upfront.

It seems that the new regulations on capital requirements will add to the scale economies associated with banking and make it harder for smaller players to break into the market.

Monday, December 21, 2009

Models and economics

Paul Krugman suggests that it was Keynes and Samuelson's effective use of economic models to understand and combat the great depression that helped gain the ascendancy over more complex and nuanced historical and institutional explanations. However, it appears that we reached a point where the institutional and historical context was lost. The model is just a model and the model used must be suited to the situation. The situation can probably only be assess with institutional and historical knowledge.

The current crisis does not appear to be that different from previous crises: there is a period of calm complacency and de-regulation; there is excess credit growth and increased risk-taking as the consequence of risk disappears into the background. What is new is the institutional and historical context: the international financial system is inter-connected; there is a huge increase in savings that is being intermediated between developing and developed countries; there is demand for safe assets.


Tim Harford discusses the issue of aggregation or the phenomenon of clustering of economic specialisation.

Recall the four possible hypotheses: knowledge spreads within industries; ideas are generated when different industries rub together; people learn from being around lots of smart people; or people benefit from the density of a labour market, which helps them find the perfect job.

There is evidence that all four have an effect. Even with the development of modern communications, it still seems that place matters.

Saturday, December 19, 2009

McKinsey and the role of the US dollar

McKinsey discussion of the international role of the US dollar. McKinsey: What Matters
This follows their own cost-benefit analysis of the US dollars' position that concluded that the benefits were rather modest. There are three main issue for me:

1) If International Seniorage is so good, why do we have rules against dumping goods. Seniorage allows countries to dump goods for paper. It harms local industry at the expense of that overseas.
2) The issue of international currency faces international pressure to allow sufficient currency to help the world economy. Though it can be argued that this pressure can be ignored (as the BBK was largely able to do in the micro-environment of the EMS), it was not the case with the US from 1998 through 2005. Monetary policy was too loose as a result.
3) International reserve currency status is a version of the Dutch disease: international demand for the currency pushes up the exchange rate and harms manufacturing interest.

The Valuation Channel of External Adjustment

The IMF looks at the valuation channel for international adjustment.

The Valuation Channel of External Adjustment

Tobin tax

The FT looks at the Tobin tax and the some of the practical limitations of its use. UK - A tax on short-term debt would stabilise the system

Yield curve

The yield curve steepens. This increases the cost of borrowing for government, increasing the attraction of long-dated index-linked borrowing (see below). It should also help to reacapitalise banks. The steep yield curve is the most simple of the carry trades - borrow from the government at one rate and lend back to them at another. There is a liquidity risk, but...Even that can be hedged. / UK - Federal Reserve renews vow to keep rates low

Friday, December 18, 2009

Ha - and you don't know it

Just to remind myself:

im in ur base, killing ur d00dz


im in ur fridge eating ur foodz

im in ur sweatshop making ur shooz

Thursday, December 17, 2009

Financing the deficit

It is hard to see why the government does not take advantage of this imbalance of supply and demand to lock in very low real rates. It is clear that this is not just a hedge against inflation, this is due to pension fund demand to match the duration of assets and liabilities and to remove the inflation risk. With a huge amount of funding to be done, now seems to be the time to find out how much demand there is for this sort of security. / Lex / Macroeconomics & markets - UK 50-year inflation-protected gilts: "Far, far away, there is bond. And, like many childhood stories that take place in another age and another land, it shares some of the qualities of a fairy tale. It is government-guaranteed to protect investors against the ogre of inflation for the next half century. Lately, it has delivered six-league boot-sized returns; since March, a gain of almost 40 per cent. As a fairytale hero, however, the UK’s 2055 index-linked gilt looks spent. Over the past three centuries, real UK yields have averaged 3 per cent. This bond offers a 10th of that, a mere 32 basis points."

Loss aversion

US treasury's loss aversion (and the risk of political backlash) halts the sale of Citigroup holding.

BBC News - Citigroup shares sale planned by US government 'halted': "The Treasury had been planning to sell $5bn worth of shares, but reports say it has reconsidered after the price was set below what it paid.
That would mean the US would have taken a politically unpalatable loss."

Friday, December 11, 2009

Equity analysis

The FT assesses a study of relative returns on equity over the last decade compared to the return on tbills.

Monday, December 07, 2009

Quasi-sovereign debt

The FT Lex column assesses the effect of Dubai on the quasi-sovereign debt.

So investors in quasi-sovereigns are likely to demand a higher risk premium. Analysts at the Royal Bank of Scotland suggest rating agencies may review assumptions on sovereign support, potentially bringing a wave of downgrades. In that case, the effects could be felt far and wide, from Russia’s “Kremlin Inc” companies such as Gazprom and Russian Railways, to South African or Israeli utilities. Borrowing costs will rise, at an awkward time for quasi-sovereign borrowers. For investors, Dubai is a reminder of the need for careful homework. And that if bonds offer a higher yield than sovereign debt, there is good reason.

Another issue is the way that uncertainty over backing for the debt encourages over-investment. This can also be seen in the case of Fannie Mae and Freddie Mac. If investors are able to convince themselves that there is state backing, the return looks very attractive and money flows into, encouraging additional bond issuance. The small risk premium remains due to the uncertainty, but this is not sufficient to compensate for the real risk. These developments, as has been the case in the US housing market and is now likely to be the case in Dubai, will lead to reduced investment in the likes of those entities that have been identified by the FT column.

Demand for money

Andrew Bailey from the Bank draws attention to the recent demand for cash which is probably a reflection of reduced confidence in the banking system.

As a share of nominal GDP, the value of notes in circulation declined from 6% in 1970 to a low point of 2.4% in the mid-1990s but has since stabilised and then increased, noticeably over the past two years. He explains that from a macroeconomic perspective, sustained low inflation has increased confidence in the real value of the currency since the mid-1990s, while more recently demand for banknotes has risen during the recession, particularly for £50 notes. This recent trend contrasts with the pattern in previous recessions. Rising demand for notes might reflect some loss of confidence in banks and very low interest rates, which reduce the opportunity cost of holding banknotes as a non-interest bearing asset. Andrew Bailey says that is “…pretty good prima facie evidence that there has been an increase in demand for banknotes as a store of value”. This pattern has been seen in other major currencies.

Monday, November 30, 2009

The cost of finance

Looking at the Kraft attempt to take over Cadbury, the FT makes the following observaton:

An investment grade company would look at paying between 300-325 basis points above Libor for bank debt today. Before the economic crisis an equivalent borrower could have obtained those funds for less than 100 basis points.

That compares with the average cost for investment grade companies issuing bonds for acquisitions of about 120-125 basis points over Libor. "There is an overwhelming trend to use the capital markets," said Ivor Dunbar, co-head of global capital markets at Deutsche Bank. "The cost of financing is more attractive and the banks generally cannot compete with that at present."

Sunday, November 22, 2009

Dark Pools

There is an item in the FT looking at possible SEC regulation of Dark Pools. It includes the following:

“Before computerised ‘dark pools’ existed, traders often chose to keep their bids and offers undisplayed . . . by giving a ‘not-held’ order to the floor brokers on the exchange who would then keep sensitive orders ‘in their pocket’,” said Dan Mathisson, head of the advanced execution strategies unit of Credit Suisse, to a US Senate panel in late October. Dark pools migrated from brokers’ shirt pockets to their computer systems by the late 1980s, and some of the largest systems are managed today by Goldman Sachs, Credit Suisse and LiquidNet.

These Dark Pools are increasingly controlled by investment banks and other financial institutions that run virtual market-making that are run by machines and controlled by algorithmic black-boxes. The system can take prices from major exchanges like the NYSE and the LSE and provide some price improvement for customers. The black-box can take positions based on simple mathematical rules and can be over-ruled by operators. The system remains very much dependent on the pricing information provided by major exchanges.

Monday, November 16, 2009

Lloyds bad debts

The FT looks at some of bad loans that Lloyds acquired from HBOS.

The development is a further sign of the fallout from the bank’s ill-fated acquisition of HBOS, made during the banking crisis.

At the end of last year, Lloyds took a £12.4bn impairment charge, mostly related to HBOS’s lending spree in commercial property. Lloyds took a further £13.4bn of impairments in the first half of this year, of which £9.7bn again related to HBOS’s corporate loan book.

However, Lloyds believes that will represent the peak of its impairment charges.

Lloyds is also Kenmore’s main lender and joint venture equity partner through its Uberior arm. The listed Kenmore European Industrial Fund is unaffected.

The Edinburgh-based investment and development property group was backed by Peter Cummings, who ran the corporate bank at HBOS. Largely as a result of his dealmaking, loans and advances in HBOS’s corporate division rose from £85.8bn in 2004 to £116.9bn by mid-2008.

Saturday, November 07, 2009

Inflation expectations

Haubrich, Pennachi and Richken take a closer look at inflation expectation by using forecasts, break even rates and inflation swaps. They conclude that the risk premium has been steady between 29bp to 61bp over the last 30 years, suggesting that break even rates provide a pretty good estimate of anticipated price pressure.

Sunday, November 01, 2009

Central Bank Discussion

There is a discussion about the central bank and the nature of its assets at Worthwhile Canadian Initiative. A flavour:
There is some truth in this criticism of standard theories of the value of money. There are indeed two equilibria: the normal one, where paper money has value, and a weird one, where it is worthless. But Ludwig von Mises, for example, addressed this problem in 1912 with his Regression Theory of Money. Historically, money needed to be commodity money, or have commodity backing, in order to get started. But once it does get started, as a social institution, the demand for a medium of exchange supplements the industrial demand for the commodity, and the commodity backing can eventually be withdrawn as custom keeps us out of the weird equilibrium. (When Cambodia reintroduced paper money, after the fall of the Kymer Rouge, it could not create paper money ex nihilo, but initially made it convertible into rice, IIRC.)

Some interesting commentary as well.

Wednesday, October 28, 2009

EMH and intervention in bubbles

Martin Wolf in the FT looks at the latest book by equity strategist Andrew Smithers. This argues that the central bank should intervene in asset bubbles. Wolf says:

Yet, for those interested in economic policy, Mr Smithers’ arguments have wider significance. If markets can be valued, it is possible to tell whether they are entering bubble territory. Moreover, we also know that the bursting of a huge bubble can be economically devastating. This is particularly true if there was an associated surge in credit. This is also the conclusion of a significant chapter in the latest World Economic Outlook. In extreme circumstances, monetary policy loses its impact, as the financial system is decapitalised and borrowers become bankrupt. What we see then is what Keynes called “pushing on a string”.

It all makes great sense, but it omits the fact that contrarian action as practised by Buffett and Smithers is not so much a triumph of analysis but of nerve, obstinacy and an accumulation of political capital. The majority will argue that it is not a bubble, that the central bank is outmoded and 'does not get it'.

Saturday, October 24, 2009


Don't let people tell you that the government can fix economic data. If they could, Q3 GDP would have shown the increase that was expected. From the Guardian:

Gordon Brown's hopes of fighting the general election on the back of a clear economic recovery suffered a severe blow today when government figures showed that Britain is experiencing its worst recession since the mid-1950s.

To the disappointment of ministers, figures from the Office for National Statistics showed a shock 0.4% fall in gross domestic product in the third quarter of the year.

The figures, which stoked tensions between No 10 and the Treasury ahead of the pre-budget report later this year, were seized on by the Tories as evidence that Brown was wrong to claim that Britain was best placed to weather the recession.

If he had fixed that, no one would have suspected as it was totally anticipated that there would be a small rise in output (and still possible given the likely revisions to the provisional number).

Thursday, October 22, 2009


The FT takes a look at Goldmans with an assessment of the 'true proprietary trading' as being 10% and additional information about the bonus pool.

Nor is it merely a giant hedge fund. Its pure proprietary activities make up about 10 per cent of its revenues. Market-making in bonds and equities, now its main business, serves companies and investors, although it is a capital-intensive and sometimes risky activity.


The bonus problem in investment banking is not the absolute size of the rewards (although shareholders ought to ask themselves if the employees really are worth it) but the incentives they create.

Goldman probably has one of the most partner-like pay structures for its managing directors. About two-thirds of bonuses are in restricted stock that vests over four years and its most senior partners have to hold 75 or even 90 per cent of the stock until after they retire.

Monday, October 19, 2009

Valuing securities

The FT talks about the effect of a re-valuation of 'toxic assets' on on the profits of US banks in Q3.

“There were some assets that had lost too much value six months ago and investors are recognising that,” said Robert Smith, chief executive of Rangemark, which specialises in structured products. “Yet despite the rally, much of the collateral is broken and banks and investors are still holding a lot of securities that even now may not have been sufficiently marked down. Valuation methods are still oversimplified, which means risks may not be property assessed.”

It raises an important point about the valuation of assets. This is not just an issue for accounting (historic cost accounting against latest market price) but also one for valuation in general. Is it possible to fix one valuation on a financial asset. Even if we take a simple bond, the valuation will depend on the rate at which future cash flow is discounted and this rate is subject to uncertainty about inflation, liquidity and, particularly, risk. As the perception of risk changes, the value of the asset changes.

Wednesday, October 07, 2009


Has 'financialisation' encouraged boom and bust? John Authers and others says that it does:

The United Nations Commission on Trade and Development devoted a chapter in its trade and development report to “the financialisation of commodity markets”.

It wrote: “Commodity prices, stock prices and the exchange rates of currencies affected by carry trade speculation moved in parallel during much of the period of the commodity price hike in 2005-08, during the subsequent sharp correction in the second half of 2008 and again during the rebound phase in the second quarter of 2009.”

The “herd behaviour” of many participants reinforced impulses to sell positions in commodity futures when prices began to fall. Financial investors treated commodities “increasingly as an alternative asset class to optimise the risk-return profile of their portfolios” and paid “little attention to fundamental supply and demand relationships in the markets for specific commodities”.

I'm not so sure. If this were the case, there would be easy profits to make from contrarian views. Where are these profits?

Wednesday, September 30, 2009

Network lock down

Tim Harford has a good overview of the network lock down.

Not everyone buys the story of QWERTY lock-in. The American economists Stan Liebowitz and Stephen Margolis call it “The Fable of the Keys” – pointing out that the evidence for Dvorak’s superiority is sketchy. (That Navy test? Conducted by a certain Lieutenant Commander August Dvorak, who owned the patent…) For Liebowitz and Margolis, network lock-in is an interesting theoretical possibility, but in practice they argue that people find a way to move to the new standard.
An intriguing new experiment supports that idea. Tanjim Hossain and John Morgan recruited Hong Kong students and paid them money if they were successfully able to coordinate on the same “platform” – an abstract representation of the choice between standards such as a Blu-Ray or an HD-DVD. What really mattered was to choose the most popular platform, and the students did that – but they also managed to coordinate a move to the higher-quality choice, even if they had started off on the low-quality platform.

The loss of the Bund contract from LIFFE to the DTB is a good example of this change over. There is an interesting paper to be written there. Some background in an Independent story.

Sunday, September 27, 2009

Banking compensation (part 2)

The NYT has an article on compensation in the banking sector.

PROFESSOR STULZ also notes that bank C.E.O.’s lost a lot of their own money during the credit crisis.

He and Professor Fahlenbrach studied 98 banks that were part of the Standard & Poor’s 1500-stock index at the end of 2006, relying on the government’s Standard Industrial Classification system to determine which companies to consider as banks.

They found that the C.E.O.’s of these banks lost more than $30 million, on average, of their investments in their own banks in 2007 and 2008, and that the executives who headed Bear Stearns and Lehman at the onset of the crisis lost close to $1 billion each.

“If the prospect of losing those amounts was insufficient to induce the firms’ C.E.O.’s to pursue different policies,” Professor Stulz says, “it’s extremely difficult to imagine any compensation reform package that contains incentives that would do the trick.”

Saturday, September 26, 2009

Bank bonus

The pitchforks are out and the mob is off and running. Amidst the green-eyed hysteria over bank bonus payments, there has been little evidence to suggest that 'excessive' bonus payments are responsible for the recent crisis. Indeed, amidst it all, there are a couple of counter-points. First, The Epicurean Dealmaker gives us an overview of investment banking compensation. The highlight.

There are a lot of knocks you can legitimately put on Wall Street, but claiming investment bankers take crazy risks just so they can walk out the door December 31st with pockets full of cash, free and clear of future effects on their employer, is not one of them. Unlike the public shareholders in their firms, who are mostly highly diversified and therefore have far lower relative exposure to the health and survival of any one bank, investment bank employees can't yank their accumulated years of compensation out of their employer when the shit hits the fan. They are stuck, and they have a hell of a lot bigger personal stake in the future health and survival of their firm than any public shareholder.

The second is a filling by the late-great Lehman Brothers on their stock incentive plan and a WSJ article outlining the exposure of Lehman employees to the firm.

Tuesday, September 22, 2009


Following up the comments by Gillian Tett, Lex offers a slightly less Machiavellian view of the Barclays disposal.

“The transaction is, if you like, a way of swapping the fair value adjustment that would otherwise be taken on a monoline downgrade over a longer period of time through reduced net interest income,” said analysts at Credit Suisse.

But the analysts note the danger is that the market will continue to view the exposures as before and that any monoline downgrade will be taken badly.

Other analysts are concerned that, in return for stability, Barclays is giving too much away to Protium’s backers and managers.

Cayman Islands-based Protium is providing $450m of funding for the assets, mostly from two unnamed substantial US and UK investors.

The investors will be entitled to fixed payments of 7 per cent a year for 10 years on their initial investment. Any excess cash flow after repayment of the loan to Barclays will also be taken by the investors.

C12, a US asset management company that runs Protium and is mostly made up of former Barclays Capital executives, will also see some of the benefits. C12 will receive a $40m annual management fee to administer the assets.

And while Barclays is transferring a chunk of the risk, it is also handing away some of the potential upside to Protium and C12 if the values of these assets recover.

If assets of $12bn went up in value by just 1 per cent, the Protium investors could have made $120m on their original $450m investment – a return of 25 per cent.

Not only that but Barclays could be exposed to any downside if the assets fall in value. Protium has working capital but does not have an equity cushion to burn through before taking losses.

The cash flows come from assets that were once valued at far more than $12bn and so Barclays believes that even if some of the assets fell in value it would not disrupt the cash flows to the extent that its loan is impaired.

The structure of the deal also means that Protium and C12 receive payments from the cash flow ahead of any interest payments made on the Barclays loan.

“This structure is unusual as it implies Barclays’ loan is subordinate to the management fees,” said one analyst.

Another oddity is the fact that Barclays has derecognised the assets on its balance sheet for accounting purposes but has kept them on its balance sheet for regulatory reasons.

Nevertheless, Barclays’ move could be the first in a series of these types of deals as investors seek to make a return on these toxic assets – particularly if the banks involved are prepared to offer juicy returns.

Friday, September 18, 2009

The cellar

Gillian Tett re-uses the cellar analogy to look at Barclays' disposal of sour assets. What is not clear, however, is whether the separate legal entity means that the fund can fail without doing damage to Barclays.

In theory, regulators could preventjavascript:void(0) that outflow, if they were willing to clamp down on the unregulated world in a co-ordinated way. In practice, though, western leaders are finding it so tough to agree on how to reform the front rooms of finance that I seriously doubt they will have the energy to attack the cellars too.

Thus far, few banks have had the political chutzpah to exploit that situation too brazenly. Barclays, however, now appears to be blazing a trail of sorts – and I would hazard a bet that plenty more banks will be tempted to follow suit. So stand by to see more Protium-style deals emerge in the coming months. After all, financial cellars can come in numerous forms – and, it would seem, ever more weird names.

Thursday, September 10, 2009

John Kay discusses Lord Turner's view on the social wealth of financial services. He says:

But more explanation is required. If my guess about the MPC decision is correct, someone on the other side of the trade gets it wrong. This activity may be very profitable for particular individuals and firms, but the gains and losses should net out for the financial sector as a whole. How can proprietary trading have been a very large source of earnings and profits for a large industry?

I find it hard to believe that this proprietary trading is really the main source of revenue. Kay goes on to suggest explanations:

Explanations fall into three broad groups. First, the profits arise from government-created distortions, particularly state guarantees of the liabilities of financial institutions and opportunities for regulatory arbitrage. Second, profits are made at the expense of the customers of financial institutions. Corporate treasurers, pension fund managers and individuals mistakenly believe they can outwit dealers at investment banks. Trading firms that are also marketmakers use knowledge gained from one activity to profit in the other. Third, the profits are illusory; the reported gains are either borrowed from the future or from other segments of conglomerate financial institutions.

There are a few government distortions - obviously the GBP exit from the ERM was a classic example of that. Breaking of pegs is a big earner, but it does not happen very often and money is also lost when the peg is not broken. Some profits come at the expense of customers. However, this is mostly a high volume low margin business that is not really proprietary but serving customers. The larger firms have experienced treasury staffed by ex-industry people; the smaller firms pay but are also expensive to service because of the odd lots and small volumes. True proprietary profits probably are illusory: the come in the good times and disappear in the bad times. The carry trade and its unwind is a great example.

This also helps to explain the cyclical nature of the proprietary game: others are making money, it looks so attractive, we get into the game and then it blows up and we vow to keep out of this business until the next time.

Sunday, August 30, 2009

Reuters vs Bloomberg

The Sunday Times has the latest on Reuters vs Bloomberg.

When the banking crisis tore through Wall Street and the City of London there wasn’t much Devin Wenig could do, apart from sit and watch the trading screens in his office turn red.

As for any supplier to investment banks, a string of collapses including Bear Stearns was not good news for Thomson Reuters, even though the financial news and data provider claims to thrive on volatility.

Wenig runs the company’s markets division — essentially the old Reuters business plus Thomson Financial, which supplies legacy systems like Topic and Datastream. He knew a new banking elite would mean fewer potential customers.

However, Thomson Reuters has been dealing with another change in its market. Thanks to the rise of the internet, today’s traders are more familiar with clicking their way through YouTube than memorising a complicated series of codes for using Reuters’ trading screens and information feeds.

“You see very different behaviour from a 25-year-old just out of the London School of Economics to a 55-year-old who has been trading for the last 25 years,” said Wenig.

“People who grew up with Google have totally different expectations of how to interact with information and media. We can’t ignore that.”

Despite the recession, in the next few months it will unveil Project Utah, the final leg of a $1 billion (£613m) technology investment to upgrade its systems in four key areas.

“We are not going to be the greatest technology company in the world and nor should we be,” said Wenig. “But technology is an enabler. We have to put money into it. We can’t just talk about it.”

In the 158 years since Reuters began flying pigeons with news alerts tied to their legs, it has had to move with the times. But the company, which merged with Thomson last year and has delisted itself from the London stock market, has never really been known for its cutting-edge advances.

New versions of old systems have underwhelmed or been released late. Innovations such as offering instant messaging between users have often been introduced first by its nimbler rival Bloomberg, which has caused a headache for Reuters ever since it set up as a direct competitor almost three decades ago.

It recently trailed in Bloomberg’s wake in mobile, but the launch of a news application for the BlackBerry and iPhone was a hit, drawing 90,000 subscribers in its first month. However, long-term followers of the industry see a change of tack.

“The difference now is that Thomson Reuters is taking a more friendly approach to how it presents information,” said Douglas Taylor, managing partner at Burton-Taylor International Consulting and a former executive at both Thomson Financial and Reuters.

“In some cases they are playing catch-up but I think their expectation is to leapfrog Bloomberg.”

Clients also have high hopes. “This is a fiercely competitive market and I welcome any change that makes business easier to execute as long as quality isn’t compromised,” said Bryan Hotston, chief information officer at JP Morgan Cazenove.

In contrast to newspapers, providers of financial information that rely on subscriptions rather than advertising have held up well despite free news and statistics being readily accessible online through Yahoo Finance and other websites.

Despite the financial crash, underlying sales at Thomson Reuters’ markets division are still growing, although only by 0.2% in the last quarter.

Taylor forecasts that the $23 billion market for electronic financial information will shrink by 1%-3% this year, with Bloomberg holding a 26% share and Thomson Reuters 34% because it dominates in areas such as fixed income. Where they compete directly, the pair are judged to be roughly neck and neck.

Often it is not the news they convey that makes one or the other a must-have for City dealing rooms. If the information is market-sensitive, it is the immediacy of it and how it is packaged, including commentary and analysis, that makes all the difference.

For this reason, Thomson Reuters is trying to drive down split-second delays in its data feeds. Some investment banks have asked it to host their applications in its data centres to increase efficiency.

The biggest change to its news provision will be Insider, a video news service for the financiers who already use its news terminals. If they pay, they can call up interviews as if they were trawling YouTube and they will also be able to search quickly through transcripts for the key points. “I don’t want to turn us into a consumer company but you ignore at your peril what YouTube and Twitter have done to online behaviour,” said Wenig.

He invoked Apple and BlackBerry maker Research in Motion as the type of company he wants Thomson Reuters to emulate.

“We didn’t tend to think of ourselves as a product innovation company. I am trying to move the company forward and encourage people to think about new things,” he said.

The biggest technology bet he will place is Project Utah. Almost two years in the planning, and arriving early next spring, it aims to create a common platform for all of Thomson Reuters’ 200 financial products for the first time, making Reuters’ systems simpler to use.

It is likely to look and feel more like a conventional web portal and all its 500,000 customers will be moved on to it, replacing 3000Xtra as its flagship product. For a company that has previously tailored everything to different customers, it marks a new direction. So does the way that Wenig plans to introduce it.

“It is the first time we are going to properly launch a product,” he said. “We never really launch products. They just emerge. This will have proper marketing and advertising.”

Some of the changes mirror Reuters’ rivals, which are also investing during the downturn. Dow Jones — which is part of News Corporation, owner of The Sunday Times — is revamping its newswires’ arm by beefing up web applications so it is less dependent on data terminals. Meanwhile, Bloomberg has added news providers such as Associated Press to its terminals and a tagging system that lets users search across them more efficiently.

The challenge for all of them is a common one: to remain not just faster than the web but to make sure they still click with the newest internet-savvy generation of City workers.

Friday, August 28, 2009

Central banking

Pepys' Diary 17th August 1666

Then to Sir W. Batten’s, where Sir Richard Ford did very understandingly, methought, give us an account of the originall of the Hollands Bank, and the nature of it, and how they do never give any interest at all to any person that brings in their money, though what is brought in upon the public faith interest is given by the State for. The unsafe condition of a Bank under a Monarch, and the little safety to a Monarch to have any; or Corporation alone (as London in answer to Amsterdam) to have so great a wealth or credit, it is, that makes it hard to have a Bank here. And as to the former, he did tell us how it sticks in the memory of most merchants how the late King (when by the war between Holland and France and Spayne all the bullion of Spayne was brought hither, one-third of it to be coyned; and indeed it was found advantageous to the merchant to coyne most of it), was persuaded in a strait by my Lord Cottington to seize upon the money in the Tower, which, though in a few days the merchants concerned did prevail to get it released, yet the thing will never be forgot.

The value of networks

Edward Glaeser highlights the importance of social interactions in a NYT article.

As an urban economist, I focus in my research on the advantages that cities create by connecting people to one another. Cities facilitate trade and learning and even friendship, by bringing people literally closer together. It is somewhat ironic that Rand chose Frank Lloyd Wright to be her model for lone wolf Roark. Wright is better seen as an example of the virtues of social learning, for he was part of a chain of connected Chicago architects — including William LeBaron Jenney, Daniel Burnham and Louis Sullivan — who learned from each other and collectively gave us, among other things, the skyscraper. The enduring strength of cities reflects the social nature of humanity which Professor Cacioppo so ably demonstrates.

Monday, August 17, 2009

Counting cards

New Scientist discusses money-making from probability theory.

The simplest way is to start at zero and add or subtract according to the dealt cards. Add 1 when low cards (two to six) appear, subtract 1 when high cards (10 or above) appear, and stay put on seven, eight and nine. Then place your bets accordingly - bet small when your running total is low, and when your total is high, bet big. This method can earn you a positive return of up to 5 per cent on your investment, says Thorp.

Seems a reasonable return.

There is also a good explanation of arbitrage.

Each bookie has looked after his own back, ensuring that it is impossible for you to bet on both Oxford and Cambridge with him and make a profit regardless of the result. However, if you spread your bets between the two bookies, it is possible to guarantee success (see diagram, for details). Having done the calculations, you place £37.50 on Cambridge with bookie 1 and £100 on Oxford with bookie 2. Whatever the result you make a profit of £12.50.

Simple enough in theory, but is it a realistic situation? Yes, says Barrow. "It's very possible. Bookies don't always agree with each other."

Guaranteeing a win this way is known as "arbitrage", but opportunities to do it are rare and fleeting. "You are more likely to be able to place this kind of bet when there are the fewest possible runners in a race, therefore it is easier to do it at the dogs, where there are six in each race, than at the horses where there are many more," says Barrow.

Even so, the mathematics is relatively simple, so I decided to try it out online. The beauty of online betting is that you can easily find a range of bookies all offering slightly different odds on the same race. "There are certainly opportunities on a daily basis," says Tony Calvin of online bookie Betfair. "It's not necessarily risk-free because you might not be able to get the bet you want exactly when you need it, but there are certainly people who make a living out of arbitrage."

Arbitrage is not risk free because you might not be able to get the bet you want exactly when you need it. But there are certainly people who make a living out of it
After persuading a few friends to help me try an online bet, we followed a race, each keeping track of a horse and the odds offered by various online bookies. Keeping track of the odds to spot arbitrage opportunities was hard enough. Working out what to bet and when was, unsurprisingly, even harder. Arbitrage is not for the uninitiated.

Monday, August 10, 2009


Solow at the Stiglitz conference:

I also doubt that universal rational expectations provide a useful framework for macroeconomics. One understands the appeal. Think of it this way: Herb Simon was surely right about bounded rationality; no one would deny that most economic agents are actually like that, and natural selection does not work fast enough to eliminate them. Why did the notion of "satisficing" never catch on? I think it is because the assumption of complete rationality tells the modeller what to do, whereas bounded rationality only tells the modeller what not to do. That is not helpful. Something similar is true about rational expectations. If there were a nice parametric family of alternative ways to model expectations, it might catch on. Most of us would happily go along with the notion of expectational equilibrium: if specific underlying expectations generate an outcome in which those expectations are systematically and non-trivially violated, that situation can not be an equilibrium. It is what happens then that needs thought. The situations that agents need to anticipate need not even be probabilistic, surely not stationary. The popular device used to be adaptive expectations; that may have been inadequate. Maybe this is a case for the application of psychological research (and sociological research as well, because the formation of expectations is a social process). Maybe experiments can be designed. Heterogeneity across agents and classes of agents is certainly important precisely here. One would like a simple, definite way to proceed, if that is possible. A good example of the sort of thing I mean is the way the Dixit-Stiglitz model made monopolistic competition easy. (The trouble is that we are dealing with an unobservable.)

Thursday, August 06, 2009


Eric Falkenstein assesses the EMH.

No one thinks markets are perfect, and EMH never says this. The proof that markets are efficient is that it is so improbable one can generate alpha — something you, like most EMH critics, concede. But the implications do not seem obvious. That you were able to find one person in 2004 and turn his measured warning into something that would have drastically reversed the regulatory emphasis on weakening underwriting standards is classic hindsight wisdom.

Thanks to Chris Dillow for the pointer.

The wider point is that though markets are very far from perfect (and we have been shown many examples of that over the last couple of years), we should not be comparing markets against perfection but against the alternative. The alternative is some command (probably political of firm-orientated) structure. The Guardian looks here at local government planning.

Saturday, August 01, 2009


The Epicurean Dealmaker tells us something that has interested me for a while.

But I guess I see why you didn't publish that data for all the banks. It would have diluted the message to disclose for everyone what Goldman Sachs insisted you report for them: that 953 Goldman employees earned bonuses of $1 million or more, but no-one at the company took home more than $885,000 in cash. Sorta undercuts the image of fat cats dining freely on the shareholders' and taxpayers' dime, doesn't it? Joe Sixpack might not get so worked up about a banker's $10 million bonus when he learns that over $9 million of it is tied up in his firm's stock for up to five years, huh?

Friday, July 31, 2009

Dertivatives and spot

Via the Finance Professor, here is a look at whether action in the futures market has an effect on the spot price. This is related to the metals market. However, there has been a lot of speculation about this in the oil market in recent year and a lot of discussion about the mechanism that can cause speculation in futures to feedback into spot.

Tuesday, July 21, 2009


Malcolm Gladwell assesses the role of over confidence in the financial crisis

The psychologist Ellen Langer once had subjects engage in a betting game against either a self-assured, well-dressed opponent or a shy and badly dressed opponent (in Langer’s delightful phrasing, the “dapper” or the “schnook” condition), and she found that her subjects bet far more aggressively when they played against the schnook. They looked at their awkward opponent and thought, I’m better than he is. Yet the game was pure chance: all the players did was draw cards at random from a deck, and see who had the high hand. This is called the “illusion of control”: confidence spills over from areas where it may be warranted (“I’m savvier than that schnook”) to areas where it isn’t warranted at all (“and that means I’m going to draw higher cards”).

This is what social scientists mean when they say that human overconfidence can be an adaptive trait. “In conflicts involving mutual assessment, an exaggerated assessment of the probability of winning increases the probability of winning,” Richard Wrangham, a biological anthropologist at Harvard, writes. “Selection therefore favors this form of overconfidence.” Winners know how to bluff. And who bluffs the best? The person who, instead of pretending to be stronger than he is, actually believes himself to be stronger than he is. According to Wrangham, self-deception reduces the chances of “behavioral leakage”; that is, of “inadvertently revealing the truth through an inappropriate behavior.” This much is in keeping with what some psychologists have been telling us for years—that it can be useful to be especially optimistic about how attractive our spouse is, or how marketable our new idea is. In the words of the social psychologist Roy Baumeister, humans have an “optimal margin of illusion.”

Saturday, July 11, 2009

Demand for liquidity

Pepys' diary 6th July 1666

Thence to Lumbard Streete, and received 2000l., and carried it home: whereof 1000l. in gold. The greatest quantity not only that I ever had of gold, but that ever I saw together, and is not much above half a 100 lb. bag full, but is much weightier. This I do for security sake, and convenience of carriage; though it costs me above 70l. the change of it, at 18 1/2d. per piece.There is a lot in the comments for this day and the next that show the need for liquidity when fears for government finances rise.

Friday, July 10, 2009

Fischer Black and the future

Rorty Bomb points us to Fischer Black and the development of derivatives.

“Thus a long term corporate bond could actually be sold to three separate persons. One would supply the money for the bond; one would bear the interest rate risk, and one would bear the risk of default. The last two would not have to put up any capital for the bond, though they might have to post some sort of collateral.”

- Fischer Black, “Fundamentals of Liquidity” (1970)

In case that doesn’t freak you out, let me explain why it should. That’s 1970 (!!!), and it predicts everything. It’s before the Black-Scholes Equation (same Black) is published and popularized, creating the derivative market, so it is during the first wave of thinking how derivatives would change everything.

Monday, July 06, 2009

Housing wealth effect

Charles W. Calomiris, Stanley D. Longhofer and William Miles take a closer look at the housing wealth effect and find that when consumption and house prices are looked at simultaneous effects of expected decline in future income, the influence is much lower than previously believed.

Other researchers have analysed data from Great Britain and have similarly found that, once one takes simultaneity problems into account, there is also little, if any, housing wealth effect in that country. Orazio Attanasio, Laura Blow, Robert Hamilton, and Robert Leicester (2009) express scepticism that a large housing wealth effect exists, and find, for instance, that (without correcting for simultaneity bias) the “wealth effect” appears to be the same for renters and homeowners. This would make no sense if household spending were really driven by housing wealth, because renters are actually hurt by rising home prices. They conclude, as we do, that housing wealth is acting mainly as an indicator of changes in perceived economic prospects, which apply to homeowners and non-homeowners alike.

Private equity buy-ins

A study by the Credit Management Research Centre at Leeds and the Centre for Management Buy-Out Research in Nottingham, suggests that buy-ins are much more risky that buy-outs.

The study also found that private equity deals are more likely to fail when outsiders are brought in to run a company (management buy-ins) than when done with the support of existing managers (management buy-outs).

“Buy-outs have a higher failure rate than non-buyouts, with MBIs having a higher failure rate than MBOs, which in turn have a higher failure rate than private equity-backed buyouts,” it said.

“However, MBOs and private equity-backed deals completed post-2003 are not riskier than the population of non-buy-outs if we control for other factors.”

Future of finance

E&Y report on the reaction of financial services companies to the downturn.

The unpredictable and uncertain market conditions have led to a dramatic increase in spending on controlling and reducing risk: 80 per cent of the banks surveyed had increased their investment in this area over the past six months, the report says.

Financial services companies are also bolstering their legal, audit and regulatory functions even as they make swingeing cuts in departments such as information technology and supply chain management.

“The end of the recession and a return to profitability is a tough one for any industry to call,” said Tom McGrath, managing partner of Ernst & Young’s Europe, Middle East, India and Africa financial services business.

“But financial services are naturally more cautious – and possibly more realistic – about when the return to profitability might happen.”

According to E&Y’s research, the financial services industry was taken aback by the ferocity and depth of the economic downturn, with 72 per cent of respondents saying they were surprised at the severity and another 70 per cent surprised by the speed of the crisis.

Saturday, July 04, 2009

Investment advice

Investment advice from the ever-reliable John Kay

So think probabilities and be detached. It’s hard advice to follow. That is why the financial services industry is better off than its customers.

Wednesday, July 01, 2009

The Winners' Curse

There is a good overview here from the FT of the winners curse (Wikipedia).

The East Coast line’s problems arise directly from the ludicrous £1.4bn National Express agreed to pay in August 2007 over the seven years it was due to operate the franchise. Two years later, the recession has laid bare the rosy assumptions it made about passenger growth, and losses have steadily mounted at the special purpose vehicle it created to operate the franchise. Once the £40m loan that National Express posted with the SPV, plus its £1m sliver of equity, are exhausted, the company has no obligation to provide more, other than a £32m bond it has already posted. The franchise will then return to the state. While the government might like to sound Churchillian about ensuring continued service, this has happened before.

Tuesday, June 16, 2009

Krugman vs Ferguson

Freakonomics discusses the rise in treasury yields via options on the t-bond. It appears that the increase in yields has more to do with the cutback in deflation risk than the increase in inflation risk in the future.

The graph below plots the probability of different outcomes for the yield on 25-year Treasuries on two different dates — late February and the end of last week. I calculated these probabilities using the technique I discussed in my last post, which extracts the probabilities implied by option prices on those dates. (Wonkish detail: I used the January 2011 options on the iShares Barclays 20+ Year Treasury Bond exchange-traded fund (TLT) and converted bond prices to yields using the portfolio average data reported by iShares.)

Friday, June 12, 2009


BBC story about piracy and what it means for bands and music.
The Fleet Foxes say that it is good for small bands. There is a suggestion that it hurts the large established bands but opens more doors for the smaller, unknown bands. Does it reduce barriers and encourage innovation?

Wednesday, June 03, 2009

Interest rate swaps

Felix Salmon with a practical application of the interest rate swap.

With interest rates low, GM was actually making money on these swaps: the banks would pay it the difference, every six months or so, between the higher fixed rate and the lower floating rate. But now that GM is bankrupt, the swaps have been torn up, and all those future payments which the banks were expecting to make no longer have to be made.

Of course, banks always hedge their positions — which means that some other counterparty will continue to pay them the money they were expecting to have to pay to GM. That's what Jansen means when he says that the bank “is long”. Now that money isn't going to GM, the bank will want to hedge its new long position, which essentially means selling that cashflow in the swap market.

A cashflow is like a bond, and when you sell bonds their yields rise. Similarly, here, when a bank hedges its new long position, yields — which in this case are swap spreads — go up. That's what Jansen means when he says they're “under pressure”. (A swap spread is the difference between the yield on the cashflow the bank is selling, and the yield on Treasury bonds of the same maturity.)

Brad DeLong on the use of finance

Brad DeLong
Of course, investors who believe that their wealth is securely liquid, and that they are adding value for themselves by buying and selling are suffering from a delusion. Our financial wealth is not liquid in an emergency. And when we buy and sell, we are enriching not ourselves, but the specialists and market makers.

But we benefit from these delusions. Psychologically, we are naturally impatient, so it is good for us to believe that our wealth is safe and secure, and that we can add to it through skillful acts of investment, because that delusion makes us behave less impatiently. And, collectively, that delusion boosts our savings, and thus our capital stock, which in turn boosts all of our wages and salaries as well.

Seventy-three years ago, John Maynard Keynes thought about the reform and regulation of financial markets from the perspective of the first three purposes and found himself "moved toward... mak[ing] the purchase of an investment permanent and indissoluble, like marriage...." But he immediately drew back: the fact "that each individual investor flatters himself that his commitment is ’liquid’ (though this cannot be true for all investors collectively) calms his nerves and makes him much more willing to run a risk...."

Moreover, for Keynes, "[t]he game of professional investment is intolerably boring and over-exacting to anyone who is entirely exempt from the gambling instinct; whilst he who has it must pay to this propensity the appropriate toll...."

Sunday, May 31, 2009

The Circle of Power

Pepy's diary 26th March 1666.

Thence alone to Broade Street to Sir G. Carteret by his desire to confer with him, who is I find in great pain about the business of the office, and not a little, I believe, in fear of falling there, Sir W. Coventry having so great a pique against him, and herein I first learn an eminent instance how great a man this day, that nobody would think could be shaken, is the next overthrown, dashed out of countenance, and every small thing of irregularity in his business taken notice of, where nobody the other day durst cast an eye upon them, and next I see that he that the other day nobody durst come near is now as supple as a spaniel, and sends and speaks to me with great submission, and readily hears to advice

Wednesday, May 20, 2009


In response to the Krugman and DeLong search for a model that explains bubbles and crashes, Arnold Kling suggests a focus on the financial system and its desire to provide households with risky liabilities (mortgages and corporate loans) and safe assets (deposits). As the financial system gets larger, the each side of the financial balance sheet expands. The burst comes when households start to doubt the safety of their assets.

1. Ordinary folks in the nonfinancial sector want to issue risky liabilities (shares of investments in fruit trees, mortgages on houses) and wants to hold riskless assets (demand deposits, money market fund shares).

2. The financial sector obliges by having a balance sheet with risky assets and supposedly riskless liabilities. The bigger the financial sector gets, the more euphoric the investment climate, because nonfinancial folks get to hold more riskless assets and issue more risky liabilities.

3. The financial sector's expansion is based in part on signaling. That is, banks signal that their liabilities are low risk. Signals include fancy buildings, the "FDIC insured" sticker, balance sheets filled with AAA-rated assets, and so on.

4. Financial expansions are gradual, because it takes a while to come up with new signaling mechanisms and to get the credibility of those mechanisms established with investors.

5. Financial crashes are sudden, because once investors lose a little bit of their confidence in financial institutions, their natural instinct is to ask for safer assets (they withdraw money from uninsured banks, or they ask AIG to post collateral). This behavior weakens the financial institutions further, leading to a rapid downward spiral. Today, we are seeing that all sorts of signals are discredited.

Chinese reserves

There is a lot of attention on Chinese huge reserves of US dollars. RBC strategist Brian Jackson suggests that the Chinese authorities are trying to hedge the potential losses from a depreciation of the US dollar against the renminbi by buying commodities. This does a number of things: it provides a hedge (because the value of the commodity rises if the US dollar falls in value); it takes advantage of low current commodity price levels; it creates a stockpile in preparation for future economic recovery. The major risk is that world economic recovery is slower and storage costs eat into the gains.

Here is the Bloomberg story.

Monday, May 18, 2009

Bubbles and Minsky

Paul Krugman give us a starting point to look at the speculation and bubbles. Of course a symmetric model cannot account for the ferocity of the crash. This needs to have more dramatic effects for the forced closure of positions, collateral calls, illiquidity and panic.

Cash and Carry

Reuters has a nice little overview of the futures market.

This “cash-and-carry” strategy rewards market participants with access to storage or finance at the lowest cost. It is providing huge profits for physical commodity merchants, investment banks, and the owners and operators of warehouses and tank farms during the downturn, and helps explain the record profitability from commodity operations reported recently by some of the largest banking and trading groups.

Saturday, May 16, 2009

Potential growth

The Economist takes a look at the outlook for US potential growth. The signs that it sees are not good. Interesting overview.
Unfortunately, the outlook for America’s potential growth rate was darkening long before the financial crisis hit. The IT-induced productivity revolution, which sent potential output soaring at the end of the 1990s, has waned. More important, America’s labour supply is growing more slowly as the population ages, the share of women working has levelled off and that of students who work has fallen. Since 1991 the labour supply has risen at an average annual pace of 1.1%. Over the next decade the Congressional Budget Office expects a 0.6% annual increase.

Thursday, May 14, 2009

The measurement problem

In our Time assesses the 'measurement problem'. At face value this appears to be much like the issue of unrealistic economic assumptions. The algorithms that work for quantum physics throw up illogical ideas like the cat that is alive and dead at the same time - yet they work! How can these two be reconciled?

Fiscal or monetary policy

Adrian Bell, Chris Brooks and Tony Moore make a comparison of today's financial crisis with one of 1294. There are some fascinating parallels and a natural experiment that compares the English use of tough fiscal measures with the French use of monetary policy.

Furthermore, deprived of access to credit, Edward was forced to rely on heavy taxation and his prerogative rights of purveyance and prise (compulsory purchases of goods). He also over-issued wardrobe bills (essentially government IOUs) to pay for wages and supplies. All of these measures aroused political opposition in England, and contributed to a major constitutional crisis in 1297 (Prestwich 1988). By contrast, Edward’s opponent, Philip the Fair of France, sought to raise money by debasing the French currency, reducing the silver content of the coins by as much as two-thirds. The income (seigniorage) received from these recoinages meant that Philip did not have to resort to direct taxation to the same extent as Edward or incur the same level of debt (Favier 1978). It is possible, however, that the long-term consequences of the expanding money supply for the French economy were more damaging that the medium-term pain of high taxation and debt in England. We would argue that this has considerable modern resonance, as today’s governments begin to grapple with the problem of how to pay for the obligations that they are currently undertaking.

Saturday, May 09, 2009

Super-senior CDOs

The second instalment of Gillian Tett's look at the banking crisis includes this,
On November 4, however, Citi suddenly warned that it would report additional losses of between $8bn and $11bn. That was such shocking news that chief executive Chuck Prince resigned. It was also baffling to analysts. Citi was supposed to be expert at measuring credit risk, so how had it managed to misjudge its losses so badly? And why was it still so uncertain about the total bill?

Demchak dialled into the conference call eager to find out. “The issue is super-senior,” one of the executives explained. The problem, he added, was that the bank held on its books $43bn of super-senior risk, linked to CDOs backed by mortgage debt. Citi had previously assumed that the value of those assets was 100 per cent of face value. Now the price was falling.

Super-senior? Demchak could hardly believe his ears. Almost a decade had passed since Krishna Varikooty, Demchak and the rest of the JP Morgan group had invented the term to describe the part of a CDO that was supposed never to default – according to the computer models. Back then, super-senior had seemed a geeky in-joke, so quirky and obscure that only a few technical experts knew what it meant. Now the Citi executives had casually tossed the word into a conference call with hundreds of mainstream investors, analysts and financiers. Demchak didn’t know whether to laugh, cry or just shake his head in wonder. In other circumstances, he might have felt almost proud that his team’s once-obscure brainchild had suddenly burst into the limelight. In fact, he was horrified: the way Citi told the story, super-senior had turned into a scourge that had created most of its unexpected losses.

“How could this happen?” Demchak wondered. During his days at JP Morgan, his team had considered super-senior so safe that it was “more than triple-A”. Even though Demchak himself had gone to great lengths to sell JP Morgan’s super-senior risk to AIG and other insurance groups, he had never imagined that it could pose more than a moderate risk. Nor had he guessed that Citi was holding so much super-senior risk on its own balance sheet. Citi had never discussed the issue before on conference calls nor highlighted it in previous results announcements. “How did this happen?” Demchak asked himself again and again. As he listened to the rest of the call, he got the distinct impression that the Citi managers were almost as baffled as he was
This fits well with the idea that it is the safe parts of the CDOs that are the real problem. No one ever thought that they would be worth less than 100%.

Sunday, May 03, 2009

Fed balance sheet

The Economist looks at the Fed's profits from taking on risky assets.

Like Wall Street’s finest, the Fed makes money on a spread. Its main source of funds comes from issuing cash, since currency in circulation is, in effect, an interest-free loan by the public to the central bank. The interest it earns on its loans and securities is almost pure profit, or “seigniorage,” most of which it remits to the Treasury.

Saturday, May 02, 2009

Keynes and loanable funds

Paul Krugman outlines the argument given by Keynes against the loanable funds theory and the view that increase government borrowing with force up interest rates by 'crowding out' the private sector.

What Keynes pointed out was that this picture is incomplete if you allow for the possibility that the economy is not at full employment. Why? Because saving and investment depend on the level of GDP. Suppose GDP rises; some of this increase in income will be saved, pushing the savings schedule to the right. There may also be a rise in investment demand, but ordinarily we’d expect the savings rise to be larger, so that the interest rate falls:

Here is the diagram that Krugman uses.

The birth of CDOs

Gillian Tett's new book looks at the birth of CDOs and CDS.

Demchak was acutely aware that modelling the risks involved in credit derivatives deals had its limits. One of the trickiest problems revolved around the issue of “correlation”, or the degree to which defaults in any given pool of loans might be interconnected. Trying to predict correlation is a little like working out how many apples in a bag might go rotten. If you watch what happens to hundreds of different disconnected apples over several weeks, you might guess the chance that one apple might go rotten – or not. But what if they are sitting in a bag together? If one apple goes mouldy, will that make the others rot too? If so, how many and how fast?

Wednesday, April 29, 2009


Good new article by Tim Harford in Forbes looking at the evolution of the market. It makes a good case for more regulation and a more graduate build up of financial innovation.

This time, the problem was that the seemingly smart ideas simply didn't fail quickly enough. This was largely because they grew so fast. Credit default swaps--quasi-insurance contracts that, unlike real insurance, can also be used to make side bets on the likelihood of financial distress--are barely a decade old. When the dot-com bubble burst, they were a niche market. Yet last summer, the Bank for International Settlements estimated that there were almost $60 trillion of over-the-counter credit default swap contracts outstanding. (The market had doubled in size in the year preceding the credit crunch, June 2006 to June 2007.) Such astonishing growth exemplifies the exotic instruments that entangled a brave new financial system. By the time the vulnerabilities of the new ideas became apparent, they were large enough to take down the world's banks.

Next time, we're going to have to make sure that the next clever financial idea grows a little slower or is tested a little earlier. One way or another, early failures are better than late ones. As for the elite, I'm not too worried. They'll be able to find something useful to do--even if it isn't on Wall Street.

Thursday, April 23, 2009

Bubble, bubble

If you ever want a story to indicate the bubble nature of the 2002-2007 financial sector, Felix Salmon points us to Jesse Eisinger's profile of Bill Ackman:

In 2007, he set up a special fund to invest in a single stock in a highly leveraged way. In a sign of how frothy the markets were, he raised $2 billion from start to finish in a week, about two-thirds of which came from other hedge funds. Investors knew the outlines of the investment but not that it would be in Target.

Brad Stetser gives us this picture of the flow of emerging market reserves to the rest of the world (US and Europe). It is hard to imagine that these two stories are not related.

Active fund management

AllAboutAlpha points to this research from S&P on the performance of active fund management in the crisis. It seems that active funds are not really able to avoice the market weakness that will engulf passive funds.

Tuesday, April 21, 2009

Swaps and comparative advantage

It is often difficult to see what would encourage an interest rate swap. As the market approaches efficiency, the gains from trade disappear. However, the FT today covers the Bank of England plan to purchase corporate bonds. Amidst some scepticism as to its positive effect, the article points to the increase in international issuance that has been encouraged by the improved liquidity.

“International issuers such as Wal-Mart and Holcim have done big sterling deals recently, helped by the fact that some investors have become more willing bidders for new issues because of that support from the Bank’s programme,” says Peter Goves at Citi.

These funds, presumably, can be swapped back into US dollars if necessary or used to finance UK operations.

Monday, April 20, 2009

The reserve currency burden

There is an article in the FT about German economic policy and the contrast between German views and those of the US. The German view is presented by BBK President Weber.

But Ms Merkel’s views are pretty mainstream in Germany. Axel Weber, Bundesbank president and a respected economics professor, said in a recent speech that Germany acted as an “anchor of trust” within Europe; this was the wrong time “to lose sight of the sustainability of public finances”. Germany had taken great steps to boost demand – their effects merely had yet to be felt.

It should be remembered that Germany is traditionally the custodian of the European reserve currency. The pressure on Germany to take more action to stimulate the economy is that often put on the reserve nation. The US has been a lot more accommodating to these pressures. We can look back at a series of monetary policy maneuvers from the Asian crisis in 1997 through LTCM, the millennium bug, 9-11 and into the current financial crisis. The opposition of the BBK to a greater reserve role for the Deutschmark in the 1970s and 1980s is based at least partly on the belief that it would bring increased and wider pressures to take monetary action to stimulate the economy that the central bank did not believe would be appropriate.

We only have to look back at the experience of the ERM when the pressure on the BBK ran from Norman Lamont in Bath through to the French President Francois Mitterrand.

Wednesday, April 08, 2009


The Guardian looks at the triumph of wikipedia as a non-tragedy of commons. The three different systems: Britannica, Encarta and Wikipedia can even be thought to represent public, market and common methods of providing services. Each have strength and weakness. However, Wikipedia seems to be the most powerful, most dynamic and cheapest for the user despite some small quirks.

Thursday, April 02, 2009

Gilt sales

The FT looks at gilt sales, suggesting syndicated sales of long-dated and index-linked issues to reach demand without leaving market-makers with interest-rate risk.

This is a crucial market. Financing costs are low; the UK can raise 30-year index-linked bonds at just 1 per cent. Potentially, there is also large demand from pension funds. One snag is that banks and market makers do not like holding long bonds as their duration makes them risky. By book building directly among pensions funds, syndicates circumvent such problems, allowing the DMO to raise more money, more securely.

Bill Gross on the outlook

Bill Gross says that the economy faces a period of de-leveraging, de-globalising and re-regulation. This is an unwinding of what we have seen over the last couple of decades. It will take some time and it will be painful.

I. Future of the Global Economy
The future of the global economy will likely be dominated by delevering, deglobalization, and reregulating, yet if so, it is important to state at the outset that we do not envision a mean reversion, cyclically oriented future, but instead a new world where players assume different roles, and models relying on bell-shaped/thin-tailed outcomes based on historical data are less relevant. Historical models look backward while modern-day finance is being fast forwarded and reconstituted almost as we speak.

Delevering – The prior half-century of leveraging and the development of the amorphous shadow banking system was growth positive. Major G-10 economies became dominated by asset prices and asset-backed lending most clearly evidenced in housing markets. Excess consumption was promoted, and investment based on that consumption followed in turn. Savings rates in many countries including Japan, the U.K., and the U.S. fell towards zero as the reliance on rainy day thrift faded. Deleveraging of business and household balance sheets now means those trends must reverse, and as they do, growth itself will slow, bolstered primarily by government spending as opposed to the animal spirits of the private sector.

This topic is one which literally could take hours to discuss, and at PIMCO forums and Investment Committee meetings, it does. There are those of us here as well as highly respected economists outside of PIMCO who would suggest destruction as opposed to slow growth, and they may have a minority, but not insignificant, case. Much depends on the effectiveness of policy responses and the simplistic answer to a simplistic question. Can global financial markets and the global economy heal by pouring lighter fluid on an already raging fire? Can too much debt be cured by the issuance of even more debt? Must the debt supercycle come to an end by crashing and burning or does the world keep breathing with a whimper instead of a bang? We shall see, but there is a near certain probability that the financially based global economy of the past half-century will not return, nor will we experience the steroid driven growth excesses that it facilitated.

Deglobalization – Lost in the wondrous descriptions of finance-dominated, Bretton Woods-initiated, global growth has been the adrenaline push provided by global trade and indeed portfolio diversification into a multitude of markets – developed or developing. Yet historians point out that globalization is not an irreversible phenomenon – witness the aftermath of WWI and nearly three decades of implosion. Now the beginning signs of trade barriers – “Buy American” and “British jobs for British workers” among them – as well as government support of locally domiciled corporations (banks and autos) suggest an inward orientation that is less growth positive. Additionally, “financial mercantilism” is an added threat – a phenomenon that speaks to growing pressure on banks to retreat from international business and concentrate on domestic markets.

Reregulation – Academics, politicians, investors, central bankers and everyday citizens are questioning the economic philosophy that idolized free markets and their ability to self-regulate. The belief in uncapped and unregulated incentives producing unlimited upside but nearly always cushioned downside losses is fading. While Sarbanes-Oxley was a well publicized but relatively toothless response to the dot-com bust of nearly a decade past, today’s politicians have gained the upper hand, driven by a citizenry that has recognized the unbalanced, disproportionate distribution of incomes. The efficient market thesis, so prevalent in academic theory and market modeling is now in retreat, and perhaps rightly so. In its place, we will experience less efficient but hopefully less volatile economies and markets – monitored and controlled by government regulation. Executive compensation, of course, is just the poster child. Government ownership and control of vital financial and manufacturing institutions will politely be described as “industrial based” policy and “burden sharing,” but we should have no doubt that we will move significantly away from the free market model that has dominated capitalistic countries for the past 25 years.

Wednesday, April 01, 2009

CDS collateralisation

More from the excellent Credit trader.

On the collateral side, clearly it was a mistake to let AIG and the monolines not post collateral. Establishing a clearinghouse will make sure this won’t happen in the future. However, apart from these two cases, margin requirements on CDS do exist and are followed rigorously. Hedge funds do post collateral to dealers when they trade CDS. It’s true that some hedge funds have to post minimal amounts, however those funds open up their books to dealers. In fact, in the case of Lehman, ISDA commented that 2/3 of the CDS exposure was collateralized.

Wednesday, March 18, 2009

Asan financing

There is a short item in the FT looking at the short-term nature of the bank credit that has financed firms in Asia.

Of the $730bn of outstanding debt analysed in the report, 45 per cent came from banks and the remainder from bonds and commercial paper. About 54 per cent of the total debt is scheduled for repayment or refinancing by the end of 2010.

Tuesday, March 17, 2009

The future of investment banks

Another idea suggesting that banks move back to partnerships.

This might include a return to the private partnership model for investment banks. Partners would have a strong incentive to deter short-termist behaviour, and would be much more able to get their way than indirect shareholders.

Monday, March 16, 2009


Great post on CDS.

Market estimates suggest that only around $150 billion of the CDS contracts were hedges. The remaining $250-350 billion of CDS contracts were not hedging underlying debt. The losses on these CDS contracts (in excess of $200-300 billion) are additional to the $600 billion. The CDS contracts amplified the losses as a result of the bankruptcy of Lehmans by (up to) approximately 50%.

Wednesday, March 11, 2009


A Credit Trader provides an overview of what went wrong at AIG
The broad outlines of the story are the following. As part of an effort to expand its insurance underwriting business, AIG (more precisely, London-based AIG Financial Products) began writing protection on supersenior (senior to AAA) ABS CDOs. By the time lax underwriting standards led AIG to get out of this business in 2005, it had sold some $560bn of protection.

By 2007 spreads had widened enough that counterparties started to demand that AIG post collateral on the trades, which by mid 2008 totaled over $16bn. Following its first and second quarterly losses of $5.3bn and $7.8bn, AIG, under pressure, adjusted the valuation methodology for its CDO portfolio (word at the time was the company was not mark-to-marking the trades) - leading to a further $8bn writedown. On September 15th - the Monday following the Lehman default, AIG’s rating was cut, effectively guaranteeing a bankruptcy of the company. Concernerned about the effect on world markets, the government stepped in with a bailout.

Tuesday, March 10, 2009

Crash and bubble

FT Editorial
No one can read the chronicles of those earlier crashes without sensing – with a chill – that history is repeating itself. The story of the modern capitalist economy is a rhythmic repetition of cycles, syncopated by eerily similar crises. These crises, while their details differ, are but variations on the same theme. Easy money, geared up by leverage, floods the financial system through innovative products. This simultaneously pumps up asset prices and obscures their speculative nature, with euphoria usurping the place of analysis. Until, one day, something triggers a loss of confidence in the continued rise of prices, and the whole leveraged edifice crumbles.

Saturday, March 07, 2009

UK banks and the government

The government has managed to get Lloyds to increase its lending as part of the scheme to insure bad assets.

Mr Darling said the deal was a vital step in giving banks the confidence to increase their lending.

"Lloyds' commitment to lend an additional £14bn this year, on top of the £25bn committed by RBS, gets to the heart of the problems we face... by easing the flow of credit," he said.

"Restoring our banks to full health and ensuring they are able to support creditworthy families and businesses is an essential part of any plan for recovery."

Of the £14bn in lending this year, £11bn will go to companies and £3bn on mortgages.

No way out

Mr Osborne said the bank must now help revive the economy.

He told the BBC: "The real question is, are we going to get value for money?

This it not about 'value for money' it is about making sure that banks don't act in their own interest by cutting new lending (much of which looks likely to be problematic) but provide some support to firms.

Wednesday, March 04, 2009

Wisdom of crowds

The 'wisdom of crowds' idea seems often to over-state the effect of the market. It seems to suggest that there is some new or greater knowledge that is created by the interaction of an efficient market. This is only true, I think, if we consider the combination of existing knowledge into a useful package.

Felix Salmon looks at the criticism of CDS by Robert Waldmann.

In general, I think it's reasonable to say that market participants do over time change their views about such things as future earnings and default probabilities, often using often inchoate macroeconomic information, including simple anecdotal observation, rather than anything granular or specific. The change in those views is reflected in a change in market prices for stocks and bonds, and indeed the market is pretty much the only place where a large number of individual anecdotal observations can coalesce into something as quantifiable as a default probability

How useful is this? Does the benefit of real-time, quantitative measure of sentiment outweigh the negative effects of liquidity?

Tuesday, March 03, 2009

Hedge fund transparency

Mebane Faber looks at using 13F files to track fund manager actions and finds that a mini Tiger fund or a copy of Berkshire can out-perform the S& 500.


* Annualized Return: 6.5%
* Volatility: 13.2%
* MaxDD: -23.4%

S&P 500

* Annualized Return: -3.6%
* Volatility: 15.8%
* MaxDD: -44.1%

Friday, February 27, 2009

Exchange rates - goods or assets?

The NBER looks at the issue of exchange rates and prices. Betts and Kehoe find that the ratio of tradable to non-tradable prices are affected by nominal exchange rates. However,

When the authors include China, for which the data is annual rather than quarterly and only dates back to 1985, the results change very little. But for the United States and its European trading partners, the relationship is dramatically weaker. Fluctuations in the relative price of non-traded-to-traded-goods account for only 7 percent of the fluctuations in the bilateral U.S./EU real exchange rates when measured in four-year differences using a variance decomposition. By contrast, these relative price fluctuations account for 29 percent of the fluctuations in U.S./non-EU real exchange rates and 39 percent of the fluctuations in U.S./Canada and U.S./Mexico real exchange rates. The authors suggest that the lower ratio for the United States and the EU nations may be attributable to the relatively low importance of trade, compared to the size of these economies. They note that just because there's a relationship between exchange rates and domestic prices, it does not follow tha! t one drives the other.

This provides further evidence that it is the capital flows that dominate the exchange rate trading.

Variable risk premia as a cause of volatility

Peel and Minford look at variable risk premia as an explanation of market volatility that some suggest means that there is inefficient incorporation of information. Thanks to Chris Dillow for the pointer amidst a review of Akerlof and Shillers' Animal Spirits.

Price discrimination

More on price discrimination as Which finds that the ticket for European train journeys is much higher on English-language versions of train operators' websites.

Researchers found that on some European sites, for example, fares were up to 60% more on the English version of the sites than on the native language version, while the sites were also difficult to navigate in order to find key information on pricing. On the Spanish version of, the Spanish rail operator, a second-class adult single ticket from Madrid to Barcelona was €43.80 (£39.30) - but €109.50 on the English version.

Sunday, February 22, 2009

Dell, competition and the life cycle

Lex looks at the demise of Dell.

There are a number of ways to look at this but the most important appears to be the life cycle of the process. Dell once had an advantage, now the way that they used to do things is commoditised. This article also points the way to valuation with the combination of PE ratio and what a regular discount factor implies for future earnings.

However, such hopes are not needed to build an investment case, because Dell’s shares are so cheap. Exclude the $6.5bn net cash pile and the interest income that it generates and Dell trades on just four times prospective earnings, according to Citigroup figures. Alternatively, to get a discounted cash flow valuation to the level implied by the current share price demands that investors assume operating margins decline to 2 per cent, from the 5 per cent expected this year, and that sales growth never returns. Struggling to run, the market is pricing Dell as if it has been put out to pasture.