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.