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.)

Competition

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?

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...."

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

Bubbles

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.

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.

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.

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.

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%.

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.

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?

Market

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.

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.

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.

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.

Wikipedia

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.

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.

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.

USD as reserve currency

http://www.reuters.com/article/newsOne/idUSTRE52H2CY20090318

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.

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.

CDS

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%.

AIG

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.

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.

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.

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?

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.

BUFFETT

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

S&P 500

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

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 renfe.es, 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.

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.

HBOS

The FT has a look at the problems at HBOS.

HBOS lent in retailing and property, often taking equity stakes as well as providing debt. This model was devised back in 2000 and developed by Mr Cummings.

It helped lift profits at the corporate division – the unit accounted for 40 per cent of HBOS profits in the first half of 2007 – but is now blamed for much of HBOS’s woes.

Providing debt and equity, such as in a 2001 hotel venture with Sir Rocco Forte, allowed the corporate lending team to establish a niche that set it apart from rivals.

It seems that there are no fancy derivatives or opaque assets. According to this, it is just good, old-fashion, bad lending.

Bankers and risk and compensation

Jamie Whyte looks at government plans to change banking compensation. I think that he has it right here:

The financial crisis was caused not by bankers’ incentive plans but by a systematic failure to price risk correctly. Without accurately priced risk, there is no way of giving bankers the right incentives, however long the period over which their performance is measured. And with accurately priced risk, there is no incentive problem to be solved.

As he says, a lot of the incentives are already fairly long-term; the problem appears to have been in the price of risk. The huge flow of liquidity into US and UK financial systems seems to have distorted all pricing and affected risk assessment. The bonus payments were there a long time before the risk premia started to collapse. There may have been a monemtum in the bonus payments and the risk-taking, but this does not seem to be the fundamental problems to me.

For another look at banking compensation see The Epicurean Dealmaker for an overview of the development of bonus culture or Chris Dillow.

The fact that excess leverage and risk-taking came across the system suggests that this was not the major feature. The relatiionship between risk-taking in the US and UK and the bonus culture seems to be confounded by the fact that the inflow of liquidity to these major financial centres meant that they were sure to suffer the most when the tide went out again.
Let's get control over the amount of money in the financial system as a whole rather than start a witch-hunt.

Markets

Robert Stavins, while discussing environmental economics, provides a very good overview of what makes markets work and what gets in the way.

Economists in business schools may be particularly fond of identifying markets where the necessary conditions are met, where many buyers and many sellers operate with very good information and very low transactions costs to trade well-defined commodities with enforced rights of ownership. These economists regularly produce studies demonstrating the efficiency of such markets (although even in this sphere, problems can obviously arise).

For other economists, especially those in public policy schools, the whole point of the first welfare theorem is very different. By clarifying the conditions under which markets are efficient, the theorem also identifies the conditions under which they are not. Private markets are perfectly efficient only if there are no public goods, no externalities, no monopoly buyers or sellers, no increasing returns to scale, no information problems, no transactions costs, no taxes, no common property, and no other distortions that come between the costs paid by buyers and the benefits received by sellers.

Therefore, we must focus on:
1) Public goods - the stability of the financial system itself.
2) Externalities - network effects, macroeconomic well being.
3) Large financial monopolies in certain markets, the government and central banks.
4) Increasing returns to scale and financial concentration.
5) Huge informational issues.
6) Other costs of involvement that lead to instiutional dominance.

Price discrimination and innovation

Ultimi Barbarorum looks at the business behind the iPhone

Problem: 4 to 6 months after release, you have run out of early adopters, and now you need to penetrate the more price sensitive punter. Volume starts falling. No matter, you cut the price 10% to 20%. This would be bad for gross margins but for the natural tendency for material costs to come down. “Price down” is like a law of the tech supply chain. Memory prices have been coming down for years, for instance, passive and mechanical bits like the keypad and casing become cheaper to make as they scale up, and one’s engineers are always coming up (or should be) with new ways of making the industrial design more efficient. So gross margins drop only a bit, to 35% to 40%, but your volume goes up again so your operating margin can even increase.

Hedge funds (2)

All About Alpha gives a great overview of the latest thinking on hedge funds. There is a huge amount here about difficult times. One interesting point:

According to Douglas, Asian markets are more informationally-inefficient because most investors there are of the non-professional persuasion. Douglas says that hedge fund managers often end up trading alongside individual investors, not large pensions and mutual funds as in North America.

Hedge funds

Felix Salmon uncovers the difference between a public company and a partnership by what happens when you take a hedge fund public.

Consider the fight between Carl Icahn and fund manager Warren Lichtenstein. Lichtenstein had a bright idea when his hedge fund -- full of illiquid assets -- faced a lot of redemption requests: he'd take it public, and investors could then sell their investments at whatever price the market put on them, without the fund itself having to liquidate. Investors might have to take a very low price -- but Lichtenstein himself would continue to collect his management fee in perpetuity.

The exit risk is removed, but at the expense of taking 20% of the upside (maybe).

Dealing with bad loans

The FT reports on the latest efforts to deal with bad loans and comes to two methods of vauing these assets:

It would acquire securities that had already been heavily marked down by financial institutions, probably using a valuation model rather than an auction-based process to determine pricing.

There is huge uncertainty over the price of assets. How do we pick the correct value? No body knows. As a result, there is no market.

Global imbalances and financial crisis

Caballero and Krishnamurthy:

The U.S. is currently engulfed in the most severe financial crisis since the Great Depression. A key structural factor behind this crisis is the large demand for riskless assets from the rest of the world. In this paper we present a model to show how such demand not only triggered a sharp rise in U.S. asset prices, but also exposed the U.S. financial sector to a downturn by concentrating risk onto its balance sheet. In addition to highlighting the role of capital flows in facilitating the securitization boom, our analysis speaks to the broader issue of global imbalances. While in emerging markets the concern with capital flows is in their speculative nature, in the U.S. the risk in capital inflows derives from the opposite concern: capital flows into the U.S. are mostly non-speculative and in search of safety. As a result, the U.S. sells riskless assets to foreigners, and in so doing, it raises the effective leverage of its financial institutions. In other words, as global imbalances rise, the U.S. increasingly specializes in holding its "toxic waste.

"

Chinese Marshalll Plan

A look at the Chinese Marshall Plan

What’s interesting to see in this story, especially the top where the Chinese leaders give American institutions a well-deserved tongue lashing, is the way the Chinese fail to see that they’ve already had the benefit of their investment in American mortgage-backed securities. In fact, the recycling of Chinese profits into American mortgage debt is beginning to look like a 21st Century Marshall plan gone awry.

By investing in the US, the Chinese primed a consumption pump that created demand for their goods. That demand absorbed the huge number of workers coming to the cities over the last decade and accelerated China’s growth. In other words, the Chinese encouraged and enabled the irresponsibility of American households because it created demand for their goods.

After World War 2, the US faced a crisis of productive over-capacity. The solution was to send a lot of money to Europe that would then be used to buy American goods. In the case of the original Marshall plan, the sorry state of post-war Europe gave the plan a humanitarian glint. But that shouldn’t mask the real value of the Marshall plan or its intent.

Flash forward fifty years and you have China eager to raise the standard of living at home. Only this time, North Americans are tapped out, not because of a devastating war but because of devasting dotcom bubble bursting. There’s no way to dress this one up as the good guys coming to the aid of their fallen cousins.

That’s a shame. I don’t know what the final accounting was on the Marshall plan loans. I’d be curious to know. But in reading these stories, I’m beginning to think the Chinese are being a little disingenuous when they keep demanding that their investment in US securities be safeguarded.

Financial flows and crisis

The Economist has an article on the link between global imbalances and the financial crisis. It brings together Rogoff, Caballero and Gournichas.

Crises, bubbles and capital inflow

Reinhart and Rogoff assess the anatomy of a financial crisis.

“Systemic banking crises are typically preceded by asset price bubbles, large capital inflows and credit booms, in rich and poor countries alike”

The interest that I have is, how far is this explained by the inflow of capital from China and the commodity exporters? What I need to do is look at the evidence of capital inflow and compare this with what happened to the US, UK and others like Iceland.

Not original - but good!

Your manuscript is both good and original, but the part that is good is not original and the part that is original is not good.
- Samuel Johnson

Market evolution

Constantinides, Jackwerth and Perrakis find that index options become more efficient over time, suggesting that market can evolve towards efficiency.

Widespread violations of stochastic dominance by one-month S&P 500 index call options over 1986-2006 imply that a trader can improve expected utility by engaging in a zero-net-cost trade net of transaction costs and bid-ask spread. Although pre-crash option prices conform to the Black-Scholes-Merton model reasonably well, they are incorrectly priced if the distribution of the index return is estimated from time-series data. Substantial violations by post-crash OTM calls contradict the notion that the problem primarily lies with the left-hand tail of the index return distribution and that the smile is too steep. The decrease in violations over the post-crash period 1988-1995 is followed by a substantial increase over 1997-2006 which may be due to the lower quality of the data but, in any case, does not provide evidence that the options market is becoming more rational over time.

VIX, volatility and risk

Don Fishback looks at the VIX index and the volatility that is implied and compares the two. He finds that the market is less volatile than the index would imply. He finds that the S&P 500 is within 1 standard deviation of its daily return for 85% of the time rather than the 68% that would be suggested by a normal curve.

UK pension assets

State Street report that UK pension fund hold following assets

- 22% UK equities
- 28% overseas equities
- 33% bonds
- 7% property
- 6% altnernative assets
- 4% cash

Report from the FT which concentrates on the postive effect of sterling's fall in the value of overseas holdings.

Risk

Mark Thoma looks at risk: was it misperceived, misrepresented or misallocated?

We know that excessive risk taking was a factor in the financial crisis, but why people were willing to take on excessive risk?

There are several explanations for this. In one class of models, misperception of risk generates excessive demand for risky assets, housing and financial assets in particular. There are a variety of stories about why risk is misperceived, ratings agencies failed to do their jobs, risk assessment models turned out to be wrong, people believed that housing prices would continue to go up, and so on. The key is that in this class of models the misperception of risk gives people a false sense of security, and induces them to take on more risk than they can handle.

In another class of models, risk is misrepresented. Here, there is out and out fraud or other practices where, essentially, people know that the house is made of cards, but advertise it as being made of bricks anyway, and assure people that it is perfectly safe. Fraud could cause the victim to misperceive risk, so this is related to the first class of models, but I am trying to separate excessive risk taking brought about by intentional misrepresentation from excessive risk taking brought about by errors in judgment (or, perhaps more accurately in some cases, from negligence).

In a third class of models risk is misallocated, and there are two strands of risk misallocation models. In one, the mechanism that causes people to take excessive risk is knowledge that the government will step in and cover any potential catastrophic losses (risk is reallocated from the private to the public sector). This is the moral hazard problem, and the claim that government intervention led to excessive risk taking has been leveled pretty much wherever government has played a role in housing and financial markets, even when the role has not been very large.

Misallocation can come from moral hazard (government is seen to guarantee the risk), agency issues (originators are not the ultimate barers of risk) or government pressure on institutions to provide more loans to minorities.

Tyler Cowen suggests that the LTCM bail-out may have been a cause of increased moral hazard.

Gathering complacency

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

Noise-trader risk

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

Here is the experiment.

Currncy returns

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

The abstract

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

.

Price discrimination

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

Using order flow

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

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

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

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

More intielligent soldiers die

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

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

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

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

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

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

Elasticity

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

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

Spanish regulation

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

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

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

The music business

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

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

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

A silver lining

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

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

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

Illiquid assets

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

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

Greenspan

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

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

Importance of FX flexibility

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

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

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

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

Where does alpha come from?

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

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

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

Importance of feedback effects

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

Buffett

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

Roman Credit Crunch

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

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

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

Global supply chain and credit crisis

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

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

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

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

Skew and tails everywhere

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

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

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

More scope for unwind and fire sale of assets.

Asian toxic assets

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

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

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

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

Overconfidence

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

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

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

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

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

Risky assets

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

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

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

Insider coup

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

Icelandic banks

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

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

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

Fancy Financing

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

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

Fancy financing and outsmarting the hedge funds!

Banks and capital

John Kay

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

Governance

Paper on governance in finance.

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

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

Sell at the low

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

A Carry Trade?

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

The Telegraph

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

.

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

Liquidity

Vernon Smith in the WSJ

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

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

German banks

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

Apple

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

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

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

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

Covered bonds

Covered bonds explained

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

CDS exchange

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

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

Barriers

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

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

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

Rising cost of borrowing

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

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

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

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

Buffett on leverage

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

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

Bias

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

Peter McCluskey

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

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

Credit crunch

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

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

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

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

This does suggest some ugly contraction to come.

Short-selling

Alex in the Telegraph.

Risk-adjusted returns

The FT

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

OIS

Willem Buiter looks at the endgame in the banking system.

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

Income elasticity of demand

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

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

Exchange rate forecasing

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

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

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

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

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

Fund strategy

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

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

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

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

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

The evolution of European exchanges

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

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