"Hilscher and Wilson reply that they do not claim that ratings have no informational content whatsoever. Having a S&P rating was certainly better than no information at all, stresses Hilscher"
"Just as individual hedge funds tend to do better when they are small, so too, his analysis shows, the industry as a whole performed better when it was a largely unknown $200bn business, rather than the high profile $1.9tn industry it had grown to become, before the financial crisis in 2008 so dramatically exposed some of its shortcomings. The comforting compounded rates of return reported in hedge fund indices give a misleading impression of the actual cash returns achieved by hedge fund investors. Most of the client money that has flowed in since the industry began to be institutionalised has not achieved anything like the returns the long-term headline index figures suggest.
"
" According to Eurostat, Germany's trade surplus with the rest of the EU grew from 46.4 billion euro in 2000 to 126.5 billion in 2007. The evolution of Germany's bilateral trade surpluses with the Mediterranean countries is especially revealing. Between 2000 and 2007, Greece's annual trade deficit with Germany grew from 3 billion euro to 5.5 billion, Italy's doubled, from 9.6 billion to 19.6 billion, Spain's almost tripled, from 11 billion to 27.2 billion, and Portugal's quadrupled, from 1 billion to 4.2 billion. Between 2001 and 2009, moreover, Germany saw its final total consumption fall from 78.5 percent of GDP to 74.5 percent. Its gross savings rate increased from less than 19 percent of GDP to almost 26 percent over the same period."
"Mr Blessing criticised the Greek agreement since investors that insured Greek bonds using CDS had not received a pay-out because the voluntary agreement was not deemed to be a so-called “credit event” and thus did not trigger CDS payments."This can lead to other bond holders selling the bonds because they find that they are not protected from default.
"The moment the psychologists uncover some new kink in the human mind, they bestow a strange and forbidding name on it (“the availability heuristic”). In their most cited paper, cryptically titled “Prospect Theory,” they convinced a lot of people that human beings are best understood as being risk-averse when making a decision that offers hope of a gain but risk-seeking when making a decision that will lead to a certain loss. In a stroke they provided a framework to understand all sorts of human behavior that economists, athletic coaches, and other “experts” have trouble explaining: why people who play the lottery also buy insurance; why people are less likely to sell their houses and their stock portfolios in falling markets; why, most sensationally, professional golfers become better putters when they’re trying to save par (avoid losing a stroke) than when they’re trying to make a birdie (and gain a stroke)"
'via Blog this'
When I hear businessmen speak eloquently about the "social responsibilities of business in a free-enterprise system," I am reminded of the wonderful line about the Frenchman who discovered at the age of 70 that he had been speaking prose all his life. The businessmen believe that they are defending free enterprise when they declaim that business is not concerned "merely" with profit but also with promoting desirable "social" ends; that business has a "social conscience" and takes seriously its responsibilities for providing employment, eliminating discrimination, avoiding pollution and whatever else may be the catchwords of the contemporary crop of reformers. In fact they are–or would be if they or anyone else took them seriously–preaching pure and unadulterated socialism. Businessmen who talk this way are unwitting puppets of the intellectual forces that have been undermining the basis of a free society these past decades."
2011 World’s Most Ethical Companies | Ethisphere™ Institute: "The World’s Most Ethical Companies designation recognizes companies that truly go beyond making statements about doing business “ethically” and translate those words into action. WME honorees demonstrate real and sustained ethical leadership within their industries, putting into real business practice the Institute’s credo of “Good. Smart. Business. Profit.”"
Lack of liquidity bad for big bond funds - FT.com: "In 2007 bond fund managers were able to trade bonds at bid/offer spreads of 0.25 per cent. That widened to 2-3 per cent at the height of the crisis from September 2008 to March 2009. Trading spreads subsequently fell back to 0.4-0.5 per cent but have since crept up again to about 1 per cent on fears of the European sovereign debt crisis. Mr Davidson says: “It’s clear the banks don’t want any credit instruments on their books, especially given everything that’s going on in peripheral Europe.”
As a result, he adds, anyone managing a bond fund with assets of £1bn ($1.6bn) or more – with individual holdings of £10m plus – has their hands pretty much tied, “unless they resort to the euro market for greater cash liquidity or the CDS [credit default swap] market for greater active liquidity – but they’d be giving away yield in both cases. It is taking people a long time to trade out of an accumulated position of over £100m in a single, not very liquid bond.”"
Reductions in equity exposure to continue - FT.com: "UK pension funds have been gradually reducing their allocation to equities in the past decade from 74 per cent in 2000 to 55 per cent in 2010, according to Towers Watson. The equity exposure of UK funds remains the highest of all the large markets; compared with 49 per cent in the US, 37 per cent in Japan, 33 per cent in the Netherlands and 28 per cent in Switzerland. But a decline in equity allocations is common, with the net overall allocation across the largest pension fundmarkets down by 13 per cent in the past five years, as pension funds diversify into alternative asset classes, which now account for 19 per cent of all portfolios."
"Ditto Stateside. The headline grabbing $400m Platinum Equity supposedly paid for the Detroit Pistons this month is equivalent in size to Stein Mart, 468th in the S&P 600 small cap index. (And the retailer makes 10 times the revenues.) Sports profitability is worse. Why? Wages. Incredibly, the market cap of Juventus FC is only 30 times the annual salary of its best paid player. Goldman Sachs’s market cap is 5,000 times its boss’s last pay packet."
"Mr Nyberg said the attendant risks went undetected or were seriously misjudged by regulatory authorities “whose actions and warnings were modest and insufficient”.
A “happy go lucky” attitude prevailed during the period, including among the bondholders that lent to Irish banks.
“When it all ended, suddenly and inexplicably, participants had difficulty accepting their appropriate share of the blame for something in which so many others were also involved and that seemed reasonable at the time,” the report states"
"That was a mistake, but what is the lesson? One is that we should not necessarily ignore something just because it cannot be found in the data. Much of the empirical work prior to the crisis involved data from the early 1980s to the present (due to an assumption of structural change around that time), sometimes the data goes back to 1959 (when standard series on money end), and occasionally empirical work will use data starting in 1947. So important, infrequent events like the great Depression are rarely even in the data we use to test our models. Things that help to explain this episode may not seem important in limited data sets, but we ignore these possibilities at our own peril."
"The resources and infrastructure required means that yield curve hedge funds tend to exist inside banks and the largest asset management firms. In Europe, well-known credit exponents include Trafalgar Asset Managers and BlueBay Asset Management, while yield curve funds include Brevan Howard, Moore Capital, Comac Capital and Prologue Capital."
"The agreement drew strong support from around the world despite predictions that regulators would be unable to come up with a common definition for bubbles. The deal uses the ratio of credit-to-GDP as its basic measure. But regulators can use other metrics, provided they make their reasoning public"
"John Maynard Keynes started off as a currency trader, moving to commodities a bit later on. He attempted to invest based on macroeconomic predictions—keep in mind that he was an economist—and it didn't exactly work out in the short run. I didn't quote the rest of the article but Keynes appears to have broke even later on but this was definitely a painful start."
"Few universal banks split out their transaction banking performance. But Deutsche Bank, for example, recorded transaction banking pre-tax profits of €1.1bn in 2008, up 17 per cent and equivalent to an ROE of 108 per cent. Though the number slipped back – to €776m – in 2009, that relatively stable performance contrasts with the investment banking result, which was €7.4bn in the red in 2008, thanks to the toxic asset fall-out from the financial crisis, and then €4.3bn in the black again last year."
"Settlements estimates that UK lenders account for almost 30 per cent of European banks’ total $509bn exposure to Ireland. RBS and Lloyds, both partially state-owned, have taken the most Irish pain, falling by about 8 and 9 per cent respectively over the past week before regaining some ground on Tuesday"
"Ireland joined Greece this week in the negative basis club. That is, the five-year asset swap spread for Ireland outpaced movement in equivalent credit default swaps. So (in basic terms) spreads in the CDS market were trading lower than in the cash market for Ireland."
"We can have the money for a national system of higher education distributed either in accordance with the tastes of 18-year-olds or in accordance with the tastes of a group of older people in London: there’s no other way to do it."
"That seems about right: car companies stand or fall, ultimately, on the strength of their product, and teaching a giant company how to build a quality car again is something that can’t be done on the private-equity timetable. The problem is that no private-equity manager wants to be thought of as a mere financial engineer."
"We’ll quickly note that the Fed’s expected QE2 measures will, if successful in bringing about inflationary pressures, further add to the pressure on China to appreciate."
And he being gone, and what company there was, my father and I, with a dark lantern; it being now night, into the garden with my wife, and there went about our great work to dig up my gold. But, Lord! what a tosse I was for some time in, that they could not justly tell where it was; that I begun heartily to sweat, and be angry, that they should not agree better upon the place, and at last to fear that it was gone but by and by poking with a spit, we found it, and then begun with a spudd to lift up the ground. But, good God! to see how sillily they did it, not half a foot under ground, and in the sight of the world from a hundred places, if any body by accident were near hand, and within sight of a neighbour’s window, and their hearing also, being close by: only my father says that he saw them all gone to church before he begun the work, when he laid the money, but that do not excuse it to me. But I was out of my wits almost, and the more from that, upon my lifting up the earth with the spudd, I did discern that I had scattered the pieces of gold round about the ground among the grass and loose earth; and taking up the iron head-pieces wherein they were put, I perceive the earth was got among the gold, and wet, so that the bags were all rotten, and all the notes, that I could not tell what in the world to say to it, not knowing how to judge what was wanting, or what had been lost by Gibson in his coming down: which, all put together, did make me mad; and at last was forced to take up the head-pieces, dirt and all, and as many of the scattered pieces as I could with the dirt discern by the candlelight, and carry them up into my brother’s chamber, and there locke them up till I had eat a little supper: and then, all people going to bed, W. Hewer and I did all alone, with several pails of water and basins, at last wash the dirt off of the pieces, and parted the pieces and the dirt, and then begun to tell [them]; and by a note which I had of the value of the whole in my pocket, do find that there was short above a hundred pieces, which did make me mad; and considering that the neighbour’s house was so near that we could not suppose we could speak one to another in the garden at the place where the gold lay — especially my father being deaf — but they must know what we had been doing on, I feared that they might in the night come and gather some pieces and prevent us the next morning; so W. Hewer and I out again about midnight, for it was now grown so late, and there by candlelight did make shift to gather forty-five pieces more. And so in, and to cleanse them: and by this time it was past two in the morning; and so to bed, with my mind pretty quiet to think that I have recovered so many. And then to bed, and I lay in the trundle-bed, the girl being gone to bed to my wife, and there lay in some disquiet all night, telling of the clock till it was daylight.
"As for the proportion of trading conducted this way? According to the last stats seen by FT Alphaville, something like 31 per cent of all US equity orders were being internalised as of January, 2010."
Still, if it’s the crash itself that is of interest, you’ll do better reading the SEC report. It is the larger dimension of the signal that interests David. He invokes the work of French mathematician René Thom, inventor in the 1970s of a formal mathematics of sudden shifts, of qualitative breaks or discontinuities, that he called catastrophes. “To appreciate that quality it is helpful to start from the mathematical rather than the ordinary language meanings conveyed the term,” David writes.A commonplace physical illustration of a “catastrophic event” – in this formal sense of the term — may be experienced by letting your finger trace the surface of a draped fabric until it reaches a point where the surface (the “manifold” as mathematicians would speak of the shawl or cloak’s three-dimensional surface) has folded under itself; there gravity will cause your finger’s point of contact to drop precipitously from the surface along which it was traveling smoothly – to land upon the lower level of the drapery beyond the fold. That little passage is the “catastrophe.” In the present context, what is especially relevant about this conceptualization of the “event” experienced by your finger is its generic nature: catastrophes thus conceived are not phenomena belonging to a category delimited by some size dimension of the system in which they occur, or according to the severity of their sequelae; nor are they to be uniquely associated with processes that that operate only in one or another range of temporal velocities (whether slow, or fast). Instead, the catastrophes to which this essay’s title refers are fractal, possessing the property of self-similarity.
Similar to what? He compares the conditions that led to the May 6 price break to the phenomenon known as “flaming.” One party breaks off a previously civil exchange with hostile abusive comment. Instead of turning it aside, others sometimes reciprocate. Anonymity is the key part of the process; isolation seems to remove inhibitions that would brake the process if the exchanges took place face to face. Silence ensues, or, worse yet, digital versions of what long ago were called “slam books” – compendia of the faults of others, sufficient to fragment the conversation once and for all. (This is the problem with Glen Beck and much of the rest of Fox News.)
Humans evolved to recognize from infancy the effect of their actions on others – facial expressions, body language, tone of voice, he notes. On the Internet, however, no one knows when they may come across as a flame-throwing tank. It is why humor is so risky on the Web.
"For investors who do not want to take simple long/short positions, an alternative tactical approach to foreign exchange markets is offered by Deutsche Bank and its db x-trackers currency returns ETF. This combines three strategies widely used by traders in currency markets: carry, momentum and valuation. Like a quantitative hedge fund, it uses a rules-based process to take long and short positions in G10 currencies with regular rebalancing of the components."
In a new book called “The Dragonfly Effect: Quick, Effective, and Powerful Ways to Use Social Media to Drive Social Change,” the business consultant Andy Smith and the Stanford Business School professor Jennifer Aaker tell the story of Sameer Bhatia, a young Silicon Valley entrepreneur who came down with acute myelogenous leukemia. It’s a perfect illustration of social media’s strengths. Bhatia needed a bone-marrow transplant, but he could not find a match among his relatives and friends. The odds were best with a donor of his ethnicity, and there were few South Asians in the national bone-marrow database. So Bhatia’s business partner sent out an e-mail explaining Bhatia’s plight to more than four hundred of their acquaintances, who forwarded the e-mail to their personal contacts; Facebook pages and YouTube videos were devoted to the Help Sameer campaign. Eventually, nearly twenty-five thousand new people were registered in the bone-marrow database, and Bhatia found a match.
Because of the capital costs of holding commodities directly, investing is almost exclusively done using futures (exceptions include commodity producers, consumers, etc.) Commodity indices, ETFs, ETNs and mutual funds manage their portfolios very similarly when using futures contracts. For the most part, they construct the portfolio by purchasing near-dated futures contracts. As the contracts near maturity, they sell the contract at or near the spot price of the commodity and purchase new near-dated contracts and the process repeats itself. The frequency and magnitude of this roll leads to the importance of the yield it generates.
Unfortunately, investing in commodity futures contracts can be complicated since total returns are comprised of three return components:
Most fundamentally, and perhaps most challenging for researchers, the crisis should motivate economists to think further about their modeling of human behavior. Most economic researchers continue to work within the classical paradigm that assumes rational, self-interested behavior and the maximization of "expected utility"--a framework based on a formal description of risky situations and a theory of individual choice that has been very useful through its integration of economics, statistics, and decision theory.9 An important assumption of that framework is that, in making decisions under uncertainty, economic agents can assign meaningful probabilities to alternative outcomes. However, during the worst phase of the financial crisis, many economic actors--including investors, employers, and consumers--metaphorically threw up their hands and admitted that, given the extreme and, in some ways, unprecedented nature of the crisis, they did not know what they did not know. Or, as Donald Rumsfeld might have put it, there were too many "unknown unknowns." The profound uncertainty associated with the "unknown unknowns" during the crisis resulted in panicky selling by investors, sharp cuts in payrolls by employers, and significant increases in households' precautionary saving.
The idea that, at certain times, decisionmakers simply cannot assign meaningful probabilities to alternative outcomes--indeed, cannot even think of all the possible outcomes--is known as Knightian uncertainty, after the economist Frank Knight who discussed the idea in the 1920s. Although economists and psychologists have long recognized the challenges such ambiguity presents and have analyzed the distinction between risk aversion and ambiguity aversion, much of this work has been abstract and relatively little progress has been made in describing and predicting the behavior of human beings under circumstances in which their knowledge and experience provide little useful information.10 Research in this area could aid our understanding of crises and other extreme situations. I suspect that progress will require careful empirical research with attention to psychological as well as economic factors.
No, he does not die, because his species and that of the creature on this foreign planet do not share an evolutionary past or a common ancestor. Although they may both be made of proteins formed from amino acids, their independent evolutionary paths should made it highly improbable that they use similar neurotransmitter molecules within their respective brains and bodies. Every spaceman from Flash Gordon to Captain Kirk to Luke Skywalker should feel safe walking around any planet (except their own) with impunity from animal and plant toxins. For this same reason, the intoxicating drinks and powerful medicines that always seem to be popular in these foreign worlds in science fiction movies would also have totally different effects, if any effects at all, on the brains of our plucky spaceman. Eating otherworldly foods might be the most disappointing and distressing experience of all: Even if they were filling and somehow tasted delicious, as products of utterly alien biochemistries they would probably prove devoid of nourishment for our Earthly bodies. Thus, starvation might be the greatest threat to any future explorers of alien biospheres. Unless, perhaps, they’d brought along a large supply of chocolate.
Second is the pro-cyclical nature of value-at-risk, a measure of the risk of loss. Recent high market volatility is sharpening attention towards risk and the need to measure and manage it. At the same time, rapid financial innovation has increased the ability to monitor and control risks, allowing measures like Var to gain further ground. This would all be good news, if the markets were using the right type of Var for establishing the risk limits.
Generally, when prices move down, Var goes up, eventually triggering the risk limits and thus enlarging the troops of sellers. Symmetrically, the reduction of Var in good times encourages traders and fund managers to pile on risk, increasing their risk exposures when prices are already high and while demand is thriving. This can compound the positive feedback mentioned earlier.
The interesting thing here is the way that a period of low volatility will provide a sample of low volatility and increased risk taking. Increased volatility leads to less risk taking. Can we model this?
John Williamson (1990) did all a great favor by writing down the rules for what he called “The Washington Consensus” for developing countries to follow to absorb aid efficiently:
To provide perspective on these ten rules, the year 1990, when Williamson wrote, is important. It was just after the fall of the Berlin Wall and the complete collapse of confidence in Soviet-style socialism. The rules reflect the hegemonic confidence that most people then had in liberal market-oriented capitalism—think Ronald Reagan and Margaret Thatcher. But, 20 years later, should the meteoric rise of socialist China—both in its own remarkable growth in living standards, and in the effectiveness of its foreign “aid” to developing countries, undermine our confidence in Williamson’s Washington Consensus?
In Germany during the same period, publishers had plagiarizers -- who could reprint each new publication and sell it cheaply without fear of punishment -- breathing down their necks. Successful publishers were the ones who took a sophisticated approach in reaction to these copycats and devised a form of publication still common today, issuing fancy editions for their wealthy customers and low-priced paperbacks for the masses.
The National Endowment for Science, Technology and the Arts, an independent trade body, calculates that just 6 per cent of the highest growth businesses generated 54 per cent of new jobs over the last decade.
In addition, stock market structure today is geared for large‐capitalization stocks with typically symmetrical order books but disastrous for the vast majority of small‐capitalization stocks with asymmetrical order books (where there is not naturally an offsetting buy order to match against a sell order and vice versa)... The “Flash Crash” was an example of where even normally liquid securities went to a state of “asymmetry” and price discovery broke down...
[Until] all trades, quotes and other messages in all interrelated markets are tagged and traceable to the trading venue, broker and ultimate investor, and disclosed to the market, markets will not be perceived as fair... With full tagging, tracking and reporting and the application of posttrade analysis and test bed techniques such as Agent‐Based Models, regulators and market participants will... once and for all be in a position to judge the impact of other participants and to regulate and plan accordingly...
Because... our desire to hold Money as a store of wealth is a barometer of the degree of our distrust of our own calculations and conventions concerning the future.... The significance of this characteristic of money has usually been overlooked; and in so far as it has been noticed, the essential nature of the phenomenon has been misdescribed. For what has attracted attention has been the quantity of money which has been hoarded... supposed to have a direct proportionate effect on the price level through affecting the velocity of circulation. But the quantity of hoards can only be altered either if the total quantity of money is changed or if the quantity of current money income (I speak broadly) is changed; whereas fluctuations in the degree of confidence are capable of... modifying... the premium which has to be offered to induce people not to hoard. And changes in... liquidity preference... affect, not [consumer] prices, but the rate of interest.
By ‘uncertain’ knowledge, let me explain, I do not mean merely to distinguish what is known for certain from what is only probable. The game of roulette is not subject, in this sense, to uncertainty; nor is the prospect of a Victory bond being drawn. Or, again, the expectation of life is only slightly uncertain.... The sense in which I am using the term is that in which the prospect of an European war is uncertain, or the price of copper and the rate of interest twenty years hence, or the obsolescence of a new invention, or the position of private wealth-owners in the social system in 1970. About these matters their is no scientific basis on which to form any calculable probability whatever. We simply do not know. Nevertheless, the necessity for action and for decision compels us as practical men to do our best to overlook this awkward fact and to behave exactly as we should if we had behind us a good Benthamite calculation.... How do we manage?... (1) We assume that the present is a much more serviceable guide to the future than a candid examination of past experience would show it.... (2) We assume that the existing state of opinion as expressed in prices and the character of existing output is based on a correct summing up of future prospects.... (3) Knowing that our individual judgment is worthless, we endeavour to fall back on the judgment of the rest of the world which is perhaps better informed....
I presently resolved of my father’s and wife’s going into the country; and, at two hours’ warning, they did go by the coach this day, with about 1300l.in gold in their night-bag. Pray God give them good passage, and good care to hide it when they come home! but my heart is full of fear: They gone, I continued in fright and fear what to do with the rest. W. Hewer hath been at the banker’s, and hath got 500l. out of Backewell’s hands of his own money; but they are so called upon that they will be all broke, hundreds coming to them for money: and their answer is, “It is payable at twenty days — when the days are out, we will pay you;” and those that are not so, they make tell over their money, and make their bags false, on purpose to give cause to retell it, and so spend time. I cannot have my 200 pieces of gold again for silver, all being bought up last night that were to be had, and sold for 24 and 25s. a-piece.
Instead, it said that a tiny number – just1%0.1% (corrected: incorrect figure given by O2 initially) of smartphone users – are using 36% of its total mobile data traffic, and that they needed to be encouraged to change their behaviour.
As I have written, Greece is in a better legal position to reschedule its sovereign debt on favourable terms than, say, Argentina back at the end of 2001. About 90 per cent of Greek sovereign debt is in the form of bonds governed by Greek law.
That means if Greece wants to reschedule the interest rate and maturity of its debt, its national parliament can just pass a law decreeing the new terms. Investors would have no legal recourse.
The practical problem with doing that unilaterally is that Greece is still running large fiscal and trade deficits, so it cannot yet run its economy on a cash basis, as Argentina and others did after their defaults. That is why the European Union-International Monetary Fund stabilisation package is needed to cover maturing debt issues and also the continuing twin deficits, at least for the three years the facilities are supposed to be in place.
From the Greek point of view, though, it doesn't make sense for the three-year plan to run its course, even if the country meets its financial targets. Assuming it all works, Greece would have a substantially higher debt that would not be in the form of loosely covenanted Greek-law bonds, but virtually un-defaultable obligations to European governments, the EU and the IMF. The notion that banks or bond investors would be willing, at that point, to offer deeply subordinated credit to Greece is mere fantasy.
The so-called Volcker rule would be slightly less feared. Prop trading is not as profitable over the long run as many realise, but if banks are also forced to stop investing in hedge funds and private equity, normalised earnings could fall by about 2 per cent, according to Goldman Sachs.
There is also this from Tyler Durden
So with a delay of about six months since Zero Hedge started pounding on the topic of prop trading as the last bastion of perfectly legal front-running, which co-opts clients into "efficient" flow execution with the few remaining monopolist entities left on Wall Street in exchange for assorted prop trading desks taking advantage of complete flow visibility (i.e., the hedge fund nature of all modern Wall Street bail out recipients) which is simply a way to run alongside (or in front of) whale orders, thus providing guaranteed and risk free returns, the administration has finally realized what we have claimed for many months: that prop trading is nothing but a quasi-illegal operation, which was made explicitly and perfectly permissible with the adoption of the disastrous Gramm-Leach-Bliley act. As long as prop trading exists, Goldman (which is reporting earnings tomorrow, and we expect will announce another quarter of 90%+ profitable trading days only thanks to it taking full advantage of a thorough visibility of the FICC and equity flow market and a commingled prop and flow order book) will have record earnings, until such time as the Minsky Moment in Goldman's balance sheet arises again and blows up the financial system one more time.
A potential answer is that global banking models are being subtly revised in response to increased regulation. One of the little understood mysteries of the boom years is why banks expanded internationally when there were no synergy benefits and shareholders could themselves diversify more efficiently. The reason was leverage: if you are 30 times geared, it is crucial to have a stable earnings base. Geographic diversification was one way to get it, even if returns in individual countries were low.
Another notion that's popular with many financial gurus these days is the claim that you can eliminate certain risks to your portfolio with the right strategy of automatic trading and stop-loss sell orders. Again that claim invites an economic question-- if you are getting an insurance policy, who is selling it to you? I believe the implicit answer is, you are counting on the market-maker to insure you by taking the other side of your escape transactions. But the curious thing about such an insurance policy is that the market-maker gets to decide what premium to charge you after you ask to collect on the policy. You just might find that the state of the world when you and your buddies all most desperately want to cash in on your insurance is exactly the time when the premium proves to be ruinously expensive.
But all of this changes market microstructure in insidiously destabilizing ways. For the first time we have large providers of this shadow liquidity, algorithms and high-frequency sorts, that individually account for large percentages of daily trading activity, and, at the same time, that can be turned off with a switch, or at an algorithmic whim. As a result, in market crises, when liquidity was always hardest to find, it now doesn't just become hard to find, it disappears altogether, like water rushing out sight via a trapdoor to hell. Old-style market-makers are standing aside as panicky orders pour in, and they look straight at shadow liquidity providers and say, "No thanks. You battle bots take it". And, they don't
Larry Tabb, chief executive of consultancy The Tabb Group, says: “We really need to step back and think about centralisation versus fragmentation and who is providing liquidity. It opens the up market to a whole series of questions about how we want our markets to function.”
A key measure of bank risk, the overnight index swap spread on futures contracts in the eurozone, rose to a record high this week. This measures the premium over “risk-free” overnight rates of three-month rates, which carry greater credit risk.
Another warning sign is a significant shift to overnight lending by banks, particularly within troubled areas of the eurozone. Of the €450bn ($589bn) in daily turnover in the European money markets, 90 per cent is now in overnight lending, according to interdealer broker
1. The Union shall not be liable for or assume the commitments of central governments, regional, local or other public authorities, other bodies governed by public law, or public undertakings of any Member State, without prejudice to mutual financial guarantees for the joint execution of a specific project. A Member State shall not be liable for or assume the commitments of central governments, regional, local or other public authorities, other bodies governed by public law, or public undertakings of another Member State, without prejudice to mutual financial guarantees for the joint execution of a specific project.
2. The Council, on a proposal from the Commission and after consulting the European Parliament, may, as required, specify definitions for the application of the prohibitions referred to in Articles 123 and 124 and in this Article.
he e-mails show signs of the agencies’ knowledge of the impending financial collapse. But in the interests of maintaining market share both S&P and Moody’s felt the need to continue their practices – even though many employees had misgivings.
“Screwing with (the model’s) criteria to ‘get the deal’ is putting the entire S&P franchise at risk – it’s a bad idea,” said one S&P employee. Another S&P employee described the drive for revenue and its effect on the relationship between banks and rating agencies as “a kind of Stockholm syndrome”.
Yet another captures that alleged conflict of interest almost perfectly: “Rating agencies continue to create an even bigger monster – the CDO market,” wrote an S&P staffer. “Let’s hope we are all retired by the time this house of cards falters.”
The agencies also failed to incorporate their growing awareness of fraud in the lending industry into their rating practices, as it was seen as a potential block to revenue.
In January 2007, an S&P analyst rating a Goldman Sachs CDO with subprime loans issued by Fremont Investment and Loan, which had just stopped using 8,000 of its brokers because they were agreeing loans with some of the highest delinquency rates in the country, asked superiors whether to take Fremont’s reputation into account.
But it strains language to breaking point to describe CDS transactions as anything but gambling. The traders in AIG’s financial products division were inheritors of the amusements of Edward Lloyd’s coffee shop rather than the values of Swiss farmers.
Greece’s most recent sales of euro-denominated bonds have attracted lower levels of interest and the government is now aiming to issue in dollars, targeting emerging market investors who are attracted by higher yields.
Indeed, the first plea of Joanne Segars, the NAPF chief executive in its pre-Budget submission was to ask that borrowing be tilted to the long end of the market where it can do the most to alleviate funding woes for pensions. Already, government issuance of 20-, 30- and 50-year debt has risen sharply. In the fiscal year ending April 2010, issuance of conventional long-dated gilts soared to £33.9bn from £23.4bn just two years earlier. Thirty-year yields have risen, too, from 4.09 per cent at September 30 2009 to 4.52 per cent as at March 31 2010.
The trouble is, with margins near pre-crisis levels again for products like rates and forex, the free lunch enjoyed by the smaller boys is being taken away. Scale once more is king. Banks down the order in certain flow products should be asking themselves serious questions. Even including the crisis, the top five banks in equities, for example, have increased their market share by 10 per cent since 2006. As the level of concentration increases again, expect more money – not to mention heat – to be generated in the biggest dealing rooms.
In the wake of the financial crisis, the use of collateral backing derivative trades in order to appease counterparty credit concerns has continued to expand.
This means that once a swap trade is executed, more margin is required if the trade starts losing money.
This daily management of margin also makes it harder to maintain an arbitrage over time as the value of any trade between swaps and Treasuries changes constantly.
Analysts at Credit Suisse say: “This makes it increasingly harder to hold arbitrage strategies to termination as arbitrageurs are forced to realise not just gains but also losses through margin calls resulting in frequent stop outs [forced exits from the trade].
Shorting bonds can be done using futures or repos [repurchase agreements], or credit default swaps. The last method is not ideal, warned Mr Inker. “There is the risk of governments declaring your contract invalid.” A number of politicians have called for restrictions on CDS trading.
Lawyers for American companies spent hundreds of billable hours drawing up contracts to which no one ever referred. Their Japanese counterparts engaged in complex business relationships with no formal agreements at all, or ones that covered a single sheet of paper. But the commercial relationships that emerged in Japan’s car industry were more successful in securing component reliability and managing just-in-time inventory than those hammered out by the hard-nosed negotiators of Detroit.
The financial crisis of 2007-09 featured large-scale losses to financial institutions from assets such as AAA rated tranches of mortgage-backed securities. Simultaneously, markets for collateralised borrowing (“repos” or repurchase agreements) froze or experienced severe stress. Investors lending in repo transactions started charging large “haircuts”. In other words, repos could be rolled over only with successively high levels of over-collateralisation, which disrupted the financing model of broker-dealers and in fact caused Bear Stearns to fail in March 2008.
The moral of the story is that regulators need to impose tighter constraints, such as higher capital requirements, on activities such as holdings of AAA rated tranches and repo financing of risky assets where there is a conflict of interest between the privately optimal and socially optimal choices. Bankers will fight such a proposal. But it should be well understood that they have all incentives to ignore the attendant systemic risk
In normal market conditions, yields on government bonds, such as US Treasuries, UK gilts and German Bunds, trade at a discount to swap rates. This is because swap rates are based on a funding rate that is linked to the interbank lending market. This rate is higher than the repo rate used for financing government bonds. Swaps are money market instruments whereas Treasuries reflect triple A sovereign risk.
Lehman’s rapid growth saw net assets increase by 48 per cent, or almost $128bn, from the fourth quarter of 2006 through the first quarter of 2008. But the bulk of the assets, according to the report by court-appointed examiner Anton Valukasreleased on Thursday, were in illiquid assets that could not easily be sold. Such assets nearly doubled to $175bn in that same time frame
