Behavioural finance

Why the Human Brain Is a Poor Judge of Risk -:

"And it's not just risks. People are not computers. We don't evaluate security trade-offs mathematically, by examining the relative probabilities of different events. Instead, we have shortcuts, rules of thumb, stereotypes and biases -- generally known as 'heuristics.' These heuristics affect how we think about risks, how we evaluate the probability of future events, how we consider costs, and how we make trade-offs. We have ways of generating close-to-optimal answers quickly with limited cognitive capabilities. Don Norman's wonderful essay, Being Analog, provides a great background for all this."

ABX.HE index

Cleveland Fed on the ABX.HE index:

"This is the ABX.HE index, which is based on credit default swaps on different tranches of subprime mortgage-backed securities (MBS). Admittedly, unless you’re a financial markets junky it’s not at all clear what this index is saying, other than something called BBB is moving a lot more than the stuff called AAA. Let’s try to deconstruct what’s going on, keeping in mind that this is most definitely not investment advice. "

Debt

Economist's view links to a story from the NY Times that looks at how debt has been stigmatised over time. It highlights a cycle of financial innovation, missuse and regulation that is apparent in the US mortgage market. The article suggests that the end result is that people are better off.

Sarkozy and the EUR

From Simon Derrick

French presidential candidate Nicolas Sarkozy says: "Competition is such with globalisation that we don't need to fight inflation like we fought inflation 30 years ago. I want the Europeans to be able to do with the EUR what the Americans do with the USD, the Japanese with the JPY and the Chinese with the CNY (i.e. use their powers to influence exchange rates). It's the very least." He adds: "We are depriving ourselves of an instrument to create growth, provide jobs, for purely ideological reasons. Well, the EUR doesn't belong to Trichet ... and I'm not the only one in Europe who thinks so."

Should make ECB job more difficult if EUR appreciates and core inflation rises to 2.0%.

Credit marke still in operation.

Freeport prices $6bn bond:

"The US debt markets absorbed the biggest junk bond deal for 18 years on Wednesday in spite of concerns about losses in the subprime mortgage market that have diminished investor appetite for risky debt.

Freeport-McMoRan Copper & Gold priced a $6bn deal to fund its acquisition of Phelps Dodge, a deal that will create the world’s largest publicly traded copper company. "

Sub-Prime

FT.com:
on the inevitable slowdown in the Residential Mortgage Backed Securities market. Of interest is the estimate of the effect on investment bank revenues. It does not actually seem that much.

"Brad Hintz, analyst at Sanford Bernstein, estimates that as investor appetite for CDOs grew, the RMBS business of major Wall Street firms ballooned to 15 per cent of total fixed income revenues. Subprime and Alt-A mortgages accounted for 25 per cent of RMBS total, he said."

Credit Derivatives and Bank Credit Supply--Federal Reserve Bank of New York

Credit Derivatives and Bank Credit Supply--Federal Reserve Bank of New York:

"We find evidence suggesting that greater use of credit derivatives is associated with greater supply of bank credit for large term loans—that is, newly negotiated loan extensions to large corporate borrowers—though not for (previously negotiated) commitment lending."

Credit Derivatives and Bank Credit Supply--Federal Reserve Bank of New York

Credit Derivatives and Bank Credit Supply--Federal Reserve Bank of New York:

"We find evidence suggesting that greater use of credit derivatives is associated with greater supply of bank credit for large term loans—that is, newly negotiated loan extensions to large corporate borrowers—though not for (previously negotiated) commitment lending."

The euro area repo market

The growth in the euro area repo market. Rising interest rates and the new BIS rules have allowed the market to develop.

FT.com :

"Repo traders also say that the rising interest rates in Europe over the past year have created more business because there is increasing scope to make money on the interest rate spread between European overnight banking rates and the repo rates set on the various securities used as collateral."

Who pays?

FT.com
looks at Citigroup data that suggests that hedge funds were selling higher yielding assets while pension funds were moving into this asset.

"Instead, the list of those nursing bruises may well turn out to include bank prop desks and pension funds. Not to mention those real money clients of Citigroup who had the bad judgment (or luck) to raise their positions in European credit last month."

Trough of creativity

As a counterwight to the stories about peak oil or peak energy, we get some insight into the potental innvoations that arise if energy become scarce and more expensive.

Thanks again to Paul Kedrosky with this story about the increased attempt to capture wasted energy.

Chinese Reserve Policy

From Simon Derrick, overview of the changes that may take place in China. There is continued pressure for diversification. However, if we move beyond asset classes, it remaisn difficult to remove questions of currency diversification from those of exchange rate peg.

The Bank of New York - Global Markets Website:

"The latest leaks out of Beijing suggest that the next step towards the formation of a new agency to manage the “surplus” portion of China is likely to be taken in the next few weeks. Market News International reported just over a week ago that next months meeting of the National People’s Congress (the nation’s top legislative body), is likely to approve plans to establish a new agency to help manage the reserves. This agency, under the control of the Ministry of Finance (and, reportedly, to be headed by Vice Minister Lou Jiwei), would be in be in charge of purchasing high-yield assets both at home and abroad including resources for China's economic growth and would report directly to the cabinet. A report in the Southern Weekly newspaper indicated that this “State Foreign Exchange Investment Corp” would manage in excess of USD 200 Bn and that the money could be spent on a wide array of domestic and international assets, from oil and gas to financial assets and entire companies. Another USD 100 Bn from the reserves would, reportedly, be allocated to Central Huijin (a division of SAFE).

The report today from Reuters (citing “sources close to the State Council”) that Vice Finance Minister Lou Jiwei is likely to replace Hu Xiaolian as chairman of Central SAFE Investment Ltd., suggests that this plan is well under way. With the report indicating that the cabinet has agreed in principal to the appointment of Lou as head of the new agency it seems the stage is set for announcement after the end of the congress. It also strongly suggests that the bureaucratic wrangling that reportedly had been taking place between the MOF and "

BIDS

The FT:
gives an overview of the BIDS system that will facilitate off exchange transactions. The technical problems that affected the NYSE on Tuesday can only add to the pressure to find alternatives.

"Earlier this week, the New York Stock Exchange introduced curbs on trading designed to ensure that the trading of large blocks of shares by specialist traders did not exacerbate market falls.
The BIDS system will offer users an efficient electronic trading platform to anonymously execute block trades and is expected to launch in spring.
“This level of industry support prior to our launch validates our model and helps build tremendous momentum in advance of the launch of the system,” said Mr Mahoney.
The system will be accessible to both buy-side and sell-side users that want to trade large blocks through continuous order matching and trade negotiation.
The company said the use of the BIDS system as a block trading service will not be exclusive or subject to volume commitment and each participant could continue to use any other automated trading system, electronic communication network or exchange service that supports the trading needs of its customer base."

MTS

An overview of the pressure in the MTS market. This highlights the way that the European bond market is much more fragmented that the US version. This makes it less liquid. A Finnish government bond is not the same as a German government bond. However, MTS forces investment banks to treat them in a way that is more similar than would be the case if market forces prevailed.
Hedge funds seek access to eurozone bonds:

"Supporters of MTS say that these practices are needed to ensure there is plenty of liquidity in the eurozone’s fragmented government bond market. The rules are popular among smaller eurozone members.

However, critics say the rules have created a quasi-cartel, which has raised the cost of bond dealing and looks increasingly anachronistic given the growing use of electronic trading. "

Diversified genes

Marginal Revolution: Beautiful People are Mean
Nothing to do with finance, but astonishing. This suggests that we appreciate that which is an amalgamation from many. We want diversified genes!

Instrumental variables

Social Science Statistics Blog: The "Imperial Grip" of Instrumental Variables: "Consider the two papers desribed in the Economist article. The first attempts to estimate the effect of colonialism on current economic outcomes. The authors propose wind speed and direction as an instrument for colonization, arguing (plausibly) that Europeans were more likely to colonize an island if they were more likely to encounter it while sailing. So far so good. Then they argue that, while colonization in the past has an effect on economic outcomes in the present, being situated in a location favorable for sailing in the past (i.e., before steam-powered ships) does not. Is this really plausible? The authors think so, I don't, and it isn't obvious that there is a way to resolve the matter."

Hedge funds

Bloomberg.com on quantitative investment and hedge funds.

Hierarchy

Excellent from Chris Dillow on the hierarchy in firms.

Here's some great empirical evidence for all this. Bart Hobijn and Boyan Jovanovic estimate (pdf) that the stock market value of US firms that existed in 1972 fell relative to GDP in the three subsequent decades. And yet the value of the overall market more than doubled relative to GDP. This means that more than all the rise in the value of shares relative to GDP came from new firms. Growth - as perceived by investors - therefore comes from new firms much more than incumbent ones.
This suggests that old hierarchic firms don't grow quickly. Rather than being a source of innovation, big hierarchical firms exist to exploit innovations that have occurred outside the firm, as this paper (pdf) shows.
Now, I'm not saying here that co-operatives would be a better source of innovations; as workers want to cling onto their jobs, labour-saving innovation would be less. All I'm saying is that whatever the benefits of hierarchies are, they don't include an ability to innovate. It's markets that give us innovations, not hierarchies.

Mifid and Dark Pools

FT.com:

"This trend toward dark pools and crossing networks is providing a lucrative source of revenues for investment banks and it is likely to accelerate, particulaly as the introduction of the Market in Financial Instruments Directive this year in Europe is likely to expand the use of private networks there."

Repo market for beginners

The FT on Barclays and the 2015 Bund.

The price of the 2015 Bund has moved sharply in the past week, suggesting that the bank could stand to make large profits in the repurchase or repo market, where securities such as bonds are lent in exchange for cash.

A lower interest rate on the cash side of the transaction indicates greater repo demand to borrow a bond. The 2015 Bund has been attracting a cash interest rate of about 1 per cent in the overnight repo market this week, down from about 3.5 per cent last week and well below the 3.5 per cent average overnight repo rate in Europe, set in line with the European Central Bank’s main interest rate.

Such a low repo rate for a Bund is rare. A bank able to lend the bond receives cash at below-market interest rates, which can then be deployed at a profit.

Trading volumes for last Friday and Monday rose to €3.4bn on BrokerTec, the electronic platform on which repo trading is conducted, suggesting that millions of euros could be made this way.

There is more detailed look at the repo market here.