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.

UK SME financing

The University of Cambridge Centre for Business Research has a survey of UK SME financing for 2007.

The survey of businesses with less than 250 employees was carried out in the autumn of 2007, but is unlikely to have captured the full consequences of the credit crunch and slowing economy. It shows that there has been a decline in the use of external finance from 81% of firms in 2004 to 69% in 2007. However, the majority of firms said that there had been no change in the ease of obtaining finance and 71% of those seeking new finance received all that they sought. The report examines these headline figures across firm sizes, regions and industrial sectors. It also includes special chapters on key topics such as female-led businesses, start-up businesses, super growth businesses and those in deprived areas.

Real appreciation

Karolina Ekholm, Andreas Moxnes and Karen-Helene Ullveit-Moe look at the effect of the 17% real appreciation of the Norwegian Krone in the 2000 to 2001 period. Using micro data of the performance of Nowegian firms, they find three things:

First, the real exchange rate shock was associated with substantial employment losses. One-seventh of the total decline in manufacturing employment over the period under study can be attributed to the real appreciation.

Second, the shock led to productivity gains at the firm level, indicating that the most exposed firms were able to improve efficiency in a period of tougher foreign market conditions. One-fifth of the productivity improvement over the same time span can also be attributed to the real appreciation. Somewhat surprisingly, we do not find evidence of market reallocation effects; the real appreciation does not seem to have been associated with a reallocation of resources from low-productivity to high-productivity firms.

Third, firms responded to the real appreciation by offshoring (Ekholm and Ulltveit-Moe 2007), thereby purchasing a larger share of their intermediate inputs from abroad. For the manufacturing industry as a whole, the real appreciation increased the import share of intermediates by about 1.5%

This gives some insight into the costs of the Dutch disease.

Michael Veseth looks at the affect of US dollar depreciation on the US wine industry.

Asymmetric risk

The FT reports Merrill Lynch having lost a quarter of its profits for the 36 year period as a listed company in the space of 18 months.

This is a similar performance to that of hedge funds that find a skewed distribution for their returns. There are steady profits in return for taking asymmetric risk. This is also linked to the short-term nature of governance and incentives.

Diamonds are forever

The Atlantic looks at the history of the diamond. The main focus is marketing and the preparation of the market. However, there is also a lot of interesting information about the control of pricing even in the face of adversity.

Here are some diamond prices from Swivel, an end of 2007 cross section rather than time series.

New technology

How do business deal with new technology that threatens to provide an alternative product?

Economic Principals looks at the way that the newspaper industry has to adapt.

Those enormous rolls of newsprint, tank-cars of ink, long lines of presses and fleets of delivery vans are the newspaper industry’s best friends. Among business strategists, they are known as barriers to entry. The capacity to print and deliver the paper product from cities around the world is what makes newspapers different from everything and everyone else in this media-sodden world. Precisely from all this impedimenta – and the paper product it produces – does the authority of newspapers’ increasingly extensive Web-based operations derive.

The example of the radio and television can provide some insight. Radio has its own strength. It is particularly powerful when you cannot watch a picture because you are doing something else. The strength of the newspaper is that it can be passed around. In some ways it is much easier to find things. The newspapers have the advantage of having good, clear links to the sources of information. That have reputation.

More on the commons

More on the tragedy of the commons and how it is being use today to tackle problems.

Soft skills

Richard Reeves looks at the importance of soft skills in the labour market and the way that they contribute to inequality.

Recent claims about social mobility in Britain grinding to a halt are exaggerated. But it does seem that the likelihood of a person being upwardly mobile is increasingly influenced by personal qualities such as confidence and self-control. Julia Margo, associate director of the Institute for Public Policy Research, has assembled an impressive body of evidence linking character to life chances. Her work, which draws on that by Leon Feinstein at the Institute of Education, shows that measured levels of "application"—defined as dedication and a capacity for concentration—at the age of ten have a bigger impact on earnings by the age of 30 than ability in maths. Similarly, what psychologists call an "internal locus of control"—a sense of personal agency—at the age of ten has a bigger impact than reading ability on earnings.

There is also a BBC Analysis programe here.

This fits well with the argument from Chris Dillow that self-esteem is associated with higher earnings. It is also consistent with his idea that we can see the world as a zero-sum or positive sum. If our circumstances, lack of resources and limited opportunity reinforce the zero-sum view of the world, this would tend to undermine our ability to get a better job; if our circumstances support a positive-sum view of the world with benefits from co-operation, trust and thrift, this will encourage this the behaviour that is more rewarded in regualar society - particularly the labour market.

Valuation

The Economist looks at valuation and returns on asset classes in the long-run.

This is roughly how GMO goes about the process: it looks at the relationship between valuations and long-term returns. The return from equities, for example, is equal to the existing dividend yield, plus future dividend growth, plus or minus changes in valuations. Ten years ago, the dividend yield on the American market was low while valuations were high. The likely long-term return looked low, and so it has proved.

Using similar reasoning, GMO has a very gloomy outlook for the American and British housing markets at the moment. By using the ratio of the median house price to the median family income, GMO reckons that prices in America need to fall by 17% instantly or stay flat for four years to return value. In Britain, prices need to fall by 38% or stay flat for seven years. And of course, there is no guarantee they will stay at fair value; in the mid-1990s, they dropped well below it.

The end of an era

The FT reports.

We’re observing the end of an era in two very specific areas. First is the uncontrolled deregulation of global financial markets ... The second point is, the mindless commitment of human and financial resources to securitisation has reached its peak and now will contract for the indefinite future.

This is a trader's comment after the 1987 crash. It may be significant that this are the words of a trader. What is heard more often today are the words of Joe Public and the government. However, as the report points out, the fear of computerised trading has dissipated since 1987. Futures markets, which were used for Portfolio Insurance, are now mundane.