ESM and seniority

FT.com / Capital Markets - Eurozone bonds face boycott by investors: "Standard & Poor’s, the US credit ratings agency, warned earlier this month that any country borrowing from the ESM could face further ratings downgrades because of the seniority issue."

Global credit gaUge

The FT.com reports on international measures to increase required capital ratios if credit growth breaches a threashold.

"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"

Merrill and the CDOs

How Merrill Lynch Traders Helped Blow Up Their Own Firm - ProPublica: "By the middle of 2006, the Merrill traders who bought mortgage securities were often clashing with the powerful division, run by Harin De Silva and Ken Margolis, which created and sold the CDOs. At least three traders began to refuse to buy CDO pieces created by De Silva and Margolis' division, according to several former Merrill employees. (De Silva and Margolis didn't respond to requests for comment.)"

John Maynard Keynes - A great investor

John Maynard Keynes - A great investor:

"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."

Transaction banking

The FT looks at transaction banking:

"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."

UK Irish exposure

Ireland: a danger zone for banks:

"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"

Negative basis in Ireland

FT Alphaville looks at the movement of Irish bonds vs CDS. In this case the bond market is leading the CDS as selling of bonds (to raise, or prevent the need to post, collateral at LCH) has been the main factor behind the move. Usually, it is the more liquid CDS that makes the move.

"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."

German banks and Basel 2

FT.com "It is also a somewhat disturbing paradox that such a successful manufacturing economy remains reliant on such a fragile banking sector. Indeed, of the 44 European banks that have had recourse to state support in the latest crisis, by far the biggest number have been based in Germany, with 13 banks, followed by the UK and Belgium with five cases each"

Allocation of education

Stefan Collini discusses education reform. The bottom line, he says, is

"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."

but does not propose an alternative. How else can education be allocated?

Private equity

Malcolm Gladwell looks at private equity and the the rescue of General Motors : The New Yorker:

"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."

You can't buck the market

The FT Alphaville looks at the real appreciation of the Chinese currency from the increase in inflation rather than the nominal appreciation. This is a forgotten channel and one that is exacerbated by the intervention to hold the rate stable. There may be ways of sterilising in a controlled economy but it is likely that the underlying pressure will emerge in some way.

"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."

Alphavile argues that these inflationary pressures will increase the pressure on the Chinese authorities.

Marginal Revolution: Classical economics reading list

Marginal Revolution: Classical economics reading list:

1) Smith

2) Hume

3) Ricardo

4) Early marginalists

5) Malthus

6) Edinburgh Review

7) Mill

8) Marx

The Economist: Junk Bonds

Drexel Burnham Lambert's legacy: Stars of the junkyard | The Economist: "Junk bonds, once despised, are now mainstream. “Milken and Drexel took high-yield bonds from a cottage industry to one of the cornerstones of the financial industry,” says Howard Marks, one of Mr Milken’s early customers and now chairman of Oaktree, a Los Angeles firm that manages around $75 billion in funds, much of it in high-yield bonds and related investments."

Before the bank

Pepy's Diary 10th October 1667. Trying to find the gold that he buried at his father's house in the country.

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.

Internalising

FT Alphaville discusses the internalising of equity market in large investment banks. This means that the bank nets the buy and sell orders and sends the balance to the exchange.

"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."

Networks and liquidity

David Warsh points us to Paul David and an essay on the "flash crash". The end to open outcry may have some effects that allow the transmission of shock or 'catastrophe beyond what would previously have been the case. It is a story of fragmented liquidity and an end to face-to-face dealing.

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.

Exchange traded fx products

FT.com discusses the lack of growth in ETP in the FX space. However, there is an interesting product from Deutsche Bank that tries to combine three basic strategies. One case study could try to set the rules for such a product.

"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."

Market or command

A comparison of social network and command as a means of organisation.

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.

The broad theme is that command is necessary for real, serious, important and difficult tasks; social networks are broader, more creative and more trivial.

Commodity fund

All About Alpha investigates commodity funds.

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:

• Collateral Yield: Futures contracts require very little collateralization (~10%). The remainder is frequently invested in high-quality, short-term instruments such as a 90-Day T-Bill. The yield from these investments is often very small relative to the total return and is known as the collateral yield.

• Spot Price Change/Yield: This represents the price change in the underlying commodity contract and is often quoted during a discussion of a commodity’s return. Investors are usually seeking exposure to these returns when choosing to invest in commodities.

• Roll Yield: This component of return is the focal point of the recent articles and is a little more complicated. Commodity investors (e.g. indices, funds, etc.) tend to buy near-dated contracts (e.g. 1-month from expiration) and sell them just prior to settlement. The revenue generated is immediately used to purchase another near-dated contract to maintain exposure to the commodity. This process continues indefinitely and represents the roll yield (sale price less purchase price). If the subsequent purchase cost is less than the revenue gained from the sale, then the roll yield is positive; if the sale prices is less than the purchase price the roll yield is negative. A positive roll yield is referred to as backwardation while a negative yield is called contango.

Information

Ben Bernanke looks at what the financial crisis means for economics. In the middle of this there is an overview of information and expectations under uncertainty.

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.

This can be tied to the modelling of expectations in the UIP model. There may be a non-linear model that is distributed with a negative skew and kurtosis in regular times and collapses into something binary in a crisis.