Euro Crisis: unintended consequences?

International financial markets have experienced high volatility for months now as the European debt crisis continues to lurch from saga to soundbite, summit to parliamentary sitting.  Ireland, Portugal and now Greece have forced changes of government.  Italy is pushing seemingly closer to a change in leadership as its bond yield rises higher, towards an unsustainable level, whatever that may be. The European leaders summit at the end of October agreed in principle to changes ushering a market rally but the volatility continues and many commentators are of the view that the underlying problems remain (ie the debt rising and growth stagnating) and the measures are themselves not enough to achieve a resolution.

...too much debt (enhanced by little growth) is the source of Europe’s problems and the three ways of dealing with it is to write it off, pay it down or inflate it away, slicing Greek debt obligations to private bondholders in half is a real long term solution. It will still leave them with extraordinary debt levels relative to their small and stagnant economy but it’s a big start. Read the article from The Big Picture here 

What of the European leaders' resolution relating to the so called "50% haircut"? Aside from the immediate political casualties in Athens and Rome, we consider there are unintended consequences.

Peter Boockvar (for his Forbes profile, see) wrote on October 27:

...next will be those looking to hedge sovereign exposure, mostly banks, will then have to short sovereign debt or outright cut credit to the region. EU officials better be careful what they wish for the holders of Greek CDS

How can a "strong-armed" 50% "haircut" not constitute a default? How can this not have ramifications for the pricing of the next lot of debt needing to be refinanced by these deeply indebtetd European sovereigns?

In addition to the CDS issue, Bloomberg reports on 8 November here that BNP Paribas SA and Commerzbank AG are unloading sovereign bonds at a loss, leading European lenders in a government-debt flight that threatens to exacerbate the problem. The European Banking Authority is requiring lenders to boost capital by 106 billion euros after marking their government debt to market values. This trend may undermine European leaders' efforts to lower borrowing costs for countries such as Greece and Italy while generating larger writedowns and capital shorftalls.

Another voice on the CDS issue is John Mauldin whom you can follow here  I have reproduced a significant portion of his note written on 29 October, 2011 and I have italicised the central point:

Let's Just Change the Rules 

I've always had a soft spot for Bunker Hunt. Yes, I know, he was a voracious manipulator who tried (and did) corner the silver market back in 1980, but boys will be boys. Maybe it's a fellow-Texan thing. He went bankrupt because they changed the rules on him. Lesson for all of us: Never assumes the rules are what you think they are just because they are written down, if someone else can change them. You can only push so far and then the peasants revolt.And that is the final thing that happened at the summit. 

The banks "voluntarily" took a 50% haircut. Voluntary in that Merkel, Sarkozy, et al. told them that the alternative was a 100% haircut. "That's the offer, guys. Take it or leave it." Cue the theme from The Godfather.And because the write-off was voluntary, there would be no triggering of credit default swaps clauses. Because if it's voluntary it's not a default capiche?And that smooth move, dear reader, triggered a rather significant unintended consequence, which resulted in the market "melt-up." 

Let me see if I can walk you through this rather bizarre world of derivative exposure without exposing too much of my own ignorance.Let's say you bought credit default swaps on a certain bank's debt (let's use JPMorgan, but it could be any bank) because you think that Morgan is exposed to too much credit default swap risk. Just in case. Now, if (say) Goldman sold you the CDS, they could and would in turn hedge their risk by shorting some quantity of Morgan stock, or perhaps if the risk was sizeable enough, the S&P as a whole. It would depend on what their risk models suggested.But as of yesterday, the risk evaporated: there would be no CDS event. So why buy CDS? Time to cover. And then the shorts get covered.Further, the risk to financials was cut by a large, somewhat murky amount. But it was definitely cut, so buy some risk assets. Which puts any long/short hedge fund in a squeeze, especially those with an anti-financial-sector bias. But because of the nature of the hedge, the whole market moves. It involves rather arcane concepts that traders call delta and gamma. (Remember that the recent rogue traders had been at delta trading desks?) Guys at those desks can calculate that risk in a nanosecond. You and I take a day just to wrap our head around the concepts.And it just cascades. The high-frequency-trading algo computers notice the movement and jump in, followed quickly by momentum traders, and the market melts up. Because a significant risk was removed. But not without cost. 

Let's go back to where I noted that Italian interest rates are rising even as the ECB is supposedly buying. What gives? It is clearly the lack of private buyers, and a lot of selling. Because now you can't hedge your sovereign debt. If you ever need that insurance, they will just change the rules on you, so why take the risk? 

Destroying the credit default swap market will make it harder to sell sovereign debt, not easier. Those "shorts" were not the cause of Greek financial problems; the Greeks did it all to themselves. As did the Portuguese, and on and on. Now admittedly, rising CDS spreads called attention to the problem, much as rising rates did in eras long past. And that did annoy politicians. And clearly, banks that had exposure to that market got the "fix" in to make their problems go away.(OK, this is just my conjecture; but I have speculated before with reason that a major writer of sovereign CDS were German Landesbanks. Think Merkel didn't have that report? As did Sarkozy, on French exposure? It was a very high-stakes poker game they were playing this week. But one side of the table could rewrite the rules.) 

Now, I know I am greatly oversimplifying the CDS situation. Even so, a great deal of the volatility of recent times can be laid at the feet of the CDS market, because it is so opaque. There is no way to prove or disprove my speculations, because there is no source that can really plumb the true depths of the situation. And that is the problem.I am not against CDS. We need more of them. But they should all be moved to a very transparent exchange. If I buy an S&P derivative (or gold or oil or orange juice), I know that my counterparty risk is the exchange. I don't have to hedge counterparty risk. The exchange tells whoever is on the other side of the trade that they need to put up more money, as the trade warrants. Or tells me if the trade goes against me. The banks lobbied to keep CDS "over the counter." The commissions are huge that way. If they are on an exchange the commissions are small. This was a huge failure of Dodd-Frank. And we all pay for it in ways that no one really sees. 

As the Bastiat quote at the beginning said, there is what you see and what you don't see.Equity markets are supposed to help companies raise capital for business purposes, not be casinos. Investors want to and should be able to buy and sell stocks with a long view to the future. And increasingly there is the feeling that this is not the case. When I talk to institutional investors and managers, it is clear that they are very frustrated.I am not arguing against hedge funds here. There is a need for short sellers in a true market. But that selling should be transparent. In a regulated exchange, you can see the amount of short interest. Everyone knows the rules. But without an exchange, things happen for reasons that are not apparent. An event like the Eurozone summit changes an obscure rule with some vague clauses about triggering a credit event and the market reacts. This time it was a melt-up. Next time it could be a meltdown, as it was in 2008.CDS markets should be moved to an open regulated exchange. 

And while we are at it, high-frequency trading should be stemmed. This could be done easily by requiring all bids or offers to last for at least one second, instead of a few microseconds. You make the offer, you have to honor it for a whole second. What a concept. That would not hurt liquidity, but it would cut into the profits of the exchanges (especially the NYSE) but I thought these were public markets and not the playground of the privileged few. 

If it weren't so cold here in New York, I might just wander down and join Occupy Wall Street and see if I could enlighten a few minds. If those kids only knew what they really should be protesting.

Super Contributions: how can Australians be helped to retire with enough super?

Super Contributions - the future

A report from actuaries at Deloitte released 2 November studies the future of Australia's superannuation industry.

Dynamics of the Australian Superannuation System: the next 20 years 2011 – 2030, explores a range of scenarios that show the comparative growth in superannuation assets by market segment, in the demographic makeup of post and pre-retirement funds, and what longevity means for retirement adequacy.

To put the average balance at retirement in context, the authors turned to the current Association of Superannuation Funds of Australia (ASFA) Retirement Standard, which suggests that a single male requires $22,000 per annum for a modest lifestyle in retirement. That means to retire on a modest lifestyle a male will require a balance of $280,000. A female will need the higher amount of $310,000 due to greater longevity. But...the average balance for a male at retirement in 2030 will only be $217,000 in today’s dollars, and the average amount for a female will be even less - $139,000.

Given that 50 percent of the population is expected to live beyond the standard 85 years of age for a male and 88 years for a female...a single male retiring with an account balance of $217,000 and taking an income stream of $22,000 per annum has a 78% chance of outliving his retirement benefit.

The Report projects that recent strong growth in industry funds, master trusts and Self Managed Super Funds (SMSFs), will continue at the expense of corporate and public sector funds.

The Deloitte model projects that SMSFs will continue to remain a popular superannuation option overall with its assets reaching $2 trillion by 2030. This is however almost one trillion dollars lower than in their 2009 projection, which is almost entirely due to the introduction of lower concessional contribution limits.

Generational change is significant.  The report finds over the next 20 years, the share of assets held by Generations X and Y will grow from about 46% in 2010 to become the dominant superannuation customers with 84% of all assets in 2030.

The combination of longer life expectancy and volatility in the investment markets is raising the risk that retirees will run out of money before they die. The Deloitte report finds this presents an opportunity for the industry to think innovatively and find new solutions to what will become an increasing challenge.

The Australian Superannuation system is still dominated by lump sums, but we are seeing an increasing proportion of retirees opting for an income stream. It is expected that this trend will continue, presenting a challenge for funds to provide services and pension benefits for members as they approach and  transition into retirement.

The decision to increase the Superannuation Guarantee to 12% and lift the qualifying age for the age pension to 67 years, are intended to help Australians provide for their own retirement – by saving more and working longer.

Addressing adequacy in retirement is described by Deloitte as "a work in progress" see here.

A significant factor under consideration by industry about which the ATO/Government is aware is the possibility of increasing the limits for concessional contributions when a person is nearing retirement. 

This would go some of the way to resolving the question of adequacy of superannuation.

Radical Bank Reform | Alan Kohler | Business Spectator

Time for Radical Bank Reform

Excellent article today from Alan Kohler who references Andrew Haldane, executive director of the Bank of England. He explains the history of banking:

the risks from banking have been widely spread socially. But the returns to bankers have been narrowly kept privately. That risk/return imbalance has grown over the past century. Shareholder incentives lie at its heart. It is the ultimate irony that an asset calling itself equity could have contributed to such inequity. Righting that wrong needs investors, bankers and regulators to act on wonky risk-taking incentives at source.

A shift away from remunerating bankers based on return on equity instead looking to return on assets would lead to different risk assessments by bankers and outcomes for the banks, for the bankers and for society at large.

A valuable macro perspective on our financial system. Read it here

SGC boost to 12%, abolition of age limit for super contributions

Super Contributions Boost

Today the federal government introduced legislation into the House of Representatives to increase the superannuation guarantee from 9 per cent to 12 per cent. The objective is to try and provide for more Australians to self-fund their retirements from their superannuation funds.

 

The bill will also abolish the age limit for when people can make contributions to their superannuation. This significant change will mean Australians can make contributions throughout their whole working life.

 

The introduction of the bill is the first step for the legislation. The debate on the legislation has been adjourned and is likely to be resumed early next year, 2012.