Investing in a QE World

www.bbc.co.uk

We've written a lot about global macro issues lately.  The debt issues of Europe and the USA are enormous and ongoing.  They remain unresolved.  The statistics are staggering: the combined central banks of the world have "printed" so much money since the GFC that their balance sheets now constitute a third of global equity values: see

Bianco Research: www.arborresearch.com, 27 January 2012

We maintain Australian investors need a global context for their investment decisions.

What is QE?
Quantitative Easing ("QE") is an expanding of balance sheets via increasing bank reserves.  The purpose of QE, as explained by this Bank of England video,  is to increase bank reserves through purchases of fixed income securities in order to lower interest rates.  This makes fixed income securities relatively unattractive/overvalued and pushes investors out the risk curve.  This should increase buying for riskier assets such as stocks, pushing them higher in price.  Theoretically these higher prices should lead to a wealth effect and increased economic activity. see

Everybody (else) is doing it
The  major economies of the world are exercising monetary policy in order to stimulate economic activity as the first chart shows.

By contrast, the Australian economy is undergoing an unprecedented mining boom at the same time as other sectors of the economy are contracting.  We call this our "two-speed" or "patchwork" economy.  Some argue it's a manifestation of "dutch disease".  The Gillard Government's trade policy is premised on the following:

Non-mining businesses seeking to retain their employees and contractors will need to bid for them against extremely profitable mining-related businesses. And since the mining boom is not confined to Australia, overseas bidders have also entered the market for Australian expertise. Similarly, the prices of materials and equipment used in mining-related activities are being bid higher.
An independent, inflation-targeting Reserve Bank, confronted with these price pressures, would be obliged to consider raising interest rates to prevent inflation from rising above its 2-3 per cent band of tolerance. The blunt instrument of interest rates hurts non-mining businesses and regions of Australia, accentuating the patchwork economy.
A further natural economic consequence of the mining boom is a rising exchange rate, the Australian dollar having surpassed parity with the greenback in November 2010 for the first time since well before the currency was floated in 1983. A high Australian dollar has the desirable consequence of putting downward pressure on prices by lowering the cost in Australia of imported goods and services — taking some pressure off the Reserve Bank to lift interest rates. But a high Australian dollar is also damaging our import-competing and export industries, weakening their ability to compete for productive resources against mining-related industries. While this, too, has an anti-inflationary effect, it is more deeply embedding the patchwork economy.

What to do?
Where does all this money printing  leave the Australian investor?  Holding your deposits in cash eats away at their value longer term if inflation kicks in.  How does the SMSF Trustee determine the best course for achieving the returns required to fund retirement?

You could take the risk of riding the upward trajectory of the risk markets such as stocks.  The risk is described well here

Until a worldwide exit strategy can be articulated and understood, risk markets will rise and fall based on the perceptions and realities of central bank balance sheets.  As long as this is perceived to be a good thing, like perpetually rising home prices were perceived to be a good thing, risk markets will rise.
When/If these central banks go too far, as was eventually the case with home prices, expanding balance sheets will no longer be looked upon in a positive light.  Instead they will be viewed in the same light as CDOs backed by sub-prime mortgages were when home prices were falling.  The heads of these central banks will no longer be put on a pedestal but looked upon as eight Alan Greenspans that caused a financial crisis.
The tipping point between balance sheet expansion being bullish for risk assets versus bearish is impossible to know.

A new option for Australian investors
One new option is to consider a high interest cash exchange traded fund such as Beta Shares new offering, the Australian High Interest Cash ETF.

Characteristics of this product include:

• diversification of investment portfolio - the product as part of a cash or term deposit allocation aims to earn a higher rate of interest than the 30-day bank bill swap rate after fees and expenses
• suitability for cash flow for SMSF pension holders - monthly income payments may be made
• the ETF is backed by deposit with an Australian bank trading under new ASX AQUA rules
• investors buy and sell units in the ETF through a broker (and pay brokerage)
• as interest is earned each day on the deposit, the value of the ETF will rise, providing investors with liquidity, coming with the ability to sell at any time without penalty (in contrast to term deposits).

We note:

• the Government Guarantee on bank deposits for Australians is now limited to $250,000 per deposit with one bank/ADI (authorised deposit taking institution).  Participation in a cash ETF does not equate to a deposit for the purposes of the government guarantee.
• A Cash ETF provides the possibility for a spread of risk from one institution to many, exposing the investor to multi-party credit risk akin to the former Macquarie Bank Cash Management Trust product.  (Note: the current Macquarie CMA attracts single party credit risk). 
• the BetaShares Cash ETF currently only offers single bank risk (Westpac) though the PDS describes the possibility of deposits with other major Australian Banks: see here Accordingly, we recommend this is a product to watch, and once they and others offer diversification of credit risk we would recommend our clients to consider these products.

There are similar new products coming onto the market in Australia such as offerings from  iShares and Russell Investments.  You can read more about these products in The Age/SMH or call us to have a chat about your needs and risk appetite.  

Please note this is not financial advice and you should not rely on opinion/s expressed in this blog post.

Barry Ritholtz: US Banks and Housing, Greek Default & Euro Sovereign Debt

www.labouratorio.it 28/07/2011

If you are trying to make sense of macroeconomic issues in the USA and Europe, and wonder about the degree of interconnectedness of the global banking system, you must see this. Watch the Bloomberg TV video:here


Barry Ritholtz, chief executive officer at Fusion IQ and author of "Bailout Nation: How Greed and Easy Money Corrupted Wall Street and Shook the World Economy," talks about the health of the U.S. banking system, the housing market, and Europe's sovereign debt crisis. Ritholtz, speaks with Tom Keene on Bloomberg Television's "Surveillance Midday" on Monday 5 March 2012 (Source: Bloomberg)


As Ritholtz notes in the Bloomberg interview, the issues surrounding CDS's  (in relation to Greek debt) have been experienced in the USA (in relation to mortgage securitization) with devastating consequences only recently.  


In 2008, Steve Hsu, Professor of Physics at the University of Oregon created a chart, designed to show the interrelationship of CDS's in the US mortgage market, see here.  It attempts to explain in simple terms the incredible complexity of the market in which AIG operated, which created the systemic risk to the US banking and financial system which ultimately required such massive public bailout.  Hsu writes:

Imagine removing -- due to insolvency, lack of counterparty confidence, lack of shareholder confidence, etc. -- one of the nodes in the middle of the graph with lots of connections. What does that do to the detailed cancellations that reduce the notional value of $45 trillion to something more manageable? Suddenly, perfectly healthy nodes in the system have uncanceled liabilities or unhedged positions to deal with, and the net value of contracts skyrockets. This is why some entities are too connected to fail, as opposed to too BIG to fail. Systemic risk is all about complexity.

The lack of transparency and complexity of CDS arrangements is a significant uncertainty in the current Euro debt crisis.  But in addition to these factors we note the perception is increasing that CDS will not achieve the purpose for which is was designed.  Why?


Ritholtz speaks plainly.  In relation to the CDS issue (which we addressed on 9 November 2011 here)  he writes on The Big Picture: What are the repercussions if CDS hedging fails?  a fascinating piece on 3 March 2012.  He lists the participants on the committee which determines whether a default has occurred for the purposes of paying out under a CDS.  

Who is on the ISDA committee?

• Bank of America Merrill Lynch
• Barclays
• Credit Suisse
• Deutsche Bank AG
• Goldman Sachs
• JPMorgan Chase Bank, N.A.
• Morgan Stanley
• UBS
• BNP Paribas
• Societe Generale
• Citadel Investment Group LLC
• D.E. Shaw Group
• BlueMountain Capital
• Elliott Management Corporation
• PIMCO

A day earlier (2/3/12), Ritholtz posted this piece explaining this history behind the deregulation of derivatives such as CDS in the USA.  We've not read this elsewhere to date.  It's worth restating (bold & italics added):

Credit Default Swaps (CDS) are Insurance Products, Not Tradeable Assets
Our story thus far:  The Commodity Futures Modernization Act of 2000, sponsored by Texas Senator Phil Gramm as a favor to his wife Wendy (who sat on the Board of Directors of Enron, which wanted to trade energy derivatives without oversight) was rushed through Congress in 2000. Unread by Congress or their staffers, it was signed into law by President Bill Clinton on the advice of his Treasury Secretary Lawrence Summers.
The CFMA radically deregulated derivatives. The law changed the Commodity Exchange Act of 1936 (CEA) to exempt derivatives transactions from regulations as either “futures” (under the CEA) or “securities” under federal securities laws. Further, the CFMA specifically exempted Credit Defaults Swaps and other derivative products from regulation by any State Insurance Board or Regulators.
This rule change exempting CDS from insurance oversight led to a very specific economic behavioral change: Companies that wrote insurance had to explicitly reserve for expected losses and eventual payout in a conservative manner. Companies that wrote Credit Defaults Swaps did not.
Hence, AIG was able to underwrite over THREE TRILLION DOLLARS worth of derivatives, reserving precisely zero dollars agianst potential claims. This was enormously lucrative, except for that whole crashing & burning into insolvency thingie.

The radical deregulation the CFMA generated led directly to the collapse of AIG, Bear Stearns and Lehman Brothers; indirectly to the collapse of Citigroup, Bank of America, and Fannie/Freddie. It was a significant factor in the near death experiences of Goldman, Morgan Stanley and others.
Despite the horrific impact this legislation had, it was never actually overturned, only modified. Obama made the personnel error of bringing back Larry Summers (he apparently had not wrought enough damage to the nation yet). Rather than admit the error of CFMA, and overturn it, Summers instead downplayed its role. Thus, the CFMA was merely modified somewhat. The same risk the CFMA presented to the economy still exists. Swaps now must be be cleared through exchanges or clearinghouses — but they are still exempt from Insurance regulations. Which is bizarre, because they are little more than thinly disguised insurance products, with the CFMA kicker that there is no reserve requirement. Counter-parties may or may not demand one, but the dollar amount is negotiable.

Which brings us to today.
The Greek government has been declared in default by S&P; most common sense definitions of default — failing to make payments on a timely basis, declaring your intention to default, involuntary change of loan terms by borrower, etc. — have already occurred.
That last point is especially important in light of the Greek Sovereign Debt default — which International Swaps and Derivatives Association, in a nonpublic meeting of derivatives bankers, declared to be a NONDEFAULT.

I’ll be damned if I can figure out why.

Any tradeable asset — stocks, bonds, futures, options, funds, etc. — settles on its own. There is a market price the asset closes at, a total volume of sales, and a final print for the day, month, quarter and year.  No interpretation required.
Yet with Greek CDS, we have a committee of bankers, lawyers, accountants and other interested (not unbiased) parties interpreting the details, weighing the circumstances, describing what happened.
Does that sound like a tradeable asset to you?  To me, it sounds more like an insurance policy dispute. Because in reality, these CDS are in fact, nothing more than an unreserved and unregulated insurance products.  That is the legacy of the CFMA, and one that apparently has not been overturned.

The banks, hedge funds, and securities firms who are the prime dealers of these products  greatly prefer to have their derivatives supervised by Federal regulators. Why? Because the standards they use — general safety and soundness — are empty-headed nonsense, easily evaded.
The State Insurance Boards and Regulators are far more exacting, far more specific — and require boatloads more money in reserve.
Hence, this is how the Greeks have managed to default, yet an insurance-like product will not (yet) payout. With insurers or their regulators involved, this would never have happened.

And the day before, read here on 1 March 2012:

“The International Swaps and Derivatives Association said on Thursday that based on current evidence the Greek bailout would not prompt payments on the credit default swaps. ”Here is a question for the crowd: Exactly how brain damaged, foolish and stupid must a trader be to ever buy one of these embarrassingly laughable instruments called derivatives? The claim that Greece has not defaulted — despite refusing to make good on their obligations in full or on time — is utterly laughable.  In order to get paid on a default, you need a committee to evaluate whether or not failing to make payments is a — WTF?!? — default?  Even more ridiculous, the committee is composed of biased, interested parties with positions in the aforementioned securities?ISDA: After this shitshow, why on earth would anyone EVER want to own an asset class that requires you to determine payout? Indeed, why should ANYONE ever buy a derivative again?

The question then becomes, what happens to CDS's held in relation to other sovereign debt after the current Greek debt situation is resolved one way or another?  Ritholtz' interview with Keene indicates there is significant doubt surrounding the future efficacy of the system as presently designed outside "blue chip" government bonds.


The coming few days will tell the story of whether the CAC (Collective Action Clauses) are triggered by virtue of the % uptake of the PSI (Private Sector Involvement) in the Greek bond deal, and accordingly, whether a default is determined by the ISDA.


A non-default declaration by the ISDA in circumstances where the CAC is triggered would beggar belief, and we remain sceptical of the system.