Hybrids - wolves in sheeps' clothing?

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In ancient times, the mythological hybrid was a creature combining the body parts of two or more species. Now the financial product bearing this name is also a beast of varied parts. Some important hybrid instruments are preference shares, convertible/exchangeable debentures/bonds and debt with attached warrants.

From an issuer perspective, hybrid securities may allow the issuer to raise capital while achieving a particular accounting, tax, credit rating or regulatory capital outcome. Following reduced activity during and immediately after the GFC, hybrid securities have recently been used for significant capital raising by both banks and well-known corporate entities.

Did you know there has been more than $18 billion of hybrids issued by banks and companies in Australia since November 2011?  There were approximately 75,000 investors in hybrid securities last year, two thirds of whom were self-managed superannuation funds (SMSFs).  

Hybrid securities often promise ‘high yields’ and are issued by well-known companies with trusted brands, but investors need to very carefully consider the features and risks before investing. Some hybrid securities make investors take on 'equity-like' risks but only give them at best, 'bond-like' returns. Some also have terms and conditions that allow the issuer to exit the deal or suspend interest payments when they choose. Some are very long-term investments (for example, more than 20 years).

ASIC is concerned about the marketing and promotion of these products. It released a report on 20 August 2013 dealing with this issue.  Why?

The issues are:

• inappropriate labelling of hybrids and unwarranted comparison of hybrids to different, less risky products eg covered bonds or senior debt
• advisers spruiking potential higher returns and using the brand name or reputation of the issuer without identifying the higher risks attached to that specific product
• investor education - do you know what a hybrid is and how it works?  Can you assess its risk profile?

Terms and conditions of each hybrid issue vary and in some cases they include features that mean they rank closer to equity than debt. Many involve heightened risks for retail investors, such as risks deriving from long maturities and more complex features such as interest deferral or potential conversion into ordinary shares. 

The overall complexity of hybrid securities makes clear, concise and effective disclosure to investors in a prospectus more difficult. 

All investors including SMSF trustees have a duty to understand their investments and ASIC has said it expects issuers, brokers and advisers to take particular care to promote clear communication to investors about the nature of an investment in these securities.  

You can download the ASIC report here: REP 365 or read more about hybrids on ASIC's moneysmart website here.  Call Sage Advisers if you have any questions about hybrids.

The rule of law and GDP

This blog post is a little different from most we have written but we consider it to be extremely important at the systemic level.  At its most basic, it can be said that all institutions require confidence in them for them to function effectively. Of central importance to that confidence is the Rule of Law.  We now also know that the trait most positively correlated with a country's GDP growth is the strength of its rule of law.  In other words, a country will perform better economically if it has a sound, functioning and respected set of laws which are enforced broadly.

Experts such as Michael Porter of Harvard Business School define "economic competitiveness"  to include the ability of the government to pass effective laws; the protection of physical and intellectual property rights and lack of corruption; the efficiency of the legal framework, including modest costs and swift adjudication; the ease of setting up new businesses; and effective and predictable regulations.

The USA now fares markedly worse than Hong Kong in all 15 of the measures of the rule of law shown in the World Economic Forum's annual Global Competitiveness Index.  These measures range from the protection of private property rights to the policing of corruption and the control of organised crime.  In the Heritage Foundation's Freedom Index the USA now ranks 21st in the world in terms of freedom from corruption, a considerable distance behind Hong Kong and Singapore (Australia ranks #3) and in the World Bank's Indicators on World Governance, since 1996 the USA has suffered a decline in the quality of its governance in three different dimensions: government effectiveness, regulatory quality and control of corruption.

Niall Ferguson, Professor of History at Harvard and Oxford Universities, makes the argument in his 2012 Reith Lecture (you can read it here) that these indicators show that the USA, and to an extent, the UK are suffering a deterioration in the rule of law.

China is now the most talked- about country whose future economic prosperity will depend on whether impartial legal institutions can replace personal and particular network- based mechanisms for ensuring compliance in commercial contracts.

The Rule of law and economic development was considered by Michael Heller, on Project Syndicate July 3, 2012. He states:

The quality of enforcement matters more than substantive content of law in developing countries. Good or good-enough law dealing with even sophisticated financial, corporate, or bankruptcy regulation is often already on the books. What is frequently absent is a credible expectation that law should and will work.

Structural and behavioural independence of the judiciary is seen to be a critical factor in the ability for laws to be enforced.

A number of other authors offer China as an example of a dictatorship that achieves economic growth by prioritizing good-enough security for property rights. Others question whether China will improve economic governance fast enough to avoid disaster. These are familiar arguments. Kenneth Dam, on the other hand, detects a promising ‘guided evolutionary approach’ to rule of law that could allow China to avoid serious economic crises. Political leaders, he thinks, seem to be coming around to an awareness of the need to enforce market rules.

Niall Ferguson has also considered this issue recently. He considers the problems of the "West" characterised as "excessive debt, mismanaged banks, widening inequality" are rather, symptoms of underlying institutional malaise.

He turns to English history and cites  the establishment of the institution of Parliament as a seminal moment empowering economic and social change:

From 1689, Parliament controlled and improved taxation, audited royal expenditures, protected private property rights and effectively prohibited debt default. This arrangement, they argued, was ‘self-reinforcing’, not least because property owners were overwhelmingly the class represented in Parliament. As a result, the English state was able to borrow money on a scale that had previously been impossible because of the sovereign’s habit of defaulting or arbitrarily taxing or expropriating. The late 17th and early 18th Century thus ushered in a period of rapid accumulation of public debt without any rise in borrowing costs – rather the reverse.

and

Not only did it enable England to become Great Britain and, indeed, the British Empire, by giving the English state unrivalled financial resources for making – and winning – war. By accustoming the wealthy to investment in paper securities, it also paved the way to a financial revolution that would channel English savings into everything from canals to railways, commerce to colonisation, ironworks to textile mills. Though the national debt grew enormously in the course of England’s many wars with France and others, reaching a peak of more than 260 per cent of GDP in the decade after 1815, this leverage earned a handsome return, because on the other side of the balance sheet, acquired largely with a debt-financed navy, was a global empire. Moreover, in the century after Waterloo, the debt was successfully reduced with a combination of sustained growth and primary budget surpluses. There was no default. There was no inflation. And Britannia bestrode the globe. 

Fast forward to today and he identifies:

The heart of the matter is the way public debt allows the current generation of voters to live at the expense of those as yet too young to vote or as yet unborn. 
But the official debts in the form of bonds do not include the often far larger unfunded liabilities of welfare schemes like – to give the biggest American programs – Medicare, Medicaid and Social Security. The most recent estimate for the difference between the net present value of federal government liabilities and the net present value of future federal revenues is $200 trillion - nearly thirteen times the debt as stated by the U.S. Treasury. Notice that these figures, too, are incomplete, since they omit the unfunded liabilities of state and local governments, which are estimated to be around $38 trillion. 

Ferguson opines that the biggest challenge facing mature democracies is how to restore the social contract between the generations and that there are three possible solutions:

1. The proponents of reform succeed, through a heroic effort of leadership, in persuading not only the young but also a significant proportion of their parents and grandparents to vote for a more responsible fiscal policy
2. Public sector balance sheets can - and should be - drawn up so that the liabilities of governments can be compared with their assets. That would help clarify the difference between deficits to finance investment and deficits to finance current consumption. Governments should also follow the lead of business and adopt the Generally Accepted Accounting Principles. And, above all, generational accounts should be prepared on a regular basis to make absolutely clear the inter-generational implications of current policy; or
3. The debt continues to mount up. But deflationary fears, central bank bond purchases and flight to safety from the rest of the world keeps government borrowing costs down at unprecedented lows. The trouble with this scenario is that it also implies low to zero growth over decades: a new version of Adam Smith’s stationary state - only now it is the West that is stationary.

He finishes with an interesting reflection (in an answer to a question from the audience): 

Debt is just a symptom of a chronic inability to take difficult decisions in the present when it is so much easier to pass the cheque to a future generation that isn’t represented. 

The laws of nations must be upheld in the face of financial crimes whatever the extent or cost.  Further, the economic benefits of doing so will be positive.

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.

Australia's Debt Position - the whole picture

Household Debt

Daily in the mainstream media we are told "Australia's debt is very low by international standards".  In terms of government/sovereign debt, this is undoubtedly true and this is extremely important.

However, add in household debt and that of companies and financial institutions and a different picture emerges.  The following chart, from macromonitors.com using 2011 data tells a very interesting tale:

Leaving aside the corporate debt position, you can clearly see Australia's household debt position relative to the ten largest mature economies of the world is significantly larger.  Yes, our government debt levels are relatively low.  But put the picture together and then Alan Kohler's excellent piece in yesterday's Business Spectator starts to make real sense.

Kohler writes:

 The only thing that makes sense as a single cause of Australia’s misery is excessive debt.He makes the points:-

• Household debt has stayed at its historic highs of around 150% of disposable income for the past five years where other countries' households have deleveraged;
• Interest paid as a percentage of income has doubled in 20 years;
• the cost of land is among the highest in the world (in spite of Australia being so sparsely populated)
• restrictions on residential developments in cities combined with population growth have also contributed to extremely high prices for residential real estate
• reductions in mortgage rates don't counteract the psychological effect of the size of household debt.

So in the current political environment in Australia where "middle class welfare" such as the private health rebate is currently in issue, it makes sense to appreciate the pressure and stress created by these levels of personal indebtedness.

Kohler again:

And now there is widespread terror that house prices will eventually collapse and leave millions with no equity, as happened in the United States. As a result the savings rate has skyrocketed and consumers are on strike, putting money aside for Armageddon.

Debt is making everyone grumpy and hypersensitive. When ANZ put up its mortgage rate by just 6 basis points last week – 0.06 per cent for heaven’s sake! – there was national outrage and attacks in parliament

Our daily diet of gloomy news from Europe and the United States in relation to debt is ringing the warning bells in Australians' minds.  We know we are part of the global economy and there will be fallout for Australia from the current financial calamity unfolding in Greece and other nations of Europe such as Spain, Ireland, Italy and Portugal. We also see from afar the politicians' seeming inability to take bold political decisions and we watch distrustfully the involvement of the hedge funds and bondholders in the process of "voluntary haircuts".

So we need to listen when Kemal Dervis (former Turkish Economics Minister, Administrator of the UN Development Program and vice president of the World Bank, currently Vice President and Director of the Global Economy and Development Program at the Brookings Institution) writes on Project Syndicate:

Beyond the specific problems of the monetary union, there is also a global dimension to Europe’s challenges – the tension, emphasized by authors such as Dani Rodrik, and Jean Michel Severino and Olivier Ray, between national democratic politics and globalization. Trade, communication, and financial linkages have created a degree of interdependence among national economies, which, together with heightened vulnerability to financial-market swings, has restricted national policymakers’ freedom of action everywhere.

Perhaps the most dramatic sign of this tension came when Greece’s then-prime minister, George Papandreou, announced a referendum on the policy package proposed to allow Greece to stay in the eurozone. While one can debate the merits of referenda for decision-making, the heart of the problem was the very notion of holding a national debate for several weeks, given that markets move in hours or minutes. It took less than 24 hours for Papandreou’s proposal to collapse under the pressure of financial markets (and European leaders’ fear of them).

Around the world, the stock of financial assets has become so large, relative to national income flows, that financial-market movements can overwhelm most countries. Even the largest economies are vulnerable, particularly if they are highly dependent on debt finance. If, for some reason, financial markets and/or China’s central bank were suddenly to reject US Treasury bonds, interest rates would soar, sending the American economy into recession.
But being a creditor does not provide strong protection, either. If Americans’ appetite for Chinese exports suddenly collapsed because of a financial panic in the United States, China itself would find itself in serious economic trouble.

These interlinked threats are real, and they require much stronger global economic-policy cooperation. Citizens, however, want to understand what is going on, debate policies, and give their consent to the types of cooperation proposed. Thus, a more supra-national form of politics is needed to re-embed markets in democratic processes, as happened during the course of the twentieth century with national politics and national markets.

The scale of this challenge becomes apparent when one sees how difficult it is to coordinate economic policies even in the European Union, which has moved much further than any other group of countries in the direction of supra-national cooperation. Nonetheless, unless globalization can be slowed down or partly reversed, which is unlikely and undesirable in the long run, the kind of “politics beyond borders” for which Europe is groping will become a global necessity.

Indeed, the European crisis may be providing a mere foretaste of what will likely be the central political debate of the first half of the twenty-first century: how to resolve the tension between global markets and national politics.

EU Creditwatch: S&P - so what?

S&P put Eurozone on credit watch

Stephen Bartholomeusz' summation of the overnight news from Europe is worth reading.  He makes the following points (emphasis is ours):-

1. The reasons cited by S&P for putting 15 of the 17 core eurozone members on negative credit watch, which means they could be downgraded within 90 days, are very familiar to the markets, which had acted pre-emptively as it became apparent that the eurozone authorities were struggling to respond to the escalating crisis.
2. The ratings agency referred to tightening credit conditions across the eurozone. Credit conditions have been tight for months, to the point where European debt markets are effectively shut and bank lending has shrivelled.
3. The continuing disagreements between policymakers about how to tackle the crisis and ensure fiscal convergence in the longer-term has been the central factor in the market’s increasing fear and loathing of all things euro, although at least the agreement between Germany and France overnight provides a pathway towards the longer-term objective, with a mechanism for binding members to fiscal discipline and sanctioning those who stray.
4. The eurozone, as S&P noted, is awash with debt at both the government and household level, a situation compounded by the near-inevitability of a region-wide recession. It is that combination, and the apparent freezing under pressure of eurozone policymakers unable to respond to the complexity of the crisis, that caused the markets to take fright months ago.

The effect of a S&P downgrade?

1. It could...impact intra-eurozone holdings of sovereign debt and the pricing of any new debt issued. There are institutions that can, or will, only hold AAA-rated paper.
2. It may also affect the ability of the European Financial Stability Facility – which the eurozone authorities are hoping to leverage to help bail out and support sovereign debt refinancings – to raise funds itself. It would certainly adversely impact the EFSF’s cost of funds.

In summary:

The pact between Germany and France does provide a blueprint for a different and more effective pan-European fiscal regime in future, but doesn’t address the near-term issues and the need to reassure markets that the authorities have a plan to stabilise Italy and Spain, to re-open credit markets, stabilise the eurozone banking system and maintain some level of economic growth to blunt the severity of the austerity policies being imposed on the more indebted nations.
In the absence of a compact that deals directly with the immediate issues, the crisis will only deepen, destabilising not just the eurozone but the global economy and financial system in the process

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.

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

Economic Outlook - Global Economy - Das' view

www.imf.org

Satyajit Das is a writer with experience in Australian and international financial markets over 30 years. In a 2006 speech called "The Coming Credit Crash" – he argued:

...an informed analysis of the structured credit markets shows that risk is not better spread but more leveraged and (arguably) more concentrated amongst hedge funds and a small group of dealers. This does not improve the overall stability and security of the financial system but exposes it to increased risk of a "crash" during a credit downturn.

1.  European Debt: the risk is that the Greek bailout plan announced on 21 July 2011 can't be implemented due to claims by Finland for collateral leading to others' similar demands and German disaffection that they are not receiving similar collateral. Greece's fall in GDP is too large to successfully make requisite debt repayments: the Greek economy has shrunk by 15% since the start of the crisis. Debt contagion to other European nations remains a real risk and concerns regarding US and Japanese national debts are increasing.
Last week Das wrote "From green to red: is Credit Crunch 2.0 imminent?" which has been reproduced on blogs around the world from The Drum on ABC online to Ritholtz' The Big Picture. He makes four excellent points which we now summarise:

2.  Bank Problems: Global banks are facing serious issues; French and German banks have very large exposures to Greek, Irish, Portuguese, Spanish and Italian debt. Das notes:

If there are defaults, then these banks will need capital, most likely from their sovereigns. As they are increasingly themselves under pressure, their ability to support the banking system is unclear. The pressure is evident in the share prices of French banks; Societe Generale’s share price has fallen by nearly 50% in a relatively short period of time.

This problem is not confined to Europe. Das comments:

Bank of America (“BA”) has recently emerged with analysts suggesting that the bank requires significant infusions of capital. The major concerns relate to BA’s investment in US mortgage originator Countrywide including continuing litigation losses, exposure to European banks, loans to commercial real estate and the quality of other assets, such as mortgage servicing rights and goodwill resulting from its acquisition of Merrill Lynch.

BA claims that its exposure of $17 billion to European sovereigns was hedged. As the world discovered in 2008, it wasn’t whether you were hedged but who you were hedged with and whether they were financially able to perform that was the issue. BA shares have fallen by roughly 40% price over the past month, compared to a 15% decline in the S&P 500. The cost of credit insurance on BA risk has also increased sharply.

BA decision to issue $5 billion in preference shares to Warren Buffett’s Berkshire Hathaway, now confirmed as the market’s lender of last resort, at distressed prices was not a statement of strength but weakness. BA needs more capital in any case and Buffett is betting on both BA and if things go wrong that the US taxpayer will bail him out as they did with his investment in Goldman Sachs.

3.  Money Markets: Banks and financial institutions are finding it increasingly difficult to raise funds. Costs have risen sharply. Spanish and Italian banks have limited access to international commercial funding. Like Greek, Irish and Portuguese banks, they are heavily reliant on funding from local investors and central banks, including the ECB.

4. Deteriorating broader economic environment: It is impossible to state it more succinctly than Das, as follows:

• Reduced exposure: American money market funds, which manage around $1.6 trillion, historically invested around 40-45% ($600-700 billion) with European financial institutions. Over the last few months, the money market funds have reduced their exposure to European entities, especially Spanish and Italian banks. The funds have also decreased the term of their loans to the European entities that they are willing deal with to as little as 7 days at a time, in an effort to limit risk. European banks are having to pay higher interest rates, if they can attract funds. 
• Flow on effect to Australia: Despite limited known direct exposure to European sovereigns and their relatively strong financial positions, Australian banks’ credit costs in international money markets have increased by more than 1.00% in less than 3 months. As a result, non-financial institutions are finding finance less readily available and more expensive. Anecdotal evidence suggest that businesses are having difficulty financing normal commercial transactions, recalling the credit problems of late 2008/ early 2009.
• Strong economies showing signs of slowing: Germany and emerging market economies, like China and India, which have contributed the bulk of global growth since 2008, are showing signs of slowing. The effects of the excessive credit expansion in China and India are showing up in bank bad debts. 
• Feedback Loops: Tighter money market conditions feed into lower growth, increasing the problems of government finances. Falling tax revenues and rising expenditures push up budget deficits, requiring greater borrowing. Lower growth feeds into greater business failures that increase bank bad debts, feeding further tightening in lending conditions and the cost of finance. 

The rapid and marked deterioration in economic and financial conditions means that the risk of a serious disruption is now significant.

Government policy options are severely restricted. Government support is restricted because of excessive debt levels and the reluctance of investors to finance indebted sovereigns. Interest rates in most developed countries are low or zero, restricting the ability to stimulate the economy by cutting borrowing cost. Unconventional monetary strategies – namely printing money or quantitative easing – have been tried with limited success. Further doses, while eagerly anticipated by market participants, may not be effective.

The outlook according to Das is decidedly bearish - if not verging on apocalyptic! However, his world view is firmly based on the interconnectedness of markets, about which we in Australia must forever be mindful. There are those who say "as long as China is ok, then so are we", but our opinion is that the economic situations in both the USA and Europe are of primary significance to China as they represent China’s major export markets and consequently the global picture must be borne in mind by us all, wherever we may be.

"Living Wills" for Banks

APRA calls for Big 4 Banks to provide "living wills'

The ABC yesterday broke this story view here.  To deal with the notion of "too big to fail", the banks are being asked to give the regulator their plans in the event of another global financial crisis so as to minimise systemic risk; part of a global regulatory process reviewing capital requirements.

The US Fed TARP props "Toxic Cocktail" of "Too Big to Fail"

An excellent article by Simon Johnson professor at MITs Sloan School of Management, has been plublished today on Bloomberg.

Johnson restates the view that "the very effectiveness of US Treasury actions and statements in late 2008 and early 2009 had undeniable side effects, by effectively guaranteeing these institutions against failure, they encouraged future high-risk behaviour by insulating the risk-takers who had profited so greatly in the run-up to the crisis from the cosequences of failure.  And this encouragement isn't abstract or hard to quantify. It gives an unwarranted competitive advantage, in the form of enhanced credit ratings and access to cheaper capital and credit, to institutions percieved by the market as having an implicit Government guarantee."

The most interesting point of this article is that the Dodd-Frank financial-reform legislation was supposed to end too big to fail in some meaningful sense. But what has changed?   Johnson says:

"at the end of the third quarter of 2010, by my calculation, the assets of our largest six bank holding companies were valued at about 64% of gross domestic product - compared with about 56% before the crisis and about 15% in 1995."

"Our largest banks are now bigger, in dollar terms, relative to the financial system, and relative to the economy, than they were before 2008. So how does that make it easier to let them fail?"

For the full article click on this link: http://www.bloomberg.com/news/2011-01-27/banking-toxic-cocktail-is-too-big-to-forget-commentary-by-simon-johnson.html