Archive for the 'finance' Category

consequences of a euro break-up (ubs analysis)

September 6, 2011

UBS economists published today a research piece on a possible breakup of the Eurozone. They contrast feasible solutions like Greece leaving the currency union or Germany doing the same. They also explain why other alternatives (like expelling Greece) are not feasible.

They estimate that Greece leaving the Euro will incur a one-off cost of about EUR10,000 per person during the first year, and about EUR4,000 each year after that. There are obviously severe social costs that cannot be monetized. The one-off figure for the Germans (should they choose to leave instead) is somewhat lower at about EUR8,000.

Contrast that to the cost of bailing out Greece, Portugal and Ireland simultaneously, which is about EUR1,000 for each German taxpayer. It seems clear that the only viable solution at this stage is a default within the Eurozone, even though this could eventually take us to the same point in a few years’ time.

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EUR60bn currency shield

September 6, 2011

The crisis in the Eurozone seems to be dragging on and on. The loosers have their heads on the chopping board, but are there any winners? On one hand the slump in Greece is perhaps going to continue for the foreseeable future, while Germany is posting record exports (in the second quarter of 2011) and is set to easily beat the staggering EUR1tr once more this year.

As the Independent shows, Germany’s main trading partners are in the Eurozone, therefore it would not make sense for Germany to initiate the breakup of the common currency. As one can easily see in the chart below, three-quarters of all German exports go to countries within the EU. The article goes even further, blaming Angela Merkel for not making clear to the German people what the benefits are. Could one make the case that this continuing fiasco is actually benefiting the German economy, and that Merkal’s objective should be to keep the circus going?

Breakdown of German exports

In the same chart, one can also notice that this mix seems to be changing: as the crisis intensified in 2010 the share of German exports outside the Eurozone steadily rises and a spike is forming. Overall, there seems to be a relative shift of about 5%. Now one can argue that this is due to the falling demand within Europe, and this can be correct. But other things equal, such an export surge would cause the currency to appreciate, making exports more expensive abroad, negatively affecting demand, and finally bringing back the revenues (as a footnote, the caveat here is the Marshall-Lerner condition). Obviously this currency appreciation has not happened, as the future of the currency itself remains uncertain.

Which brings us to the question: has Germany benefited from the uncertainty surrounding the future of the Euro? and if yes, to what extend? This is not easy to answer, as we do not have access to an alternative universe where the Euro experiment never took place. Peter Brandt uses the Swiss Franc as a proxy of what a Deutschemark would look like, and we take this approach a step further.

Fortunately, European currencies have been moving in step with respect to USD for a while now. We take exchange rates of the old Deutschemark (DEM) and other non-Eurozone currencies from 1971-2000 (British GBP, Swiss CHF, Swedish SEK and Norwegian NOK). Out of these, a regression analysis (in logs) shows the the DEM can be approximated rather well by a mixture of CHF and GBP. We then apply this mixture and impute a fitted DEM exchange for the period after 2000. The results are shown below, with some emphasis on the recent period after the crisis begun.

German exchange rate

German exchange rate (detail)

The fitted DEM explains rather well the movements of the DEM pre-Euro, and of the Euro afterwards, up to the crisis. After that point the two series deviate substantially: the Euro appears weaker by about 10% during 2010, and has weaken even further to over 25% by mid-2011. A freely-floating DEM should have been 25% more expensive in terms of USD, and obviously for a net-exporter like Germany this can have very significant implications.

A back-of-the-envelope calculation goes as follows: Germany exported EUR990bn worth of goods in 2010, and is expected to reach EUR1,150bn in 2011 (EUR550bn was achieved in the first half). We can assume that 25% of these exports went out of the Eurozone, and therefore benefited from the weaker Euro. The size of the benefit depends on the so called ‘export elasticity’, which the EU estimates to be around 0.60 (this means that every 1% depreciation will cause a 0.60% rise in exports). Putting all these together we can estimate that in 2010 the benefit of the crisis for Germany was EUR15bn, which rose to about EUR45bn in 2011. In total, the benefit that the German economy extracted from the ongoing lack of direction amounts to EUR60bn, and keeps rising fast. Perhaps the Greeks should factor this out in their negotiations with the EU, as they are the ones providing this EUR60bn currency shield.

This German advantage cannot continue in perpetuity, and the currency wars are on. Today the Swiss central bank (SNB) have decided to weaken the Swiss franc by pledging to buy foreign currencies at ‘unlimited quantities’. It is perhaps a matter of time for the rest of the advanced economies to step in and restore a more level playing field.

argentine illusions

August 24, 2011

The Greek stock market (the Athens Stock Exchange, or Ase) has now reached a 15-year low at 900 points, as the country marches towards formal default. For some time now, a number of commentators, politicians and various forum dwellers have started making comparisons with late 2001 Argentina. The general line is that the Buenos Aires (Merval) index was 200 points when the country defaulted, and reached 500 points within three months. This offered the patient (or intrepid) investor a 150% return before you could say ‘I-am-broke’.

This is an argument to support one of the following: either “if you happen to be in the stock market, and feel possibly creamed at the moment, don’t panic and make the mistake to sell”, or “if you are not holding stock this is the best time to get a bit adventourous and go long; after all, how much lower can the stocks go from here?”.

Both messages, if taken at face value, would contribute to slowing down the rapid market decline. I can see that trying to prop up a collapsing stock market or forecasting happy days in the near future serves the punters’ own agendas, but they are misleading the public.

Since many middle class Greek families are “entrapped” in the falling market, pundits aligning with the ruling Pasok party are quick to claim that there is hope for a quick rebound. Supporters of the opposition, after placing the blame on the current governments amateur approach to the problem, want to put themselves in a position to reap any potential future benefits. A significant number of (probably badly burnt) investors roam unregulated investment fora spreading the same lines, presumably believing that they are looking after their own interests.

But notwithstanding ones intentions, they are blatantly wrong. Greece might be similar to Argentina, but only to the extent that they both found themselves committed to an exchange rate peg that they find hard to support. Pundits are confusing real and nominal returns, or returns denominated in hard or soft currencies. And while small investors might argue that they were ignorant, politicians and commentators should know better.

Merval, Merval$ and the Ase

Merval (in ARS), Merval$ (in USD) and Ase (in EUR) indexes

In the chart above I put forward the Merval index from 2000 to 2005 (in blue). I rebase the index to 100 in November 2001, which is when the final leg of the crisis begun to unfold. This makes it easier to assess the performance as we approach or move away from the crisis. Merval is denominated in Argentinian Pesos (ARS), the local currency. I also chart the Merval$ (in red), which is the same index denominated in USD and rebased at the same point. Before the end of 2001 there a one-to-one fixed exchange rate between the ARS and the USD; for that reason the two charts overlap in the former part of the chart. This peg broke in November 2001, and the ARS rapidly lost three quarters of its value in the next few months; therefore, following the default, the Merval index produced divergent nominal returns for investors in ARS or USD.

It is true that the Merval rebounded in nominal terms, and more than doubled after the country defaulted and the peg to the USD was broken. But investors received cashflows in a worthless currency that was had lost 75% of its purchasing power; the 150% increase is irrelevant. Denominated in USD, the Merval index has a different story to tell: even after Argentina formally defaulted, the market carried on sliding at the same pace, and bottomed out after it had lost another 50% within the next six months. It then took a further year to return to the level it was when the currency peg was broken.

But how does that relate to Greece? I also collected nearly two years’ worth of the Ase index, and rebased them to the same point (as if we are sitting in November 2001) to make some comparisons. For a start, the decline in the two markets looks surprisingly similar, given that they are ten years apart: both have lost two-thirds of their value over the same length of time. For all practical purposes Greece is essentially pegged to the Euro, in the same way Argentina was up to the breaking point. The decision to be made (by Merkozy perhaps?) is whether this peg is to be maintained.

The Argentinian experience suggests a path for both eventualities: Staying within the Eurozone implies that the Ase investor is still a Euro investor, and the USD-based index indicates a further drop by 50% before recovery begins. This means that one should brace themselves for a ride down to 500 points. Leaving Euro for a New Drachma (or some dual currency setup) can cause the index to rebound, if it is denominated in this new heavily devaluated currency. Then the gains are illusional, as the ARS-based index gains were.

Obviously things are much more complex in practice, and the path of Argentina is not going to be followed exactly by every country that defaults. One should hope so, given that Argentina experienced a 10% contraction during 2002 (the year after default was declared), inflation which topped at more than 10% per month, and more than 50% of the population below the poverty line. Argentina only recently re-entered the capital markets; the abundance of agricultural commodities she produces and rising commodity prices kept her at a surplus through the years following default. This was a relief that Greece does not seem to possess. But it gives an indication of where things can go from here, and a message to the punters to keep their mouth shut.

floating shorts

January 26, 2010

The markets have pounded Greece heavily last week, both in the equity and the debt front. There is widespread concern on the ability and comittment of the new government to service the country’s debt. Social unrest is evident. Greece also stands acused that, for years, statistics produced by her agencies were flawed at least.

Unlike statistics that are subject to interpretation, creative public accounting or outright reporting fraud, I take a look at the debt Greece issued over the last few years. These amounts are unambiguous, and any patterns that change over the years can give useful insights. To this end, I collected all information on Greek bonds and bills that Bloomberg records from 1993. As debt before 2001 was issued in old dracmae as well as an assortment of different currencies (ranging from pessetas to yen), I focus on the data after 2001. I expect Bloomberg to keep a representative, if not complete, sample.

Hopefully the data can shed some light on any policy changes that relate to the structure of debt. Also, the historical issues can serve as a yardstick to assess the magnitude of new bond or bill issues. One of the key years is 2004: this is the year of the overly expensive Olympic games, and also the year when the “socialist-technocrat” government of Costas Simitis was ousted, with a “conservative-liberal” government of Konstantinos Karamanlis taking their place in power.

In the attached tables you can find 105 short term Bills issues and 88 longer term bond issues. Number 23 in this list is the infamous structured bond that was in the center of the scandal that rocked the country, involving hedge funds, Greek state-run pension funds and JP Morgan.

The table below gives my summary, year-by-year:


YEAR
OF ISSUE
T-BILLS
ISSUED
(MIL EUR)
BONDS
ISSUED
(MIL EUR)
BOND
MATURITY
(YEARS)
PERCENT
FLOATING
2009 14,560 60,589 7.25 18.30%
2008 1,788 35,736 6.66 15.67%
2007 1,364 46,527 18.50 0.60%
2006 1,804 24,562 7.11 11.11%
2005 2,072 40,416 13.40 14.56%
2004 2,273 32,526 7.81 13.37%
2003 1,702 33,004 9.94 1.00%
2002 1,471 31,713 10.36 2.21%
2001 1,178 10,041 8.21 4.86%

Treasury Bills are issued many times in a year, offer no coupons, and have maturities of 13 weeks (~3 months), 26 weeks (~6 months) or 52 weeks (~1 year). Bonds offer coupons payable every six months that can be fixed or floating, and have maturities that range from 2 to 50 years.

One immediate observation is the spike of T-Bills issued in 2009, which is an order of magnitude larger than the typical amount of the previous decade. Presumably this is an attempt to accommodate the appetite of the lenders (or lack of it) to long-term commitments. It also indicates severe cashflow or liquidity problems on the part of the borrower (in the same way one goes to loan sharks for a few weeks until the benefits’ check comes through). And this trend looks likely to continue, if January auctions are an indication (EUR1.6bn and EUR1.2bn borrowed this January, compared to a total of EUR2.55bn last year).

Longer term borrowing has also increased substantially, standing now at about six times what is was 10 years ago, and two times the 2004 levels. But there are some details here worth mentioning: up to 2004, nearly all debt had maturity up to ten years, with the exception of only EUR18bn issued for longer maturities. After 2004, there appears to be an attempt to spread the debt across maturities, a policy that ended abruptly in late 2008. From this point on, most of the debt is very short, with the typical maturity being 5 years. And the new bonds issued this month will also have a 5 year maturity. Investors don’t seem to like putting their money on Greece for the long run.

Another interesting policy shift that happened in 2004 was an increase of floating debt. Up to this point practically all bonds offered fixed coupons, while at the moment about 20% pay interest which is linked to an external index, like the Euribor or some other combination of interest rates. A notable exception is 2007, which follows the scandal of the structured bond (yes, I know that correlation does not mean causation…) The last issue of 2009 pays 2.5% above Euribor; the new EUR8bn 5-year January issue will pay a premium of an extra 3.5% (for comparison, in January 2009 Greece borrowed EUR12.5bn, at 5.50% fixed coupon rate). This means that any interest rate rises in the next years will be increasingly painful for the Greek government, since interest payments for these new bonds will also increase.

These observations indicate investors that are only prepared to lend short-term, demand substantial premiums to do so, and do not want to bear any risk of future interest rate moves. These inverstors are nervous, and nervous investors can pull their money from the table if the going gets tough. Had Greece been able to borrow long-term and at fixed rates, she would not have to worry about investors getting itchy and pulling their money.

And all this matters. The Greek government keeps repeating that it is “they” and not “the markets” that determine their policy, but reality is different. As the figure above shows (borrowed from this FT article), Greece is heavily dependent on foreign investors, as they are holding about 30% of issued debt. As Greece takes her place as a central node in a potential systemic crisis, the probability of foreign banks that try to get out first increases. And this is an event that sets the domino off. The Greek government is desperately trying to front-run this eventuality, trying to expand the debtors’ base by promising bonds in USD and JPY.

The finger will remain on the trigger until investors decide to move away from short term government debt into long term fixed-rate issues. Only then will Greece have the space needed to produce a meaningful strategy that will put her house in order. It is chicken and egg once again…

always in your debt

December 24, 2009

This is how the Greek debt looks like for the next thirty years. EUR349bn is due, of which EUR95bn (or 27%) is interest and the remaining EUR254bn is the face value.

Distribution of the Greek national debt. Principal and interest in million euros. Source: Bloomberg, Dec09

Greece would typically issue 5- and 10-year bonds. As an example, the notional due in 2012 (approx EUR30bn) would consist of 5-year bonds issued in 2007 and 10-year bonds issued in 2002 (perhaps EUR15bn each). There are also some smaller notional from longer issues, but the bulk of the debt expires before 2019 (the weighted maturity is actually 2017 or thereabouts). This means that in 2010 the government can issue bonds that expire in 2015 and 2020, say EUR15bn each. Then, the notional for 2015 will increase to something around EUR28bn, and a new notional of EUR15bn will be added for 2020. There is a suspiciously large peak in 2019, but I did not have time to investigate its origin. I will collect some more information on each issue and come back with the breakdown.

The bonds Greece issues have typically fixed coupons, that is to say they pay fixed interest. Only a very small number of the issues in the chart pay floating or variable coupons, meaning that the whole current debate on interest rates is irrelevant to Greece’s current exposure. But they will affect the forthcoming issues, as investors will demand higher coupon rates in order to lend to the Greeks. Also, given that Greece might need to borrow money just to pay off the interest of previously issues bonds, there will be a refinancing cost as new coupons will be added. The new orange bars will be a bit larger than they would have been if debt was issued three months ago, and since Greece borrows at fixed rates they will remain higher for the duration of the debt.

Interest rates are close to historic lows, so even with this extra premium the actual amount will not be that different from what it was before: the new orange bars will not be a lot bigger than the existing ones in the chart. It is more of an opportunity missed: other EU countries will take advantage of the low rates to either improve their balance sheets or spend their way out of recession, Greece can do neither. The recession will bite harder, as there will be insufficient fiscal stimulus given the higher cost of money. Moreover, Greece is missing all infrastructure improvements that take place elsewhere in the name of fiscal stimulus. And when interest rates finally pick up, Greece will find herself in the back seat: she did not invest when money was cheap, but still has the same debt burden as if she did.

So who are the immoral bankers that pile up Greek debt, taking advantage of the high spreads that has driven the whole country in despair? Hugh Edwards brings forward some analysis by Goldman Sachs on Greek banks making extensive use of the ECB liquidity facility (which allows institutions to draw funds from the ECB using rated bonds or ABS structures as collateral). This facility was put in place in order to provide liquidity to the holders of highly rated but ‘misunderstood’ securities, and certainly not to provide cheap funding for speculative activities. For some reason Greek banks are always there asking for more, even though they do not appear to be liquidity drained under any measure. In fact, it appears that Greek banks have overdone that to the point where the Central Bank of Greece had to tell them off (presumably under instructions from a pissed off ECB). What do Greek banks do with all that money?

[…] the current spreads on Greek government bonds […] offer Greek banks an exceptional arbitrage opportunity, since by taking advantage of the uniform ECB liquidity rate Greek banks can buy higher Greek government bonds with a much higher yield than the government bonds which their French or German counterparts buy. Regardless of the risk implied through by the Greek CDS spread, Greek government bonds carry a zero risk weighting when calculating riskweighted assets for capital purposes. So for Greek banks this arbitrage carries no capital impact whatsoever. That is to say the Greek banks have been doing very nicely indeed out of the Greek sovereign embarassment, than you very much. Hence it is not difficult to understand the ECB’s growing sense of outrage with the situation.

This means that essentially ECB money is given to Greek banks at very low interest rates, under a scheme designed to help banks that are genuinely in distress. Greek banks use these funds to buy Greek government bonds, which offer a substantially higher rate of return. As far as ECB rules are concerned, these are risk free bonds and Greek banks are not penalized for holding vast amounts of them. The end result is that Greece ends up paying through the nose for funding that comes from the ECB printers via a Greek bank, and Greek banks make huge profits for just taking advantage of a loophole in the rules. One might say that Greek banks are taking on sovereign risk (at the end of the day there is a non-zero probability that Greece will default), but the fates of the Greek state and large Greek banks are so highly intelinked, that a Greek default will wipe them out anyway.

Surely, Greek banks must feel embarassed of employing a regulatory arbitrage scheme that many in Europe see as immoral, especially when the purpetrators are state-owned institutions. Enter Apostolos Tamvakakis, the newly appointed (by the newly elected government) CEO of the National Bank of Greece, the country’s biggest banking institution. Even befor Moody’s decided to let Greece go with a slap on the wrist, he made the bank’s intentions clear:

A downgrade by Moody’s would not affect our decision to fund the Greek state

Enough said.

the case for transparent taxation

December 19, 2009

Imagine a corporation that is not required to share financial information with its own shareholders. Imagine that there is no independent external auditing in place to verify the claims of employees, ensure good financial governance and protect shareholder value. Such an organisation will be soon plagued with problems: even if the CEO has the best intentions, without external scrutiny, pockets of corruption will soon form and grow. At some points these pockets will cross and a network will be formed, indicating the point of no-return: each corrupt cell will cooperate with other corrupt cells, offering support and protection. Changing the CEO is now irrelevant; the shareholders must take their role as owners, step in and clean up the mess.

Such an organisation exists, and it is called the Hellenic Republic: the financial information concerns tax receipts, and the shareholders are the citizens, the ones who own the country and are the beneficiaries of this tax. At the moment, rampant tax evasion means that large amounts never find their way to the government coffers where they belong, while widespread corruption inflates expenses and directs assets into the hands of the few that have ‘a special relationship’ with the system.

A casual investigation of Greek internet posts, discussions and blogs reveals strong feelings and confusion: Civil servants blame the self employed enterpreneuers for not declaring their full income, paying little tax and drawing benefits; the self employed claim in return that civil servants are corrupt, produce next to nothing, and provide no tangible return for their tax-funded salaries; while White collar workers blame both, as they are forced to work long hours in the private sector for a fully taxed salary. Everyone blames the politicians for indecision or for dipping their hands in the honey pot too, but no one offers hard data or evidence, largely because such evidence is not accessible. Everything is based on conjectures and rumors, but still fuels resentment, finger pointing and anger. It is not a healthy state of affairs, creating frictions between different strata of the social fabric.

The newly elected government seems to be willing to use new technologies to remove some of the archaic layers of opaqueness, having promised to publish online key committee minutes, hiring decisions and some payroll data for senior civil servants. This is certainly a step in the right direction, but it is not going far enough. It adressess to some extent the mismanagement of cash outflows, but does not touch the bigger problem of tax inflows. The new measures just implement something that is common state practice in other Western Countries for years, nothing radical or impressive. Coupled with a barrage of new taxes, it has left the holders of Greek debt unconvinced that these measures are sufficient to halt the downward spiral of the economy. Anyway, what is the added value of imposing new taxes in a country that cannot collect the taxes already due?

And the Greek government needs a radical, decisive, headline-grabbing initiative to convince. They must attack the tax evasion problem head on, by publishing online all income tax statements and receipts every year, starting from 2010. Every citizen will be able to go online and check the declared income and contribution of any tax payer. There are compelling reasons for doing that:

1. It is feasible, cheap and easy to implement. The relevant government departments already have this information in digital form. All needed is a front end that can be set up in a matter of days with minimal cost. A lot more cost-effective than the alternatives.

2. It has been tested elsewhere. Nordic countries have implemented similar methods successfully for years, and they should know: they have some of the highest tax rates in the world, and manage to collect them efficiently. There you can access this information digitally or even by sending an SMS. If they solved the problems associated with the privacy of financial data, why can’t the Greeks? The new government certainly has a very comfortable majority to pass any law required to achive that.

3. It is fair and transparent. Tax contributions belong to everyone, and everyone has the right to know what their fellow citizens contribute (or not contribute). By publishing everyone’s receipts, no one is pointed at, treated unfairly or victimised. And the government shows that they are serious when it comes to transparency and equity, treating all citizens equally and without discrimination.

4. It puts the problem into perspective. Now everyone has data to construct arguments and back up theories; no one can falsely blame dentists, doctors, lawers or plumbers for undercontributing. The true magnitude of the issue becomes real to everyone, when her own contribution is compared to the ones made by her peers. It brings home the notion that tax evasion is theft from schools, hospitals and the classes that need support.

5. It allows everyone to spot the discrepancies between declared and apparent wealth. At the moment the scale of tax evasion for certain classes is the stuff of rumors, and there are doubts on the contributions of individuals that have a lavish lifestyle with villas, yachts and frequent appearences in magazines. But nobody knows for sure what the real situation is.

6. Fear and shame are strong deterrants. Fear, because when everything is in the open it is easy to report obvious cases. Shame, because no one will want to be the odd one out that sticks below the bottom: it will be bad for business if you are known as the dentist that declares substantially less than his peers in town. Not before long, websites will be offering aggregated information, and I am sure that many Greeks would prefer to hire a plumber with an decent looking tax record. Such an initiative can create a race to the top, increasing dramatically the tax receipts.

The Greek government must make decisions that enhance transparency in the ways the country is run. There is an opportunity to take back the initiative, and show financial markets that the Greeks mean business. They can also illustrate that they are not afraid of bold statements or using novel ways to tackle age long problems.

will higher tax rates bring more money?

December 16, 2009

This week the Greek prime minister produced an array of measures to cut the deficit over the next year or so. Most of them amount to either direct tax increases (a progressive tax rate with a maximum up to 50%, a tax or millage levy on large properties, the re-introduction of inheritance tax, 90% tax on bank bonuses) or indirect taxation (freeze of civil servant salaries beyond a EUR2,000 threshold, no bonuses in government run organisations). The question is of course whether or not these measures will bring more money in the depleted state coffers.

What is the evidence? Kurt Hauser in 1993 observed that “no matter what the tax rate has been, the post-war tax revenues in America have been stable and around 19.5%”. This observation became known as “Hauser’s law”. Taxation is not ‘static’, as economic agents will have an increasing incentive to use accounting techniques to shift or hide their tax exposure. In addition, increasing tax rates will have an adverse impact on the GDP and thus increasing taxes will reduce the actual Euro amount that comes in the government coffers.

This article in the WSJ revived Hauser’s law in 2008, and the 15 years of new data also confirm its validity.

Tax receipts and rate

Greek tax receipts (blue) and the tax rate (red). Dotted line for projected values. Source: Eurostat

But what is the evidence for Greece? Unfortunately the statistical data are scarce and not overly reliable, but I managed to dig some information from the EuroStat website from 1995 onwards. The effective tax rate for a family of two full-time working individuals with two children has risen from 18% in 1995 to about 24% in 2000, 25% in 2004 and 27% today. On the other hand the tax receipts as a percentage of GDP have remained without a clear trend at about… errrr 20%.

For that allow me to be sceptical on the effectiveness of these measures.

PS: The data I managed to dig are as follows (P denotes a projection, otherwise known as a wish :–) (a) tax rate 96-08: 17.9, 18.2, 18.5, 17.8, 23.9, 23.7, 24.6, 23.2, 25.5, 26.1, 27.8, 27.6, 27.2; (b) tax receipts 95-04 projected to 07: 19.0, 19.1, 20.0, 21.6, 22.6, 23.5, 22.1, 21.7, 20.0, 19.8, P20.3, P20.3, P20.3

The case for fragile regulation

April 7, 2009

Arnold Kling has a very interesting piece on regulation. Crises are endogenous, as economic agents and market participants learn how to game the system. He argues, that we are facing two alternatives: a system that does not break easily, but when it does it is costly and difficult to fix, or a system that breaks more frequently but is easier and cheaper to repair.

Kling argues that measures taken following crises are pivotal in creating the next one. He draws his examples from the mortgage markets from the Great Depression of the 30s, to the Savings and Loans crisis of the 80s, to today’s securitization dead end.

After the Depression it was acknowledged that mortgages with balloon payments are too sensitive to credit shortages. Balloon mortgages have a short term, say 5 years, but the monthly payments are similar to a long term mortgage, say 30 years. This means that in the end of the 5 year period there will be a substantial part of the capital still in place (the balloon), which has to be refinanced. If there is a credit crisis, refinancing might not be an option, leading to foreclosures. To this end long term fixed rate mortgages and adjustable rate mortgages (where refinancing is essentially mandatory) were subsequently encouraged. Such mortgages were given by Savings and Loan associations in the US, or Building Societies in the UK. Fannie Mae was established to promote and guarantee mortgages to families with lower income.

But this shifts the maturity mismatch from the mortgagor (borrower) to the mortgagee (lender). They would borrow short (from their depositors) and lend long in the form of mortgages. In the high inflation and interest rate period of the 70s and 80s, they would receive low cashflows from past mortgages, while at the same time they had to pay higher interest rates to their depositors in order to cling on their deposits. This eventually led to the crisis, where it was made clear that such maturity mismatches were also unsustainable. What emerged from the crisis was securitization, as a means of offloading the long component of their assets. In an ideal world, institutions that had long term liabilities (like insurance companies) would be the buyers of these long term assets.

Unfortunately, it didn’t work as intended with the current crisis being a direct result. Rather than insurance companies, it was investment banks and hedge funds that were left with mortgage backed assets. Also, the originating mortgage providers lost the incentive to monitor the quality of the mortgages they were granting.

The bottom line is that regulation, albeit well meaning, cannot be all encompassing and accommodating. Market participants will eventually work their way around, and there will be unforeseen consequences. It would be better then to have a fast moving framework that keeps the spirit rather than putting rigid constraints.

This is al good in paper of course, but how would such a flexible regulatory framework look like? What capacities should regulatory bodies have to make sure that the system does not descend into chaos? In a world run by politicians that want to cover their bases, the easy option is to talk big and construct a rigid international financial system. Which will probably take us back to the 1930s.

They told us that they told them to lend

April 1, 2009

James Hamilton in a brilliant post discusses the recent expansion of the monetary base.

As it stands, the Fed has bought an array of securities from the banks, of a varying degree of toxicity. They did not go to the bank headquarters with a truckload of money, they, sort of, wrote a check or an IOU.

Every bank is required to keep some reserves with the central bank. In that way they force banks to keep some of their assets in cash form, thereby reducing the risk of banks over-leveraging themselves (or at least that was the principle). In order to buy these dodgy assets, the Fed did not actually pay for them, they just extended the reserves of the corresponding banks, without the banks putting any money themselves.

To make things more concrete, say that Pitibank is required to keep USD50 with the Fed as reserve. Also, say that the Fed decided to buy from them a bunch of mortgages (of face value USD300), but which they agree to buy at USD200. These are “toxic” because if the bank sold them in the market, then at the moment they cannot find a buyer that will pay more than USD30.

The Fed gets these mortgages from Pitibank, and instead of paying in cash, they just increase Pitibank’s reserve to USD250. It is essentially the same thing, since Pitibank can draw from these reserves if they want to (down to the requirement of USD50). The Fed will then essentially “print” money to give Pitibank when asked.

What politicians are telling us, is that they want banks to start lending again. This essentially means that they want Pitibank to ask for these reserves and lend the money to individuals, small businesses and each other.

But banks don’t appear to be doing that. They prefer to let the money in their reserves with the Fed. Why do they do that? Are they keeping good money idle? Well not really, because the Fed has decided to actually pay interest on these reserves. This increases the opportunity cost of lending the money to you and me, and acts as a dis-incentive for Pitibank.

Does that make sense? Well, no matter what the politicians are saying, central banks are having nightmares of all that money reaching the consumers and sparking inflation. As J Hamilton points out, doubling the monetary base will eventually translate into 100% inflation: all prices will double.

It seems to me that with that interest rate on the reserves, the Fed is trying to control how fast this huge amount of money reaches the real economy. And they don’t seem to be very keen for this to happen.

as if it wasn’t bad enough

March 31, 2009

The Rapture Index is picking up. It is now well above 160 points, after dropping below 150 during the George W Bush years.

The Rapture Index

The Rapture Index

This index is measuring the distance to the end of the world. It is like a Dow Jones average of indicators that point towards the Antichrist. As the index breakdown illustrates, the Middle East crisis together with the financial unrest take us one step closer to the end of times. Electing Obama does not help neither. On the other hand, the low interest rates that we experience and the election of Sarkozy contribute to a partial offset.

In the extremely informative FAQs we find that the Antichrist will most probably come from the European Union, and will arguably be homosexual. A real beast I say!

It is also reassuring to find out that the esteemed IMF are using the rapture index in their quest to uncover the determinants of house prices in the US.

Lovely…