
- J.M. Keynes

Wednesday, 30 May 2012

Monetisation: The last arrow in the quiver

As politicians squabble on whether to grow more austere or promote growth austerely, the Eurozone is fast reaching the point of no return. Unproductive summits and proclamations of well being are only adding to the general sense of bemusement. At this point, the Eurozone is well past the stage of ‘moral suasion’ where officials can make the market believe that they will resolve all problems satisfactorily. Fiscal union, structural reform and Eurobonds which are being bandied about as solutions can only be achieved in the long-term, if at all.

The current situation resembles a bank run. Capital is fleeing Europe as foreigners and funds scale back their exposure. While this is a symptom of a more serious malaise that ails Europe, it has to be arrested to ensure that the patient lives. Effective treatment of the malaise through reform requires time which is only available if the system survives. In moments of panic, tactics dictate that a lender of last resort must step in to provide succour even if it runs contrary to longer term strategy. National governments along with the ECB performed this function during the credit crisis when they supported the banking system. The design flaw of a monetary union without a fiscal union meant that governments were ill-equipped to perform the role of lender of last resort. Unsurprisingly they now find themselves embroiled in the crisis and sinking fast. At this juncture, and much to its distaste, the ECB is the only lender of last resort available.

The ECB has been cognisant of its duty and has intervened at various stages to stem panic through MROs, SMP, LTROs etc. However it has been a hesitant lender of last resort out of respect for the principles of its father, Deutsche Bundesbank. This hesitation has been justified to some degree by the reluctance of peripheral economies to undertake painful reform as soon as market pressure is lifted. Time bought by the ECB has been squandered by European politicians in meaningless summits, backtracking and poor policy decisions.

However, all this is water under the bridge. Given massive loss of confidence and preparations for a Greek exit, the critical question that European officials and politicians need to answer is whether they want the union or not. At this point, it has become a simple yes and no answer without ifs and buts. Conditionality and reform has to happen later after assuring survival. Assuming that the answer is yes, the ECB has to step in and uninhibitedly perform its duty as lender of last resort.

This only means one thing – explicit monetisation. The reasons for this are threefold. 

First, investor distrust of peripheral sovereign debt has increased new debt servicing costs to such a great extent that it risks pushing otherwise solvent nations into insolvency. Higher interest rates also impact growth through both fiscal and monetary channels. On the fiscal side, to achieve the same deficit target governments have to cut spending by more. On the monetary side, increased interest rates on household and corporate credit increase debt servicing costs and curtail credit growth. These classic debt-deflationary conditions are in evidence across the periphery. Unless arrested, economic depression and social unrest will soon to follow as is happening in Greece. Although structural and fiscal reform will work, they will only do so over the medium to long-term. The immediate need is to artificially lower interest costs facing the periphery and assure their continued access to the market.

The second reason for monetisation is to support the banking system. There is a collateral constraint on borrowing by banks. Not only is quality collateral in extremely short supply but European banks have already pledged most of their eligible collateral to borrow. In addition, even though collateral eligibility criteria have been relaxed, they have not been uniformly implemented. Also, the large haircuts on newly eligible collateral further reduce the actual amount that can be borrowed by banks. As deposits leave and markets refuse to roll over funding, banks may soon exhaust their collateral and insolvency will surely follow.

The third reason why explicit monetisation is required is because implicit monetisation through ELA (Emergency Liquidity Assistance) has failed. ELA by national central banks has proved counterproductive. Accepting dodgy collateral to provide cash has increased investor distrust in the country’s banks and led to capital flight, the very outcome ELA was seeking to prevent. Moreover, ELA causes conflict within the Eurosystem due to the internal difference in monetary policy stance created by it. Central banks which engage in it are viewed suspiciously by others who suspect them of engaging in monetary debauchery.

In view of these three reasons, the ECB needs to embark on a policy of explicit monetisation to prevent economic collapse and dissolution of the union. Rather than buying multiple assets, it should only support European government debt through its purchases. This is because the associated risks are easier to monitor and evaluate. Also, once the panic subsides at the national level, the benefits can be passed through.  However, article 123 of the Lisbon treaty prohibits ECB from buying government debt directly. This can be easily circumvented by tweaking the SMP and buying debt in the secondary market without sterilisation. The strong signal that this action carries should obviate large scale bond buying as long as two conditions are met.

The first condition is that the ECB must emphasize that Greece did not set a precedent regarding de-facto debt seniority. Its bond buying should not subordinate private bondholders. This would make them more likely to hold on to their bonds. The second condition follows from the first. If the ECB is going to take credit risk then it must ensure that governments must not rejoice and increase credit risk by rescuing every Bankia in the country. The governing principle should be: depositors to be protected; insolvent banks to fail. If every country follows Ireland (as Spain seems to be doing) then the monetisation requirement will increase drastically causing a precipitous decline in the value of the Euro and subsequent loss of confidence. The ECB’s task is to ensure that national debt is beyond reproach not that all bank, municipal, city and regional debt will be repaid in full.

The consequences of such an action would be the immediate shutdown in funding of banks, municipalities, cities and regions in peripheral and probably some core countries as well. Investors will flee first and analyse later. Federal support will be required to ensure that the system does not collapse. However, this is not antithetical to the idea above that national governments should not bail out everyone. A certain realistic deficit level can be agreed while monetisation is taking place. This ensures that welfare and essential spending is maintained at a level to prevent economic collapse. It also ensures that fiscal policy is expansionary in an environment where the private sector is contracting. Simultaneously, a resolution and restructuring authority must be created for banks and local governments. The insolvent must be terminated quickly while the solvent should be nurtured until the markets reopen for them. 

ECB monetisation and subsequent policy will still prove to be painful. Moreover it is an extremely difficult course to pursue successfully. The two biggest problems are monetary policy disagreement within the Eurozone and ECB, and the politics of patronage. The former makes it impossible to act quickly and cohesively in a situation which demands the two. The latter ensures that any advantage gained by an initial action is frittered away. Politicians are loath to change the very power structures which brought them to power and provide sinecures to them and their supporters. As soon as the headlines recede, they do a volte-face. The two rounds of bank stress tests in 2010 and 2011 are emblematic of the lack of political will to face up to reality and reform. JK Galbraith put it well when he said that people of privilege will always risk their complete destruction rather than surrender any material part of their advantage.

Given political intransigence, the situation gives little cause for optimism. The Eurozone has only one arrow in its quiver which it is reluctance to use. If it doesn’t fire it now, it may not get another chance.  

Latest fashion trend in the City and Wall Street

Apparently the Chinese are making more money selling T-shirts than investing in Eurozone debt. 

Thursday, 24 May 2012

Eurozone summit: Behind the scenes

You've read the official press that European leaders delay key decisions. This is a gross injustice perpetrated by the Anglo-Saxon press. A key decision was made. It is the decision to meet again. Read the unbiased account of what actually happened (or not) behind the scenes at the summit.

Minutes of the meeting

- There was unanimity that a pleasant dinner should not be ruined by frivolous talk of crisis.
- Leaders congratulated themselves on reaching a unanimous decision (Note to press officer: Use "momentous", "historic" when describing this "solidarity").
- One leader thought the dinner was excellent and they should all do it again sometime soon.
- This proposal was also accepted unanimously (Note to press officer: Talk about how there are many points of agreement with only a few points where "agreement has not been reached").
- Another leader suggested June for the next festive occasion but stated that the expense to the taxpayer would have to be justified under the pretext of planning for closer fiscal co-ordination, european wide deposit guarantee and eurobonds.
- General laughter from North European leaders.
- Orders were issued for someone to write a report (Note to press offier: Replace "someone" with "heads of EU's main institutions").
- There was concern that such an ambitious announcement may lull everyone into a false sense of security.
- It was agreed that Herman Van Rompuy would temper expectations while talking to the press (Note to press officer: Use "Building blocks", "Rome wasn't built in a day", "Work in progress", etc in Van Rompuy's script).
- One leader wished to talk about the developing banking crisis and the possibility of bank runs.
- Clarification was sought whether he was talking about stronger supervision and resolution.
- On answering in the affirmative, he was immediately poured more wine to general chants of "Chug, chug, chug".
- The newly elected president of France and the unelected prime minister of Italy expressed a view that solution of the banking problem requires Germany and northern European states to offer a European wide deposit guarantee (Note to press officer: Change "Germany and nothern European" to "commonly backed").
- The leader of the state which almost went bankrupt guaranteeing its banks proposed that everyone should follow their lead.
- He further suggested that the new rescue fund should be used for this purpose to murmurs of agreement from southern European leaders.
- A glance from the German leader halted further conversation.
- Herman Van Rompuy broke the uneasy silence by volunteering to talk to the press on the discussion around banks. The master diplomat conciliated both sides by stating that it was clearly not a real discussion and more dinners will be needed in the upcoming weeks (Note to press officer: Replace "dinners" with "work").
- The subject of Greece was raised late into the evening.
- There was a general discussion on the best beaches in Greece and an academic discussion on how to see Greece on a shoestring.
- One leader wanted an in-depth discussion but was interrupted by the French president.
- Francois Hollande stated that it was very simple. 'Greece is an integral part of the Eurozone as long as it does what it is told and pays back the money. It is in the interests of French and German banks.' (Note to press officer: This requires major rework! Replace "French and German banks" with "Greece, Eurozone, World" at the very least).
- Francois Hollande then asked Germany and other Northern European states to fund his election promises.
- The remaining time was spent on amusing jokes such as the one where 10bn new capital into EIB saves the 9trn Eurozone economy.

(Hortatory note to press officer: Make the taxpayer proud of your skills while communicating this to the press otherwise you'll be transferred to the UK)

Wednesday, 23 May 2012

Fixing Credit Ratings: Harder Than A, B, C

[This article was originally published by Fair Observer on May 22, 2012.]

A single-pronged approach is unlikely to solve the problems inherent in the current model for credit rating agencies.

A cynical colleague once remarked that credit rating agencies (CRAs) were like cockroaches; distasteful, but with an unmatched ability to survive. This flippant remark had the weight of experience behind it. But to a young trader near ground zero of the nuclear blast that was the US housing and structured credit market meltdown, CRA survival looked unlikely. Their fingerprints were all over the structured credit disaster and it looked as if it was only a matter of time before the regulators hauled them off to join the Arthur Andersons of the world.

Cynicism and experience triumphed once again in financial markets. CRAs have not only survived but they are now enshrined as Nationally Recognised Statistical Rating Organisations (NRSROs) in the US. Their share price may have halved from the peak but their influence has probably doubled. Sovereign governments across the Western world shake at the mention of the ‘D’ word from any of the three CRAs (for all intents and purposes, only the three matter). Their banking system is kept afloat by central banks that use credit ratings to disburse cash against assets pledged by commercial banks.

The Twin Problems

The rating agencies owe their survival to the inherent nature of debt markets rather than to some unusual talent that they possess. Disintermediation of the debt market means that several lenders advance sums to a single borrower with each accounting for a small proportion of the whole. It also drastically reduces barriers to entry for potential lenders, leading to non-specialist and smaller investors buying debt instruments. In addition, slavish devotion to the theory of diversification has led each lender to invest only a small proportion of his/her portfolio in the borrower’s debt. Thus for most individual investors, the costs of due diligence and continual monitoring of the borrower’s credit strength are too high compared to the expected return. This opens the gap for an expert independent assessor of credit quality who can provide due diligence and monitoring cheaply by spreading the cost to all beneficiaries. In theory, this is what CRAs are supposed to do. However, practice has deviated from theory with credit evaluation costs being borne by the borrower rather than lenders. The conflict of interest is obvious since he who pays the piper calls the tune.

If conflict of interest is the original sin then it has been compounded by investor indolence. The combination of a liquid tradeable market in debt and a short-term investment horizon dissuade time-consuming analysis by investors. Moreover, ratings are a shield behind which highly intelligent fund managers and bankers can lose money conventionally. Cutting through the verbiage, the gist of most post-crisis explanations was: ‘It’s not my fault, subprime collateralized debt obligations (CDOs) were rated AAA. And our closest competitors have lost even more money.’ Unfortunately this shield has been institutionalised and officially recognised through Basel norms and other regulatory directives that use ratings to determine capital and liquidity requirements.

Dodd-Frank and Basel III

Any regulation that seeks to improve the entire credit rating and application process needs to address these twin problems of conflict of interest and investor indolence. In the US the Dodd-Frank Act, despite its drawbacks, goes far in eliminating the egregious excesses of CRAs that fed the credit bubble. Although unable to eliminate the revenue model in which the borrower pays for the ratings, the Act increases the potential liability for wrongdoing. By eliminating Rule 436(g) under Section 11 of the Securities Act, the Act effectively brands them as experts and opens them to lawsuits. CRAs are liable if a credit rating included in a debt security’s offering and registration statement is found to be inaccurate. It speaks volumes that after the passage of the Act, the four biggest CRAs (Moody’s, Standard and Poor’s, Fitch, DBRS) indicated an unwillingness to permit the inclusion of their ratings in offering documents. Additionally, the Act makes the enforcement and penalty provisions of the Exchange Act applicable to rating agencies. It also reduces the burden of proof that the plaintiff has to bear in such cases.

Simultaneously, Dodd-Frank attempts to take away the ratings crutch that investors relied upon. It replaces references to credit ratings in federal laws and regulatory directives, which impact investment decisions, by broader standards of creditworthiness. This is not a cure for investor indolence but is in the direction of a correct policy response. Reduction and elimination of official sanction to credit ratings is the most that policy can hope to achieve in a free market. Unfortunately, branding CRAs as Nationally RecognisedStatistical Rating Organisations is a retrograde step. Coupled with vagueness on the standards of creditworthiness deemed appropriate, investor reliance on ratings will continue.

The reliance on credit ratings and the apparent irreplaceability of CRAs is even more pronounced beyond the USA. Basel III norms, which are sought to be applied globally, make use of credit ratings to evaluate liquidity and counterparty credit risk. Moreover, the pressure to game ratings or indulge in ratings arbitrage by banks will still be prevalent since Basel III calculates their Risk Weighted Assets (RWAs) and capital requirements based on ratings. The continuation of the central role that CRAs play is due to a lack of alternatives. Basel III encourages banks to use internal rating models but these are opaque and cannot be easily evaluated on their effectiveness and conservatism. Also less sophisticated banks do not have the expertise or money to develop these models.

Is there a solution?

Therefore on an international level, little has changed with regard to credit ratings in the aftermath of the credit crisis. Additionally there is no consistency in the application, evaluation and regulation of credit ratings across nations. In each country, international CRAs are usually supplemented by domestic CRAs and both operate under different legal and regulatory regimes. The regulatory disconnect between Dodd-Frank and Basel III is just one instance. Furthermore, as Basel III is not an enforceable treaty, national bank regulators have considerable leeway over implementation. All of this poses a problem for regulators and policymakers looking to control transnational financial institutions from repeating their mistakes.

Counter intuitively, the solution lies not in the area of improving credit rating methodology and application but in enforcing market discipline. It is true that consistency in rating methodology, application, and regulation across national boundaries is desirable and would go a long way. But it is almost impossible to achieve not only because of political compulsions but also because of differences in debt markets across nations. Therefore the solution is two pronged. First, there needs to be an international effort to ensure that national regulators address the twin problems of conflict of interest and investor indolence. In this regard, Basel III is a disappointment and Dodd-Frank should be the starting template. Exposing the CRAs to market forces and regulating them as any other professional market participant, would temper their behaviour. And it can be achieved without draconian regulatory interference. Second, the basic precept of capitalism; failure, should be allowed. Indolent and idiotic financial institutions and investors should face the consequences of their actions. A bankruptcy regime that minimises fallout to the real economy is clearly not beyond the ability and understanding of policymakers to devise. There is no need to inject moral hazard into an already diseased financial system. 

Tuesday, 22 May 2012

Nonsensical Austerity

Even though the backlash against austerity has gathered momentum, the political leaders of the uprising hardly inspire confidence. They seem to believe that a free money tree grows in the Black Forest which can easily pay for their structurally inefficient state’s spending. This is highly unfortunate since the dogma of austerity is going to bring about a great depression. The last time such economic dogma prevailed was in the 1930s with catastrophic consequences.

Part of the reason why austerity is so appealing is that it is an easy concept to communicate to the masses. In the age of the 5-second soundbite, advocating austerity makes today’s glib and vapid politicians appear statesmanlike. Every man and Swabian housewife understands that one cannot live beyond one’s means. Ergo, the government must balance its budget despite the pain and suffering it might entail. As John K. Galbraith said, “Few can believe that suffering, especially by others, is in vain. Anything that is disagreeable must surely have beneficial side effects.”

This facile comparison of government finances with those of a household is flawed on two levels. First, the government is completely unlike a typical household which has a budget limit. Second, the whole concept of government austerity suffers from the fallacy of composition.

The government differs from a household in that it has the power to change its income at will. Apart from the coercive power to raise taxes and seize assets, a government also has the capability to create money. Thus the government is not restricted as a housewife managing the household finances. A better comparison would be with a housewife whose husband runs a counterfeiting operation on the side. Such a housewife does not face a budget constraint determined by the legitimate income of her husband. She only needs to tell her husband how much money to counterfeit to satisfy any additional spending. However, the amount of money that the husband can safely counterfeit is not infinite. Counterfeiting carries the risk of being caught by the authorities and the risk increases with the amount of counterfeit money printed. In reasonable amounts no one notices but in large amounts detection, arrest and imprisonment become inevitable.

Now if the husband’s legitimate income reduces due to a recession should the housewife pull their children out of school and cut their meals to keep within the budget constraint? Unless she has a masochistic streak, the obvious solution is to increase the counterfeiting income while cutting optional luxuries. It enables investment in the family’s future while largely maintaining the family’s standard of living. Once the economy improves and legitimate income rises, counterfeiting activity can be stopped or even reversed by buying back counterfeit notes.

At this juncture, critics will cry out that counterfeiting is illegal and morally reprehensible. If every household indulged in it, the economy would collapse. This is where the fallacy of composition comes in. What is correct at the household level is not necessarily correct at an aggregated level. The paradox of thrift is part of this fallacy. If everyone in the economy saves and no one borrows, the economy would descend into a deflationary spiral1. Therefore at the aggregate level there must be at least zero saving. When the private and household sector as a whole is saving, government must step in to spend to prevent deflationary collapse. It is unique in being the only economic actor which does not face a hard budget constraint.

Sceptics will counter the last assertion by pointing out the long list of sovereign defaults and the current Greek and European situation. This counterargument glosses over two major details. The first, as pointed out above, is that a government does not have an infinite capacity to increase spending and debt. Like the counterfeiter, if they get too ambitious they get caught and hard default, restructuring or inflation follows. However, despite the scaremongering by the high priests of the cult of austerity, this limit is far away for governments with control of their monetary policy and currency.

This leads to the second detail that many defaults are due to the government surrendering its sovereignty in some way. Hence its ability to avoid default is severely curtailed. Bond issuance in foreign currencies and foreign law jurisdictions cedes sovereignty. It artificially imposes a hard budget constraint thereby leading to disaster when the domestic economy takes a leg down. History is fairly clear on this: Latin American crisis was on dollar bonds; East Asian crisis was due to foreign borrowing. In the extreme case, a complete loss of monetary sovereignty results from a peg or monetary union and the eventual bust is more catastrophic. Argentina is testament to this and the European Union soon will be.  
Does this mean that indebted nations with control of their monetary policy and currency like the US and UK should engage in fiscal expansion? The answer is unequivocally in the affirmative. In the short-term it will increase public debt and lead to a deterioration of debt ratios but it will prevent a depression. The current debt ratios are sunk costs and should not enter into policy calculations. Once growth restarts debt will be brought down. And growth will restart eventually. Not even the most austere austerity proponent argues against that2.

Unfortunately political leadership is sorely lacking. Instead of leaders of the stature of FDR, opinion-poll-following politicians have been inveigled by austerity proponents to rush headlong into a depression. The greater tragedy is that the leaders of the anti-austerity brigade, especially in Europe, seem to be delusional. They want to play on voter angst without offering a credible plan. Everyone wants the trappings of office without shouldering the responsibility which comes with power. Therefore economic suffering looks set to continue.

1 Very simplistically: since any saving is income not spent on goods and services, a net saving leads to unsold goods and services. This leads to price reductions (reduction in value produced) and labour retrenchment. This leads to reduced total income in the economy in the next period which implies lower spending on goods and services. Saving leads to unsold goods and services again. The cycle repeats.

2 Those who quote Japan seem to have missed the small demographic difference between Japan’s and US/UK’s population pyramid and growth. They have also missed the adherence to neoclassical dogma and the hesitant pump priming which has accompanied Japan’s lost two decades. The VAT rise of 1997 leading to a renewed slump being the most cited example.

Thursday, 17 May 2012

Trading on TIPS

Central banks across the developed world are boldly going where no monetary policymaker has gone before. Apart from generating acronyms they have also generated raucous debate between the inflationistas and the deflationistas. The former believe Weimar is around the corner while the latter fear contracting the Japanese malaise. Trapped in between are investors, one day joyously contemplating recovery and fearful of inflation. The next day depressed about lack of growth and buying every safe haven bond in sight to escape Eurmageddon.

In this extreme Risk On/Risk Off volatile market there are two ways to trade/invest. The first is the Warren Buffett way. Do the analysis, form an opinion, put on the position and have the conviction to see it through over the long term. This requires an enormous amount of self discipline when portfolio NAVs are updated every second and each day generates a mountain of conflicting opinion and data.

The second way is hunt for assets and trades which provide a reasonable return over a broad range of future scenarios. Such opportunities largely obviate the need for the investor to decide which school of thought is going to be proved right. However, this is not a free lunch as extreme events can cause return expectations to be belied.

In the inflation vs deflation argument, one trade which works in both scenarios is shorting 5Y TIPS (Treasury Inflation Protected Securities) and buying duration adjusted notional of 30Y TIPS. The table below outlines the trade.

Bond (ISIN)
Duration (years)
Long 1 unit
Short 5.4 units

The inflationistas along with safe-haven buyers have pushed the current 5Y TIPS to an incredible negative yield of 1.13%. In contrast, current 30Y TIPS yields 0.67%. The yield differential is at the wides as Graph 1 shows.

Graph 1: 30Y-5Y Yield Differentials
Data Source: Federal Reserve

Since inflation expectations do not exhibit daily volatility nor change appreciably over short periods, TIPS yield differential is closely correlated to the nominal yield differential (R = 0.66). Therefore a longer term perspective spanning episodes of high and low inflation is possible by looking at nominal yield differentials. This shows that the current yield curve is the steepest in half a century (Graph 2).

Graph 2: Yield differentials across different interest rate regimes (1962-present)
Data Source: Federal Reserve

However this trade is not a blind reversion to mean play. In the event of higher inflation the yield curve is likely to bear flatten (i.e. yields will move higher with the short-end tenors moving more). Given the limited yield history of TIPS, it is not possible to check the relationship between real interest rates (given by TIPS yield) and nominal rates but the expectation is that real rates are positively correlated with nominal rates. The justification is that lenders are likely to demand a higher real compensation for loaning money in an inflationary environment. This is due to the uncertainty inherent in measuring inflation expectations and the tendency of inflation to accelerate upwards. This behaviour is evident for the short time period in which data is available (Graph 3). Therefore, even though 30Y TIPS yield will increase (and consequently the price will decrease), 5Y TIPS yield will increase much more and is very unlikely to remain at current negative levels. A duration matched long-short position in 30Y-5Y will provide handsome gains in such a scenario. In addition, as inflation expectations become unanchored and move higher investors are likely to pay a premium for long term capital protection. Therefore 30Y TIPS should outperform 5Y TIPS.

Graph 3: Real yields are positively correlated to nominal yields
Data Source: Federal Reserve

In case the deflationistas win the argument then the deflation floor in TIPS means that 30Y TIPS will outperform 5Y TIPS. Since TIPS pay the higher of inflation-adjusted principal or par at maturity, any negative inflation prints will lead to capital losses in 5Y TIPS (as the yield is negative and below coupon) but not in 30Y TIPS. Capital loss would be greater in an off-the-run bond which has a larger inflation accrued principal due to a longer period of time elapsing since issuance. So investors who put more weight on a deflationary outcome may choose to short an off-the-run 5Y. Moreover, a deflationary economy will cause the Fed to stay on hold and indulge in more QE leading to a grab for yield. 30Y TIPS yield should fall (and price rise) in such a scenario.

The trade provides a reasonable return even in a third scenario where the current muddling through continues for some time. As maturity approaches, 5Y TIPS yield has to rise to 0% leading to a capital appreciation on the short position. In the meantime, 30Y TIPS should fluctuate around similar levels while paying a coupon of 0.75% to the holder.

Although the trade is likely to work well in a broad range of scenarios, tail events will cause losses. The three main tail events are very high inflation, heightened credit risk and collateral crunch following a flight to safety. Very high inflation can cause a loss of confidence in Treasuries in general and lead to higher loss on the 30Y leg. If political gridlock starts impacting economic efficiency and competitiveness apart from raising credit risk, investors may cut longer term exposure to the US. This will again cause greater loss on the 30Y TIPS position. Finally, a chaotic collapse of the Eurozone will cause a desperate flight to safety along with a massive collateral crunch. This is likely to be focused on the short-end causing losses on the 5Y TIPS short position.

However, tail events should not impact the main investment strategy since a part of the portfolio is allocated to purchasing insurance against them. Unless the investor considers tail events as the central scenario, the 30Y-5Y TIPS long-short trade seems to provide a reasonable return for the risk.

NB: I have deliberately not provided any targets for final yield differentials. Prices and yields are path dependent and hence price/yield targets assume omniscience on part of the author. To this I can lay no claim.

Disclaimer: This is not an investment recommendation. It is merely an idea and the reader should perform his/her own analysis before making any investments. 

Wednesday, 16 May 2012

Eurozone: The train allegory revisited

This is something I wrote almost a year back (27-May-11) in my earlier avatar as Sovereign CDS trader at a local bank.

On a foggy day a train is heading towards a bridge on a river. Gazing out through the fog some of the passengers notice the bridge broken. A few of them try to alert the guard and train staff to the danger but their concerns are brushed aside. "I assure you gentlemen, the bridge was built by some of the finest engineers in the world" says the guard. "In fact my brother was incharge of the building project and he has top grades from the best schools". This satisfies most of them and they return to their seats confident in the ability of the engineers. "After all the guard is the expert and must know better" they reason as they dismiss what they saw as an optical illusion. The persistent ones who still harangue the guard are warned sternly not to create panic and disturb other passengers otherwise they will be ejected from the train at the next stop. The smarter ones realise the futility and prepare to jump out at the earliest opportunity. Indeed some waste no time in doing so. They reason that risking injury is better than certain death. The remaining try and pull the emergency alarm but it doesn't work. Then they attempt to wrest control from the driver and run towards the engine, pursued by the guard and staff. Their shouts warning the passengers about the danger ahead are countered by the staff shouting about the impossibility of it. The PR system plays a tape about the unblemished safety record of the railway company. Some of the passengers are injured by the crowd of people running through them and all are confused by the conflicting statements. Most realise something is wrong but don't know what to do about it. All the while, the train is chugging along.

It seems that the train has reached the bridge. The only thing that remains to be seen is how many bogeys fall into the river.

It is interesting to compare CDS levels prevailing at that time when there were more than a few people insistent on selling protection and buying bonds.

(27-May-11 close)
Current 5Y CDS (16-May-2012)
% change in spread
iTraxx® SovX index
301bps (excludes Greece)
Not comparable

Monday, 14 May 2012

Investing in banks after JP Morgan's debacle

Investors in bank stocks must be feeling as if they’ve been hit by the Cruciatus curse. It was all going so well with the S&P 500 Financial Sector Index registering a 20% YTD gain. Then came JP Morgan’s shock $2bn loss which led to its stock plummeting more than 10% and dragging the rest of the sector with it. Although still up on the year, investors need to reconsider whether owning bank stocks makes sense. The gut wrenching volatility and renewed realisation that equityholders are the first loss piece of what are effectively black box trading operations should prima facie weigh against owning bank stocks. Add to it the negative impact to earnings and RoE from stricter regulation and higher capital limits, the investment case starts looking weaker. JP Morgan’s debacle is a disaster for the banks in their war against regulation. The fortress has been breached from within.

However, this does not mean one should impulsively sell all bank stocks or even get out of the sector completely. There are always relative value plays within the sector. But more interestingly for a long-only retail investor willing to take exposure to the banking sector, it might be better to invest in bonds rather than common stock. The reasons are three fold. First, the principal is protected in bank bonds due to sovereign backing. The government’s response to the financial crisis shows that banks will not be allowed to fail. In the current low interest environment, senior unsecured bank bonds offer a significantly higher yield than 5-year treasuries at 0.71% for not much more credit risk. The cost of this semi-explicit support is going to be borne by equity holders and the benefits are to be enjoyed by the bondholders (and the Iksil-lent management of these firms).

Second, the yields on offer are certain compared to uncertain EPS and DPS. Increased regulation, higher capital requirements, flattening yield curve, shutdown of the fixed income money machine, inflated cost base and the danger of investment banking “rogues” cropping up are just some of the headwinds to earnings that equityholders face. Bondholders in contrast will have to be paid by a going concern.

Third, current senior unsecured bond yields are higher than dividend yields for most banks (Table 1). And for some like Bank of America and Morgan Stanley, they are even higher than earnings yield. This implies that equity holders are dependent on capital appreciation to achieve returns at par or higher than bonds. Unless banks can achieve this difficult task of delivering capital appreciation in a deleveraging environment, bonds will provide superior returns.

For investors with greater risk appetite, moving down the bond seniority structure can provide an even higher yield. However, it also increases risk and introduces uncertainty of principal repayment due to call optionality embedded in subordinated bonds. Moreover, liquidity is poorer and associated bid-offer spreads wider leading to a less than commensurate increase in return for the enhanced risk.

Table 1: Comparative equity and senior unsecured bond returns for US banks
Earnings yield (E/P)
Dividend yield
Current Bond Yield (~5 year)
Bond yield / Dividend yield
Bank of America
4.291% (06050TKW1)
3.872% (172967EH0)
JP Morgan
3.369% (48121CVZ6)
Goldman Sachs
4.360% (38144LAB6)
Morgan Stanley
5.164% (617446V71)
Wells Fargo
2.193% (929903DT6)
Source: Google Finance, FINRA

In the final analysis, investors who are negative on the banking sector can still take advantage of the moral hazard engendered by the SIFI (Systemically Important Financial Institution) designation by buying bank bonds. For those who are more optimistic about the sector and the earning ability of banks, a mixed portfolio of common stock and bonds is preferable. Banks stocks with low bond-to-dividend yield and bond-to-earnings yield ratios can be combined with bank bonds with high ratios to get the best of both worlds. 

Sunday, 13 May 2012

Greece, Spain and the week that was

Looks like I chose a very eventful week to be on vacation. It was great to soak up the sun and history in Granada without cellphone and internet coverage. Since I had strict instructions to not engage in financial disaster tourism, I could only admire the beautifully constructed apartments in Malaga from a distance.

On getting back the only news which surprised was JP Morgan’s $2bn hole. Looks like Ms. Drew didn’t detect what the (fool)hardy boys were up to.

In Europe, things are rocketing towards their inevitable conclusion. Greek election results weren’t that surprising and neither is Spain’s continued delusion.

On Greece there are only two alternatives, either radically reduce demand for austerity and pump more money or prepare for exit. The first is unpalatable and unacceptable to the northern creditors. It also suffers from moral hazard. Any loosening on Greece will ensure that other peripheral countries ease off reforms too. Vested interests will oppose and block most structural reforms even as investors flock to the mirage of a “growth” pact. The rescue of Bear Stearns only emboldened people to buy Lehman senior debt. And it made Lehman management think that the plug wouldn’t be pulled on them.

Therefore the second seems more likely and indeed talk is veering in that direction. This is going to be a guaranteed 100% disaster. And it will make Lehman’s demise a study of excellence in public policy execution. The first problem is that official creditors will take a bath on the €145bn lent so far in addition to the contingent liabilities through the Eurosystem. The second problem is that the market will then start the hunt for the next victim (Portugal). There isn’t going to be just one member exiting. The third problem is that international support for more IMF loans to Europe will change from hesitant to nonexistent. It will make the practice of attempting to impress gullible carry traders by mentioning large numbers a historical curiosity.

Meanwhile in Spain, Bankia, supposedly the super senior tranche of 7 Cajas, was found not to be as highly rated as was thought earlier. Even then, Spain is still unable to grasp the extent of the problems which lie ahead. Not having learnt anything from Ireland it is set to go down with its banks. The €30bn to be set aside is laughable given the €1trn exposure of Spanish banks to real estate and construction.

Let’s see what tomorrow brings.

Friday, 4 May 2012

Quick Note on European Election Weekend

Election weekend is here and even though the verdicts will have little fundamental impact (apart from Greece) they are sure to generate impassioned headlines. And since headlines determine short-term market direction, the results are more important from the perspective of the market than from the perspective of the European economies. 
The markets have baked in some amount of negative outcome so a positive surprise may lead to a temporary bounce in European risk. A quick note on the four elections results to look out for, in decreasing order of market importance:
  1. Greece: National parliamentary elections. This has the potential to spring a nasty surprise especially since the market has taken its eyes off Greece.
    1. Market’s expected scenario – Shabby coalition (with/without Democratic Alliance) which professes to stick to the IMF/EU schedule.
    2. Positive outcome – ND and PASOK win a big majority and the far left and far right have marginal influence.
    3. Negative outcome – Fractured mandate with far left and far right capturing a better than expected share of the vote.
    4. Order of probability: Expected > Positive > Negative
  2. France: Presidential election. The reason why this is lower on the list is because unlike Greece the impact on Eurozone will not be immediate (but the impact on markets may be). Also Hollande can pursue policies which mitigate the market’s current fears.
    1. Market’s expected scenario – Hollande victory
    2. Positive outcome – Sarkozy surprises by snatching almost all of Le Pen’s support.
    3. Negative surprise – Hollande victory accompanied by harsher anti-capitalist/anti-market rhetoric.
    4. Order of probability: Expected > Negative > Positive
  3. Italy: Local elections for Mayoral and Council offices. The press has tried to make it into a referendum on Monti. It isn’t. But headlines will roll (and roil) nonetheless.
    1. Market’s expected scenario – Fractured verdict with no clear winners or losers.
    2. Positive outcome – Centre-left and centre-right parties take a major share of the vote which will be spun as a vote of confidence in Monti.
    3. Negative outcome – Given the internal machinations of Italian politics, any verdict which sparks off speculation of Monti departure. This may be due to a better than expected showing for Northern League or a vote which makes some parties believe that they can form a government if elections are held soon. Given Monti’s individual popularity, the latter is unlikely to be followed through but uncertainty can cause market turmoil.
    4. Order of probability: Expected verdict > Negative outcome > Positive outcome
  4. Germany: Regional election in Schleswig-Holstein. This may make headlines but is largely irrelevant to the European situation. Regional elections are fought on local issues and a win/loss does not indicate acceptance/rejection of austerity etc.
    1. Market’s expected scenario – Merkel’s party (CDU) loses power
    2. Positive outcome – CDU/FDP retain power
    3. Negative outcome – Larger than expected loss leading to more sensationalist headlines
    4. Order of probability: Expected >> Negative ~ Positive
NB: I have intentionally not put numerical probability estimates. Putting numbers on highly uncertain events doesn’t remove the fuzziness. It only gives the (false) impression of precision.

Goodbye Indian Stocks?

The NIFTY has broken lower (Graph 1). And the INR is in free fall (Graph 2). As I've said before, this is all about politics. The economic fundamentals aren't dire but the current government is lurching from scandal to reform rollback and back to scandal. The biggest concern is the current account deficit which isn't being helped by high oil prices and rupee depreciation. India imports about 70% of its oil consumption and Brent in INR is back to it's highest ever level (Graph 3). But because of a weak government supported by populists, the rise is going to swell the subsidy bill worsening government finances. There is apparently a brain-dead suggestion about dual pricing of fuel. The last time such a brand of politics was practiced it gave India the Hindu rate of growth of 2-3%. Sell in May applies.

Graph 1:  Indian stock market looks set to retest lows

Graph 2: INR at its lows

Graph 3: Oil price shock to a government which has lost the ability to shock