The global financial and economic crisis
A Shift in Sovereign Sentiment
In his excellent recent piece, Todd Harrison describes the sovereign debt problems
the globe now faces as a result of the financial crisis and compares the situation in
Greece with that at Bear Stearns in early 2008. US is far from being immune to the
problems in Europe. In fact, many states are much larger than European countries and
are in the same boat. Or, actually, they are much worse off.
A Shift in Sovereign Sentiment
By Todd Harrison
A message to CFTC – gaming the system will work no more.
CFTC recently engaged in a massive regulatory overhaul of the
commodity markets, targeting limited positions and increasing margins in commodities, in particular, in energy.
This affects exchange traded funds such as UNG (Natural Gas) and USO (oil). In their view, commodity speculators drove
oil and gas to unreasonable levels in the Summer of 2008, in part, triggering the current crisis.
While limited trading in any derivatives is a welcome step, this is, of course, ridiculous.
The run in commodities was triggered by the Fed drastically lowering interest rates and printing money to
save the literally huge derivative Ponzi scheme that our global financial system has become.
“Gaming” free markets is not the way to go. We did that for quite some time now, and that’s why
the financial crisis happened. The Free market broke free from all this derivative model manipulation
and this resulted in a Black Swan. As long as OTC derivative bubble is inflating further,
chances of another, deeper systemic crisis are increasing. If the current
policy of bailing out too big to fail counterparties continues, there is a chance the derivative
Ponzi scheme will eventually blow up and take down entire countries – including, possibly, USA.
Regulate what matters – OTC interest rate derivatives and credit derivatives!
Deutsche Bank 2010 investment outlook – sovereign debt.
Here’s what the Deutsche team, led by Jim Reid, say:
Although we’re positive in the near-term, looking at the world today it’s clear that the current macro environment will be
difficult to sustain. The markets will need evidence in 2010 that there is an observable path back to fiscal discipline for those
countries that have been most aggressive in responding to the fall-out from this crisis. If not we continue to run the risk of
Sovereign land mines disturbing the benign corporate landscape.Indeed if 2010 is a difficult year it’s highly unlikely that the catalyst comes from within the equity or corporate credit markets.
This means the macro environment will decide 2010, and in reality investors in Sovereign debt around the world will probably
decide the fate of risk assets. In late 08/09 the authorities had little to lose in aggressively attempting to stave off a
Depressionary cycle. So far they deserve extremely high marks. However 2010 could be a transitional year between heavy
intervention and the paying of the bills. A return to positive global growth should help but we would expect more volatility in
2010 than in H2 2009.Back to Sovereign risk, history is littered with examples of inflation, devaluations and Sovereign defaults after financial crisis.
One might wonder why this time should be any different. Sustainability is the key word. As soon as markets doubt the
sustainability of a country’s deficit then we have a problem. This is why it’s important that in 2010 the authorities provide a
credible path for future fiscal discipline, even this path involves many years of adjustments. One of the largest challenges will
be funding the still large global government issuance in a world with less QE. QE limited the discussion on the impact of
crowding out in 2009. Will we be as fortunate in 2010?Deutsche Bank has the following scenarios:
Scenario 1 — This scenario is the most optimistic and is one where the authorities have as good a year as they did in 2009.
They likely keep stimulus extremely high in the system without there being any noticeable consequences of their actions (e.g.
rates at the short and long-end stay low). Under this scenario we would expect equities to be significantly higher, credit
spreads be much tighter but with bond yields only edging slightly higher as the authorities are seen to have firm control of
inflation expectations and may even be continuing to buy bonds.Scenario 2 – This scenario is the most likely and suggests that we start to see gradual easing off the gas from the authorities
but only as it’s proved that there is some momentum in the underlying economy. Under this scenario risk assets have a good
year but returns are checked to some degree by rising bond yields and less stimulus being injected into markets. A satisfactory
year for risk, especially equities, but a mildly negative one for fixed income. Credit investors will likely have to rely on spreads
(and higher beta credit) to get positive total returns.Scenario 3 – This is the second most likely scenario overall in 2010 but one that potentially becomes more likely as the year
progresses. Here we are likely to see sharply higher bond yields start to disrupt the positive momentum in markets. These
higher yields could be either due to Government supply starting to overwhelm demand (especially as the impact of QE, and
similar schemes, wane), or because of inflation fears. It seems unlikely that actual inflation will be a concern in 2010 but it’s
quite possible for expectations to become unanchored. We would also have to include the potential for a Sovereign crisis
somewhere in the Developed world within this scenario. We would note that the higher yields in this scenario are not based on
positive growth momentum but by inflation/Sovereign risk. Such a scenario is incorporated in Scenario 2.Scenario 4 — This is the nightmare scenario of Deflation or in less extreme terms perhaps a double-dip. Given that much of the
world is currently still in negative YoY inflation territory it is difficult to completely rule out even if we do live in a fiat currency
system and even if inflation is expected to return to positive territory in early 2010. For deflation to be sustained we would
probably need an exogenous event to hamper the authorities ability to continue to successfully fight this credit crisis. Such
events could be a fresh banking crisis arising, a political backlash encouraging immediate increases in 2 December 2009 Macro
Credit and Equity Page 4 Deutsche Bank AG/London economic regulation or withdrawal of stimulus, or possibly a Government
bond/currency sell-off that forces the authorities to aggressively reign in stimulus for fear of a sovereign crisis. A Sovereign
crisis outside the Developed world could also encourage this scenario as there would be a flight to quality into Developed
market bond market in spite of the fact that these markets have their own large fiscal issues. Bond yields would eventually rally
strongly but risk assets would experience a very poor year. As time progresses this scenario becomes less likely as the system
gradually repairs itself and the authorities are allowed more time to inflate the global economy. As we discuss in scenario 3, the
more likely risk scenario is inflation, especially as time progresses.We have tried to simplify and narrow down the scenarios as much as possible to allow for easy explanation but the reality is
that there are many other permutations for the year ahead. For example and as discussed above, within the worst case
scenario we would have to include a slightly less severe outcome where growth fails to show any momentum after the stimulus
starts to fade (a double dip perhaps?). If the authorities are unwilling or unable to stimulate further then we could have a weak
economy even if we don’t see outright deflation. This would likely be negative for equities/credit but the outcome would be
unlikely to be as negative as the -30% outcome.The other big problem in differentiating between the two negative scenarios is with regards to Sovereign risk. If we have
Sovereign risk within the EM complex (e.g. Dubai) then Western bond yields could rally strongly on a flight to quality basis. So
an element of this risk is priced into Scenario 4. However we are in a fairly unusual point in history where there is also an
increasing risk of a Sovereign crisis occurring in the Developed world at some point. The fiscal deficits arising from this crisis
have to be addressed at some point. If the market eventually sees no credible medium-term way of certain Western countries
balancing their budgets and repaying their debts then we may see a large rise in Government yields. This in itself could be
enough to raise funding costs to levels that encourage a vicious circle.Figure 1 and Figure 2 help us understand why we are entering into unknown territory in terms of Developed market debt. These
charts simply show the Debt to GDP ratio of the US and the UK. The Government part of the deficit is starting to rise sharply in
both regions and although it looks within the range of historic observations we have to remember that Governments have
implicitly and explicitly backed the debt of other parts of the economy. This makes Government liabilities potentially much
larger. The hope is that growth rebounds strongly enough for the Debt/GDP ratio to fall naturally over time. Such a scenario
would also require yields to stay low to facilitate such an adjustment. All we can say is that there are risks that the deficits of
such indebted countries at some point appear unsustainable to the market. This is when far more difficult decisions than those
made in 2009 would have to be made.
US and UK debt to GDP ratio
Derivatives – a disaster we avoided or a disaster in the making?
I have quite a few quant friends (and family) who are occupied in derivatives.
They know very well how to run stochastics and
Monte Carlo codes to price these complex instruments, but are unaware of
more pressing issues, such as why this huge Ponzi scheme caused a market
crash in 2008, why such enormous bailouts around the globe were required
to save it. Unfortunately, the repeated bailouts and saves by the global
central banks only provided liquidity to this Ponzi scheme and fostered further
expansion, pretty much ensuring another financial crisis in the future. The first time
derivatives caused a crash was 1987, when portfolio insurance (or put options, in
modern equivalent) caused a meltdown due to hedging as the market fell through
put strikes. Of course, quants say they were not perfect, since implied volatility was
then flat.
Here is what Myron Scholes has to say on the subject, and I totally agree. I would add,
blow up not just OTC CDS market, but all of it. Scholes knows. Not only he is the Nobel
Laureate and the father of Black-Scholes, he also ran LTCM that blew up for the very
same reason in 1998. Cancelling contracts while things are good seems to be an
excellent option. The reason for a complete seizure of the libor market was the
market pricing of couterparty risk. It happened before, and it can happen again.
The notional size of derivatives market is 10 times the size of the global GDP,
and the usual Central bank liquidity fix will only make it bigger.
Myron Scholes, intellectual godfather of the credit default swap, says blow ‘em all up
Myron Scholes, whose Black-Scholes option pricing model provided the intellectual underpinning for modern derivatives markets, thinks one particular derivatives market—that for credit default swaps—is due for a Red Adair style rescue. Or a Fred Adair style rescue.
Red Adair put out oil well fires by setting off gigantic explosions at the wellhead. “My belief is that the Fred Adair solution is to blow up or burn the OTC market in credit default swaps,” Scholes said this morning. What that means, he elaborated, is that regulators should “try to close all contracts at mid-market prices” and then start up the market anew with clearer rules and shorter-duration contracts.
This was at a conference at New York University occasioned by a new collection of papers on how to fix the financial system, authored by a bunch of NYU Stern School faculty. Scholes kept saying Fred Adair. Sometimes he’d notice and correct himself, sometimes he wouldn’t. The FT’s John Gapper, who was on a panel with Scholes, finally speculated that this was because the government response to the financial crisis has been such an unwieldy mix of Fred Astaire (dancing around the problems) and Red Adair (doing something to fix them). Scholes did not disagree.
The blow-up-the-CDSes option is intriguing, and I’m going to check in with Scholes later to see if he wishes to elaborate. But for now, a few more notes from the panel, which was moderated by Paul Volcker and also featured NYU finance professor Matt Richardson:
Some would say Scholes is partly to blame for this whole mess, and Volcker dropped a couple of hints in that direction. Scholes didn’t exactly accept responsibility, but neither did he give a blindered, Chicago-style defense. For one thing, he cited John Maynard Keynes—still a nonperson to many of Scholes’s fellow Chicago Ph.Ds—arguing that we’re currently stuck in a situation where the financial system needs to deleverage, but its current deleveraging is causing asset values to plummet, meaning that it’s not succeeding in deleveraging at all (that is, debt is down, but so is the value of everybody’s capital, so leverage ratios aren’t declining). For another, he seemed to agree with one of the main criticisms of the Wall Street risk models that evolved in part from Black-Scholes—that they have some ability to capture the risks faced by one investor operating in a financial market that the investor is too small to influence, but aren’t much good at capturing the risks faced by the entire market. “Risk aggregation is not linear,” he said. “It’s nonlinear.” (This is what Chapter 13 of The Myth of the Rational Market is about. Doesn’t that sound exciting?)
As the moderator, Volcker didn’t say all that much. He did talk for a bit, though, about how “maybe we ought to have a two-tier financial system,” with a heavily regulated “core part that I will for purposes of simplicity call commercial banking” and a less-regulated outer realm of hedge funds, proprietary trading desks, and such. Hmmm, said Gapper, that “reminds me of something I once heard of called the Glass-Steagall Act.” This Glass-Steagall revivalism is happening all over. I’m even beginning to feel the spirit. But Gapper had an interesting question: “If you wanted to set up a new Glass-Steagall, where would you draw the line?”
Scholes finally got his free-market Chicago dander up over the possibility of synchronized global financial regulation—something that Volcker has been advocating as chairman of the Group of Thirty project on financial reform—sparking this entertaining exchange:
Scholes: If we internationalize everything, we end up with rules that stifle freedom and innovation. Mr. Sarkozy and others say our system has failed and we should adopt theirs. Do we want to become French?
Volcker: I’m not an acolyte of Mr. Sarkozy.
Gapper: Actually, the French banks are big derivatives users.
Volcker: The U.S. is no longer in a position to dictate to the rest of the world.
US standard of living is dropping
The crisis didn’t start last year, it was building up for some time.
The real reason was not the housing bubble. Yes, housing prices soared due to
Greenspan’s ultra easy monetary policy in the early 2000-s,
but, in fact, in gold terms they are quite average historically, as of late 2009/early 2010.
The real problem was falling US standard of living, and that has been happening for some time,
as seen on these charts below. The falling standard of living is a direct consequence of
the falling currency.
Stocks and dollar
Thanks to the Fed promising to keep interest rates at zero for some time, the US dollar has
already partially replaced Yen as #1 carry trade funding currency. As a result, the anticorrelation
that developed between stocks and the dollar is worth noting. The chart below illustrates
SP 500 index vs inverse US dollar index. While both could rally sharply on positive news like
better than expected jobs number, eventually the currency trade should prevail. Don’t be surprised
if stocks correct sharply early next week.
SP500 vs inverse USD, 3 months
SP500 index vs inverse dollar, 6 months
Injecting liquidity to inflate the derivative bubble.
It is well known mathematically that liquidity injections cause
volatility to decline. How does it do the job? By inflating the derivative bubble.
This has been our “solution” for every financial mess since 1987 crash.
It has been our “solution” in the Fall of 2008, when TED spread
(spread between 3-month libor and t-bill rates) soared to unimaginable
highs. Why did it soar? Simple, really, as a few large firms went under,
counterparty risk skyrocketed, for which Ted spread is a direct indicator.
While CDS were blamed for the crisis, naturally, these beasts are only a tiny part
of the whole universe. The real values for interest rates contracts skyrocketed
much further. Unlike CDS, however, interest rate swaps are “slow bleeders” -
they don’t bankrupt a firm right away when the bet goes bad, rather, they
cause insolvency and large payments over time.
A little problem here – the derivative Ponzi scheme inflated 10-fold during
the last decade due to these policies and now stands at 10 times the GDP
of the World. Thus, bailing it out in 2008 required enormous liquidity injections.
About 23 Trillion in government guarantees, loans, and direct printing for the US,
or 1.5 times US GDP, by some estimates.
Instead of being the lender of last resort for this Casino, don’t we need to just let
the gamblers go broke and go home, then deal with the economic mess that results?
Yep, we do. But that requires political courage because of incredible mess
the blowup will cause, and that’s not what we did.
BIS derivative report for June 2009 is out.
Highlights? It “worked” yet again
1. Volatility declined.
2. Markets soared as a result.
3. Notional values increased, except for CDS market, where they dropped
4. Real values declined (expected with decline of volatility)
Resume: Derivative bubble, the biggest bubble of them all, inflated again to 605
Trillion dollars notional. Note that this is only a part of the derivative universe.
The other, much smaller part, trades on the exchanges.
Next time the mess will be even bigger.
Key developments:
•notional amounts of all types of OTC contracts rebounded somewhat to stand at $605 trillion at the end of June 2009, 10% above the level six months before,
•gross market values decreased by 21% to $25 trillion,
•gross credit exposures fell by 18% from an end-2008 peak of $4.5 trillion to $3.7 trillion,
•notional amounts of CDS contracts continued to decline, albeit at a slower pace than in the second half of 2008 and
•CDS gross market values shrank by 42%, following an increase of 60% during the previous six-month period.
The “new bull market” – the rally goes bye bye in real terms
Both stocks and bonds are now losing value in real terms due
to the dollar decline. US treasury bonds lost value all year relative
to gold, US stocks started to decline in real terms in August
after a 5-month rally.
SP 500 in gold Oz
30 year Treasury bond in gold
Former managing director at Goldman Sachs reveals the truth about the bailouts
Nomi Prins, former managing director at Goldman Sachs, exposes the revolving door
between Wall Street and Washington. This is a must read. Corruption must end
and the system must be restored before we can talk about the new boom and the
end of the crisis in the USA. The crisis is a culmination of what has been going on for
some time – the crony capitalist system and unfair profits for Wall Street at the expense
of the real economy. By perpetuating the same system that has led to the crisis, the
collapse will only deepen. This economic crisis cannot be solved by printing money;
the financial system must be reformed and the corruption must end.
JH: Now, we hear a lot about the little people’s irresponsibility
in all this — in the collapse. They took on more debt than they could sustain,
they thought the good times would roll forever. You argue this was never about
the little guy, right?NP: Neither the crisis, nor the bailout was about the little guy. Former
Treasury Secretary Henry Paulson was explicit in stating several times,
and in several ways, that the government should not be bailing out homeowners
who got in over their heads. And true to those sentiments, it didn’t. Instead, amidst
trillions of dollars of subsidies to the industry were made available in the most original
and creative of ways, and no heed was paid the jointly humane and economical solution
which would have been to find ways to restructure personal mortgages and loans,
as opposed to dumping buckets of money over the top layers of the financial community
and promising it would somehow trickle down and loosen credit for the “little guy.”The people that blame the Community Reinvestment Act for the avalanche of
predatory lending are missing the true numbers that represent the situation.
Only $1.4 trillion worth of subprime loans were extended between 2002 and 2007.
On the back of those loans, the industry created $14 trillion worth of various types
of assets and borrowed up to 10 times that amount using those new assets as collateral.If the government had wanted to help homeowners and contain the costs of the bailout,
it could have subsidized underwater mortgages directly at the loan level, or made it mandatory
for banks to renegotiate credit terms or mortgage balances with individuals, as opposed to
making it a mild suggestion that the banks have no incentive to follow.For the money spent on subsidizing the industry, the government could have bought
out every single outstanding mortgage in the country. Plus, every student loan and
everyone’s health insurance. And on top of that, still have trillions of dollars left over.That’s why I get so enraged at the bizarre notion that a 10-year, $900 billion health
care option is somehow egregious and government interfering with our lives. We should
all take $90 billion a year to sustain our health and access to health care over lavishing
trillions on the banking system any day, no matter what our political party affiliation is.
Option Arms resets and a double dip recession
Option Arms resets wll start to accelerate some time in the Spring of 2010,
most likely causing another leg of the credit crisis in the Fall of 2011.
Credit Suisse (CS) estimates that the resets will begin to accelerate next
spring, rising from about $4 billion resetting in March 2010 to a peak of $14 billion in
September 2011. The current level is about $1 billion. About $500 billion of option
ARM loans are outstanding, according to the bank. “Things have gotten pushed out,”
says Chandrajit Bhattacharya, director in U.S. Mortgage Strategy for Credit Suisse.
“Right now it looks like the big increase is probably going to be somewhere toward the
middle of next year.”Option ARMs typically reset after five years, at which point the monthly bill increases
65% or more. About 37.5% of option ARMs originated in 2005 are still outstanding, 63%
of the 2006 vintage are outstanding, and 82% of the 2007 loans remain, according to
Barclays Capital (BCS). And about a third of the outstanding loans in these years are
deeply delinquent.In a given month, between 4% and 5% of borrowers who are current on their option
ARMs taken out in 2006 and 2007 default in the following month, says Sandeep Bordia,
Barclays’ head of residential credit strategy, who also expects resets to be delayed until
next year. “These things have been performing horrendously,” Bordia said. “I don’t know
how much of it will last into the recast.”
Option arm resets
Mortgage loan resets – all