30/7/18: Impact of Terrorist Events on European Equity Markets

Our recent paper on the impact of terrorist events on equity markets valuations in Europe has been published in the Quarterly Review of Economics and Finance (November 2017): https://www.sciencedirect.com/science/journal/10629769

14/7/18: Elephants. China Shop, Enters a Mouse: Global Debt Bubble

Bank for International Settlements Annual Report for 2018 has a very interesting set of charts covering the growing global debt bubble, one of the key risks to the global economy highlighted in the report.

First, levels:

• Global debt rose from 179% of GDP at the end of 2007 to 217% at the end of 2017 - adding 38 percentage points to the overall leverage carried by the global economy.
• The rise has been more dramatic for the Emerging Economies, with debt levels rising from 113% of GDP to 176% between the end of 2007 and the end of 2017, a net addition of 63 percentage points.
• Advanced economies faired somewhat better, posting an increase from 233% of GDP to 269%, a net rise of 36 percentage points.
• As it stood at the end of 2017, Global Debt was well in excess of x3 the Global GDP - a degree of leverage not seen in the modern history.

As noted by BIS: “...financial markets are overstretched, as noted above, and we have seen a continuous rise in the global stock of debt, private plus public, in relation to GDP. This has extended a trend that goes back to well before the crisis and that has coincided with a long-term decline in interest rates".

Next, impacts of monetary policy normalization:

As the Central Banks embark on gradual, well-flagged in advance and 'orderly' overall rates and asset purchases 'normalization', the global economy is likely to bifurcate, based on individual countries debt exposures. As the chart above shows, impact from a modest, 100bps hike in rates, will be relatively significant for all economies, with greater impact on highly indebted countries.

Per BIS: "Since the mid-1980s, unsustainable economic expansions appear to have manifested themselves mainly in the shape of unsustainable increases in debt and asset prices. Thus, even in the absence of any near-term market disruptions, keeping interest rates too low for too long could raise financial and macroeconomic risks further down the road. In particular, there are reasons to believe that the downward trend in real rates and the upward trend in debt over the past two decades are related and even mutually reinforcing. True, lower equilibrium interest rates may have increased the sustainable level of debt. But, by reducing the cost of credit, they also actively encourage debt accumulation. In turn, high debt levels make it harder to raise interest rates, as asset markets and the economy become more interest rate-sensitive – a kind of “debt trap”."

Thus, the impetus for rates and monetary policies normalisation is the threat of continued debt bubble inflation, but the cost of such normalisation is the deflation of the debt bubble already present. In other words, there's an elephant and here's the china shop.

"A further complication in calibrating normalisation relates to the need to build policy buffers for the next downturn. Indeed, the room for policy manoeuvre is much narrower than it was before the crisis: policy rates are substantially lower and balance sheets much larger". And here's the mouse: cyclically, we are nearing the turning point in the current expansion. And despite all the PR releases about the 'robust recovery' current up-cycle in the global economy has been associated with lower growth rates, lower productivity growth, lower real investment (as opposed to financial flows), and more debt than equity (see http://trueeconomics.blogspot.com/2018/07/14718-second-longest-recovery.html).

In other words, things are risky, but also fragile. Elephants in a china shop. Enters a mouse...

25/4/18: Dombret on the Future of Europe

An interesting speech by y Dr Andreas Dombret, Member of the Executive Board of the Deutsche Bundesbank, on the future of Europe, with direct referencing to the issues of systemic financial risks (although some of these should qualify as uncertainties) and resilience of the regulatory/governance systems (I wish he focused more on these, however).

https://www.bis.org/review/r180226b.pdf (Links to an external site.)

21/4/17: Millennials, Property ‘Ladders’ and Defaults

In a recent report, titled “Beyond the Bricks: The meaning of home”, HSBC lauded the virtues of the millennials in actively pursuing purchases of homes. Mind you - keep in mind the official definition of the millennials as someone born  1981 and 1998, or 28-36 years of age (the age when one is normally quite likely to acquire a mortgage and their first property).

So here are the HSBC stats:

As the above clearly shows, there is quite a range of variation across the geographies in terms of millennials propensity to purchase a house. However, two things jump out:

1. Current generation is well behind the baby boomers (when the same age groups are taken for comparatives) in terms of home ownership in all advanced economies; and
2. Millennials are finding it harder to purchase homes in the countries where homeownership is seen as the basic first step on the investment and savings ladder to the upper middle class (USA, Canada, UK and Australia).

All of which suggests that the millennials are severely lagging previous generations in terms of both savings and investment. This is especially true as the issues relating to preferences (as opposed to affordability) are clearly not at play here (see the gap between ‘ownership’ and intent to own).

That point - made above - concerning the lack of evidence that millennials are not purchasing homes because their preferences might have shifted in favour of renting and way from owning is also supported by a sky-high proportions of millennials who go to such lengths as borrow from parents and live with parents to save for the deposit on the house:

Now, normally, I would not spend so much time talking about property-related surveys by the banks. But here’s what is of added interest here. Recent evidence suggests that millennials are quite different to previous generations in terms of their willingness to default on loans. Watch U.S. car loans (https://www.ft.com/content/0f17d002-f3c1-11e6-8758-6876151821a6 and https://www.experian.com/blogs/insights/2017/02/auto-loan-delinquencies-extending-beyond-subprime-consumers/) going South and the millennials are behind the trend (http://newsroom.transunion.com/transunion-auto-loan-growth-driven-by-millennial-originations-auto-delinquencies-remain-stable) on the origination side and now on the default side too (http://www.zerohedge.com/news/2017-04-13/ubs-explains-whos-behind-surging-subprime-delinquencies-hint-rhymes-perennials).

Which, paired with the HSBC analysis that shows significant financial strains the millennials took on in an attempt to jump onto the homeownership ‘ladder’, suggests that we might be heading not only into another wave of high risk borrowing for property purchases, but that this time around, such borrowings are befalling and increasingly older cohort of first-time buyers (leaving them less time to recover from any adverse shock) and an increasingly willing to default cohort of first-time buyers (meaning they will shit some of the burden of default onto the banks, faster and more resolutely than the baby boomers before them). Of course, never pay any attention to the reality is the motto for the financial sector, where FHA mortgages drawdowns by the car loans and student loans defaulting millennials (https://debtorprotectors.com/lawyer/2017/04/06/Student-Loan-Debt/Student-Loan-Defaults-Rising,-Millions-Not-Making-Payments_bl29267.htm) are hitting all time highs (http://www.heraldtribune.com/news/20170326/kenneth-r-harney-why-millennials-are-flocking-to-fha-mortgages)

Good luck having a sturdy enough umbrella for that moment when that proverbial hits the fan… Or you can always hedge that risk by shorting the millennials' favourite Snapchat... no, wait...

24/2/17: 2016 to 2017: Continuity of Risks

My article for the Cayman Financial Review covering the transition in strategic and systemic risks between 2016 and 2017 is available here: http://www.caymanfinancialreview.com/2017/02/01/the-continuation-of-a-horrible-year/.

9/6/2012: Why IMF 'vision' on EA crisis is missing major points

An interesting speech given by the IMF Managing Director, Ms Christine Lagarde to the Annual Leaders’ Dialogue Hosted by Süddeutsche Zeitung last night. Here are some extensive exerts from it and my thoughts - sketched out, rather than focused - about her ideas.


Part 2 of the speech focused on the need for breaking the cycles of the crisis(that amplify risks to the economy, including global economy). Do note - coincidentally, the theme is exactly identical to my forthcoming Sunday Times article and to the research note currently awaiting legal clearance (both will be posted here early next week).


Per Ms Lagarde:
"One is an economic cycle. The feedback loop between weak sovereigns, weak banks and weak growth that continually undermine each other.

"...Another cycle on my mind: the political economy. It is a cycle that has become too familiar since the start of the crisis, like a movie we have watched one too many times. It looks something like this. Tensions escalate and, out of necessity, policymakers take action. But, just enough for the danger to subside. Then the urgency is lost, momentum wanes, and the policy discourse begins to fracture, too focused on their own backyards and not enough on the big picture. And so tensions start to rise again.
But, with the passing of each cycle, we reach a higher and higher level of uncertainty, and the stakes rise.

"In the case of Europe, the cycles are now threatening the very existence of the European project. We must break both of these cycles if we are to break the back of this crisis. And one cannot happen without the other."

So far, on the money, although Ms Lagarde seems to be unwilling to recognize that we also have a structural growth problem in Europe, a problem linked with the above cycles, but also independently grave enough to warrant concern.

To break these cycles, "...the policy debate needs to move beyond the false dichotomies of growth versus austerity, stability versus opportunity, national versus international interests. We need to agree on a comprehensive strategy that is good for stability and good for growth."

So, per Ms Lagarde, the core pillars of such a strategy are: "First, macroeconomic policies should help support the recovery and also tackle the underlying causes of the crisis.

• Monetary policy should continue to be very supportive. Central banks, in particular the ECB, should further loosen monetary conditions, and remain ready to use unconventional tools to ease tensions and provide funding to address liquidity constraints. [In other words, Ms Lagarde is wisely going well beyond the rates policy alone. Good news, but no specifics.]
• Public debt remains too high and countries need credible and ambitious roadmaps to bring it down over the medium term. For the most part, that adjustment should be gradual and steady, unless countries are forced by markets to move more aggressively—which is, of course, the case for several countries in the Eurozone. If growth becomes weaker than expected, countries should stick to announced fiscal measures, rather than announced fiscal targets—as economists say, they should let the automatic stabilizers to operate. [Basically: do austerity policies, but don't chase targets too much. Unless you have to. In which case... well, nothing really new. Just do something?]

"Second, more effective crisis management. This is very urgent and mainly an issue for the euro area. But, a broader element is the collective effort to reinforce the global financial safety net. In this context, I welcome the increase in the IMF’s resources by $430 billion." [A complete 'Fail' for Ms Lagarde here. Increasing 'global safety net' is hardly the only factor in carrying out effective crisis management. How about recognizing that all problems are inter-linked with each other, and thus effective crisis management should be not about creating another pot from which lending can occur to the sovereigns, but actually creating a system that can permanently and swiftly resolve the singular core pressure cause that might be specific for each country? E.g. for Ireland - a system that can address the banking sector debts loaded into the real economy, for Greece - a system that can write off a large portion of the country sovereign debt without restructuring it into new debt, and so on]

"Third, we need more determined progress on structural reforms. For example, labor market and product market reforms that can carry the torch of growth beyond the immediate support from macroeconomic policies.' [Again, Ms Lagarde is exceptionally weak on specifics, in part because structural reforms are country-specific, but in part despite the fact that structural reforms for the euro area must include some - e.g. markets structure changes, moving economy away from state-dominated management and investment etc.]


In part 3 of her speech, Ms Lagarde focused on financial sector reforms.


"Let me be clear: the heart of European bank repair lies in Europe. That means more Europe, not less. ... To break the vicious cycle of financial-sovereign risks, there simply must be more risk-sharing across borders in the banking system. ...In the near term, this should include a pan-euro area facility that has the capacity to take direct stakes in banks. Looking a little further ahead, monetary union needs to be supported by building a true financial union that includes unified supervision; a single bank resolution authority with a common backstop; and a single deposit insurance fund."

[Aside from the 'true financial union', the common deposits insurance system is exactly what I suggest as well, although my proposals go further to include a common resolution mechanism for banks insolvencies that is systemic, not debt-based, unlike Ms Lagarde's approach that will simply pool bad debts into a larger warehousing facility, other than national one. Sadly, the logic of failed banking resolution policies to-date escapes Ms Lagarde. Pooling bad debts into a pan-European system instead of current national systems is equivalent to suggesting that putting all sick and healthy patients in one ward will somehow prevent contagion.]

"Moves toward deeper fiscal integration should go hand-in-hand with these efforts. In particular, the area needs to take the further step of some form of fiscal risk-sharing. Options here include some form of common bonds or a debt redemption fund. This would allow for common support before economic dislocation in one country develops into a costly crisis for the entire euro area." [This is an extraordinary statement for IMF MD - as I show in my forthcoming Sunday Times article, pooling sovereign debt risks will mean euro area sovereign debt/GDP ratio in excess of 110% by 2014-2015. Where is Europe's capacity to raise such debts and where its economic capacity to finance such debts?]

"And, on the upside, breaking the shackles of the sovereign-financial nexus will allow financial institutions to deliver credit and, in turn, create growth and jobs." [This is a rather silly conclusion/ promise that resembles the Irish Government's promises that first a global systemic guarantee, then Nama, subsequently extensive recaps - all policies advocated in this speech by Ms Lagarde, albeit at EA-wide level, instead of national levels - will create a healthy banking system with ample funding and risk-taking capacity to lend into the economy. In Irish case - this clearly did not happen. Neither has it happened in Japan. Why increasing the scale and spread of the diseases - the insolvent banking system - to supernational level should do the opposite?]

25/08/2011: BIS publishes a wish-list for global regulation of OTC derivativatives markets

The Committee on Payment and Settlement Systems and the Technical Committee of IOSCO released a report on over-the-counter (OTC) derivatives data that should be collected, stored and disseminated by trade repositories (TRs). The market for these instruments is current estimated at over $600 trillion. Details and report are available here.

Per BIS statement: "The committees support the view that TRs, by collecting such data centrally, would provide the authorities and the public with better and timely information. This would make markets more transparent, help to prevent market abuse, and promote financial stability."

I happen to agree with the above, subject to one core caveat: collecting data is not enough. It is imperative that data collected is organically integrated into analytical frameworks that actually have a meaningful connection to supervision. This, however, is hardly an easy (and low cost) measure to achieve.

The report implies:

• minimum data reporting requirements and standardised formats
• the methodology and mechanism for data aggregation on a global basis
• these requirements and data formats will apply to both market participants reporting to TRs and to TRs reporting to the public and to regulators
• new information currently not supported by TRs is also identified as being helpful in assessing systemic risk and financial stability, including: current exposure, netting and collateralisation details on bilateral portfolios of OTC transactions; current market values of individual open OTC derivatives transactions; information on collateral assets that are applied to OTC derivatives portfolios, including the valuation and disposition of these assets
  

Back in 2009, the G20 called for OTC derivatives to be centrally cleared and transactions reported to repositories by the end of 2012. In a number of cases, national markets regulators are already setting up such facilities, for example the Trade Information Warehouse for credit default swaps and the Equity Derivatives Reporting Repository, under the US DTCC.

The CPSS and the IOSCO latest call comes as the global authorities are trying to set international minimum standards to apply to derivatives markets from the end of 2012, when a global system of Legal Entity Identifiers (LEI tags) for individual transactions should come in place.

In addition, the authorities also want to develop a standardized international product classification system to provide better sorting of transactions and underlying data, with potential links to higher level risk analytics.

IOSCO previously published a discussion paper on the role of securities regulators with regard to systemic risk which:

• Identifies transparency and disclosure as an important tool for dealing with systemic risk, including product transparency and financial sector stress tests. To meet these requirements, the authorities "would need aggregate data on, inter alia, (i) each entity's current gross exposure and exposure net of collateral (in order to assess both the absolute size of its exposures and its relative importance for the markets under consideration); (ii) each entity's current gross exposures and exposure net of collateral to each of its major counterparties (in order to quantify interconnectedness); and (iii) aggregate exposures of all counterparties in terms of specific asset classes, products, currencies, reference entities and underlying sectors." This data can help evaluate potential "knock-on effects of financial distress at any one institution and identify concentrations of risk among groups of closely related institutions".
• Measuring counterparty exposure will require data regarding bilateral positions, market values of open positions, netting arrangements, collateralisation and disposition and valuation of collateral
• Determining bilateral positions will require "data on the full set of open trades between a pair of counterparties and their economic characteristics, including all terms that are required to calculate and assign a value to a trade such as effective and termination dates, notional amounts, underlier reference data, counterparty information, coupon amounts and schedules, and other salient economic terms specific to individual types of transactions (e.g., restructuring clauses for credit default swap ("CDS") contracts and reference interest rates for interest rate swaps)"
• Determining the effect of netting arrangements will require "data on the set or sets of positions whose gains and losses can be netted against one another in determining amounts owed to any counterparty".

It is, perhaps, revealing to read in the paper candid assessment of the two panels that current reporting infrastructure simply cannot cope with the data required for risk analysis (including higher level systemic risk analysis) in relation to the overall derivatives markets.

"Existing TRs, ...do not track and report market values of open positions with regular frequency. ...existing major TRs are organised along asset-class lines while counterparty risk is managed at the bilateral portfolio level. For example, in computing current exposure, gains in a counterparty's position in one derivative product may be netted against losses in another derivative product. ...TRs as currently implemented would be unable to provide a complete set of information for determining current exposures, and ...some data gaps would still remain. For example, gathering information about collateral and reliable market value for non-cleared OTC derivatives is a challenge. Similarly, it is challenging to create an effective system for capturing information on bilateral netting arrangements."

So on the net - the consultative process launched by today's announcement should be a very interesting one and I will be covering it here. In addition, myself and industry research co-author are working on a paper for the QJ of Central Banking which will touch on some of the issues relating to the above.

14/08/2011: A warning on synthetic ETFs class

An interesting, much overlooked working paper from the Bank for International Settlements, shines some light on recent innovations in financial engineering. It also contains a warning of the rising probability of the next asset class meltdown.

BIS Working Paper Number 343 (available here) “Market structures and systemic risks of exchange-traded funds” by Srichander Ramaswarmy starts from some historical stylized fact from finance.

“Crisis experience has shown that as the financial intermediation chain lengthens, it becomes complicated to assess the risks of financial products due to a lack of transparency …at different levels of the intermediation chain.”

Despite the crisis, however, the appetite for structured credit products is now growing, especially amongst the institutional investors with access to low cost funding (courtesy of the lax monetary policies). The problem, according to Ramaswarmy, is finding higher risk and higher returns products to beef up institutional portfolia returns – the very same problem identified back in 2002-2003 when, following the collapse of ICT bubble, tech stocks (high risk, high return products of the late 1990s) were wiped out.

“This time, financial intermediaries have responded by adding some innovative features to existing plain vanilla …exchange-traded funds (ETFs)... The structuring of these funds initially shared common characteristics with that of mutual funds. In particular, the underlying index exposure that the ETF replicated was gained by buying the physical stocks or securities in the index.”

As a result, of investors appetite for higher returns while simultaneously desiring high liquidity, “ETFs have moved away from being a plain vanilla cost- and tax-efficient alternative to mutual funds to being a much more complex and diverse array of products and replication schemes…” using derivative products. “As the volume of such products grows, such replication strategies can lead to a build-up of systemic risks in the financial system.”

Here are some interesting facts – all from Ramaswarmy:

• As of end-2010, there were close to 2,500 ETFs offered by around 130 sponsors and traded on more than 40 exchanges around the world.
• Global ETF assets under management rose from $410 billion in 2005 to $1,310 billion in 2010 (Chart left hand side panel) roughly 5.7% of the global mutual fund industry.
• “Almost all of the ETFs that are benchmarked against fixed income or equity indices in the United States are plain vanilla structures that involve” physical holding of securities that comprise the underlying index. “In Europe, roughly 50% of the ETFs are plain vanilla types, and the rest are replicated using synthetic structures (Chart, centre panel).”
• “Regulatory rules …encourage the adoption of plain vanilla structures in the United States [including notification, stress-testing and control over derivatives held, especially over-the counter derivatives]… The UCITS regulations that apply in Europe, on the other hand, permit exchange-traded as well as over-the-counter derivatives to be held in the fund…”
• As the result of more lax regulation in Europe, a significant share of more risky ETFs benchmarked to emerging market assets is “domiciled in Luxembourg or Dublin… ETFs benchmarked to emerging market assets now total $230 billion (Chart, right-hand panel).”
  

Synthetic ETFs replicate the index using derivatives such as unfunded total return swaps or the funded swaps as opposed to owning the physical assets.

The former type of a swap is a transaction between two counterparties to exchange the return arising from an asset for periodic cash flows. Under this swap system:

• ETF can end up holding physical securities / assets that are completely different from the benchmark index that the ETF is supposedly replicating.
• Underlying securities can incorporate potential conflicts of interest between the funding counterparty and the securities it pledges.
• “The composition of the assets in the collateral basket can change daily... Under UCITS regulations, the daily NAV of the collateral basket, …should cover at least 90% of the ETF’s NAV...”
  

An alternative is the funded swap under which, “the ETF sponsor transfers cash to the swap counterparty, who then provides the total return of the ETF index replicated. This transaction is collateralized… [usually to 110-120% of the NAV, using a system that] can potentially lead to delays in realising the value of collateral assets if the swap counterparty fails…”

These synthetic ETFs, per Ramaswarmy “transfer the risk of any deviation in the ETF’s return from its benchmark [the tracking error risk] to the swap provider... However, there is a trade-off: the lower tracking error risk comes at the cost of increased counterparty risk to the swap provider.”

In addition, many synthetic ETFs are at a risk of non-transparent “possible synergies that might exist between the investment banking activities of the parent bank and its asset management subsidiary or the unit within the parent bank that acts as the ETF sponsor. These synergies arise from the market-making activities of investment banking, which usually require maintaining a large inventory of stocks and bonds that has to be funded. When these stocks and bonds are less liquid, they will have to be funded either in the unsecured markets or in repo markets with deep haircuts. By transferring these stocks and bonds as collateral assets to the ETF provider sponsored by the parent bank, the investment banking activities may benefit from reduced warehousing costs for these assets…”

In other words, if ETF sponsor is cross-linked to the funding bank, the cost savings to the investment bank from synthetic ETF collateral are directly and inversely linked to the quality of the collateral held by the ETF – the lower the quality, the higher the savings. As Ramaswarmy puts it, “for example, there could be incentives to post illiquid securities as collateral assets.”

Furthermore, liquidity regulation, “such as the standards now proposed under Basel III, may also create incentives to use synthetic replication schemes” to artificially reduce the run-off rate on short maturity assets. This can be used to allow banks “to effectively keep the maturity of the funding short” and inflate bank’s liquidity positions.

All of the above benefits can yield short-term gains to ETF investors, but they come at a cost of:

1. increased risk to financial markets stability
2. lack of transparency in the quality of collateral held and liquidity positions
3. decreased transparency on ETF leverage and composition,
4. decreased liquidity of the ETF collateral can be further compounded by securities lending, and etc
   

Ramaswarmy summarizes these as follows: “Drawing on [the 2000-2008] experience, there are a number of channels through which risks to financial stability could materialise from ETFs, especially when product complexity and synthetic replication schemes grow in usage. They include:

1. co-mingling tracking error risk with the trading book risk by the swap counterparty could compromise risk management;
2. collateral risk triggering a run on ETFs in periods of heightened counterparty risk;
   
3. materialisation of funding liquidity risk when there are sudden and large investor withdrawals; and
4. increased product complexity and options on ETFs undermining risk monitoring capacity.”

Core ETFs’ risk minimisation mechanism – overcollateralisation – “might provide little comfort, as crisis experience has shown that collateral quality tests and collateral coverage tests designed by rating agencies for structured products did not protect senior tranche holders from losses.”

And there is a warning note to the investors: “by employing a variety of markets and players to replicate their benchmark indices, ETFs complicate risk assessment of the end product sold to investors. There is little transparency and no investor monitoring of the index replication process when this function is taken over by the swap counterparty. Financial innovation has added further layers of complexity through leveraged products and options on ETFs.”