By Juan Pablo Painceira
The possibility of a sovereign default in the Eurozone has been worrying not only the countries in question, but also European authorities and the global financial system. CDS spreads (or risk premiums) on European sovereign debt have widened dramatically in the last 6 months. In February, the situation deteriorated further and European sovereign CDS traded higher than companies rated close to the “junk” level! The main suspects for sovereign default would be Ireland and Greece with the risk premium around 250bp (over Germany) and to a lesser degree Spain and Portugal; but, even Germany (the benchmark EU sovereign), Austria and Belgium have suffered from the widening of CDS spreads.
So, what are the main reasons for this dark scenario? The causes, of course, lie in the unfolding of 2007-08 financial crisis and range from current account concerns to government deficit financing, passing on export demand and external finance problems. This year was already a scheduled year with huge sovereign bond issuance in which has been piled up with new finance needs, mainly stemming from banking bailout plans.
However, the role of ECB interventions to shore up the European money market has not been fully highlighted by the media and analysts as one of the main causes of widening on European risk premiums. Since the beginning of crisis, the ECB has decreased the quality of credit collateral in its repo-operations and other lending operations with the banking system. Basically, the banking system has been allowed to access the ECB’s standing facilities using securities with lower ratings or, even worse, with no trading at all. In simple words, the banking system has raised its finance needs through financial operations where they pump their bad assets into ECB’s balance sheet. In the end, it has effectively created an over supply of prime rated securities in the market and mostly important for European countries there has been a kind of crowding out between “toxic” banking securities and sovereign bonds. Financial investors can transform a “frog” into a “princess” through the ECB’s standing facilities so what would be the reason of buying a “princess” if you can buy much cheaper a “frog” and.…..
In the traditional economic theory, the solution to deal with the problem is straight forward, increased labour market flexibility! The relative price of wages would be the only adjustment mechanism in these countries given that devaluation is not possible within a single currency. So, it is clear that we have a great asymmetry between banking and sovereign debt! The result is that European states have to raise funds to cover their banking recapitalisation plans at a much higher fiscal cost and this is partly caused by its own central bank’s interventions!!
George Soros raised a related point in the FT, he claims the creation of Eurozone government bond market would help deal with the government finance problem. The problem is that right now the implementation of a European Treasury would only reinforce the financial interests managing the banking recapitalisation and not meet the needs of European population as might at first appear to be the case. The promises in public social investments coming with this new authority would be only carrots, in the end the sticks would be on our heads!
Wednesday, 25 February 2009
Monday, 16 February 2009
A definition of financialisation (one among many):
by Duncan Lindo
I wanna tell you a story:
It is a sunny day in early 2007. Robin Banks slips into the hushed corridors of the plush building in mid-town Manhattan that houses his wealth manager. It’s time to try one of these hedge funds.
Robin decides to invest $1milllion and his private bank is willing to lend him $3million more against his stake giving a total investment of $4m. Of course the private bank will charge some interest and a fee for arranging the purchase of the hedge fund stake.
The hedge fund they choose is big on structured credit trades – Collateralised Debt Obligations (CDOs) are the hottest deal in town. First thing, the hedge fund takes its 2% upfront fee. Because they understand the statistical models better than the rating agencies, they decide to go for the riskiest part of the CDO. They buy exposure to the equity tranche of a credit default swap (CDS) Index in derivative format from an investment bank. A fairly standard instrument and therefore one that their investment bank will sell to them for a 5% deposit (initial margin). Robin’s $1m which became $4m becomes $4m ÷ 5% = $80m of equity tranche exposure.
Over at the investment bank they can make money between the price at which they sold the risk and the price at which their models value it - but to capture the profit they need to hedge. Their pricing models tell them that with correlation trading as low as it is their delta hedge is 18.75. So to hedge their exposure to changes in the price of the CDS Index they need 18.75 x 80 = $1.5 billion of the index itself. The investment bank calls their most trusted market maker and starts to work an order for $1.5bn of index – a big order but should be manageable over a day or so. Robin’s 1million became 1.5bn!!
The market maker is more than happy – for such an order he can widen his bid-ask spread and should make 4-5bps running or approx 0.2% of $1,5bn.
Laying off that much risk though moves the market slightly. Across the room the index arbitrage desk notices that the spread between the price of the index and the combined price of the constituents is wide enough for him to put on a trade. It will pay off when the price of the index and the constituents come back into line – even if it’s at maturity. He trades the index and gets to work trading the underlying, single name CDS.
The single name CDS market makers know the index guy and get to work passing the risk to their clients – taking their bid ask. In a few of the less liquid names their hedging trades are enough to move the price of the CDS. Upstairs on the convertibles trading desk, someone notices that the new price for the credit risk (automatically input into their models) tells them that in order to remain hedged they need to trade…so they call their market maker….across the road an equity trader notices the price has changed…time to re-hedge, so they call their market makers…
I wanna tell you a story:
It is a sunny day in early 2007. Robin Banks slips into the hushed corridors of the plush building in mid-town Manhattan that houses his wealth manager. It’s time to try one of these hedge funds.
Robin decides to invest $1milllion and his private bank is willing to lend him $3million more against his stake giving a total investment of $4m. Of course the private bank will charge some interest and a fee for arranging the purchase of the hedge fund stake.
The hedge fund they choose is big on structured credit trades – Collateralised Debt Obligations (CDOs) are the hottest deal in town. First thing, the hedge fund takes its 2% upfront fee. Because they understand the statistical models better than the rating agencies, they decide to go for the riskiest part of the CDO. They buy exposure to the equity tranche of a credit default swap (CDS) Index in derivative format from an investment bank. A fairly standard instrument and therefore one that their investment bank will sell to them for a 5% deposit (initial margin). Robin’s $1m which became $4m becomes $4m ÷ 5% = $80m of equity tranche exposure.
Over at the investment bank they can make money between the price at which they sold the risk and the price at which their models value it - but to capture the profit they need to hedge. Their pricing models tell them that with correlation trading as low as it is their delta hedge is 18.75. So to hedge their exposure to changes in the price of the CDS Index they need 18.75 x 80 = $1.5 billion of the index itself. The investment bank calls their most trusted market maker and starts to work an order for $1.5bn of index – a big order but should be manageable over a day or so. Robin’s 1million became 1.5bn!!
The market maker is more than happy – for such an order he can widen his bid-ask spread and should make 4-5bps running or approx 0.2% of $1,5bn.
Laying off that much risk though moves the market slightly. Across the room the index arbitrage desk notices that the spread between the price of the index and the combined price of the constituents is wide enough for him to put on a trade. It will pay off when the price of the index and the constituents come back into line – even if it’s at maturity. He trades the index and gets to work trading the underlying, single name CDS.
The single name CDS market makers know the index guy and get to work passing the risk to their clients – taking their bid ask. In a few of the less liquid names their hedging trades are enough to move the price of the CDS. Upstairs on the convertibles trading desk, someone notices that the new price for the credit risk (automatically input into their models) tells them that in order to remain hedged they need to trade…so they call their market maker….across the road an equity trader notices the price has changed…time to re-hedge, so they call their market makers…
Wednesday, 11 February 2009
Economic inequality and asset inflation
by Jan Toporowski
In the discussion about the financial crisis, one important factor has been overlooked, namely the distribution of income and wealth. It is obvious that the social consequences of the financial crisis have been made so much more painful by the growing inequalities of income and wealth in the United States and the United Kingdom. But there are also connections between such inequalities and financial instability. These have been highlighted by many critics of financialised capitalism. For example, John Hobson, most famous for his 1902 classic Imperialism A Study, argued that inequalities of wealth and income gave rise to over-saving, and hence economic stagnation. More recently, the late John Kenneth Galbraith noted the connection between tax cuts for the rich and asset inflation.
Asset inflation and income and economic inequalities are intimately linked. Asset inflation means rising values of financial assets and housing. Such inflation allows owners of such assets to write off debts against capital gains, buying an asset with borrowed money, and then repaying that borrowing together with interest and obtaining a profit when the asset is sold. Hence the proliferation of borrowing by households and consumption ultimately financed by debt. When the asset is housing, its inflation is especially pernicious. The housing market then redistributes income and wealth from young people earning less at the start of their careers and indebting themselves hugely in order to get somewhere decent to live, to people enjoying highest earnings at the end of their careers. But housing inflation is also like a pyramid banking scheme because it requires more and more credit to be put into the housing market in order to allow those profiting from house inflation to be able to realise their profits.
Nevertheless, even those entering the system with large debts hope to be able to profit from it. Such has been the dependence of recent governments and society in general on asset inflation that the political consensus is ‘intensely relaxed’ about such regressive redistribution of income. That consensus has encouraged the belief that the best that young people can do to enhance their prospects is to indebt themselves in order to ‘get on the property ladder’, i.e., enrich themselves (or at least improve their housing) through housing inflation.
Those at the bottom of the income distribution inevitably suffer most from rising house prices because, living in the worst housing, they have the least possibility to accommodate their house purchase to their income by buying cheaper, smaller housing. Having little other option but to over-indebt themselves in order to secure their housing, default rates among households in this social group are also most likely to rise with house price inflation. This inequality lies behind the problems in the sub-prime market in the U.S. and the equivalents of that market in the U.K. and elsewhere. Paradoxically, a more equal distribution of income and wealth is more likely to keep the housing market in equilibrium, because any increase in house prices above the rate of increase in income and wealth is more likely to result in a fall in demand for housing. Where income and wealth are already unequally distributed, and house prices rise faster than incomes, a fall in demand from those who can no longer afford a given class of housing is off-set by the increased demand for that class of housing among households that previously could afford better housing. In this way, the redistribution of income and wealth from those with more modest incomes to those with on higher incomes also facilitates asset inflation in the housing market.
Thus asset inflation has increased inequalities of wealth and income and those inequalities have further fed that inflation. Such inflation is therefore a self-reinforcing pathology of financial markets and society, rather than, as the economics establishment tells us, a temporary disequilibrium (a ‘bubble’) in the markets. Financial stability rests not only on sound banking and financial institutions. It also requires a much more equal distribution of income and wealth.
In the discussion about the financial crisis, one important factor has been overlooked, namely the distribution of income and wealth. It is obvious that the social consequences of the financial crisis have been made so much more painful by the growing inequalities of income and wealth in the United States and the United Kingdom. But there are also connections between such inequalities and financial instability. These have been highlighted by many critics of financialised capitalism. For example, John Hobson, most famous for his 1902 classic Imperialism A Study, argued that inequalities of wealth and income gave rise to over-saving, and hence economic stagnation. More recently, the late John Kenneth Galbraith noted the connection between tax cuts for the rich and asset inflation.
Asset inflation and income and economic inequalities are intimately linked. Asset inflation means rising values of financial assets and housing. Such inflation allows owners of such assets to write off debts against capital gains, buying an asset with borrowed money, and then repaying that borrowing together with interest and obtaining a profit when the asset is sold. Hence the proliferation of borrowing by households and consumption ultimately financed by debt. When the asset is housing, its inflation is especially pernicious. The housing market then redistributes income and wealth from young people earning less at the start of their careers and indebting themselves hugely in order to get somewhere decent to live, to people enjoying highest earnings at the end of their careers. But housing inflation is also like a pyramid banking scheme because it requires more and more credit to be put into the housing market in order to allow those profiting from house inflation to be able to realise their profits.
Nevertheless, even those entering the system with large debts hope to be able to profit from it. Such has been the dependence of recent governments and society in general on asset inflation that the political consensus is ‘intensely relaxed’ about such regressive redistribution of income. That consensus has encouraged the belief that the best that young people can do to enhance their prospects is to indebt themselves in order to ‘get on the property ladder’, i.e., enrich themselves (or at least improve their housing) through housing inflation.
Those at the bottom of the income distribution inevitably suffer most from rising house prices because, living in the worst housing, they have the least possibility to accommodate their house purchase to their income by buying cheaper, smaller housing. Having little other option but to over-indebt themselves in order to secure their housing, default rates among households in this social group are also most likely to rise with house price inflation. This inequality lies behind the problems in the sub-prime market in the U.S. and the equivalents of that market in the U.K. and elsewhere. Paradoxically, a more equal distribution of income and wealth is more likely to keep the housing market in equilibrium, because any increase in house prices above the rate of increase in income and wealth is more likely to result in a fall in demand for housing. Where income and wealth are already unequally distributed, and house prices rise faster than incomes, a fall in demand from those who can no longer afford a given class of housing is off-set by the increased demand for that class of housing among households that previously could afford better housing. In this way, the redistribution of income and wealth from those with more modest incomes to those with on higher incomes also facilitates asset inflation in the housing market.
Thus asset inflation has increased inequalities of wealth and income and those inequalities have further fed that inflation. Such inflation is therefore a self-reinforcing pathology of financial markets and society, rather than, as the economics establishment tells us, a temporary disequilibrium (a ‘bubble’) in the markets. Financial stability rests not only on sound banking and financial institutions. It also requires a much more equal distribution of income and wealth.
Monday, 9 February 2009
The Brazilian Real’s “Fundamental” Problem
by Annina Kaltenbrunner
Between August and December 2008 the Brazilian Real depreciated by more than 60 %. At the same time, foreign exchange reserves at the central bank stood at over US$ 200 billion in August 2008 and for the first time in its history the country had acquired “net creditor status”. Forgotten were the claims of “decoupling”, as the international financial crisis (once again) hit the countries at the periphery. However initially, “decoupling” seemed to have become reality.
When financial markets in the developed world first started to be shaken by the sub-prime implosion in autumn 2007, money continued to pour in some emerging markets as high real interest rates became particularly interesting in the face of falling yields in developed markets. Indeed foreign reserves at the Brazilian central bank continued to increase by near 30% between August 2007 and 2008 and the Real gained another 20% against the US dollar over the period.
Then, in August 2008 the market turned, first slowly and later in an accelerated fashion as the US government refused to support the struggling Lehman Brothers. Although expectations of faltering domestic growth – on reduced external demand – and slowing commodity prices might have contributed to the currency’s decline, the Brazilian Real’s main “fundamental” problem was (and is) the country’s increased and ongoing integration into international financial markets and the financialisation of the domestic economy.
First, as losses in international financial markets mounted, deleveraging and the flight from risky assets did not spare emerging markets. Brazilian (currency) assets are among the most liquid and widely traded emerging market assets in (international) investors’ portfolios, whose adjustments can result in large capital flows and currency movements, seemingly unwarranted by “fundamentals”. And indeed, Brazil’s capital account reversed from an average monthly surplus of around US$ 6 billion over the first half of the year to a deficit of more than US$ 9 billion in October and November 2008!
Second, the reversal in the currency’s value hit several of Brazil’s biggest companies, which – on the backdrop of years of sustained currency appreciation – had taken substantial currency bets on the derivatives market. The increased involvement of real sector companies in the financial market weighed on the currency through two channels: first, a scramble for foreign exchange as the affected companies hurried to cover their losses; and second, concerns about financial sector stability, as uncertainty about banks’ exposure to the affected companies reigned.
Finally, and probably most importantly for currency dynamics, increased financial integration has not only affected exchange rate behaviour through capital markets, but also through the banking sector. Although unique among Latin American countries in having a strong presence of domestic banks, Brazilian banks have increasingly used the wholesale market to acquire - short-term - funding. Thus, as international money markets dried up in the wake of the crisis, so did credit lines to Brazilian banks, which found themselves unable to extend short-term financing, mainly trade credit lines. The inability to obtain and/or rollover outstanding external debt and the necessity to meet other foreign exchange payments again led to scrambling in an already strained foreign exchange market, pushing the currency to recently experienced depreciated level.
And why should we care? Around 44% of the income generated in Brazil continues to accrue to the richest 10% of the population (and this excludes wealth!), while the 20% poorest of the population earn a total of 2.9%. This is also related to the processes described above, because while gains on currency speculation are reaped by a few market participants, the costs of (currency) crisis are borne by the population as a whole!!
Between August and December 2008 the Brazilian Real depreciated by more than 60 %. At the same time, foreign exchange reserves at the central bank stood at over US$ 200 billion in August 2008 and for the first time in its history the country had acquired “net creditor status”. Forgotten were the claims of “decoupling”, as the international financial crisis (once again) hit the countries at the periphery. However initially, “decoupling” seemed to have become reality.
When financial markets in the developed world first started to be shaken by the sub-prime implosion in autumn 2007, money continued to pour in some emerging markets as high real interest rates became particularly interesting in the face of falling yields in developed markets. Indeed foreign reserves at the Brazilian central bank continued to increase by near 30% between August 2007 and 2008 and the Real gained another 20% against the US dollar over the period.
Then, in August 2008 the market turned, first slowly and later in an accelerated fashion as the US government refused to support the struggling Lehman Brothers. Although expectations of faltering domestic growth – on reduced external demand – and slowing commodity prices might have contributed to the currency’s decline, the Brazilian Real’s main “fundamental” problem was (and is) the country’s increased and ongoing integration into international financial markets and the financialisation of the domestic economy.
First, as losses in international financial markets mounted, deleveraging and the flight from risky assets did not spare emerging markets. Brazilian (currency) assets are among the most liquid and widely traded emerging market assets in (international) investors’ portfolios, whose adjustments can result in large capital flows and currency movements, seemingly unwarranted by “fundamentals”. And indeed, Brazil’s capital account reversed from an average monthly surplus of around US$ 6 billion over the first half of the year to a deficit of more than US$ 9 billion in October and November 2008!
Second, the reversal in the currency’s value hit several of Brazil’s biggest companies, which – on the backdrop of years of sustained currency appreciation – had taken substantial currency bets on the derivatives market. The increased involvement of real sector companies in the financial market weighed on the currency through two channels: first, a scramble for foreign exchange as the affected companies hurried to cover their losses; and second, concerns about financial sector stability, as uncertainty about banks’ exposure to the affected companies reigned.
Finally, and probably most importantly for currency dynamics, increased financial integration has not only affected exchange rate behaviour through capital markets, but also through the banking sector. Although unique among Latin American countries in having a strong presence of domestic banks, Brazilian banks have increasingly used the wholesale market to acquire - short-term - funding. Thus, as international money markets dried up in the wake of the crisis, so did credit lines to Brazilian banks, which found themselves unable to extend short-term financing, mainly trade credit lines. The inability to obtain and/or rollover outstanding external debt and the necessity to meet other foreign exchange payments again led to scrambling in an already strained foreign exchange market, pushing the currency to recently experienced depreciated level.
And why should we care? Around 44% of the income generated in Brazil continues to accrue to the richest 10% of the population (and this excludes wealth!), while the 20% poorest of the population earn a total of 2.9%. This is also related to the processes described above, because while gains on currency speculation are reaped by a few market participants, the costs of (currency) crisis are borne by the population as a whole!!
Tuesday, 3 February 2009
The Current Situation in Greece: a sketch
by George Lambrinidis
The state of affairs in Greece is hot, no doubt about that. This is not new, nor is it directly correlated to the current financial crisis; rather, we have a scaling of the tension that is definitely related to the fact that the Greek oriented capital manages to achieve very high rates of profitability, while there is a very strong political movement. The key factors in this contradiction are the low level of organization of the workers and the historical roots of the Communist Party in society. This post is the first of a series that will highlight some key features of the current situation in Greece, starting with the presentation of the main frontiers.
At the time of writing the farmers were in the 9th day of their blockage of the highways, borders and other major roads with their tractors, practically paralyzing the road network. Some of their claims are against the Common Agricultural Policy and the policies that shrink the income of smaller producers to the benefit of big companies. This has been an open frontier for years, and has its own issues.
In the cities, now, there are two frontiers. The first one concerns education. The students are preparing their next move, after the demonstrations of December and those supporting the Palestinians. The main issues concern the founding of private universities (until now constitutionally forbidden), the abolishment of asylum (so police can enter the universities), the equalization of diplomas from universities with those from private colleges, the breakdown of the undergraduate into two cycles (until now 4 years minimum), the imposition of fees, the salaries and the working conditions of the professors, the facilities; practically everything.
The events of December following the execution of a 15-year old by a policeman also deserve some comment. First, they occurred against a background of already heightened tension due to very low wages and incomes, strict fiscal policy, inflation, persistent unemployment at the official rate of 9% (the real figure is at least 14%), state terrorism and government corruption and, most importantly, no perspective for improvement; on the contrary, the country was on the brink of crisis. So the murder of the child was the last straw.
Second, several other factors were less reported. Another pupil was shot on the 10th, outside his school, while discussing with other pupils their participation in next day’s demo. The bullet stuck in his arm and that prevented him from dying. On the 22nd, the secretary of the union of the cleaners, a 44-year old woman from Bulgaria was murderously attacked with acid in response to her fighting stance the previous period. The murderers even forced her to drink the acid! During the time that the cities were on fire, the police forces were beating and arresting 10- to 15-year old pupils in the morning, while successfully playing an old game with rioters at night.
Finally, big strikes were held, workers demonstrated in the streets with their children and teachers with their pupils, but the media of the bourgeoisie ignored them, presenting only repeated scenes of destruction, appalling people and discouraging them from participating in the demonstrations.
Which brings us to the third frontier: that of the workers. Despite the fact that the workers are struggling, there are serious limits to their fight. In the next post we will discuss the working movement and the political situation.
The state of affairs in Greece is hot, no doubt about that. This is not new, nor is it directly correlated to the current financial crisis; rather, we have a scaling of the tension that is definitely related to the fact that the Greek oriented capital manages to achieve very high rates of profitability, while there is a very strong political movement. The key factors in this contradiction are the low level of organization of the workers and the historical roots of the Communist Party in society. This post is the first of a series that will highlight some key features of the current situation in Greece, starting with the presentation of the main frontiers.
At the time of writing the farmers were in the 9th day of their blockage of the highways, borders and other major roads with their tractors, practically paralyzing the road network. Some of their claims are against the Common Agricultural Policy and the policies that shrink the income of smaller producers to the benefit of big companies. This has been an open frontier for years, and has its own issues.
In the cities, now, there are two frontiers. The first one concerns education. The students are preparing their next move, after the demonstrations of December and those supporting the Palestinians. The main issues concern the founding of private universities (until now constitutionally forbidden), the abolishment of asylum (so police can enter the universities), the equalization of diplomas from universities with those from private colleges, the breakdown of the undergraduate into two cycles (until now 4 years minimum), the imposition of fees, the salaries and the working conditions of the professors, the facilities; practically everything.
The events of December following the execution of a 15-year old by a policeman also deserve some comment. First, they occurred against a background of already heightened tension due to very low wages and incomes, strict fiscal policy, inflation, persistent unemployment at the official rate of 9% (the real figure is at least 14%), state terrorism and government corruption and, most importantly, no perspective for improvement; on the contrary, the country was on the brink of crisis. So the murder of the child was the last straw.
Second, several other factors were less reported. Another pupil was shot on the 10th, outside his school, while discussing with other pupils their participation in next day’s demo. The bullet stuck in his arm and that prevented him from dying. On the 22nd, the secretary of the union of the cleaners, a 44-year old woman from Bulgaria was murderously attacked with acid in response to her fighting stance the previous period. The murderers even forced her to drink the acid! During the time that the cities were on fire, the police forces were beating and arresting 10- to 15-year old pupils in the morning, while successfully playing an old game with rioters at night.
Finally, big strikes were held, workers demonstrated in the streets with their children and teachers with their pupils, but the media of the bourgeoisie ignored them, presenting only repeated scenes of destruction, appalling people and discouraging them from participating in the demonstrations.
Which brings us to the third frontier: that of the workers. Despite the fact that the workers are struggling, there are serious limits to their fight. In the next post we will discuss the working movement and the political situation.
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