Session 5 August 22, 2012


. ISDA; ISDA on Greece [see]


. See Michael Dooley, David Folkerts-Landau and Peter Garber: "An Essay on the Revived Bretton Woods System", NBER Working Paper 9971, 2003

. In February 2012, the stock of Central bank liquidity swaps was at $109.1 billion [see]. It now stands at $30 billion [see].
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Credit Default Swaps / Futures Markets


. CDS prices from Markit

. Federal Republic of Germany [see]. Note the change created by the Lehman Brothers crisis. As the flight-to-safety intesified with the worsening Eurozone crisis, CDS prices climbed. 

. Russian Federation [see]. A remarkable story. The country is perceived by the CDS market as very stable; oil prices are a key to Russia’s CDS prices. Look, on the longer-term chart, at what happened in 2009.


. Republic of Argentina [see]. Argentina defaulted on its sovereign debt in late 2001; since then, the country was unable to issue new debt at reasonable interest rates. Maybe the highest CSD prices in the world!


. CME VIDEO
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BALANCE SHEET EXERCISE

AM | @MackinlayEuruni


QUESTION. READ FIRST AND ‘LOCATE’ PROBLEMS IN THE BALANCE SHEET: DOES IT AFFECT ASSETS? DOES IT AFFECT LIABILTIES? DOES IT AFFECT BOTH?. AS YOU PROVIDE ANSWERS, WE PLOT THE POINTS INTO THE BALANCE SHEET.

(1) “Many banks are struggling to fund themselves as Europe’s debt crisis deepens” (David Oakley: “CDS highlights funding worries”, Financial Times, October 5 2011).

(2) “Austrian banking supervisors have instructed the country’s banks to limit future lending in their eastern European subsidiaries … The government is concerned about losses in eastern Europe –where they are the biggest lenders- and their exposure to Italy … Erste Bank, Raiffesen Bank and Bank Austria have a CEE exposure that exceeds Austria’s GDP”. (Eric Frey: “Austrian banks ordered to limit central and east Europe exposure”, Financial Times, November 22 2011).

(3) “Many European banks have been shut out of traditional funding markets in recent months, forcing them to rely on central banks for liquidity or to become more creative in obtaining new financing amid market turmoil. Accordingly, some of the strongest UK banks are providing strained European lenders shut out of global funding markets with large amounts of financing. The deals average €200-€500m in size, with maturity dates of two to 10 years. However, amounts of up to €1bn have also been heard. ‘Haircuts’, or collateral taken to protect the lender from adverse movements, were very high, at 15 to 25 per cent or more”. (“Tracy Alloway: “Europe’s banks strike funding deals”, Financial Times, November 24 2011).

(4) “Some banks in countries such as Spain and Italy are finding it harder to secure euro funding from conventional sources amid concerns about a possible Greek sovereign debt default, and in the face of deep skepticism from foreign banks. One measure of the pressure on Spanish banks in particular was their net borrowing from the European Central Bank, which increased sharply to average €6992bn in August, from €52.05 in August, according to figures from the Bank of Spain” (Victor Mallet: “Small banks remain in need of funding”, Financial Times, October 5 2011).

(5) “The onslaught on European banks is unremitting. In the latest setback for banks in Europe, Moody’s Investors Service has put the subordinated debt of nearly 90 per cent of them under review for a possible downgrade. No surprises here: European sovereigns have limited appetite or ability to support them, let alone bondholders. But the warning highlights the risk of a European credit crunch as banks shrink assets and as they struggle to fund those assets”. FROM THE CHART: Italy’s Unicredit pays a 700 basis point spread in the interbank market; Santander is at 480 bps, while Barclays stands at 201 bps. (Lex: “Euro bunch of losers”, Financial Times, December 1 2011).

(6) “Mario Draghi, ECB president, told the European Parliament last week: We have observed serious credit crunch tightening which, combined with a weakening in the business cycle, does not bode at all well for months to come. Small and medium-sized companies are being the hardest hit. The most important thing for the ECB is to repair the credit channel” (Ralph Atkins: “ECB sets sights on shoring up banks”, Financial Times, December 5 2011).
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FINANCIAL CRISIS, FLIGHT-TO-QUALITY AND THE DOLLAR PROBLEM

AM | @MackinlayEuruni

. The Role of the Dollar as the key international reserve currency. Understanding the banking crisis: a (brief) look at the US dollar as the key international reserve currency. 1945-1973: Germany & Japan; 1978-2007: China. The stock of productive capital destroyed; authoritarian political culture. The solution: LOW COST OF LABOUR through a fixed (and undervalued) local currency against the dollar.

 . China’s economic development model. In order to avoid an exchange rate adjustment, China recycles its foreign-exchange reserves into the US credit market. [QUESTION: IMPACT ON THE US CREDIT MARKET??][CHART] [Annex to the Federal Reserve’s Weekly Balance Sheet]. Michael P. Dooley, David Folkerts-Landau & Peter Garber: “An Essay on the Revived Bretton Woods System”, NBER Working Paper 9971 (2003).

. Psychology & Markets: Attitudes toward risk. US credit markets flooded with cash! Jacques Rueff. Le péché monétaire de l’Occident. Paris: Plon, 1971:

The process works this way. When the U.S. has an unfavorable balance with another country (let us take as an example France), it settles up in dollars. The Frenchmen who receive these dollars sell them to the central bank, the Banque de France, taking their own national money, francs, in exchange. The Banque de France, in effect, creates these francs against the dollars. But then it turns around and invests the dollars back into the U.S. Thus the very same dollars expand the credit system of France, while still underpinning the credit system in the U.S. The country with a key currency is thus in the deceptively euphoric position of never having to pay off its international debts.

The money it pays to foreign creditors comes right back home, like a boomerang … The functioning of the international monetary system is thus reduced to a childish game in which, after each round, the winners return their marbles to the losers … The discovery of that secret [namely, that no adjustment takes place] has a profound impact on the psychology of nations (la psychologie des peuples) … This is the marvelous secret of the deficit without tears, which somehow gives some people the (false) impression that they can give without taking, lend without borrowing, and purchase without paying. This situation is the result of a collective error of historic proportions.
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FLIGHT-TO-SAFETY: SOME FOOD FOR THOUGHT

AM | @MackinlayEuruni

The F-t-S episode triggered by the collapse of Lehman Brother and by the European debt crisis has reached such proportions that more and more scholars, regulators and journalists are turning to the question from a variety of points of view. Here's a brief review of some of the most recent material.

. John Coates. The Hour Between Dog and Wolf: Risk Taking, Gut Feelings and the Biology of Boom and Bust. Penguin, 2012 [info] [VIDEO]. See review by Clive Cookson: "The biology of banking", Financial Times, May 19-20, 2012.

. Paul Ormerod. Positive Linking. How Networks Can Revolutionise the World. Faber & Faber, 2012 [info]. See review by Claire Jones: "When copying others is the rational choice", Financial Times, July 9, 2012.

. Akerlof, George A. & Schiller, Robert A. Animal Spirits. How Human Psychology Drives the Economy, and Why it Matters for Global Capitalism (Princeton University Press, 2009) [see]

. Turner Review. A regulatory response to the global banking crisis (London: Financial Services Authority, 2009). See p. 41: “Individual behaviour is not entirely rational. There are moreover insights from behavioural economics, cognitive psychology and neuroscience, which reveal that people often do not make decisions in the rational front of brain way assumed in neoclassical economics, but make decisions which are rooted in the instinctive part of the brain, and which at the collective level are bound to produce herd effects and thus irrational momentum swings”.

. J. M. Coates & J. Herbert: “Endogenous steroids and financial risk taking on a London trading floor”, Proceedings of the National Academy of Sciences, April 2008 [Judge Business School, University of Cambridge, Cambridge CB2 1AG, United Kingdom ; Cambridge Center for Brain Repair, University of Cambridge, Cambridge CB2 0PY, United Kingdom]. Edited by Bruce S. McEwen, The Rockefeller University, New York, NY, and approved November 6, 2007 (received for review May 1, 2007). Abstract: Little is known about the role of the endocrine system in financial risk taking. Here, we report the findings of a study in which we sampled, under real working conditions, endogenous steroids from a group of male traders in the City of London. We found that a trader's morning testosterone level predicts his day's profitability. We also found that a trader's cortisol rises with both the variance of his trading results and the volatility of the market. Our results suggest that higher testosterone may contribute to economic return, whereas cortisol is increased by risk. Our results point to a further possibility: testosterone and cortisol are known to have cognitive and behavioral effects, so if the acutely elevated steroids we observed were to persist or increase as volatility rises, they may shift risk preferences and even affect a trader's ability to engage in rational choice.

. Roger Boyes: "Age of Testosterone comes to end in Iceland", TimesOnline (February 7, 2009). Iceland, ravaged throughout history by volcanic eruptions and natural catastrophes, is struggling with a man-made disaster so overwhelming that the women are taking over. It is, they say here, the end of the Age of Testosterone. Next week a newly minted left-leaning Government led by Johanna Sigurdardottir will start to tackle the tough agenda of cleaning out the old-school-chum networks that have led Iceland to the verge of bankruptcy. Half of her Cabinet will be women; female advisers carrying briefcases move in and out of the Prime Minister's whitewashed office, a former jailhouse in the middle of Reykjavik. Two women, Birna Einarsdottir and Elin Sigfusdottir, now run the struggling and disgraced New Landsbanki and New Glitnir banks. We have to create a new sense of solidarity,” says the Social Democrat Prime Minister. The departing Government — retreating would be more precise — put business first, people second, say the premier's counsellors. Now is the time for a shift in values. Listening to Ms Sigurdardottir talk in her dry, schoolmistress manner, it becomes clear that the fall of the Icelandic Government was not just the first political casualty of the global downturn, but also a signal that men in suits have led the world astray. “We are going to base our economic policies on prudence and responsibility, but we also stress social values, women's rights, equality and justice,” she says. “You can see what is happening,” says Katrin Olafsdottir, Associate Professor of Economics and a member of the board of New Glitnir, which is trying to devise a new mission for the crippled bank. “The men went out there and took these incredibly irrational risks — and getting loads of money for doing it, feeling really good about it - and then the women have to come in to clean it up.”
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UNDERSTANDING CREDIT MARKETS: FLIGHT-TO-SAFETY!

AM | @MackinlayEuruni

When Lehman Brothers declared bankruptcy on September 15 2008, one money-market fund that had lent as much as $785 million to Lehman declared that it was unable to pay the full amount of its liabilities. It was the first time that such an event took place! Investors promptly took $40 billion out of that fund. NOW EVERY PARTICIPANT IN THE CREDIT MARKET STARTS TO FEAR ABOUT THE SOLVENCY OF EVERYBODY ELSE!!! WHO HAS LENT TO LEHMAN? WHO HAS INSURED THOSE WHO HAVE LENT? ETC. ETC. ETC.

This feeling of general distrust sets in motion a flight-to-quality episode in credit markets. Let us see how that works. Imagine one Ms. De Souza, a 37-year old hospital manager in Sao Paulo, Brazil. A mother of two, she wants to send her children to a US college. She needs to very cautious about her $400.000 nest egg! She watches the Lehman news on TV; she reads the newspapers. She starts to worry. “What if my investments in loans to companies both in Brazil and the US decline in value as banks refuse to lend to private companies? What if my investments in loans to emerging market states decline in value as global economic trade and growth falls, forcing some states to default on their debt?” She makes up her mind and calls her broker in Sao Paulo, with three very precise instructions:

1. Stop all lending to entrepreneurs, wherever they are located

2. Stop all lending to sovereign issuers from emerging markets countries

3. Invest all the available resources into loans to the US Federal government, or to the German government.

The behavior of our hypothetical Ms. De Souza is replicated worldwide. Many investors react exactly like her: in Russia (INVESTING IN GERMAN BUNDS), in Thailand, in the Netherlands, etc. Now remember the paper from Horace Brock (Session 1): INTEREST RATES CHANGE WHENEVER NEW INFORMATION ALTERS THE BEHAVIOR OF EITHER/OR THOSE WHO SUPPLY LOANABLE RESOURCES AND THOSE WHO DEMAND CREDIT. The Lehman Brothers bankruptcy IS INDEED NEW INFORMATION! Interest rates are bound to change. But how? Let us look at two different kinds of credit markets: (a) sovereign borrowers; (b) corporate borrowers. 

(a) Sovereign borrowers (national governments). They can be further divided into two categories. Some countries that feature an institutional framework that protects the performance of contracts (rule of law, stable property rights, judicial independence). That list would include: US, UK, Canada, Germany, The Netherlands, Japan, most Nordic countries, Switzerland, etc. These tend to be perceived as risk-free borrowers.

(b) Corporations (companies). Unlike sovereign issuers, private companies are unable to impose taxes; their solvency is at risk whenever the economy goes into a prolonged recession.

Note that the definition of “risk-free” is not set in stone. The USA were very risky issuers of debt between 1776 and 1783! Nowadays, some emerging-market countries have made phenomenal progress in terms of property rights protection and credit market sophistication (Brazil, Singapore and South Korea come to mind here). BUT GENERALLY SPEAKING, FLIGHT-TO-QUALITY EPISODES TEND TO END UP WITH LOANABLE RESOURCES BEING REDIRECTED TO SOVEREIGN BONDS OF COUNTRIES WITH INDEPENDENT CENTRAL BANKS, JUDICIAL INDEPENDENCE, RULEOF LAW, ETC.

[DIAGRAMS. WE PLOT CHANGES IN THREE CREDIT MARKETS]

(a) AT EACH LEVEL OF THE INTEREST RATE, SUPPLIERS OF LOANABLE RESOURCES SUPPLY LESS IN THE ENTREPRENEURS CREDIT MARKET: THE INTEREST RATE GOES UP.

(b) AT EACH LEVEL OF THE INTEREST RATE, SUPPLIERS OF LOANABLE RESOURCES SUPPLY LESS IN THE CREDIT MARKET FOR RISKY SOVEREIGN BORROWERS: THE INTEREST RATE GOES UP.

(c) AT EACH LEVEL OF THE INTEREST RATE, SUPPLIERS OF LOANABLE RESOURCES SUPPLY MORE IN THE CREDIT MARKET FOR RISK-FREE SOVEREIGN BORROWERS: THE INTEREST RATE GOES DOWN.

A FLIGHT-TO-QUALITY EPISODE OCCURS WHENENVER EVENTS (a), (b) and (c) take place.
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Credit spreads

Credit spreads are important financial and economic indicators. Credit spreads are simply the difference between two interest rates, one from a risk-free credit market and the other from a risky credit market.

(a) Credit spread between entrepreneurs’ and risk-free credit markets. Example. In the USA, the so-called “junk bonds” are credit contracts issued by entrepreneurs (see here). The risk-free credit market is the Treasury debt market – that is, debt issued by the US Federal government. If the interest rate for entrepreneurs is 6.70% and the interest rate for US Treasury debt is 1.86% (see), then the credit spread is 6.70% minus 1.86% = 4.84% [Note: these rates change every day, every hour, every minute!] 

(b) Credit spread between sovereign emerging market debtors and risk-free credit markets. Example. The average interest rate paid by risky sovereign issuers in emerging markets is currently 5.30% (see). The risk-free credit market is the Treasury debt market – that is, debt issued by the US Federal government. If the interest rate for risky sovereign emerging markets issuers is 5.30% and the interest rate for US Treasury debt is 1.86% (see), then the credit spread is 5.30% minus 1.86% = 3.44% [Note: these rates change every day, every hour, every minute!]

DURING A FLIGHT-TO-QUALITY EPISODE, CREDIT SPREADS TEND TO WIDEN, AS INTEREST RATES IN RISKY CREDIT MARKETS RISE, WHILE INTEREST RATES IN RISK-FREE CREDIT MARKETS DECREASES.

[CHARTS: JUNK BOND SPREADS]

NEGATIVE INTEREST RATES? ON DECEMBER 19, 2008, THE US 3-MONTH TREASURY BILL GOES NEGATIVE. WHAT DOES THAT MEAN?
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