Goldman Sachs Stock Price & Credit Spreads

Look at the following numbers, taken from January 31 (first session) and February 7, 2012:

- Junk bond: 6.87% (January 31); 6.70% (February 7) [see]:

- Treasury Note: 1.83% (January 31); 1.86% (February 7) [see].

[QUESTION 1: HAS THERE BEEN A PROCESS OF FLIGHT-TO-SAFETY IN THE COURSE OF LAST WEEK? HOW CAN YOU TELL?]

[QUESTION 2: ALL OTHER THINGS BEING EQUAL, WOULD IT MAKE SENSE FOR THE STOCK PRICE OF GOLDMAN SACHS TO FALL OR TO RISE?]
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Some Interest Rates & Credit Spreads ...

- Spain 10-Year Treasury bond: see.

- Germany 10-Year Bund: see.

- Spread: Italy - Germany: see.

- Sovereign yields & spreads (November 2011): see.

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Understanding Credit Markets: Flight-to-Safety

When Lehman 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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Understanding Credit Markets: Hungary

Take a look at some of the measures announced by Hungarian Prime Minister Viktor Urban (*):

. Orban has been reducing the power of independent institutions and asserting his influence since winning elections in 2010, ignoring objections from the U.S. and the United Nations.

. Lawmakers in Orban’s Fidesz party last week approved a central bank law that expands the rate-setting Monetary Council while curbing the power of central bank President Andras Simor. The International Monetary Fund and the EU broke off talks on a bailout last month over the plan.

. Ruling-party lawmakers ousted the chief justice of the Supreme Court, narrowed the jurisdiction of the Constitutional Court, replaced an independent Fiscal Council with one dominated by the premier’s allies, created a media regulator led by ruling-party appointees and chose a party member to lead the State Audit Office.

. One judge, Tunde Hando, the wife of Jozsef Szajer, a European Parliament member from Orban’s Fidesz party, will be responsible for naming all new judges, including replacing scores who were forced into retirement last year.

[QUESTION: WHAT WAS THE REACTION IN THE CREDIT MARKET? WHAT HAPPENED TO INTEREST RATES? THE ANSWER IS HERE].

(*) Edith Balazs and Zoltan Simon: "Hungary’s New Constitution Triggers First Joint Opposition Demonstration", Bloomberg.
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Understanding Credit Markets: UT Bank

A wonderful story by the Financial Times (*). "The bank keeps a permanent office open at both the land and vehicles registry. Cars are a favourite. 'Ghanians don't want to lose them', she says. When financing trade, or clearing goods for clients through customs, the bank holds a portion of the imports until the loan is paid off. Financial analysts familiar with UT, say the bank has also built its reputation on the strict military discipline with which its affaires are run and its ability to recover as well as collateralise loans.

It does not go to the police and the courts ... The interest rates UT charges are not exactly a gift, sometimes 3 to 5 per cent a month for indigenous traders".

(*) William Wallis: "UT Bank: Reaching parts of the market others shun", Financial Times, December 15, 2011.
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Understanding Credit Markets: A Word on Credit, Banking & Property Rights

[1] An unduly disregarded topic? Today's topic looks, at first sight, a bit excentric. It does not feature in economic textbooks, much less in manuals about banking. [IT WILL NOT FEATURE IN ANY EXAM]. Yet it is an important one. There are at least two reasons why I am willing to spend half an hour on this issue. (a) Credit & banking in the developping world. All of us here share something in common: an 'emerging-markets' background (Argentina, Armenia, Bulgaria, Chile). Credit and banking instructors, in the 'developed' world, take it for granted that property rights are stable, that the executive power does not meddle in judicial affairs, that the central bank is independent, and that there is relatively little policy risk. But things are very different in Emerging nations! (b) The notion of flight-to-safety during a banking crisis. It will help us understand the notion of flight-to-safety, of critical importance in times of banking and financial crisis. (c) The sheer complexity of credit markets. Interest rates can change for an amazingly complex set of reasons that can alter the behaviour of either/or those who supply and demand credit. This is just another case!

[2] Look at the Table. What are the key differences between, say, the Netherlands and Peru? Look closely at columns 2 and 6. The size of the credit market is taken from the following paper:

[3] [NOT REQUIRED READING] John D. Burger & Francis E. Warnock: “Local Currency Bond Markets”, IMF Staff Papers, Vol. 53, 2006 (only pp. 141-142). From the paper: "To gauge the importance of various factors, our estimates in column 1 of Table 3 imply that (other things being equal) if Brazil had Denmark’s rule of law, its bond market as a share of GDP would be 43 percentage points higher".

[4] How do we account for this? Broady speaking, we can think of two sets of reasons. (a) The stability of property rights. To lend is to transfer the possession of real ressources to somebody else; if, for wathever reason, property rights are unstable, then it stands to reason that THOSE WHO SUPPLY LOANABLE RESOURCES WILL DO ... WHAT?? [QUESTION]. Now, history shows that property rights are most unstable when the executive power controls the judiciary. This is what the Table appears to show: overall, the higher (lower) the degree of judicial independence, the higher the size of the local-currency bond market. (b) Policy risk. The more concentrated political power is, the higher the degree of policy risk, that is to say, the risk of ever changing laws, regulations, and even ... constitutions! (see Hungary).

[5] Some anecdotical evidence.

- Russia. The Hermitage Capital story. In 2007, 230 million were stolen from Russian tax authorities by a gang of murderers who obtained “sham” judgments from judges in Moscow, St. Petersburg and Kazan. The fraud involved three subsidiaries of Hermitage that had paid taxes worth $230m. Soon after the police raid, these companies were fraudulently re-registered under new owners, who applied for, and immediately received, a tax rebate of $230m. [DOCUMENT: Hermitage Capital Video]. Lawyer Sergei Magnitsky found dead in his cell

Says Hermitage Capital’s Bill Browder: “Now, you have a bunch of law enforcement people who are essentially organised criminals with unlimited power to ruin lives, take property and do whatever they like and that's far worse than I have ever seen in Russia before. Russia is essentially a criminal state now.” From an unnamed senior banker in Mosow: “Russia's judicial system is totally compromised. It is strangling entrepreneurship. What happened is a clear impediment for investments coming in, not just for foreign investment but even for local ones”. (Catherine Belton: "Questions remain about Russia tax fraud", Financial Times). 

- Russia. Charles Clover: "Bonds and barter in the sauna", Financial Times, March 28, 2010. "No one will lend to anyone because they fear the risk", says M. Kazhin. Interest rates for a friendly loan are 20-40 per cent. Unless you sell narcotics, it's not a sustainable business model to borrow right now ... No one trusts anyone these days". 

- Russia. Catherine Belton: "Financial reform: rise on credibility is overdue", Financial Times, April 27, 2011. "With a corrupt judicial system and many other investment risks, most Russian companies seek to raise long-term capital on international exchanges. Most of Russia's billionaires also keep their fortunes offshore ... There is a growing realization in the government that some kind of enduring reform of the financial and judicial system is needed, because currently the rate of capital outflow is unsustainable ... A lot of oligarchs say they are happy to make money in Russia, because the return on capital is much higher. But once they've made it, they want to bank it offshore. Whether this situation will change will depend on whether a lot of institutions improve, including whether there is a credible judicial system".

-Iran. Najmeh Bozorgmehr: "Iranians switch to informal savings funds as loans dry up", Financial Times, March 13, 2010. [see].

- China. (From several sources). "Monthly lending rates at credit unions and informal lending institutions in the entrepreneurial cities of Wenzhou and Xiamen have reached 5 per cent in the past few weeks, up from 1.5 per cent nine months ago. On Monday, more than 200 people besieged a government building, setting fire to cars, in the southern city of Chazhou after a worker was stabbed on the orders of his factory boss for asking for unpaid wages ... Chinese entrepreneurs feel there's no security for their wealth or possessions, and that their assets could be taken away at any time. Nobody feels protected against the system any more"; "Wenzhou’s 400,000 businesses are facing financial hardship because of rising costs, soaring black market interest rates and a sudden credit squeeze ... Businesses in Wenzhou used family and hometown networks because bank loans were hard to come by ... Small and medium-sized businesses account for 80 percent of jobs in China, according to the country’s industry ministry. Yet they’re largely unable to get loans from banks ... Zhong needed cash to keep paying his suppliers, rent and employees. Scanning the local paper one day, he saw an ad for loans without collateral. He dialed the number and arranged to borrow 600,000 yuan for one month, from what Zhong called a “gaolidai,” a Chinese term for a loan shark. He borrowed again and started to just pay interest and roll over the principal, he said. Rates rose to 7 percent a month. Black market rates have doubled this year." Jami Anderlini & Patti Waldmeir: "Chinese doubt the road ahead"; Kathrin Hille: "China's IT chiefs to tighten clamp on web", Financial Times. Bloomberg News: "China Credit Squeeze Prompts Suicides", November 6, 2011.Simon Rabinovitch & Jamil Anderlini: "Beijing warned of effect of cash squeeze", Financial Times, June 2011.

- China. From an Australian lawyer interviewed by the Financial Times: "The perception that the legal playing field is not level is a larger impediment to Shanghai's ambition to become a global financial centre by 2020 than any number of potholed streets or immature trading mechanisms. Without an independent legal system that resolves disputes fairly no one will bring real money to Shanghai. No one is going to park $1bn in Shanghai to pick up a bit of margin unless they have confidence that they can call a judge at 2am and get an injunction against behaviour that could damage them ... In a country without an independent judiciary, laws are only as good as the politicians allow them to be enforced." See Patti Waldmeir: "Things improve, but judiciary still lacks independence", Financial Times.

- China. Financial Times: Lunch with Ai Weiwei [see]. Document: “Who is afraid of Ai Weiwei?”

- Switzerland. Taking a look at Swiss bank UBS's balance sheet, we note that the institution has SFR 1.317 billion in assets, of which SFR 262.9 bn are loans, and about SFR 385,0 bn bonds. This is about 2.5 times the value of Swiss GDP.

[6] [NOT REQUIRED READING] Kee-Hong Bae & Vidhan Goyal: “Creditor Rights, Enforcement, and Bank Loans”, The Journal of Finance, Volume 64, Issue 2, 823–860, April 2009. ABSTRACT: "We examine whether differences in legal protection affect the size, maturity, and interest rate spread on loans to borrowers in 48 countries. Results show that banks respond to poor enforceability of contracts by reducing loan amounts, shortening loan maturities, and increasing loan spreads".
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Understanding Credit Markets: Inflation expectations

The Financial Times definition:


Rate of inflation that workers, businesses and investors think will prevail in the future, and that they will therefore factor into their decision-making.


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