by Jeff Powell
Clearly NGOs around the world are too diverse to allow meaningful generalizations of their reactions to the evolving crisis. Some have seized the opportunity, embracing new ideas and reaching out to different actors and constituencies. Others are grafting new issues on to an old agenda: add crisis and stir. Still others are finding their agenda drowned out, at the same time as direct debits get cancelled and stock-market dependent foundations pull up the funding drawbridges.
Here in the UK, development and environment NGOs have come together with the Trades Union Congress in an unprecedented coalition (which, in the name of transparency it should be stated that the author is a part of), initiated by the Bretton Woods Project. The Put People First coalition (PPF) has come together around a short manifesto highlighting jobs, social justice and the environment. The focus for the time being is on the G20 meetings in London in April and then in St. Andrews in November. It's too early to say whether the coalition will be longer-lasting, and if it will be able to get beyond the 'lowest common denominator' politics which held back the Make Poverty History campaign in 2005.
On finance, PPF has joined the general chorus for increased transparency and accountability, without yet articulating a clear vision of what this means. More developed are its ideas on eliminating tax havens, drawing on the groundwork done by the Tax Justice Network. The investigation that TJN inspired in The Guardian has shamed the Labour government into its first tentative (and long-overdue) steps on tax havens, particularly those in the City of London or UK protectorates. Gordon Brown has announced plans to discuss multilateral exchange of information on offshore accounts at the G20 meeting. The PPF coalition is trying to use the crisis as an opportunity to broaden the reform agenda to include a re-invigoration of public services and a shift of economic priorities towards environmental sustainability. Managing the need to focus on shorter-term policy developments with these longer-term objectives will not be easy.
Similar networks and coalitions have formed across Europe. Brussels-based groups Eurodad (the European network of NGOs working on debt, development and poverty reduction) and CONCORD (the European Confederation of Relief and Development NGOs) have started to work with some European trade unions at National and Supra-national level. Like the UK's PPF, Eurodad has a developed campaign on capital flight issues. Groups in these networks with a history of advocacy on financial issues include Germany's World Ecology Economy and Development (WEED), the Dutch group SOMO and of course the ATTAC network which, with others, has been working for over a decade on issues of regulating and democratising finance.
At the international level, the key cue for NGO policy positions comes from agreed positions at the World Social Forum in Brazil, earlier this year. The WSF attempts to bridge the (sometimes elusive) divide between NGOs, trade unions and social movements. While it is short on details, and the process of getting from A to B is absent, the principles of the WSF statement ('Put finance in its place') are radical and clear. They include a call to “implement a global mechanism of state and citizen control of banks and financial institutions” and the creation of “regional reserve currencies”. Taking up the issues of financial sector reform is Re-thinking finance, a new coalition which brings together the Bretton Woods Project, Eurodad, Amsterdam-based Transnational Institute, the Asian network Focus on the Global South, and Latin American network Choike.
In the coming months the ability of all of these NGOs to sharpen and deepen their analysis of financial sector issues, and their capacity to communicate these ideas to a wider audience and build broad-based movements for fundamental change is critical if the crisis is to be transformed into opportunity.
Monday, March 30, 2009
Monday, March 23, 2009
In the Hot Seat: Private Equity and the Financial Crisis
by Sherif H. Elkholy
Private Equity History
For a long time spanning from the 1980s private equity has been one of the main drivers of market-based finance, catalyzing the transformation of the processes and institutions of direct finance. Back then private equity was a specialized form of finance characterized by its long-term investment strategy, its hands-on approach, and its capacity to add tangible value by investing in companies. This changed significantly over the 2003-2007 boom cycle: private equity was no longer confined to savvy investors, it no longer needed to have a long-term horizon, and it no longer needed to add real value in order to make money. This was made possible by three factors: a seemingly endless supply of cheap debt (annual LBO debt issuance rose from $71 billion in 2003 to $669 in 2007), growing reported profits across all sectors (16% annual growth in the S&P 500 earnings from 2003 to 2007), escalating asset prices (41% growth in US valuation multiples and 43% in European valuation multiples between 2003 and 2007), and more portfolio allocations to private equity by institutional investors (around triple the historical amounts). Then came the perfect storm.
Where it Currently Stands
The financial crisis has hit all the pressure points of private equity at once. Corporate earnings are down thus negatively effecting the financial position and the fundamental value of companies owned by private equity funds. Asset prices are also down, thus deferring any divestiture of companies by private equity owners. More critically, debt markets are extremely tight, virtually freezing the previously flourishing leveraged buy-out market. Finally, portfolio allocation to private equity by institutional investors is down due to limited liquidity and heavy losses across all asset classes. The immediate problem which private equity has to wrestle with is keeping it’s investments afloat. It is unavoidable that many private equity owned companies will default on their debt obligations- simply because the debt levels piled up during the boom years are not in line with current earnings. However, every cloud has a silver lining. Amidst the financial crisis many babies are being thrown out with the bath water- the smartest private equity companies will pick up under-valued high quality businesses for a fraction of the fair value... if they have the liquidity to do so.
The Future of Private Equity
Private equity is facing the ultimate truth test. A close look at the private equity model of the 1980s reveals that private equity had a lot of shared similarities with bank-based finance: investment decisions premised on relationships and knowledge of companies, hands-on control, monitoring through board representation, active management, and long-term “buy and hold” approach. Private equity needs to re-invent itself back to this initial form and it needs to do so fast to guarantee a place in the new financial system which will rise from the ashes of the global crisis. Whatever form private equity will take in the coming years, it will most certainly involve less fees, more work, real operational value-add, and less debt. For the real economy, perhaps this shake out is not so bad after all.
Private Equity History
For a long time spanning from the 1980s private equity has been one of the main drivers of market-based finance, catalyzing the transformation of the processes and institutions of direct finance. Back then private equity was a specialized form of finance characterized by its long-term investment strategy, its hands-on approach, and its capacity to add tangible value by investing in companies. This changed significantly over the 2003-2007 boom cycle: private equity was no longer confined to savvy investors, it no longer needed to have a long-term horizon, and it no longer needed to add real value in order to make money. This was made possible by three factors: a seemingly endless supply of cheap debt (annual LBO debt issuance rose from $71 billion in 2003 to $669 in 2007), growing reported profits across all sectors (16% annual growth in the S&P 500 earnings from 2003 to 2007), escalating asset prices (41% growth in US valuation multiples and 43% in European valuation multiples between 2003 and 2007), and more portfolio allocations to private equity by institutional investors (around triple the historical amounts). Then came the perfect storm.
Where it Currently Stands
The financial crisis has hit all the pressure points of private equity at once. Corporate earnings are down thus negatively effecting the financial position and the fundamental value of companies owned by private equity funds. Asset prices are also down, thus deferring any divestiture of companies by private equity owners. More critically, debt markets are extremely tight, virtually freezing the previously flourishing leveraged buy-out market. Finally, portfolio allocation to private equity by institutional investors is down due to limited liquidity and heavy losses across all asset classes. The immediate problem which private equity has to wrestle with is keeping it’s investments afloat. It is unavoidable that many private equity owned companies will default on their debt obligations- simply because the debt levels piled up during the boom years are not in line with current earnings. However, every cloud has a silver lining. Amidst the financial crisis many babies are being thrown out with the bath water- the smartest private equity companies will pick up under-valued high quality businesses for a fraction of the fair value... if they have the liquidity to do so.
The Future of Private Equity
Private equity is facing the ultimate truth test. A close look at the private equity model of the 1980s reveals that private equity had a lot of shared similarities with bank-based finance: investment decisions premised on relationships and knowledge of companies, hands-on control, monitoring through board representation, active management, and long-term “buy and hold” approach. Private equity needs to re-invent itself back to this initial form and it needs to do so fast to guarantee a place in the new financial system which will rise from the ashes of the global crisis. Whatever form private equity will take in the coming years, it will most certainly involve less fees, more work, real operational value-add, and less debt. For the real economy, perhaps this shake out is not so bad after all.
Monday, March 16, 2009
Mark to market madness
by Duncan Lindo
The news last week that only 2% of GE’s assets are market-to-market will have shocked some investors. What murky mischievous mark-to-model is being used to mask the mess that is the remaining 98% of assets (98% by what measure we might ask…). The stock has plummeted and now they’ve lost their 50year old AAA rating.
But wait..! GE doesn’t intend to sell these assets (not at these prices anyway the cynic might add) – so of what relevance is their mark-to-market (MTM). Whilst we’re right to worry about how they are valued why on earth should mark-to-market be better?
Firstly what happens when there is no market? As noted in a House Committee on Thursday: “Illiquid markets have resulted in great difficulty in valuing sizable assets”. The assumption of ever increasing markets for assets implicit in the spread of MTM across balance sheets is looking a little bogus. Most famously the secondary markets for mortgage assets have disappeared… albeit from a low base.
Blessed are the financial intermediaries
Perhaps given a bit more time it was hoped that MTM would become self fulfilling. As more of balance sheet value becomes subject to market valuation more opportunities have arisen for the derivative traders to sell hedging instruments to mute the volatility of market valuation. Thus markets for the assets appear. This is less chicken-and-egg than golden goose eggs for financial intermediaries inserted into yet another area of the economy. The alternative is the constant surveillance of the balance sheet for restructuring possibilities – selling businesses with high hedging costs. There are always investment bankers ready to advise you on that too. Everything market to market means everything for sale.
Procycliality
Market to market accounting is also pro-cyclical – even Hank Paulson admits it. The classic mechanism of bubbles through collateralised lending against rising market value of assets fuelled by leveraged buying and the deleveraging spiral that follows the burst. As soon as you admit herd behaviour, euphoria, bubbles then accounts based on market price look non-sensical. For the time being though it doesn’t look like the law-makers are ready to make the U-turn on the law. It’s pro-cyclical but… err… we don’t want to change it.
Symmetry and the Farce of Own Credit
“Fair Value” was also partly born of a desire for symmetry between buyers and sellers of instruments – an idea at odds with neoclassical theory which requires differing utilities in order for trade to occur! One consequence was billions of dollars of profit for banks during the crisis in the form of “Own Credit”. Holders of bank debt have marked down their assets as bank default probabilities rise (as measured by CDS spreads) taking losses; conversely arguments of symmetry under “fair value” accounting regulations have required banks to reduce the value of the equal and opposite liability resulting in a “profit” for the bank! The more the market writes down their debt the bigger the profits banks can book! The more debt they have the bigger this profit is! The incentives created are clearly crazy. Furthermore the balance sheet as a description of reality further distorted – e.g the distance between “retained earnings” and bank’s ability to pay dividend clearly increases. At least here it might be argued that MTM is anti-cyclical!
Yeah and –what you gonna do about it?
You’ll notice that I’ve spent 500+ words knocking MTM accounting with not one constructive suggestion.. well… as Hank P agrees.. it’s tricky. Any ideas out there???
The news last week that only 2% of GE’s assets are market-to-market will have shocked some investors. What murky mischievous mark-to-model is being used to mask the mess that is the remaining 98% of assets (98% by what measure we might ask…). The stock has plummeted and now they’ve lost their 50year old AAA rating.
But wait..! GE doesn’t intend to sell these assets (not at these prices anyway the cynic might add) – so of what relevance is their mark-to-market (MTM). Whilst we’re right to worry about how they are valued why on earth should mark-to-market be better?
Firstly what happens when there is no market? As noted in a House Committee on Thursday: “Illiquid markets have resulted in great difficulty in valuing sizable assets”. The assumption of ever increasing markets for assets implicit in the spread of MTM across balance sheets is looking a little bogus. Most famously the secondary markets for mortgage assets have disappeared… albeit from a low base.
Blessed are the financial intermediaries
Perhaps given a bit more time it was hoped that MTM would become self fulfilling. As more of balance sheet value becomes subject to market valuation more opportunities have arisen for the derivative traders to sell hedging instruments to mute the volatility of market valuation. Thus markets for the assets appear. This is less chicken-and-egg than golden goose eggs for financial intermediaries inserted into yet another area of the economy. The alternative is the constant surveillance of the balance sheet for restructuring possibilities – selling businesses with high hedging costs. There are always investment bankers ready to advise you on that too. Everything market to market means everything for sale.
Procycliality
Market to market accounting is also pro-cyclical – even Hank Paulson admits it. The classic mechanism of bubbles through collateralised lending against rising market value of assets fuelled by leveraged buying and the deleveraging spiral that follows the burst. As soon as you admit herd behaviour, euphoria, bubbles then accounts based on market price look non-sensical. For the time being though it doesn’t look like the law-makers are ready to make the U-turn on the law. It’s pro-cyclical but… err… we don’t want to change it.
Symmetry and the Farce of Own Credit
“Fair Value” was also partly born of a desire for symmetry between buyers and sellers of instruments – an idea at odds with neoclassical theory which requires differing utilities in order for trade to occur! One consequence was billions of dollars of profit for banks during the crisis in the form of “Own Credit”. Holders of bank debt have marked down their assets as bank default probabilities rise (as measured by CDS spreads) taking losses; conversely arguments of symmetry under “fair value” accounting regulations have required banks to reduce the value of the equal and opposite liability resulting in a “profit” for the bank! The more the market writes down their debt the bigger the profits banks can book! The more debt they have the bigger this profit is! The incentives created are clearly crazy. Furthermore the balance sheet as a description of reality further distorted – e.g the distance between “retained earnings” and bank’s ability to pay dividend clearly increases. At least here it might be argued that MTM is anti-cyclical!
Yeah and –what you gonna do about it?
You’ll notice that I’ve spent 500+ words knocking MTM accounting with not one constructive suggestion.. well… as Hank P agrees.. it’s tricky. Any ideas out there???
Tuesday, March 10, 2009
Part 2: Protagonists of an old game: Political Processes behind Greece’s troubles
By George Lambrinidis
Picking up the story behind the recent riots described in the last post, it is helpful to delve deeper into the relations between the working class and capitalists in Greece by way of a few key observations.
First, we have to observe that Greek financial capital is bank-based, rather than market-based. Banking was until recently under state control, privatization was forced by industrial capitalists which partly explains the strong links between industrial and financial capital.
Second, Greece is a small place. Over 99% of firms employ less than 50 employees and the Greek bourgeoisie is made up of only ~300 families – not that this limits their prosperity; Greek capital is found amongst the first positions of OECD countries in terms of profitability. The Greek commercial fleet is the largest in the world with around 19.5% of world capacity. Moreover, a (very) small group of capitalists control most forms of media. The political influence of the bourgeoisie is indisputable e.g. the minister of mercantile marine (a crucial post given Greece’s concentration) is assigned directly, or must be approved by the ship owners.
Finally, Greek-oriented capital has a strong regional presence, especially in the Balkans and SE Europe, with what might be labeled minor imperialistic tendencies. Of major significance are the contracts signed for the building of a couple of oil pipes that will provide Europe through Turkey, Greece and Italy with Russian oil and gas.
Leaving financialisation aside until the third post in the series we can see how this economic, political and ideological power was built by focusing on the Greek working class. There were two major evolutions in the condition of the working class. The first, common to many nations is the pressure on real wages, volatile working practices, extension of retirement age etc., which is in somehow related to the subversion of the USSR. The second more specifically Greek process is a weakening of the unity of the working class during the rule of the Social Democrats from the early 1980s’ until 2004. An ideological split emerged between a model where worker’s leaders moved into government and one of unified struggle. It can be argued that many were led or even forced to see the Unions as a road to personal advancement by political cooperation with the ruling party e.g. it became natural that the president of the workers confederation became Minister of Labour. Increasing disillusionment with this approach led to falling union numbers. Meanwhile the Communist party enjoyed deep roots in Greek society and it managed to slow this process and stabilize the situation in the unions from the early 2000s. From mid 1990s onwards protests were often marked by two separate demonstrations (a class frontier of unions of all levels and individual workers backed primarily by the CP, and one by the compromised leadership of the unions and their political allies), with different content, demands and direction, reflecting the two conflicting views of consent and conflict.
In our next post, we will see how these political processes link with financialisation in Greece, review December’s events in this light and finally attempt to look into the future.
Picking up the story behind the recent riots described in the last post, it is helpful to delve deeper into the relations between the working class and capitalists in Greece by way of a few key observations.
First, we have to observe that Greek financial capital is bank-based, rather than market-based. Banking was until recently under state control, privatization was forced by industrial capitalists which partly explains the strong links between industrial and financial capital.
Second, Greece is a small place. Over 99% of firms employ less than 50 employees and the Greek bourgeoisie is made up of only ~300 families – not that this limits their prosperity; Greek capital is found amongst the first positions of OECD countries in terms of profitability. The Greek commercial fleet is the largest in the world with around 19.5% of world capacity. Moreover, a (very) small group of capitalists control most forms of media. The political influence of the bourgeoisie is indisputable e.g. the minister of mercantile marine (a crucial post given Greece’s concentration) is assigned directly, or must be approved by the ship owners.
Finally, Greek-oriented capital has a strong regional presence, especially in the Balkans and SE Europe, with what might be labeled minor imperialistic tendencies. Of major significance are the contracts signed for the building of a couple of oil pipes that will provide Europe through Turkey, Greece and Italy with Russian oil and gas.
Leaving financialisation aside until the third post in the series we can see how this economic, political and ideological power was built by focusing on the Greek working class. There were two major evolutions in the condition of the working class. The first, common to many nations is the pressure on real wages, volatile working practices, extension of retirement age etc., which is in somehow related to the subversion of the USSR. The second more specifically Greek process is a weakening of the unity of the working class during the rule of the Social Democrats from the early 1980s’ until 2004. An ideological split emerged between a model where worker’s leaders moved into government and one of unified struggle. It can be argued that many were led or even forced to see the Unions as a road to personal advancement by political cooperation with the ruling party e.g. it became natural that the president of the workers confederation became Minister of Labour. Increasing disillusionment with this approach led to falling union numbers. Meanwhile the Communist party enjoyed deep roots in Greek society and it managed to slow this process and stabilize the situation in the unions from the early 2000s. From mid 1990s onwards protests were often marked by two separate demonstrations (a class frontier of unions of all levels and individual workers backed primarily by the CP, and one by the compromised leadership of the unions and their political allies), with different content, demands and direction, reflecting the two conflicting views of consent and conflict.
In our next post, we will see how these political processes link with financialisation in Greece, review December’s events in this light and finally attempt to look into the future.
Monday, March 2, 2009
The Political and Analytical Diversions of ‘Financial Regulation’
by Paulo L dos Santos
The only thing governments seem to be doling out in greater amounts than bailouts to private banks these days are promises for all sorts of ‘financial regulation’. The EU recently promised sweeping financial regulation. Gordon Brown insists it must be international, while the Obama administration promises it will be wide-ranging and strict.
My first problem with these promises is not simply that the horses bolted long ago. It is that those now calling for doors to be shut are the same political forces that only yesterday sang the virtues of open barns and assured us that competition would ensure horses always came back. That in itself should give pause and good reason to question the motivations behind these proposals.
But my bigger problem is the implicit presumption that the current financial crisis is simply the result of a lack of effective (sweeping, international or wide-ranging) regulation, with little to no serious relationship to the underlying economic and social trends of recent years. This is not only plain wrong, but also politically diversionary.
Analytically, this presumption mirrors the weaknesses of mainstream economic theory. First there were perfect markets, financial or otherwise, and they would lead to socially efficient outcomes. Then came ‘imperfections’, typically caused by ‘informational’ or other micro-level problems with transactions, which gave rise to conflicts of interest, potential misallocations of capital and crises. Virtue lies in deducing the contracts, ‘institutions’ and state regulation that can ameliorate these microeconomic conflicts, align incentives, and help earthly markets become more perfect.
This scheme not only leaves out the destructive endogenous tendencies of financial markets towards instability, but also abstracts from the historical, social, economic and political processes that condition the formulation, enforcement and avoidance of regulation. There is no ‘optimal regulation’ that applies equally to all periods and benefits the interests of all social groups. Financial regulation is an important but nevertheless secondary element of broader economic and political regimes. It is only ‘optimal’ in relation to specific socio-political interests.
Following the Second World War, financial regulation imposed a degree of ‘financial repression’ to facilitate the reindustrialisation of Europe and Japan, the restoration of international trade, and the stabilisation of capitalism in the face of the USSR and radicalised domestic working classes. Over the past two or three decades, financial regulation has served the broader push for international market liberalisation and privatisation. The result of this push has been growing inequality, falling real investment and the rising levels of household debt that triggered the current crisis. Sustainable economic recovery requires the reversal of these realities.
The first issue for those committed to equitable societies and economic justice cannot be what kind of financial regulation is necessary. The first issue is the kind of economy we want—more equitable distributions of income, full employment, increases in environmentally sound productive investment, increases in the growth of physical productivity, high standard of universal social services, the rapid and environmentally responsible industrialisation of developing countries, etc. The second issue is the kind of political, economic and financial institutions that can help deliver those goals. A third issue arises if and only if those institutions include private financial firms (and I take a dim view on that possibility): how to ensure regulation represses their destructive tendencies and forces them to deliver in line with broader social aims.
A debate that jumps straight into discussions about financial regulation and its minutiae, without questioning the economic and policy regime of the past few years, will be a debate on how to build the shiniest new pails to serve up the old garbage of rising inequality, privatisation, low investment and underdevelopment.
The only thing governments seem to be doling out in greater amounts than bailouts to private banks these days are promises for all sorts of ‘financial regulation’. The EU recently promised sweeping financial regulation. Gordon Brown insists it must be international, while the Obama administration promises it will be wide-ranging and strict.
My first problem with these promises is not simply that the horses bolted long ago. It is that those now calling for doors to be shut are the same political forces that only yesterday sang the virtues of open barns and assured us that competition would ensure horses always came back. That in itself should give pause and good reason to question the motivations behind these proposals.
But my bigger problem is the implicit presumption that the current financial crisis is simply the result of a lack of effective (sweeping, international or wide-ranging) regulation, with little to no serious relationship to the underlying economic and social trends of recent years. This is not only plain wrong, but also politically diversionary.
Analytically, this presumption mirrors the weaknesses of mainstream economic theory. First there were perfect markets, financial or otherwise, and they would lead to socially efficient outcomes. Then came ‘imperfections’, typically caused by ‘informational’ or other micro-level problems with transactions, which gave rise to conflicts of interest, potential misallocations of capital and crises. Virtue lies in deducing the contracts, ‘institutions’ and state regulation that can ameliorate these microeconomic conflicts, align incentives, and help earthly markets become more perfect.
This scheme not only leaves out the destructive endogenous tendencies of financial markets towards instability, but also abstracts from the historical, social, economic and political processes that condition the formulation, enforcement and avoidance of regulation. There is no ‘optimal regulation’ that applies equally to all periods and benefits the interests of all social groups. Financial regulation is an important but nevertheless secondary element of broader economic and political regimes. It is only ‘optimal’ in relation to specific socio-political interests.
Following the Second World War, financial regulation imposed a degree of ‘financial repression’ to facilitate the reindustrialisation of Europe and Japan, the restoration of international trade, and the stabilisation of capitalism in the face of the USSR and radicalised domestic working classes. Over the past two or three decades, financial regulation has served the broader push for international market liberalisation and privatisation. The result of this push has been growing inequality, falling real investment and the rising levels of household debt that triggered the current crisis. Sustainable economic recovery requires the reversal of these realities.
The first issue for those committed to equitable societies and economic justice cannot be what kind of financial regulation is necessary. The first issue is the kind of economy we want—more equitable distributions of income, full employment, increases in environmentally sound productive investment, increases in the growth of physical productivity, high standard of universal social services, the rapid and environmentally responsible industrialisation of developing countries, etc. The second issue is the kind of political, economic and financial institutions that can help deliver those goals. A third issue arises if and only if those institutions include private financial firms (and I take a dim view on that possibility): how to ensure regulation represses their destructive tendencies and forces them to deliver in line with broader social aims.
A debate that jumps straight into discussions about financial regulation and its minutiae, without questioning the economic and policy regime of the past few years, will be a debate on how to build the shiniest new pails to serve up the old garbage of rising inequality, privatisation, low investment and underdevelopment.
Wednesday, February 25, 2009
European sovereign debt: how sovereign is it?
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!
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!
Monday, February 16, 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…
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