Archive for August, 2007

Financial system?messy, tangled ball of yarn

Thursday, August 30th, 2007
Just how horrible is the current rot in the global financial system? Frankly speaking, no one really knows. Not even central bankers. As the Reserve Bank of Australia (RBA)’s March 2007 Financial Stability Review said,

Rapid growth in the use of credit derivatives is also posing financial regulators with a number of issues relating to transparency (Graph 11). In some cases, the balance sheet data received from financial institutions are becoming less meaningful, as credit exposures are taken on or divested through derivatives. The growth of credit derivatives markets has also meant that it is less clear where the credit risk actually resides, and how those holding this risk will react in a less benign environment.

Back in January this year, in Prepare for asset repricing, warns Trichet, we quoted the warning by Trichet, the president of the European Union central bank, that

There is now such creativity of new and very sophisticated financial instruments . . . that we don?t know fully where the risks are located… We are trying to understand what is going on?but it is a big, big challenge.

As Bill Gross, the founder and chief investment officer of PIMCO, the world’s largest bond mutual fund., said in Why We Need a Housing Rescue,

Goodness knows it’s not easy to understand the maze of financial structures that appear to be unwinding. They were created by wizards of complexity: youthful financial engineers trained to exploit cheap money and leverage and who have, until the past few weeks, never known the sting of the market’s lash.

Although has been estimated that the amount of bad debt (derived from sub-prime loans gone bad) losses could amount from US$100 billion to US$200 billion, nobody knows where they are. It may be possible that your pension fund may be sitting on a time-bomb and still not aware of it!

All these ?wonders? of the modern financial system, namely debt and derivatives, enabled the creation of a complex tangled mess of linkages between participants (e.g. financial institutions, funds, investors, banks, etc). The former (debt) allows the use of leverage while the latter (derivatives) allows risks to be transferred like a hot potato from one hand to the other. That sounds good, does it? But what if the derivative that you used to hedge your risks become useless because the counter-party of that derivative could not honour its obligation? In that case, you may not be able to honour your obligation against another party. Imagine repeating this scenario countless times over, forming a yarn of complex entanglements. What if a small section of the yarn catches fire? What will happen to the yarn as a whole?

There are those who said that there is so much liquidity in the world that asset prices can never fall. We suspect they are wrong. If liquidity is largely made up of debt and derivatives, it is very possible for them to disappear (see Spectre of deflation).

Central bank market operations in the light of the recent instability

Tuesday, August 28th, 2007

In our previous article, How does a central bank ?set? interest rates?, we explained how the central bank set the interest rate. Today, we found an article from the Reserve Bank of Australia (RBA), Central Bank Market Operations, which explained central bank market operations (to set the target interest rate) in the light of the recent financial market instability.

In our earlier article, Consumers paying for the implosion of dumped risk, we mentioned about the ?cockroach theory:?

… if you see one cockroach in the kitchen, then there must more of them somewhere else. In the same way, if we see some of these crises in hedge funds coming to light, then there must be more of such rot somewhere else.

That article from the RBA said it nicely,

What seemed to be worrying people was that, while the US Fed had calculated the losses in the sub?prime market as being potentially as high as US$100 billion, only a few billion of losses had been announced by investment funds. This naturally led market participants to question who was sitting on the prospective losses, and what this meant for the creditworthiness of market counterparties. Investors became much more risk?averse and banks severely curtailed their lending to each other, causing gridlock in the money market. The process spread quickly because once banks started to worry that others may stop lending to them, they in turn stopped lending to others.

For those who are interested, it is a good read for learning purposes. For those who aren’t interested, it is a rather dry and boring article.

Is the worst over yet?

Monday, August 27th, 2007

For the past week, volatility seems to be decreasing. Some investors believe that the recent falls and volatility was just a correction in an ongoing bull market. Has the correction ended? Before we declare the restoration of the bull trend, let us take a look at this graph (click on it to see its full size):

Value of adjustable rate mortgages due for reset

The red line shows where we are right now. As the graph shows, there are going to be more adjustable rate mortgages in the US that will have their mortgage rates reset in the coming months. That is, a lot more home loan borrowers will find that their mortgage rates will revert from the ?honey moon? rate to the standard rate. Therefore, more people are going to find that their mortgage expense will shoot up suddenly. When this happens, we can expect the rate of foreclosures and home loan debt defaults going to rise in the US. With the financial system already wobbly, it is going to further destablise in the months to come.

Show of confidence or an empty show

Saturday, August 25th, 2007

We saw this article in the press, Bank of America invests $2 bln in Countrywide:

In a move that could help the largest U.S. mortgage lender survive a crisis that’s rocking the home-loan industry, Bank of America said late Wednesday it invested $2 billion in convertible preferred securities of Countrywide.. The nonvoting securities pay an annual interest rate of 7.25%.

Where does Bank of America gets its money?

With the banks getting suspicious of each other’s exposure to bad debt (e.g. sub-prime debt), they stopped lending to each other (see How does liquidity dry up?). Thus, the Fed stepped in to become the lender of last resort. Not only did the Fed cut its discount rate by 0.5%, which is the rate that banks can borrow from it, it also lowered its lending standards by accepting dubious sub-prime mortgage debts as collaterals (which is pretty much worthless as judged by the financial market). The Fed, with its license to print money, need not worry about the quality of the collaterals that it borrowed or whether the banks could actually repay the loans.

In U.S. banking giants borrow $2 bln from Fed:

J.P. Morgan, Bank of America and Wachovia said in a joint statement that they each borrowed $500 million, including some on a term basis, at the discount window.

So, 25% of Bank of America’s investment in CountryWide comes from the Fed!

Complex math fails in investing

Thursday, August 23rd, 2007

Today, we saw this article in the Washington Post: For Wall Street’s Math Brains, Miscalculations. In that article, it reported that

… Goldman Sachs’ Global Alpha quant fund lost 27% of its value had lost 27 percent of its value this year because its computers failed to anticipate what the firm called “25 percent standard deviation moves” or events so rare Goldman had seen them only twice before in the firm’s history.

For those who do not know what a quant fund is: it is basically a fund in which computers and mathematical models take over the decision-making process.

For those of us who had already read Nassim Nicholas Taleb’s provocative book, The Black Swan: The Impact of the Highly Improbable, this is hardly surprising. As we said before in How the folks in the finance/economics industry became turkeys?Part 2: The Bell curve, that great intellectual fraud, using complex mathematics to make automatic investment decisions is not ?scientific? at all?in fact, it is pseudo-scientific. In this example, using pseudo-science can have devastating consequences to your financial well-being.

So, beware of salesman touting funds that utilises mathematics so complex that only a genius can understand. Chances are, it is another case of obscurity through complexity.

Why was the US dollar rising as Aussie stocks were falling?

Monday, August 20th, 2007

Over the previous weeks, stock prices around the world had been falling. The Australian stock market is no exception. Strangely, in reaction to the tumbling of stock prices, the US dollar rose against many major currencies except the Japanese yen. The rise of the Japanese yen against the US dollar can be explained by the reversal of the yen carry trade (see Another source of potential financial crisis?reversal of yen carry trade). But what about the rise of the US dollar?

There are a three theories we can think of. The first two can be found in Dollar’s fall is no bad thing in the Sydney Morning Herald:

1. The US dollar is rising because the market turmoil prompted a flight to the ?safety? of the US dollar.

2. The US dollar is rising because it is part of the reversal of the yen carry trade.

The third theory is this:

3. A lot of debt (e.g. margin lending for hedge funds) is denominated in US dollars. The credit problems in the US resulted in a surge in the demand for US dollars to repay those debts. Thus, to raise those US dollars, funds had to sell whatever financial assets that they can get their hands on. For overseas assets (e.g. Australian stocks), this means selling them and buying US dollars with foreign currencies (e.g. Australia dollar).

Of the three theories, we feel that the first one is most likely to be wrong.


Federal Reserve cutting interest rates

Saturday, August 18th, 2007
The US Federal Reserve had announced that they will cut the discount rate by 0.5%. In another statement, they said that

In these circumstances, although recent data suggest that the economy has continued to expand at a moderate pace, the Federal Open Market Committee judges that the downside risks to growth have increased appreciably. The Committee is monitoring the situation and is prepared to act as needed to mitigate the adverse effects on the economy arising from the disruptions in financial markets.

In other words, the Fed is fearing that whatever is happening in the financial side of the economy may spill over into the real side of the economy (see Analysing recent falls in oil prices?real vs investment demand for our explanation of the difference between the real and financial sides of the economy), pushing the US economy into a recession. If this happen, it is possible that a global slowdown will ensue.

Back in March this year, we already expressed our expectation that they will be doing this (see Money printing operations begin). How should we interpret their action? Is the Fed merely taking ?preventive? measure or are they panicking?

Anyway, we believe that Friday’s stock market rally (in the US) is a good opportunity to liquidate any existing holdings of stocks.

How to implement an asymmetric payoff strategy: Part 2- Using options

Thursday, August 16th, 2007
In our previous article, How to implement an asymmetric payoff strategy: Part 1- stop loss, the wrong way, we talked about using a wrong way to implement an asymmetric payoff strategy. Today, we will talk about the proper way to do so.

 Our preferred method of profiting from a possible stock market crash (see How to take advantage of an impending crash- Part 4: asymmetric payoff) is to use derivatives called options. Contrary to common misperception, options are inherently not ?risky? and ?dangerous.? When used properly, options can in fact reduce your risks significantly. It is the misuse of options that can result in severe loss, which probably give it such a bad reputation in the first place (see our articles on options here).

Also, options are arguably the most complex topic in finance, which could explain why they have the feel of mystic and danger to those who are uninitiated. Understanding options involves knowing options pricing theory, which uses complex mathematical formulas and algorithms that involves the Bell curve (see How the folks in the finance/economics industry became turkeys?Part 2: The Bell curve, that great intellectual fraud). Thus, we cannot go too much into any detail about options for today’s article. We can, however, point you to the right direction.

The great thing about using options is that with specific combinations of short (sell) and long (buy) puts and calls, you can profit from all kinds of market conditions (bullish, bearish or neutral, volatile, stable, trending, trendless, etc). For example, there are options strategies for taking advantage of extremely stable (and boring) markets. There are also strategies for taking advantage of highly volatile markets when you have no conviction on the direction of the market.

For the very specific purpose of profiting from a possible stock market crash, a suitable options strategy would be the Put Backspread. The profit/loss pay-off diagram for this strategy is this:

Put Backspread

As you can see, with such a strategy, you maximum loss is if the stock price remains stagnant at $90 by the time the options expire. If you are wrong about the direction of the stock price (i.e. stock price shoot up suddenly), you still can make a profit. But if you are right about the stock price crash, your profit can be unlimited.

There are much more about options that what we mention here. If you want to learn more about options, there are some books that we recommend here.

Is China ‘sweating’ less and ‘thinking’ more?

Wednesday, August 15th, 2007

In our previous article, Transference of wealth from West to East, we said that

It all began with the outsourcing of manufacturing to the East. This common myth was often believed in the West: They sweat, we think. The assumption was that we will push the base, labour-intensive and low-level jobs to the East, while we concentrate on the more capital-intensive, high-level, technologically advanced and value-added jobs.

It is this kind of complacency that we wish to shake off. As the West manufacture less and less, its manufacturing industries got more and more hollow. As the manufacturing industries migrated to the East, technology hitched a ride along as well. As the East manufacture more and more, they learn from us more and more. As they learn more, they moved up the technological ladder, create better products and move up the value-added chain. With the wasteful and spendthrift ways of the West, more jobs get outsourced to the East to protect corporate profits while the real wage of West stagnate and even decline. As the trend continues, Western skills, know-how, capital and industries get increasingly eroded. This erosion is a portent for the eventual loss of wealth by the West.

In this article in the BBC, ‘Sharp rise’ in Chinese patents, it reported that

China has seen a sharp increase in requests for patents, according to the UN’s intellectual property agency.

How does a central bank ?set? interest rates?

Tuesday, August 14th, 2007

Today, one of our readers asked this question: how does a central bank ?set? interest rates? To answer this question, we will look to the Reserve Bank of Australia (RBA) as an example. For this, we will get the answer straight from the horse’s mouth (RBA), which can be found in How is Monetary Policy Implemented? on their web site.

First, we have to understand that there are many kinds of interest rates, which can be categorized into either short-term interest rates and long-term interest rates. An example of a long-term interest rates include the 10-year Commonwealth Treasury bond yield. An example of a short-term interest rate includes bank bill rates.

The relevant interest rate for today’s article is the cash-rate, which is

… the rate charged on overnight loans between financial intermediaries.

The RBA can only control the cash-rate, which

… has a very strong influence on other interest rates, and therefore helps to set the level of short-term interest rates in the wider economy.

 The RBA control the cash-rate through

… its financial-market operations and it functions as the policy instrument.

What this means is that the RBA does not ?set? interest rates by issuing a decree that has to be obeyed. Instead, it ?sets? interest rates through its Domestic Markets Department which

… has the task of maintaining conditions in the money market so as to keep the cash rate at or near an operating target decided by the Board.

In essence, the money market operation works this way:

If the Reserve Bank supplies more exchange settlement funds than the commercial banks wish to hold, the banks will try to shed funds by lending more in the cash market, resulting in a tendency for the cash rate to fall. Conversely, if the Reserve Bank supplies less than banks wish to hold, they will respond by trying to borrow more in the cash market to build up their holdings of exchange settlement funds; in the process, they will bid up the cash rate.

Basically, the RBA ?sets? interest rates by adjusting the money supply. This implies that the central bank cannot control both interest rates and money supply simultaneously?it can control either one or the other but not both.

Recommended reading for this article: What makes monetary policy ?loose? or ?tight??.