Posts Tagged ‘Black Swans’

Black Swans lurking around Australia’s banking system

Sunday, March 28th, 2010

We must confess, we are getting more and more nervous about the potential for a Black Swan hitting the Australian economy. Particularly, we are looking at a vulnerability in the banking system. Here are some facts about Australian banks:

  1. As at December 2009, around 75% of the Australian mortgage market is held by the Big 4 banks. 50% are held by Commonwealth and Westpac while 25% are held by ANZ and NAB. (source: CoreData’s Australian Mortgage Report Q1 2010)
  2. 60% of Commonwealth’s lending books are residential mortgages.
  3. 50% of Westpac’s lending books are residential mortgages.

Now, here’s an interesting news report from almost two years ago:

The Reserve Bank of Australia has a dark worry about our banks: they get 90 per cent of their cash from each other. If one bank gets into trouble, the Australian financial system could be snap-frozen overnight.

The question is: how true is this today? Since we are not banking analysts here, we are guessing that the situation in 2008 is not much different today. If Commonwealth Bank’s balance sheet is representative of the banking system, then judging from the fact that only around 1% of its total assets are government bonds, it seems that this is still true today. If we have any more information about this peculiar nature of the Australian banking system, we will inform you.

GoldMoney. The best way to buy gold & silverAssuming that this is true, then think of the implication: All it takes to paralyse Australia’s banking system is for some mortgage debts to go bad. Why? That’s because by nature, banks are highly leveraged. As we explained in Effect of write-down on bank balance sheet, bad debts will have more than proportionate effect on the equity of banks. For example, take a look at Commonwealth Bank (CBA) 2009 Annual Report– you can see that its leverage ratio is almost 20 times (total assets of $620.4 billion against $31.4 billion of equity). Among the the $620.4 billion of assets, $473.7 billion are loan assets. That means, if around 6.6% of CBA’s loans go bad (any loans, not just mortgages), 100% of its shareholder equity will be wiped out. In reality, long before that happens, alarm bells will be ringing in APRA (the banking regulator).

At the current state of affairs, the health of Australian banks’ mortgage loan books is very dependent on Australia’s unemployment rate. Once the unemployment goes up to a certain level, a tipping point will be reached whereby mortgages will start to default. When enough mortgages default, any of the Big 4 can become insolvent. With that, the solvency of the banking system will be threatened.? As we wrote in RBA committing logical errors regarding Australian household finance,

As unemployment rises, it will eventually reach a critical mass of prime debts turning sub-prime. Once this critical mass is reached, the deterioration in the Australian economy will accelerate (see what?s happening in the US and UK today).

Of course, economists, politicians, media will harp about how ‘safe’ the banks’ mortgage debts are. A quick read on the Reserve Bank of Australia (RBA)’s latest Financial Stability Review will give you a feel that they are not worried about the solvency of mortgage debts.

But that is beside the point.

The issue is not how ‘safe’ or ‘risky’ mortgage debts are- on paper, they are ‘safe.’ The issue is this: Why on earth is Australia concentrating the risks to its banking system? Every financial adviser will counsel you on the importance of diversification. Yet, when it comes to the Australia’s banking system, the opposite is happening.

The greater the concentration of risks, the less the margin for error is. If you live life with less and less margin for error, that’s when accidents are waiting to happen. That is where Black Swans lurks (see Failure to understand Black Swan leads to fallacious thinking).

We are getting more and more nervous.

Black Swans lurking because Uncle Sam has less margin for error

Tuesday, March 16th, 2010

Yesterday, we can’t help but notice newspapers headlines reporting that China’s Premier Wen Jiabao warned of a double-dip recession in the global economy. The reason is simple- governments all over the world are expected to scale back their ‘stimulus’ spendings for fear of price inflation and/or blowing a bigger hole in their budget. This goes to show that the word ‘stimulus’ is a weasel word that only has value as a propaganda tool. As we wrote in Will governments be forced to exit from ?stimulus??,

In fact, the word ?stimulus? is the most misleading word in economics lexicon because it conveys the idea of a surgeon ?stimulating? a heart into self-sustained beating. In reality, what government interventions did was to put the economy on a crutch.

If the right word is used (e.g. “crutch,” “prop up”) to describe the counter-productive government policies of spend, spend and spend, then it will do wonders to increase the economic IQ of the masses (see Are governments mad with ?stimulating??). Consider this very simple chain a logic:

  1. Someone is falling.
  2. You place a crutch to prevent him from falling.

Isn’t it plain common sense to see that once you remove the crutch, that person will crumble? From this, it follows that government crutch (‘stimulus’) lifts government expenditure to a higher plateau. Once we have bigger government, it is very difficult to shrink it as the difficulty currently faced by Greek government shows. Consequently, with a government budget already in deficit, there’s very every chance for it to go deeper into debt. Sooner or later, the bond vigilantes will doubt the credit worthiness of the government, which means the interest rates on government debts will rise, which in turn makes debt servicing even harder. Eventually, this will result in a currency crisis.

This time, governments are cornered with very little margin for error. As Moody’s warns about diminished margin for error on U.S. debt reported,

Cutting back on public spending too soon risks a double-dip recession, Moody’s said, while leaving stimulus measures in place too long could lead to a sharp rise in interest rates “with more abrupt rating consequences a possibility.”

Wherever there’s very little margin for error, Black Swans (see Failure to understand Black Swan leads to fallacious thinking) will be lurking. You see, it is open knowledge that the United States government is heading towards where Greece is in right now (see Currency crisis: UK, Japan and US). What if, there’s another macroeconomic shock? It could be a meltdown in the Credit Default Swap (CDS) market, trade war with China, another wave of mortgage default (see Next wave of defaults to come?), or something else. With the United States government already stretched thin on faith and credit, any additional macroeconomic shock that requires further faith and credit of Uncle Sam will simply be unavailable.

GoldMoney. The best way to buy gold & silverTo understand what we mean, consider what a typical bond vigilante will be thinking. The only reason why he is still lending money to Uncle Sam is because Europe is a worse debtor. Since it is open knowledge that the US is heading towards a Greek tragedy, he knows that it is only a matter of time he will stop lending to Uncle Sam (assuming that Uncle Sam remains unrepentant of his spendthrift ways). But what if Uncle Sam is hit with an unexpected huge bill (macroeconomic shock) today? Will he continue to lend to Uncle Sam? Perhaps he may even demand his money back straight away? After all, if he worries whether Uncle Sam can repay his debt in 10 years time, wouldn’t that unexpected bill bring forward the day of reckoning? Or perhaps that will be trigger for giving up on Uncle Sam?

That’s where another macroeconomic shock can potentially descend into a USD currency crisis. We are not saying it will happen. But given that we are in a situation whereby the margin for error is getting smaller and smaller, it pays to watch out for Black Swans.

Now is the time to implement asymmetric payoff strategy?

Thursday, May 28th, 2009

A couple of years ago, when it was still a raging bull market, we wrote this guide, How to profit from a stock market crash?. In that guide, we gave a thorough treatment on the correct and safe way to profit from a possible price crash in the context of a bull market. The way to do it is to implement a trading strategy that carries an asymmetric pay-off. An asymmetric pay-off strategy is one that, as we said before in How to take advantage of an impending crash- Part 4: asymmetric payoff,

First, you structure your bet in the market such that if you lose the bet, your loss is very tiny, but if you win, your gain is very massive. Next, you bet that the market will crash within a specific period of time. If you lose that bet, place another bet for the next period of time. You do this repeatedly until the day of the Black Swan event when your profit overwhelmingly overshadows your accumulated small losses.

Obviously, the disadvantage of this strategy is that it requires fortitude to absorb small losses indefinitely while waiting for a highly rewarding final vindication in the end.

Today may be another ripe time to set up up such a strategy for aggressive traders. As this news report opined,

Apparently, Wall Street has factored all bad news into stocks. Is that a good sign, or should investors be worried if something unexpected really happens?

The market is putting itself in a position that negative surprises are no more. It may be true, but then again, Black Swans can still be lurking. We had listed two possible Black Swans in Two major Black Swans looming ahead for the global economy and one more in Is this a bear market rally or a turning point?. These Black Swans can potentially introduce another round of panic in the financial markets. For Australia, we see another possible trigger for panic- the Australian banking system (see How safe are Australian banks?).

If you are an aggressive Black Swan trader, now is the time to sharpen your tools.

Is it a good time to buy Australian financial stocks?

Tuesday, September 30th, 2008

By the time you read this, the global financial markets will be in mayhem, thanks to Congress’s rejection of Henry Paulson’s bailout plan. Last night, the Dow fell 777 points, the greatest one-day drop since the crash of 1987. Central banks are busy pumping hundreds of billions of dollars worth of credit into the financial system as the credit market freezes up. Stock markets around the world are plunging.

Some people reckon that this is a good opportunity to buy Australian stocks, especially financial and bank stocks, which are hardest hit. After all, the mainstream belief is that the Australian banking system is rock solid and prudently regulated. That implies that the sell-off of financial and bank stocks will be overdone and lead to opportunities for value-oriented investors.

What do we think of this idea?

The problem with this idea is that it is only half-right. This half-right idea is dangerous. Sure, it may be true that the Australian banking system is strong. But this is based on the premise that the current situation will extend into the indefinite future. This leads to the very crucial concept of Black Swans. Due to a quirk in the human mind, it is very easy for one to understand Black Swans nominally, but when it comes to decision-making, act as if one has totally lost that understanding. To understand the concept of Black Swan, we highly recommend our earlier article, Failure to understand Black Swan leads to fallacious thinking. We must stress that it is crucial that you understand the content of that article before reading the rest of this article.

Now, what’s wrong with Australian banking and financial stocks?

Well, the issue is not with their future earnings. Based on statistical probability of the past, there is no reason to doubt the forecasts of their future earnings. The more cautious analysts may even adjust their forecasts downwards to account for the expected reduction in earnings due to the credit crisis. Thus, a sell-off in banking and financial stocks may lead to their prices looking very undervalued.

This is where the fallacy such thinking begins. As we said before in Two uncertainties of valuing a business- risk & earnings,

Between earnings and risk, the latter is the most subjective of all in the business?s valuation. In a world of Black Swans, risk is not something that can be easily quantified into a precise number (discount rate). It is also a number that cannot be verified for correctness.

In other words, earnings are very much ‘visible’ and taken into account. But risks are ‘invisible’ and therefore, get ignored and overlooked. That is where the grave error lies. Risk is the playground of the unknown unknowns. The problem with such stocks is that at this stage of the credit crisis, they are particularly vulnerable to the unknown unknowns. In other words, these unknown unknowns will have a massive and colossal impact on their earnings. As we explained before in Common mistakes in failing to see economic turning points,

The importance of a particular event is the likelihood of it multiplied by its consequences. Black Swan events are events that are (1) highly unlikely and (2) colossal impact/consequences. One common mistake investors (and many professionals) make is to look at the former and forget about the latter i.e. ignore highly unlikely but impactful events.

Why do we say that?

A simple word answers this question: leverage.

Due to the amount of leverage (in the Australian economy, banks balance sheets and the global financial system), when the unknown unknowns pops up, earnings can go terribly, utterly, totally and massively wrong (we are running out of adjectives here). For example, as we quoted Brian Johnson in How safe are Australian banks?,

?We?re talking banks geared 25-30 times, whereas the global peers may be geared 15-20 times… even a moderate loan-loss cycle creates negative earnings,? he said.

The Australian economy itself is highly leveraged. As we explained before in Outlook 2008,

Currently, Australia?s total private debt is around 160% of GDP, which is at a unprecedented level even exceeding the Great Depression (when it was just 80% of GDP). Australia?s economic prosperity is financed by debt. However, it is such high levels of debt that can accentuated the inevitable bust.

As we refuted Shane Oliver in Aussie household debt not as bad as it seems?,

A severe downturn to the Australian economy may or may not be statistically likely, but given the level of unprecedented leverage, you can be sure the impact will not be small.

The global financial system is still highly leveraged, particularly with derivatives (see How the CDS global financial time-bomb may explode?). As we said before in Potential global economic black hole: credit default swaps (CDS),

Currently [January 2008], the CDS market is valued at around $45 trillion, which is three times the GDP of the US.

The notional value of derivatives world-wide is said to be at the range of hundred of trillions of dollars.

Australian banks are highly leveraged to a highly leveraged economy in a highly leveraged global financial system. To put it simply, there is only a razor thin margin for ‘error.’ When there’s no ‘error,’ all will be fine. But if there’s an ‘error,’ there can be a colossal bust. Please note that we are not predicting financial Armageddon. For all we know, maybe there will be no ‘error.’ But should it slips in, the last thing you would want to hold are the banking and financial stocks.

How do we prepare for a possible economic crisis?

Sunday, June 29th, 2008

We will continue with some of our readers’ questions from our previous article, What is a crack-up boom?:

My comment/question is how do you plan, as a family, for an event that is this big and catastrophic and that could happen any day over the next 10 years, or take place ?slowly? over months or years (or really is happening already at some rate)? Buying gold it seems is a good investment strategy, but not a complete preparation by any means.

Is another great depression an inevitable event that will occur sometime in the near future? Can it be AVOIDED or at least, the effect minimised with any sort of human intervention? My main concern would be that I am still in the early stage of my career and have not yet accumulate sufficient wealth to withstand any significant recession/depression.

Personally, I think it would be great (if you have the time) to see an article explaining why it’s unlikely; and perhaps explaining how – given the stark possibilities we’ve been shown – it will be possible for the US (and the rest of the world) to NOT enter an inflationary or deflationary recession.

To be honest, we do not really have all the answers to these questions. This is because what we are experiencing today is unprecedented in the history of humanity. Therefore, history can only be a limited guide to what is to come. As we said before in Epic, unprecedented inflation (remember, that was written 12 months ago, when the bear market had not yet arrived),

Today, the world is experiencing an unparalleled inflation of asset prices. This is the first time ever that the world is experiencing asset price inflation in all asset classes (e.g. property, bonds, commodities, stocks and even art!) and in all major nations (e.g. US, China, Japan, Australia, UK, Russia, etc). We will repeat this point again: never before had such a universal scale of asset price inflation ever happened in the entire history of humanity! Today, even artwork is also in a ?bull? market (if you consider artwork as an asset class)!

Since 1971 (when President Nixon severed the final link between gold and the US dollar), this is the first time in the history of human civilisation that the entire world is using freely fluctuating and pure fiat money (see What should be your fundamental reason for accumulating gold? for the meaning of what fiat money is).

Therefore, we must impress upon you that we do not know what the future holds and hence, are not making any predictions. Understanding what is to come lies outside the realm of economics and finance, into the realm of psychology, politics, sociology and so on. The latter group are outside our circle of competence. As such, this topic is full of Black Swans. As we said before in Failure to understand Black Swan leads to fallacious thinking,

For this reason, that is why we delve more on the big picture and economic history and get mired less on minute statistics and detailed numbers. In technically philosophical terms, it means we are taking on a meta-view i.e. we are taking on a view of our view. At times, this means we have to expand our circle of understanding and venture outside of finance, investing and economics into fields such as psychology, politics and history. The broader our circle of wisdom and experience (that includes borrowed experience from a study of history), the less vulnerable we will be to being caught out like that turkey.

Thus, your guesses of the future are as good as our guesses. Here are some of our thoughts…

A lot will depend on the level of law and order if/when the epic economic crisis happens. In the United States during the Great Depression, there was still a functioning government, with law and order still functioning. We can think of modern examples of countries that are not so lucky: Rwanda, Yugoslavia, Somali, Congo, and so on. If anarchy reigns, we doubt money in any form would be useful- guns, food and survival equipment may be better bets. On the other extreme, we can imagine a potential demagogue secretly practising his incendiary orations in some back rooms today, to be used tomorrow to seize absolute power and authority- a case if ‘too much’ law and order.
As David said, buying gold may be a good idea. But gold ownership was outlawed in the United States during the Great Depression. Currently, Vietnam is banning gold imports (see Vietnam Suspends Gold Imports) as price inflation surges to 25%. This is another example of Black Swans. For our United States reader, this is one thing to bear in mind.

Can an economic catastrophe be avoided, or at least be minimised?

Firstly, the coming ‘catastrophe’ may not happen in a way that we expect, in a manner that we may recognise today as a conventional ‘catastrophe.’ Would life under the coming ‘catastrophe’ be some form of hellish tribulation or just a very difficult disruption of the life, as we know it? The answer may depend on the context of which country/currency/region you live in. The Middle-East is the place we would like to avoid. Australia, the “lucky country” may be a safer place. There is a possibility that we may have to revert back to a much simpler lifestyle (e.g. cycling to work, planting our own vegetable gardens, no television at night, etc). Maybe the financial markets as we know it, will be completely different and much simpler under an overhauled system (e.g. a gold standard)? Some may welcome this while others may fear it. For those who live in the third-world countries, it may not be any difference.

Who knows, perhaps another Paul Volcker may take on the helms of the Federal Reserve? As we said before in Peering into the soul of Ben Bernanke,

In a way, Paul Volcker, the chairman of the Fed in the 1980s, is the anti-thesis of Ben Bernanke. He was credited with ending the US?s stagflation crisis in the 1970s by crushing the economy into the worst recession since the Great Depression. To do this, he had to raise interest rates to unbelievably high levels, to the point that in 1981, interest rates charged by banks exceeded 20 percent (Note to Australian readers: the Labor was often blamed for the super high interest rates of the 1980s. Now you know where such high interest rates come from- such high interest rates was a global phenomenon). Paul Volcker crushed severe inflation by crushing the growth of money supply.

If such a person heads the Federal Reserve today, you may want to consider selling your gold straight-away. On the other hand, with the United States mired in so much more debt than in the early 1980s, can such a harsh medicine work without killing the patient?

Can an inflationary/deflationary recession be avoided?

Well, how do we see ‘avoidance?’ Back in 2001, the United States briefly dipped into a very shallow recession before the economy bounced back into growth. But did it really avoid a recession? Or was it merely postponed? Back in November 2006, as we said before in How will asset-driven ?growth? eventually harm the economy?,

In 2001, when the US economy was faced with a threat of recession, the Federal Reserve embarked on an expansionary monetary policy (aka ?printing money?) in an attempt to prevent it from happening. We believe this policy does not prevent a recession?it merely postpones it, in which the upcoming one will be more severe instead.

So, if the world manages to ‘avoid’ another severe recession, will that be setting itself for an even larger one down the track?

With such a colossal amount of debt owed today, the consumption of the present generation will consign the future generation to slavery paying off what was owed by their parents. If Peak Oil is true, how can the future generations have the capacity to do so? Who knows, perhaps a new technological breakthrough is about to happen, bringing us to a new paradigm shift? This looks to be the only way for both inflation and deflation to be ‘avoided.’

Are young people more vulnerable to an economic crisis?

We believe that having a large nest egg is no guarantee as much as having a minuscule one. When inflation strikes, the purchasing power of any nest eggs will be severely eroded very quickly in no time. For example, say you had accumulated 1 million Zimbabwe dollars for your retirement. But today, that nest egg is worthless through hyperinflation, unless you have a foresight to convert that to foreign currencies or gold BEFORE it happens. Our point is, to protect yourself against hyperinflation, it is not how much you accumulated that makes the difference. It is what you hedge it with that means the difference between the poorhouse and a much better life. With deflation, no matter what amount of nest egg you have is useless if your counter-parties (e.g. bank, superannuation fund) default on their liabilities to you. See Should you hold gold or cash in times of deflation? for more details on this.

For young people, you have one advantage that the old folks does not have- the energy and drive to learn new skills and embark on useful enterprises/projects that may be far more useful and relevant in a tougher and different economic scenario. In that sense, retired people are far more vulnerable than young people.

What are your thoughts on how to prepare for an economic crisis? Share them at this forum!

Pressure on global financial system is still simmering away

Monday, April 28th, 2008

One of the financial veterans you have to respect is Peter Bernstein. As this Wall Street Journal article, One Guy Who Has Seen It All Doesn’t Like What He Sees Now said,

Peter Bernstein has witnessed just about every financial crisis of the past century.

As a boy, he watched his father, a money manager, navigate the Depression. As a financial manager, consultant and financial historian, he personally dealt with the recession of 1958, the bear markets of the 1970s, the 1987 crash, the savings-and-loan crisis of the late 1980s and the 2000-2002 bear market that followed the tech-stock bubble.

Today’s trouble, the 89-year-old Mr. Bernstein says, is worse than he has seen since the Depression and threatens to roil markets into 2009 and beyond — longer than many people expect.

If you look at the financial press today, you will find that the market is ‘optimistic’ that the credit crisis is turning for the better. It has hope that the situation will get better. Consequently, you get to see some recovery of financial stocks and the US dollar. But Peter Bernstein is not so hopeful. As he said,

If China goes into a recession, God knows. The Iraq war and the whole situation with terrorism, we really don’t know where that is going to come out. There are so many things that have got to get buttoned down before you say that the future looks good enough to take a risk.

In other words, there are too many unknown unknown lurking around (see Failure to understand Black Swan leads to fallacious thinking). We share his concern about China and had written a long article about it in Can China really ?de-couple? from a US recession?. Peter Bernstein will only start to get hopeful when he sees that

… housing trouble has to at least flatten out. As long as that is going on, I think the pressure on the credit system is going to persist. It is kind of the leading indicator. It is where the trouble started. We have to underpin the consumer. That is why this is different. That is why this is like nothing we have had before.

This brings us to the Credit Default Swaps (CDS). As we said before in Potential global economic black hole: credit default swaps (CDS),

What happens if these waves of bad debts trigger the contingent obligations of CDS sellers to honour these mass of credit defaults? If these CDS sellers default themselves, what will happen to those who depend on CDS to remain solvent in the event of defaults?

As long as the house price deflation is still under way, the solvency of the financial system will be under pressure, which in turn will lead to further deflation and contagion of credit default. That will test the CDS. As this Economist article said, Swap shop,

However, many market participants were equally reassuring about the health of the CDO market in early 2007?and look how that turned out. Independent observers will not be really reassured until the system survives the test of a big, juicy default. Given the weakness of the American economy and the scale of the credit crunch, it probably will not be long before that test comes along.

If the CDS time bomb explodes (and some will argue that it is a matter of when), the first share market casualty will be the financial stocks. Just as the Germans did not know when and where D-Day will occur (though they knew it was a matter of time), so will the day of CDS reckoning be.