Monday, 21 June 2010

Yuan back to normal

In a statement crafted with traditional Chinese care, it was announced the China's monetary authorities would allow for more flexibility in the movements of the Yuan. This Newspeak caused something of a stir in the markets, which immediately began to brace themselves for a major appreciation of the Chinese currency. Markets are likely to be disappointed in this respect.

There had been rather quiet around the Yuan for a while. USA's China-bashers had for some reason backed down and that created the situation we described in an earlier post: China needs to revalue the Yuan for purely internal purposes, but cannot be seen to bow to pressure from the most populist US lawmakers.

China has an urgent need to control the capital inflows that result from running a huge current account surplus, but has not equipped herself with a modern money market and the necessary instruments. Instead, Chinese monetary policy is run on the basis of quantitative methods reminiscent of the period of central economic planning.

Needless to say, when there is a huge appetite for credit in one segment of the economy (property and construction sectors), and the government tries to cut off this sector's access to otherwise abundant liquidity, you set yourself up for major distortions that provide huge incentives for corruption.

In 2008, the Chinese government was the first to introduce a major package to cushion the impact of the international banking crisis: This package has now been proven efficient, and the Chinese leadership can rightly be proud of the timely action. However, the package did not shift as much growth over to domestic demand as hoped, and recently the Chinese trade surplus has begun to grow again.

Thus the monetary inflows have begun to increase again at a time where the Chinese economic policy authorities have clearly signalled that they want to see slower growth.

Before the outbreak of the international crisis, the Yuan had been allowed to appreciate in a clear but controlled manner against the USD. In July 2008 this policy was reversed and the currency was again locked to the USD. As a defensive initiative it was a brilliant move. Nobody knew if the Dollar would go up or down as a result of the goings-on in the banking sector. Roughly half of the world's economy is running a de facto peg to the USD.

By locking the Yuan to the dollar, China chose to protect their relative position towards the major export markets. Obviously not against Europe, but the Euro proved to be the stronger currency. This solution helped Chinese exports but created some other problems.

Now the exports are back on track, and the Chinese authorities appear poised to resume a policy of a slow and controlled revaluation of the Yuan. The probability of a sudden, major appreciation of the Yuan is close to zero.

The winners will be China's direct competitors as well as companies exporting to China. This has been clear for a while. This week-end's announcement is not revolutionary. It is just a reassurance that China's monetary policy has reverted back to the crawling peg policy from 2005-2008.

Friday, 18 June 2010

Stressful stress testing

EU leaders yesterday agreed to publish the results of stress tests, performed by European banks. Spain was forcing the hand of her fellow Euro-zone members by declaring that the results of stress tests performed by Spanish banks would be published irrespective of the EU decisions. The stated goal of conducting stress test and of publishing the results is to increase transparency. Hopefully this will calm down the markets, which are now increasingly doubtful about Spain's public debt.

A stress test is a series of calculations, aimed at simulating losses incurred by a bank under a series of specific assumptions about the economic developments. The purpose is to show whether the bank has sufficient capital to survive if accident strikes. US banks were subject to a stress test in 2009 and some banks were revealed as being undercapitalised. The US government subsequently provided help to those banks under the TARP program.

The direct reason for the EU move is the increasing rumours concerning the health of the Spanish banking sector. Spain is currently undergoing its own savings bank crisis, with most of the 45 regional savings banks having ventured into lending activities that are now killing them. 16 of the savings banks are on the brink of collapse and one, CajaSur was taken over by the central bank.

Markets now fear that a) the commercial banks are in similar dire straits and b) that healthy banks will be forced to take over the unhealthy ones, given that the government finances will not allow a bail-out.

The Spanish government and central bank (who had impeccable credentials before the creation of the Euro) have attacked the issue head-on. They have pushed Spanish banks to bring losses forward instead of hiding them, as it is now allowed under European accounting rules.

This step towards transparency has already brought two consequences: Spanish banks have underperformed their European counterparts, and they are already rumoured to come out on top once the stress tests are performed and presented. Seen on this background, the Spanish government had little to lose by releasing the stress tests.

Not surprisingly, virtually every European banker has taken to the microphone in the past 18 hours. 'Stress tests are a not a bad idea, but please do not publish the results' seems to is the message they convey.
This looks like a living proof how little bankers have learned from the crisis over the past couple of years. They still believe that their businesses are best protected behind a shroud of secrecy, when it is increasingly clear that transparency is the way to create reassurance.

Of course some European banks are badly capitalised. European governments have tried to make bank rescue packages on the cheap and that will show. But the correct way of handling this is not by pretending that the problems do not exist.

Armies of financial analysts are convinced that Spanish banks are carrying tonnes on hidden bad loans on the books. This is a clear sign that the secrecy thinking is deeply entrenched in Europe. It can only be bad for business.

In a past life I worked in an investment firm where we almost never had European financials in the portfolio – for the simple reason that they were not sufficiently transparent. While stress testing for sure has its shortcomings, there are only reasons to cheer the EU for the decision to force the banks' hands. Obfuscation is no solid basis for business.

Wednesday, 16 June 2010

Rating agencies under heavy pressure

As an element in the ongoing political battle for financial reform in the US, the newspapers report a victory for the rating agencies. Well, sort of.

First, for those who have not yet heard of rating agencies, an ultra-short primer. A rating agency is a commercial company that produces ratings of various debt instruments, paid for by the issuer. The ratings are supposed to be based on a thorough analysis of the issuers' ability to repay the debt. There are three US based rating agencies that have government authorisation, Moody's, Standard and Poor's, and Fitch. Across the world, pension funds and insurance companies have used the ratings to "control risk" in their portfolios.

Many of financial institutions have a provision that if one of the rating agencies has issued a rating below investment grade, the institution simply cannot hold the security in their portfolios. US government agencies are required to use the ratings. Further, the ratings agencies have been protected under a peculiar interpretation of the Constitution, whereby their ratings were considered an expression of "free speech", meaning that it was impossible to sue them for any kind of malpractice. Their ratings are – despite the supposedly thorough analysis – just an opinion.

In the aftermath of the dotcom bubble, the reputation of the agencies took a bad hit, as the ratings of companies such as Enron dropped from the coveted AAA to "junk" in a matter of weeks before the company went bankruptcy (and months after the stock price had fallen by more than 90%). Surely the ratings agencies should have seen it coming, if they really had checked the books.

In the wake of the Sub-Prime Crisis it became abundantly clear that the rating agencies had "adapted" to the wishes of the issuers and had bestowed their highest ratings on packages of dodgy debt based on a paper-thin assurance from badly capitalised insurers. Who had by the way also been rated by the very same rating agencies.

And most recently, the rating agencies began to meddle with the EU as they have lowered the rating of Greek debt to "junk" status, despite a massive underwriting by the EU. Yes, the rating agencies defend themselves, but the underwriting will end in three years. Apparently their experience with both Sub-Prime issues and Enron or WorldCom have taught them a lesson about being ahead of the curve. But many institutional investors decided not to sell their holdings of Greek government debt, breaking with the diktat from the agencies.

Now their previously unassailable status is under heavy attack. The EU is actively trying to promote European rating agencies. The planned US reform of the financial sector will most likely lead to a change in the constitutional protection (so they can be sued for telling fibs), US government agencies will not any longer be required to use the services of the rating agencies. There will have to be far more openness and transparency about their ratings and analysis.

Amid all this bad news for the rating agencies, it is made out to be a victory that the US Congress has dropped an idea of assigning rating assignments on a random basis. Some victory.

For the rest of us who take an interest in risk management, what is going on is highly interesting. In a recent blog post I laid out how some of the thinking members of the financial community have arrived at the conclusion that mathematical models of risk are useless when they are most needed.

Now all of those who had used ratings as an excuse for independent thinking are receiving yet another blow. If you cannot consider the ratings as the results of proper diligence, how should you then manage a portfolio of debt instruments? I am afraid that I again come back to my conviction that there is no alternative to independent thinking.

In the real world, businessmen know that there is no such thing as a free lunch. Risk exists, even if you would really, really like it to go away (or to be sold off in tasty little morsels). Faced with this categorical imperative, too many risk managers have for too long relied on mathematical models and ratings. The mathematical models are built on assumptions alien to the real world. Ratings are issued by commercial companies who have shown clearly that ratings are a product which can be moulded to the clients' needs. For sure it is not quite as independent and well-founded as rating agencies would like us to believe.

Risk managers of the world, unite. You have everything to lose if you don't start thinking.

New risk regime – or “Houston, we have a problem”

We have long been adamant that risk models based on Value at Risk (VaR) or other backward-looking statistical models are close to useless. The reason is that the underlying correlations between financial variables are inherently unstable, and that this instability is most pronounced in periods of strong market movements.

In a remarkable piece, Jim Caron, Morgan Stanley's Head of International Bond Strategy admits to have found out that something is wrong. In a recent piece, he admits to having been wrong on interest rates and bond yields. It may well be so, but the more interesting is his observation of recent market movements.

"April and May were difficult months for us and others, judging by fund data on market performance. We did not properly discount the risks associated with peripheral Europe. As a result, we had a larger risk exposure than we should have. We measure the return potential for our positions on a per-unit-of-risk basis, similar to a Sharpe Ratio. That unit of risk turned out to be much higher than we anticipated. This will force us, and many others, to right-size our risks."

In other words: the models used to discount risk have understated the risk. Caron is optimistic that it is possible to "right-size". It counts in his favour that he actually tries to find a way out of the problem. He suggests the following

Liquidation of risk exposure: Portfolio positions turned out to be much more correlated than we had initially anticipated. Traders seek to reduce correlation by liquidating many positions, leaving behind perhaps only a few core positions. We saw these liquidations in May and early June

Sit, wait and re-assess: Traders will now have to evaluate the new risk relationships. Since there is great uncertainty, traders might start by making small and short-term tactical bets to get a feel for the risks. Again, only a few core positions may still be left on.

Right-size risk: As the new market environment becomes somewhat better understood – albeit still marked by great uncertainty and higher realized volatility – traders could now start to make an assessment on the proper risk they should have relative to the increased level of expected volatility of returns. For example, if the market is twice as volatile today as it was before, then one should run positions with half the size of risk.

For better or for worse – the introduction of a new tail risk: Given the losses taken and positions liquidated in the past few months, the new tail risk is for risky assets to reverse sharply higher and for yields to rise. This could cause traders to chase performance, so as not to be left behind relative to their peers. Similarly, if markets turn against them, then they will be quick to exit. This introduces two-way risk: traders may start to react equally to both good and bad news. Previously, the tail risk traders were mostly focused on a worsening of risky assets. Now they have to be concerned about both tails, for better or for worse, which will add to market volatility.

It all sounds very reasonable. But it sidesteps one important issue: the complete collapse of predictive models when multiple sigma events like the May Flash Crash and the accelerating sovereign collapse of the past several months occur.

Carons observation that "Portfolio positions turned out to be much more correlated than we had initially anticipated" hammers the point home - markets are not inherently stable. But the situation is more serious than Caron thinks: There are no models that can model the behaviour of the financial markets when disaster strikes. The solution is to introduce much simpler and much more pragmatic ways of dealing with risk, once it appears. Risk cannot be dealt with by a machine, however clever. This has been known for ages outside of the financial markets. The financial markets need to reconnect with the real world.