The financial turmoil of 2007-?
April 23, 2008 3:31 PM   Subscribe

The financial turmoil of 2007-?: a preliminary assessment and some policy considerations (pdf) "All episodes of financial distress of a systemic nature, with potentially significant implications for the real economy, arguably have at their root an overextension in risk-taking and in balance sheets in good times, masked by the veneer of a vibrant economy. This overextension generates financial vulnerabilities that are clearly revealed only once the economic environment becomes less benign, in turn contributing to its further deterioration." A scholarly, sane, relatively brief, accessible-to-the-layperson, and mostly apolitical look at the current turmoil.
posted by Kwantsar (36 comments total) 14 users marked this as a favorite

 
from the conclusion:

In this essay, a number of areas for action have been highlighted. They include: strengthening transparency, including with specific reference to measures of the uncertainty that surrounds point estimates of value, to multi-dimensional rating classifications and to liquidity risks; encouraging improvements in risk management systems, not least seeking to limit the procyclicality of risk measures; reflecting further on how to promote more prudent compensation schemes; strengthening the macroprudential orientation of prudential frameworks, building on the important improvements in minimum capital regulation yielded by Basel II; and refining monetary policy frameworks so as to take better account of both the build-up and unwinding of financial imbalances, including by ensuring effective liquidity management operations at times of stress. Working along these lines holds out the promise of helping to limit the incidence of serious episodes of financial distress in the future.

Translation: buy gold.
posted by ornate insect at 4:17 PM on April 23, 2008


Translation: buy gold.

Right, because there's absolutely no history of commodities being vulnerable to bubbles.

Translation: diversify.
posted by thecaddy at 5:14 PM on April 23, 2008 [1 favorite]


thecaddy--er, joke, much?
posted by ornate insect at 5:25 PM on April 23, 2008


Sorry, OI. My brain is fried. Now I'm going to get a drink, and let some other people post.
posted by thecaddy at 5:28 PM on April 23, 2008


Buy tulips.
posted by Falconetti at 5:28 PM on April 23, 2008 [3 favorites]



Thanks for the article, Kwantsar. It's interesting to look at the chronology of events with the benefit of hindsight. The first public information that big problems were ahead came a little over a year ago, with the pace of bad news accelerating in the summer. But despite that, if you look at the market and at some sectors, there was still plenty of upside. There was a shock in August, which the market recovered from after the Fed acted, then it was off to the races again until November, when it became clear that the problems were widespread throughout all industries.

A lesson here is that there is always time to act. The bad news doesn't always come out at once, and it isn't clear that when the bad news does come out, it's fully priced in all at once. There's a lot of noise in the market these days, especially with CNBC and govt. spin.
posted by Pastabagel at 5:49 PM on April 23, 2008


including by ensuring effective liquidity management operations at times of stress.

This is exactly what got us so sick in the first place; the continued intervention by the Fed. By preventing all bad outcomes, ever, they also prevented adjustment to new economic realities. Now we get to do a whole lot of adjustment all at once.

The economy is impossibly fucked up, and it's primarily due to this kind of interventionist mismanagement.
posted by Malor at 7:06 PM on April 23, 2008


This is what I've been saying to my friends all along. I'm not a financial expert, but the Wall Street approach to capitalism in this country has endowed a lot of greedy people with great fortune. Meanwhile, hundreds of thousands of decent, hard-working people have been shut out and are the silent victims when the house of cards inevitably topples (e.g. hedge funds).
posted by sswiller at 8:01 PM on April 23, 2008


Why are the "decent" people "hard-working"? For the same reason as the "greedy" Wall Streeters. Also, most hedge funds are not "toppling", and not all of them are even in the same markets as this trouble.

I'm not a financial expert

Indeed.
posted by Spacelegoman at 8:18 PM on April 23, 2008 [2 favorites]


Will better instrumentation give us better control, or just a better view of the cycles we ride?
posted by owhydididoit at 9:41 PM on April 23, 2008


Spacelegoman--it must make you feel extremely superior to take a dump on someone in a thread like this.
posted by ornate insect at 9:55 PM on April 23, 2008


I think we can say that historical reference proves that if you:

1. Remove safety checks between financial companies that prevented collusion

2. Encourage falsehoods in financial reporting

3. Encourage parasitic financial relationships between watchdogs and their wards

4. Have any and all government agencies emasculated

5. Have the rest of the agencies focused on bolstering top-level profits

6. When in trouble, provide anonymous money to hide the problem

7. When in a lot of trouble, bailout those at the top.

The Government and these financial fuckos have lied their way through this shit since Glass-Segal was revoked.

Mix in an incompetent and chicken shit SEC, sleazy ratings agency, FED/Treasury Department that will cut you a check if you drop a load of manure on their doorstep, and poof!

PROFIT!
posted by Lord_Pall at 9:57 PM on April 23, 2008 [1 favorite]


Ah thanks for posting this. I hadn't seen this paper yet but after a brief read I'm not surprised by its views, as BIS has been pushing out a wide range of communiqués on the credit crunch.

A few observations: All in all, an interesting read. I haven't read many of his citations, so this will keep me busy for a while.

Many thanks!

ornate insect -- "Translation: buy gold."

Well, I went long both gold and silver starting in 2004, and I'm still long. Don't think the markets are collapsing, but I've long held the view inflation was going to (perhaps sharply) trend up, and it looks like this is indeed happening.

Almost any long run time series reverts to the mean, and inflation is no different. Too low for too long.

In an inflationary environment, you really don't want to be sitting on cash, at least NOT until the initial, corrective interest rate shocks have entered the system (i.e., rates rise significantly to counter).

So yeh, good advise.


Pastabagel -- "The bad news doesn't always come out at once, and it isn't clear that when the bad news does come out, it's fully priced in all at once. There's a lot of noise in the market these days, especially with CNBC and govt. spin."

Certainly true about the emergence of bad news, but also keep in mind that even when news is out it isn't interpreted the same way by all market participants for many reasons -- different tolerances for risk, not all participants receive nor act upon the same information at the same time (arguments about efficient markets aside), etc. All these present opportunities for traders to take advantage of situations as they develop. I'm personally active in high yield these days, and still think there is a lot of value out there. Munis have caught my eye recently as well for the same reason. Many of these markets have seized up (combination of the credit crunch and an upcoming Supreme Court case on tax deductibility at the State level) and there are some eye popping deals out there.

I've been reading an interesting paper on noise traders, and working it into a FPP that hopefully I'll get up in a day or so; timely comment.


Malor -- "The economy is impossibly fucked up,..."

That statement stands on its own merits.


owhydididoit -- "Will better instrumentation give us better control, or just a better view of the cycles we ride?"

Ah great question.

Over the long view, we (finance as a discipline) learn much from each crisis. But while we learn much I can't honestly tell you we always internalise and improve our practice after each crisis. But we do learn something, and improved instrumentation - for example, improved financial controls and reporting under a post Basel II regime - would indeed help.

We can go back maybe five hundred plus years, looking at financial crisis' and illustrate the lessons. We can also (to a lesser extent) point to the current regulatory regimes (plural, as we don't have an effective global framework in place), point to a practice and link it to a crisis (or series of crisis').

So while we do learn, we can't change the fundamental nature of capitalism. There will always be cycles. There will always be bubbles. And crashes.


Lord Pall -- "The Government and these financial fuckos have lied their way through this shit since Glass-Segal was revoked."

Ah while I understand (and agree to some extent) about the spirit of your post, I think you'll find the various factors you've illustrated were in force long before Glass-Steagall.

A lot of the issues you (correctly, but there are more) raise are, sadly, reflective of basic human nature.

Folks get all weird about money. A fundamental fact of human nature, and (IMHO) lots of other stuff flows naturally from this premise.

Once again, great post. Many thanks for some interesting comments!!

I've been working in Amsterdam all week and will be heading back to London in about an hour or so; if I don't follow up I haven't abandoned this thread, hopefully I'm just making money ... heh. Will certainly catch up in the AM.
posted by Mutant at 2:33 AM on April 24, 2008 [7 favorites]


Mutant: What are "structured positions"?
posted by Laugh_track at 7:08 AM on April 24, 2008


Thanks for the fantastic, informative, thoughtful post Mutant.
posted by thedanimal at 7:23 AM on April 24, 2008


"All episodes of financial distress of a systemic nature, with potentially significant implications for the real economy, arguably have at their root an overextension in risk-taking and in balance sheets in good times, masked by the veneer of a vibrant economy. This overextension generates financial vulnerabilities that are clearly revealed only once the economic environment becomes less benign, in turn contributing to its further deterioration."
Or, more to the point:
"You don't know who's been swimming naked until the tide goes out." - Warren Buffett
posted by edverb at 10:11 AM on April 24, 2008


including with specific reference to measures of the uncertainty that surrounds point estimates of value, ...

As a statistician, this, in particular, "resignates" with me. When I worked for a venerable manufacturer of medical devices, they kept insisting on targeting manufacturing quotas to hit their point estimate for demand. If they projected demand of 20,000 units, then, by god, they set up for manufacturing exactly 20,000 units. If demand was over that, they couldn't meet it. However, there was considerable uncertainty about this point estimate. Since they manufactured for US$3000/unit and sold for US$30,000/unit, undershooting was considerably more costly than overshooting. But when I tried to explain the wisdom of going over the point estimate based on the uncertainty, all I got from the MBA geniuses were blank looks. So I wrote a longer proposal on the topic, thinking that would help. But all I got back were annotations on the (printed) copies that over-production would be a waste of real dollars, whereas the under-production was only potential dollars(!).

Yeah, we got some real geniuses running our big corporations.
posted by Mental Wimp at 11:07 AM on April 24, 2008


Laugh track -- "What are "structured positions"?"

Ah really great question as I realise this phrase is often tossed about rather casually in the finance threads. I'm certainly guilty of this, so please allow me to make amends by starting from the beginning to insure full clarity of my explanation.

Let's consider these instruments solely in the context of the stock (aka, "equity") markets, as it's easier to understand (at least initially) than looking over credit linked products. This explanation might be a little long, but we'll work our way through lots of jargon along the way so hopefully it will be worth the read.

Now then. If an investor has some spare cash and a view on a company traded in the US equity markets, say that this firm is going to go up (increase in value), then he or she has a few courses of action available.

The most well known approach is to simply purchase the shares - "go long". Then, having bought, hold the shares until they (hopefully) increase in value and sell. Ok.

But most professionals don't trade like that (i.e., single purchases), especially so as they are tossing large, sometimes very, very large amounts of money into the market, or perhaps trading over protracted periods of time. If a hedge fund, for example, wants to purchase they (almost always) will gradually acquire shares, adding to their position in a security over a series of individual trades.

To better understand this definition, lets look at a real company; this example will help us understand the detailed explanation of a structured position later in my comment.


So given we've got a cash rich trader with a bullish view on, for example, a firm such as Brunswick, let's also assume our investor has some cash - say, $50M dollars - that (for reasons we won't speculate on here) must be piled into this single firm. $50M is chump change for some market participants.

But looking at the Yahoo! Finance data on Brunswick, we see the company has a market capitilisation of some $1.4B dollars. This means the value of all outstanding shares in this enterprise is about $1.4B, or in other words, our intrepid (not to mention bullish!) trader is trying to purchase about 3.6% of the company.

Looking further into this problem, the average daily trading volume is roughly 1.7 million shares. So every day about $28 million dollars worth of Brunswicks stock changes hands (1.7 million shares traded every day, times a rough price of $16.50 / share).

Remember, we've got to invest about $50M dollars, or what is normally traded over a period of almost two days (recall, every day we see about $28 million dollars worth of shares change hands). At $16.50 a share, we're looking to acquire roughly three million shares, this for a company which "normally" has a daily trading volume of about 1.7 million shares.

Such a large increase in trading volume - i.e., the "normal" 1.7 million shares traded every day plus the trades we need to do to acquire $50M dollars worth of shares (or about three million) - will certainly be noticed if done in a short period of time. Many market participants watch for suspicious changes in trading volume, and will wonder what's going on if they notice a spike like we're describing (these folks are called "momentum traders", and volume is but one indicator they look for).

First and foremost, we don't want other market participants knowing what we're up to; presumably we're purchasing because we've identified a good deal at a good price. If other folks know about our trade they might also go long. And what's the problem there you might ask?

Another good question. Keep in mind that that price of a share of stock traded on the organised exchanges represents an equilibrium point between supply and demand, between buyers and sellers. As we acquire our three million shares, if this isn't done slowly we'll impact the price. As in cause it to increase.

And if our actions attracts that attention of other traders, as they mimic our actions ("Something must be up with Brunswick. Someone's buying a lot of shares. We'd better go long") their actions will also impact the price, reflecting the increased demand for a finite supply Brunswick's shares.

So clearly if our trader does $50M in a single transaction or in a short period of time (if at all possible, that's another question), this action will move the market - in other words, cause the share price to increase.

No, a professional trader like the individual we're describing here will do a series of transactions for many reasons, a few we've touched upon - not to move the market, not to impact the share price, secrecy, etc. The acquisition of this $50M worth of shares will be broken up and done in a series of smaller transactions, taken over a period of time, perhaps days.

So a position (in our example, Brunswick's stock) is simply the combination of a number of individual transactions. That's the first definition to take away.


But what if our trader, for various reasons was very, very bullish. Wanted to acquire MORE THAN $50M worth of shares, but only had access to $50M. How could the trader attain this goal?

Well, the answer is leverage. In other words, via leverage we can use the $50M in capital to control a much, much large amount of Brunswick's shares. Sure, this isn't a problem. Lots of ways to get leverage, but let's look at one that's germane to your query.

The trader could purchase what's known as a call option, in other words, a derivative that allows our trader to purchase the shares at a pre-agreed upon price.

When to use such an instrument? We purchase a call option when we think the share price will increase in value, as the option allows us to purchase at an agreed upon price which, we hope, will be much lower than market. Our profit is the difference between market and the lower price we can purchase at. If we own a call option that allows us to purchase Brunswick shares at $17 each, and if the prevailing market price is $30, we can profit to the tune of $13 (i.e., 30-17) a share.

So by introducing a derivative, we've effectively identified a second way that our trader can take a view on the prospects of the firm.

Now it gets really interesting when we consider what would happen if our trader had the opposite view regarding the prospects of this firm; in other words, negative, that its going to perform poorly.

The mirror image works sorta well here. The trader can sell short shares, hoping to profit on future declines in price. Simple, easily understood. But this isn't leveraged, and what if the trader wanted to control far more than $50M worth of Brunswick shares?

Well, the trader could purchase what's known as a put option, a derivative that's works the opposite of the call option introduced previously. In other words, a put option allows our trader to sell shares at a pre-agreed upon price.

When to use such an instrument? We purchase a put option when we think the share price will decrease in value, as the option allows us to sell at an agreed upon price which, we hope, will be much higher than market. Our profit is the difference between the price we can sell at and the (we hope) much lower price of the shares in the open market. If we own a put option that allows us to sell Brunswick shares at $17 each, and if the prevailing market price is $5, we can profit to the tune of $12 (i.e., 17-5) a share.


So now we've got two different ways to take either a bullish or bearish view on Brunswick; the traditional approach, that is, purchase or sell shares. Or we could employ a derivative; that is, purchase either a call option or a put option. Pretty neat, because having derivatives gives us flexibility that we can't acquire in the cash markets, ways to profit that you just can't duplicate without these instruments.

For example, what if we thought that the price of Brunswick's shares were going to change in value - sharply - but we're not sure in which direction. It happens. Earnings season is a good time for such movements; sometimes companies shares are very, very volatile after earnings are reported, and its tough to figure out which was the price will move.

So if we've got a trader who is confident that Brunswick's share price will be volatile, but isn't sure whether or not the price will go up or go down, we can use derivatives to (possibly) make money NO MATTER WHAT THE MOVEMENT.

Here's how it works.

What if we were to purchase both a call option and a put option? What if we were to assume a position consisting not of a series of equity trades (buying or selling), but what if we purchased both a call option AND a put option?

This is by definition a structured position; nothing more than a combination of other, simpler instruments into something greater than the sum of the individual parts. And something magical happens when we combine instruments into such a position. Let's see the magic in action.

Ok, if we purchase both a call and a put option, we've got the following position. Having read this far, you're already an expert and will be able to put this together.

Call option, we hope for an increase in the share price as we can purchase the shares at a pre-agreed upon price. If there is an increase in share prices, we're hoping our pre-agreed price will be lower than market, as then we'd be acquiring shares cheaper than the prevailing market price. We don't have to own or purchase the shares either; the call option will increase in value as the price of the shares in the open market increases.

Put option, we hope for a decrease in the share price as we can sell the shares at a pre-agreed upon price. If there is a decrease in share prices, we're hoping our pre-agreed price will be higher than market, as then we'd be selling shares at a higher price than the prevailing market price. We don't have to own or purchase the shares either; the put option will increase in value as the price of the shares in the open market decreases.


But wait - read this carefully! We own BOTH a call option and a put option. Not just one or the other, but BOTH.

So we can profit NO MATTER IF SHARES GO UP OR IF SHARES GO DOWN.

That is a simple example of structured position. Lets break it down a little further:

Position because we've got a combination of instruments. In this case, two derivatives - a call option, and a put option.

Structured, because as by purchasing the two derivatives, we've got specific price points whereby this position will pay off (profit).

Keep in mind, that by combining two derivatives, we've created an instrument that doesn't exist in the cash markets, namely we can profit no mater how the share changes in value. And this is just the tip of the iceburg, through financial engineering we can create all sorts of customised payoff profiles, and not just along changes in share prices, but also time, changes in interest rates, market volatility, credit worthiness (or lack of), on and on, the list of value adds that derivatives bring to the financial markets is almost endless .

Pretty cool, huh? Personal aside: this is the kind of shit that turns me on.


By the way, there are a couple of downsides to this structured position; it's not a guaranteed money maker under all scenarios, as I'm sure you've already caught on.

First, what if the share price doesn't change?. Yep. We make - what a surprise - NO MONEY.

In fact, we lose money as there are two - count 'em - two - sets of transactions fees for every call / put pair. We purchased a call option, and we purchased a put option. We've got breakeven points on this trade that are a function of our costs and the prices that we can buy / sell at; the share price has to change, and change at least a specific amount. If it doesn't change by this amount, we lose money. Keep in mind that a modern banks trading desk, such a structured position would probably consist of hundreds of individual transactions.

And finally, even though banks can do these deals much cheaper than retail traders, there areopportunity costs to consider. This is probably the biggest issue a trader has to deal with when evaluating what course of action to undertake with limited capital.

Ok, hope this helps guys! I'm back to perusing some of the citations in Borio's paper...good stuff there.

edverb Agreed, Buffett does indeed have a singular way with words.
posted by Mutant at 11:38 AM on April 24, 2008 [8 favorites]


Keep in mind, that by combining two derivatives, we've created an instrument that doesn't exist in the cash markets, namely we can profit no mater how the share changes in value.

Ahem: Presumably in his specific case, the share price has to move far enough in one direction to make the payoff worth more than the cost of buying the options. Otherwise it isn't going to be profitable...
posted by pharm at 12:25 PM on April 24, 2008


Never mind, I'm an idiot & didn't read the entirety of your post. I'll go stick my head under the nearest brown paper bag.
posted by pharm at 12:26 PM on April 24, 2008


mutant wrote:
ornate insect -- "Translation: buy gold."

Well, I went long both gold and silver starting in 2004, and I'm still long. Don't think the markets are collapsing, but I've long held the view inflation was going to (perhaps sharply) trend up, and it looks like this is indeed happening.

Almost any long run time series reverts to the mean, and inflation is no different. Too low for too long.

In an inflationary environment, you really don't want to be sitting on cash, at least NOT until the initial, corrective interest rate shocks have entered the system (i.e., rates rise significantly to counter).

So yeh, good advise.
I always take exception to this advice even when (as now) I'm long metals. The reason being that the Internet seems to be filled with this interesting class of investor who believes that Gold is the only possible investment.

Furthermore, these strange Internet Gold investors tend to turn absolutely everything into 'Buy Gold', while claiming that nearly all financial problems result from a failure of most modern nations to back their currencies with gold.

The reality is that there are plenty of reasonable places to be long today, and Gold is but one of them. If a reasoned and intelligent investor advocates a long position in metals or commodities, they almost certainly have a reason for doing so. If some guy on the Internet says "Buy Gold", it's almost a lock that they're self-taught economists who play the same note for decades at a time.
posted by Project F at 1:30 PM on April 24, 2008


This is a really interesting post, as all financial posts are these days. I feel like the current disaster is encouraging a lot of people (like myself) to actually care about the economy for once and try to understand what's going on. However, I disagree with Kwantsar that the article is particularly accessible for the layperson. As soon as I got past the prologue, I found myself awash in economic jargon and graphs plotting jargon against jargon.

If the author of this paper is right, then --correct me if I'm wrong --nothing new is going on in the economy right now, and if this period of distress is "systemic", and anyone could have predicted it in 2006, then why is all this linguistic debris being dumped into the lexicon? Exactly which terms will be useful for the next generation of investors and economists? What variables (in government and business) are really behind these systemic periods of distress?

I'm not complaining. It's kind of fun for me to try and parse it all. But it makes you wonder why kids these days just don't learn about economics, and knowledge is hard to come by even when you go looking for it, that is, unless you've got rogue investment-banking veterans who take it upon themselves to enlighten the masses (ahem Mutant).
posted by Laugh_track at 1:47 PM on April 24, 2008


In an inflationary environment, you really don't want to be sitting on cash, at least NOT until the initial, corrective interest rate shocks have entered the system (i.e., rates rise significantly to counter).

OK. Please explain how raising interest rates counteracts inflation.
posted by Laugh_track at 2:03 PM on April 24, 2008


Gosh Project F I'm really not sure where you're going with this comment; if you read the entirety of my post I followed up that point with

"I'm personally active in high yield these days, and still think there is a lot of value out there. Munis have caught my eye recently as well for the same reason. Many of these markets have seized up (combination of the credit crunch and an upcoming Supreme Court case on tax deductibility at the State level) and there are some eye popping deals out there."

So yeh, I'm long gold & sliver, both physical and ETFs and one miner as well. Still think there is upside in both, but believe in diversification to some extent. I say "some", as I'm overweight metals in my personal portfolio at this point in time.

I'm also long high yield, scattered across a variety of sectors. As I mentioned before, I'm looking at Munis, but am aware that the outcome of Kentucky vs. Davis has the potential to drastically change the landscape of these vehicles. Still, as it seems that many Munis are selling at what amounts to distressed prices, these are indeed attractive.


"Furthermore, these strange Internet Gold investors tend to turn absolutely everything into 'Buy Gold', while claiming that nearly all financial problems result from a failure of most modern nations to back their currencies with gold."

Heh - check out this recent thread. It seems like we're both on the same side of the commodity based currency argument. I won't derail the current topic by reposting, but suggest you might want to read through the link to get a better view of positions.


"...they're self-taught economists ..."

Oh we've got more than a few of them here. Unfortunately ours, full of doom and gloom, are very vocal.
posted by Mutant at 2:12 PM on April 24, 2008


My joke about gold was just that: a joke.

Oh we've got more than a few [self-taught economists] here. Unfortunately ours, full of doom and gloom, are very vocal.

Can't imagine why anybody would be pessimistic about the economy, when every day brings new stories like these: Wall Street May Lose 36,000 Jobs; New Home Sales Plunge To Lowest Level in Over 16 Years
posted by ornate insect at 3:13 PM on April 24, 2008


Laugh track -- "Please explain how raising interest rates counteracts inflation."

Ok, I think you're asking about holding cash before and after interest rate shocks - please let me know if I've read this query wrong.

As many folks here have posted, inflation destroys wealth. Given a high enough rate of inflation, savings will be effectively destroyed. To completely understand the argument I'll present, it's important that we can clearly define between two types of interest rates - nominal, or stated. And real, or what remains of nominal after inflation.

The relationship is pretty easy to understand.
Real = Nominal - Inflation
Lets work through a couple of illustrations. Assume we've got an inflation rate of a relatively benign 3% pa, with banks paying 5% pa (nominal).

Now you might think you're getting 5% interest, and you are - nominal, or stated. But in real terms you're only earning 2%.

But folks like us don't think in terms of interest rates, we're more interested in what we can buy - or purchase - with this money.

Under this scenario, at the end of one year you'll be able to purchase 2% more goods that before. Not a bad payoff, but hardly as good as the 5% increase you reasonably expected under nominal interest rates.

Flip it around, inflation is burning away at perhaps 10%, with banks paying 5%. In real terms your savings, on deposit in the bank of your choise, are being eroded in terms of purchasing power (remember, Real = Nominal - Inflation, or 5% - 10% or a NEGATIVE 5%.

Not good at all. No, at the end of a year you can purchase five percent LESS than you could at the beginning of the period. And this is your reward for keeping your money in the bank? Unfortunately, yes.

So getting to your query - why don't you want to be holding cash until after initial, corrective interest rate shocks? Good one.

As inflation surges the Central Banks are almost always slow to counter. Just two years of, for example, 10% inflation, will significantly erode your savings in terms of purchasing power.

Meanwhile, The Fed, BOE, whoever, is slow to raise interest rates to counter. Meanwhile, your savings, cash in the bank, is effectively being eroded / destroyed by the inflation. In real terms, you're losing value. Not good.

But looking back at past inflationary cycles in the US and other G7 countries, we see that tangible assets do indeed hold their value. And to the point of sometimes, overshooting (asset valuation bubbles, by another name). So without naming specific assets, you really don't want - at the start of an inflationary cycle and indeed well into it - to be long cash. At least not significant amounts of cash in terms of your total assets. Hold physical assets that you believe will be a store of value. That will appreciate, perhaps sharply, in times of relatively high (and increasing) inflation.

However once the Central Banks react nominal interest rates will sharply rise to counter inflation. It's then that you'd like to move into cash, because as the inflationary wave recedes, you'll still be earning positive, real returns. In fact the banks will be slow on the other side of the inflationary wave as well, simply because they'll be cautious and need to insure that inflation is well and truly under control.


ornate insect -- "Can't imagine why anybody would be pessimistic about the economy, when every day brings new stories like these: Wall Street May Lose 36,000 Jobs; New Home Sales Plunge To Lowest Level in Over 16 Years"

Its called "noise" and if you traded on this information you'd be reacting to it. A classic mistake of the retail investor, looking at short term noise and acting upon it.

And for every story you post with bad news, there is a complimentary, good news tale. This is just the nature of noise. For example, you posted two links of what you perceived to be bad news. However in today's FT Deutsche Bank reported significant asset sales; they aren't doing this in a panic, they are doing it as they believe the markets are in an upswing, and wish to dispose of underperforming assets. They are hoping to clear down their balance sheets to pick up some of the relatively cheap assets we now see.

In fact FT's exact quote (linked to above) was "...adding to evidence of a rally in corporate credit markets." referring to the markets positive interpretation of Deutsche's activity.

Further, looking at the US Government yield curve, we see it's looking pretty healthy these days. Although active in the equities markets, I'm fundamentally a bond trader (my first job on Wall Street was on a US Government Securities trading desk) and believe in the predictive power of the yield curve (amoung other indicators).

And I'm hardly alone in this view; Estrella from the New York Federal Reserve, published a paper back in 1996 that addressed the predictive power of the yield curve, specifically in the context of a predictor of recessions. Here is the paper [.pdf] if anyone is interested enough to take a gander through; it's good stuff.

So while many in banking knew as far back as 1996 there was a high degree of probability of a US recession, many today think its coming to an end.

Sorry, your two links are hardly indicative of anything other than noise in the system.

But it takes two views to make a market; after all, for every seller there must be a buyer. And I'm sure you folks know me by now; I'm an incurable optimist.
posted by Mutant at 4:52 PM on April 24, 2008 [1 favorite]


Mutant: to be clear, yours was the reasonable voice to which I referred.

I was criticizing ornate insect's post, largely because I couldn't tell whether or not it was a joke. The Internet is full of horrifically terrible financial advice, and much of that begins with Buy Gold. I always feel an urge to say 'No, Don't. Not unless you have some really sound reasoning.' because a certain sector of people tend to grossly underestimate gold's volatility, and to grossly overestimate it's probable future values.

I know that Gold nuts are real because I have an acquaintance who is a Gold nut, and it's nearly comic. He's been saying 'Buy Gold' since the mid-90s, and when gold was peaking a few months ago he went on about how he was vindicated. This despite the fact that my portfolio had outperformed his by almost an order of magnitude over 15 years. Even despite this, he continues to claim that his all-gold, chartist strategies are more sound than my far more conventional methods of creating a portfolio.

Sadly, I haven't heard from him recently, and part of me wonders if it's because he blew up by taking highly leveraged bullish positions and losing.
posted by Project F at 10:23 PM on April 24, 2008


Mutant--more "noise" in the system today:

Stocks decline on consumer survey, earnings and inflation

Commercial Banks Step to Fed Window

Economy, Credit Woes Foil Big City Projects

I'm neither an optimist nor a pessimist, but merely a realist who has been following this stuff closely for some time now. All the smart money seems to suggest we are not, as you claim, out--or even nearly out--of the recession yet. Far from it.
posted by ornate insect at 9:38 AM on April 25, 2008


Yeh, thanks for three interesting links off the internet ornate insect. But all your comment proves is that we've got different views. No news there, eh?

As I previously posted, we could go back and forth ad nauseam with good news & bad news. We're not going to agree, that's clear. As it takes two views make a market, if you're selling go for it and best of luck with your trades.

Its obvious from your comments you haven't read Estrella's paper I provided (he's with the Capital Markets Research Group at the Federal Reserve Bank of New York). If you can take a few minutes to read it, and if you research the yield curve somewhat (feel free to ask any questions you'd like) you'll see that we consider the Yield Curve to be a "predictor", not a concurrent indicator. What's the difference you might ask? Well, your news is current, while the yield curve looks forward.

Back in Q2 2006 the Yield Curve was screaming "recession". The Yield Curve inverted, which is almost always a strong indicator of recession (subject to caveats that Estrella researched). I write market commentary at the banks and financial institutions I work for, and we linked the high probability of a US recession to a simultaneous collapse of the US housing bubble. An excerpt of this briefing paper :

"Almost three months ago the US yield curve inverted. We believe this event will have wide ranging and significant ramifications, as the fundamentals underlying the US Economy continue to deteriorate with housing leading the way.

The difference in the US Yield Curve between yesterdays close in New York (below) and last February (attached pdf) is pronounced, and our conclusion remains the same; there is a remarkably high degree of probability that the United States will enter a recession in six to twelve months time. The argument is presented further in these two emails, and in the research papers attached.

Looking at the Bloomberg data below you'll see that as of the New York close yesterday, US five year notes yield 4.53% compared to 4.94% for six month bills.


In other words, investors would actually earn more yield for lending short term, meaning a rate cut was priced in. Interest rates get cut during recessions. Now, at the same time the Stock Market was hitting new highs the Yield Curve predicted a recession. Typical divergence of signals, and we (like many other banks) chose to follow the Yield Curve.

And we were hardly alone in this view. No, towards the end of 2006, this opinion was slowly gathering momentum across the industry, and banks began to hire specialists in distressed debt and corporate liquidations. This was in 2006, and NOT because banks thought the party would never end, no, banks were incurring cost to hire these people because many of us thought the party might very well may end. And relatively soon. We suspected this because of the Yield Curve, in addition to other indicators (that I wont' raise in this comment).

Now, however, the yield curve is looking pretty healthy. That by no means implies the recession is OVER. But the yield curve is predicting it will come to an end. Nothing more.

That being said, I'm glad to hear you've "been following this stuff closely for some time now". I've been a life long student of the markets myself, I love finance with a passion, always have. And I'm lucky enough to be married to a banker so we can talk shop without me having to worry about getting divorced due to boring husband. I'm an avid reader of not only financial internet news but also finance books and especially finance journals. Lots of journals.

I've posted before about what we've learned of human nature in finance, specifically greed, but another is novelty; we all think we live in exceptional times, that somehow these times are different.

That's a rather naive view. The history of finance, the long view, tells us there's nothing new under the sun.

I don't think there's much going on now that's particularly unique. Variations on a theme, really, if you look deep enough into the history of finance. And the end result will be largely the same. Nothing unique there. That's why I suspected sharply higher inflation back in 2004; seen it before (an aside: watch out for stagflation; we think there is a good chance the G7 might end up with a nasty case of it before this is all over).

In fact many of us have seen similar things before. Sure, a few new bells and whistles, a few new details, but many of the same issues, the same problems, the same faults underly the new shiny veneer we're all talking about. That's why I never get too excited about noise in the system.

The history of finance tells us when emotion and fear start to dominate the news, the mainstream media you're quoting, that is is the time to buy. Retail money is largely scared at that point. And I don't blame them! Scary news, to be sure. Especially scary - damn scary in fact! - if you lack the long term view.

But if you've got the appropriate perspective and time frame, if you chose to go long, either establish new positions or add to existing ones, you'll do well.

By contrast, the literature is rife with evidence showing people who follow and act upon news lose money; it's that simple.

I do find it interesting however that you adopt the label "realist" while using the phrase "smart money". I have to admit, I don't think I've ever heard the phrase "smart money" used on a trading floor.

But the phrase "smart money" as retail investors use it? Well, there is no such thing. That phrase implies the existence of a group of investors who, in the possession of near perfect information, are consistently capable of generating superior amounts of alpha.

And those people simply do not exist.
posted by Mutant at 1:44 PM on April 25, 2008 [1 favorite]


By contrast, the literature is rife with evidence showing people who follow and act upon news lose money; it's that simple.

Gross? If the explanation is anything beyond the mundane (but shrinking) phenomenon of negative one-day serial autocorrelation, I'd dearly appreciate a cite or two. (pay journals okay)
posted by Kwantsar at 8:18 PM on April 25, 2008


By contrast, the literature is rife with evidence showing people who follow and act upon news lose money; it's that simple.

I'm also curious about this statement. I would think that the biggest problem would be the costs associated with increased trading activity.

That said, I would've predicted a most-common result of slightly reduced profits, rather than outright losses.
posted by Project F at 7:43 AM on April 26, 2008


Mutant: Your explanation of structured positions was excellent, but I'm afraid I still don't fully understand the concept of "leverage". Investopedia gives two separate definitions. One definition simply appears to be debt-- a company which is highly leveraged is financing a large part of its operations with borrowed money. The other definition of leverage seems to be the use of several financial instruments, including the structured positions you already explained, to gain control of a company's stocks without actually buying them. You say...

A significant omission from this work - Borio makes absolutely no mention at all of The Carry Trade. This is very interesting, as BIS has been rather vocal about this practice, to the point of putting it onto the agenda at Davos. Malcom Knight (General Manager of BIS) warned of "... rising leverage in the financial system . . . and we have some very crowded trades in some areas of the foreign exchange markets,".

I'm not sure which definition Knight was using here. Is he commenting on an increase in debt, or an increase in the use of financial instruments?
posted by Laugh_track at 10:37 AM on April 26, 2008


Mutant: Reading that FT article a little more closely, the author states that in the most recent sale of loans on its books Deutche Bank lent the money to the buyers so that they could buy them! Are we to presume that they're going to do the same thing again this time around?

In which case, this isn't exactly going to generate much cash for DB. I gues it might shift their risk profile enough that they can do other deals whilst remaining within the confines of Basel II?
posted by pharm at 1:01 PM on April 26, 2008


"By contrast, the literature is rife with evidence showing people who follow and act upon news lose money; it's that simple. "

Ok guys, guess I got carried away somewhat while crafting that comment; I'd like to retract "rife" (looking at my posting history you'll see this is an uncharacteristically emotive phase for me!), and restate as

"By contrast, the literature provides evidence showing people who follow and act upon news tend to lose money; it's that simple."

A subtle difference, to be sure, but important to me. And to your queries, both posted here and in emails (thanks all!) My apologies for getting somewhat carried away (combination of long day / interesting topic / not much sleep this week / another great MeFi finance thread / and not enough alcohol). So there it is.

Anyhow, kwanstar, you're absolutely correct (if I read your comment correctly) and Project F you're spot on; this is indeed net net and does reflect (largely) diminished profits, but there are actual losses under a wide range of documented and commonly observed scenarios. So, ok, let's get started with this view.

I'd like to start out by quoting Fisher Black. When discussing the impact of news on the market, Black mentioned that "most of the time noise traders will lose money trading" (Black, 1986).

Black went on further commented such market participants "trade on noise as if it were information…. Noise makes financial markets possible, but it also makes them imperfect.". I've always thought this to be a rather profound observation.

Black's imperfect markets, of course, refer to opportunities retail money provide either to other, more disciplined and experienced retail traders, or to (I suspect more often) institutional class investors by classic mistakes. For example, holding losing positions far too long and selling positive gainers much too early (Shefrin & Meir, 1985) see also (Grinblatt, Sheridan & Russ, 1995).

The literature also tells us retail money tends towards the (possibly irrational) selling of shares with recent, positive gains (Grinblatt & Kelharju, 2001, see also Jackson, 2003). On MeFi I've often quoted my first boss in this business, and one of my favourites is particularly appros here - "Plan your trade, then trade your plan". Retail don't plan.

Another classic / expensive mistake? Retail money long in a particular firm will tend to purchase additional shares ("doubling up!") if the current share price is lower than their purchase price (Odean,1998). Lack of first fundamental analysis then planning.

A real curious one - retail investors who sold out their position in a companys stock are more likely to re-purchase the same shares later if the price has dropped since they liquidated their holdings (Barber, Odean & Strahilewitz (2003)). One can only speculate if retail knew why they entered - not to mention exited - their position in said firm in the first place.

Retail money tends to purchase shares that generate noise ("news" by another name), as such companies are more likely to attract their notice (Barber & Odean, 2008). From this one might conclude retail money tends to eschew traditional, bottoms up financial stock picking research, preferring news flashes, "tips" or other noise.

Looking past stock picking / trading for a moment, its well documented retail money tends to lack appropriate diversification strategies in their portfolios (Lewellen, Schlarbaum, & Lease, 1974, see also Goetzmann & Kumar, 2002). These omissions occur regardless of whether or not the investors are long individual shares, or participating in the markets via collective investment vehicles such as Unit Trusts, Investment Trusts or Mutual Funds, and irrespective of the entity used to hold the assets (i.e., retirement or taxable brokerage account) (Benartzi, 2001).


We also know (again, on aggregate, there will always be exceptions) that individual investors tend to earn the bulk of their positive returns in rising markets, and, further, tend to lose money when they engage in speculative trading, trading undertaken according to plan, trading triggered by noise (Barber & Odean, 2000)

So, lots of mistakes made by retail money. At times expensive mistakes that will erode profits. I saw some interesting research the other day (can't cite as its on my Mac at Uni ... thought I'd fixed that but just bought myself a new MacBook and the fix didn't come along for the ride with the rest of my data ... ) that noted the upper decile of active retail traders will annually incur transaction costs in excess of 50% of their original capital base; in other words, for active retail money the break even is 50%, which is a fairly high hurdle rate by anyones standards.

Of course there are (many, many) caveats to these observations & statements.

First off, we know that some of these phenomenon have been observed in specific domiciles. For example, Jackson had what he called "unique access" to a dataset of Australian equity trading data, while Odean's research team somehow managed to acquire a database of ALL equity market transactions, both retail as well as institutional, that took place in Taiwan over roughly one decade. I haven't seen such complete data sets covering ALL transactions in the US equity markets - the markets are so much larger, for example, these would be rather huge and difficult to work with - so some of these results are indeed being extended to cover the behaviour of American traders.

Second, these studies took place looking backward across the business / credit cycle. Just because we've observed a phenomenon in the past doesn't necessarily imply this will hold going forward.

Finally, these mistakes. I'm going off on a personal tangent here, but during my career I've made every one of these errors (and some other very embarrassing ones that I won't admit to, even given the relative anonymity MeFi provides) and I've learned.

Although Deutsche paid for my first Masters, I openly tell everyone that I financed my real education, by trading - and losing - my own capital, long before I went to Business School.

I trade a lot better now, much more effectively and tend to make money fairly consistently (I'm a cash flow investor), but mistakes, folks I've made them all. Never any regrets, but I detach emotionally from money.


Laugh track -- I'm not sure which definition Knight was using here. Is he commenting on an increase in debt, or an increase in the use of financial instruments?"

Knight was actually talking about both, because many of the structured positions out there are funded by debt, borrowed money. The derivatives involved give the holder leverage, as does the borrowing. Leveraged leverage, I guess you could call it.

I always like to cast things in the retail model, and in this case the retail equivalent would be purchasing shares on margin; you put up, for example, 50% of the cost (this is share specific, can be more, can be less) and then you control 100% of the shares. Margin, aka leverage or credit, allows one to purchase substantially more that otherwise could be acquired in a cash deal. Meanwhile, you get 100% of the economic exposure to these assets.

But watch out! If the shares increase in value you make a leveraged profit, but leverage works both ways.

Of course financial entities can leverage up far more than the two to one example just presented; some hedge funds can get leverage ratios in excess of thirty to one or more. And that can be a problem.

The Carry Trade issue I raised refers to the practice of borrowing across countries; if for example, you can borrow Yen at 0.5% interest, covert Yen to US Dollar, then invest in US Dollars at, for example, 10% yield, you're making some serious returns on your borrowings. Of course, there are downsides - Yen can't appreciate (strengthen) against the US Dollar too much, interest rates can't change too much; I'm sure you get the idea.

I wrote something a couple of years back when the Icelandic Krone dropped almost 10% in two days, due, largely, to The Carry Trade. What's sorta scary now is that I'm hearing many market particpants who engage in The Carry Trade are using the US Dollar as a funding currency; i.e., they are borrowing dollars and lending into Australia or other such, relatively high yielding currencies.

Doesn't speak well for intermediate term strength of the US dollar, and another reason why I'm longer term I'm still bullish on metals.

I'll followup this post with a more detailed (and I hope accessible) explanation of The Carry Trade that I wrote a few years ago.


pharm -- "I gues it might shift their risk profile enough that they can do other deals whilst remaining within the confines of Basel II?"

Yeh, I read that the same way. There's a lot of really good value out there now and I suspect they'd like to clear down their balance sheet so they can take advantage of the fear. Besides, its all relative, and it appears that DB sees better opps elsewhere. They've clearly calculated the financing costs and are ok with the haircut they've come up with as they aren't offering 100% financing.

--------------

Barber, B., M., Odean, T., 2000, 'Trading is hazardous to your wealth: The common stock investment performance of individual investors', Journal of Finance, 55

Barber, B., M., Odean, T., Strahilewitz M., 2002, 'Counterfactuals, naïve learning, and the purchase previously owned common stocks', University of California, Working paper

Barber, B, M., Odean, T., 2008, 'All that glitters: The effect of attention and news on the buying behavior of individual and institutional investors', Review of Financial Studies

Benartzi, S., 2001, 'Excessive Extrapolation and the Allocation of 401(k) Accounts to Company Stock?', Journal of Finance, 56

Black, F., 1986, 'Noise', Journal of Finance, 41

Goetzmann, W., N., Kumar, A., 2002, 'Equity Portfolio Diversification',” National. Bureau of Economic Research Working Paper, No 8686

Grinblatt, M., Sheridan T., Russ W., 1995, 'Momentum investment strategies, portfolio performance, and herding: A study of mutual fund behavior', American Economic Review, 85

Jackson, A., 2003, 'The Aggregate Behaviour of Individual Investors', London Business School, Working Paper

Lewellen, W., Schlarbaum, G., Lease, R., 1974, 'The Individual Investor:Attributes and Attitudes', Journal of Finance, 29

Lewellen, W., Schlarbaum, G., Lease, R., 1974, 'The Individual Investor: Attributes and Attitudes', Journal of Finance, 29

Odean, T., 1998, 'Are investors reluctant to realize their losses?', Journal of Finance, 53

Shefrin, H., , Meir S., 1985, 'The disposition to sell winners too early and ride losers too long: Theory and evidence', Journal of Finance, 40
posted by Mutant at 3:10 PM on April 26, 2008 [17 favorites]


THE CARRY TRADE

This was originally written in early March of 2006, and I've pushed out at least two updates since. While the concepts are still broadly applicable, some of the specifics have clearly changed with the markets.

I have removed stale web links, as well as links to intranet based resources (i.e., jpg graphs); hopefully I haven't butchered the text too much in doing so.

This article was targeted at several of the banks back office and support teams. Part of my mandate that particular financial institution was not only to write market commentary (I usually get to write about anything that interests me as I've mentioned on MeFi before ...) but also to raise business awareness of the various leveraged capabilities (IT, Application Support, DBAs, SAs, etc) and I accomplished this via a series of articles addressing significant market events.

----

A little noticed obituary was published recently, formally announcing the death of what's known as “The Carry Trade” .

What's The Carry Trade all about you ask? Well, to impress that hot young prospect you've been chatting up just tell her that you've discovered a way to make money, all the money you and her would ever need and at almost no risk.

How's that, she'd ask provocatively, perhaps fluttering an eye lash.

“Ah!” you'd answering knowingly and simply. Borrow money cheap and invest it dear.

And that, my friends, is The Carry Trade in a nutshell. Simple eh? Like most of Modern Finance, there is absolutely nothing arcane or deep about it. Its a simple concept that's been relabelled.

The Carry Trade has been around for decades, centuries in fact, but it's most recent reincarnation arose from the ashes of the Japanese economic collapse when nominal interest rates there were cut almost to zero. Further fuel was added to the fire when the United States and many other countries sharply cut interest rates in the first half of this decade.

Thus The Carry Trade was born; borrow money for almost 0% in the US, Japan or Switzerland, and invest in countries such as Australia or New Zealand at sharply higher interest rates. Borrow cheap and invest dear; a money machine, by any other name.

And what was the reaction of Wall Street and The City to this opportunity? They went on a global binge, with the Bank for International Settlements (BIS) attributing sharp increases in daily turnover of both foreign exchange and interest rate products to The Carry Trade.

But all good things must come to an end, and The Carry Trade is no different.

Two weeks ago Fitch downgraded Iceland's sovereign debt which in turn kicked off an 8% decline in the Krone over a two day period. Why do we care you ask? Because the Krone was one of the higher yield currencies, with overnight interest rates well above 12%. Borrow in Japan at rates close to 0% to earn 12% in Iceland – why panic?

Traders panicked because interest rates are rising across the globe. The United States has increased interest rates 14 times to 4.5%, with the futures markets pricing in a further two rate hikes. Last week the European Central Bank (ECB) raised interest rates to a three year high, with additional rate hikes expected.

And finally Japan, the country which kicked off this party is widely expected to announce an increase in interest rates after annualised GDP growth in the fourth quarter of 2005 was recorded.

So what's going to happen? Well, there are several hundred billion dollars invested in carry trades that will have to be unwound as soon as they become unprofitable.

Keep in mind as interest rates rise more and more of these positions become unprofitable. As Japan – the only G7 country where interest rates remain close to zero – starts to increase interest rates more and more of these trades will become unprofitable.

And that's when the trouble will start.



----------

Ok folks
posted by Mutant at 3:13 PM on April 26, 2008 [11 favorites]


Euh? not sure what happened there ....

----------

Ok folks, thanks for another wonderful MeFi Finance thread.

Kwanstar great paper, I'm surely enjoying the cites.

Take care
posted by Mutant at 3:15 PM on April 26, 2008


« Older In LA, a 63 (70!)-piece orchestra blends the style...  |  Thomas Friedman... Newer »


This thread has been archived and is closed to new comments