Financial Markets » Satyajit Das

Satyajit Das : Back to the Future

mano — Mon, 23 Nov 2009 11:56:21 +0000

A global market perspective that I agree with . . .

November 23, 2009

The Future That Was

China’s economic model is reminiscent of 17^thcentury mercantilist policies. Thomas Mun, a Director of the East India Company, in England’s Treasure by Foreign Trade (1664), wrote that the purpose of trade was to export more than you imported. At the same time, a country should amass foreign ‘Treasure’ that would be the basis of acquiring foreign colonies to allow control of essential natural resources. The strategy required reducing domestic consumption and imports and export of goods manufactured with imported foreign raw materials. China’s strategy coincides almost entirely with Mun’s views.

China’s mercantilist strategies have important implications for other developing countries. Chinese investment in and trade with Latin America and Africa is concentrated on securing access to resources forcing these nations to specialise in commodities. This reversion to a 19^th century trend may not be compatible with Latin American and African long term development and stability.

The Chinese economic model may be unsustainable. It relies on global trade and investment (much of it export related), which together contribute a high proportion of China’s GDP. This trade entails importing foreign components that are then reassembled and then exported. Domestic consumption has been kept low. Treasure has been built up in the form of domestic savings and trade surpluses.

Recently, China announced that its $2 trillion treasure would be used to make foreign acquisitions to secure exclusive access to raw material. The problem is that China’s treasure is already invested in assets of dubious value and limited liquidity to finance global consumption.

Chinese Premier Wen Jiabao warned that the Chinese growth was becoming increasingly “unstable, unbalanced, uncoordinated and ultimately unsustainable“. That was two years ago! Currently, China may be aggravating the problems by massive liquidity-driven stimulus to perpetuate a failed strategy. Speaking at the meeting of the World Economic Forum in Dalian on 10 September 2009, the Chinese Premier Wen Jiabao repeated his message from two years ago without signalling any change in direction: “China’s economic rebound is unstable, unbalanced and not yet solid. We cannot and will not change the direction of our policies when the conditions aren’t appropriate.“

There is broad agreement that a key component of the GFC was the problem of global capital imbalances. A central feature was debt-funded consumption by the U.S. that allowed 5% of the global population to constitute 25% of its GDP, 15% of consumption and 48% of global current account deficit. Japan, China, Germany and the other savers funded the consumption.

Any lasting solution to the GFC requires this imbalance to be dealt with. The glib solution requires the U.S. to save more and consume less and the savers to save less and consume more. The problems in implementing the solution are considerable. Timothy Geithner’s recent discussion with Chinese officials, to assure his hosts of the safety of their investments in dollars and U.S. Treasury Bonds, reveals the dilemma.

On the one hand, America needs the Chinese to continue and increase their purchase of U.S. Government debt to finance its fiscal stimulus and bailouts. On the other hand, America needs China to cut the size of its current account surplus, boost government spending, encourage personal consumption and reduce savings. All this should also occur ideally without any major decline in the value of the dollar or U.S. Treasury bonds or the need for China to liberalise it currency and allow internationalisation of the Renminbi.

A cursory look at the respective economies also highlights the magnitude of the task. Consumption’s contribution to GDP in the U.S. is 71% while in China it is 37%. Given that the GDP of China is around $4-5 trillion versus $15 trillion for the U.S. and average income in China is around 10-15% of U.S. earnings, the difficulty of using Chinese consumption to drive the global economy becomes apparent.

During the last quarter of century, Chinese savings have risen and exports have been the engine for growth. Given that a significant portion of exports is driven ultimately by American and European buyers, lower global growth and declining consumption creates significant challenges for China.

Dealing with the global imbalance has not been a high priority in the various summits global leaders have shuttled to and from.

In March 2009 in advance of schedule G-20 meeting, the Chinese central bank proposed replacing the US dollar as the international reserve currency with a new global system controlled by the International Monetary Fund. In an essay posted on the Peoples’ Bank of China’s website, Zhou Xiaochuan, the central bank’s governor, argued that creating a reserve currency “that is disconnected from individual nations and is able to remain stable in the long run, thus removing the inherent deficiencies caused by using credit-based national currencies“. Mr. Zhou wrote: “The outbreak of the [current] crisis and its slipover to the entire world reflected the inherent vulnerabilities and systemic risks in the existing international monetary system.”

The US predictably dismissed the proposal. The Wall Street Journal argued that: “For all its faults, the dollar is attractive as a reserve currency because it is the common language of global finance and trade. In other words, its appeal is proportionate to how many other market players use it. For decades, the dollar has been a convenient medium of exchange for everyone from a central bank seeking to buy US Treasury bonds to a business exporting commodities from Latin America to Asia.” The unstated reason was the loss of the ability to finance itself in its own currency would significantly disadvantage the US.

In July 2009, at the G8 Summit in the earthquake damaged town of L’Aquila in Italy, Dai Bingguo, Chinese state councillor, was again openly critical of the dominant role of the U.S. dollar as a global reserve currency: “We should have a better system for reserve currency issuance and regulation, so that we can maintain relative stability of major reserve currencies exchange rates and promote a diversified and rational international reserve currency system,”

Western leaders expressed concerns about even raising the issue fearing that discussion of long-term currency issues could undermine the nascent recovery in markets and economies. Gordon Brown, Britain’s prime minister, spoke on behalf of the West: “We don’t want to give the impression that big change is around the corner and the present arrangements will be destabilised.” The West it seems was heeding Deng Xiaoping’s advice to: “Keep a cool head and maintain a low profile. Never take the lead – but aim to do something big.“

In September 2009, the Americans and Europeans proposed an effort to tackle global economic imbalances at the G20 summit in Pittsburgh. Against a background of rising trade tensions, China’s ambassador to the U.S. Zhou Wenzhong expressed scepticism about the proposals, seeking focus instead on avoiding protectionism.

Still heavily reliant on exports, China was wary of a global push on imbalances that would focus of its large trade surplus (which reached nearly 10 per cent of GDP in 2008). Zhou pointedly blamed the crisis on “the lack of supervision and abuse of the openness of the market, very risky levels of leverage and too much speculation.” He proposed improving global financial supervision, strengthen bank capital and create global early warning systems to identify threats but resisted action to address the imbalance.

Ironically, recent modest improvements in the global economy potentially risked increasing the same imbalances that were one of the factors that caused the current financial crisis. China’s and the world’s economic future requires resolving fundamental global imbalances that lie at the heart of the GFC.

Turning Japanese

China’s problems, to a degree, mirror earlier problems of Japan, its neighbour and competitor for global influence.

Japan’s export driven model successfully generated strong growth of 10% average in the 1960s, 5% in the 1970s and 4% in the 1980s. This growth was driven by a number of factors, including an artificially low exchange Yen rate.

On 22 September 1985, Japan, the U.S., the U. K., Germany and France signed the Plaza Accord agreeing to depreciate the dollar in relation to the Japanese Yen and German Deutsche Mark by intervention in currency markets. The Accord had limited success in reducing the U.S. trade deficit or helping the American economy out of recession.

The Plaza Accord signalled Japan’s emergence as an important participant in the international monetary system and global economy. The effects on the Japanese economy were disastrous.

The stronger Yen triggered a recession in Japan’s export-dependent economy. In an effort to restart the economy, Japan pursued expansionary monetary policies that led to the Japanese asset price bubble that collapsed in 1989. Economic growth fell sharply and Japan entered an extended period of lower growth and recession, generally referred to as ‘The Lost Decade’.

In the 1990s, Japan ran massive budget deficits to finance large public works programs in a largely unsuccessful attempt to stimulate growth to end the economy’s stagnation. Only structural reforms in the late 1990’s and early 2000’s restored modest rates of growth. Japan’s public debt is now approaching 200% of Japan’s GDP.

Significant shifts in economic strategy are now necessary. Chinese President Hu Jintao recently noted: “From a long-term perspective, it is necessary to change those models of economic growth that are not sustainable and to address the underlying problems in member economies.”

China can try to continue its existing economic strategy, which looks increasingly difficult. Changing its economic model is also difficult if it means a slower rate of growth. China’s challenge will be to learn from and avoid the problems and fate of Japan.

History and cultural issues compound China’s dilemma. The 1842 Treaty of Nanking entered into at the end of the first Opium War awarded Britain war reparations, eliminated the Chinese Hong monopoly, set Chinese exports and imports at a low rate, provided British access to several Chinese ports and transferred Hong Kong to the English. The humiliation of the Treaty is deeply etched into China’s dealing with the West.

China should have heeded the warning of Kang His, emperor of China, on the British presence at Canton in 1717: “There is cause for apprehension lest in centuries or millennia to come China may be endangered by collision with the nations of the West.”

The trade-off between economic and political liberalisation may also be problematic. As Fang Li, a renowned astro-physicist often called China’s Andrei Sakharov, remarks in dissident author Ma Jian’s novel about China “Beijing Coma”: “Without a democratic political system in place, [China’s] economy will eventually flounder. The people’s wealth will be eaten up by the corrupt institutions of this one party state.”

There is an apocryphal story about a visiting world leader drawing back the current of his hotel room to be stunned by the futuristic skyline of Shanghai’s Pudong Financial District. “How long has this being going on?” He asked. Today, the question might be: “How long can this go on?”

Satyajit Das is a risk consultant and author of Traders, Guns & Money: Knowns and Unknowns in the Dazzling World of Derivatives (2006, FT-Prentice Hall).

Credit Default Swaps – an informed perspective

mano — Mon, 13 Apr 2009 04:34:21 +0000

The last paragraphh is very interesting !!!

Credit Default Swaps – Through The Looking Glass

Posted At : April 12, 2009 12:42 AM | Posted By : Satyajit Das

CDS contracts and credit derivatives are complex and powerful financial instruments that frequently have unforeseen consequences for market participants and the financial system. As former New York Federal Reserve President Gerald Corrigan told policy-makers and financiers on 16 May, 2007: “Anyone who thinks they understand this stuff is living in lala land.”Financial innovation can offer economic benefits. A number of major benefits of CDS contracts are often cited by academic acolytes and fans, generally those promoting the product.

The first is that CDS contracts help complete markets, enhancing investment and borrowing opportunities, reducing transaction costs and allowing risk transfer. CDS contracts, where used for hedging, offers these advantages. Where not used for hedging it is not clear how this assists in capital formation and enhancing efficiency of markets.

CDS contracts also, it is claimed, improve market liquidity. It is generally assumed that speculative interest assists in enhancing liquidity and lowers trading costs. Where the liquidity comes from leveraged investors, the additional systemic risk from the activity of these entities has to be balanced against potential benefits. The current financial crisis highlights these tradeoffs.

CDS contracts also, it is claimed, improve the efficiency of credit pricing. It is not clear whether this is actually the case in practice.

Pricing of CDS contracts frequently does not accord with reasonable expected risk of default. The CDS prices, in practice, incorporate substantial liquidity premia, compensation for volatility of credit spreads and other factors.

CDS pricing also frequently does not align with pricing of other traded credit instruments such as bonds or loans. For example, the existence of the “negative basis trade” is predicated on pricing inefficiency.

In a negative basis transaction commonly undertaken by investors including insurance companies, the investor purchases a bond issued by the reference entity and hedges the credit risk by buying protection on the issuer using a CDS contract. The transaction is designed to lock in a positive margin between the earnings on the bond and CDS fees. Negative basis trades exploit market inefficiencies in the pricing of credit risk between bond and CDS markets.

In early 2009, the pricing of corporate bonds and CDS on the issuer diverged significantly. For example, the CDS fees for National Grid, a UK utility, were around 2.00% pa (200 basis points) compared to National Grid’s credit spread to government of around 3.30% (330 basis points). Similarly, Tesco, the UK retailer was exhibited CDS fees of around 1.40% (140 basis points) against a credit spread to government of around 2.50% (250 basis points).

In effect, market pricing of credit risk as between the CDS market and the bond and loan market was significantly different.

Another area of pricing discrepancy is the relative pricing of different firms. For example, in early 2009, bonds issued by borrowers rated “A” were trading at a higher credit spread than bonds of borrowers rated lower (say “B”) in the bond market. At the same times, CDS fees for borrowers rated “A” were trading at a lower level than CDS fees of borrowers rated lower (say “B”) in the credit derivatives market.

There are also notable discrepancies in the pricing of corporate credit risk relative to their sovereigns. In early 2009, Cadbury, the UK confectionery firm, was trading for 10 years substantially below the CDS fee of the UK government but Cadbury bonds were trading at a spread of around 2.00% (200 basis points) above UK government bonds. As people on one side of the Atlantic Ocean might remark: “Go figure!”

CDS contracts also are supposed to enhance information efficiency, improving availability of market prices for credit risk allowing more informed decisions by market participants. As CDS contracts are traded in the private OTC derivative markets, there is limited dissemination of market prices. This limits price discovery and therefore any informational benefits.

In reality, pricing and trading information is only available readily to large active dealers in CDS contracts. This informational asymmetry may advantage these dealers. Knowledge about trading flows in CDS contracts may allow these dealers to earn economic profits.

Benefits of CDS contracts must be balanced against any additional risks to the financial system from trading in these instruments. CDS contracts may create additional risks within the financial system. While CDS contracts did not cause the current financial crisis (excessive reliance of debt did), they may have exacerbated the problems and complicated the process of dealing with the issues.

The CDS market originally was predominantly a market for transferring and hedging credit risk. The contract itself has many attractive economic features and can serve useful purposes in hedging and transferring risk. Even this hedging application is dogged by some of the identified documentary issues that may reduce the effectiveness of CDS contracts as a hedge. Such problems may well be fundamental to the nature of the instrument and incapable of remedy, at least easily.

In recent years, the ability to trade credit, create different types of credit risk to trade, the ability to short credit and also take highly leveraged credit bets has become increasingly important. To some extent the CDS market has detached from the underlying “real” credit market. If defaults rise then the high leverage, inherent complexity and potential loss of liquidity of CDS contracts and structures based on them may cause problems.

The International Swaps and Derivatives Association (“ISDA”), the derivatives industry group, have recently implemented initiatives to “hard wire” the auction based protocols into the standard CDS documentation. They have also initiated changes in market practices, such as fixed coupons for CDS contracts, designed to facilitate trading in these instruments. These actions increasingly focus on CDS contracts as an instrument for trading on default risk and credit spreads rather than one whose primary objective is the hedging of credit risk. The latter would emphasis less standardisation and a greater focus on matching the nature of underlying bond or loan being hedged.

The excesses of the CDS market are evident in the recent interest in contracts protecting against the default of a sovereign (known as sovereign CDS). For example, the CDS market for sovereign debt is increasingly pricing in increased funding costs for the US. The fee for hedging against losses on $10 million of Treasuries currently peaked at about 1.00% pa for 10 years (equivalent to $100,000 annually). This is an increase from 0.01% pa ($1,000) in 2007.

The specter of banks, some of whom have needed capital injections and liquidity support from governments to ensure their own survival, offering to insure other market participants against the risk of default of sovereign government (sometimes their own) is surreal.

The unpalatable reality that very few, self interested industry participants are prepared to admit is that much of what passed for financial innovation was specifically designed to conceal risk, obfuscate investors and reduce transparency. The process was entirely deliberate. Efficiency and transparency are not consistent with the high profit margins that are much sought after on Wall Street. Financial products need to be opaque and priced inefficiently to produce excessive profits or economic rents.

In October 2008, Alan Greenspan, the former Chairman of the Fed, acknowledged he was “partially” wrong to oppose regulation of CDS. “Credit default swaps, I think, have serious problems associated with them,” he admitted to a Congressional hearing. This from the man who on 30 July 1998, stated that: “Regulation of derivatives transactions that are privately negotiated by professionals is unnecessary.”

On 6 March 2009 Bloomberg reported that Myron Scholes, the Nobel prize winning co-creator of the eponymous Black-Scholes-Merton option pricing model, observed that the derivative markets have stopped functioning and are creating problems in resolving the global financial crisis. Scholes was quoted as saying that: “ [The] solution is really to blow up or burn the OTC market, the CDSs and swaps and structured products, and … start over…” ISDA, the beleaguered derivatives industry group, predictably countered limply that: “… the notion that you would, as he said, blow up, the business in that way is just misguided.”

Satyajit Das is a risk consultant and author of Traders, Guns & Money: Knowns and Unknowns in the Dazzling World of Derivatives (2006, FT-Prentice Hall).

Satyajit Das on Credit Default Swaps

mano — Thu, 19 Mar 2009 12:07:08 +0000

Credit Default Swaps – Exercises in Surrealism

March 16, 2009 5:35 AM | Satyajit Das

At the quantum level, the laws of classical physics alter in intriguing ways. In financial markets, at the derivative level, the rules of finance also operate differently.The derivative industry’s indefatigable advocacy of credit default swaps (“CDS”) centers on the fact that contracts related to recent defaults settled and the overall net settlement amounts were small. Closer scrutiny suggests causes for caution.

The CDS contract is triggered by a “credit event”; broadly, default by the reference entity. CDS contracts on Freddie and Fannie were ‘technically’ triggered as a result of the conservatorship necessitating settlement of around $500 billion in CDS contracts with losses totaling $25 to $40 billion. Government actions were specifically designed to allow the firms to continue fully honouring their obligations. Triggering of these contracts poses questions on the effectiveness of CDS contracts in transferring risk of default.

Practical restrictions on settling CDS contracts has forced the use of “protocols” – where counterparties may substitute cash settlement for physical delivery. In cash settlement, the seller makes a payment to the buyer of protection to cover the loss suffered by the protection buyer based on the market price of defaulted bonds established through an “auction” system.

For the GSEs, the auction prices resulted in the following settlements by sellers of protection: Fannie Mae – around 8.49% for senior debt and 0.01% for subordinated debt. Freddie Mac – around 6.00% for senior debt and 2.00 % for subordinated debt.

Subordinated debt ranks behind senior debt and is expected to suffer larger losses in bankruptcy. The lower payout on subordinated debt probably resulted from subordinated protection buyers suffering in a short squeeze resulting in their contracts expiring virtually worthless. Differences in the payouts between the two entities are also puzzling given that they are both under identical “conservatorship” arrangements and the ultimate risk in both cases is the US government.

In other CDS settlements in 2008 and 2009, the payouts required from sellers of protection have been highly variable and large relative to historical default loss statistics. This may reflect poor economic conditions but are more likely driven by technical issues related to the CDS market.

For example, the Washington Mutual payout (around 43%) may have been affected by capital remaining at the holding company, Washington Mutual Inc. (estimated at $2.8 billion). More recently, the auction settlement of Lyondell (around 80-85%) reflected complication from the role of debtor in possession financing and complex collateral allocation mechanisms.

Skewed payouts do not assist confidence in CDS contracts as a mechanism for hedging. In addition, the large payouts are placing a material pressure on the price of underlying bonds and loans exacerbating broader credit problems.

Low overall net settlement amounts may also be misleading. In practice, there are actually two settlements. The ‘real’ settlement where genuine hedgers and investors deliver bonds under the physical settlement rules (i.e. those who actually own bonds and were hedging). The ‘auction’ where dealers who have both bought and sold protection and have small net positions settled via the auction.

In the case of Lehman Brothers, the net settlement figure of $6 billion that was quoted refers to the auction. Some banks and investors that had sold protection on Lehmans did not participate in the auction choosing to take delivery of defaulted Lehman debt resulting in losses of almost the entire face value.

CDS contracts can amplify losses in credit market. Lehman Brothers defaulted with around $600 billion in debt implying a maximum loss to creditors of that amount. In addition, according to market estimates, there were CDS contracts of around $400-500 billion where Lehmans was the reference entity.

Market estimates suggest that only around $150 billion of the CDS contracts were hedges. The remaining $250-350 billion of CDS contracts were not hedging underlying debt. The losses on these CDS contracts (in excess of $200-300 billion) are additional to the $600 billion. The CDS contracts amplified the losses as a result of the bankruptcy of Lehmans by (up to) approximately 50%.

The CDS market is also complicating restructuring of distressed loans as all lenders do not have the same interest in ensuring the survival of the firm. A lender with purchased protection may seek to use the restructuring to trigger its CDS contracts.

As the global economy slows and the risk of corporate default increases sharply, the identified issues with CDS contracts are likely to complicate the problems of credit markets and banks generally.

Ludwig von Mises, the Austrian economist from the early part of the twentieth century, once noted: “It may be expedient for a man to heat the stove with his furniture; but he should not delude himself by believing that he has discovered a wonderful new method of heating his premises”.

Satyajit Das is a risk consultant and author of Traders, Guns & Money: Knowns and Unknowns in the Dazzling World of Derivatives (2006, FT-Prentice Hall).