It’s time for a wider European policy debate
By Mohamed El-Erian The opinions expressed are the author’s own.
It is safe to say that there is broad agreement on what is most desirable for solving the Irish crisis — namely a mix of domestic policies and external financing finely calibrated to enable the country to grow strongly, create jobs, stabilize the banks, and overcome large and mounting indebtedness.
Unfortunately, what is most desirable is not feasible given the path Europe is embarked on; and, to make things even more complicated, what appears feasible to Europe is not necessarily desirable. As a result, Ireland finds itself stuck in an unstable muddled-middle. It can’t get ahead of the crisis; it is far from a first best solution; and it confronts choices that are painful to implement and uncertain in outcome.
What is evolving in Ireland today resembles what was done in Greece six months ago. Expect the Irish government to commit to even greater budgetary austerity, its European neighbors and the IMF to provide massive funding, and the banks to receive liquidity, capital injections and other unconventional forms of support.
While seemingly exceptional to many, this approach constitutes the path of least resistance. In fact, it is the most feasible. But we should not confuse feasibility with desirability.
At its roots, the approach addresses liquidity but not solvency. It adds to the debt overhang rather than reducing it. And it uses the socially-painful method of income and growth compression as the principal way to promote international competitiveness over time.
It should come as no surprise that, six months after having embarked on such an approach, Greece is still in crisis mode. Risk spreads remain at elevated levels that discourage new investment. Society faces a higher-than-programmed contraction in economic growth and poorer employment prospects. The government is forced into even greater fiscal austerity. Meanwhile, private creditors have been using the exceptional support provided by the EU/ECB/IMF to exit their Greek exposures rather than co-invest with the official sector.
Betting on tail risk seriously endangers your wealth
Investment strategies designed to benefit from tail risks are fast becoming the next bubble. Investors are paying over the odds to reap benefits from remote catastrophic risks and are ignoring more moderate but much more likely outcomes that will cost them a great deal in the interim.
Following the banking crisis and the flash crash, Wall Street is rushing to meet demand from investors wanting to make money from betting on extreme market dislocations and other “black swans” by taking long positions in rare, high-impact events at the tail ends of probability curves.
Bets on tail risks have become increasingly popular and come in a variety of guises. Buying out-of-the-money puts on the major stock averages to benefit in the event of another crash; commodity futures and options to benefit from resurgent inflation or a sudden supply disruption in supply; or physical gold and long-dated Treasury bonds to protect against deflation.
What all these strategies have in common is they function like insurance contracts. Investors incur a small cost each month (in the case of gold and Treasuries, the opportunity cost from not owning higher-yielding assets) but receive a big payout in the event disaster strikes.
A report to the trustees, staff and advisers of the California State Teachers Retirement System (CalSTRS) confirmed: “Investors should view commodity performance as analogous to insurance. Commodity investments may not always produce high returns and may impose some form of opportunity costs similar to an insurance premium. During unexpected investment-related events, such as high inflation, commodities are expected to outperform”.
A similar case is being made for why investors should include 100-year bonds, gold, commodity futures and a host of other insurance-like contracts in their portfolio to protect against a range of investment risks — from inflation and deflation to flash crashes, a global energy crisis or bad harvests.
OVER-PAYING FOR INSURANCE The comparison with insurance should give investors pause. The only people who make money from insurance are generally the sellers. For buyers, they amount to a cost — and sometimes not very good value. Some companies such as BP and some other oil majors decide it is cheaper to self-insure against at least some risks.
Morgan Stanley commods risk hits post-crisis high
John Kemp is a Reuters market analyst. The views expressed are his own.
Morgan Stanley reduced the amount of risk-taking in its trading book last quarter, but only marginally, and boosted risk in commodities to its highest level since the financial crisis struck in summer 2008, according to the firm’s earnings release.
Morgan’s relatively high appetite for trading risk sets up an intriguing contrast with Goldman Sachs, the other leading commodity bank, which cut risk aggressively across most asset classes, including commodities, in the three months April-June. Morgan Stanley cut firm-wide value-at-risk (VaR) to an average of $139 million per day, down just 2.8 percent from the first quarter’s $143 million, and slightly up from $132 million in the same period a year earlier. In contrast, Goldman cut firm-wide VaR more than 15 percent in April-June compared with the previous quarter.
Morgan Stanley boosted the VaR allocated to commodity risk slightly from $27 million to $29 million, while Goldman slashed its own commodity exposure from $49 million to $32 million. Goldman and Morgan Stanley have traditionally dominated commodity trading. But in recent years Goldman’s commodity exposure has outpaced its rival, in line with Goldman’s greater appetite for trading risk. The contrasting performance in Q2 2010, with Goldman taking risk off while Morgan Stanley continued to boost it, suggests the gap might be starting to close.
It is part of a broader reshuffling. The commodity trading business is being reshaped. Instead of the traditional top tier (Goldman and Morgan Stanley) and as many as six banks following in a second tier, trading is increasingly consolidating around four or five bulge bracket banks, with Barclays Capital <BARC.L>, the combined JPMorganChase-Bear Stearns-Sempra and Deutsche Bank bidding aggressively for a place in the top tier, followed by a host of smaller more niche operations and some increasingly large independent traders.
from The Great Debate UK:
Development of the risk trade
- Jane Foley is research director at Forex.com. The opinions expressed are her own.-
A willingness to differentiate between risk on a country or at a regional level is an important part of the repair process in financial markets.
Credit worthiness is at the core of any assessment of risk and naturally credit worthiness can sort "risk" into a hierarchy which should be instrumental to the pricing of assets and currencies.
At the start of this year, fear and uncertainly herded investors in and out of "risky" investments fairly indiscriminately. Even though the overall rally in risk since the spring suggests that broad based fear has been dispersing, strong correlations between some of these "risky" assets persist.
Forecasts of slow levels of growth for most of the G10 in 2010 suggests that there are still a few more negative shocks in store for the markets in the coming months.
That said, reduced levels of fear should allow fundamentals including assessments of credit worthiness to play a greater part in asset allocations.
from MacroScope:
Step aside capitalism, how about leverageism
Our recent post on the End of Capitalism triggered much interest and comment. There were plenty of diverse views, as one would expect. But one thread that came out was that what we are now seeing is not true capitalism (nor, of course, is it old-style communism). Ok, but what is it?
Anthony Conforti suggested in a comment that we need a name for what is happening,:
The first step in defining a new economic paradigm is coming up with the proper terms…new words to define a new economic environment. As words, “capitalism”, “communism”, “socialism” may now be inadequate to describe the emerging economic reality. We need new nomenclature. Any thoughts?
Here's one suggestion. There seems to have been precious little capital building going on is the last few years, so even in a free market, capitalism sounds a bit inaccurate. How about "leverageism"? Borrowers of the world, unite. You have nothing to lose but your shirts.
Time to pick up the challenge. What should we call the dominant economic system?
from MacroScope:
The end of capitalism
Hard to imagine with financial markets still buoyant and newspapers full of tales of bonus greed, but there is still the possibility that captialism will end. At least there is according to prestigious investment consultants Watson Wyatt in their latest study called "Extreme Risks".
The firm listed the demise of the system of private ownership as one of 15 threats to investors and the global economy that probably won't happen but which it reckons are worth worrying about anyway. The idea behind the report is that such things as climate change, the break up of the euro zone and war are always worth being included in an investment risk management process.
As for the future of capitalism:
In our view, the most likely scenario is moving along from one end of a spectrum where market is king (minimum regulation) towards the other end, where we could see more onerous regulations and government intervention in, and control of, the economy. The extreme risk, however, is the demise of the capitalist system and the end of the market as the primary means of resource allocation.
And the impact:
The economy would be likely to run a higher risk of failure and economic growth would be sluggish in the long run due to lower productivity. Centrally controlled economies tend to be characterised by shortages, which are inherently inflationary. Private investment activities would collapse or even be terminated. The end of capitalism is simply the ultimate extreme risk. The economy is likely to be associated with extreme uncertainty and a large amount of wealth destruction during the transition period.
Watson Wyatt does try to give its free market clients some hope, suggesting that buying gold may be one way to hedge against the propect of capitalism's demise. But it admitted that in such a circumstance investors would probably be more concerned about the return of their investments rather that the return on them.
I’m probably wrong but, hasn’t true capitalism been dead for nearly 100 years now if not more?
from Commentaries:
Giving props to Wall Street’s risks
Wall Street would like you to believe that when investment banks take on risk they are largely doing it for the benefit of investors -- maybe even you and me.
Bankers say much of the capital that their firms put at risk each day is to complete trades for big corporations, mutual funds, pension funds, hedge funds and university endowments. And contrary to the conventional wisdom, proprietary trading -- bets made for a bank's own behalf -- is really just a small part of their business.
Lately, Wall Street's captains of capitalism have been aggressive in pushing the "we take big risks for our customers, not for ourselves" line of argument.
That's especially so in the wake of the public furor over the outsized trading gains at the big banks like Goldman Sachs Group, JPMorgan Chase and Barclays and even Citigroup, so soon after the collapse of Lehman Brothers.
The notion that risk is being taken for customers as opposed to for the firm's own benefit is somehow supposed to make it seem more palatable and somehow less risky.
Still, for many, the image persists that investment banks spend a lot of time and resources gambling on stocks, bonds, commodities or currencies to generate fat profits and big bonuses. And there's good reason for that image: Wall Street firms don't break out the dollars they take in from client trades versus those generated by prop trading.
Yet from the perspective of Wall Street bankers, it's perfectly logical to see much of their risk taking simply as part of trades for their customers.
There is no denial that banks take risks for the investors.The important point is that the risks must be manageable even if the investments go bad & should not lead to making the very institution bankrupt like Lehman Brothers seeking taxpayers money to rescue them or vanish.Do the same very banks when in good times pass on surplus money to the state treasury instead of frittering it away illogically high salary,perks & bonuses to their executives? Why the banks don’t find inbuilt provisions to withstand such critical situations without asking for state crutches?
Brace yourself: Political-market risks in 2009
– Preston Keat is director of research at Eurasia Group, a global political risk consultancy, and author of the forthcoming book “The Fat Tail: The Power of Political Knowledge for Strategic Investors” (with Ian Bremmer). Any views expressed are his own. For the related story, click here.
There are a number of macro risks that will continue to grab headlines in 2009, including the conflicts in Afghanistan and Iraq, cross-border tensions and state instability in Pakistan, and Iran’s ongoing quest to develop advanced nuclear technologies.
These risks are real, and will not be resolved easily or quickly. But there are two other general groups of political risks that could be defining both for investors and policy makers: first, the prospect of a number of interrelated market risks in developed and emerging Europe, and second, the challenges faced by the United States regarding multilateral leadership (particularly in the area of financial regulatory reform).
Political risks have historically mattered much more in emerging markets, but political risk in the developed, industrial democracies is rising more quickly than anyone would have predicted a year ago.
Europe
Political-market risk in emerging Europe is significantly higher now than any time in the past decade. Russia and Ukraine, and even recent star “emerging Europe” performers such as Turkey, Hungary, and Romania face serious vulnerabilities in the coming year. In addition, western financial institutions based in countries like Germany, Italy and Austria are particularly vulnerable to a credit crisis in Eastern Europe, where they have large loan exposures. Russia’s growing anti-westernism, its state intervention in strategic economic sectors, and its assertive posture regarding Georgia have been widely discussed, and will remain concerns in 2009.
This also plays into one of the most problematic country risk stories right now: Ukraine. Its steel-centric economy is in free fall due to dramatically reduced global demand, many of its companies have large foreign debt financing needs that they will struggle to meet, and its domestic politics are gridlocked and bordering on dysfunctional.
Some good points about where direction should come from in the next stage of this downturn.
Lets have an open mind about the framework and be thankful that the international economy and political will is diverse enough to absorb multiple ideas. Ultimately some political and economic choices are going to have to be made, some will join the new framework and some will resist due to a lack of political or economic capacity, often due to a lack of public/ market confidence. Lets put some greater emphasis on the quality of an economy (strong institutions and productivity of intelligence), rather than pure economic growth.
I respect the man’s opinion, his position allows him a great deal of insight. But exactly what would he propose to do?Please spell it out for those thickheaded politicians, who are more concerned with their own survival than the future of their respective countries. Something will have to give. A modern day financial sintflut might ensue.Poor Angela Merkel, getting bashed from all sides. God only knows what’s going on behind closed doors all over Eurpe.