I wish it were your decision Mr. Bernanke.

Dear,

Last Thursday, world’s Financial Markets listened carefully the speech of Mr. Ben Bernanke, chairman of the Federal Reserve, as one of the most important events of the quarter.

http://www.youtube.com/watch?v=KRiRX1dR12U

Since 2008 Financial Crisis, the main response of the FED, under Mr. Bernanke’s mandate, has been injecting liquidity in the US economy, by keeping interest rates in historically low levels and buying debt in Quantity Easing cycles.

But this measures, which have proved to be successful on Keeping high levels valuation of the Capital Markets and maintaining economic activity on the US, have also increased the vulnerability of the US economy by rising US debt to unsustainable levels.

As a difference to the European Union, when the painful austerity measures have started to reduce the bubble of Financial and Economic overcapacity, US economy has continued “growing” by wasting solvency.

http://www.usdebtclock.org/

By listening Mr. Bernanke’s speech, one could get the idea that US FED has been able of keeping their monetary stimulus because is a sovereign decision, and those stimulus will dissapear at the end of this year because US economy is in the path to recovery.

Unfortunately, the reality is that US economy was already very vulnerable on September 2008 and the FED has been capable of injecting liquidity with the massive QE programs, because the capital markets have let them to do it.

Remember, inflating bubbles is a very good business till they explode.

China’s economy has played a significant role in this game. China’s banks are some of the majors US debt holders and while Chinese’s investors have been willing to buy and hold US debt, FED reserve has been able of issuing paper without raising their Yield.

The question is, what will happen if Chinese economy has their own liquidity problems, big enough to have to concentrate on them, and not using their funds on supporting US debt?

If Capital markets and Chinese banks cannot buy US debt, or even worse, become net sellers of US bonds, the FED will be unable of keeping low interest rates.

But that’s exactly what’s started to be visible this week.

http://www.nytimes.com/2013/06/21/business/global/china-manufacturing-contracts-to-lowest-level-in-9-months.html?pagewanted=all&_r=0

In my opinion, US economy will not be in better shape at the end of the year than what’s today.

But interest rates will be higher by then, not because the FED is willing to, but because in a global economy countries carrying high levels of debt become dependent on the interests and capacities of their debt holders.

At the beginning of this crisis we were said that the growth of Brasil, India, China and Russia will compensate the lack of growth on developed economies.

Five years later India’s debt is close to junk level, Brazil economy is slowing down and China is facing a liquidity crisis.

http://online.wsj.com/article/SB10001424127887324767004578488872271273296.htmlhttp://www.bloomberg.com/news/2013-05-29/brazil-s-economic-growth-disappoints-for-fifth-quarter.html

The truth is the exit strategy of this crisis is efficient Capital Management and the BRIC’s have been wasting capital because they still had some solvency to waste on 2008. US economy has also been wasting capital, but in this case with Capital Markets permission.

Now, we’re facing the burst of a huge debt bubble with hard consequences for the economy and the financial system, but that’s the lesson we have to learn before we’re ready to accept the change.

http://www.reuters.com/article/2013/06/21/markets-usa-bonds-idUSL2N0EX0ZV20130621

Looking forward to read your opinions.

K. Regards,

Ferran.

Toxic Assets strike back.

Dear,

As I explained here some weeks ago, speculation is one of the causes of the current Financial and Economic crisis, but not the main one.

http://sapbank.blogspot.fr/2013/05/why-bankers-play-casino-dear-common.html

The root cause is Capital scarcity which has generated a systemic problem, and the solution requires a Systemic Change; from a Financial System based in Volume to a Financial System based in Efficient Capital Management.

In fact, 5 years after the official start of the Great Recession some of the toxic and risky assets, publically condemned at the time, are back in the Capital Markets.

http://www.ft.com/cms/s/0/76778796-cebe-11e2-ae25-00144feab7de.html#axzz2WAS0jtrr

One of the most criticized products after 2008 crash were the Synthetic CDO’s; let’s see why.

A Synthetic CDO is a form of Collateralized Debt Obligation in which the investor takes long positions betting some referenced securities will perform. In a standard CDO the investor is paid with the interests of borrowers paying their mortgages loans, while in a Synthetic CDO, the investor is paid with the fees of Credit Default Swap insuring financial assets from a default event.

Simplifying, if the asset protected by the Credit Default Swap performs well, the investor in the Synthetic CDO will receive a portion of the fees paid by the client who has bought the CDS. In case the issuer of the insured asset defaults, the investor will have to pay his portion of the insured asset to the buyer of the Credit Default Swap.

For investment banks, synthetic CDO’s are like a securitization of Credit Default Swaps, which helps them to reduce their exposures and Capital consumption. On the other hand, for the investors, Synthetic CDO’s are a financial instrument which lets them participate in the derivatives business by selling Credit Default Swaps and receive a portion of the fees paid for the insurance.

The main advantage for an investor taking a long position in a synthetic CDO, instead of directly selling the CDS, is risk diversification. The seller of a Credit Default Swap takes all the default risk on a specific security, while investing in a Synthetic CDO the investor will be able of diversifying the risk with a portfolio of securities, with even different tranches of ratings (Probabilities of Default).

Synthetic CDO’s were severely criticized after the Financial Crisis of 2008; the main reason was their capacity for multiplying losses, with standard CDO’s the limit of the exposures is determined by the total volume of the securitized mortgage loans. This limit does not exist for synthetic CDO’s, as the investing banks can issue an infinite numbers on Credit Default Swaps on the existing securities, as long as investors agree to take the other part of the bet.

While economy is performing well, Synthetic CDO’s are generating liquidity which feeds the economic engine and helps to maintain high valuations in the Capital Markets.

But as it happened in 2007, when the economy slows down the probability of default of the insured securities will rise. If a default event activates the Credit Default Swaps, a payment obligation will be triggered for the Synthetic CDO’s, generating enormous losses for their holders.

After the event, we will probably blame Bankers for not learning the lesson; but Banks are private companies whose objective is generating dividends for their shareholders and bonus for their executives. On the other side investors are moved by greed and the low interest rates are incentives for them to invest in more risky, purely speculative, assets.

Once again, the exit strategy of this Financial Crisis is Efficient Capital Management. Growing by inflating bubbles (Real Estate, Gold, Public Debt, Derivatives, etc.) is a waste of Capital that we could afford when Capital was abundant, but this is not the case anymore.

Looking forward to read your opinions.

K. Regards,

Ferran.

Rating, Scoring and SAP Banking - Chapter II.

Dear, 

A complete scoring system also requires combining internal rating determination, like described in the Chapter I of this post, with evaluations from external sources.

These external sources include Credit Rating and Scoring Agencies and analysis of the Capital Markets behavior.

Credit Risk managers use two main approaches for credit risk modelling based on Capital Markets data analysis; Structural and Reduced models.

- Structural models, like Merton, are used for calculating probabilities of default focusing on equity prices.

- Reduced models, like Jarrow-Turnbull, focus on debt values, and perform the analysis looking at evolution of interest rates.

Obviously they also use combinations or evolutions of the above on their internal models. For instance, some months ago I had a conversation with the VP responsible of Risk Management in an investment bank in Singapore. He explained me some interesting details of their rating models and particularly, how they included the current, future and volatility prices of some Financial Instruments in their model for estimating the solvency of governments and corporate
counterparties.

Those models are not directly supported by SAP tools, but it could be done by complementing SAP Components (Bank Analyzer, Market Risk Analyzer, etc) with external statistical analysis tools (SPSS). It’s not a standard construction, but in my opinion it’s worth exploring it during the project preparation.

Finally, managing ratings requires more than effective determination of the Business Partner Risk, it also requires centralized management of the scoring data and seamless integration with the Operational Systems. Not having centralized controls is a big weakness in a Credit Risk System, as it can be the root cause of erroneous decisions and consequently wasting Capital.

For instance; without a centralized credit control, a Business Partner, considered insolvent in one country or by a business line, would be able of over-passing his credit limit by borrowing funds in another. A well known example is how the Greek government could hide part of its deficit, getting funds by using derivatives contracts with Goldman Sachs support.

http://www.spiegel.de/international/europe/greek-debt-crisis-how-goldman-sachs-helped-greece-to-mask-its-true-debt-a-676634.html

The Credit Risk component of SAP combines the capacity of acting as central repository of counterparty risk data, with the flexibility of adapting the risk data to different business scenarios, by storing it in separated credit segment data. This segment data could be tailored to the requirements of specific business lines or jurisdictions, and then be delivered this way to separated business areas or legal entities of the Financial Group (Insurance, Leasing, Retail and Private Banking, etc.).

As it happens with other SAP Banking solutions, some of the components described in this post are not very well known in the market; the Historical Database of Basel II has been implemented in several banks in Asia Pacific and Africa and a good number of European Banks, but I’m not aware of any implementation in the America region and it’s even more difficult to find references of the described integrated scenarios.

On the other hand, the advantages of using an integrated platform for the management of credit risk are abundant, rating calculation and risk management require effective calculation and centralized control, but also common semantics that helps Banks’ executives to understand
the root cause of their risk exposures, from the operational to the analytical level and vice-versa.

That’s SAP value proposition; common semantics and seamless integration of software components. From this perspective I don’t have doubts that as soon as we improve the on field knowledge of SAP Banking capabilities on Credit Risk management, it will become the market leader.

K. Regards,
Ferran.