Subprime Crisis 2.0

Dear,

As the Tapering has started, instability has arrived to the Financial Markets

http://www.cnbc.com/id/101387956

This is not a surprise; as liquidity is dried from the system risky assets become less attractive.

This is just the first step in the process of normalizing the monetary policy, the key question is how deep the consequences will be at the end of it.

Maybe we can learn something from recent history.

Subprime crisis started on February 2007, as interest rates began to raise some borrowers were unable to refinance and housing prices started to drop moderately.

At the time, economy was performing well and credit kept flowing, the stock market recovered quickly and the subprime crisis was described as a Storm in a Teacup. 

One year and half later the Financial System faced the biggest crash since the Great Depression.

In my opinion, there’re similarities between February 2007 and 2014 events that deserve to be analyzed.

Last years' liquidity injections of most of the Central Banks (Bank of England, FED, Bank of Japan, etc) have reduced drastically the interest rates and carry trade has transferred the liquidity excess to the emerging economies, increasing their external debt.

For instance, Brazil external debt has grown from 200000 USD Million to 312021 USD Million in the last 6 years, with most of this capital flowing to real estate investment and consumption.

http://www.tradingeconomics.com/brazil/external-debt

As the economic activity increased, rating improved and local banking systems gave more loans increasing their leverage. Again, most of this capital flowed to real estate investment increasing property valuations.

Additionally, in some countries, like China, shadow banking has grown exponentially, making very difficult the estimation of the size of the problem. By the way, as it happened with the estimation of the size of the Collateralized Debt Obligations problem of the US Subprime Crisis.

http://blogs.wsj.com/marketbeat/2011/10/25/chinas-shadow-banking-system-the-next-subprime/

At you know, historically, this is the root cause of credit and real estate bubbles with very bad consequences. Please, spend ten minutes watching the video below.

http://www.cbs.com/shows/60_minutes/video/2340027515/china-s-real-estate-bubble/

Most of the emerging countries economies depend on the export of commodities, whose prices also rise during the monetary expansion cycle. As the cycle ends, commodities prices are dropping increasing their trade deficit.

In a globalized world capitals can flow very quickly in and out of a country; this is what we've seen in the last weeks with the logical impact in the Foreign Exchange markets. For instance Turkish Lira dropped by 10% in the last 2 weeks of January, and nearly 30% in the last 6 months.

Trying to stop capitals flight, some central banks have raised interest rates but this is likely going to slow down the economy, increasing the probability of busting the credit bubble.

http://blogs.wsj.com/moneybeat/2014/01/28/turkey-central-bank-raises-interest-rates/

Someone would say that Man is the only animal that trips twice over the same stone, but the reality is that as we’re still in a financial system oriented to volume, history repeats itself, 

But for how long?

Looking forward to read your opinions.

Kindest Regards,

Ferran.

Apples and Oranges. Bank Analyzer for Non-Financial Companies. Chapter III

Dear,

Managing means taking decisions; requires giving priority to some actions in front of others and allocating resources to the most important activities.

This is not an exception when it comes to Risk management, every investment and business activity requires taking a risk and it’s a candidate to request risk hedging actions.

But hedging a risk also has a cost that will potentially reduce the profit of the investment; at the end the profit of an investment is determined by all the revenues less all the costs.

Determining the profit of an investment without risk (arbitrage) is relatively easy, it just requires comparing homogeneous magnitudes. A typical example is the following; if we buy 3 oranges from someone for 3 $, and we sell them immediately after to someone else for 5$ we’ll make a non-risk profit of 2 $.

But if we buy the oranges for 3 $ and we exchange them for 3 apples, we can’t determine the profit immediately; we also need the value in $ of the apples to determine our profits.

That’s a typical risk management problem, if we’re storing and selling 2000 barrels of Oil; we’re taking many risks (explosion, leaks, price fluctuation, etc.) which require risk hedging activities. As risk zero does not exist, the more we invest in risk hedging activities (for instance, buying an insurance policy or installing a fire control system) the more costs we’ll support, reducing our profits.

Managing risk requires comparing the cost of the risk hedging activities with the cost of risk of the business activity, and that’s not easy.

Risk hedging activities can be measured in EUR or USD; but how I do it to compare them with the cost of risk? Again, I can’t compare apples with oranges.

This is a handicap of Integrated Information Systems, even SAP-ECC, the most successful of the Integrated ERP’s, does not offer an integrated and homogeneous vision of risk and its associated costs.

In a growing economy this is not a big issue, big margins cover inefficiencies on risk management, but we’re in a new model of limited growing economies with limited margins for the companies. In the new model, efficient management requires integrated Enterprise Risk Management systems.

But, do we have a candidate for building Enterprise Risk Management Information systems, capable of offering an integrated and homogenous vision of risk management?

In my opinion we do, and this is Bank Analyzer.

In the following lines I’ll try to give a brief description of the approach.

First we need the conversion of risk costs in USD, and we’ll look at Financial Mathematics’ for finding the function to convert risk exposures to USD, Oranges in Apples and vice-versa.

In Bank Analyzer, we can determine the NPV of a loan (Key Date Valuation), by discounting the expected cash-flows of the loan according to a yield curve, which depends on the probability of default of the counter-party. This is the probability of the expected cash-flows to become effective.

In a similar way, potential costs due to fluctuations in the Oil price, explosions, leaks, etc. represent expected Cash-Flows; by estimating the probability of those events happening, and selecting a Yield curve according to the probability of the events, we’re also estimating the Net Present Value of the Business Activity.

As you can see, from financial mathematics’ perspective there is not a big difference in calculating the Net Present Value of Lending money or the NPV of storing and selling Oil.

The challenge is modeling the business activity as SDL-Primary Objects. If we do, the risk engines of Bank Analyzer will provide us the Net Present Value, the expected losses due to counterparty risk and in future versions of BA, the Value at Risk and expected losses due to Market Risk.

We saw some weeks ago how to do it with a Sales Order of Crude Oil

http://sapbank.blogspot.com/2014/01/bank-analyzer-for-non-financial.html

I’m working on the modeling of many other business activities that I’ll share with you in future posts.

K. Regards.

Ferran.

I wish it were your decision Mr. Bernanke – Chapter V

Dear,
Some months ago, we saw the US economy confronting a real possibility of default as the US representatives disagreed on the terms of raising the nation's debt limit, with a number of economic consequences, like the US debt rating or rating perspective being downgraded by several rating agencies.

http://sapbank.blogspot.com/2013/10/i-wish-it-were-your-decision-mr.html

On October 16, the Senate passed the Continuing Appropriations Act, 2014, suspending the debt ceiling until February 7, 2014 which “apparently” solved the problem.

From this perspective, it seems we’re confronting a political issue, impacting the biggest world’s economy.

Unfortunately not, we’re going to see that politics have nothing to do with this and the problem is purely economic.

The below graph shows that US Federal debt has risen from 35% to nearly 75% of the US GDP in the last 10 years, and particularly since the starting of the Financial Crisis in 2008.

http://en.wikipedia.org/wiki/File:FederalDebt1940to2012.svg

And if we look at the evolution of the total debt of the US economy, we see how it has reached 350% of the US GDP with a very significant contribution of the Financial Sector, whose debt has speeded up since 1980’s deregulation.

http://upload.wikimedia.org/wikipedia/commons/e/e0/Components-of-total-US-debt.jpg

Today US economy presents an uncontrollable deficit and an unsustainable debt, growing independently of the government party, republican or democrat. Once again, this is not a political problem but an economic one.

This growing debt has fueled economic growth; this is logical as the current economic model requires wasting capital for generating economic growth.

As debt is a Financial Asset (Liability for the counterpart), growing debt means oversizing the Financial System. The U.S. finance industry comprised 10% of total non-farm business profits in 1947, but it grew to 50% by 2010. Over the same period, finance industry income as a proportion of GDP rose from 2.5% to 7.5%, and the finance industry's proportion of all corporate income rose from 10% to 20%.

This wouldn't be a problem if debt could grow indefinitely, but the question is; is that even possible?

Since the starting of the financial crisis, the FED has injected 2.3 Trillion Dollars in the economy.  This month, as “Tapering” has reduced the liquidity injections from 85 to 75 billion dollars a month, a storm has been triggered in the Forex, Stock and Commodity markets.

http://www.telegraph.co.uk/finance/business-news-markets-live/10603717/Business-news-and-markets-as-it-happened-January-29-2014.html

What will be the impact in the Financial System when the Financial Markets decide to open their eyes and burst this huge debt bubble, raising the interest rates?

We saw it already in 2008, as the Financial Markets decided to not believe that real estate prices could grow indefinitely, interest rates of the CDO’s raise, and the world’s financial system was put on the edge of collapse.

The alternative at the time was bailing out the Financial System with public funds, collateralizing their debt and giving new and fresh guarantees to the debt holders.

At the time US Public debt was 5 trillion USD (36% of the GDP) and today it is more than 12 trillion USD (73% of the GDP). What’s the alternative now, who is going to rescue the Financial System if the interest rates start to rise?

When in the great movie “Too Big to Fail” http://www.imdb.com/title/tt1742683/ Hank Paulson asks Ben Bernanke for reducing the capital requirements of Bank of America so they can merge with Lehmann Brothers, Ben Bernanke replies.

“You want me to allow them to raise their leverage so they can buy a bank that's about to fail because it was overleveraged?”

Ok, now we have the US Central Bank overleveraged, what are we going to do about it?

Looking forward to read your opinions.

Kindest Regards,
Ferran.