Research Recap Twitter Update Highlights

Led by China, foreign governments/central banks sold record amount of US financial assets in January (FT Alphaville)

US Bank Failures Threaten Small-Business Lending (WSJ)

Global harmony on financial regulation a distant prospect despite Lehman outrage( FT’s Gillian Tett) Sad but true

Junk Bond Avalanche Looms for Credit Markets (NY Times)

Traders Tapping Social Media to Gauge Market Sentiment using Alacra Pulse (WSJ)

Technorati Tags: bank lending, china, financial-regulation, junk bond, small business, Twitter

FX Swaps May Exacerbate Risks During Periods of Turmoil

The use of foreign exchange (FX) swaps as a source of funding and as a hedging tool may increase the risk of financial and economic instability during periods of turmoil, according to a new Working Paper published by the International Monetary Fund (not official IMF policy).

Selected Excerpts from FX Swaps: Implications for Financial and Economic Stability (free pdf) Prepared by Bergljot B. Barkbu and Li Lian Ong1

The spillover of the liquidity crunch in international money markets into the FX swap market during the recent financial crisis has placed a spotlight on the latter’s potential impact on macro-financial stability. The increasing reliance on FX swaps for FX funding by some market participants and the sharp increase in cross-border transactions in this instrument gave rise to significant concerns when the market faltered during this tumultuous period. Specifically, the role of banks as key dealers and users of FX instruments—and their central importance for financial stability and economic activity—raised worrying questions in some countries about the possible impact of FX swaps on the health of the banking system and real economy.

Capital adequacy requirements under the Basel Accords hold implications for the application of capital charges when these instruments are held by banks, either for speculation purposes, to finance their FX needs and/or to hedge their open FX positions. FX swaps held by banks could also impact their liquidity positions, through margin calls by counterparties, even though they may be fully hedged for FX movements. Encouragingly, the accounting requirements under IFRS are aimed at improving the transparency of reporting by users of these instruments, by bringing them onto the balance sheets of the reporting entities.

During the recent crisis, central banks used FX swap facilities extensively to facilitate the rollover of FX swaps by the private sector during the crisis, in some cases, supported by swap lines with other central banks.

We conclude that the application of FX swaps is not infallible, despite their usefulness. That said, this paper is not intended as a critique of FX swaps, but rather, to examine the channels through which FX swaps could affect financial and economic stability, given their increasing popularity leading up to the crisis.

As recent events have shown, the use of this instrument could actually exacerbate risks to financial and economic stability during periods of turmoil. Thus, central banks, which typically use FX swaps as a monetary policy tool, and banks, which transact in this instrument for funding, hedging or speculative purposes, need to ensure that they have the necessary measures in place to address the stability problems that could arise from its use.

Technorati Tags: banking-system, central-banks, financial-regulation, FX swaps, money markets

Why ‘Too Big to Fail’ is Too Short-Sighted to Succeed

NERA Economic Consulting argues in a new white paper that limiting the size of financial institutions may actually result in more risk-taking, not less.

Selected excerpts:

Legislative proposals that rely on a size-based identification process would erroneously identify a number of financial firms as systemically risky, when in fact they are not. Other firms that do in fact pose significant systemic risk would fail to be identified. Such a process, if enacted, would create a cross-subsidy of significant magnitude from firms that do not pose systemic risk to those firms whose activities are systemically risky.

The resulting moral hazard would encourage increased risk-taking and, as such, could ultimately defeat the legislation’s intent of reducing the economy’s exposure to systemic risk.

Further, if a size-based process for identification of systemically risky financial firms were accompanied by heightened regulatory requirements and new systemic risk charges, the following economic results would be expected:

• Increased financial system risk as a result of new sources of moral hazard;
• Distortions in the competitive environment, impacting economic efficiency and creating
  potential barriers to entry;
• Increased costs to consumers for basic, often required, financial services, as a result of the pass-through of assessment cost, and costs associated with increased regulation; and
• U.S. job losses, including those predicted to result from reductions in capital and labor expenditures and economic dislocation, as a result of efforts by firms to structure to avoid size thresholds.

On balance, the costs of the proposal, considering the moral hazard and economic impacts, are economically significant, easily exceeding the benefit of the actual systemic risk fund itself. Though reducing systemic risk and related taxpayer costs is critically important, to achieve these goals and avoid negative economic distortions, underlying sources of firm systemic risk must be properly identified. Elements not directly linked to size, including interconnectedness, cyclicality, leverage, liquidity, and transparency are important considerations in the identification and quantification of systemic risk. While incorporating such elements into the official identification and assessment of systemically risky financial institutions may increase the complexity of the process, a size-based process could result in more economic harm than good.

The full paper, prepared for the Property Casualty Insurers Association of America, is available here.

Technorati Tags: big banks, financial institutions, financial-regulation

Research Recap Twitter Update Highlights

Ten Wall Street Blogs you need to bookmark now (WSJ)

News moves stock prices shock (Academic study analyzing press release market impact) FT Alphaville

Recent price moves in bond market are a reminder of how entrenched the credit rating agencies are (WSJ)

The Euro’s Next Battleground: Spain (WSJ)

Obama may compromise on consumer agency to pass financial regulation (WashPost)

A cellphone-based cash transfer system has changed the way Kenyans handle their finances (MIT)

Wall Street shifting political contributions to Republicans (WashPost)

‘Volcker Rule‘ Stalls in Senate (WSJ)

Technorati Tags: blogs, credit-rating-agencies, financial-regulation, mobile, Spain, Volcker Rule

Financially Integrated Markets Pose Significant Short-Term Risks

A new Working Paper from the IMF (not officially policy) takes a refreshingly candid look at the need for, and the obstacles to, meaningful financial regulatory reform, noting the formidable power of the financial lobby to undercut reform efforts.

Selected excerpts from Lessons and Policy Implications from the Global Financial Crisis

…the crisis has made clear that policy makers have to watch many targets, including the composition of output, the behavior of asset prices, and the leverage of different agents. It has also made clear that they have potentially many more instruments at their disposal than they had used pre-crisis. The challenge is to learn how to use these instruments in the best way. The combination of traditional monetary policy and regulation tools, and the design of better automatic stabilizers for fiscal policy, are two promising routes.

The reform agenda is enormous, much remains to be done, and new questions have come up for the design of more stable national and global financial systems. The global nature of the financial crisis has made clear that financially integrated markets, while offering benefits in the long run, pose significant short-term risks, with large real economic consequences, and that reforms are needed to the international financial architecture to safeguard the stability of an increasingly integrated global financial system. Such reforms need to be guided by the right principles rather than being formulated as rushed responses to the public pressure. In particular, the reforms should rely on economic reasoning to identify the market failures and the externalities as well as to device the best way to solve the incentive problems.

Vested interests in the financial services industry are large in most countries and political lobbying will therefore be a key determinant of the final outcome of this process. Intense efforts by the financial industry to protect these interests can create obstacles to implementation of the necessary reforms.

Hence, policymakers should not underestimate the ability of the financial industry to influence the reform process as well as the ability of the markets to find loopholes to get around restrictions and recognize limits on what regulation and supervision can realistically achieve.

The paper includes a number of illustrative charts, including this one:

Technorati Tags: financial-regulation, IMF, risk

Big Ratings Agencies Likely to Lose Hegemony Over Time

A new report from Aite Group finds that credit ratings agencies are too integral to the financial system to disappear. However, they are likely to lose their hegemony over time as a result of proposed regulatory actions and changes in the marketplace.

The report examines the role that Nationally Recognized Statistical Ratings Organizations (NRSROs) play in the debt issuance and investment process, and looks at pending regulations and possible credit rating agency (CRA) responses to these regulations.

Historically, CRAs have measured the financial strength (i.e., provided gradations of creditworthiness) of corporations that have tapped publicly traded debt markets to finance their operations. Because of recent write-downs and expected losses – primarily related to mortgage-related securitized debt – credit rating agencies have taken a hit to their reputation for providing credible credit analysis.

These SEC-sanctioned credit rating agencies (known as NRSROs), comprise 10 firms, including Moody’s Investors Service, Standard & Poor’s, and Fitch Ratings, which have for years held onto their constituent firms with a near-monopoly grip. Nothing lasts forever. Investor dissatisfaction with NRSROs, and drafted regulation, such as the Restoring American Financial Stability Act have primed the playing field for major changes.

“While NRSRO ratings will remain a part of the global debt markets, NRSRO hegemony may wane in the face of proposed legislation and investor displeasure,” says John Jay, senior analyst with Aite Group and author of this report. “Consequently, NRSROs will need to share their sandbox with other credit ratings agencies, and even investors themselves. More than any other party, investors have some ability to look out for their own interests by taking credit analysis onto their own shoulders.”

The report notes that potentially $2.8 trillion of cumulative credit market losses remain on the books of financial institutions for the period 2007-2010.

Holders of existing debt and regulators that oversee segments of these holders may wish to consider either outsourcing or building their own infrastructure to analyze credit risk.

Technorati Tags: credit-markets, financial-regulation, Fitch, Moodys, ratings agencies, Standard & Poor's

Research Recap Twitter Update Highlights

UK RMBS peformance to suffer if  £300bn in gov’t aid isn’t replaced with private capital (Moody’s via FTAlphaville)

Tougher financial regulations not coming fast or easy for SEC’s Mary Schapiro (WashPost)

US Q4 2009 Mortgage loan delinquency rate increased for 12th straight quarter to 6.89 percent (TransUnion)

US CMBS deliquency rate posts record rise to to 5.42% in Jan from 4.5% inDec (Moody’s via FT Alphaville)

Stanford study provides further evidence suggesting many companies tweak earnings to meet investor expectations. (WSJ)

Another blow for bipartisanship: Top Pharma lobbyist resigns after criticism of his support for health care reform (WSJ)

Technorati Tags: financial-regulation, mortgage-backed-securities, pharma

Smart re-regulation could boost US financial markets

Guest Post by Oxford Analytica

While the crisis of 2008 was self-evidently a market failure, in terms of the mis-pricing of certain assets (particularly property), it was also a regulatory failure in three key respects:

• Regulators did not adequately consider the possibility that the short-term credit market could collapse, threatening several major financial institutions with insolvency.
• This was the by-product of an intellectual failure to keep abreast of how the macroeconomic framework was changing as a result of globalisation.
• While there was an arguably correct perception in the late 1990s that the 60-year-old Glass-Steagall framework was outdated, there was no effort to replace it with a 21st century successor.

In the wake of the crisis, political debate has focused on whether to return to the outmoded pre-1999 regulatory framework, rather than on how to adapt this model to address globalisation.

Glass-Steagall no panacea. Even a cursory examination of the old Glass-Steagall framework — which separated deposit-taking commercial banks from investment banks, or ‘broker-dealers’ (BDs) — indicates that it would not have been sufficient to prevent the 2008 crisis:

• Almost all of the banks that failed or were forced into mergers were either BDs (Lehman Brothers, Bear Stearns, Merrill Lynch) or purely commercial banks (eg Washington Mutual or the UK’s Northern Rock).
• The ‘universal banks’ created after Glass-Steagall did not perform noticeably worse — although a few (Citigroup, UBS) were in deep distress before being bailed out by governments. Indeed, some entered the crisis in relatively solid shape (eg JP Morgan Chase, Barclays) and have since benefited from the collapse or absorption of rivals.

Intellectual context of crisis. Thus, the crisis was not simply caused by deregulation, but by a deeper shortfall of risk comprehension in prevailing economic frameworks — which downplay such factors as shifting social contexts and changes in forecasting strategies that determine asset evaluation and market movements.

In other words, difficult-to-quantify human factors and the adaptive interactions of market players were downplayed by many economists and risk managers, who became enamoured of quantitative modelling:

• In the 25 years prior to 2008, academic economics became dominated by an emphasis on numbers — particularly quantitative modelling and statistics associated with ‘rational choice’ theory.
• This intellectual paradigm allowed neoclassical growth theorists to advance a framework with the premises that markets tend to equilibrate around efficient resource allocation and that government policy always does more harm than good in fostering economic growth. This increased the distribution of risk and reliance on complex quantitative modelling techniques to mitigate risk — with disastrous results.

Intellectual reaction. The crisis has significantly undermined this approach, although the economics discipline has been slow to adapt, with the initial impetus to fall back on a Keynesian framework. This reaction drove President Barack Obama’s embrace of the ‘Volcker Rule’ that would prohibit commercial banks from engaging in proprietary trading, and the Senate bill co-sponsored by Republican John McCain and Democrat Maria Cantwell that would reinstate Glass-Steagall in its entirety. However, in order to defuse incipient crises created by asset price bubbles, financial disintermediation and the attendant rise in systemic risk, any new regulatory paradigm would need to incorporate the insights that behavioural economists have developed since the 1970s — eg evolutionary models of how markets reach efficiency and group behavioural studies.

Outlook. Many economists still cling to the validity of their modelling techniques, which appear usefully predictive over the short term — but that are inaccurate as models of human behaviour over time. They tend to protest that improved modelling, rather than a wholesale re-evaluation of their approach, is apposite. This leads many to conclude that any re-regulation would be counter-productive.

However, this fails to account for innovative new research that has emerged from inter-disciplinary and behavioural economists in recent years. This includes the work of John Geanakoplos of Yale University on ‘leverage cycles’, which suggests that leverage cycles have observable and predictable characteristics, targetable by regulators.

Technorati Tags: banks, financial-markets, financial-regulation, Hedge-Funds, private-equity

History Suggests Recovery From Financial Crisis Will Be Slow and Painful

Several sectors, including commercial real estate in several countries are at high risk of deleveraging, McKinsey says in new study.

The recent bursting of the great global credit bubble not only led to the first worldwide recession since the 1930s but also left an enormous burden of debt that now weighs on the prospects for recovery. Today, government and business leaders are facing the twin questions of how to prevent similar crises in the future and how to guide their economies through the looming and lengthy process of debt reduction, or deleveraging.

McKinsey Global Institute created an extensive fact base on debt and leverage in each sector of ten mature economies and four emerging economies. In addition, MGI analyzed 45 historic episodes of deleveraging, in which an economy significantly reduced its total debt-to-GDP ratio, that have occurred since 1930.

Key Findings:

• Leverage levels are still very high in some sectors of several countries—and this is a global problem, not just a U.S. one.
• To assess the sustainability of leverage, one must take a granular view using multiple sector-specific metrics. The analysis has identified ten sectors within five economies that have a high likelihood of deleveraging.
• Empirically, a long period of deleveraging nearly always follows a major financial crisis.
• Deleveraging episodes are painful, lasting six to seven years on average and reducing the ratio of debt to GDP by 25 percent. GDP typically contracts during the first several years and then recovers.

If history is a guide, many years of debt reduction are expected in specific sectors of some of the world’s largest economies, and this process will exert a significant drag on GDP growth.

The right tools could have identified the unsustainable build-up of leverage in pockets of several economies in the years leading up to the crisis. Policy makers should work to develop a more robust system for tracking leverage at a granular level across countries and over time. One needs to look at specific metrics such as the growth of leverage, and the borrowers’ ability to service debt if there is a disruption to income or rise in interest rates. MGI found that sufficiently granular data do not exist today.

MGI’s analysis provides support for several of the current regulatory proposals, including improving the quality of bank capital through higher Core Tier I ratios, monitoring leverage as a proxy for asset bubbles, and creating better macro-prudential regulation to reduce systemic risk. However, the analysis raises questions about some aspects of the current regulatory agenda, such as limiting gross leverage ratios (which did not change appreciably in most banks).

Coping with pockets of deleveraging is also a challenge for business executives. The process portends a prolonged period in which credit is less available and more costly, altering the viability of some of business models and changing the attractiveness of different types of investments. In historic episodes, private investment was often quite low for the duration of deleveraging.

Technorati Tags: financial crisis, financial-regulation, fiscal-policy

US Regulators Seek to Throw Light on Hedge Fund Impact in Energy Trading

Guest Post by Darrell Delamaide of OilPrice.com

Do hedge funds have an impact on energy trading?

While the answer might seem intuitive, the debate as to whether they actually do has come to resemble the medieval theological dispute about how many angels can dance on the head of the pin.

Because, like angels, many trades in energy futures are invisible, and it is often not possible to pinpoint where they take place.

And yet, for most of us, including lawmakers on Capitol Hill, it seems obvious that when hedge funds buy and sell billions of dollars worth of oil and gas futures, it must be having an impact on energy prices. While hedge funds and other speculative traders would never dream of taking delivery of a barrel of oil, their trading activity affects the prices for actual consumers of oil and gas and their downstream customers – or so it would seem.

When Gary Gensler, a former Goldman Sachs banker and Treasury Department official, was nominated last year as chairman of the Commodity Futures and Trading Commission – the chief regulator for energy futures trading – he reversed the CFTC party line that speculators don’t have an impact on energy trading.

“I believe that excessive speculation in commodity futures can cause sudden or unreasonable fluctuations or unwarranted changes in commodity prices,” Gensler said in a written response to lawmakers’ questions ahead of his nomination hearing.

Gensler went on to pledge that if confirmed, he would have the CFTC guard against such speculation.

While he stopped short of saying that excessive speculation had taken place in the run-up of energy prices in 2008, he did express the opinion that the rapid growth of commodity index funds and increased hedge fund allocation to commodity assets contributed to the “bubble in commodities prices that peaked in mid-2008.”

He noted that non-commercial investors sometimes account for up to 90% of open interest in a contract. (Open interest is a calculation of the number of active trades for a particular market, and is used as an indicator whether trading is becoming more or less active.)

Gensler’s answer, enshrined in draft legislation currently before Congress, is to make trades more visible by requiring all over-the-counter derivatives to trade through an approved clearing house. While the thrust of new legislation is to get a better handle on financial derivatives such as credit default swaps, it will give regulators a better picture of all derivatives trading, including energy contracts.

At the same time, the CFTC and the Securities and Exchange Commission both are beefing up their ability to monitor hedge fund activity. The SEC for the first time will require hedge funds to register as investment advisors, and Gensler has pledged closer oversight of the funds that it supervises as commodity pool operators.

The industry, predictably, is pushing back. In congressional testimony on the new legislation, the Chicago Mercantile Exchange, the largest futures exchange in the world, and other exchange operators presented studies based on CFTC data to show that large positions held by index funds and other managed money were not “routinely detrimental” to the commodity markets in the period January 2005 to June 2008.

“All of the trader groups displayed instances of non-optimal behavior (including small traders), but none were consistently harmful to the studied markets,” they said.

A task force of the International Organization of Securities Regulators (IOSCO) released a report last March that came to a similar conclusion.

“While reports reviewed by the task force concluded that fundamentals rather than speculative activity was the plausible explanation for price changes, the task force has made a number of recommendations to improve the transparency and supervision of these markets,” IOSCO said.

These included suggestions regarding information about the underlying commodities, access to and sharing of information about trading positions, beefing up enforcement powers, and improving global coordination.

The spectacular collapse of the Amaranth Advisors hedge fund in 2006 when it lost $6 billion on natural gas futures did pull back the veil on hedge fund activity in energy markets. Amaranth built up its huge position in natural gas futures through OTC contracts that exactly mirrored the contracts on the New York Mercantile Exchange but remained hidden from regulators, who were unable to enforce position limits designed to rein in speculative trading.

In hearings about Amaranth before various House and Senate committees as well as at the CFTC itself, it became clear, at least to many lawmakers, that contracts on unregulated trading venues can influence prices.

The case was so straightforward that it prompted the Federal Energy Regulatory Commission to flex its new post-Enron mandate to stop manipulation of energy prices by pursuing disciplinary action against Amaranth.

This led to a turf war with the CFTC, which claimed exclusive jurisdiction over futures trading and argued that FERC’s mandate extended only to spot trading. FERC countered that when activity in the futures market affected spot prices, it was authorized to act.

Those proceedings ended in a joint settlement last August, before either CFTC or FERC held their administrative hearings and before an appellate court could decide the jurisdictional issue.

But the Amaranth case remains as a reminder of what a hedge fund can do in energy markets if these trades are not more transparent. Legislation bringing more visibility to the market and strengthening the hand of regulators will ensure that hedge fund activity in the energy markets will be more closely monitored and limited.

OilPrice.com focuses on Fossil Fuels, Alternative Energy, Metals, Oil Prices and Geopolitics.

Technorati Tags: Amaranth, derivatives, financial-regulation, Hedge-Funds, oil prices