Dear readers,
This newsletter will be the last one for the year. For an economist who tries to think outside the box, 2008 was a fantastic year. One could compare it with a meteorologist who would get the chance of a lifetime to observe a perfect storm. However the social drama’s caused by the crisis counterbalance the academic joys. 2009 unfortunately will most probably not be any different.
We do have the reputation to be the ‘Waldorf and Statlers’ of the finance industry, but one can not expect that the excesses and imbalances which have built up the last 25 years can be digested by a stock market correction of 30-40 % and a bailout plan of USD 1 trillion. This is the core philosophy of Givanomics. In this dangerous ocean of liquidity some tectonic plates need to be reshuffled and this is going to keep on causing giant waves in the near future. Volatility is going to be something we will have to deal with in the next coming years.
Before we have a closer look at another potential black swan, i.e. China and its demographics, let us for the record make some projections what to expect for 2009. One of the central themes will be further de-leveraging. It is naïve to think the market has de-leveraged sufficiently. Past experience of credit bubbles taught us that they would be followed by a credit contraction. Until now the major banks have only written down apx. EUR 800 bio of a potential EUR 5.5 trio still outstanding. So, we haven’t seen anything yet .
Leading indicators clearly show a contraction of economic growth around the world. As a consequence banks will be faced with write downs of bad corporate debt. Areas that will be hit first are most probably commercial real estate and shipping, two industries which built up huge over capacity. Then given the problems Ukraine, Russia and Hungary are facing, we see East and Central Europe deteriorating. Based upon discussions we have with our contacts with banks that have exposure in the region, we get clear indications that economic activity in e.g. Czech Republic is also coming to a stand still.
All this will in turn cause further funding needs for the banking industry, as further write downs will jeopardize their capital ratios further. Stress tests from Merrill Lynch show the European banking sector could potentially require between EUR 60 – 120 bio of additional new capital depending on how much the economic downside would be.
So far for our 2009 expectations…
In our newsletter on deflation we briefly mentioned the potential thread of Chinese social unrest which could have a major impact on the global economy.[1] For this week we would like to elaborate a bit more on these social issues China is facing.
One would have thought that Europe and Japan and to a lesser extent the US have some serious challenges ahead with the aging of their population. You ain’t seen nothing yet until you have a closer look at China. Their single child policy in the late seventies created a potential monster which is about to be unleashed.
The sociological nature of the Chinese society traditionally preferred male above female children. This combined with the implementation of a one-child policy has triggered a sex ratio imbalance which has caused far reaching damage towards the demographic structure of their society. An interesting paper on the subject was written in 2006, at the University of Michigan [2]
Initially the one-child policy matched its objectives. However after a while it overshot its goal, and it is believed that in the last 20-25 years the policy brought down the population growth by more than 300-350 mio people. This caused a sex ratio (males over females) of up to 1.30 in certain rural areas. Bear in mind that a normal ratio ranges between 1.03 – 1.07 in industrialized countries.
Together with the urbanization of China’s economy, which caused higher or better living standards, this has led to an increasingly aging population. In the beginning of the eighties people older than 65 were only 5 % of the total population. The percentage at this moment has risen to 9%, but will start to rise exponentially over the next 25 years to hit 22 % by 2035. The age group of 0-4 years old dropped from 94 million people to 68 million over the last decade. This together with a drop of the birth rate itself makes the bias of the population age profile moving to the age category of 40. To put this into perspective at the moment 52% of adults are over the age of 40. By 2015 this will rise towards 60 %. Another interesting number is the households who do not have a child younger then 20. This is 37% at the moment. Models forecast a rise to 51 % by 2015 and 71 % by 2025.[3]
All this will have a dramatic effect on the labor force. Models anticipate the labor force already to have peaked this year and will start to decline rapidly. Of course, part of this decline will be offset by an increase in productivity given the improved education and rise in investments, but it won’t be enough. The labor force is declining at a faster pace than increase in productivity and investments can keep up with. As a result this will slowdown GDP growth further, as an aging population reduces the labor force and on in turn lower the return on capital. Investments will fall due to lower returns, which completes the vicious circle: labor falls -> investment falls -> output falls -> living standard falls.
Their one-child policy also has some indirect socio-economic effects. Since it almost became a privilege to have a child, parents start to adore and spoil their children which turned into a mass psychological disorder. Among sociologist they are talking about the ‘Little Emperor Syndrome’. These children carry high expectations for the future and lose their Chinese cultural values. They grow up in a more Western oriented atmosphere and falling victim of the negative influences of the fast food culture. Studies expect by 2010 one in five children in China will be coping with obesity. This is rather dramatic given the fact that the Chinese culture was known for good health and gastronomy practices.[4]
Another socio-economic effect ofto the sex imbalance is that it becomes increasingly difficult for men to find a partner. This has triggered a huge kidnapping campaign and is increasing crime and violence.
Next to an aging population, Chinese officials face another demographic challenge. The rush from the rural areas to the coastal cities of China. This urbanisation already started in the early eighties, but it accelerated when the Chinese government started to experiment with capitalism in some of their provinces near the coast. People from the country heard about the success stories of people who left and became overnight a millionaire and decided to throw the dice and try their luck out in the city next door. This has triggered an exodus from the inland towards the coast. This rush is even expected to accelerate.
In the next 15 years Chinese cities expect to add 350 mio people who all will be looking for a better future. By 2030 the total amount of people living in cities is expected to hit the one billion mark.
All this is going to put a lot of pressure on resources such as water and energy, but the government will need substantial amounts of public funds to offer social services. Apart from that the economy will have to keep up growing by 8-10 % annually for the next 20 years in order to offer employment to those people.
There are already social unrests in many cities, because the difference between the expectations they have for a better future and the real outcome of it once they arrive in a highly polluted and super competitive city is extreme.[5] One can imagine what is going to happen when growth is falling back to 3-4% levels and millions of people keep rushing into those cities…
One can wonder what this has to do with the current crisis. In the short term probably not much. China has enough of financial reserves to manage these social unrests for now. However in the long run it might be, given the huge exodus that is still expected ( 350 mio people even outpaces the total population of the USA!!!) they would have to dig very deep in their reserves to keep this situation under control. As indicated in our previous newsletter it might very well be possible that at a certain stage the Chinese government might be forced to unwind their strategic investments to buy off social unrests. This would trigger huge changes in exchange rates and interest rates.
To give you an idea what the impact could be, just look at the recent move in EURUSD in the last 3 weeks. The EURO rallied sharply from 1.28 to all the way up to 1.46. One of the major drivers behind this move was the Peoples Bank of China who was diversifying at least a minor part of its reserves away from the USD. During that period they bought about USD 60 bio of EURUSD starting from the 1.25 area. A big chunk of that came from emerging market bonds denominated in USD which came to maturity and which were not rolled over. If a move of USD 60 yards can trigger this kind of volatility in the market, imagine what it would trigger when they would have to use only 20-25% of these reserves. For the record, the reserves of China’s central bank are estimated at USD 1.7 trillion at the moment.
The Chinese government is aware of these developments and is anticipating to that in a way you can only expect from totalitarian regimes. At this very moment they are modernizing and expanding their army. This is not for the purpose to conquer the world but to maintain domestic order. One can compare it with the military of Saudi Arabia. To support this thesis, in March 2007 the Chinese government announced they would increase their military spending by 18 % annually. This was the biggest increase in more than 10 years. This is also called the ‘Dark Theory’ which goes around in the highest Japanese intellectual circles nowadays.[6]
[1] http://givanomics.blogspot.com/2008/12/its-all-in-curve-or-scary-story-on.html
[2] C. Chan, M. D’Arcy, S. Hill and F. Ophaso : “Demographic Consequences of China’s One-Child Policy”, April 2006, University of Michigan
[3] Research numbers JP Morgan 2006
[4] Dr. Philip James, chairman of the International Obesity Task Force, quoted in “Study Foresees Soaring Rate of Childhood Obesity,” March 6, 2006. Xinhua News. http://news.xinhuanet.com/english/2006-03/06/content_4263297.htm.
[5] Thomas Lum, “Social unrest in China”, may8, 2006
[6] For more insight we refer to D. Smick “The World is Curved, 2008 Marshall Cavendish
www.theworldiscurved.com
Tuesday 23 December 2008
Thursday 18 December 2008
It's all in the curve... or a scary story on Deflation
Dear readers,
This is an article I wrote on the 5th of December as part of my research job I am doing at EAB, but I thought it still would be relevant to share. The FED decision earlier this week has made this article even more relevant, and the debate about demonetizing debt will resume.
As we are working ourselves through the credit crisis and the recession we will regularly look back to see what got us into this and try to learn from the past in order to avoid the same mistakes are made. This morning we were discussing Kaletsky’s column in the Times. Apart from which camp you are in, the doom and gloom supporters or the band that kept on playing on the Titanic, the measures that have been taken will take time before they start showing signs of economic improvement.
Kaletsky has a valid point that most of the Central Banks are ahead of the curve this time and flooding the market with liquidity and cutting rates like there is no tomorrow. At least on the monetary front people learned from the mistakes that were made in the past. Japan is in every central bankers text book nowadays how things should NOT been done.
To refresh your memory, let us go back in time and see what exactly happened there, and whether this might give us some insights whether history will repeat itself?
Japan in the eighties was the China of today. It was the economical miracle of the century, even more than the impressive turn around that Germany experienced after WW II. After the Plaza Accord[1] the JPY rallied dramatically against the USD. Especially in the late 80-ties they were using their JPY strength to buy up the world, with the most eye catching move the purchase of the Rockefeller Centre in NY. It was a sign of the times their economy was becoming a bubble. Everything rose on a day-by-day basis. Stocks (Nikkei went from 20.000 to just below 39.000 in 2 years) and real estate went through the roof.
Property became highly inflated due to reckless financing by Japanese banks, similar to what American banks did during the last decade, but with one exception: in Japan there wasn’t subprime involved and even less SIV’s and shadow banking (proving by the way, as I have always said, that one does not need fancy derivatives or synthetic instruments in order to lose money!).
The only similarity with the current crisis was that models assumed that real estate couldn’t drop, or certainly could not drop on a national level. Typical for every bubble the talk of the street was TINA (there is no alternative) or ‘this time it is different’. But it wasn’t. All bubbles pop, one more brutally than the other, but burst they do. What ultimately triggered the sell off in the Nikkei is difficult to say even now, as this is more an area for behavioural finance. Lemmings behaviour is part of the explanation as markets get ahead of themselves. However, usually one can also look at the build up of all this and there one ends up with human error. This is a people business after all, and some people are just better at their jobs than others…
What was the human error in Japan? The reckless behaviour of banks? No. This was only the consequence of a far more serious error. As was pointed out above, the JPY started to strengthen on the back of the Plaza Accord. The Bank of Japan (BoJ), under political pressure, tried to counter the negative impact of JPY strengthening on their export competitiveness by lowering interest rates even all the way to 2.5% at the beginning of 1987. Only 2 years later Japanese officials started to realize the mistake they made, and started to hike aggressively all the way up to 6%. They actually kept on hiking far beyond the burst of their bubble.
The latter is the big difference with today. At this moment especially the FED and BoE – the ECB is more lagging in all this – showed strong signs of leadership., however especially the FED has played its cards on the short term interest rate front, and similar as the BoJ in the late 90-ties, is facing the liquidity trap. Basically this means that a central bank is unable to continue to stimulate the economy with the traditional monetary tools, being the discount rate, as it is already close to zero. As a consequence an even more uglier ghost shows up : DEFLATION.[2]
Let us first explain why the FED doesn’t have a lot of room to manoeuvre anymore with the classical monetary tools, given the fact that FED fund rates are still at 1 %. The simple answer to that question is the money market industry. Especially in the US the business model of money market funds breaks down when rates drop below 0.5 %. The reason for that is because of their fee income.
Money Market Funds Fee structure
Fee bp Assets($bio) %
> 75 235 7%
50-74 613 19%
25-49 736 23%
< 25 1.619 51%
Total 3.203
Source : Bank of America
This is a fee they charge for managing the fund. As a consequence, at a certain point the assets of the fund will not generate enough return to pay the fees of the manager and simultaneously offer a return to the investor/client.
This means that the Fed has still one more bullet of 50 bp to go before the liquidity trap is turning around the corner for them.
However there are other tools that a central bank can use in case of deflation, and Bernanke already gave a hint back in November 2002 :
“To stimulate aggregate spending when short-term interest rates have reached zero, the Fed must expand the scale of its asset purchases or, possibly, expand the menu of assets that it buys. Alternatively, the Fed could find other ways of injecting money into the system--for example, by making low-interest-rate loans to banks or cooperating with the fiscal authorities. Each method of adding money to the economy has advantages and drawbacks, both technical and economic. One important concern in practice is that calibrating the economic effects of nonstandard means of injecting money may be difficult, given our relative lack of experience with such policies. Thus, as I have stressed already, prevention of deflation remains preferable to having to cure it. If we do fall into deflation, however, we can take comfort that the logic of the printing press example must assert itself, and sufficient injections of money will ultimately always reverse a deflation.
So what then might the Fed do if its target interest rate, the overnight federal funds rate, fell to zero? One relatively straightforward extension of current procedures would be to try to stimulate spending by lowering rates further out along the Treasury term structure--that is, rates on government bonds of longer maturities.”[3]
Whether we will be dragged into a deflationary spiral is not clear yet, because there will be other forces into play which can have an influence on this. China for instance will be an important factor in all this. When the Chinese bubble bursts, and trust us it will, it can either result into deflation or inflation. It all depends how the Chinese government would react. Deflation risks would come in case of the consequential economic slowdown. As a result China would have no other choice to dump the stocks of commodities that they have been building up recently and next to that the world markets would be flooded with Chinese finished goods at fire sales prices.
An inflation outcome is also possible in case the Chinese government would act under extreme internal social unrests and withdraw their massive reserves from the global system to use these sources to buy off social riots. This would raise interest rates because one would need to buy off the Chinese bond holdings and central banks would have to increase the money supply. We will pay more attention to the potential social problems of China in one of our following news letters to explain the above.
What we are trying to explain is given the current imbalances it is a very difficult call what the final outcome will be, however for 2009 we think that the chances of dealing with / proactively fighting deflation are quite high, as Bernanke prefers to prevent it instead of to cure it.
Why do we think deflationary forces might be an issue next year?
Recessions and bubbles have per definition a deflationary effect
Financial institutions will have to continue deleveraging
US consumer will be forced to save and cut expenses due to credit limitations
Commodity prices are falling ( China is already reducing their stocks)
Considerable slowdown in the velocity of money
This view is also reflected in the swap market. Since last week we saw a strange phenomenon. The swap spread between the 10 years and 30 years in USD (but also EUR’s) is starting to invert. In the US Treasury market we don’t see this yet. So basically the swap market is already anticipating that the FED somewhere in the future will be forced to start using unorthodox monetary tools to fight the deflation ghost.
Cfr. Bloomberg Chart Swaps USD 10 – 30
Cfr. Bloomberg Chart US Treasuries 10 – 30
I wish you a very good trading week.
---------------------------------------------
Gino Landuyt
[1] Plaza Accord was put in place to weaken the USD and address the trade imbalances that were build up with the USA
[2] For a more detailed discussion see D. Smick in “The world is curved” – Chapter 5 : “Japanese Housewives take the commanding heights.”
[3] Speech by Governor Ben Bernanke before the National Economists Club, Washington. “Deflation: Making sure ‘it’ doesn’t happen here.”
This is an article I wrote on the 5th of December as part of my research job I am doing at EAB, but I thought it still would be relevant to share. The FED decision earlier this week has made this article even more relevant, and the debate about demonetizing debt will resume.
As we are working ourselves through the credit crisis and the recession we will regularly look back to see what got us into this and try to learn from the past in order to avoid the same mistakes are made. This morning we were discussing Kaletsky’s column in the Times. Apart from which camp you are in, the doom and gloom supporters or the band that kept on playing on the Titanic, the measures that have been taken will take time before they start showing signs of economic improvement.
Kaletsky has a valid point that most of the Central Banks are ahead of the curve this time and flooding the market with liquidity and cutting rates like there is no tomorrow. At least on the monetary front people learned from the mistakes that were made in the past. Japan is in every central bankers text book nowadays how things should NOT been done.
To refresh your memory, let us go back in time and see what exactly happened there, and whether this might give us some insights whether history will repeat itself?
Japan in the eighties was the China of today. It was the economical miracle of the century, even more than the impressive turn around that Germany experienced after WW II. After the Plaza Accord[1] the JPY rallied dramatically against the USD. Especially in the late 80-ties they were using their JPY strength to buy up the world, with the most eye catching move the purchase of the Rockefeller Centre in NY. It was a sign of the times their economy was becoming a bubble. Everything rose on a day-by-day basis. Stocks (Nikkei went from 20.000 to just below 39.000 in 2 years) and real estate went through the roof.
Property became highly inflated due to reckless financing by Japanese banks, similar to what American banks did during the last decade, but with one exception: in Japan there wasn’t subprime involved and even less SIV’s and shadow banking (proving by the way, as I have always said, that one does not need fancy derivatives or synthetic instruments in order to lose money!).
The only similarity with the current crisis was that models assumed that real estate couldn’t drop, or certainly could not drop on a national level. Typical for every bubble the talk of the street was TINA (there is no alternative) or ‘this time it is different’. But it wasn’t. All bubbles pop, one more brutally than the other, but burst they do. What ultimately triggered the sell off in the Nikkei is difficult to say even now, as this is more an area for behavioural finance. Lemmings behaviour is part of the explanation as markets get ahead of themselves. However, usually one can also look at the build up of all this and there one ends up with human error. This is a people business after all, and some people are just better at their jobs than others…
What was the human error in Japan? The reckless behaviour of banks? No. This was only the consequence of a far more serious error. As was pointed out above, the JPY started to strengthen on the back of the Plaza Accord. The Bank of Japan (BoJ), under political pressure, tried to counter the negative impact of JPY strengthening on their export competitiveness by lowering interest rates even all the way to 2.5% at the beginning of 1987. Only 2 years later Japanese officials started to realize the mistake they made, and started to hike aggressively all the way up to 6%. They actually kept on hiking far beyond the burst of their bubble.
The latter is the big difference with today. At this moment especially the FED and BoE – the ECB is more lagging in all this – showed strong signs of leadership., however especially the FED has played its cards on the short term interest rate front, and similar as the BoJ in the late 90-ties, is facing the liquidity trap. Basically this means that a central bank is unable to continue to stimulate the economy with the traditional monetary tools, being the discount rate, as it is already close to zero. As a consequence an even more uglier ghost shows up : DEFLATION.[2]
Let us first explain why the FED doesn’t have a lot of room to manoeuvre anymore with the classical monetary tools, given the fact that FED fund rates are still at 1 %. The simple answer to that question is the money market industry. Especially in the US the business model of money market funds breaks down when rates drop below 0.5 %. The reason for that is because of their fee income.
Money Market Funds Fee structure
Fee bp Assets($bio) %
> 75 235 7%
50-74 613 19%
25-49 736 23%
< 25 1.619 51%
Total 3.203
Source : Bank of America
This is a fee they charge for managing the fund. As a consequence, at a certain point the assets of the fund will not generate enough return to pay the fees of the manager and simultaneously offer a return to the investor/client.
This means that the Fed has still one more bullet of 50 bp to go before the liquidity trap is turning around the corner for them.
However there are other tools that a central bank can use in case of deflation, and Bernanke already gave a hint back in November 2002 :
“To stimulate aggregate spending when short-term interest rates have reached zero, the Fed must expand the scale of its asset purchases or, possibly, expand the menu of assets that it buys. Alternatively, the Fed could find other ways of injecting money into the system--for example, by making low-interest-rate loans to banks or cooperating with the fiscal authorities. Each method of adding money to the economy has advantages and drawbacks, both technical and economic. One important concern in practice is that calibrating the economic effects of nonstandard means of injecting money may be difficult, given our relative lack of experience with such policies. Thus, as I have stressed already, prevention of deflation remains preferable to having to cure it. If we do fall into deflation, however, we can take comfort that the logic of the printing press example must assert itself, and sufficient injections of money will ultimately always reverse a deflation.
So what then might the Fed do if its target interest rate, the overnight federal funds rate, fell to zero? One relatively straightforward extension of current procedures would be to try to stimulate spending by lowering rates further out along the Treasury term structure--that is, rates on government bonds of longer maturities.”[3]
Whether we will be dragged into a deflationary spiral is not clear yet, because there will be other forces into play which can have an influence on this. China for instance will be an important factor in all this. When the Chinese bubble bursts, and trust us it will, it can either result into deflation or inflation. It all depends how the Chinese government would react. Deflation risks would come in case of the consequential economic slowdown. As a result China would have no other choice to dump the stocks of commodities that they have been building up recently and next to that the world markets would be flooded with Chinese finished goods at fire sales prices.
An inflation outcome is also possible in case the Chinese government would act under extreme internal social unrests and withdraw their massive reserves from the global system to use these sources to buy off social riots. This would raise interest rates because one would need to buy off the Chinese bond holdings and central banks would have to increase the money supply. We will pay more attention to the potential social problems of China in one of our following news letters to explain the above.
What we are trying to explain is given the current imbalances it is a very difficult call what the final outcome will be, however for 2009 we think that the chances of dealing with / proactively fighting deflation are quite high, as Bernanke prefers to prevent it instead of to cure it.
Why do we think deflationary forces might be an issue next year?
Recessions and bubbles have per definition a deflationary effect
Financial institutions will have to continue deleveraging
US consumer will be forced to save and cut expenses due to credit limitations
Commodity prices are falling ( China is already reducing their stocks)
Considerable slowdown in the velocity of money
This view is also reflected in the swap market. Since last week we saw a strange phenomenon. The swap spread between the 10 years and 30 years in USD (but also EUR’s) is starting to invert. In the US Treasury market we don’t see this yet. So basically the swap market is already anticipating that the FED somewhere in the future will be forced to start using unorthodox monetary tools to fight the deflation ghost.
Cfr. Bloomberg Chart Swaps USD 10 – 30
Cfr. Bloomberg Chart US Treasuries 10 – 30
I wish you a very good trading week.
---------------------------------------------
Gino Landuyt
[1] Plaza Accord was put in place to weaken the USD and address the trade imbalances that were build up with the USA
[2] For a more detailed discussion see D. Smick in “The world is curved” – Chapter 5 : “Japanese Housewives take the commanding heights.”
[3] Speech by Governor Ben Bernanke before the National Economists Club, Washington. “Deflation: Making sure ‘it’ doesn’t happen here.”
Tuesday 16 December 2008
Globalization and the merits of securitization
Dear readers,
Since the crisis broke out mid 2007 a witch hunt was organized to find the scapegoats who brought us into this. In a discussion like this you always end up with the banks and their financial weapons of mass destruction as Warren Buffet used to call them. It might be wise though to take a step back and leave the emotions aside in this debate. The last thing we want to do is throwing the child with the bath water away.
What most people often forget is that the current crisis goes far beyond the use of derivatives, securitization, CDO’s and Structured Investment Vehicles (SIV’s). The dynamics which created the global imbalances were US consumers who bought goods from Asia and energy from oil exporting countries. The best way to illustrate this trend is by referring to the evolution of the trade balance of the US.
Chart 1 : US Trade Balance : 1968 - 2008
Since the crisis broke out mid 2007 a witch hunt was organized to find the scapegoats who brought us into this. In a discussion like this you always end up with the banks and their financial weapons of mass destruction as Warren Buffet used to call them. It might be wise though to take a step back and leave the emotions aside in this debate. The last thing we want to do is throwing the child with the bath water away.
What most people often forget is that the current crisis goes far beyond the use of derivatives, securitization, CDO’s and Structured Investment Vehicles (SIV’s). The dynamics which created the global imbalances were US consumers who bought goods from Asia and energy from oil exporting countries. The best way to illustrate this trend is by referring to the evolution of the trade balance of the US.
Chart 1 : US Trade Balance : 1968 - 2008
Source : Bloomberg
However, the value of those goods was far much greater then their consumer income. As a result they had to fund this gap with home equity and/or mortgage refinancing. The rising of the US mortgage debt was on its turn repackaged by US investment banks and placed among Asian and oil exporting countries. The major mistake in this model was the assumption of the rating agencies (plus from investors as well) that the value of house assets would never decline, certainly not on a national level (cfr. Newsletter of 5 Dec.)
As with all bubbles is the case, one usually gets an acceleration at the end. This happened when investment banks started their Shadow Banking system, where they decided to set up SIV’s in which they could undertake activities which didn’t need the capital backing which would be required by the regulator if this was applied ‘on balance’ sheet. Under this activity the technique of securitization was (ab)used. For those who are not familiar with this technique, it is best described as bundling a number of individual loans into a reference pool. On its turn one divides this pool up into several tranches of risk. Each investor can pick out a tranche in relation to its risk appetite.
There are two important things to remember though:
this whole process of creating a global imbalance started long before the Shadow Banking System (cfr. Chart 1 : US Trade Balance)
the abuse of a valuable technique called securitization, was driven by pure greed
The question we need to ask: “Does securitization has its benefits and merits?” To answer this we need to look at the journey of globalization and the liberalization of markets over the last 25 years. It goes beyond a doubt that the G-10 countries experienced a remarkable period of rising wealth and falling unemployment during that time. But did globalization contribute to a decline of poverty on a more global scale?
This question was answered by Surjit Bhalla, who used to work for Goldman Sachs and the World Bank. He compared 2 periods, 1950-1980 where the World Bank and other international agencies pumped in billions of dollars of government money in developing countries and the era of globalization starting around the early 1980s. He concluded that poverty even rose during the period of considerable international aid and poverty only started to decline when free trade and liberalization was embraced across the global. This fell together with globalization, when communication, transportation and production costs were considerably reduced.[1]
Also Greenspan came to a similar more intuitive conclusion by arguing that the first who would suffer from a set back of globalization would quite ironically be those in the developing countries.[2] This to the great upset of the anti-globalist movement that is still lingering among left intellectualists.
It is not a coincidence that during the era of globalization we noticed an exponential rise of derivatives products. [3]
However, the value of those goods was far much greater then their consumer income. As a result they had to fund this gap with home equity and/or mortgage refinancing. The rising of the US mortgage debt was on its turn repackaged by US investment banks and placed among Asian and oil exporting countries. The major mistake in this model was the assumption of the rating agencies (plus from investors as well) that the value of house assets would never decline, certainly not on a national level (cfr. Newsletter of 5 Dec.)
As with all bubbles is the case, one usually gets an acceleration at the end. This happened when investment banks started their Shadow Banking system, where they decided to set up SIV’s in which they could undertake activities which didn’t need the capital backing which would be required by the regulator if this was applied ‘on balance’ sheet. Under this activity the technique of securitization was (ab)used. For those who are not familiar with this technique, it is best described as bundling a number of individual loans into a reference pool. On its turn one divides this pool up into several tranches of risk. Each investor can pick out a tranche in relation to its risk appetite.
There are two important things to remember though:
this whole process of creating a global imbalance started long before the Shadow Banking System (cfr. Chart 1 : US Trade Balance)
the abuse of a valuable technique called securitization, was driven by pure greed
The question we need to ask: “Does securitization has its benefits and merits?” To answer this we need to look at the journey of globalization and the liberalization of markets over the last 25 years. It goes beyond a doubt that the G-10 countries experienced a remarkable period of rising wealth and falling unemployment during that time. But did globalization contribute to a decline of poverty on a more global scale?
This question was answered by Surjit Bhalla, who used to work for Goldman Sachs and the World Bank. He compared 2 periods, 1950-1980 where the World Bank and other international agencies pumped in billions of dollars of government money in developing countries and the era of globalization starting around the early 1980s. He concluded that poverty even rose during the period of considerable international aid and poverty only started to decline when free trade and liberalization was embraced across the global. This fell together with globalization, when communication, transportation and production costs were considerably reduced.[1]
Also Greenspan came to a similar more intuitive conclusion by arguing that the first who would suffer from a set back of globalization would quite ironically be those in the developing countries.[2] This to the great upset of the anti-globalist movement that is still lingering among left intellectualists.
It is not a coincidence that during the era of globalization we noticed an exponential rise of derivatives products. [3]
The financial innovation that we knew over the last 25 years was a major contributor to let globalization flourish across the globe. The growth in derivatives reduced barriers and opened up markets to investors who would never been able to enter these initially. Securitization played a major role in this financial innovation process. Due to its characteristics of tranching a pool of loans in different risk categories it enables venture capitalists to participate in funding major projects, and this to the most broadest sense of the word.
A very good example is the securitization programme that Deutsche Bank launched in the microcredit market. Microcredit are very small loans which are extended to the unemployed, and extremely poor who lack collateral or who don’t have a credit history. Microcredit is a financial innovation which originated in Bangladesh where it has successfully enabled extremely impoverished people to engage in self employment projects that allow them to generate an income and, in many cases, begin to build wealth and exit poverty.
By securitizing such a deal Deutsche Bank enabled private and ethical institutional investors to participate in the financing of this and make an effective contribution to the fight against poverty by distributing at least 120,000 very small loans to micro businesses in 15 developing and emerging market countries.
There are many other examples to show that securitization is a valuable tool and has its merits. Chief Investment Officer of Pimco, the largest bond manager in the world, Mohamed El- Erian, described it very well. Securitization broadens the potential group of buyers and sellers due to its characteristics of diversification and customization. As a result it increases liquidity and simultaneously reduces transaction costs. “The combination of greater liquidity, diversification, customization is illustrative of the more general process of integration of financial markets. Like other components of this process, it is subject to excesses, including overproduction and overconsumption, but this need not necessarily derail the phenomenon over the medium term. Indeed, it may even render it more sustainable over the long term.”[4]
Gino Landuyt
[1] Surjit Bhalla in Imagine There’s No Country : Poverty, Inequality and Growth in the Era of Globalization ( Peterson Institute, Oct 2002)
[2] Alan Greenspan in The Age of Turbulence: Adventures in a New World (Penguin Press, 2007)
[3] Bank for International Settlements (BIS) Triennial and regular OTC Derivatives Market Statistics, November 2007
[4] Mohamed El-Erian in “When Markets Collide. Investment Strategies for the Age of Global Economic Change.” (McGraw Hill 2008)
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