Too big to fail..too big to save..too small to repay.

Are today’s banks too big to save or to (let) fail ? Does the current system creates some kind of moral hazard towards big banks which are able to pay back their debt more easily ?

Here are some ideas :

Firstly, the opinion of Alan Schwartz, chief executive of Bear Stearns in the middle of the financial crisis. The video can be found at the website of CNN.

Secondly, the NYTimes published a nice overview of the changing market values of the American financial institutions.

Vacation.

Taking with me for some ‘beach-reading’ : ‘Animal Spirits: How Human Psychology Drives the Economy, and Why It Matters for Global Capitalism by George A. Akerlof and Robert J. Shiller’ and ‘The Black Swan by Nassim Taleb’.

Opinion BCBS concerning replacement of IAS 39.

I just saw a new publication on the Basel website : Guiding principles for the replacement of IAS 39. Here are some highlights :

The new two-category approach for financial instruments should not result in an expansion of fair value accounting, in particular through profit and loss for institutions involved in credit intermediation.

The new standard should:
(a) reflect the need for earlier recognition of loan losses to ensure robust provisions;
(b) recognise that fair value is not effective when markets became dislocated or are illiquid;
(c) permit reclassifications from the fair value to the amortised cost category; this should be allowed in rare circumstances following the occurrence of events having clearly led to a change in the business model;
(d) promote a level playing field across jurisdictions.

Loan loss provisioning should be robust and based on sound methodologies that reflect expected credit losses in the banks’ existing loan portfolio over the life of the portfolio. The allowance or provision should be presented separately from total loans. The accounting model for provisioning should allow early identification and recognition of losses by incorporating a broader range of available credit information than presently included in the incurred loss model and should result in an earlier identification of credit losses. For the purpose of these principles, expected credit losses are estimated losses on a loan portfolio over the life of the loans and considering the loss experience over the complete economic cycle.

The new standard should apply the same impairment approach to all financial assets measured using amortised cost.

I guess these kind of recommendations could be expected. The only thing I am not sure of is that we will have less financial instruments at fair value under the proposed new standard.

Emerging markets.

‘A picture says more than a 1000 words..a graph is probably worth more’

 

 

 

 

 

 

 

 

 

 

 

 

 

Read the whole article here.

Hat tip : Econoshock : http://bit.ly/15SdYA

To burst or not to burst.

Give me your opinion, what will be the next bubble?

(1) Commercial real estate.

(2) Higher education.

(3) Carbon trading.

(4) Exchange-traded funds (ETFs).

(5) Food and water.

(6) China.

(7) Governments and central banks.

(8) Bubbles ? The housing bubble was the last one to occur.

(9) Another one : ….

I will try to provide some background articles for each subject later this week.

Non-normality of market returns.

The distribution of market returns is a quite difficult topic (at least in my humble opinion). However, I already wrote something about it a month ago. Here are some more insights based upon a white paper of JP Morgan Research.

The authors address two specific weaknesses in the current conventional risk assessments, which lead to underestimations of the portfolio risk :

• Frameworks assuming “normality”: In broad scope, conventional asset allocation frameworks make a range of assumptions about the “normality” of asset returns, the most problematic of which are that returns are independent from period to period and normally distributed. In reality, we can observe that in many cases returns are not independent, and in all cases they are not normally distributed.

• Inadequate risk measures: If one adopts an asset allocation framework that incorporates non-normality, then standard deviation becomes ineffective as the primary quantifier of portfolio risk.

Furthermore they conclude the following :

We believe that conventionally derived portfolios carry a higher level of downside risk than many investors believe, or current portfolio modeling techniques can identify. The primary reason for this underestimation of risk lies in the conventional approach to applying mean-variance theory, which was pioneered by Harry Markowitz in 1952. Such assumptions of “normality” have appeal due to the ease with which they can be implemented.

Next step, three main issues which cause non-normality :

(1) Serial correlation, if not adjusted for in the underlying data, masks true asset class volatility and biases risk estimates downwards, leading to underestimation of overall portfolio risk.
(2) An asset allocation framework based on the normal distribution will understate both the frequency and magnitude of extreme negative events, as well as their potential effects on portfolio returns and efficiency.
(3) Relying on linear correlation matrices tends to overestimate the benefits of portfolio diversification during periods of high market volatility. This leads to a systematic underestimation of downside portfolio risk.

The final step is to suggest possible solutions for these three elements. The paper contains an illustration of how to incorporate non-normality into a model on page 23. At the end, the authors also suggest Conditional Value at Risk (CVaR) as a possible solution to overcome the drawbacks of the more conventional risk measure (read : standard deviation).

Biggest companies of the moment.

Every day, the Economist publishes a so-called daily chart. Last week, the biggest publicly listed companies by market capitalisation were compared to see what they lost (in terms of market cap) during the past year.

The market capitalisation of PetroChina may have fallen by almost half in the past year, but it remains the world’s most valuable publicly listed company. Chinese firms now occupy three of the top four slots. (The state’s large non-traded holdings are valued at market prices.) Seven of the 12 most valuable companies are either banks or oil producers. Wal-Mart, Johnson & Johnson and Procter & Gamble have all climbed the table in the past year; their industries tend to weather recessions better than others. Market capitalisation does not necessarily tally with other measures of size. Microsoft is worth more than Royal Dutch Shell, which has nearly eight times the revenue of the software company and 10,000 more employees.

The Black Swan Squawks : Taleb and Roubini

The Black Swan Squawks – CNBC.com

I was too young to read it at that time (1999)…

Fannie Mae Eases Credit To Aid Mortgage Lending. Published : Thursday, September 30, 1999. NYTimes.

In a move that could help increase home ownership rates among minorities and low-income consumers, the Fannie Mae Corporation is easing the credit requirements on loans that it will purchase from banks and other lenders

Fannie Mae, the nation’s biggest underwriter of home mortgages, has been under increasing pressure from the Clinton Administration to expand mortgage loans among low and moderate income people and felt pressure from stock holders to maintain its phenomenal growth in profits.

In addition, banks, thrift institutions and mortgage companies have been pressing Fannie Mae to help them make more loans to so-called subprime borrowers. These borrowers whose incomes, credit ratings and savings are not good enough to qualify for conventional loans, can only get loans from finance companies that charge much higher interest rates — anywhere from three to four percentage points higher than conventional loans.

”Fannie Mae has expanded home ownership for millions of families in the 1990’s by reducing down payment requirements,” said Franklin D. Raines, Fannie Mae’s chairman and chief executive officer. ”Yet there remain too many borrowers whose credit is just a notch below what our underwriting has required who have been relegated to paying significantly higher mortgage rates in the so-called subprime market.”

Fannie Mae, the nation’s biggest underwriter of home mortgages, does not lend money directly to consumers. Instead, it purchases loans that banks make on what is called the secondary market. By expanding the type of loans that it will buy, Fannie Mae is hoping to spur banks to make more loans to people with less-than-stellar credit ratings.

”From the perspective of many people, including me, this is another thrift industry growing up around us,” said Peter Wallison a resident fellow at the American Enterprise Institute. ”If they fail, the government will have to step up and bail them out the way it stepped up and bailed out the thrift industry.”

No further comment.

Carbon trading : the next bubble ?

During the last couple years, the carbon emission trading market experienced a boom :

Source : The World Bank : Carbon Finance Unit.  Annual report 2008.

As you can see, the European Union Emission Trading Scheme (EU ETS) contributes the most to the overall value of transactions. Since 2005, some 10,000 large industrial plants in the EU have been required to buy and sell permits to release carbon dioxide into the atmosphere. An ETS enables companies that exceed individual CO2 emissions targets to buy allowances from ‘greener’ ones to help reach the EU’s targets under the Kyoto Protocol. In other words, the EU ETS is a international trading system for CO2 emissions. In the meantime, the EU improved the system. Firstly, because of over-allocation of allowances, the member states decided to lower the total amount of allowances (for the period starting in mid-2008). Furthermore, thanks to an overall review and evaluation of the system, some changes were approved by the member states in December 2008. Among others, the member states agreed that a higher percentage of allowances will be auctioned by 2013. Also by 2020, the EU will ‘cap’ the total EU industrial emissions at 21% below 2005 levels. With these kind of changes in mind, you could expect the price of carbon credits to rise again in the future.

Let us now turn to the American carbon market. Last week, I saw an interesting article at WallStreet Technology : ‘Is carbon trading the next big thing ?’. I would like to quote some parts of it :

The fledgling U.S. carbon credit market, currently a $100 million-plus business, is poised to skyrocket if The American Clean Energy and Security Act of 2009, which recently was passed by the House, makes it through the Senate. The bill would limit, or “cap,” the amount of carbon emissions that companies can produce each year. Under the bill, sponsored by Representatives Henry Waxman (D-CA) and Edward Markey (D-MA), firms that produce more greenhouse gases than they’re allowed would be able to buy credits from companies that have produced fewer emissions than they’re allotted, creating a large market for carbon credits. President Obama has estimated that more than a half-trillion dollars’ worth of carbon credits will be auctioned in the first seven years after the bill is enacted.

As you can see, the ‘American Clean Energy and Security Act of 2009′ would impose a quite similar cap-and-trade system as currently being employed in Europe. For the moment, only a voluntary carbon credit trading market exists in America.

The European carbon market has been growing quickly; the U.S. market still is in its infancy. Trading activity in the European Emissions Trading Scheme grew by 54 percent in the first quarter of 2009 compared to Q4 2008, reaching $28 billion, according to Carbon Finance. This represented 84 percent of the world’s carbon market in terms of value and 78 percent of its volume. Carbon trading in the U.S., on the other hand, made up only 3.7 percent of the trading volume and 1 percent of the value of the global carbon market.

What can be expected in the future ?

Even as firms build out their carbon credit trading capabilities, the market is expected to reach significant levels fairly quickly. President Obama has predicted that about $646 billion worth of carbon credits will be auctioned in the first seven years of the mandatory cap-and-trade system in the U.S.; others have suggested the number could be two or three times that. Trayport’s Pejman notes that once the legislation is passed, there will be a race to the market. “Whoever is already in production will have a tremendous advantage over those that are scrambling to get ready,” he asserts.

To finish, the price evolution. As an example, I took a graph of the European Climate Exchange. The current spot price of EU permits is around €14…but probably will rise again in the future.

 

(BTW, the carbon market is also mentioned as one of the next bubbles in a ‘famous’ article about an investment bank. I didn’t feel the need to mention this article again but most of you probably know which one I am referring to.)