Tag Archives: finance

The New Normal

With the Intergenerational Report now released, the meme of “intergenerational theft” is spreading. Bill Mitchell has already shredded the core assumptions of the report, and now first time guest author Andrew Baume brings to the Mule brings the perspective of a financial markets practitioner to our possible future wealth. In broad strokes, he concludes

post-paid retirement is now the exception not the rule
the balance sheet that supports your retirement is now your own
absence of inflation is the enemy

Many older Australians have ridden the magic carpet of high levels of inflation which brought asset valuations to today’s levels. This has been particularly felt in the property market which has been the foundation for most of the “unearned” growth in asset base for anyone aged 50 or older. Property has been the asset which we have been most comfortable to leverage at incredibly high multiples.

Downsizing has liberated much of this unearned wealth and turned it into retirement income. This transfer is much like Potential Energy being transferred into Kinetic Energy. As with physics there is no perpetual motion machine so the transfer is permanent for those who do it. It is however also true they do continue to store some of the liberated KE but not into the illiquid high ticket indivisible item that the large family home generally represents. It is usually reinvested into different asset classes.

Although investing is a core competence for some, (certainly not this author!) normal people with money have found good clips of that money fall into their lap by having lived somewhere or having contributed to super. They have been comfortable in property because it “always goes up” and over their lives they have traded it as little as twice. Reinvesting the nest egg is a massive step.

Some commentators have made very strong cases for being heavily invested in risk assets post retirement whilst others have argued that timing of shocks can have a massive and unexpected effect on post retirement incomes. Both are right of course but the big impact that seems less understood it the massive shift in post-retirement income from post-paid to pre-paid and how that has fundamentally changed the return equation.

Rates of Return
Once pre-paid retirement hits its straps the clamour for return creates a dynamic associated to the paradox of thrift. As the population ages and demographic analysis promotes the concept that the welfare safety net needs to be drawn tighter, government services are reduced. The need to build a safety net for ourselves drives our return expectations lower and lower as the “best” assets (like bonds and bank shares) are bid upwards and the marginal assets assets (including higher leveraged companies and marginal property assets) benefit from that bid due to a crowding in effect. The impact of this trend has been seen most clearly in the global bond markets.

30 years ago when I started as a foreign exchange and interest rates trader the US 30 year bond was the bellwether for the health of the financial system. It was highly volatile and its movements reflected the broad market’s view of the capacity for the US to manage its (and therefore the world’s) economy. It seemed strange to me at the time that an instrument that was the projected average fed funds rate over the next 30 years would have any movement at all that related to the near term health of the economy.

Its volatility existed because in 1985 most retirement incomes were funded by the issue of that bond and others like it (by other governmental authorities) or by corporate debt in the case of corporate pension providers. Most defined benefit schemes were not close to fully funded so debt financed the pension provider’s obligations.

Chart 1 – US 30 year Treasury yield
Source: Bloomberg

I wish I was smart enough to have bought a zero coupon 30 year US Government bond back then. It would have smacked me in tax over the 30 years, but I would be getting back 17.5 times the money invested this month. As a comparison the US stock index the S&P 500 is up by a factor of 11.7 times (unfair direct comparison because it is not tax adjusted).

These returns happened because the bond market was pricing way too much inflation and the equity market benefitted by there being just enough.

The dynamic in 2015 is the almost total reverse. Equity markets have lofty valuations underpinned by mediocre revenue growth, capital buy backs (as the companies can’t use the capital themselves) and bond yields that are ridiculously low as pre-paid retirement drives yields lower and lower in concert with global government policy of zero rates and Quantitative Easing (QE).

There is little doubt that it is appropriate for governments around the world to try to influence capital to take risk in the current environment. The paradox of thrift has driven risk aversion even further than the salutary lessons of the global financial crisis.

The investment profile of most companies has gone defensive with little entrepreneurialism and widespread equity buy backs. This lack of capital formation sees equity markets continue to rally on flows not earning. Consequently investors have gone massively short volatility –and has done so with one overriding reason near total absence of inflation expectation.

Inflation
Gordon Gekko said “greed is good”. If greed is good and it is fed by a healthy inflation expectation. Inflation has a musky quality, like a magnificent Burgundy it needs to have a little funk, but get too funky and it spoils everything. No funk and you have strawberry cordial. Current markets are strawberry cordial and they are thus by design at the government level reacting to fear still holding the upper hand in the zeitgeist. For the next generations’ sake let’s hope we get some fear back.

Most Baby-Boomers and older have experienced the best fortune inflation can bring you. Liabilities that are nominal in nature against real assets (property and equity) are able to bring massive compounding benefits. As wages grow to match inflation (and employees advance through the ranks) the liabilities whittle away into nothings. Those conditions allowed us to regurgitate the old saying “it’s not timing the market it’s time in the market”. History is a great indicator of history, but absent inflation and with an incredibly long period of defensiveness from a capital formation standpoint it seems ever more likely that the current and next phase of markets will look like little else that has gone before.

In the last two years the Australian Index has increased circa 18% which certainly gives the lie to this argument. That suggests that the drive to low returns is a long way from over, keeping the bid in the equity market strong. It is this authors’s contention that as over 9% of that growth has occurred since the RBA decided the Australian economy was fragile enough to require a rate cut to a level not seen in my lifetime, in fact we are solidly in the execution phase of this return compression. Those of us lucky enough to have money to invest should do so now in any asset with moderate leverage and a high yield.

Once the compression of yields is more complete, the market will roll down one of three clear but quite different paths:

Inflation returns moderately and gradually and allows the central banks around the world to very very slowly unwind the extraordinary accommodation so that the dividend discount model is basically unchanged (i.e. dividends rise as fast as the need to raise rates to combat overstimulation). This path is technically known as Nirvana and we all get to retire rich.
Inflation does not develop for some time meaning returns remain bid down and bond markets globally provide savers with approximately zero income driving investors into earning whatever they can from “real assets”. This is a great outcome for those already invested as they benefit from the compression in returns and their living expenses remain low. The paradox of thrift keeps returns low as fear remains in the system and lack of confidence provides negative feedback loop on inflation and fuels currency devaluation wars. This path is technically known as “the Baby Boomers stealing food from their children’s (and grandchildren’s) mouths.”
Inflation takes some time to develop but when it does it takes a classical monetarist predicted path and smashes valuations very hard as rates back up markedly to try to not just reverse the accommodation but put the brakes on rampant price indiscipline. This path is technically known as “Timing the market has never been so important”

Interestingly path 3 is probably the best outcome for a youngster without much yet in the market. They may have leveraged a bit and after the valuations adjustment works through they get a higher wage and the absolute (not real) level of their assets recovers based on the higher cashflow brought by inflation. Anyone who doubts this should think about their own personal balance sheet in 1973.

The Balance Sheet
When retirement was provided by either a defined benefit scheme or government pension (especially pensions for the government) the issues of timing were completely irrelevant and the investment landscape was also largely irrelevant. Many firms’ pension schemes were “underfunded” and the government did not recognise future liability at all in the budget, only the current FY expense. Someone else’s balance sheet took all the variability. This all changed once governments realised that the unfunded liability would cripple them (admittedly rating agencies had a big role to play in helping them realise this). Post 1987 crash company balance sheets also began to recognize the potentially life threatening exposure that they were taking to equities via their pension schemes.

S&P estimates that the anticipation of quantitative easing in Europe squashed bond yields so much that the liabilities of defined-benefit pension plans rose by up to 18 percent last year. Its analysis looked at the top 50 European companies it rates that have defined-benefit pension plans and are “materially underfunded,” meaning, the plans have deficits of more than 10 percent of adjusted debt, and that debt is more than 1 billion euros. In 2013, liabilities outstripped obligations for that group by more than 30 percent on average.”

Source: Bloomberg

Moves to defined contribution and superannuation guarantees are not localized Australian issues. The world has shifted and as Chart 1 shows one key outcome has been that there is more money to be potentially invested for 30 year debt-like returns than there are creditworthy borrowers who want the money.

Companies that switched to “Liability Driven Investments” to fund their pension schemes more than 7 years ago are less vulnerable. These shortfalls will force many unprepared companies to play catch up in their asset allocations.

Variability is much harder to take in a personal balance sheet when external income is no longer being received (i.e. when you are retired). It seems that extreme variations in equity markets is an inevitable consequence of the current reach for yield unless world economic growth has a strong and sustained recovery that outweighs the downward pressure on valuations from the consequent increase in bond yields. In the case of Japan, time in the market has not been your friend:

Chart 2 – Japan’s Nikkei stockmarket index
Source: Bloomberg

I have actually been generous in this chart as the vertical axis starts well after the 38,915 peak in 1989. It is a dangerous assumption that markets will behave differently in the future than they have in the past, but perhaps this chart shows an economy operating a little like the new normal for the last 20 years. It is also interesting to note the massive rally over the past 12 months has been driven by QE.

Timing of that market would have been one of the most lucrative investments possible and funnily enough it was completely predictable and transparent.

Conclusion
The paradox of thrift has usually been applied to emerging economies where very few social services are supplied by the state. The aging of the population combined with the shift to pre-funded retirement in an environment where social services are being pared back is creating this phenomenon in the advanced economies. This is potentially the most egregious form of intergenerational theft.

The associated absence of inflation will also tend to remove the fantastic wealth building effect of unearned capital appreciation primarily through property. This source of wealth for over 50s may be replicated by modern young parents but the scale of success that older folk have had seems unlikely.

In all but the Nirvana case outlined above the outcome seems clear. The retirement age may stay where it is but the size of the pension relative to retirement income expectations will continue to deteriorate as pension growth does not keep pace with lifestyle. People will have little choice but to continue some form of labour-driven income generation into their late sixties and most likely their 70s. Our personal balance sheet which now bears the risk will demand it.

A set and forget equity portfolio may work but also lead us into a very active post retirement game of catch up. Those with no nest egg may struggle hard to get a retirement savings pool that allows them to leave employment until well into their 70s and further may be subject to violent valuation adjustments.

Wall of Liquidity

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Once again a misconception is gaining currency. There is increased talk of a build up of cash just waiting to be converted into equities or other assets. I wrote about this years ago in cash on the sidelines, but apparently the financial commentariat did not read the post, so it is time to revisit the subject.

I believe that the reason the misconception is so widespread is that the subject is not discussed in technical terms, but in metaphors. Some of you have heard the phrase “the great rotation”, which refers to the idea that investors will shift en masse from cash and bonds to shares. It’s a compelling phrase, but it leaves one question unanswered: who will sell the shares to these rotating investors and, given that these sellers will be paid for their shares, what happens to the money they receive? It’s still cash after all. Likewise, if these rotators are selling their bonds, someone has to buy them. Post-rotation, there is still just as much cash in the system and just as many bonds. Cash and bonds don’t just magically turn into shares. Reality is messy…why spoil a good metaphor?

A simpler, more dramatic and more vacuous metaphor that has also made a reappearance is the “wall of liquidity”.

No one using this compelling phrase would be so crass as to explain what it means. Such is its power, it is assumed that we all know what it means. So, let’s have a look at “wall of liquidity” out in the wild. In an article about rising bank share prices, Michael Bennet wrote in The Australian:

But pump-priming by global central banks has created a so-called wall of liquidity looking for income that is flowing out of cash and into high-dividend-paying stocks, with banks attractive due to their fully franked dividends.

Here it certainly sounds as though “wall of liquidity” is just “cash on the sidelines” in a fancy suit. But let’s zero in for a moment on the other metaphor in this sentence, “pump-priming”. Doubtless, the author has the US Federal Reserve (Fed) in mind. The standard line runs something like this: with low interest rates and purchases of securities through the “QE” (quantitative easing) programs, the Fed has flooded the banks with liquidity. More prosaically, reserve balances (i.e. the accounts banks have with the Fed) have grown. So far so good, as the chart below shows.

The next step in this line of thinking is that as this cash builds, it is a “wall of liquidity” desperate to find somewhere to go and, in the quest for investments, it will push up asset prices.

But before we can accept this reasoning, there is an important point to note. Reserves with the Fed are assets of banks only. Contrary to a common misconception, these reserves cannot be lent, they can only be shuffled around from bank to bank. Nevertheless, there is a theory that, because in the US and some other countries, a certain percentage of bank deposits must be backed by reserve balances, there is a “money multiplier” which determines a fixed relationship between reserve balances and bank deposits*. If this theory is correct, bank deposits should have grown as dramatically as reserve balances. They have not.

M1 money

Taking the same chart and displaying it on a log scale shows that growth in deposit balances has been very steady over the last 20 years.

M2 - log scale

Whatever is going on in financial markets, it has nothing to do with a dramatic build up of cash which is poised to be converted into “risk assets”.

Yet another way to see this is to think about what is going on in Australian banks at the moment. Credit growth is slow in Australia. This is not because banks are reluctant to lend. Quite the contrary. Banks are looking at the slow credit growth and fretting about their ability to deliver the earnings growth that their shareholders have come to expect. The problem is that there is a lack of demand for credit as households and businesses continue to save and pay down debts. In response, banks have begun to compete aggressively on price and, in some cases, on terms to attempt to grow the size of their slice of a pie that is not growing. And yet these very same banks continue to compete for customer deposits. Australian banks are not sitting on vast cash reserves that are compelling them to lend. Rather it is simply renewed risk appetite that is driving banks to compete for lending.

The same is true around the world. Looking at cash balances as a sign that yields will fall and asset prices will rise is a pointless exercise. What is happening is much simpler. Animal spirits are emerging once more. Low interest rates (not cash balances) will help, but fundamentally it is risk appetite that drives markets.

The last time I heard people talking in terms of walls of liquidity was in 2005-2006 in the lead-up to the global financial crisis. These putative piles of cash were used to support a change of paradigm in which the returns for risk could stay low indefinitely. Of course this turned out to be dramatically wrong. The cash didn’t disappear, but risk appetite did. I am not predicting another crash yet, but I do foresee this nonsense being used to justify more risk-taking for lower returns. If that happens for long enough, then there will be another crash.

* As an aside, given that Australia has no minimum reserve requirements, if the money multiplier theory was valid, there should be an infinite amount of deposits in the Australian banking system. For the record, this is not the case.

Photo credit: AP

Trust

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During the week I attended a farewell function for a retiring colleague. The turnout was impressive, a sign of deep respect earned over a career at the bank spanning more than forty years. In the speeches, a recurring theme was trust.

The primary business of a bank is lending money, which exposes the bank to credit risk, the risk that a borrower will be unable to repay the loan. On more than one occasion, our retiring colleague had turned down a loan based on prior bad experiences with the prospective borrower. Why would you lend money to someone who has lied in the past? Learning from past betrayals of trust proved time and again to be a wise risk management strategy.

In Trust: The Social Virtues and The Creation of Prosperity, Francis Fukuyama argues that trust has played a crucial role in the development of capitalism. While some point to the role of the rule of law for enforcing contracts in enabling business, Fukuyama emphasises that legal recourse only serves as a last resort. More important is the simple confidence of a handshake: the confidence that those you do business with will live up to their end of the bargain. Those societies which developed mechanisms for extending trust beyond small networks of families and friends were rewarded with greater economic success.

If trust is important for business, it is particularly so for banking. But, scanning the financial headlines over the last few months shows a banking system apparently intent on destroying society’s trust in banks and bankers.

Serious Fraud Office investigating the rigging of LIBOR rates

Barclays is just the first bank to be fined for allowing traders to manipulate the LIBOR interest rate benchmark. The scandal cost chief executive Bob Diamond his job and this story will be back in the headlines as the findings extend to other banks and civil cases unfold.

HSBC accused of providing a conduit for “drug kingpins and rogue nations”

Before a US Senate hearing, HSBC’s head of compliance faced charges that the bank had acted as knowing banker to Mexican drug cartels. He acknowledged that “there have been some significant areas of failure” and resigned his position there and then.

Standard Chartered alleged to have “schemed” with Iran to launder money

The BBC article in the link above is coy in its language. The New York Department of Financial Services is a little less so. Page 5 of their report quotes a Standard Chartered executive as saying, “You f—ing Americans. Who are you to tell us, the rest of the world, that we‟re not going to deal with Iranians?”

The front page of the Economist epitomises where this has led.

The worldwide reputation of bankers is at its lowest point, in my lifetime at least. The result will be new and more stringent regulation and more intrusive oversight of banks by regulators. This outcome will be well-deserved as banks have proved themselves unworthy of the trust of their communities. However, it is also likely to keep borrowing costs and transaction fees high as banks struggle to deliver shareholder returns while covering the costs of new regulatory requirements. So, it will not just be banks bearing the cost of their misdeeds.

Trust is hard to earn and, once lost, harder to recover. Every bank around the world should be thinking very hard right now about how to restore trust in banks.

Shadow Banking

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The Financial Services Authority (FSA) is the banking and financial services regulator in the UK. For now at least.

Back in 2010, the Chancellor of the Exchequer (the equivalent of the Treasury in Australian terms) announced plans to scrap the FSA in response to a failure during the financial crisis of the 10 year old “tri-partite system”. This tri-partite system split responsibility for national financial stability management between the Treasury, the Bank of England and the FSA. The government is now working on shifting responsibility back from the FSA to the Bank of England, a process which will establish three new regulatory bodies: the Financial Policy Committee (FPC), the Prudential Regulation Authority (PRA) and the Financial Conduct Authority (FCA). More three-letter initialisations and, dare I say it, a new tri-partite system?

Until this process is complete, the FSA continues about its business. The chairman of the FSA is Lord Adair Turner, Baron of Ecchinswell. Turner is also a member of the steering committee of the G20 Financial Stability Board (FSB). In March this year, he spoke at the London CASS business school on the topic of “shadow banking” and its role in the financial crisis.

Shadow banking, a term coined by Paul McCulley in the early days of the crisis, refers to a diverse range of entities such as “structured investment vehicles” (SIVs), hedge funds and money-market funds which have evolved to provide some very similar functions to banks, while not being subject to the same regulatory controls. A nightmare scenario for any bank is a “run”, when too many people try to withdraw their deposits at the same time. Shadow banks can also fall victim to runs. These runs may not be very obvious outside the financial markets, there are no queues of angry depositors on the streets, but they can be just as dangerous and runs on shadow banks were in fact a major factor underlying the global financial crisis. For this reason, regulators like Turner and the FSB are not only focused on strengthening controls on banks, but on better understanding shadow banks and, if possible, subjecting them to regulation to reduce the chances of future financial crises.

So what is it that shadow banks do? To answer that, I’ll first go back to the basics of banking. Although banks have evolved to provide many other products and services, the essence of banking is taking deposits and providing loans. The diagram below illustrates the flow of capital from an investor to a bank and from a bank to a borrower. Having given the bank some money, the investor now has a financial asset in the form of a deposit (and the deposit is a liability from the bank’s point of view). Likewise, the loan now represents a financial asset for the bank (and a liability from the borrower’s point of view). So the bank acts as intermediary between savers and borrowers. In doing so, however, banks act as more than a simple broker matching borrowers and lenders. Most bank lending also involves maturity transformation. More colloquially, this is known as lending long and borrowing short.

The typical depositor wants their money to be readily available in an at call transaction account. Some may be tempted by higher interest rates to put money in term deposits, usually no longer than 6 months to maturity. On the other hand, most borrowers do not want their loans due and payable too quickly. Home buyers borrow in the expectation that their earnings over coming years will allow them to pay interest and principal on their loans. Likewise, companies making capital expenditure, building factories, buying equipment or acquiring other businesses borrow in the expectation that the revenue generated by their expanded business capability will allow them to repay their loans. In both cases, the term of the loans must match the timeframes over which earnings are generated.

Some lenders will be prepared to make longer term investments, some borrowers may be able to repay more quickly, but overall there is a mismatch in maturity preferences of lenders and borrowers. Banks are in the business of bridging this gap in preferences. In the ordinary course of events, they can allow depositors to withdraw funds before loans are due to be repaid, making use of funds from other depositors, borrowing from other banks or, in need, borrowing from the central bank. But if too many borrowers withdraw at the same time and the bank is unable to meet those demands, then the bank can fail. This is known as liquidity risk, and has become an enormous focus of regulators, risk managers and rating agencies around the world in the wake of the global financial crisis.

While the financial crisis certainly highlighted the dangers of liquidity risk for commercial and investment banks such as Northern Rock and Lehman Brothers, it was outside the traditional banking sector that the greatest liquidity problems arose, particularly as a result of securitisation.

Securitisation is a form of structured finance that predates the financial crisis by many years. Essentially it involves setting up a trust (or similar legal entity) which provides loans that become the assets of the trust (often referred to as a “pool” of loans). The funds to provide these loans are obtained by selling a special kind of bond to investors, known as asset-backed securities (ABS). Principal and interest flowing from the loan pool is collected by the trust and periodically passed through to investors.

The most common form of securities bundles up pools of home loans, in which case they are referred to as residential mortgage-backed securities (RMBS).

Unlike bank-lending, there is essentially no maturity transformation involved in financing by means of ABS. Investors cannot withdraw their money early from the trust, they have to wait until it is repaid by borrowers. The only other option for an investor wanting to “liquidate” their investment (i.e. turn it back into cash) is to find another investor to sell their securities to.

The problem with ABS is the overall mismatch of maturity preferences between borrowers and lenders. Without getting into the business of maturity transformation, there was always going to be a limit on how large the market for ABS could become. Faced with a problem like this, it was only a matter of time before innovative financiers came up with a solution. One such solution was asset-backed commercial paper (ABCP). This involves adding another step in the chain, often referred to as a “conduit”. The conduit was simply another legal entity which would buy ABS, funding the purchase by issuing short-dated securities known as asset-backed commercial paper.

Just like a bank, the conduit is exposed to liquidity risk. Before the crisis, this risk was considered fairly low. After all, the assets of the conduit were readily trade-able securities. Most of the time the conduit could repay investors simply by issuing new ABCP to other investors but, in the unlikely event that no such investors could be found, it could simply sell the ABS. In some cases, investors were provided with additional assurance of repayment in the form of “liquidity backstops” provided by banks, essentially a guarantee that the bank would step in to repay investors in need (although these commitments were not always very clearly disclosed to bank shareholders). This whole arrangement was considered highly satisfactory and conduits typically received the highest possible rating from credit rating agencies.

Unfortunately, liquidity risk is a real risk as the world eventually discovered. Once the US mortgage market started to get into trouble in 2007, investors around the world began, quite reasonably, to be rather reluctant to invest in RMBS and other ABS. Prices on these securities began to fall. Managers of large-scale cash investment funds, until then enthusiastic buyers of ABCP, decided that more traditional cash investments were more attractive. The conduits were forced to sell ABS at precisely the time when prices were falling. Their selling pushed prices down further in a vicious cycle, a perfect illustration of the close relationship between funding liquidity risk (the risk of not being able to repay obligations) and market liquidity risk (the risk of being unable to sell financial assets at anything other than a painfully low price). As a result, some conduits were rescued by the banks backing them (“taking them back on balance sheet”), while others collapsed.

The problems of ABCP were just one example of non-bank liquidity failures during the financial crisis. Others include the venerable US money market fund, the Reserve Fund “breaking the buck” or Australian non-bank lender RAMS finding itself unable to continue funding itself by means of “extendible commercial paper” (ECP).

ABCP conduits, money-market funds, non-bank mortgage lenders along with many other non-bank financiers that make up the shadow banking sector had well and truly entered the business of maturity transformation and are all exposed to significant liquidity risk as a result. There are many linkages between banks and these shadow banks, whether through commitments such as liquidity backstops, direct lending or even partial or complete ownership. Regulators are concerned that too much risk in the shadow banking sector means too much risk for banks and too much risk for the financial system as a whole.

One strategy for regulators is to enforce a cordon sanitaire around banks, protecting them from shadow banks. But many, including Lord Turner, worry that is not enough to protect our global financial system with its complex interconnections from damage when shadow banks fail. Ideally they would like to regulate shadow banks as well, preventing them from running too much liquidity risk. But this is not an easy task. As the name suggests, it is not easy to see what is going on in the world of shadow banks, even for well-informed financial regulators.

Currencies punching above their weight

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I recently enjoyed lunch with a group of former colleagues. At one point, the conversation turned to the Australian dollar, a natural enough topic for a bunch of finance types. Someone observed that the Aussie is the 5th most actively traded currency in the world, which is impressive since Australia is certainly not the 5th largest economy in the world (that honour currently goes to France).

Thinking about Australian dollar punching above its weight led me to wonder which country had the most actively traded currency relative to the size of its economy. A quick vote around the lunch table came up with four candidates: the Australian dollar, the New Zealand dollar (which is much beloved by hedge funds), the Swiss franc and the Norwegian krone. The most popular choice among these was the Australian dollar. I was wavering between the New Zealand dollar and the Norwegian krone, but none of us knew the answer. That meant only one thing: a Stubborn Mule post would ensue to settle the bet.

Starting with turnover in the chart below, it is no surprise that the US dollar is by far the most actively traded currency. Not only is the United States the largest economy in the world, but an enormous amount of international trade is conducted in US dollars, and sellers and buyers have to transact in the currency markets to convert US dollars to and from their local currency.

Top 10 Currencies by Turnover (2010)

There are a number of reasons the Australian dollar is traded as much as it is. Our higher interest rates attract many into the carry trade (borrowing in low interest rate currencies, investing in higher interest rate currencies and hoping that the currency you are buying does not collapse). As a very commodity-driven country, many international investors see investing in Australia as a proxy for investing in commodities and, more particularly, jumping onto the China growth band-wagon. For many investors, simply buying the Australian dollar is cheaper and easier than investing in our stock-market.

But back to our bet. Only one of the assembled diners picked the Swiss franc, but it turns out to be at the top of the league table. With a GDP in 2010 of US$500 billion, there was average of $253 billion traded in Swiss francs every day in April 2010!

I have never made a close study of the Swiss franc, so I would be very interested in hearing any theories people may have as to why it is so heavily traded.

Next in the list is New Zealand, so my instincts were right there (let’s not mention the fact that I also tipped the Norwegian krone which came in a disappointing 11th place). Interestingly, third and fourth place, the Hong Kong and Singapore dollar respectively, did not even make it into our short list. And it turns out that the Australian dollar ranks 5th not only in terms of outright turnover, but also in turnover relative to economy size.

Top 10 Currencies by Daily Turnover relative to Annual GDP (2010)

If you are interested in exploring the league table further, the table below has all of the data.

Currency	Daily Turnover (US$)	Annual GDP (US$)	Turnover/GDP (%)
Swiss franc	253	500.3	50.6
New Zealand dollar	63	128.4	49.1
Hong Kong dollar	94	215.4	43.6
Singapore dollar	56	181.9	30.8
Australian dollar	302	1013	29.8
US dollar	3378	14440	23.4
Pound sterling	513	2680	19.1
Swedish krona	87	479	18.2
Japanese yen	755	4911	15.4
Canadian dollar	210	1500	14
Norwegian krone	53	451.8	11.7
Hungarian forint	17	155.9	10.9
South African rand	29	276.8	10.5
Euro	1555	18140	8.6
Danish krone	23	340	6.8
Korean won	60	929.1	6.5
Polish zloty	32	527.9	6.1
Malaysian ringgit	11	221.6	5
New Taiwan dollar	19	391.4	4.9
Mexican peso	50	1088	4.6
Philipine peso	7	166.9	4.2
Turkish new lira	29	730	4
Chilean peso	7	169.5	4.1
Czech koruna	8	216.4	3.7
Indian rupee	38	1207	3.1
Israeli new shekel	6	202.1	3
Thai baht	8	273.3	2.9
Russian Rouble	36	1677	2.1
Brazilian real	27	1573	1.7
Colombian peso	4	240.8	1.7
Indonesian rupiah	6	511.8	1.2
Chinese renminbi	34	4327	0.8
Saudi Riyal	2	469.4	0.4
Other currencies	190	NA	NA

Data sources
Currency turnover: Bank for International Settlements (BIS)
GDP: CIA World Fact Book (official exchange rates)

S&P being silly again

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The debt rating agency Standard and Poor’s (S&P) has placed their rating of the US on negative outlook. What this means is that they are giving advance warning that they may downgrade their rating of the US from its current AAA level (the highest possible rating). Their actions were motivated by concern about “very large budget deficits and rising government indebtedness”.

To me this shows that S&P do not have a good enough understanding of macroeconomics to be in the business of providing sovereign ratings. How can I doubt such an experienced and reputable organisation as S&P? Well, keep in mind that this is the same agency which maintained investment grade ratings for the likes of Bear Stearns, Lehman Brothers and AIG right up to the point where these firms were on the brink of collapse (while it was only Lehman that actually failed, that was only because the other two were bailed out). Likewise, it is the same agency which assigned investment grade ratings to sub-prime CDOs and other structured securities many of which only ended up returning cents in the dollar to investors during the global financial crisis.

Of course many commentators are very nervous about the growth in US government debt (notably, the bond market seems far more sanguine) and typically assert, with little justification, that growing government debt will lead inevitably to one or more of:

a failure of the government to be able to meet its debt obligations,
rising inflation as the government seeks to deflate away its debt (and interest rates will rise in anticipation of this future inflation), and
a collapse of the currency as the government seeks to devalue its way out of the problem.

Before considering how likely these consequences really are, it is important to emphasise that while there is a widespread tendency to label all of these as a form of “default” by the government it is only the first of the three, a failure of the government to make its payment obligations, that the S&P rating reflects.

In fact, I do not consider any of the three consequences above to be inevitable. The quick and easy counter is to point to Japan. As its government debt swelled to 100% of gross domestic product (GDP) and beyond, it never missed a payment, would have loved to generate a bit of inflation but consistently failed year after year and, while its currency has its ups and downs, the Yen remains one of the world’s solid currencies. While I certainly do not think that the US should aspire to repeat Japan’s experience over the last couple of decades (I would hope for a better recovery for them), this point should at least dent the simplistic assumption that default, inflation or currency collapse follow rising government debt as night follows day.

Since it is only a true default that is relevant for the S&P rating, it is worth considering more specifically how likely it is that the US government will be unable to honour its debt obligations. Regular readers of the blog will know that I regularly make the point at the heart of the “modern monetary theory” school of macroeconomics, namely that in a country where the government is the monopoly issuer of a free-floating currency, the government cannot run out of money. If your reaction to that is “of course they can print money, but that would be inflationary!”, ask yourself why that did not happen in Japan and then remind yourself that even if it did happen, it is not relevant to the S&P rating.

There is one important caveat to this monopoly issuer of the currency argument. While it certainly establishes that the US government will never be forced to default on its debt, it is still possible that it could choose to default. This choice could come about in a dysfunctional kind of way since the US imposes various constraints on itself, in particularly a congress legislated ceiling on the level of debt the government may issue. So it is possible that a failure of congress to agree to loosen these self-imposed constraints could end up engineering a default. Now that is a more subtle scenario than the one that S&P is worried about, but since it is possible, it is worth considering how serious debt-servicing is becoming for the US government. To make a comparison over time meaningful, I will take the usual approach of looking at the numbers as a proportion of GDP. Taking the lead from a recent Business Insider piece*, the chart below shows US government interest payments as a share of GDP rather than the outright size of the debt. This has the advantage of taking interest rates into account as well: even if your debt is large, it is easier to meet your payment obligations if interest rates are low than if they are high.

US federal government interest payments as a share of GDP

So the interest servicing position of the US government has actually improved of late and is certainly much better than it was in the 1980s and 1990s. So why is S&P reacting now? I would say it is because timing is not their strong suit (and they do not really understand what they are doing). Ahh, you say, but what happens when interest rates start going up? Since the US Federal Reserve controls short-term interest rates and of late, through its Quantitative Easing programs, has been playing around with longer-term interest rates as well, the US government is in a somewhat better position than a typical home-borrower, and interest rates will only start to rise once economic activity picks up again. Then the magic of automatic stabilisers come into play: tax receipts will rise as companies make more profit and more people are back at work, and unemployment benefits and other government expenditure will drop and the growth of government debt will slow or reverse.

So, there is no need for panic. Once again, the rating agencies are showing that we should not be paying too much attention to them. After all, as they all repeatedly said in hearings in the wake of the financial crisis, their ratings are just “opinions” and not always very useful ones at that.

Data Source: Federal Reserve of St Louis (“FRED” database).

* As Bill Mitchell, @ramanan and others have noted the Business Insider chart, while looking much the same as my chart, has the scale of the vertical axis out by a factor 10.

A way with words

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Sometimes the things that are unsaid are far more telling than the things said.

I had cause to reflect on this when I stumbled across a book on my shelves that I have not opened for many years. The book, entitled “Deutsche Bank: Dates, facts and figures 1870-1993”, is an English translation of the year-by-year history of the bank compiled by Manfred Pohl and Angelike Raab-Rebentisch. In keeping with the title, the style is more bullet points than narrative. Nevertheless, I continue to find the pages spanning World War II strangely fascinating.

In 1938, with the connivance of the French and British, Germany annexed Sudetenland in Western Czechoslovakia. For Deutsche Bank, this meant more branches.

The following year, Deutsche Bank was fortunate enough to be able to continue its branch expansion, this time into Poland. At least this time, there is a mention of the events outside the bank that may have been relevant.

Another year, and some more expansion for the bank including a few branches in France. No need to mention the invasion of France here, of course.

From 1942, outside events start to interfere with the bank: the “impact of war” forces rather inconvenient branch closures.

To see these extracts in the full context, here are the pages spanning 1934 to 1940 and 1940 to 1946.

Where does the money go?

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A regular Mule reader drew my attention to an article in the Sydney Morning Herald (also published in The Age) which attempts to defend Australian banks from some of the criticisms levelled at them in recent months. It is something of a laundry list of points, some accurate, some dubious and has little in the way of hard data behind it.

What my correspondent was more interested in, however, was that one powerful argument was missing. If banks had not bolstered their margins by raising mortgage rates by more than the Reserve Bank cash rate rises, the Reserve Bank would in all likelihood have increased the cash rate by even more. This contention is supported by the Reserve Bank’s own board meeting minutes from the 2 November meeting. Discussing the considerations which led to the November rate hike, the following observations appear:

Members noted that lending rates might increase by more than the cash rate, but this tendency would not be lessened by delaying a change in the cash rate. Lending rates had been rising relative to the cash rate since the global financial crisis, and the Board had taken this into account in setting the cash rate. It would continue to take account of any changes in margins in its decisions in the period ahead.

From this it seems clear that if the banks had kept to moving their mortgage rates in line with the cash rate, the cash rate would now be higher and the end results for borrowers would be much the same.

Of course, if this had happened, bank margins would have been squeezed, which leads to this question from my correspondent:

Where banks don’t increase margins but RBA increases base rate more so overall level the same, where does the “banks’ profit” go? RBA [Reserve Bank of Australia]?

This question gets to the heart of how banks work.

While we tend to think of banks as lenders, it can be more useful to think of them as intermediaries between borrowers and lenders. The real lenders are the banks’ depositors and bondholders. Banks pay interest on deposits and bonds and charge a somewhat higher rate interest on their loans. The difference between the interest they pay and the interest they receive is their net interest margin which, along with fees and charges, is their source of profit. In the wake of the financial crisis, the market for deposits has become very competitive and bond investors now demand higher returns on bank debt compared to lower risk alternatives (such as government bonds…at least if the government in question is not European!). Both of these effects have resulted in the interest banks pay increasing by more than the amount the Reserve Bank’s cash rate has increased. Banks have attempted to recoup the resulting increases in the interest they pay by passing through bigger increases to their borrowers (you can read more of the details in an earlier post on bank funding costs).

So, if banks had kept their mortgage rates strictly in line with the Reserve Bank’s cash rate, their margins would certainly have been smaller than they are today. If that had happened, where would the money have done? It does not go to the Reserve Bank: while they set the target rate, the Reserve Bank itself does very little lending at that rate. Rather they ensure that any lending overnight from one bank to another is done at or very close to the target rate by promising to lend or borrow large amounts at rates only slightly above or below the target respectively. No, the real beneficiaries of the higher rates are the ultimate lenders: depositors and bondholders.

Anyone with a balance in a superannuation fund is likely to have a certain amount invested in bond funds which would invest in, among other things, bonds issued by banks. Self-funded retirees and others seeking to keep their investment risk to a minimum may have money in bank term deposits rather than shares or property. All of these people lend money to banks and benefit through higher earnings when interest rates go up*. The banks do get some of the benefit themselves. Some deposit balances are paid little or no interest and so when the cash rate rises, these deposits represent an increasingly cheap source of funds for banks, although these low interest balances represent a much smaller proportion of banks’ funding than they used to.

The effect of changing interest rates is thus an exercise in wealth redistribution between the ultimate borrowers (including those borrowing to buy a home), the ultimate lenders (depositors and investors) and the banks themselves. What we have seen over recent months can be seen as a bit of a tussle between banks on the one hand and depositors and investors on the other as to who should get how much of the higher rates borrowers are paying.

* There is a timing issue for bond investors: fixed rate bonds actually fall in value when interest rates go up, but from that point onwards the ongoing earnings of the investment are higher.

Do your block in!

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Sydney’s property market is a subject that has found its way onto the Stubborn Mule more than once. In this post, regular guest contributor Zebra (James Glover) manages to combine property and television with some now-traditional beer coaster calculations.

Channel 9’s high rating renovation show The Block just finished its successful second series on Wednesday night. It concluded with an auction of the four properties that the contestant couples had spent 8 weeks, and in excess of $80,000 each, renovating. The prize for the contestants was the “profit” of whatever they made at auction in excess of the stated reserve. The reserves were varied to reflect unique features of each apartments such as views, an outdoor living area or double garage. The idea was that the couple with the best renovation skills would see their apartment achieve the most above the reserve. In the end the couple who won, John and Neisha, achieved a price of $1,105,000 with a reserve of $900,000 and so made $205,000 (they also won first prize and an additional $100,000 which we’ll ignore for now). Wow! $205,000! Okay that was for 8 weeks of back-breaking unpaid labour. But still. It makes you think that this renovating lark might be a pretty profitable way for making a living. A couple of apartments like that a year and you’d be in gravy! Or would you?

The first thing to consider is the fact that the other couples didn’t do quite so well, making $87,500 (Jake and Erin), $47,000 (Mark and Duncan) and nix (Brendan and Chez’s apartment passed in below the reserve). Okay, you say, but that is still an average of $85,000 for each couple or $42,500 per person for a couple of months’ work. So take $42,500, divide by 8 weeks times by 52 weeks, carry the 2, take off 20% for holidays less breakages tap, tap, tap, that represents an annual profit of about $200,000 each. Still not bad. Break out the champagne!

But buried in the self-congratulatory articles, no doubt generated by Channel 9’s PR department, are some sobering facts. Put away the Kristal and maybe open a cask of Ben Ean and take a seat. The entire unrenovated apartment block was bought for $3.4m. The total amount spent on renovations (not including the couples’ labour) was $470,000 (including $100,000 on common areas). That makes $3.87m. The total sale price was $3.89m. So the total profit was a pretty modest $20,000. And that doesn’t include stamp duty (about $200,000) or agent’s commission ($78,000 @ 2%) plus, let’s say, legal costs of $2,000. So, in reality, the washup of The Block is a loss of $260,000. They don’t mention that in the publicity.

My back of the beer coaster calculations show John and Neisha were still the “winners” having only lost $60,000 on their reno. Jake and Erin and Mark and Duncan each would have lost $66,000 and, still last, Brendan and Chez’s reno lost $67,000. Perhaps Channel 9 should deduct John and Neisha’s loss from the winners’ prize of $100,000 and present them with a cheque for the $40,000 difference.

More revealing than the illusion that this was a profitable business from a renovators point of view is that the total reserve price was $3.55m. Now I’d expect the total reserve to at least equal the break-even cost of the apartments, or $4.15m. In fact it was $600,000 below the actual cost of buying, renovating and selling The Block. If in a very public show like this, with 1.2m viewers, the agents can so blatantly quote below the break-even reserve then what hope for the tens of thousands of buyers in suburbia struggling to match house ads with reality? It’s enough to do your block in.

Bank funding costs

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This post returns to the theme of interest rates on Australian mortgages. The first post showed the extent of the increases in mortgage rates over and above the Reserve Bank cash rate. The rationale banks have been giving for these increases is that their own funding costs have been continuing to blow out in the wake of the global financial crisis. In the spirit of occasional Stubborn Mule contributor @pfh007, it is time for some beer coaster calculations to see how plausible this argument is!

A number of commentators have accused the banks of out and out dishonesty on the subject of their funding costs. A few weeks ago in the Sydney Morning Herald, Ian Verrender focused on banks’ offshore borrowing and argued

if that really is the case, and only half their funding is sourced locally, then logically they should be raising interest rates by only half the rise in the official cash rate

Last week, also in the Herald, Richard Denniss built on this argument and argued that not only are offshore borrowings unaffected by Reserve Bank interest rate movements but so are all of their customer deposits. This led to the following conclusion.

Only about one-third of the banks’ funds come from the Australian money market, which means that when the official rate rises by 1 per cent, the banks’ costs only rise by about a third of 1 per cent.

But these simplistic arguments are incorrect. In saying this I am not defending the actions of the banks. There is no divine right for businesses to be able to preserve their margins at all times. Margin compression is a fact of life for many businesses. But more importantly, the ability Australian banks have to recoup costs from existing borrowers not just new borrowers is inherently anti-competitive.

Nevertheless, given the heat in the issue, it is worth getting a better understanding of exactly what is happening to bank funding costs.

A look at the balance sheet of any of the major Australian banks will show that their liabilities (which effectively represent the “funding” for their assets) are drawn from a range of sources. While the makeup will vary from bank to bank and change over time, roughly 50% of their funding is sourced from customer deposit balances and 50% from the wholesale markets (both domestic and offshore). Within those two categories, further distinctions can be made.

Wholesale Funding

Wholesale funding is a mix of short term “money market” borrowings and longer-term debt. Again, very roughly, about 50% of this wholesale funding is short-term (prior to the financial crisis, quite a bit more would have been short-term) and 50% long-term. Somewhat arbitrarily, “short term” tends to be defined as borrowings with a term of less than one year. Much of this borrowing takes the form of “certificates of deposit” (CDs) which are mostly bought by other banks or financial institutions like fund managers (much of the “cash” component of superannuation funds is invested in these sorts of instruments).

The interest rate paid on these deposits depends on the term and will be closely related to what the Reserve Bank does with its cash rate. For example, since the Reserve Bank just raised rates to 4.75% and it is almost a month until the next rate decision, the 30 day rate on CDs is currently very close to 4.75%. When the Reserve Bank hiked last week, markets were caught by surprise and the CD rate, which had been 0.20% lower jumped up in response to the central bank’s move. The correlation between these short-term borrowing rates and the Reserve Bank’s cash rate is not perfect, but on average over time, they are quite closely linked. So, the cost of this component of the banks funding can be expected to move in line with the cash rate, but should not increase significantly more than the cash rate.

Things are a bit different when it comes to long-term debt. For a start, most bonds are fixed rate: the interest the bank pays investors does not change even if the Reserve Bank cash rate goes up or down. However, while a fixed rate may suit investors, most of the bank’s assets have variable rates. Banks deal with this mismatch by using interest rate swaps (and other derivatives) which effectively convert their fixed rate borrowing into floating rate borrowing. The diagram below gives a simplified version of the mechanics of an interest rate swap. The bank enters into a contract with another party (typically another bank) to receive a fixed stream of interest payments in return for paying a variable or “floating” rate of interest. The floating rate is reset periodically, usually quarterly or semi-annually, with reference to a published rate which tracks short-term bank borrowing costs. The swap is set up to ensure that the fixed rate payments it receives match the payments it has to make on the bond. In this way, the fixed rate the bank pays on the bond is effectively turned into a variable rate from the bank’s perspective.

Interest Rate Swap

This starts to make the cost of long term borrowing look a lot like the cost of short-term borrowing, but there is another factor: credit risk. If an investor buys a 5 year bond issued by, say, ANZ then it runs the risk that ANZ will collapse some time over the next five years. As compensation for this risk, the investor will demand an extra “premium” on the interest rate. This premium, also known as the “credit spread” or “credit margin” was fairly small before the global financial crisis, but shot up when investors suddenly realised that banks were not so safe after all.

Fortunately for banks (unlike their poor customers), they only had to pay the higher margin on new bonds. Even today, banks would still be paying off bonds issued before the crisis which have very low margins compared to the new bonds they are issuing. The average term of bonds issued by banks is around 3 years and the chart below shows how credit spreads have behaved over the last 12 years* along with a 3 year rolling average which gives a reasonable indication of the overall credit spread Australian banks are paying.

Credit Spreads for Financial Institutions (1998-2010)

The first thing to notice is that, although credit spreads have reduced since the peak of the financial crisis, the rolling average effect means that the effective cost of wholesale funds is still going up. Having old, cheap bonds maturing is adding to their cost of funds more than the fall in current spreads is saving them. On this point, at least, it would appear that banks are telling the truth!

But what about all of their borrowing outside Australia? Contrary to Verrender’s argument, Australian banks are not getting huge benefits by borrowing in countries with lower interest rates. Anyone with memories long enough to recall the notorious Swiss franc loans taken out by farmers and other small businesses in Australia in the late 1980s would appreciate that low interest rates do not count for much if the Australian dollar drops, thereby pushing up the amount of money you owe. Banks have no interest in running this sort of currency risk and so, much like their interest rate risk, they use swaps to hedge themselves. A “cross-currency swap” can be understood with a very similar diagram to the one above. Simply replace “Fixed” with, say, “US$ interest” and “Floating” with “A$ interest” and you have the picture for a cross-currency swap. This means that hedging is not a matter of paying some sort of small insurance fee, rather it effectively converts foreign interest rates to Australian interest rates. Even though perhaps half of the term funding raised by Australian banks is sourced offshore, it may as well be raised locally as far as the costs are concerned.

But how much is this increase in spreads costing the banks? As mentioned above, long term wholesale funding provides about half the wholesale funding for Australian banks, which is in turn about half of their total funding. So, a back-of-the-envelope estimate can be made by taking 25% of the 3 year rolling average. While I am at it, I will also project the rolling average forwards, assuming that credit spreads stay where they are today.

Estimated Impact of Term Spreads on Bank Funding Costs

This suggests that banks will see their funding costs continue to rise for about another year, but the overall impact of elevated costs in wholesale markets is only about a 0.45% increase. Compare this to what has been happening to mortgage rates.

Australian Mortgage Spread to the Cash Rate 1998-2010

The increase in mortgage rates over and above the cash rate has been about 1.2%, which is a lot more than 0.45%. So, while it may be true that wholesale funding costs are still increasing, it would appear that banks have already charged home buyers far more than the increase in costs the banks have suffered.

There is another source of costs for the banks that we need to consider: customer deposits. As wholesale funding costs rose during the financial crisis, banks began to compete aggressively for customer deposits as a (somewhat) cheaper alternative to wholesale funds. So, it is only fair to take the cost of customer deposits into account as well.

Customer Deposits

It is certainly true that on some of the customer deposits there is little or no interest paid, but there are also customer deposits which, particularly in recent years, pay very decent rates of interest. These include corporate deposits: imagine if a large mining company were to deposit a lazy $100 million into their account with one of the majors and was offered no interest…how long would it take for that money to move to another bank prepared to pay something very close to wholesale funding rates? Not long.

On this basis, we can reasonably assume that the cost of raising at least a portion of the banks’ customer deposits has risen as much as the increase in wholesale funding costs. To be generous, I will assume that all of their customer deposits have experienced this cost increase (although there are, of course, still plenty of low interest deposit balances out there…have a look at your own savings interest rates). Based on this assumption, I have recalculated the estimates of the increase in bank funding costs (i.e. taking 75% of the rolling average increase in wholesale spreads).

Estimated Impact of Wholesale and Customer Spreads on Bank Funding Costs

This revised estimate gets to an increased cost for banks of 1.3% which, given that the calculation is definitely too generous on the customer deposits side, is reasonably comparable to the increases passed through to mortgages.

However, the increases passed through to other types of loans (small business, credit cards, corporate loans, etc.) have been even bigger than those passed through to mortgages. So the only conclusion that can be drawn from this beer coaster is that:

The banks are not lying when they say their margins are still increasing, but
They have already gone beyond recouping these increased costs from their customers.

* Data source: Merrill Lynch. This data is the average asset swap spread across the financials sector and includes non-bank financial institutions and thus the spreads for the Australian major banks would, if anything, be slightly lower. I have now also got hold of data on some individual bonds issued by the majors and I will also analyse that to confirm it fits the same pattern.