Aamer Ghaffar's Blog

Although the famous quote may have worked for Frank Costanza from the popular sit com Seinfeld, the EU banking sector is going to have to say a lot more to instill confidence in its ailing economy.

The top ninety-one banks that account for roughly two-thirds of the banking assets in Europe passed the stress tests that were conducted later last week. I would have had absolutely no reservations in betting my mortgage on the results of the European stress test being positive. This is not because I have undying faith in the economy, but  because a positive result was expected. Stress tests would not have been announced if a bunch of banks were in the position to fail. The purpose of conducting the stress tests was to instill confidence, not ruin it.

I am not entirely sure if that goal was achieved. The Wall Street Journal has a well thought out article discussing the stress tests conducted by European regulators . The article asserts that the scenarios were not tough enough to give a true picture of whether or not the banks could survive a double dip recession. If you do not like to read (which would be  ironic as you are reading a blog at the moment) the graph at the end of the article says it all – it shows a huge cluster of banks barely making the 6% tier one ratio requirement. Therefore, though only seven banks failed, there are a boat load of banks teetering at the brink of failure. The article covers some good points for both sides of the argument but does not really touch upon the issue that I have with the tests.

All this talk about ‘transparency’ and getting  ‘insight into Europe’s banking’ is fine and dandy, but it seems like a classic case of not looking at the real issue. My beef with the test, aside from the fact that the rules were not stringent enough, is quite simple: the tier one ratio itself can be massaged to a great degree (much like a discounted cash flow valuation). Since the essence of tier one is to measure a variation of a shareholder’s equity to risk adjusted measure of assets, trying to ascertain what the “correct” risk weighting of the assets is open to subjective judgment.

Second, the Sovereign debt issue which is a huge threat to the EU was out of scope of the stress test. Spain is currently plagued with a huge number of over levered banks due to its property crisis. Not taking sovereign debt into account is like focusing on losing 15lbs but ignoring your soaring cholesterol level. Yes it’s a good goal, but it’s not going to lower the risk of a heart attack. I am not advocating that the stress tests should be scrapped, but they should not be considered a harbinger of things being OK at the moment. I do not expect anything drastic to happen in the next year or two since the crisis is still fresh. However, once the IMF and EU tighten their pockets and local governments funds start to dry up, sovereign debt will be a big issue for European banks as well as the Global economy.

P.S. Food for thought: here is an article on Bloomberg discussing how the European debt market, specifically German bonds may take a hit as a result of the the stress tests in Europe. Lets see how the next week pans out.

Finance

After a short break I have decided to start writing again. Thanks for the notes of encouragement.

Europe has finally decided to join the ‘economic meltdown party’ the US threw almost 3 years ago. Wow, did she make an entrance. The Euro is at a fourteen month low against the dollar primarily due to the uncertainty regarding sovereign debt in Europe. (Sovereign debt is a debt instrument guaranteed by the government). What started with Greece being unable to honour its sovereign debt soon morphed into, Italy, Spain and now Portugal being, or in the process of being downgraded by the rating agencies. Though the analysts seem to be spilt on the problem of  financial contagion (as defined by Investopedia to be the likelihood of significant economic changes in one country spreading to other countries, in this case referring to economic crises). It is still an issue to be very worried about. The last time we saw severe financial contagion was in 1997 when the Asian economic crisis, started in Thailand and eventually spread to South East Asia and Latin America. In the case of the EU what is even more worrying is that the Euro-Zone is connected not only through geography and low trade barriers but a common currency as well.

Affect on the EU economies:
If the suffering of Greece and Portugal was not bad enough, the Wall Street Journal Blog has an interesting post discussing how Spanish spreads are widening as we speak. This is a serious issue considering that Spain is the 4th largest economy in the EU. Though Spain’s debt problem is not as bad as the one in Greece, it does have problems of its own regarding unemployment. Affected European countries are cutting spending to tackle the crisis which in turn is going to have a negative impact on future growth rates of these countries. The current rioting opposing the austerity measures taken by the governments is not making the situation any better.

Though the UK is not having problems with its sovereign debt, it is still in the news with the looming elections. It will be interesting to see how the UK election will pan out. I am curious to see what kind of government the people want — one that is big on bailouts and intervention or one that takes a more conservative, survival of the fittest approach. Needless to say the election will have a significant impact on how the crisis unfolds.

Affect on the Euro:
The current crisis can have an effect on the future of the Euro as well. Stuart Burns makes a great case for how Greece, (along with most of the Mediterranean countries) have enjoyed the fixed borrowing rates by being a member of the European Union. Greece with little or no organic growth and double digit unemployment and inflation was allowed to borrow money at the same rate as France or Germany. As a result the Greek economy grew rapidly (mostly through financing by the public sector) but did not have the means to support herself. With the current bailout and fear of contagion, responsible countries like Germany or France are being tested, and are not taking kindly to the increase in the  borrowing costs and taxes in order to bail out other EU member countries.

Affect on US Markets
The dow lost around 200 points yesterday and 95% of S&P stocks were down while the Vix was moving up. Though these movements could be attributed to the Oil spill on the Gulf of Mexico and the foiled terrorist plot in NYC, it would be naive to think that the state of Europe is not causing a significant burden on the US or even global markets. The unemployment numbers to be released in the next few days will have a significant impact on how the US economy will react to the current declines.

If the US should learn any lesson from this European crisis, it should be that the inability to repay sovereign debt is a real concern, especially after accumulating a large deficit. Is it time for the US to start taking care of its own debt? Jim Owens, CEO of Caterpillar Inc. writes a phenomenal article in which he goes over major areas of the economy that the government should be focusing on in order to tackle the current deficit problem in order to heal the ailing economy.

Note- The ECB (European Central Bank) general meeting tomorrow morning is going to have a significant impact on the direction of the Euro. Hopefully, the ECB will restructure the debt of the struggling countries and cut interest rates. Such cuts will devalue the Euro, but it is a necessary step at this point.

Finance, The Economy

Unfortunately Hollywood was wrong about 2010, we are no where near to having flying cars, jet packs or robots as butlers. However, here’s what we can expect:

1) Policy:
The past year it was easy to make policy to counter the global economic meltdown because of coordination amongst the leading economies.  There was no special reason for the coordination and cooperation except that it was painfully obvious that it was the only move that could be made. The real test is going to come now when the countries will have to start planning exit strategies from the current stimulus driven global economy (since governments can’t fund their recovery efforts for ever). Developed economies like the US and Britain have to be careful not to make the mistake of withdrawing the stimulus too quickly like in the case of the US in 1937 and Japan in 1997, where the ill timed change in policy (in this case a tax increase) sent these already fragile economies back into recession. In short, withdrawing the stimulus too soon= recession and deflation!

With the large US current account deficit I feel fiscal policy should remain the same  for most of 2010 (with modest tightening)  since a tightening of fiscal policy will happen when the tax cuts susnset in 2011. This could prove to be tricky, as this is right around the time the stimulus programs will begin to start tapering down. As mentioned earlier, if not handled with care the US can fall back into the deep dark gallows of the recension. Therefore, after a very busy crisis management 2009, 2010 should be quiet for policy makers as governments will be focusing on taking charge of their over inflated budget deficits.

2) Shape of the recovery: will it be in the shape of a  V, U  or a reverse square root?
The recovery of the US economy should be interesting. The recovery after a recession is traditionally strong whereas after a financial crisis it is obviously weak. Since the US was caught in the perfect storm between both, it is difficult to determine which route the recovery will take. A a lot will depend on how fiscal and monetary policy pan out.

I think it is safe to assume that the a V or U shape recovery of out of the question. The excess spending and borrowing of the past few years will take a lot more to recover than a few months of good economic news and data. I have to agree with the economists that believe that that the  recovery will be in the shape of a reverse square root. This basically means that the economy will expand briskly and then taper down to an extended period of weak growth.

3) Interest rates:
In the past high interest rates were caused by inflation and their lowering ended recessions (well it was not that simple but it was pretty darn close). This time is an exception (we’ve all heard that before). At the time of entering the recession the US had a modest interest rate of 5.25%. The Fed effectively cut it to zero and aggressively bought bonds, mortgage backed securities and anything else it could to get the economy going again. However, bank loans to both businesses and individuals still continue to decline with only government backed Fannie and Ginnie Mae along with Freddie Mac are the only one to really give out credit.

Interest rates, as mentioned earlier, will have to be treated with great care. If growth is good the Fed will resist the temptation to increase rates.  However, as of right now I feel that a very modest increase will be witnessed by mid 2010 and go through 2011. Depending on how interest rates will move, stocks will be impacted as well. When interest rates move up people move from ‘offensive stocks’, semi conductors, tech etc. to ‘defensive’ ones like pharma and food.

4) Housing market:
This is going to be a tough one to call. Some analysts are seeing a bottom while others are expecting it to go down further. The facts are quite depressing: new home construction is at its lowest point of GDP since the 1960′s and inventory of  unsold new homes is the lowest its been in nearly 2 decades.  Ive already mentioned (in a previous post) that commercial real-estate is a ticking time bomb, ready to wreak havoc. I feel that with unemployment still in double digits, housing stats will not be improving any time soon.

5) Unemployment:
Though double digit unemployment is concerning, in terms of employment numbers improving your guess is as good as mine. I expect it to peak at around 10.4% and then be in check after Q2 in 2010.

6) Inflation:
Inflation is something to be worried about in the long term. Currently there is not a high probability of any run away inflation. Basic economics states that inflation is caused when there is excess aggregate demand. However, currently the economy is dealing with excess capacity (firms are not producing to their optimal capacity) rather than excess aggregate demand.

7) Company earnings:
Pundits have been quite happy with earnings from companies and with the economy in general. Without sounding like a pessimist, though the end of 2009 did seem encouraging it is important to note that the numbers may be a little skewed as the economy went through a serious tightening followed by a widening of credit spreads. Furthermore, a lot of companies feeling the pinch were able to strip out a lot of the bad results while conveniently leaving in the non-recurring (one time) positive results.

2010 will not see the economy soar. It will consist more of policy makers trying to tackle weak demand for borrowing, fixing their balance sheets and developing strategies to ween the economy off the stimulus. It is going to be a year that needs to be handled with intense care, finesse and economic prowess.

It has been a tough year for a lot of people. Lets work hard not only to improve our lives but the lives of those around us. I hope people realize that they have a lot to be grateful for and that though things may be tough, we have it better than a lot of those less fortunate around us… On that note, I would like to both wish all my readers a very happy and prosperous new year and thank you for reading and supporting my blog.

Finance, The Economy

Too much of anything is bad, and government regulation is no different. I have been asked time and again why I fear and dislike too much governmental intervention. Though I have written about this issue a lot, an example of a double-jointed pendulum provides a nice visual which provides an analogy to my reservations about nationalization: It is easy to anticipate the path of the pendulum when the joint is locked. However, when the joint is released the movement of the pendulum is totally unpredictable. This is a great visualization of chaos theory – where a small change causes a large amount of uncertainty. In short, the more complexity we add to the financial system, the more the unpredictability and randomness.

The current administration is trying its best to mitigate risk in the markets in order to prevent another financial meltdown of this magnitude from ever occurring again. However, I do not think that throwing money at the problem is a viable solution. The premise of a Capitalist economy is based on the survival of the fittest. However, the current president has been the complete opposite. Bailing out companies without requiring them to change their business plans (the initial auto bailout) or the new cash for clunkers deal (in which case if you bought a gas guzzler you get a $4000 rebate) are a few of the governments policies rewarding those who made poor decisions. I can accept (to an extent) giving people second chances, but punishing those who make good decisions makes no sense to me. Why should a person ‘A’ who has a 1998 Nissan Sentra not be allowed to trade in her car (because it is considered fuel efficient) but person ‘B’ be qualify  for the program after buying a 2004 Hummer.

Lets look at the issue from a different perspective. The carrot and stick theory is a simple premise of how a market economy works (rewarded if you do well => Carrot, punished if you do badly => Stick). This theory has been completely violated in the past few months. One cannot reward good work with bonuses or let everyone get a rebate on a car due to government regulation, nor can one fire for inefficiency or incompetence due to Workers Unions. (I am completely in favor of what unions USED to stand for, but I find them a hindrance to business now a days). In short, throwing money at issues, legislating regulation favoring the few and curtailing business and bonuses is not the best way to approach the current situation. I am by no means saying that the bailout was not necessary, but we need to know when to say enough is enough.

It is important to understand that risk management is an evolving science and the current situation is unprecedented, the basic lesson remains the same – the more regulation and complexity that is added to the system, the less likely the risk managers are able to account for risk, making it a lot harder to remedy our current situation.

Finance, Politics

Last year, pundits around the country painted a grim picture of rampant unemployment and a second great depression if GM and Chrysler were allowed to go bankrupt. Since then both companies have declared bankruptcy and restructured their way out of it. The economy did not spiral into a depression, and the floodgates of unemployment were not unleashed. Though some suppliers did file for bankruptcy, many survived, and Detroit… well Detroit is still Detroit.

As I have mentioned in previous posts, straightening out the balance sheet was not the hard part. GM was such a poorly run corporation, it was inevitable that restructuring both management and financials would lead to cost savings and an increase in efficiency. Furthermore, the decision to reduce the brand offerings was bound to help (only the Chevrolet, GMC, Buick and Cadillac brands remain.) GM will operate 13 fewer American factories and shrink its dealer network from 6,000 to 3,600 by the end of 2010.

General Motors Co. CEO Fritz Henderson revealed a revamped management and is determined to repay loans from the U.S. government “much sooner” than 2015. Henderson expects to cut the workforce from 91,000 (at the end of last year) to 64,000 by the end of 2009. He further proclaimed that GM would launch 10 new products in the U.S. over the next 18 months, as well another 17 overseas. An IPO could be launched as early as the second quarter of 2010 (provided that the market conditions are conducive).

Though GM will be keeping a watchful eye on the condition of its suppliers, the biggest challenge for the ‘new and improved’ GM is going to be to change the perception of the company. The fact that GM has had no marketing for the past six to nine months could be a blessing if they play their cards right. The idea of government motors, overpaid workers and poor quality cars has to be replaced with the thought of an efficiently run organization that makes durable and fuel efficient cars. Furthermore, GM has to ensure that the cars are competitive in the market in order to have a chance to be able to win back the faithful support they once had. It is by no means an easy task and will be a long road ahead…

Finance

I have recently been involved in a number of debates about the efficiency/usefulness of VaR (Value at Risk). Much like Macs, you either love it or hate it. In this post I have examined both the usefulness and the effectiveness of the VaR calculation by looking at the pros and cons of its use as a risk management tool.

In financial math VaR is a popular measure used to gauge the risk of loss on a specific portfolio. The VaR itself is a single number that represents the minimum loss that a portfolio can suffer in a period of time, for a pre-calculated percentage of worst cases with the caveat that the absolute weights of the portfolio are not changed during that period.

Proponents of VaR believe that the process behind the calculation is as important as the result because it forces organizations to confront their exposure to risk and set up proper risk management functions to attempt to mitigate the revealed risk. They acknowledge that the benefit of VaR is not in the single number but in everything that goes into calculating the threshold.

A second advantage would be that VaR calculates the minimum loss that will occur one day in a hundred (assuming 99th percentile) enabling the risk manager to allow the company to take all the risk it wants within the VaR limit, as statistically the firm will remain safe. However, outside the limits indicated, nothing can be accounted for and the risk manger is on his own. Proponents of VaR believe that that though it cannot account for everything, the fact that VaR provides the decisive line between what is acceptable risk and what is not proves it to be a useful tool for risk management.

The problem with VaR begins with its definition, which fails to account for the fact that the actual loss could be far deeper than the minimum. Since these losses are buried deep within the ‘tail’ of the portfolio they go largely unobserved.

Another problem with VaR is that it seems to factor in correlations between risk factors that come up during the time the data is gathered (normally VaR takes into account data from the past few years). However, these correlations tend to breakdown in times of turbulent markets. Furthermore, banks are only required to reveal a number but not the method with which it was calculated. A bank can say its VaR is down twenty percent but that does not necessarily mean that the risk is down twenty percent, as the decrease could just be a result of assumptions made by the analyst. The problem once again is that companies and governments both stress too much on the number that VaR shows but do not scrutinize the assumptions driving that number, resulting in the public getting a false sense of security.

The biggest complaint with using VaR has to be the argument for using normal distributions to create scenarios. The normal distribution is a symmetric bell shaped curve that is focused on the center and decreases on each side, and hence has less of a tendency to produce extreme values. Working with the assumption of a normal distribution (in regard to the real life market) seems to be the most unrealistic choice. Simply put, normal distribution fails to capture what is going on in the lower tails of the distribution. Even if we were to accept the assumption that actual portfolio returns would be normally distributed, the market would not be representative of this due two major factors: Firstly, VaR leads to a bunching of risk that contradicts the diversification principle. Secondly, VaR does not take into account the increased complexity that is added by aggressive trading and the use of derivative instruments.

In conclusion, although VaR does have some benefits, it cannot be solely relied on as a measure of risk as it is not designed to deal with extreme shocks or “black swan” events. Rather, by using volatility and correlations calculated from past market movements, VaR estimates a singular risk number that in no way utilizes or takes into account market expectations or movements. As a result I believe that VaR is ineffective as single risk management tool (especially) in the turbulent markets we are faced with today.

Note: General Motors has filed for bankruptcy protection, Chrysler is on its way out of bankruptcy after filing less than two weeks ago…

Finance