No 1706 Posted by fw, June 19, 2016
“My accountant says I did this at a very bad time. My stocks are down. I’m cash poor or something. I got no cash flow. I’m not liquid, something’s not flowing. They got a language all their own.” (Woody Allen character, Isaac Davis, in the movie Manhattan).
I immediately thought of the above line from the Woody Allen film as I struggled to understand the article by Satyajit Das, reposted below.
When asked by a Globe and Mail reporter in a January 2016 interview, “Is there anything about the global economy or markets that keeps you up at night? Das replied:
“The risk that policymakers could make a catastrophic error. I don’t think they understand that they’re in a very deep hole. They just assume that their [usual] models and ways of thinking are somehow going to work. And I worry that they’re going to miscalculate really badly.”
Das’ answer to the reporter about policymakers not understanding they’re in a deep hole, that and the Manhattan quote, “They got a language all their own”, provide a perfect lead-in to Satyajit’s article, featured in today’s post. In his article, Das does have “a language all his own” – a financial guru’s language for financial nerds.
To navigate this unfamiliar territory, I ended up creating a glossary of terms – 27 terms – which I have listed at the end of this article. Alas, definitions alone did not bring clarity: the definitions of “soft” financial terms, unlike definitions of “hard” scientific terms, can vary considerably, presenting a serious barrier to understanding for neophytes – like me.
If Das’ article verges on the incomprehensible for average folks, why did I decide to repost it? Perhaps for no other reason than its turgid language style communicates the daunting complexity of the subject matter, making it difficult, even for financial experts, to explain the entanglements among the numerous variables. As Das himself concludes: “The exact sequence of events is unpredictable because of the complexity of transmission pathways. But once these feedback loops start, they are very difficult to control.”
If Das can’t foresee how the next financial crisis will unfold, then what chance is there for our political masters to understand that they’re in a very deep hole,” which could lead to their making “a catastrophic error”?
The subheadings added to the repost of this article are intended to help readers grasp the daunting complexity of financial capitalism. It’s the very complexity that creates the risk, especially the risk of unforeseen feedback loops. To read the original piece, without the glossary, click on the following linked title.
Note, the underlined terms in the reposted article indicate that they can be found in my glossary at the end of the article.
We are on the brink of a new economic crisis
A new economic crisis, which I believe we are on the brink of experiencing, will have similarities, and differences, to 2008. The problem of crowded trades – where market participants all have the same basic positions and strategies, and identical risk models – will be familiar.
New regulations designed to minimize risk will create new problems
The effect of new regulations, ironically designed to minimize the risk of a new crash, and a reduction in trading liquidity will create new problems. Extra capital, while welcome, does not alter the level of risk, but merely who bears it.
Regulators have approved risky financial instruments to boost banks’ liquidity
To recapitalize banks, regulators have approved risky hybrid securities, such as contingent capital and bail-in bonds. In the event of a systemic crisis, losses will be transmitted to insurance companies, pension funds and private investors; bailing them out may be politically necessary or expedient.
So-called bankruptcy-proof agencies have added complexity, thus creating new instability
With simpler solutions proving politically difficult, attempts to reduce the risk in the chains of derivative contracts have focused on Central Counter Parties (CCPs), a theoretically bankruptcy-proof guarantor of transactions and collateral. CCPs have added complexity, creating new instability; CCP risk management is unproven under conditions of stress.
Reliance on collateral entails three risks —
1/ The reliance on collateral is likely to prove troublesome under conditions of real stress. The emphasis shifts from the borrower or counterparty’s creditworthiness to the collateral, creating different risks.
2/ Government securities now are not risk free. It assumes liquid markets for the collateral, which must be realized in case of default.
3/ Unexpected changes in the amount of collateral needed create liquidity risks. Collateral use also entails significant modelling, operational and legal risk.
Reduced number of trading dealers has negatively impacted market liquidity for investors looking to readjust portfolios
Trading liquidity in markets has also diminished markedly since 2008. Traditionally, market makers act as shock absorbers in periods of stress allowing investors to readjust portfolios at a price. But consolidation – through bankruptcies, mergers or acquisition or withdrawal – has reduced the number of dealers.
Higher trading costs increases market volatility
Higher capital charges and specific prohibitions on trading, such as the Volcker rule or narrow banking, have increased the cost of trading. The amounts that can be transacted without moving prices materially have fallen, meaning shocks will be rapidly transmitted.
From here on, Das launches into an explanation of the complexity of relationships among variables – well beyond my grasp
The decline in liquidity is exacerbated by the changing structure of many markets. There is increased participation by high frequency traders (“HFT”), retail and private investors either directly or through funds. Paralleling the decline in the number of dealers, the number of major asset managers through whom these funds are deployed is small.
The combination of size, the nature of the underlying assets and the redemption feature may prove especially toxic. It is simply not possible to transform highly illiquid instruments, using financial engineering into liquid equivalents. This lack of liquidity is not reflected in pricing, with the premium for liquidity risk in most segments having fallen to 2007 levels of below.
As the following scenario outlines, these changes in market structure likely help to create instability in any new crisis. The key drivers will be higher liquidity reserves for banks, more stringent calculations of risk in derivative transactions and use of government securities to lower capital requirements as collateral. Given pre-existing exposures to government bonds via repurchase transactions, investments or trading inventories, the regulations increase bank exposure to sovereign bonds. This coincides with the deterioration in the quality of government securities and unprecedented low rates driven by policy, creating a dangerous source of instability, which will feed market volatility and transmit losses across different markets.
Where rating downgrades or deteriorating credit quality result in falls in the value of sovereign securities, banks suffer losses on their holdings. Where the securities are used as surety for funding or derivatives, banks need to lodge additional collateral, draining liquidity from markets. The deterioration in a sovereign’s credit quality will affect risk calculations, requiring additional capital as well as collateral.
Banks may hedge this risk, usually by purchasing default protection on the sovereign or shorting government bonds. This will exacerbate losses as the sovereign bonds’ value falls further. Market constraints may necessitate use of proxies for the sovereign, including shorting or buying insurance on equity indices or major stocks. Banks may short sell the currency as a de facto hedge. Proxy hedges transmit the volatility into other asset markets. They create additional risk where volatility is high and correlation between major asset classes becomes unstable, such as in a risk-on risk-off trading environment.
Second round effects focus on the financial position of banks adversely affected by losses on government bond investments and reduced ability of the nation to support its financial institution. The increased default risk of affected banks sets off a chain reaction of additional capital charges, increase and loss exposures across international active banks who deal with them, requiring further hedging, compounding the negative spiral.
The reduced demand for the affected sovereign’s bonds result in higher funding costs and reduced market access, which is transmitted to banks and other firms in the country. Higher counterparty risk or downgrades may trigger more collateral calls.
Financial market shocks flow through into the real economy, affecting the supply of credit, growth, investment and employment. In turn, this feeds back into further sovereign and financial sector weakness.
The exact sequence of events is unpredictable because of the complexity of transmission pathways. But once these feedback loops start, they are very difficult to control.
Satyajit Das is a former banker and the author of ‘A Banquet of Consequences: The Reality of our Unusually Uncertain Economic Future’
Glossary of terms
The Biggest Bank Heist Ever, posted on You Tube February 13, 2012
MUST WATCH — Satyajit Das appeared in the 2011 award-winning documentary film Inside Job, about the 2008 financial crisis. In this 49-minute segment from the film, the 8:24-minute Das interview begins at the 32:55-minute point and ends at 41:19. (Fast forward to watch the segment). Derivatives expert Das explains how derivatives amplified market losses, which led to the fall of Lehman Brothers. In a not-to-miss section of the interview, he talks about his experience with employees from Icelandic banks who started to attend his London-based course in the late 1990s, providing a great insight into how Iceland became a completely financial economy with devastating results. The interviewer also asks Das, who meets with a lot of bankers, what bankers say about the crisis. His response is a real eye-opener. Little wonder there’s another looking financial crisis.
For more information about Satyajit Das — http://www.financialsense.com/contributors/satyajit-das
For articles by Das in the UK’s Independent newspaper — http://www.independent.co.uk/author/satyajit-das
For articles by Das in Nouriel Roubini’s EconoMonitor — http://www.economonitor.com/blog/author/sdas3/
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