Saturday, April 26, 2014

Berne Union Yearbook 2013 – How to finance trade when banks lack liquidity.

The Berne Union federates the major export credit agencies. It has recently published its yearbook 2013 that describes what happened in the industry in the past year. Here are the main points:

Commemorative Logo for the 80th Anniversary

Banks lack liquidity.

In 2013, banks had difficulties financing trade. This was especially true for long-term, USD, and investment projects.

How did ECAs react? They developed (more or less) direct lending programs:

  • They encouraged investors to refinance trade finance banks through securitization guarantee schemes. The major example is Euler Hermes' securitization guarantee scheme.
  • ECAs provided loans directly to exporters.
  • Many ECAs put working capital covers in place.
  • The European Commission installed a regime for short-term trade credit insurance under the premise that private insurance coverage is insufficient.

Naturally, ECAs only intervene to fill the gaps of commercial markets, not to displace private market appetite.

Basel III compromises trade finance.

In 2013, the Basel Committee continued discussing new bank capital requirements. The leverage ratio (a minimum of capital that banks must hold, as compared to their total exposure) created particularly strong reactions in the trade finance community.

The basic idea of the leverage ratio is to set absolute minimum standards, i.e. exposure = exposure, irrespective of the risk involved. As trade finance involves low risk (and low margin), the community didn't like the new leverage ratio. It argued (and, in the end, succeeded), that banks would lend less to the real economy (trade finance = real economy!), as a consequence of the leverage ratio.

Both commercial risk and political risk are omnipresent.

The yearbook points out that political risk often realizes as a surprise, despite improving statistical analysis tools. However, the Berne Union writes that countries with authoritarian or totalitarian regimes tend to be particularly vulnerable.

In terms of country risk, this is not only linked to the sovereign's solvency but, more and more, to its technical capacity to pay. Moreover, country risk and obligor risk often overlap, especially when quasi-sovereign entities such as Dubai World or systemically important banks are involved.

ECAs brave frontier markets.

Which countries were particularly relevant in 2013 or will become important for ECAs?

  • The Berne Union sticks to so-called frontier markets such as Vietnam, Gabon, Ghana, Nigeria, Kenya, Tanzania, Congo, Mongolia, and Zambia.
  • With the rise of inter-Asian trade, ECAs expect the continent becoming more important in the near future.
  • Due to its strong growth, Latin America is considered a promising market for export and investment insurance in the next decade. Top markets today are Brazil, Bermuda (cruise ship registration), Mexico, Panama, and Argentina.

(More or less) meaningful quotes and buzzwords

The annual report is a marketing document and, as such, contains many nice business language. Some make me think, others simply make me laugh. Please judge yourself:

“Credit and investment insurers stand by their customers in difficult times, and grow with their customers in more prosperous times.”

“Both commercial risk and political risk are omnipresent.”

“The world of plentiful liquidity, low borrowing spreads, and high risk appetite that we experienced until 2007 will not come back any time soon.”

“Some risk management models may be too complicated: By reducing complexity, accuracy may improve. Risk management in the export credit business is relatively easy: It is a business with large and concentrated exposures. Monitoring requires simple tools.”

“Notwithstanding the benefits of improving technology and risk management techniques and software, political risk will always remain difficult to predict.”

“Good underwriting is more an art than a science.”

“In general when analyzing risks in developed countries we tend to emphasize the credit risk of the buyer or the borrower and not consider sufficiently the functioning of the banking sector or foreign exchange market and other political risks related to the host country.”

“If we [export credit agencies] cannot get in the space and really understand the evolving needs for proper capital relief within banks' trade, export, and project finance teams, we [export credit agencies] will lose our relevance at the end of the day.”

“US Exim has sought to systematize its ability to understand and evaluate customer needs by establishing a new functional area within the bank focused exclusively on customer experience. This function is providing a mechanism for US Exim to comprehensively assess the needs of its bank partners (and other customers) and evaluate program, product or progress changes to better serve their needs and ultimately to maximize the volume of support provided to exporters.”

“We understand that holding long-term, ECA-backed assets may become less attractive to banks, but the asset is a good fit for the capital [bond] market.”

“ECAs play an important role in letting products and services compete on a global market.”

“Awareness of credit insurance is still below the optimum level in Asia.”

“The atmosphere [among Prague Club members] is very informal and there is a free exchange of information. The members are not in competition with each other, so there is much room for sharing and helping each other.”

“The third round of the Basel accords will continue to limit the ability of banks to provide trade finance to benefit importers and exporters.”

“Insurance companies are slowly starting to use their liquidity to invest in trade finance instruments as a new area of business.”


Thursday, April 17, 2014

Finance News Q1 2014 – “Tail risk has now been taken away.”

“Tail risk has now been taken away.”
Anshu Jain (Deutsche Bank) – January 23, 2014

Let's assume you spend the last three months on an island in the Pacific Ocean without access to the outside world. Tomorrow, you will be back in the office. Here are the key topics that you need to know something about:

Monetary policy – tapering vs. asset purchases

The U.S. FED continues its tapering policy and disrespects criticism from emerging markets. In Europe, the ECB sticks to its loose monetary policy and even evaluates asset purchase programs. Germany doubts whether the ECB can do that.

Bank scandals – Madoff, LIBOR, and FOREX

Madoff, LIBOR, and FOREX are still with us. By the way, Goldman Sachs has found what was responsible for these scandals: It's the computer messaging services that traders use... BNP Paribas adds international embargo violation to the list of scandals.

Banks' earnings – trading volumes down.

Banks' earnings suffer in Q1. Many suffer from decreasing trading volumes, namely in commodity, fixed income, and FOREX markets.

European debt crisis was yesterday. Deflation is today?

As Ireland issues its first post-bailout bond, Greece obtains another bailout tranche, and sovereign bond yields in Europe decline, we hear less about sovereign debt. Politicians, beware of complacency! Deflation fills the news gap and becomes the new hot macro topic in Europe.

For those who didn't know yet: AQR means asset quality review.

The European Central Bank reviews the quality of banks' assets and this starts making people nervous. Are German shipping loan portfolios worse than expected? Will the European banking sector consolidate?

Is Bitcoin good or bad?

The U.S. and Russia take action to welcome the new currency (if ever it is a currency). Germany, as always, criticizes.

Is securitization back?

In the U.S., auto-loan securitization, namely of sub-prime loans, is in vogue again. In Europe, the ECB also takes action to revitalize its securitization market. How does that fit with fears in Europe about covenant lite loans and new credit bubbles?

Bonus up / Staff down

Barclays learns that timing is important in communication: It raises bonus payments by 10 % and, at the same time, cuts 10,000 staff. The financial press is more than willing to take up the story.

19 BUSD for a smart-phone application!

Facebook buys WhatApp for 19 BUSD. Did you try to explain that to your grandparents?

Is China's credit market dangerous?

The People's Bank of China tries to decrease lending by retaining liquidity from the market. We also learn about a bank run in the country; the PBC ensures that deposits are safe. Finally, China allows private companies to default.

European Banking Union

At the beginning of the year, politicians disagree about the decision-making mechanisms in case of winding up European banks and about how to fund the bailout mechanism. By the end of the Q1, they reach an agreement and Europe celebrates its banking union. Will it work?

As time goes by...

The German constitutional court again rejects plaints against the European ESM. The French Cour de Cassation confirms Société Générale's ex-trader's Jérôme Kerviel's condemnation in last resort.

These topics were ground-breaking news some time ago. Today, they are worth a small newspaper article, at most.

Sunday, April 13, 2014

Morgan – the uncrowned king of the world? – A look at J.P. Morgan in the 1930s

Today, J.P. Morgan holds total assets of 2.4 trillion USD. That is about half the cumulated net worth of the 500 richest people in the world or 32 times the net worth of the richest man in the world (currently Bill Gates). Roughly 260,000 employees work for the bank. That is 3 % of London’s total population or 65 % of Zürich’s total population.
How can a bank become that big?

In 1932, Fritz Schwartz provided some answers in his book “Morgan – der ungekrönte König der Welt”. Clearly, Fritz Schwartz doesn’t like the Morgan family and the business practices of its two main representatives of that time, John Pierpont Senior and John Pierpont Junior. If you read German, I encourage you to have a look at this short book. Whether you believe in all the stories or agree with the author is not relevant here. The book is simply funny to read.

„Morgen ist Herr über die Geldmenge!“

“Morgan is the master of money supply“

The Morgan family
The Morgan family stems from the Normandy region in France. It migrated to the United States in the early 19th century where Josef Morgan made a fortune in the agriculture and stage coach businesses and Junius Spencer Morgan became, as Peabody Bank’s shareholder, the financial representative of the United States of England during the American civil war.

„In der Familie Morgan war die Jagd nach dem Dollar eine beliebte Beschäftigung.“

“In the Morgan family, chasing the dollar was a popular activity.”

John Pierpont Morgan Senior (1837 – 1913)

Fritz Schwarz offers a surprising theory for J.P. Morgan’s business acumen: When studying mathematics in Germany, he fell, at the age of 22, in love with Miss Amelia Sturges. Unfortunately, a few months after the marriage, she died prematurely. According to the author, this triggered a rancorousness which made J.P. Morgan focus relentlessly on his business activities. This is somewhat contradictory to his second marriage and the birth of his son in 1867

J.P. Morgan Senior

Let’s have a look at some of the transactions Fritz Schwartz describes in his book:

Carbine trade
Through undercover agents, Morgan bought 5,000 carbines from the American army. They were seen as defective and dangerous and, thus, sold for USD 3.50 per piece. A few months later, Morgan declared the same carbines as new and faultless and sold them back to the U.S. army for 22 USD per piece. Even though the army contested, it lost in court.

Contraction of money supply between 1873 and 1893
Before 1873, the money supply was dependent on gold and silver reserves. On February 12, 1873, silver was abolished as support metal. As gold reserves were rare at that time, money supply contracted and, as a result, aggregate demand and prices dropped. Morgan benefited from this situation by buying cheap stocks of railway companies. When gold reserves recovered later on, Morgan resold the stock at higher prices, thus making a huge profit.

„Morgan galt als der mächtigste amerikanische Eisenbahnmagnat, ohne dass er selber jemals eine Eisenbahn gebaut hätte, woraus wieder klar hervorgeht, dass der Geldmann dem Unternehmer überlegen ist.“

"Morgan was considered the most powerful American railroad magnate, although he himself had never built a railroad. This shows once again clearly that the financier is superior to the entrepreneur."

Proprietary trading
As you can read in Fritz Schwartz’ book, proprietary trading was already an issue back in the 1930s. He blames J.P. Morgan for speculating with deposits of the middle class instead of using these funds to give credits to start-up companies.

„Selbst wenn sich der Mittelstand vorsichtig von den Gefahren des Geldmarktes fern hält, so wird sein Geld doch von den Banken benutzt, wie wenn es ihr Eigentum wäre. […] Die Börsenherren beherrschen die Banken; diese ihrerseits spekulieren mit dem Geld der kleinen Sparer, wobei ihnen die Verluste aufgehalst werden, während die Gewinne den Großen zufallen, die besser unterrichtet sind als die kleinen Banken.“

“Even if the middle class keeps away from the dangers of the money market, its money is still used by the banks, as if it were their property. […] The stock market masters dominate the banks that speculate with the money of small savers saddling them with the losses, while distributing the profits to the big banks which are better informed than the small banks.”

1907/08 world economic crisis
The author accuses J.P. Morgan of having triggered the world economic crisis in 1907/08 to earn a profit of 3 BUSD. In this context, he cites President Roosevelt as follows:

„Die Majestät des Staates und der Gesetze wurde in den Kot gestampft unter dem goldgepanzerten Fuß eines meineidigen Zuchthäuslers [J.P. Morgan].“

"The majesty of the state and the law was rammed into the mire under the gold-plated foot of a perjured convict [J.P. Morgan] committing perjury."

Death of John Pierpont Morgan Senior

Morgan dies in 1973. Fritz Schwarz describes the scene:

„Er, der einen Magen gehabt hatte, der Nägel vertragen konnte, der stets für zwei aß und trank und dreißig bis vierzig schwere Havannas täglich rauchte, konnte plötzlich nichts mehr verdauen. Schwach und immer schwächer werdend, wollte er in Karnak [in Ägypten] noch im Wagen durch die Säulenreihen des Ammon-Tempels fahren. Man gestattete es ihm nicht, wollte aber die Fahrt in einem Krankenwagen erlauben. Das aber wollte wiederum Morgan nicht, «denn», bemerkte er bitter, „wenn Wall Street erfährt, dass sich Morgan nicht mehr auf den Beinen halten kann, so werden die Kurse fallen und ich wünsche jetzt keine Baisse.“ Mit seiner Jacht «Corsair» fuhr er nach Rom; er wollte nicht unter Mohammedanern sterben. In der ewigen Stadt erlöste der Tod den sechsundsiebzigjährigen, nun ganz abgezehrten Mann nach einem mehrtägigen Todeskampf, am 31. März 1913.“

“He, who had had a stomach that could digest nails, always ate and drank for two and smoked thirty to forty heavy Havana cigars daily, suddenly couldn’t digest anything. Weak, and becoming weaker and weaker, he still wanted to drive, in his car, through the colonnades of the temple of Amun in Karnak, [Egypt]. The doctors only wanted to allow the ride in an ambulance. Morgan, however, did not want this, because he remarked bitterly, "if Wall Street learns that Morgan cannot stay on his feet, prices will fall and I wish now no bear market for now." With his yacht, the "Corsair", he went to Rome, as he did not want to die under Mohammedans. In the eternal city of Rome, the death redeemed the 76 year old, now very emaciated man after several days of agony, on March 31, 1913.”

Temple of Amon - Karnak

John Pierpont Morgan Junior (1867 – 1943)

Fritz Schwartz starts off criticizing the appearance of the Morgan family but noting a positive evolution over generations: While he pinpoints to the “deformed and swollen nose of J.P. Morgan Senior” and the excess weight of J.P. Morgan Junior, he welcomes Junius Morgan’s look, as he is “tall, svelte, and blond”.

J.P. Morgan Junior

„Er [J.P. Morgan Junior] ist heute einer der einsamsten Menschen und sein Bekanntenkreis ist selbst unter Geschäftsfreunden nicht groß. Jeder spricht über Morgan, aber niemand kennt ihn; er ist zu einem Mythos geworden.“

"Today, he [J.P. Morgan Junior] is one of the loneliest men and even in business his circle of acquaintances is not large. Everyone is talking about Morgan, but no one knows him, and he has become a myth.”

JP Morgan’s office life in the 1930s
Morgan shared his office with 12 collaborators. According to Fritz Schwartz, the group was called “Christ and the 12 apostles”. He writes that the office resembled a school class, as the desks were arranged in rows, with J.P. Morgan sitting in the last row. I am, however, wondering where Fritz Schwartz got all this detailed knowledge from…

Financing the First World War
The author describes how J.P. Morgan benefited from the First World War. As a matter of fact, his bank arranged and placed bonds issued by the Allied forces. At this stage, Fritz Schwarz’ book becomes a bit preposterous as he writes, “to earn these sums and to save funds invested in Europe, American soldiers have been sent to the European theater of war”.

J.P. Morgan’s fight for the gold standard

„Der Kampf gegen die Goldwährung ist der Freiheitskampf des 20 Jahrhunderts.“

"The fight against the gold standard is the struggle for freedom of the 20th century.”

Until 1976, the value of the U.S. dollar was pegged to the value of gold. This gold standard had already been debated in the U.S. in the 1930s. Fritz Schwarz was not a great believer in the gold standard. In his view, it only allowed banks like J.P. Morgan to speculate. Hence, they defended the gold standard ferociously. The writer describes two main stories:

In 1924, J.P. Morgan Junior fought successfully against the U.S. presidential candidate Robert La Follette, who wanted to abolish the gold standard. Fritz Schwartz writes that J.P. Morgan threatened voters to stop lending to their employers if La Follette became president.

In 1930, the Bank for International Settlements (BIS) was founded to recover and settle reparation payments imposed on Germany after the First World War. Where is the link to the gold standard? It’s the choice of Basel as seat of the BIS, records Fritz Schwartz: Switzerland is said having promised to stick to the gold standard in exchange for locating the BIS in the country. This is obviously not the story that BIS tells about its foundation: “The choice of Switzerland for the seat of the BIS was a compromise by those countries that established the BIS: Belgium, France, Germany, Italy, Japan, the United Kingdom and the United States. When consensus could not be reached on locating the Bank in London, Brussels or Amsterdam, the choice fell on Switzerland. An independent, neutral country, Switzerland offered the BIS less exposure to undue influence from any of the major powers.”

Tax fraud?

Let’s finish with a quote from J.P. Morgan Junior, as reported by Fritz Schwartz. Accused of tax fraud, he allegedly said in court:

„Ich unterstehe keinen Gesetzen, sondern einem ungeschriebenen Ehrenkodex. Mein Kredit ist mein wertvollster Besitz.“

"I am not governed by laws but only by an unwritten code of honor. My credit is my most prized possession."

Again, I actually don’t know which stories in Schwartz’ book are right and which are wrong. But that’s not my point. I have read the book simply because it’s a piece of history which gives a sense of how people thought about the finance industry at that time.


Sunday, April 6, 2014

Regulating LIBOR, EURIBOR, and the like – Help restoring confidence in benchmarks’ integrity?

The story has been told many times in the financial press: Bank employee A communicates data to a financial index provider. The data then flows into the index. Bank employee B trades on the same index. As both employees know each-other, data communication and index fixing “somehow influence each-other”. Because this is illegal, we had first the LIBOR / EURIBOR scandal and, currently, the FOREX scandal.

On September 18, 2013, the European Commission has published a proposal to tackle the problem. Keeping in mind that the FOREX scandal is just about to unfold, this is certainly not the final draft. Nevertheless, the main principles should remain relevant in any case:

When does the regulation apply?

The EU proposal covers three types of activities – contributing data to a benchmark, publishing a benchmark, and using a benchmark. But what is a benchmark? A benchmark is an index that influences on the value of a financial instrument. You will have noticed that I have swapped one general term (benchmark) by another one (index). So what is an index? An index is a figure that is calculated regularly, on the basis of other underlying parameters, and then published. Now we put this together and understand what the regulation intends to cover:

  • Underlying data
  • Regular calculation of a number
  • Number relevant for valuing financial instruments
  • Publishing the number

The nature of the data (economic data or non-economic data such as weather conditions) is not relevant for the scope of application. Thus, the proposal covers a wide range of benchmarks. It includes not only LIBOR / EURIBOR but also other indexes such as commodity indices.

“Today's proposals will ensure for the first time that all benchmark providers have to be authorized and supervised; they will enhance transparency and tackle conflicts of interest. As a result, the integrity as well as the continuity and quality of key benchmarks will be ensured.”
(Michel Barnier, European Commission, 18 September 2013)

What have benchmark administrators to do?

Benchmark administrators gather data, calculate benchmarks, and then publish them.

The European Commission suggests enhancing their internal corporate governance. The detailed proposals include

  • defining organizational responsibilities clearly and consistently;
  • creating an internal oversight function and compliance framework;
  • allowing for outsourcing functions as long as the benchmark administrator keeps control over the provision and supervision of the benchmark.

A benchmark administrator must be authorized by EU regulators. If the administrator stems from a non EU member country, he must still be recognized by the European Commission. This will be an equivalence decision; it basically says that the third country imposes conditions on the administrator, in essence comparable to those applicable in the EU.

For each benchmark, its administrator establishes a benchmark statement summarizing

  • the market or economic reality that the benchmark measures;
  • the purposes for which the benchmark is used;
  • the calculation parameters;
  • the factors that can lead to changes or cessation of the benchmark.

Benchmark data must be transparent. Thus, input data of a benchmark is published. The only exception to this rule is where such publication would have serious adverse consequences, either for the contributors or for the integrity of the benchmark.

Finally, a procedure must be in place that guides changes to or the cessation of a benchmark.

What are the conditions for benchmark data?

Four key criteria apply to benchmark data:

  • Benchmark data should be sufficient and accurate. It must reflect the economic reality that the benchmark intends to measure.
  • A reliable and representative panel or sample of contributors must provide the data.
  • Whenever possible, the benchmark data should consist of real transaction data as opposed to estimates about the right market price. The reason is very simple: Real transaction is what it is – real. Manipulation is only possible in a very restricted way. If non-transaction data is provided and one contributor has more than 50 % market share, the administrator of the benchmark must check that the market is virtually subject to supply and demand forces.
  • The administrator should use a robust, reliable, and transparent methodology to determine the benchmark.

How must benchmark contributors behave?

Benchmark contributors must put in place a code of conduct for each benchmark. The code will specify the administrator’s and contributor’s responsibilities and obligations; both administrator and contributor must sign it.

A benchmark can only be as good as its underlying data. This is why important market participants must contribute their data for a benchmark to be reliable. More specifically, this means that regulators can force market participants to contribute to a benchmark. However, this is limited to a scenario where the benchmark influences on financial instruments with a notional value of at least 500 BEUR and at least 20 % of its contributors are likely to cease contributing to the benchmark.

My impression when reading the Commission’s proposal is that it is both very detailed and very general at the same time. I am wondering whether we really need additional regulation of this topic. Isn’t current legislation (both criminal and anti-trust) clear enough? Isn’t the whole story more about effective application of today’s rules rather than creating new ones?