ISDA responds to European Comission

The European Commission just released it's communication on derivatives. It is actually a reasonably well thought out paper, though misguided in a few places:




ISDA immediately responded. Here is a quote from the response that goes to the heart of the matter (that we've discussed numerous times on Sober Look):

ISDA welcomes the Commission’s Communication as the Association has a strong interest in the central clearing of CDS as one part of a strong and healthy market. At the same time, ISDA values recognition by regulators of the continuing need for bilateral customised transactions which by their nature are not suited for clearing.

ISDA believes that those exposed to credit risk should have the option to choose the type of transaction that best suit their business and risk management needs, as works so well for customers in the equity, interest rate, commodity and FX sectors. Removing that flexibility, such as by forcing bilateral participants to trade on an exchange or otherwise limiting the availability of customized risk management solutions, would be a step backwards.

The anatomy of the crisis

It's easy to get caught up in the "now" and miss the full picture of what we've gone through. Sometimes it helps to superimpose policy moves and historical data to get to the true anatomy of the crisis. Here is the investment grade corporate spread as it first reacted to the crisis and risk started getting priced in.



People often forget that the crisis first revealed itself in 2007, while 2008 was simply the full manifestation. In fact you can see the first blip in VIX in the spring of 07:



Here is a great timeline from the Fed with all the key events and policy responses of the financial crisis.

IKEA - another symptom of Russian commercial dysfunction

The news coming out of Russia continue to show a deteriorating commercial climate of that nation. Following up on our recent post Russia's latest troubles here is a quote from the Economist:

The clearest indictment of Russia’s investment climate came a few days ago from IKEA, a Swedish retail chain, whose local operation has grown quickly since it opened its first store near Moscow in 2000. On June 23rd IKEA said it was suspending its investment in Russia because of the “unpredictable character of administrative procedures”, a euphemism for graft. A symbol of Russia’s economic rebound from the 1998 financial crisis has become an emblem of its dire investment climate.

Among 181 countries surveyed by the World Bank for ease of doing business, Russia occupies 120th place, below Nigeria. Transparency International gives Russia barely two points out of ten—its worst performance in ten years, which puts it on a par with Kenya. Until recently the Kremlin had no need to worry about things like property rights and the rule of law. Its oil wealth ensured an economic boom, no matter how it treated investors. Most of the money that flowed into the country came in the form of loans rather than foreign direct investment.

Now the loans have dried up. The Russian economy is forecast to contract by 8.5% this year, an especially dire performance by the standards of the so-called BRIC countries (the others are Brazil, China and India).

Ironically Russian non-energy exports are lower than that of Sweden. One way for the Russian "democratically elected" dictatorship to maintain it's grip on power in the face of economic decline is to Wag the Dog (from the famous 1997 film). That is we are likely to see Russia get entangled in another conflict such as the one with Georgia to "rally" the people in nationalistic fervor. And the longer oil prices stay subdued, the more antagonistic the Russian leadership will become. The Obama administration will have it's hands full.

California and the Recovery Bill

Leave it to the Russians to report on California's little budget problem. It's actually a concise and reasonably accurate overview of what's going on in CA.



Not a pretty sight. The state is now bankrupt with a $23 billion dollar budget hole to plug (see earlier post called California running out of options)

So here is the question: shouldn't the Recovery Bill help with the problem? If you don't remember the Recovery Bill with all the federal money that's being spent, here is a reminder from the NY Times.

If you look at the amounts allocated to California under the Recovery Bill, it adds up to a nice chunk of change. Here is what our friends from the Eureka state are getting:



This should make a dent in the old budget problem, right? It turns out that it's too little too late. The Recovery Bill is scheduled to spend about $50 billion nationally in fiscal 2009. Below is the "handouts" schedule of the "easy come, easy go" taxpayer money. The point is this will take a while to get to California and the bigger issue still is what happens after they spend the Recovery Bill money.

Mutual fund flows keep HY issuers alive. For now.

New HY debt issuance has hit levels that we saw back in 07 as the appetite for bonds returned (at least for now). Not so for loans. In fact some of the bond issuance has been used to refinance loans (see our post called Leveraged loans - a race against time)



The bond demand is coming from the usual suspects - mutual funds. Mutual funds have been keeping the credit markets open. Here is the recent history of mutual fund flows, both bond and equity funds. Note the pop in bond inflows (green line).

Mutual fund flows($MM); source: Investment Company Institute


Loan demand in the past mostly came from CLOs and other types of funds who ended up leveraged them. Most of that market is now gone. Yet there is a great deal to be refinanced as the maturities for loans are scheduled to accelerate, peaking in 2014 (see the latest chart from JPM below). By refinancing their loans now (with bond issuance), some firms have delayed the day of reckoning. Those who are unable to do so in the next 2-3 years will be facing default.

A sober reader comments on DOE

Here is an email from a sober reader asking some tough questions about the US Department of Energy:

What was the Reason for Establishing the Dept of Energy???

Does anybody have any memory of the reason given for the
establishment of the DEPARTMENT OF ENERGY ...... during the
Carter Administration?

Anybody?

Anything?

No?

Didn't think so !

Bottom line .. we've spent several hundred billion dollars in
support of an agency ... the reason for which not one person
who reads this can remember.

Ready???????

It was very simple .. and at the time everybody thought it very
appropriate... The 'Department of Energy' was instituted on
8- 04-1977 TO LESSEN OUR DEPENDENCE ON FOREIGN OIL.

Hey, pretty efficient, huh????? AND NOW IT'S 2009,
Only 32 YEARS LATER ...

AND THE BUDGET FOR THIS NECESSARY DEPARTMENT IS AT
$24.2 BILLION A YEAR

IT HAS

16,000 FEDERAL EMPLOYEES AND APPROXIMATELY

100,000 CONTRACT EMPLOYEES

· AND LOOK AT THE JOB IT HAS DONE!

· THIS IS WHERE YOU SLAP YOUR FOREHEAD AND SAY

· 'WHAT WAS I THINKING?'

Ah, yes, good ole bureaucracy..

And NOW we are going to turn the Banking System, health care & the Auto Industry over to them?

God Help Us !!!

Looking for work? Become a construction spending forecaster

From Reuters:

U.S. construction spending fell 0.9 percent in May to the lowest rate in more than five years, with the economic stimulus plan passed in February providing little relief in public construction, according to Commerce Department data released on Wednesday.

The drop was more than expected, with economists polled by Reuters forecasting a fall of only 0.5 percent.

Construction spending is clearly off as the industry continues to struggle, but it seems that economists are having a real tough time forecasting the number.

In fact the Bloomberg survey of forecasts historically has little correlation with the actual numbers, particularly recently.



Anyone out there interested in trying to forecast construction spending? Shouldn't be hard to beat the consensus.

B F Skinner, the Fed, and the housing market

Here is a psychologist’s perspective on the housing bubble: it may just be the result of positive reinforcement. Burrhus Frederic Skinner, a US psychologist was an early pioneer of the "reinforcement" construct in behavioral science.



Here is the definition of what's called Positive Reinforcement:

Positive reinforcement is an increase in the future frequency of a behavior due to the addition of a stimulus immediately following a response. Giving (or adding) food to a dog contingent on its sitting is an example of positive reinforcement (if this results in an increase in the future behavior of the dog sitting). Note that in order for positive reinforcement to be effective, the stimulus doesn't need to be intentional.

What does this have to do with housing? Well over the last 20 years or so the Fed has been providing stimulus to the housing markets and built up a nice positive reinforcement process.

Here is a chart showing the Fed Funds target rate and the Case-Shiller YOY housing price changes. One can point to 3 cases (particularly the last case) when slower growth in housing prices was quickly followed by an accommodative action by the Fed. Whether or not the Fed was actually trying to prop up the housing market is irrelevant - the reason for stimulus has nothing to do with developing a certain response behavior.




This is to a large extent what got banks, consumers, and rating agencies behaving in ways they did with respect to housing. Sadly some of the roots of this crisis may just come down to the basic concept of stimulus-response.