Big Gains for Intel

Going back to the start of the last bull market in October 2002, Intel has now had a one-day gain of 7% or more 13 times. Below we highlight these 13 days and also show how the stock has performed the next day and over the next week. As shown, the stock has traded lower on the day after a...

The Morning Leverage: Testing The Financial System

In this morning’s media roundup:

News: CIT Group said yesterday “there is no appreciable likelihood” of fresh government support for it. As our colleagues at the Wall Street Journal write, “What happens next will be a major test of whether the financial system and economy are sufficiently healed to absorb CIT’s problems.” Click here for an analysis of just how bad CIT’s loan portfolio really is and here for our look at the problems a CIT bankruptcy could pose to the mid-market private equity world.

Is Brynwood Partners’ decision to shut Stella D’Oro’s Bronx plant half-baked? The Huffington Post reports on various attempts by the company’s union to fight the move.

Jim Spanfeller, chief of Elevation Partners-backed, is stepping down in the latest shakeup in the financial publishing world. Our colleagues at All Things Digital have the memo.

Huntsman Gay Global Capital joins the exclusive club of debut funds that have been able to raise capital in this environment, closing its new fund at $1.1 billion. Like another debut fund we recently reported on, Huntsman Gay attributed part of its success to the rather large $100 million commitment to the fund by its own partners. Read the LBO Wire story.

Blackstone Group is facing some community protest over three coal-fired power plants its Sithe Global Power portfolio company is building. Protesters say the plants don’t make environmental or economical sense. Here’s the LBO Wire story.

Opinion: Olivier Sarkozy and Randall Quarles of the Carlyle Group have taken the private equity industry’s quarrel with proposed new FDIC rules governing private investment in banks to the op-ed pages of the Wall Street Journal. Taking issue with the “super-capital” rule, the “source of strength” rule and the “cross-guarantee” rule, they write that “any one of these requirements would pose a substantial deterrent to private investors. Together, the three would dramatically reduce the amount of capital that the FDIC could attract to its auctions of failed banks.”

Analysis: BusinessWeek takes a look at the time bomb lurking in corporate debt - an issue that makes the PE industry especially queasy. It says economists are worried by the thought that the corporate default rate could remain high for an extended period of time - a change from previous recessionary patterns.

Just for fun: Guess the financial bust, over at FT Alphaville.

CIT Group may not be too big too fail, but this sheep is.

Lehman, Again, Must We?

“A shut-down in rational decision making”

Good afternoon. In today's call we will continue to use the word unprecedented to describe our environment. As a Company, we have never seen a change as abrupt as the one that has occurred in our E&C market since early September.

The first break came in mid-September when demand dropped as a result of the meltdown in the financial markets….—Steven Berglund, CEO Trimble Navigation; February 3, 2009

Trimble Navigation is, for readers who don’t know the company, the Garmin or Tom-Tom of the agriculture and E&C (engineering and construction) businesses.

Steve Berglund, for readers who don’t know him, is about as straight-talking a CEO as they make.

And it was Berglund’s comments about the credit collapse from the company’s February conference call—especially “the first break in mid-September”—that played in our minds as we considered the following headline on our Bloomberg:

CIT Says U.S. Bailout Unlikely as Talks End, Studies Options With Advisers

CIT, for readers who don’t know the company, is to the retailing and manufacturing businesses of America what Lehman Brothers—whose collapse triggered that “first break in mid-September” of 2008—was to hedge funds and commercial real estate developers.

And it was the collapse of Lehman Brothers that triggered the credit crisis Steve Berglund, in that same February call, described as forming “two distinct periods” in 2008:

Total year 2008 really consisted of two distinct periods. The first nine months were recession conditions and difficult....
The sharp break in the fourth quarter represented a major loss of confidence by businesses which constituted our primary customer business base.

This resulted in businesses across the U.S. and Europe cutting back dramatically on investments. In practical terms, the E&C market has shut down rational decision-making while awaiting events.

Now, we hear at NotMakingThisUp are not suggesting CIT's problems will have any impact on Trimble Navigation. If CIT goes down, it will not be the engineering and construction business that will “shut down rational decision-making.”

Rather, it will be thousands of small and middle market and large companies that borrow money and lease equipment from CIT that may well see a “shut down in rational decision-making.”

For CIT lends to manufacturers and wholesalers and distributors and importers and retailers and technology companies, and broadcasting, publishing, security, gaming, sports and entertainment companies.

And it provides credit to Small Business Administration borrowers.

In addition, CIT does business with “all of the U.S. and Canadian Class I railroads,” according to the CIT 10K. It leases hopper cars to ship grain, gondola cars for coal, open hopper cars for coal, and center beam flat cars for lumber through CIT.

And CIT leases aircraft to airlines—23 aircraft placed in 2008, and 114 aircraft on order at the end of 2008—and it finances parts for defense companies.

And woe be the retailers who finance their accounts receivable through CIT—$42 billion worth in 2008—and the small commercial businesses who lease office equipment financed by CIT.

When Lehman went down, the Feds claimed they couldn’t get involved, even while they were preparing the necessary documents to take over AIG, the collapse of which would have brought down the world (see
“Widespread Panic, Starting Today” from September 18, 2008).

CIT may not bring down the world, but its failure, we think, could well trigger an echo of the Lehman collapse.

Why the Feds are not prepared to help—a shut down in rational decision making in and of itself—we can’t fathom.

Jeff Matthews
I Am Not Making This Up

© 2009 NotMakingThisUp, LLC

The content contained in this blog represents the opinions of Mr. Matthews.
Mr. Matthews also acts as an advisor and clients advised by Mr. Matthews may hold either long or short positions in securities of various companies discussed in the blog based upon Mr. Matthews’ recommendations. This commentary in no way constitutes investment advice. It should never be relied on in making an investment decision, ever. Nor are these comments meant to be a solicitation of business in any way: such inquiries will be ignored. This content is intended solely for the entertainment of the reader, and the author.

July 15 Recap — “Super Rally” Time?

If you've been watching CNBC this week you may have seen Art Cashin lay out his "super rally" scenario. It's essentially a massive short-squeeze caused by those bears who bit on the S&P's break of the neckline of the head & shoulders pattern (H&S) many people had been watching. Of course that breakdown turned out to be a head-fake. So Art theorizes that as the S&P takes out the right shoulder and then the head of the H&S those bears will scramble to cover their positions and push the market even higher. Judging by the intraday action (no dips/melting up) on Monday and yesterday I think there's a lot of short-covering going on. Heck, I'd just call it panic buying, which is probably also being done by people who are not short but are fearful of missing out on any upside.

I've always preferred to see the market weak ahead of earnings because it felt as though it was easier to spark a rally since expectations were apparently lowered. We were in that situation to start this week but now we're in the opposite situation. The indices are short-term overbought and heading into resistance from the 2009 highs. It may be tempting to try to chase stocks here but I believe there will be some earnings disappointments in the coming weeks that will create better buying opportunities.

Trend Table

Everything is up once again...

TrendNasdaqS&P 500Russell 2000

(+) Indicates an upward reclassification today
(-) Indicates a downward reclassification today
Lat Indicates a Lateral trend

*** I'm simply using the indices' relations to their 200, 50 and 10-day moving averages to tell me the long, intermediate and short-term trends, respectively.

Google, IBM Net Rise; Nokia Net Falls

Google Inc second quarter revenues rose 3% to $5.52 billion and net income rose 19% to $1.48 billion or $4.66 a share. International Business Machines Corporation second quarter sales fell 13% to $23.3 billion and net income rose 12% to $3.1 billion or $2.32 a share.

Forget Evolutionary, This Could Be Revolutionary

IndexUniverse has a post up about an ETF filing from a firm called FactorETF that could be huge. The basic idea is that the ETFs would capture performance dispersions between different asset classes or different segments of the stock market. The filing appears to be for 22 funds.

There is one fund listed that captures 200% (they are all levered) of the difference between US value over US growth and then one that captures the difference between US growth over value.There are similar pairings between large cap and small cap, US and developed foreign and US and emerging markets. There are three funds that capture the excess return (or lack thereof) of a US sector over the broad domestic market and two similar funds for groups of stock over the broad market. There are pairings for stock versus government bonds, plays on the yield curve, credit spreads and inflation versus bond yields.

These funds, if any of them actually list (sorry to be negative but look at page two of the ETFWatch on IndexUniverse), offer a tremendous step up in portfolio sophistication for certain types of hedging. For example for a period last year certain foreign stocks lagged domestic because of a panic rally in the dollar. The FactorETF 2x Non US Developed Factor Shares could help offset this. The yield curve products could be especially helpful now given the likelihood of higher rates coming down the road. The FactorETF 2x Financial Factor Shares could be a way to buy into the sector without buying the sector. Making a couple of assumptions, someone nimble enough to have bought financials in March could have bought a small position in 2x Financial Factor Shares which would have gotten progressively bigger in the portfolio as the sector began to rocket higher ahead of the market.

There are caveats galore here. First, this is just a filing who knows if any of these will ever list. If any of them do come to the market I would give them quite a few months to show how they actually trade. There is a lot of learning that needs to be done between this post and actually buying one of these in terms of strategic implications in addition to whether these funds would actually work. The biggest caveat is anyone who would consider using these, and they will not be right for everyone, would be advised to do so in moderation.

Assuming they work, I would still prefer SDS (clients have a small position in this now) for the bulk of my bear market hedge. The Factor equity funds would have more application in mitigating the consequences of getting things wrong like growth versus value for people that invest that way and so on. They could go up in a bear market as growth might drop 2% one day and value 3% so the growth fund would be up but you know SDS will go up on a down day.

Part of my first reaction is to compare these proposed funds to the ones from IndexIQ. They have two ETFs trading; a multi hedge fund strategy ETF (QAI) and an emerging market macro ETF (MCRO). You can look at the full list from IndexIQ here. I'm a tad underwhlemed by QAI and MCRO but maybe some of their proposed arbitrage funds could be useful.

Hopefully these funds list and we can have a more productive look at these.

Data Explorers – Focus Stock – Rexam Plc [REX] – 16 July 2009

On Tuesday packaging makers were among the top performers on the London market.  The attributed this increase in share price due to  investors seeking predictability in a range bound market.  Rexam (REX) gained 2.1% after Goldman Sachs forecast the beverage can maker could deliver sector-leading growth over the next five years.   The short side of the market does not seem to share this view as the short base (as measured by Percent Shares Outstanding on Loan) for the stock has been steadily rising over the past few months and has hit a 52 week high of 4.64%. 

Other packaging companies have also seen an increase in short interest over the past few months but Silgan Holdings (1.94%), Crown Holdings (1.95%), Ball Corp (2.25%) and Amcor (1.57%) are still below the short base of Rexam.


Download the full report by clicking here



Data Explorers Focus Stock - REX 16 Jul 2009.pdf163.27 KB

The VIX is Up! The VIX is Up!

You know what they say. When Bloomberg tries to analyze volatility, run the other way. Or something like that.

This from yesterday.

The VIX rose with the Standard & Poor’s 500 Index, a sign from the options market that the steepest three-day rally for stocks since June is poised to end.

The Chicago Board Options Exchange Volatility Index, as the VIX is known, added 1.7 percent to 25.44 at 2 p.m. in New York. The S&P 500 gained 2.4 percent. They have moved in the same direction 6 percent of the time since January 2003, according to data compiled by Charles Schwab Corp. The S&P 500 reversed course the next day 66 percent of the time, including seven of the past nine instances.

Now those are some impressive sounding numbers. But I would suggest there is way more to the story than this. As we often note, the VIX is not the sole gauge of volatility in the marketplace. We have RVX (Russell 200o Index volatility) which closed down 1.33%. We have VXN (Nazz volatility) which closed down 2.88%. We have VXX (the VIX ETN, basically a 30 day VIX future) that closed down 2.47%. Bill notes all this and more.

And to top it all off, we simply had a misleading VIX close on Tuesday. The chart above shows the last 2 days of VIX motion. See that precipitous drop at the bell Tuesday? Remember, the VIX is a STATISTIC. It measures volatility of SPX options. I suspect there was big SPX trade near the bell that knocked SPX volatility down. If we just assume it was a one off order that had the luck (skill) of screwing the the close and forget it ever happened, you could just as easily say the VIX declined yesterday. Albeit not as much as the others and with some afternoon strength thrown in.

Of course you run down a dangerous technical path by picking and choosing when you should ignore data. Then again, you really shouldn't go nuts with technicals here to begin with.

But we did see interesting behavior later in the day.

Why might that have happened? Ryan Renicker of NewEdge suggests it's some covering by trapped options shorts (remember volatility works in up moves too) which I would agree is a logical explanation as any. And not particularly indicative of the next move.

Just always remember that this pup, while informative, is truly not gospel to the tick.

Consecutive Strong Momentum Days: What Next?

Bears who counted on a breakdown of a seeming head-and-shoulders pattern (another eloquent reminder of the folly of believing that shapes on charts dictate global capital flows) have been taken to the woodshed with a high momentum rise in stocks. Specifically, we've seen back to back strong days in the Demand/Supply indicator, which tracks the proportion of stocks closing above the volatility envelopes surrounding their short-term moving averages to those closing below their envelopes. Tuesday saw a near 10:1 ratio of Demand to Supply (upside momentum to downside momentum) and Wednesday was about 15:1.

When we've had back to back days of 5:1 (or greater) Demand to Supply going back to September, 2002 (when I began archiving these data), the next five days in the S&P 500 Index (SPY) have averaged a considerable loss of -1.73% (6 up, 12 down). That is quite a bit weaker than the average five day change of .06% (928 up, 767 down) for the remainder of the sample.

By the time we've had consecutive high momentum days, it appears that--in the short run--the bulls are all in and we've tended to give back some of those gains. Indeed, after a single day of greater than 10:1 momentum, the next four trading days have averaged a loss of -1.22% (10 up, 17 down). Chasing highs after several days of strength, overall, has not been a winning strategy in the short run.

Minsky, mortgages and you

In practice:

Minksy’s protracted moment

If you follow this blog, you’ll recognise these names: Jeremy Grantham, Nouriel Roubini, Robert Shiller, and James Montier. I’ve quoted them many times, and they anticipated the financial crisis.

They have something else in common, they’re all followers of economist Hyman Minsky. Grantham describes himself as a Minsky maven. Roubini  feared we were at the top of Minsky credit cycle in July 2007. There’s an intellectual genealogy linking John Maynard Keynes to Robert Shiller via Charles Kindleberger, Shiller’s teacher, and Minsky, who influenced Shiller. James Montier describes himself as a proponent of the Kindleberger/Minsky framework for analysing bubbles.

Montier recently left Soc Gen, for GMO, Jeremy Grantham’s company. It’s a small, Minskyish club of financial crisis Cassandras.

Here’s Montier’s Kindleberger/Minsky crib-sheet showing the phases of bubbles and crises current and past (click on it for the full sized version):


There are at least five phases, and no prizes for spotting we’re in either phase four or phase five now:

  1. Displacement: A new development, the Internet say, or low interest rates, creates investment opportunities.
  2. Credit creation: Banks create credit to fund the boom, new banks form, and invent new ways of lending and borrowing.
  3. Euphoria: As stockmarket prices rise, overconfident investors ignore risks, abandon safeguards, and make bad  investments.
  4. Distress: Insiders cash out, the prices of investments start to fall and some prove to be fraudulent.
  5. Revulsion: Investors can no longer bring themselves to participate in the market. Investments are cheap again.

Minsky, who died in 1996, explained the credit cycle which fuels booms and busts.  In his Financial Instability Hypothesis (for a nutshell explanation see CXO Advisory Blog) he said the economies are not self-correcting, or equilibrium-seeking, as is commonly supposed, but, depending on the nature of borrowing and lending, can be wild and unstable.

According to the FIH there doesn’t need to be any reason for a recession, or a depression, beyond a long period of prosperity, which lulls borrowers, investors and regulators into complacency, a situation which seems to describe the year 2007.

As confidence in the status quo grows the kind of debt used to finance investment and consumption changes from:

  1. Hedge financing where the borrower can repay the debt out of income and has a high equity stake, to…
  2. Speculative financing where the borrower can repay interest but not the loan, which must be refinanced when it’s due, to…
  3. Ponzi financing: where the borrower cannot repay interest or the loan but must sell assets or borrow more to meet its commitments.

When hedge financing dominates, the economy is stable. When the other two categories dominate, it’s not. Ever-riskier borrowing leads to financial bubbles, and when confidence bursts Ponzi and speculative borrowers are unable to refinance. Instead they must sell assets to stay afloat, driving markets downwards and squeezing more borrowers.

In a recent paper Paul McCulley, managing director of Pimco the giant American asset manager, explains how this time a shadow banking system, unregulated investment banks, hedge funds and the now notorious structured investment vehicles, created explosive growth in debt which ratings agencies and regulators were ill equipped to deal with because they simply hadn’t seen this kind of debt before (and the rating agencies were in the pockets of the shadow bankers).

Since Minsky first published his theory in 1986, McCulley says:

…the first thing we do when we discuss Prof. Minsky is show reverence.

Chalk up another acolyte, who warned that interest-only and subprime mortgages are textbook examples of speculative and Ponzi finance in March 2007.

For a graphic, and somewhat easier to absorb illustration, you only had to watch Freefall on BBC 2 on Tuesday night (you still can on iplayer), and judging by the reviews on, Robert Barbera has written an excellent explanation in his book The Cost of Capitalism.

Freefall dramatised the human side of what McCulley calls the Minsky Moment, or the bursting of the bubble.

He coined the term to describe the Asian credit crisis of 1997, when it was Asian corporations doing the risky borrowing, but the pattern repeats itself through history, as Montier’s crib-sheet shows.

It’s apparent now that nearly everybody’s carried away by these credit fuelled business cycles, from the commanders of the economy, like Alan Greenspan and Gordon Brown, to the family that borrows more than it can afford, reassured by rising house prices.

But this chart, which accompanied an article in Der Spiegel about another economist, William White, who also warned of the impending crisis, makes me wonder whether we have reached revulsion, the final phase of the cycle, yet.

Grafik CS4

Although it refers to America, the UK’s had nigh-on thirty years of falling interest rates too, which probably makes us very complacent.

Figures from the Council of Mortgage Lenders show that the number of new and probably speculative interest only mortgages have declined from a high of about 34% of house purchases in 2007 to 19% in May, but 26% of remortgages are interest only.

More worrying, I think, is borrowers’ predilection for short-term fixed-rate deals and lenders’ willingness to supply them. The CML doesn’t have statistics for the relative popularity of short and long-term fixes but says that one to three year deals are by far the most popular.

The nation’s gambling that interest rates when we come off those rates will remain low. I’m not sure where these deals sit in Minsky’s scheme, but they look speculative.

Add in more risks; house prices falling further, lenders unwilling or unable to refinance loans on similar terms, unemployment, and mortgage holders enjoying low rates now on mortgages that aren’t fixed for the long-term face an incalculable future.

Borrowers haven’t yet learned Minsky’s lesson. Don’t even get me started on bankers!


Have asset prices further to fall? The economy is distressed, but there’s a big difference between phase four of the cycle (distress) and phase five (revulsion). In phase four asset prices are still falling and in phase five they’re cheap.

My modest contribution to the study of asset prices, measuring the long-term price earnings ratio of UK shares, shows they are cheapish but not necessarily revoltingly so.

And just to add even more ambiguity to that statement, Robert Shiller, who believes that lower long-term price earnings ratios do predict higher returns, says the precarious state of the economy means stockmarket predictions are even more unreliable than usual.

In theory:

Vampire Squid is a buy

Some more economists who know what they are talking about. This time Alphaville highlights research by Dirk J Bezemer, including a list of analysts ‘who saw it coming’. Contrary to main stream economists, these analysts paid a great deal of attention to the role of finance and property in the economy.

Another one, Nassim Nicholas Taleb, says instead of inflating assets, banks need to deflate debt by offering homeowners lower interest rates for part ownership of their property.

Pimco’s Paul McCulley, pulls out Ben Bernanke’s roadmap, and sees Washington cutting taxes and printing money like never before.

Meanwhile, the Federal Reserve Bank of New York has published two timelines showing what governments have done so far.

Jeremy Siegel: “Stocks always win in the long run”. Barry Ritholz says “No!”

Meredith Whitney, an analyst that was bearish on banks before the financial crisis, issued a buy note on Goldman Sachs, aka ‘The Great Vampire Squid’.

Ric Traynor, of restructuring specialists Begbies Traynor, says corporate insolvencies could exceed peak levels at the height of the last recession in 1992. They’re up 43% year-on-year.

Graeme defines a value trap.

If financial comment isn’t free, it isn’t influential says Felix Salmon.

Bernard Madoff is transferred to the same prison Charles Ponzi was jailed in.

“Ideas and Rules for the World in the Aftermath of the Storm”

This is a summary of the "causes and nature" of the financial crisis. I've added a few comments along the way:

Lessons for the future: Ideas and rules for the world in the aftermath of the storm, Part I, by Guido Tabellini, Vox EU: Almost two years after the beginning of the financial crisis that has overwhelmed the world economy, it may be time to draw some conclusions and outline the main lessons for the future. Is it really a turning point for market economies, a systemic crisis that will radically change the division of tasks between state and market? Or will everything be back to normal once a number of important technical problems concerning financial regulation are solved?

Market failure

Let us start with the market failure. There is no doubt that the crisis has revealed a serious failure in one of the most sophisticated markets in the world – modern finance. One of the crucial tasks of financial markets is allocating risk. They have failed stunningly. Risk has been underestimated, and many intermediaries took excessive risks. The reasons for this failure and the implications for economic policy, however, are less clear.

One possible explanation is that it was just due to poor judgement. Financial innovation has been so fast that even sophisticated operators were not always able to fully understand the degree of risk of the financial instruments that were constructed. The systemic implications of those instruments were even less clear. As a consequence, many investors overestimated global financial markets’ capacities, overlooking the systemic risk and the illiquidity risk that proved crucial in this crisis. This mistake can partly be explained by the difficulty of correctly evaluating the probability of rare or infrequent events. If this were all, there would be no need to worry. This crisis will not be forgotten, and it will certainly leave a mark on risk management practices and organisation models of financial intermediaries.

There is also a less benevolent explanation for the failure of financial markets, however, that highlights a systematic distortion of individual incentives rather than a mistake. First of all, the “originate and distribute” model, which separates the concession of the loan from the financial investment decision, entails obvious moral hazard problems. Secondly, rating agencies, paid by those issuing the very assets being rated, experience an obvious conflict of interest. Third, managers’ remuneration schemes encourage myopic behaviour and excessive risk taking – if the bonus depends on short-term performance indicators, each individual manager is induced to take risks that are large but rare. If this is true, it means that we cannot trust the ability of markets to learn. Distorted incentives must also be redressed, through new, stricter regulation, even at the cost of significantly slowing down financial innovation or giving up some of its beneficial effects.

It's worth pointing out that there are distinct market failures here because the best policy to overcome the market failure depends upon the type of market failure it addresses. I would have also highlighted the asymmetric information problem in these markets since the desire for reliable information on risks is what drives the need for the ratings agencies, and I would have also noted that the mal incentives extended beyond just the "originate and distribute" model, homeowners (with no recourse loans), real estate agents (who want to sell as many houses as they can for as much as they can to increase commissions), appraisers (who share some of the conflicts that ratings agencies have and also exist to solve an information problem), and so on. So it wasn't just banks and brokers responding to the bad incentives of the originate and distribute model, just about every link in the chain had bad incentives that distorted outcomes in ways that encouraged the build up of excessive risk.

Also, these two explanations are not mutually exclusive. The market failures can lead to excessive risk accumulation, and the extent of this risk could be misperceived. I think it was the interaction of the market failures and the misperception, not predominantly one or the other. If the market failures do not allow dangerous risk levels to accumulate, misperceiving it is not nearly so dangerous.

Regulatory failure

Mistakes in risk management cannot be only attributed to private operators. Supervisors have made major mistakes as well, allowing banks to accumulate off-balance-sheet liabilities and tolerating an excessive growth of leverage (i.e. the ratio of total assets to shareholders' equity) and indebtedness. This could be due to capture of supervisors by banks, arbitrage and international competition among supervising agencies, or implementation deficiencies. But more importantly, there has been a fundamental conceptual mistake –monitoring each financial institution solely on an individual basis, considering as the value at risk of the individual intermediary without taking systemic risk into any consideration. This is the same mistake that the individual intermediaries made.

I agree with the conceptual mistake noted here, but there was another one too. Everyone thought it was a good idea to get risk off of the traditional banking systems balance sheet. Somehow the notion was present that this would - through worldwide distribution of risks - reduce the chances of a meltdown to nearly zero, i.e. to reduce systemic risk. This, of course, turned out to be wrong since risk did, in fact, get concentrated in dangerous ways.

A crisis of these proportions cannot have stemmed exclusively from mistakes in risk management. The reason is that high-risk investments were relatively small compared to the overall dimension of global financial markets (Calomiris 2007). Many observers expected that the American real estate bubble would burst. But few imagined that that would overwhelm financial markets all over the world. If this has happened, it must be that the shocks hit important amplifying mechanisms. This amplification can largely be attributed to financial regulation. In other words, even more than a market failure, the crisis was triggered by a failure of regulation (see the eleventh ICMB-Geneva Report, summarised by Wyplosz 2009).

Not so much that regulation was too lenient, or that deregulation had gone too far – rather, the very founding principles of regulation have amplified the effects of a shock that in reality was not that large. Subprime mortgages, the financial products whose insolvency has originated the current crisis, amount to about one trillion dollars. It is a large number in absolute terms, but small with respect to the total of about 80 trillion dollars of financial assets of the world banking system. As a comparison, consider that the losses originally estimated in 1990 during the savings and loans crisis were about 600-800 millions of dollars, less than the total of subprime mortgages, but the total amount of financial assets was much smaller then. Yet, that crisis was quickly overcome without major upheavals. Why has it been so different this time?

There are two aspects of regulation that have amplified the effects of the initial shock: (i) the procyclicality of leverage, induced by constraints on banks’ equity, and (ii) accounting principles that require assets to be evaluated according to their market value. In case of a loss on investments, which erodes the capital of financial intermediaries, capital adequacy constraints under the Basel accord require reduced leverage and thus force banks to sell assets to obtain liquidity. The problem is thus exacerbated: forced sales reduce the market price of assets, worsening the balance sheets of other investors and inducing further forced sales of assets, in a vicious circle. Exactly the opposite happens during a boom: capital gains on portfolio assets allow intermediaries to expand leverage, which means taking on more debt in order to acquire new assets, in such a way that the price of assets is pushed up and other intermediaries become indebted chasing increasingly high prices. In sum, banking regulation has created a mechanism that amplifies the effects of shocks and accentuates cyclic fluctuations in the indebtedness of financial intermediaries.

I am coming around on the need to regulate leverage, and it does appear to have important cyclical variations. As to the mark to model versus mark to market debate, I still don't like the bad incentives and the possibility for error that exists with the mark to model framework. But the general question of how to best value the assets on a balance sheet during a time like this is an area where I still have some uncertainty.

One of the main lessons to be drawn from this crisis is that we need to deeply reconsider financial regulation and ask ourselves what its ultimate objective is – correcting distorted incentives of agents, creating buffers that reduce procyclicality of leverage, or reducing risks, and, if so, which risks? A sound regulatory system should address two concerns:

  1. Correct distorted incentives of individual intermediaries or financial operators;
  2. Reduce negative externalities and systemic risk, bearing in mind that evaluating risk management practices within individual intermediaries is not sufficient.

Finally, inevitably, this will have to translate into rules that reduce the size of leverage in absolute terms and its procyclicality.

And just to amplify a point from above, since a variety of problems caused the crisis, no single solution can fix them all. It will take a variety of fixes to shore up the system going forward.

Mistakes in managing the crisis

It is widely held that the current situation is mostly the result of economic policy mistakes (in regulation, in supervision and, according to some, monetary policy) made before the outbreak of the crisis. The corollary of this thesis is that it is sufficient to correct these mistakes in order to avoid the next crisis. But the truth is that many serious mistakes have been made during the management of the crisis and have significantly contributed to worsening the situation.

The unclear causes of the crisis have resulted in its management being improvised from step one without a clear path in mind. Bear Stearns was saved, Lehman Brothers failed, AIG was saved. Each decision was improvised, guided by neither pre-established criteria nor a sound and consistent strategy. The result is that, rather than boosting confidence, economic policy interventions have contributed to increasing confusion, panic, and fear.

I have made this point many times as well, and believe it created a lot of additional uncertainty. The handling of Lehman was a costly misstep.

Loss of confidence is always at the heart of any financial crisis. Expectations concerning the behaviour of authorities and other operators play a fundamental role in determining whether there will be contagion or whether the shock will be absorbed. But in order to influence expectations and restore confidence, policymakers must act according to procedures and criteria that are agreed upon and well understood, identifying the ultimate objectives and the policy tools to reach them. There has never been such clarity in this crisis, and that is an important lesson. To avoid repeating similar mistakes, it will be necessary to elaborate new and detailed procedures for managing complex phenomena such as the bankruptcy of large banks and more general policies aimed at preventing the worsening of systemic crises.

I agree, but how do we make these plans credible? We cannot bind future policymakers - they can do as they please - so how do credibly commit to these plans? When the next crisis hits and we have bankruptcy plans for a too big to fail institution, will we actually carry through or will we worry that it might not work out so well after all and step in as we did this time? Still, I think it's important that we try, and if the plans are good ones, we at least have a chance.

Given that large banks with systemic implications are typically multinational, these procedures will need to be coordinated at the international level. This is not easy, since, after all, only the state, and hence taxpayers, can cover systemic risk. Taxpayers must take on the burden of failing institutions’ debts, at least temporarily. But which state, which taxpayers, when the institution is a large multinational bank?

Although difficult, this problem is not new. Financial crises in developing countries, which occurred almost yearly in the 1990s, have now become less frequent and less devastating thanks to the procedures of crisis management elaborated within the International Monetary Fund. It is now time to learn from those experiences, adapting them to the specific problems of large multinational banks.

Yes, we need an institution that can serve as a global and modern version of a lender of last resort.

In my next column, I will outline where we might go from here.

One final comment. I think there are dangers when political power becomes concentrated in too interconnected to fail financial institutions, and this potential contributor to the crisis deserves more emphasis.


Brunnermeier, Markus K, Andrew Crockett, Charles A Goodhart, Avinash Persaud, and Hyun Song Shin (2009). The Fundamental Principles of Financial Regulation. Centre for Economic Policy Research and International Center for Monetary and Banking Studies.
Calomiris, Charles (2007). “Not (Yet) a ‘Minsky Moment’”, 23 November.
Wyplosz, Charles (2009). “The ICMB-CEPR Geneva Report: ‘The Future of Financial Regulation’”, 27 January.

This article may be reproduced with appropriate attribution.

Enough Punishment for One Day

When you are teaching a course, imposing rigorous standards and giving lots of homework can be of great benefit to your students: 

The rigors of the USC Masters in Real Estate Development Program, by Richard Green: A student of ours emails:

I just wanted you to know that this assignment got me out of a traffic ticket this morning.

La Cienega was shutdown to due an accident and I was trapped. So, I made a u-turn which included driving over a curbed median. A motorcycle cop pulled me over and gave me a lecture about how this isn't Texas (I have texas plates) and "cowboy driving" is not acceptable....whatever that means. So I told him that I had to get to campus for the mid- term and I had a limited amount of time to complete the homework assignment. I pulled out assignment #3 to make my story credible and he took it with him when he went back to his motorcycle.

When he came back he told me that it seemed like the assignment was going to be enough punishment and he let me go.

links for 2009-07-16

Volatility Analysis for July 15, 2009

One what was one of the more interesting days in volatility in a long time, I thought I should pass along a few random thoughts:

  1. The intraday tick for tick positive correlation between the VIX and the SPX was as strong as I have ever seen. Most of the time the VIX and the SPX move in opposite directions. Today it was almost as if someone has inverted the gravitational forces acting upon these two indices. (For more on the correlation between the VIX and the SPX, check out the posts with the SPX-VIX correlation label.)

  2. The SPX finished the day up 2.96%, with the VIX up 3.48%. This is the first time ever that both indices moved more than 2.8% in the same direction on the same day.

  3. For more on days in which the VIX and SPX both have strong moves to the upside, check out my June 1st post, Eerie Déjà vu as VIX and SPX Both Jump More Than 2.5%

  4. When both the VIX and SPX are up on the same day, this is historically bearish, generally conveying an edge of 0.25% or to the bears for 3-5 days. This edge begins to diminish substantially after about a month or so.

  5. Regarding today’s VIX movement, keep in mind that the VIX gapped down about 0.80 when Intel (INTC) earnings were announced after hours yesterday. So with the SPX essentially frozen, there was a 0.80 offset going into the day from the 15 minute twilight zone while trading that took place yesterday from 4:00 to 4:15 p.m. ET. If we were to back out the 0.80 after hours VIX drop, then the VIX would have finished approximately flat today – still an interesting development, but a lot less noteworthy.

  6. As predicted earlier today (VXX Volume Spiking to New Record as Investors Bet on Increasing Volatility), the iPath S&P 500 VIX Short-Term Futures ETN (VXX) crushed the old volume record, with 1,537,844 shares exchanging hands, eclipsing the old record by more than 440,000.

  7. Finally, Tuesday was a particularly interesting day to see volatility drop so low, with so many very important volatility events right around the corner, including a critical earnings reporting season, a flood of highly anticipated economic data and options expiration.

techfile 16.07.09

  • Twitter is facing death by a thousand cuts - well, at least 310, anyway. That is the number of confidential internal documents that Mike Arrington of TechCrunch says he has been supplied with by an anonymous hacker, who obtained the information from a Twitter employee’s account with Google. The leak has caused red faces both at Twitter, which also revealed that personal internet accounts of co-founder Evan Williams had been hacked before, and Google, which defended the security of its Gmail and Apps services.
  • The PC market is looking up. Sales were stronger in the second quarter than industry analysts had predicted, suggesting that the industry could be bottoming out as consumers begin to spend more. Worldwide PC sales slipped only 3.1 per cent by volume from a year earlier, about half the retreat expected by market researcher IDC and less than half of the first-quarter’s 6.8 per cent drop.
  • Two more significant technology companies follow Intel’s upbeat report with their second-quarter earnings today - Google and IBM’s results will be eagerly awaited for further signs of a recovery, after the close in New York. Nokia reports earlier in the day.
  • The PC and the Mac guy could be visiting adjacent stores soon.  Kevin Turner, Microsoft chief operating officer,  told its partner conference that Microsoft stores would open close to Apple ones in the autumn.
  • Facebook users have grown to 250m. The social networking service announced the 200m milestone on April 8, so that’s 25 per cent growth in just over three months. At this rate, 350m by Christmas looks likely.

GE, Akamai Fall; Citigroup, CIT Rise

CIT rebounded as the company and its creditors are in advanced stages of discussion to avert bankruptcy filing. A.O. Smith increased after earnings surged. Bank of American earnings declined 25%. Citigroup returned to profitability. General Electric revenues and earnings declined.

John Gapper: Little laptops snap at the oligopoly

The FT’s John Gapper says the most influential piece of personal technology to emerge in recent years did not come from Apple, Amazon or Research in Motion. Instead, he points to the Asustek’s Asus Eee PC, which created the category now known as “netbooks”.

Few analysts grasped the significance of the Eee because they did not think that people in the developed world would buy a not-very-powerful device with a tiny screen and a small keyboard. Meanwhile, US companies from Dell to Microsoft and Apple gazed studiously elsewhere.

Yet, nearly two years on, evidence of the Eee’s influence is everywhere, from the weak outlook reported by Dell this week to Google’s announcement that it will build a rival to Windows in its Chrome OS operating system, and Microsoft’s move to offer a free web version of its Office software suite.

Continue reading “Little laptops snap at the oligopoly”

Leaders Can Fall Fast on the Internet

Just a few years ago, the industry-leading incumbent in the Internet local search category was IAC's It had an apparently unassailable position in local search with no meaningful competition.Well, times have changed. San Francisco Mayor Gavin Newsome gave a speech earlier this afternoon during which he mentioned a number of leading Internet companies such as Google, Twitter,