Hearing that the conditions are sufficiently onerous that the borrower may not want it is great news. At the very least this reflects a balanced package rather than one heavily in favour of the undemocratic absolute monarchy of our neighbour.

I wonder how many of these conditions were added or modified after the initial public announcement. Cosatu, amongst other powerful groups, has also been very outspoken against the loan.

I’m not going to try to sell you mine. I would like to present you with some ideas to think about before you overpay for someone else’s though.

Jon commented on a recent post of mine and, guessing I’d be interested, directed me to a fascinating opinion piece by Mark Gilbert on Bloomberg covering a range of current economic issues. I suggest you read it now. It’s ok, I’ll wait.

Right, some pretty compelling points are made there. I disagree with many of them, but they are pretty compelling at first read. Here’s my rebuttal to those I’ve heard discussed most commonly in recent times (typically with head nodding all around).

Gold is not the answer to all our currency problems

All of a sudden it’s popular to talk about how fiat currencies are not worth the paper they’re printed on, how it’s a scam, how we’d be better off with a metal-backed currency. They’re wrong. This is a complex area so I’ll only touch on the points rather than try to explain each of them in detail.

Broken promises and speculator spectacles

A metal-backed currency is only as good as the government’s promise to stick to the standard. History shows this promise has been broken regularly. By attempting to stick to a standard, it’s like waving a red, pheromone-doused flag to an amorous bull (a.k.a. currency speculators. The Bank of England was hit by this in the 1930s and again, albeit with a different kind of peg, in the early 1990s by Soros).

Shackling monetary policy can cause recessions

The gold standard contributed to the Great Depression through the restrictions on monetary policy and the enforced coordination of monetary policy around the world. (Research it, even Milton Friedman, often brought into these conversations as a support of these views on inflation, understands how the gold standard exacerbated the Great Depression.) The liquidity trap that Paul Krugman fears we may be entering is the same as a fundamental cause of the Great Depression. Ben Bernanke understands this only too well, as his speech from 2004 shows (read the whole thing, it’s worth it). The hikes in interest rates that happened around the world at different times of the Great Depression were responses to pressure on the gold standard. Imagine increasing interest rates with deflationary prices and plummeting employment and GDP?

Deflation and liquidity traps

With a gold standard, the world’s money supply is dictated by the supply of gold. This has two important impacts. Firstly, it’s like that the price of gold would need to increase sharply in order to be used internationally as a currency with all the economic havoc and redistribution that would follow. Secondly, since the expansion in the money supply would relate to the speed at which we can get it out of the ground, we would most likely have persistent deflation with prices decreasing over time. Deflation is toxic to the economy as it encourages people to sit on their money rather than spend or invest it elsewhere. Why spend your money today when it will be worth more tomorrow, just sitting under your mattress.

To be very clear, the gold standard is not the answer to our problems.

Treasury bills were never the right asset for a pensioner to be invested in

If you retire at age 65 today, you should still have a significant portion of your wealth in risky, inflation beating instruments such as equities and property. Throw some index-linked bonds into the mix to reduce the risk profile, and an amount in fixed interest instruments and cash to provide income and decrease risk in the short term. You’re going to be living for 20 to 35 more years, it’s not time to be invested in zero-risk-guaranteed-not-to-keep-pace-with inflation T-Bills.

Pension funds will be just fine if the correct political decisions are taken around retirement age

Yes, life expectancy is up. Yes, fertility is down and the populations of developed countries are ageing. This doesn’t automatically mean that social security is bankrupt. Increase in life expectancy has brought with it the ability to work productively way past normal retirement age in some countries of 60 to 65.

In Greece, some employees can reach “normal retirement age” with full benefits at age 50 for women and 55 for men. Apart from the astonishingly young age of retirement, on what planet does it make sense for women to retire before men given that they will outlive men on average?

The average retirement age in Greece is 61, the lowest in Europe. So state pension in Greece are problematic because of daft (but politically popular) decisions around retirement age. This has nothing to do with monetary policy, gold or the global credit crisis. This reflects bad decisions made every year for the past couple decades.

There are other sensitive political decisions that need to be understood around ownership of assets. The ageing populations of the developed countries have accumulated enormous wealth. They will need to sell these assets to pay for goods

Stimulus and Keynesianism are only inflationary when the economy is near full employment

Everyone is concerned about inflation it seems.  Well, everyone except those putting their money with their collectives mouths are.  Bond yields, even long-bond yields, are down sharply. Investors are stashing money away for 10 years at less than 3%. Not exactly a sign of hyperinflation coming around is it?

Why is this, with low interest rates, quantitative easing and central banks doing (ok, stopped now with short-sighted austerity measures) everything in their power to increase the money supply?

The money supply is created in part by central banks but in much larger part by commercial and retail banks through lending. Lending has dried up massively since 2008, with a result massive decrease in liquidity available to the economy. Private borrowing has disappeared, almost but not quite entirely replaced by government borrowing. With high unemployment, there is no pressure to increase prices when production volumes can so easily be increased without straining factors of production.

This is the very widely accepted position of Keynesianism with Aggregate Demand far away from Aggregate Supply. These models are also still working, but some have chosen to ignore them now because they don’t feel right.

Inflation measures aren’t lies because you don’t like the numbers

Inflation, typically measured through the chain-linked change in price of a basket of goods defined in some way, is low everywhere. In spite of low interest rates and the crows crowing about inflation fears, inflation is low.

I recall a true story told during our previous low inflation cycle. A lady (I think she was old, but I don’t see that it matters except for age-inspired gumption) somehow got hold Sean Summers at Pick n Pay. I don’t know whether she had his number on speed dial or whether she knew someone who knew someone, or whether her query was passed through to him internally. She was complaining that although the government said inflation was so low, the prices of the goods she purchased had been going up at a much faster rate. Sean (or one of his underlings) called up her purchase history going back a few years (linked to a credit card number I believe – fantastic data resources these clued-up retailers have…) and showed her that the inflation she was personally experiencing was actually below of  overall Consumer Price Inflation.

There is a huge difference between what we feel and what we experience through our human interactions with the world and what the hard, measurable reality is when the numbers are crunched. This goes to the same point about bond yields I mentioned previously.

Where does that leave us?

I don’t pretend to have convinced you with this drag-race through some fundamental economic issues. If I’ve persuaded you that maybe there is more to these issues than the charismatic gut feel story and encourage you to reader further, well I consider that a success.

I’ll finish with an excerpt from that same speech by Ben Bernanke covering the Great Depression and the role of monetary policy and the gold standard:

Some important lessons emerge from the story. One lesson is that ideas are critical. The gold standard orthodoxy, the adherence of some Federal Reserve policymakers to the liquidationist thesis, and the incorrect view that low nominal interest rates necessarily signaled monetary ease, all led policymakers astray, with disastrous consequences. We should not underestimate the need for careful research and analysis in guiding policy.

Today, more than ever, we seem to be in need or careful research and analysis to save us from the hell that is waiting for us if we follow  ideas that are compelling, dangerous and wrong.

One last quote:

For every complex problem there is an answer that is clear, simple, and wrong.
H. L. Mencken

Junk Bonds, also known as High Yield Bonds, are debt instruments issued by companies with poor credit ratings, or are the debt instruments of companies that were issued as high quality bonds from strong companies that have since fallen on hard times (“Fallen Angels”).

Typically these are any bonds that are not classified as Investment Grade (BBB rated or better).

Junk Bonds behave very differently from Investment Grade bonds. Their value depends only marginally on market interest rates and far more on the underlying economic strength and operational performance of the issuing company.

Junk Bond return characteristics

They don’t often the unlimited upside of ordinary equity, but with the high starting yield (10% to 25% depending on the circumstances) it can provide a very healthy return if the company doesn’t default. There is also a chance for rerating where if the strength of the company improves dramatically, the bond may be repriced to a lower market yield, resulting in a significant capital gain.

Founders keeping control

So company founders can issue junk bonds rather than diluting themselves by issuing equity and still provide attractive returns to investors and an opportunity for savvy investors (and those who just think they are savvy) to “pick” their company with the prospect of fantastic returns if it performs really well.

Did I mention the interest payments on the issued junk bonds are tax deductible for the business?

Why would investors be happy to invest in junk bonds?

Aside from the attractive returns possible, now is a particularly good time for investors to consider junk bonds. With low interest rates (particularly in the US, Europe, Japan sphere of the world) investors are looking for instruments to boost their yield. Junk Bonds can do just that.

Further, with the Fed (and to a lesser extent, other central banks) promising to keep interest rates low and therefore debt cheap for an extended period, the risks to investors are fairly low. Certainly, the perception is that the risk is lower in bonds than equities as an asset class – this is probably at least partly a mirage given the equity-like characteristics of junk bonds.

Moody’s has also shrunk it’s list of companies most likely to default, further encouraging views of low default probabilities.

I’ll be writing a few more posts related to bonds and junk bonds over the next few weeks so keep an eye out for those if you’re interested.

The economics of a fund manager depends entirely on growing funds under management so that revenues (based on assets under management) grow to be larger than costs (significantly fixed and at most semi-variable). Details of performance fees and the second order impact of investment performance aside, a successful fund manager must attract positive net client cashflow, and lots of it.

Half the 960 available unit trusts have less than R100m in AUM. Some of these may be rapidly growing new funds, but many have been stagnant with slow growth for several years.

The FSB’s attention presents opportunities for consolidation between funds and should place larger funds in a stronger position competitively. Total Expense Ratios (TER) for these funds with significant scale should already be lower than smaller funds. Maybe it’s time the larger funds made more if their size and cost efficiencies. If they are going to take the heat for being too large to be nimble, they might as well reap the benefits too.

It will be interesting to see what this means for white labelled funds and whether the economics of these convince the regulator that they should survive.

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Zurich Financial Services has just been fined £2.3m for a data loss event incurred in 2008 in South Africa.

Zurich joins HSBC, Nationwide and Norwich Union in the club of companies fined by the FSA now.

In fairness, the fine wasn’t so much for losing the data, but rather for:

• losing
• unencrypted data
• and not having monitoring and controls in place
• so that it was only discovered and reported to regulators a year later

The South African perspective

The FSA’s seriousness about these issues is mirrored in our looming Protection of Personal Information Bill. This is not the same as the disturbing proposals for a Protection of Information Bill which covers public or government information.

The Protection of Personal Information (POPI) Bill seeks to effect provisions in our constitution for rights to privacy. As more and more private and confidential information about each of us is stored, processed, transmitted and mined by institutions, there is a clear need for controls around what can done with this information and what controls and safeguards are required.

Operational or legal risk?

The fines and penalties associated with data and privacy laws create additional risks for any enterprise with customer data on file.  Operational risk is often (although not uniquely) defined as the failure of people, processes or systems giving rise to a loss. Legal or compliance risk is the risk of falling afoul of the law through non-compliance with laws and regulations.

Yes, this risk should be covered by your risk management system

It’s not particularly important how your organisation classifies the risk, but it is critical to identify, measure, manage and monitor the risks as part of an enterprise-wide risk management system.

As with all risks, it’s often the allocation of specific responsibility for risks, the listing of risks in a risk register and the regular reporting on these risks that slowly changes and organisations attitude to it more than anything else. Whether or not you model the risk in detail or attempt some sort of quantitative analysis is decidedly secondary.

Key amongst these new considerations is the limitation of mismatches between the term of assets and liabilities, which would limit the danger of a removal of deposits and wholesale funding in a crisis scenario. The problem is that this has been fundamental to the business model of banks for decades. Short-term assets (call, overnight, 30 day deposits) have been used to finance long-term liabilities (vehicle loans, home loans, business loans).

Retail deposits, even those technically call deposits, are generally quite sticky. This is in spite of the easily recallable image of queues of depositors wanting to get their money back. Typically, this is still a small fraction of total depositors (certainly in countries with retail deposit protection). Further, other banks have usually pulled or tried to pull their short-term funding (or simply not renewed overnight lending) well before the public even gets wind that there might be risks. As banks rely increasingly on wholesale finance, the risks of a liquidity and credit crisis are amplified as this money is teflon-coated and greased in terms of stickiness.

The banks argue there are other ways of managing the risk. It’s understandable that regulators around the world have had their confidence in banks’ risk management ability dented.

The real danger of overregulation of banks is not “too safe banks”, but rather an increase in the cost of providing banking and credit services to the economy (individual countries as well as the global economy) which could make limit economic growth and the replacement of jobs lost during the recession.

It’s going to be interesting to see how this develops.

Banks and others using risk management tools often back-test their models against historical data to see how whether the models capture past market movements in estimating potential future market movements. This blip may appear as an anomaly in these tests for some time.

(It’s more typical for the tests to use only closing prices rather than intra-day prices. However, this actually reflects a weakness in the typical models and is only a fortunate escape from today’s problems)

Why was a new OpRisk formula needed?

The original formula for OpRisk proposed in QIS4 was widely condemned. Complaints included being too simplistic, being insensitive to risk (and basely primarily on business size) and the impossibility of calibrating to 99.5% in a meaningful way. CEIOPS accepts most of this criticism, but counters by reminding stakeholders that the aim of the standard formula is partly about being simple.

A more serious problem is that in comparison against companies’ own internal models, the standard formula produced results lower than companies’ own assessment. Median internal model requirements for OpRisk were 133% of the standard formula and 13 out of 16 countries reported higher requirements under their insurers’ internal models.

One of the aims of the standard formula is to be slightly conservative to provide an incentive for insurers to develop their internal models. Clearly this objective is not being achieved.

Current OpRisk recommendation for Solvency II

CEIOPS has issued final (they’re calling it final anyway) level 2 guidance on OpRisk requirements under the standard formula.

CEIOPS-L2-Final-Advice-on-Standard-Formula-operational-risk

Although there are a few detailed differences (around negative components, for example) but the most significant change for most insurers will relate to the change in parameters. In many cases the changes are close to doubling of the parameters. This will significantly increase capital requirements for many insurers.

QIS5 is planned, so presumably the financial implications of the new recommendations will be tested.

It’s still clear to most that OpRisk is particularly poorly suited to Pillar 1 and purely quantitative requirements. While the updated formula wont have won over many of the loudest critics, it does better match capital requirements to those companies were getting from their own models.

Best solution is still a company-tailored internal model combining actual loss data collected, supplemented by subjective frequency/severity assessments mapped to density functions using work-shopping techniques.

Other relevant CEIOPS documents on Operational Risk

Comments and responses paper (pdf)

Earlier suggested OpRisk paper (superseded by November version) (pdf)

Note from the Actuarial Society of South Africa outlining recommendations for use in conjunction with PGN104 (December 2009):

ASSA OpRisk guidelines

Having written a brief summary of the different techniques used in this really important area, I thought I should use it as a blog post. Maybe “Daan d.” from Cape Town will stumble across this answer eventually.

The question:

What is the standard practice to allow for diversification benefits when allocating capital required between different insurance products?

My brief answer (this is a huge topic!):

There is no standard practice. It’s one of the more irritating and subjective aspects of allocating capital between imperfectly correlated product

Economic Capital doesn’t have to be calculated as VaR, but I will use VaR below as a generalisation. Banks are typically slightly more mature in their capital allocation processes so what I’m describing below is often used in the banking world, but applies equally to insurance (life and non-life / P&C).

Splitting the capital in proportion to the sum of the components is frequently used, but is flawed and usually doesn’t give good results unless speed and simplicity are primary objectives.

Incremental VaR is the increase in VaR from the current position when adding the new product. Measuring the added value from the new product using Incremental VaR leads to optimal decisions. However, it doesn’t sum to the total capital requirement and so is less useful for capital allocation for existing business.

Marginal VaR, based on the marginal risk contribution of each product, is quite often used and generally produces sensible, consistent results. The Marginal VaR for all risks sums to the total VaR and allocates diversification benefits in a single, objective measure. (It’s not necessarily “correct” since there is no single correct answer.)

You calculate Marginal VaR or Marginal Economic Capital for each by multiplying the size of the product by the rate of change of the total Economic Capital with respect to size. This requires the calculation of the first derivative of Economic Capital. This can sometimes be done analytically when using delta normal or volatility based methods, but is usually a fair amount of calculation work. It also requires a fair definition of product “size”.

Marginal VaR works well when each product is small in relation to the size of the overall firm since it is based on derivatives. When the product groups are large, the sum of Marginal VaR will differ slightly from total VaR due to the discrete approximation to the continuous case. Here I recommend rescaling the final results to ensure the sum still equals the total economic capital.

In short, there is no standard method, but much to recommend Marginal VaR in many cases, or Incremental VaR in others.

This is an incredibly important aspect to managing an insurer on a risk-reward basis, calculating risk-adjusted performance metrics and allocating capital to best create shareholder wealth. With Solvency II on the way in Europe and equivalent measures already planned by the FSB in South Africa, these questions will be asked over and over again in the coming years.

Creative Commons License photo credit: Näystin

If you are, you’re not alone. 88% of readers polled in a News24 poll were “outraged” at the increase. The problem is that all this outrage is irrelevant at best, and dangerously distracting at worst.

Why price is the wrong thing to worry about

Eskom produces electricity for the country and makes a profit or a loss doing so. This profit or loss goes back into treasury, which, inefficiencies aside, belongs collectively to the citizens of South Africa.

If prices are too low and Eskom makes a loss, this shortfall must be made up through higher taxes or lower government spending. If Eskom is not given additional capital, it will have to stop buying coal and stop investing in new infrastructure.

Those who complain about the inflationary effects of electricity prices are considering the issue too narrowly. Electricity prices may be easier to see than broader macro-economic issues about budget deficits, growth-disincentives from higher taxes and other implications of funding electricity generation from general taxes, but that doesn’t mean it is the right way to look at the problem.

Expensive electricity is better than no electricity. Complaining about higher electricity prices, while understandable, is not useful since the money must come from somewhere.

The real 5 issues we should be discussing

1. Is Eskom generating electricity efficiently, and at an appropriate cost (compared  to international benchmarks, adjusted for our local fuel costs and other differences)? If Eskom is not producing power as cheaply as they should, let’s focus on fixing the operational and industrial design problems to fundamentally lower the costs of production. More efficiency benefits entire country.
2. Are Eskom’s medium- and long-term plans appropriate for our needs, and are they funded through the optimal mix of government support (out of general tax base), retail and industrial electricity prices, debt financing, partial/full privatisation, supplier credit, IMF money etc. Long-term projects such as building power stations should be financed over 25+ years if the credit is available, so that the generations that benefit from the infrastructure pay for it through paying off the loan over time. This doesn’t change the overall cost, just who pays for it.
3. Should public or private enterprise generate and transmit electricity? Which combination is most effective from a cost, security and reliability perspective? If private enterprises can produce power cost effectively, while promoting economic growth, employment and without undermining the stability of our infrastructure, why shouldn’t they be included?
4. Are we, as citizens and as a country, happy with the mix of fossil-fuel, nuclear, wind, solar and hydroelectric mix of our planned infrastructure? Who pays for pollution? For that matter, who pays for damage to roads from coal transport?
5. How should the cost of electricity be distributed amongst all users? What minimum electricity consumption should be free or subsidised? Basic electricity to light a room or two is required if students are to be able to study at home. Some level of progressive charging (where bigger consumers pay more per kWh than small consumers) is appropriate. Should labour-intensive industries get cheap electricity to promote employment? Should important growth industries for the future success of the economy get a helping hand? These are much broader policy issues than pure electricity pricing and should arguably be addressed outside of the primary electricity tariff debate.

These are five critical issues that should be analysed and debated. The more time that is spent on superficial pricing, the less time and energy is spent on the real issues.

Where low prices are the problem

One last point – when our electricity prices are too low, the only parties who benefit are international companies who use our below-cost electricity and take the benefits with them. As a country, we don’t benefit from underpriced electricity, it harms us.