For every complex problem, there is a solution that is clear, simple and wrong.
Greece is a complex problem. Paul Krugman points to this Choose Your Own Adventure on the Greek crisis. Much like the original books, there are many, many nasty ends.
Read it, try it, explore a few paths. This is the best resource I’ve seen recently to explain exactly how bad almost all the alternatives are, and how there are no really good outcomes from this mess.
Rest of The World, watch out.
Some serious research, pointed out to me by FT Alphaville, showing that the 2010 Soccer World Cup had a marked impact on JSE trading volumes, patterns and correlation with global markets.
I’m not sure what to do with this information, but it’s remarkable all the same.
The Make a Million competition, as I’ve mentioned before, is an awful idea. It doesn’t promote investing or even “normal” trading, but rather massive, speculative risk-taking trading because the prize for performing well is nothing and the prize for performing best is significant.
I’m continually disappointed that Moneyweb continues to partner with this distraction.
As I’ve done in the past, I’ve analysed very quickly some of the results of the most recent competition. As background to that, the basic rules are:
So let’s be clear, there are no long-term investment learnings here.
The winner did return 165.5% over 3 months, which is not an impressive performance even though it might look like it. The point is, given the volatility of the investment universe available for the competition and the encouragement towards rampant risk-taking, it’s entirely pedestrian performance. It’s very likely an individual’s performance will be good given the wide range of possible outcomes.
Let’s look at some other statistics
| Average performance | -18.4% |
| Annualised average performance | -73.4% |
| Proportion making a profit | 26% |
| Total amount won | -R1 020 762 |
| Standard Deviation of performance | 48.0% |
| Annualised standard deviation | 96% |
These are not performance statistics of which to be proud. They are similar to the losses incurred in prior competitions.
So in short, the competition cost the entrants in total just over a million rand. Losing a million rand is a great way to Make a Million.
Best practice for matching non-profit annuities in most countries, certainly from a risk perspective, is still to cash flow match (or at the very least, match key durations) using government bonds.
The theory is that the insurer isn’t then exposed to changes in the term structure on interest rates, only exposed to illiqudity/reinvestment risk to the extent of mortality fluctuations, isn’t exposed to currency risk and certainly isn’t exposed to credit risk. Without complex margining requirements like some swaps and without the need to roll cash investments over, government bonds should allow ALM teams to sleep well.
Now, Solvency II is likely to adopt a swap yield curve rather than bond yield curve. There are some good reasons here, including arguably fewer distortions from temporary supply and demand imbalances, improved liquidity and so on. The same yield curve is used for liquid liabilities so the allowance for an illiquidity premium over and above the swap curve at some times, in some ways and for some products is still under debate.
But what should Greek insurers do in the meantime?
Frankly, Greek government bonds don’t remove credit risk and the huge credit spreads on these instruments will create huge funding gaps and variability in earnings unless a Greek govi yield curve is used to value liabilities as well. It’s not clear at all that Greece will stay part of the Euro, so German government bonds don’t remove currency risk. German government bonds in any case are show signs of nervousness as yields creep up.
The swap market is exposed to the same Euro break-up risks as bonds. Which banks will survive, what happens to currencies in the meantime and what does that do to long-term Euro swaps? What about Euro-Sterling swaps issued by Greek banks (I’m not sure if these even exist though).
All in all, it’s good to be involved in ALM in South Africa, and even the Middle East just at the moment.
I wouldn’t want anything to do with any bank that has much at all to do with European banks or European sovereign debt. The old South African Rand is seeming like a safer relative bet than at pretty much any other time in the last decade.
So European politicians have more or less agreed a deal which may, more or less, push some of their problems to one side for a period. Yes, I’m not madly optimistic about this as a cure-all. This is not the end of the Euro problems.
Part of the deal is a “50% loss for private investors”. Which is part true and part nonsense but will be an effective Greek default when enacted / agreed. (I don’t care how “voluntary” it may be, it’s a default and almost all definitions of default include restructuring of debt in any way that isn’t what was originally promised.)
Why is it only partly true? Well it’s not necessarily a “loss” for private investors. The probability of default on Greek bonds has been just about 100% for a while now. This probability of default is derived from market prices for Greek bonds and market spreads on Greek Credit Default Swaps (CDS) and an assumed Loss Given Default or Recovery Rate for investors when the bonds do default. Actual Recovery Rates vary widely, but often analysts plug in the average Recovery Rate over most of this century on unsecured debt which is around 40%.
So if market prices for Greek bonds assumed 100% default probability and a 40% recovery, then a 50% recovery doesn’t sound so bad. The potential downside is that Greece may still (need to) default on these written-down bonds at some point in the next two decades.
So the real question is what will the new probability of default be? Then we will know whether investors “took a loss” and perhaps gain the market’s view on how successful the deal really will be.
This is really fantastic news. The Swazi King is apparently reluctant to accept the loan from South Africa because of the conditions imposed in the agreement. I was quite harsh in criticising the granting of the loan with only conditions for improvement far down the line. (I still believe the first condition should be an immediate unbanning of political parties.)
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 don’t think many serious investors care that S&P downgraded US debt. Bond yields are down (more on this in my next post), which means prices are up. US stocks are down, but that’s more about concerns about US and global economic prospects than the credit of the US government.
Nevertheless, S&P did downgrade. Why? I don’t think it is primarily to do with a materially increased estimated probability of default. It has more to do with a change in the payoffs in a ‘game’ (as in game theory) S&P is playíng.
Consider the quadrant of options. S&P downgrades or doesn’t and the US defaults or doesn’t. I’ve constructed totally hypothetically, but perhaps plausible scenarios below, for the S&P’s potential assessment of losses under each possibility given their views and external perceptions of them before and after 2008.
Before 2008, the fallout that would come from downgrading the US and the US not defaulting would be significant and cries of “un-American” might be heard again. Even if the US were downgraded, default would still be a blow for S&P since anything above a BBB rating really shouldn’t ever default if there models are “correct”. I’ve thrown in another hypothetical, a 0.01% probability of default – in other words very low, and as you’ll see in the next scenario, not necessarily higher now for S&P to change their view.
Now, either on a traditional minimax (minimizing the maximum cost) or an expected value basis, before 20008 S&P wouldn’t downgrade the US. This is an important calibration, since S&P didn’t downgrade the US.
After 2008, even if we leave the assessed probability of default unchanged, the world is different and therefore we have different costs. If S&P doesn’t downgrade the US – even if the US doesn’t default, there will be a cost to S&P since might share the view that the US could default now. The dent in credibility since 2008 means that S&P has to try harder to convince the skeptics that they don’t rate risky instruments as AAA. Along with this goes a massive hit if the US does default and S&P hasn’t downgraded the US. The good news is that at least now a downgrade is viewed more with more understanding even if the US doesn’t default (although be sure Obama’s White House is not happy at the moment).
After 2008, even if the assessed probability of default is unchanged, the minimax and expected value rules both suggested a downgrade is the better option for S&P.
| Before 2008 | |||||
|
Don’t downgrade |
Downgrade |
PD |
0.0001 |
||
| Default |
-500.0 |
-50.0 |
|||
| No Default |
0.0 |
-1,000.0 |
|||
| Expected |
-0.1 |
-999.9 |
|||
| After 2008 | |||||
|
Don’t downgrade |
Downgrade |
PD |
0.0001 |
||
| Default |
-10,000.0 |
-50.0 |
|||
| No Default |
-10.0 |
-10.0 |
|||
| Expected |
-11.0 |
-10.0 |
|||
Now the example is contrived – I chose a set of parameters that demonstrates the point I’m trying to make. This isn’t a problem since I’m not saying this is what happened. I‘m saying it is plausible that S&P made a perfectly rationale (for them) decision to downgrade even if they didn’t think the US was more likely to default now than before.
In truth, the US might be more likely to default now than before, although the change is probability not sufficient on its own to merit a downgrade at this point. Especially since S&P have their maths wrong.