Twenty Third Floor
Technical Business Advantage

It’s clear some people just don’t get that deflation is catastrophic from an economic perspective. You would have though that Japan’s lost decade (is it still only a decade?) would be sufficient warning.

Michael Pento from Euro Pacific capital writes about the options open Bernanke to stimulate the US economy through open market purchases given that interest rates are up against the zero bound.

He’s right about the options, but horribly misguided when it comes to wishing for deflation:

By keeping prices from falling more that they would have naturally, Fed intervention has created a burden.

The US public (and private) debt is such a significant portion of GDP, the correct answer cannot be to increase it as a percentage of GDP by deflating prices and keeping the nominal value of outstanding debt the same. Moreover, what the US needs is economic activity; encouraging everyone to leave their money in the bank because it increase in value every day and “nobody else is spending so deflation will continue” doesn’t sound like a success story to me. Downward price stickiness, particularly with wages (yes, even in the US) would add to the catastrophe.

Pent also raises the risk of hyperinflation:

…investors would be forced to once again abandon savings and chase runaway prices.

I don’t know how we went from fears of deflation to “runaway prices”. The challenge with this policy is to credibly promise moderate inflation for several years (depending on how strong your Ricardian views are).

Runaway prices are much easier to control than deflation. With inflation, we actually have a range of tools to use.

It’s unreal how many people have views on the economy that aren’t rooted in any economic theory at all.

Sharemax appears to be spiralling to its doom. Multiple stories today report that they are late on dividend payments to investors and may not be able to pay dividends in the forseeable future.

Cash has run out. The overvalued, over-geared properties cannot support the income stream that was demanded from them.

No surprises here then.

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Lightstone have a trick up their sleeves. Their raison d’être is collecting, analysing, understanding and packaging data for themselves and others to use to understand past, current and future property valuations.

Their housing price index is more robust (and more independent) than those of the banks based off their own data and target markets. Rather than consider only the average price of houses sold in that particular month (which is a function of house price growth / decline but also how the type, condition, size and location of the houses sold that month differ from the prior month and year) they consider repeat sales where the same property has been bought and sold more than once.

This data is combined or “chain-linked” to provide a continuous measure of house price inflation over time.

House Price Inflation 2010 source: lightstone.co.za

The result of all of this data, best-in-class methodology and analysis? When Lightstone says “opportunities abound in local market” I actually listen. Since their business model is to sell information, I’m more likely to trust what they say.

From Stats SA

The headline inflation rate in July 2010 (i.e. the Consumer Price Index for all urban areas in July 2010 compared with that at July 2009) was 3,7%

The official inflation rate (i.e. the percentage change in the CPI for all urban areas in July 2010 compared with that in July 2009) was 3,7% at July 2010. This rate was 0,5 of a percentage point lower than the corresponding annual rate of 4,2% in June 2010 (i.e. the Consumer Price Index for all urban areas in June 2010 compared with that in June 2009).

From June 2010 to July 2010 the Consumer Price Index for all urban increased by 0,6%

CPI Headline July 2010 = 3,7%

So this is close to the bottom of our 3% to 6% inflation targeting range. Economic growth is struggling, unemployment is high, but we haven’t reduced interest rates? Something here is a little odd.

I’ll put another $100 in Kiva, to be “microlent” to businesses and people across the world, if the next monetary policy committee meeting doesn’t cut interest rates.

Michael Lewis, of Liar’s Poker fame, has written an engaging account of the role that subprime lending played in the global financial crisis. The new book is called “The Big Short: Inside the Doomsday Machine”.

The jargon that Lewis uses is generally explained and shouldn’t prevent non finance geeks from understanding the role of subprime lenders, mortgage originators and, of course, the Wall Street banks that fed the frenzy with CDSs, synthetic CDOs and bonuses for all.

The story places a few characters at the centre of the story. I wasn’t convinced that these guys were all skill and no luck, but they certainly seemed to have a clearer idea of what was going on in the murky, muddy waters of securitisations of that era than many of the supposed experts.

Overall, it’s won’t be the smash hit that Liar’s Poker is, but it’s entertaining reading all the time. The links to Gutfreund are tenuous and smell a little of name-dropping. If Lewis wanted to remind the reader of his role in toppling the ex CEO of Salomon Brothers he succeeded. If he wanted to somehow project the glory onto the new book, he failed.

The Big Short at Amazon.co.uk

The Big Short at Kalahari.net

Check out Book Finder for prices from several stores (new and used) in your currency including delivery costs to your location.

The FT has an article (Banks win battle to tone down Basel III) describing how the proposed new rules for banking capital requirements might have some of the new requirements around liquidity removed or weakened.

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.

May 6 2010.  Dow falls more than 1,000 points intraday, including a drop of P&G from around $60 to (according to some accounts) below $40. The Dow recovered most of the falls quickly, but these trades are now part of the historical time series.

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)

A friend “volunteered” me to answer an insurance question from Aardvark on allocating economic capital across different insurance products. After writing a short response, I received the frighteningly useful message: “Error”.

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. (more…)