Who Cries for Argentina?

Argentina could default again at any time.

It´s actually up to a New York Court of Appeals (perhaps up to the US Supreme Court, if it comes to that).

Argentina has been ordered by a NY judge to pay $1.4 billion to creditors that hold bonds that did not participate in the 2005 and 2010 debt restructurings offered by the country. The Court of Appeals has already upheld that decision once. We are awaiting its final ruling.

Unless Argentina pays those “holdout” creditors, it is not allowed to pay anybody else. That is, a forced default. Argentina wants to and can pay exchange bondholders. But it certainly doesn´t want and may not be able to pay those holdout “vulture” funds.

Does anybody care if Argentina defaults, again? The Argentinian government may not care much. Many say that the country doesn´t really need access to international capital markets. In fact, the NY rulings may provide Argentina with a wonderful excuse not to pay any of its creditors, saving in the process billions of dollars in hard reserves.

What about the rest of the world? Does anybody care? Creditors may care (pensioners who were induced into putting all their money in Argentinian bonds may care a lot), but most of them already agreed to a huge haircut, so the loss would be somewhat relative (more a confirmation of a death foretold).

But Argentina is already close to pariah state. The IMF wants to kick it out from its premises. The country has “managed” its macroeconomic statistics with abandon. It is blatantly refusing to abide by the rulings of a court (Argentina chose to be judged by NY jurisdiction when it issued NY law bonds). It has imposed very harsh terms on people who lent her money. It consistenly uses very defiant language.

The worst side of this sorry tale is that no one may care anymore about the outcome. Many tried to help Greece, Portugal, Ireland. Many actually cared profoundly about the fate of these nations. Many prayed for their well-being.  Many made huge sacrifices in their aid.

Those same people and institutions may not want to be bothered by Argentina ever again. The very strong temptation is to get rid of her, evacuate her from our surroundings, and enjoy life in an Argentina-free universe.

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Half of the world´s government bonds yield less tan 1%, according to a recent bank study.

The apparently “safe” money is close to giving you zero return. People will continue to buy these bonds, for a while at least, driving yields further down. We live in a world where Rwanda´s bonds are 10 times oversubscribed. Welcome to History.

This is paradoxical for many reasons. A lot of those governments are in pretty bad shape, economies are not growing, unprecedented monetary expansions should generate inflationary expectations, we see sovereign bond investors getting killed via haircuts and court decisions, it´s the private sector that we should be trying to bump up, etc etc etc.

Welcome to a world where no asset is seen as risky anymore. The “lust for yield” caused by those paltry official sector yields makes people kneel at the altar of anything promising something closely resembling a return.

Welcome thus to CoCo-Land, with people buying securities with triggers that can´t (as in cannot) be understood or ascertained by outsiders.

Welcome to a world where Greece (as in Greece) can say that it will be back in the capital markets next year.

Welcome to Zero.

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The Easiest Job In The World

What´s the easiest job in the world?

Selling financial products to investors has got to be up there. It´s just got to be one of the most captive markets in the world. Your customers just keep coming, no matter what, no matter what you are selling, no matter if they happened to go broke just three months before. Or as Tony Soprano would put it, “Degenerate Gamblers!”.

We are in the midst (again) of one of the most frantic manias financial markets have ever seen. Stocks are reaching all time highs, rich (and not so rich) country bonds trade at record high prices, so do corporate bonds, so do junk bonds, weird bonds (Rwanda, CoCos) are being wildly wildly oversubscribed. Even Ireland and Portugal, apparently hopeless cadavers just a few weeks ago, are selling securities again.

What´s behind all this? The conventional line is “search for yield”. Official policies are, once more, keeping official interest rates so low that one is forced to venture into adventurous territories to earn a bit more than nothing. Remember Subprime CDOs? Same storyline.

But I suspect there´s more to it. Financial markets offer people (many of whom may have less than exciting lives) the unique chance to play and to feel like a player. What´s more glamorous than going into a dinner party and proclaim that you just bough Rwandan bonds? What can make you look more savvy and in-the-know as walking into your high school reunion waving some of the new Apple bonds? What can make you look more impossibly sophisticated to your golfing pals than, off-handedly and in between the 17th and the 18th hole, letting it be known that you hold a sizeable chunk of Barclays Additional Tier 1 CoCos?

Financial markets allow you to spend your day checking prices and news updates on your BlackBerry. Even better, it allows you to do so in front of others. You can always do that with plaid stocks, of course. But why not add some glamour and exoticness into the mix? And certainly the promised higher returns help, though those are now becoming perilously lowish.

In a Soprano episode, a childhood friend of Tony´s is desperate to enter the high-stakes poker game that the Family runs. Tony repeatedly warns him against it, given the potential downside. Eventually, Soprano gives in, as his friend beggingly crawls to his feet. Predictably, and after the initial high, the friend loses it all (business, home, car) and is forced to abandon his family and move somewhere far away.

Today´s investors are similarly begging in desperation at the feet of the investment banks that underwrite and design the fancy high-stakes securities. Many may be amply aware of the likely fate awaiting. And yet, they keep crawling. And crawling. And crawling.

Capital preservation is just not, and will never be, as sexy as North Korean bonds.



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Vogue and Banking

I am reading the biography of a former top US financial regulator, a humble woman from humble Kansas who did her utmost to maintain the safety of the banking system in the pre (and post) crisis years. She appears as a Joan of Arc of sorts, fighting not only the big banks but also those other regulators eager to please those under their watch. It is hard to not feel sympathy towards this woman, with her apparently perfect All-American family and her unfettered concerns for the little people.

And yet we are not sure if many people would want to be like her. Even those who admire her honesty and determination to keep things safe may shy away from trotting her path, instead rather choosing the precise opposite.

This goes to the heart of who becomes a regulator and who becomes a banker-trader. These are two very different species, and generalizations can often be unfair. But here is one generalization: it is a safe bet that the college sports star or the high school beauty queen won´t want to go into regulation, while dying to go into banking-trading. These days that would also extend to the top science student, finance having become so much more complex. Beautiful, well-built, always-successful people can be found roaming trading floors and corner offices. These types don´t want to regulate. They leave that chore to other types.

In one highly illustrate part of the book, Vogue magazine eventually refuses to show pictures of the woman regulator because they don´t think she is attractive enough. For the world´s most beauty-conscious people, this woman is second class. Not part of the club. Of a different (worse) status. Most telling is the regulator´s naive enthusiasm at the thought of being considered by Vogue. You can detect decades of yearning to be called on by the cool crowd. And then the sad resignation when, once more, you are put in your place.

People who could be in Vogue and who have always read Vogue and who know those who are in Vogue and who date those who are in Vogue want to work and work for Goldman Sachs or Blackrock. Never in a million years would they want to work for those who regulate Goldman Sachs or Blackrock.

This explains a lot of what happens in finance. Many regulators have always wanted to be like the regulated, even if they honestly want to confront the latter´s most dangerous practices. And it can be hard for the average girl who always looked up to the people in Vogue to be too tough on those beaus who actually reside in a Vogue world and who have to keys to such universe.

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Voodoo Finance

I know, I know here I go again with bank capital.

But what can I do, it´s one of the (perhaps the) most pressing themes in finance these days.

And we just had some pretty interesting news at the local level, with BBVA issuing a path-breaking hybrid bond that qualifies as regulatory capital (so-called “Additional Tier 1″ capital to be precise).

The BBVA bond is part of the very notorious and very in vogue CoCo family (“here comes the CoCo!”). Without getting technical, CoCos are Contingent Convertibles, or debt that transforms into equity if certain trigger is reached.

The key with these new instruments (regular convertible bonds had existed for decades) is the trigger. It is based on regulatory capital ratios, that is on Risk Weighted Assets (recall my prior post). In the case of BBVA, if core equity capital goes below 7% of the bank´s RWA the CoCo will trigger (there could be a second trigger at 5% but that´s another story).

But, and here is the tricky part, RWA are calculated by the bank itself and from convoluted internal mathematical models. How is an investor to ascertain the probability of the trigger being reached and thus of his debt investment turning into an equity stake in an, apparently, suddenly undercapitalized bank? How can outsiders have a clue as to what a bank´s RWA will be like? RWA are simply undecipherable black boxes, infinitely manipulable by the bank.

I call this the “voodooization” of finance taken to the extreme. People buy complicated securities endowed with a lot of risk and may not hope to have a clue as to the drivers behind that security. When you buy Apple stock you are buying Apple stock, no mystery there. But when you buy securities where the underlying asset is voodoo, well that´s another thing completely.

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Capital vs Capital

Back to European banks´ capitalization levels.

Deutsche Bank is calling itself “one of the best capitalized banks in our global peer group”.

They say that because their regulatory capital ratios are indeed quite high: 12% Core Tier 1, 16% Tier 1

This means DB already complies, by far, with the new “stringent” Basel III requirements (7-9.5% Core Tier 1, but only by 2019).

So what´s all this talk about Euro banks (and DB in particular) being way undercapitalized, especially with regards to US counterparts? Why is JP Morgan´s boss screaming to the high heavens about such discrepancies, if they do not apparently exist?

Well, those ratios are calculated over Risk Weighted Assets (RWA), not actual assets. And RWA (a kind of “voodoo”) can represent just a tiny fraction of actual assets. So a very high Capital over RWA ratio can in fact stand for a very low Capital over Assets ratio. Of course, what matters for bank solvency is the latter (i.e. how fast can my equity be wiped out if assets fall in value).

What´s DB true leverage ratio? Q1 2013 on-balance-sheet equity is just 2.75% of total on-balance-sheet assets. If those assets drop by 2.75%, DB is insolvent.

Which capital number do you trust best?

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A New Adventure Begins

We´ve kick-started a new academic adventure: the Finance Lab Workshop MBA elective course. About 20 brave and pioneering souls have decided to venture into unknown territory to sample what promises to be an innovative and enlightening experience. This is a course where students are in command (under some “adult” supervision). The course truly tests their ability and desire to learn in a self-driven fashion. It´s very dynamic and attuned to real world urgencies. It should help refine and polish students´ oral and written communication skills. There are no homeworks or exams. Just in-class in-group presentations, all leading to a final report. You face no stringent deadlines on very specific assignments, but you must prove yourself every week. Self-directed dynamic demanding work that aims to tackle some pressing real-life theme? Doesn´t sound too different from what you should expect on the job out there.

For this year we have selected Sovereign Debt as the central topic. I don´t need to elaborate on its utter relevance and immediacy.

The first in-class presentations went really well and I have a feeling we are all going to learn a lot from each other. This course encapsulates a lot of the things that can make ESADE a great place to study and experience: diversity (we have students from all over, from Vietnam to Japan, from the US to Saudi Arabia, from Brazil to Hungary), freshness (very “unstructured”, very new, very individualized, very “unconventional”), and fearless innovation (I don´t think many schools offer such an opportunity, especially so early in the MBA; and it´s part of the overall Finance Lab, pretty unique in itself certainly)

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Are All Euro Banks Insolvent?

Let´s not forget that the problem with Cyprus is first and foremost a banking problem. Which takes us to the issue of banks blowing up because they have very little capital. When your capital is depleted by losses you become insolvent. If no one steps in, it´s good bye time.

So Cypriot banks will get a bail out plus liabilities are reduced via haircuts.

Everybody and theit brother are wondering about spillover effects over other Euro banks. As if Euro banks needed Cyprus to get in touble before they could get in truble. They were already in trouble. For a long long time. Basically, they haven´t had a lot of (real) capital in a long while.

Many of the most relevant Euro banks essentially have no equity capital (2-4% of total on-balance sheet assets, i.e zero capital). Any smallish reduction is asset value wipes them out.

How could this happen? Even five years after the subprime crash, banks are essentially as exposed. The reason is simple: Basel Committee rules. Banks seem extremely well capitalized according to those rules, but in truthness they are anything but. The regulatory ratios are saying “job well done, you are now robust!”. The real ratios say “you are five minutes from death”.

American banks hate all this, because the rules force them into higher real capital ratios (though still not mountainously high). American banks envy their European sibblings.

But I bet that European taxpayers and depositors are the ones envying their US counterparts.

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Beware of 27-year olds selling protection

Finance Lab students who have been to my lectures on tail risk, VaR, selling optionality, etc would appreciate the following recent comments by a leading US hedge fund manager making a bet on Japan getting in trouble:

“I have 27-year-old kids selling me one-year jump risk on Japan for less than 1bp – US$5bn at a time. You know why? Because it’s outside of a 95% VaR, it’s less than one year to maturity, so guess what the regulatory capital hit is for the bank? I’ll give you a clue – it rhymes with hero”

Of course, the 2007-08 crisis happened for similar reasons (substitute “Japan” with “Subprime bonds”). The risk was also considered impossible to materialize, the capital charge was also zeroish, the VaR was also negligible. It looked like free money. It looks like free money again. Like infinite ROE for the banks selling the protection.

Current 27-year olds saw/have heard about how their predecessors made a killing killing their employers through the unfettered sale of “no problem” tail risk. They know about Fabulous Fab. Why, they ask, should they show restraint now that it´s their chance to make dough by employing the simplest trick in the financial book, namely selling ”unlikely” risk in massive amounts. A one-eyed monkey can sell “long odds” options and credit swaps. It doesn´t take much ingenuity or smartness. All it takes is a willing employer with the cah to hire some Russian Physics PhDs willing to declare that the premium collected upfront is free money with 99,999999% probability.

Of course, the key is to find someone eager to buy that optionality and protection. The best way to do that is to sell it very cheaply. And the best way to justify that is to have Boris and Nikolai build a computer model that yields a zero VaR.

And now you know why banks hire folks like Boris and Nikolai.


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Finance Edu at ESADE

Without a doubt, finance education has gone through a radical global revolution in the past twenty years. Perhaps the most profound revolution in the academic sphere ever. Tons of new programs in quantitative finance (first) and general finance (later) began to be offered by some of the world´s very best universities and b-schools. Today a good yardstick of innovation is whether a school has chosen to launch a finance degree. While the vast majority of US schools have yet to do so, things (as I humbly predicted many years ago) are changing even at the very top. Those institutions with a more rigid structure have been missing out, depriving their students with direct and easy access to some of the most exciting and remunerative jobs out there. Those visionary pioneers who in constrast chose to innovate are now global leaders in a key field, reaping substantial rewards in reputational and monetary terms.

How about ESADE? Well, we are doing quite fine, thanks very much. ESADE is one of the few schools to offer an MSc in Finance + an MBA Finance Lab + an EMBA with very substantial financial component. Most of the other schools don´t offer an MSc, have plain uber generalist MBAs, and even plainer EMBAs. If finance is important, then ESADE is on the right path.

Now, all we need to do is tell the world with a loud voice.

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