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The macroeconomic context: structural current-account imbalances (part 1)

admin — Mon, 29 Mar 2010 12:46:57 +0000

To an important extent the financial crisis has been a response to tensions built up because of the large structural current-account imbalances in the global economy. These current-account imbalances reflect some extraordinary financial relationships. The savings of thrifty households and companies in China, Japan, Germany, Taiwan or Singapore has found its way, eventually, to the pockets of bank borrowers in the United States, Spain, Australia, the United Kingdom and other countries. The vast surpluses enjoyed by the major resource- exporting economies such as Russia, Saudi Arabia and the United Arab Emirates follow similar routes as they are channelled to the governments and citizens of the major consuming economies of the West. Banks are the intermediaries that recycle these massive global flows of capital, either directly on their balance sheets or indirectly through financial markets.
How big are the flows of credit between nations? The International Monetary Fund (IMF) collects statistics on current-account surpluses and deficits that generate global capital flows. In 2007 the government and citizens of the United States – the biggest net importer – borrowed nearly $750 billion from other countries to finance their expenditures – about $2,500 a year for every man, woman and child. Spain and the United Kingdom each also borrowed around $140 billion from other countries in 2007. Australia, Italy, Greece, Turkey and France were also major borrowers, together borrowing a further $220 billion. At the other end of the scale are the major lending countries. The largest surpluses are those of the big exporters of manufactured goods. China, the biggest of them all, generated a surplus of income over expenditure of $360 billion, Japan of $212 billion and Germany of $185 billion. Not so far behind them are the major resource-exporting countries of Algeria, Iran, Kuwait, Norway, Kuwait, Russia, Saudi Arabia, and the United Arab Emirates which together generated surpluses totalling nearly $400 billion.
What do these large numbers mean? They reflect the balance of income and expenditure for the country as a whole. A current-account surplus of say $5 billion means that a country is generating $5 billion more income from all its economic activities than it is spending on goods and services. Any activity for export, including taking oil out of the ground or manufacturing products for shipment around the world, contributes to an external current-account surplus; and any goods or services purchased from foreign suppliers contribute to an external current-account deficit.
A current-account surplus of $5 billion is similar to the situation of an individual with an excess of income over expenditure of, say, $5 per day. Each day this individual saves $5 and over a year he or she would save around $1,800, investing this money in (for example) bank accounts, government bonds or corporate stocks. What is true for an individual is also true for a country. A current-account-surplus country is a net saver, investing in overseas bank deposits and securities and thus exporting its savings to other countries around the globe. These savings are mirrored by household and other borrowing in deficit countries, such as the United Kingdom, the United States and Spain.
It is helpful to express these current-account deficits as percentages of income. Spain’s deficit of 10 per cent of national product stands out; the economic adjustment necessary to cope with a deficit of this magnitude is very large indeed and its economic situation is extremely challenging, even when compared with the United States, with its 2007 deficit of 5.3 per cent of national product, or the United Kingdom (4.9 per cent) or Australia (6.2 per cent).

The macroeconomic context: structural current-account imbalances (part 2)

admin — Fri, 19 Mar 2010 12:47:07 +0000

Most bank wholesale funding comes, directly or indirectly, from the current-account surpluses of the savings-exporting countries. China, Japan, Germany, Saudi Arabia, Kuwait and the others are the major source of the ‘hot money’ that has now been scared away, and will no longer finance bank holdings of structured securities. Their surpluses provided a large share of the cash deposited with banks through shortterm money markets (this can happen in many ways, through sale and repurchase or ‘repo’ lending, through purchase of asset-backed commercial paper, by investing in money market mutual funds or, most directly, by holding bank deposits).
There are other linkages as well. Government, companies or banks from the surplus countries also hold some bank-issued securities directly (shares, bonds or mortgage-backed and other structured securities). In addition to this direct funding surplus, country savings are invested in many non-bank securities, for example equities, government bonds, corporate bonds or short-term bills and commercial paper. This pushes down their returns and makes them less attractive.
As a result there is displacement of other domestic funds, from companies, insurance companies and pension funds into both short-term funding of bank portfolios through the money markets and bank- issued securities.
This pattern of world savings and investment, with high-saving countries, including Germany and Japan and the emerging market manufacturing exporters and resource exporters such as China, Russia and Saudi Arabia, lending large sums to the high-consuming countries has been a feature of the global economy for several years. Instead of shrinking, these imbalances have risen over the years.
Increasing global trade has opened up tremendous opportunities for growth. The rapidly growing economies of south-east Asia, including South Korea, Malaysia, Taiwan and Thailand, have all benefited, and, more recently, so have India and China. These rapidly growing economies should be the ones with the most attractive business investment opportunities. Yet the world’s savings are being channelled mostly from these fast-growing economies to mature developed economies, ones where the prospects for productive investment are relatively poor.
Why have savings been channelled to governments and consumers in the West rather than to productive investment in the emerging markets? One reason is that returns to investment in emerging markets are surprisingly low, due among other reasons to weak enforcement of property rights in the courts and bankruptcy laws that provide little protection to lenders.
A further part of the answer is the different operation of their banking systems. Banks in the United States, the United Kingdom and other developed countries have been extremely skilful in persuading households to borrow freely in order to finance both house purchase and general consumption. Meanwhile banks in emerging markets have been much less successful at finding opportunities to lend in their own countries, either to companies or to individuals. This reflects both much stronger social security systems in Western countries (households worry less about saving for old age) and more effective systems of credit referencing and credit scoring to identify creditworthy borrowers – systems that have been developed over many years.
The export of savings has also been encouraged by the fiscal and monetary and exchange-rate policies in the exporting countries, for example in China, where the exchange rate has been maintained at a very competitive level to encourage export growth.
This borrowing, or ‘capital importing’, has not just been used for household consumption. It has also financed government expenditures, including, for example, the large increase in military expenditure, especially in the United States, because of the campaigns in Iraq and Afghanistan. Companies and governments have borrowed directly from overseas investors. But the most important destination for this flow of savings has been households, borrowing money from banks through mortgages, credit cards and other forms of personal credit, in turn financed on wholesale funding markets.

What does selling or buying a house really cost?

admin — Wed, 22 Jul 2009 19:37:57 +0000

Brokerage Commissions, a direct cost: In the United States, if a house is sold, the seller’s broker typically receives six percent of the value of the house as commission (and splits this commission with the buyer’s agent). Thus, if a real estate agent manages to sell a house for $300,000, the commission is $18,000. Put diﬀerently, without an agent, the buyer and seller could have split the $18,000 between them. (Of course, brokers do many useful things, such as matching buyers and sellers, shepherding the selling process, etc., so the $18,000 may just be the intrinsic transaction cost to selling a house. However, inconsistent with this view, real estate commissions are much lower in other countries, and it is diﬃcult to see why the cost of selling houses would be exactly 6% in practically all markets in the United States.)
Although only the seller pays the broker’s cost, it makes sense to think of transaction costs in terms of round-trip costs—how much worse you are oﬀ if you buy and then immediately sell an asset. You would mislead yourself if you thought that when you buy a house, you have not incurred any transaction costs because the seller had to pay them—you have incurred an implicit transaction cost in the future when you need to resell your investment. Of course, you usually do not immediately sell assets, so you should not forget about the timing of your future selling transaction costs in your NPV calculations.
Housing transaction costs are so high and so important that they are worth a digression. If you borrow to ﬁnance the investment, transaction may be higher than you think. The real estate agent earns 6% of the value of the house, not of the amount of money you put into the house. On a house purchase of $500,000, the typical loan is 80% of the purchase price, or $400,000, leaving you to put in $100,000 in equity. Selling the house the day after the purchase reduces the owner’s wealth of $100,000 by the commission of $30,000—for an investment rate of return of –30%. This is not a risk component; it is a pure and certain transaction cost.
Let us brieﬂy consider what happens if the house price decreases or increases by 10%. If house prices decline by 10%, or the buyer overpays by 10%, the house can only be resold for $450,000, which leaves $423,000 after agent commissions. The house owner is left with $23,000 on a $100,000 investment. A 10% decline in real estate values has reduced the home owner’s net worth by 77%! In comparison, a 10% increase in real estate values increases the value of the house to $550,000, which means that $517,000 is left after real estate commissions. The house owner’s rate of return for the same up movement is thus only 17%.
With the tools you already know, you can even estimate how the value of a typical house might change if the Internet could instantly and perfectly replace real estate agents. You cannot be too accurate—you can only obtain a back-of-the-envelope estimate. A typical house in the United States sells every seven years or so. Work with a $1,000,000 house, and assume that the expected house capital-gain appreciation is 0%—you consume all gains as rental enjoyment. In this case, the house will stay at $1,000,000 in value, the commission will stay constant at$60,000 and will be paid every 7 years. If the appropriate 7-year interest rate were 40% (around 5% per annum), then the value of the brokerage fees would be a perpetuity of $60, 000/40% = $150, 000. The capitalized transaction cost would therefore have lowered the value of the $1,000,000 house by $150,000. If you could eliminate all commissions, e.g., by selling equally eﬃciently over the Internet, such a house would increase in value by about 15%. However, if you believed that the brokerage commission were to go up by the inﬂation rate (2% per annum, or 15% per 7-years), the friction would not be $150,000 but $240,000—more like 25% of the value of the house, not just 15%.
Other direct costs: In addition to direct agent commissions, there are also many other direct transaction costs. These can range from advertising, to insurance company payments, to house inspectors, to the local land registry, to postage—all of which cost the parties money.
Indirect and opportunity costs: Then there is the seller’s own time required to learn as much . about the value of the house as possible, and the eﬀort involved to help the agent sell the house. These may be signiﬁcant costs, even if they involve no cash outlay. After all, the seller could spend this time working or playing instead. Furthermore, not every house is suitable for every house buyer, and the seller has to ﬁnd the right buyer. If the house cannot be sold immediately but stays empty for a while, the foregone rent is part of the transaction cost. The implicit cost of not having the house be put to its best alternative use is called an opportunity cost. Opportunity costs are just as real as direct cash costs.

Typical Costs When Trading Financial Goods—Stocks

admin — Fri, 19 Jun 2009 10:55:18 +0000

Similarly, ﬁnancial markets transactions also incur transaction costs. If an investor wants to buy or sell shares of a stock, the broker charges a fee, as does the stock exchange that facilitates the transaction. In addition, investors have to consider their time to communicate with the broker to initiate the purchase or sale of a stock as an (opportunity) cost.
Brokerage and Market-Maker Commissions, direct costs: Still, the transaction costs for selling ﬁnancial instruments are much lower than they are for most other goods. Let’s look at a few reasons why. First, even if you want to buy (or sell) $1 million worth of stock, some Internet brokers now charge as little as $10 per transaction. Your round-trip transaction, which is a buy and a sale, costs only $20 in broker’s commission. In addition, you have to pay the spread (the diﬀerence between the bid and the ask price) to the stock exchange. For example, a large company stock like PepsiCo (ticker symbol PEP) may have a publicly posted price of $50 per share. But you can neither buy nor sell at $50. Instead, the $50 is really just the average of two prices: the bid price of $49.92, at which another investor or the exchange’s market-maker is currently willing to buy shares; and the ask price of $50.08, at which another investor or the exchange’s market-maker is currently willing to sell shares. Therefore, you can (probably) purchase shares at $50.08 and sell them at $49.92, a loss of “only” 16 cents which amounts to round-trip transaction costs of ($49.92
− $50.08)/$50.08 ≈ −0.32%. You can compute the total costs of buying and selling 20,000 shares ($1,000,000 worth) of PepsiCo stock as This is not exactly correct, though, because the bid and ask prices that the exchange posts (e.g., on Yahoo!Finance or the Wall Street Journal ) are only valid for 100 shares. Moreover, some transactions can occur inside the bid-ask spread, but for most large round-trip orders, chances are that you may have to pay more than $50.08 or receive less than $49.92. So 0.32% is probably a bit too small. (In fact, if your trade is large enough, you may even move the publicly posted exchange price away from $50!) Your buy order may have to pay $50.20, and your sell may only get you $49.85. In real life, the true round-trip transaction cost on a $1 million position in PEP is on the order of magnitude of 50 basis points.
The above applies primarily to a market order, in which you ask your broker to buy or sell at the prevailing market price. A limit order can specify that you only wish to buy or sell at $50.00, but you are patient and willing to take the chance that your order may not get executed at all. There is a common belief that limit orders are “cheaper” in terms of transaction costs, but also “riskier.” For example, if you have a standing limit order to buy at $50, and the company reveals that it has managed earnings, so its value drops from $51 to $20, your limit order could still easily execute at $50.
Indirect and Opportunity Costs: Investors do not need to spend a lot of time to ﬁnd out the latest price of the stock: it is instantly available from many sources (e.g., from the Internet such as Yahoo!Finance). So, the information research costs are very low: unlike a house, the value of a stock is immediately known. Finally, upon demand, a buyer can be found practically instantaneously, so search and waiting costs are also very low. Recall the often multi-month waiting periods if you want to sell your house.
Compare the ﬁnancial securities transaction costs to the transaction costs in selling a house.Broker fees alone are typically 6%: for the $100,000 equity investment in the $500,000 house, this comes to $30,000 for a round-trip transaction. Add the other fees and waiting time to this cost and you are in for other transaction costs, say, another $10,000. And houses are just one example: Many transactions of physical goods or labor services (but not all) can incur similarly high transaction costs.
In contrast, if you want to buy or sell 100 shares in, say, Microsoft stocks, your transaction costs are relatively tiny. Because there are many buyers and many sellers, ﬁnancial transaction costs are comparably tiny. Even for a $100,000 equity investment in a medium-sized ﬁrm’s stock, the transaction costs are typically only about $300–$500. To oversimplify, this blog will make the incorrect, but convenient assumption that ﬁnancial transaction costs are zero (unless otherwise described). For individuals buying and selling ordinary stocks only rarely (a buy-and-hold investor), a zero transaction cost assumption is often quite reasonable.

Covenants, Collateral, and Credit Rating Agencies

admin — Mon, 08 Jun 2009 10:50:21 +0000

So, if you are an entrepreneur who wants to start a company, what can you do to reduce the expected cost of capital? The answer is that it is in your interest to disclose to the lender all the information you can, provided you are the type of entrepreneur who is likely to pay back the loan. You want to reduce the lender’s doubt about future repayment. Unfortunately, this can be very diﬃcult. The lender can neither peer into your brain, nor give you a good lie detector test. Attempts to convey information credibly in the real world are many, but there will always be residual information diﬀerences—they are just a fact of life. Still, if you can reduce the information diﬀerences, your ﬁrm will be able to enjoy lower costs of capital. Also, if you as borrower fail to give your best try to convince the lender of your quality, then the lender should not only assume that you are an average company, but instead assume you are the very worst—or else you would have tried to communicate as much as possible.
There are at least three important mechanisms that have evolved to alleviate such information diﬀerences. The ﬁrst mechanism is covenants, which specify upfront what a debtor must do to maintain credit. This can include such requirements as the maintenance of insurance or a minimum corporate value. The second mechanism is collateral—something that the creditor can repossess if payments are not made. But anything that inﬂicts pain on the debtor will do. For example, if defaulting debtors were thrown into debtor’s prison (as they often were until the 19th century), the promise to repay would be more credible and lenders would be more inclined to provide funding at lower rates. Of course, for the unlucky few who just happened to suﬀer incredibly bad luck ex-post, debtors’ prison has some deﬁnite drawbacks.
The third mechanism to alleviate repayment uncertainty are credit rating agencies, which keep a history of past payments to help assess the probability of future default. This is why you need to give your social security number if you want to take out a substantial personal loan—the lender will check up on you. The same is true for large corporations. It may be easier to judge corporate default risk for large companies than personal default risk, but it is still not easy and it costs both time and money. The two biggest bond credit rating agencies for corporations are Moody’s and Standard&Poors. (The other two are Duﬀ and Phelps and Fitch.) For a fee that the corporate borrower pays, they will rate the bond’s quality, which reﬂects the issuer’s probability that the bonds will default. This fee depends on a number of factors, such as the identity of the issuer, the desired detail in the agencies’ investigations and descriptions, and the features of the bond (e.g., a bond that will pay oﬀ within one year is usually less likely to default before maturity than a bond that will pay oﬀ in thirty years; thus, the former is easier to grade). The credit rating agencies ultimately do not provide a whole set of default probabilities (e.g., 1% chance of 100% loss, 1.2% chance of 99% loss, etc.), but just an overall rating grade. It is up to the ratings’ reader to translate the rating into an appropriate compensation for default risk. The top rating grades are called investment grade, while the bottom grade are called speculative grade (or junk).
There is often a sharp diﬀerence in quoted interest rates between the worst investment grade bond and the best speculative grade bond, partly also because many investing institutions are allowed to hold only investment grade bonds.
So, is there a diﬀerence between bonds of diﬀerent rating quality? Yes! Altman studied corporate bonds from 1971 to 2003 and reported default and recovery rates. Very few investment grade bonds default—and especially right after issue when they would have still carried the original credit rating. However, many speculative bonds will eventually miss at least one coupon payment (which is considered default). Upon default, an AAA or AA bond price was worth about 75 cents on the dollar; an A bond price was worth about 50 cents on the dollar; and lower rated bonds were worth about 30 cents on the dollar.
Unfortunately, although bond rating agencies will update their rating if the condition of the ﬁrm changes, the empirical evidence suggests that these bond ratings are not very good in helping an investor earn superior rates of returns. In fact, the ratings seem to respond more to drops in the value of the underlying bonds than vice-versa. The bond rating agencies seem to be more reactive than proactive.
How do bond ratings translate into diﬀerences in promised (quoted) bond yields? lists the borrowing rates of various issuers in May 2002. (Many other current interest rates can be found at www.bloomberg.com/markets/rates/index.html and bonds.yahoo.com/rates.html.) Most of the diﬀerences between these borrowers’ promised interest rates and Treasury interest rates are due to default risk, which compensates lenders for diﬀerential default probabilities.

Corporate Finance vs. Entrepreneurial or Personal Finance?

admin — Thu, 28 May 2009 10:49:14 +0000

Where do such market imperfections apply? In the world of large corporations, the interest rate spread between similarly risky borrowing and lending rates is often mild, so they can pretend they live in a “perfect” market in which they can separate the project choice from their ﬁnancial situation. Their promised borrowing interest rates would still be higher than what they can receive investing their money in Treasury bonds—but, given that these large ﬁrms still have some possibility of going bankrupt, their expected borrowing cost of capital would probably be fairly similar to the expected rate of return that they could earn if they invested money into bonds with characteristics similar to those that they themselves issued.
In the world of individuals, entrepreneurs, and small companies, however, expected borrowing interest rates are often higher than expected saving interest rates. In fact, this issue of an extraordinarily high diﬀerential between expected borrowing and lending rates—and with it the role of cash-on-hand—is one important diﬀerence between “ordinary corporate ﬁnance” and “entrepreneurial ﬁnance.” Entrepreneurs ﬁnd it very diﬃcult to convey credibly their intent and ability to pay back their loans. As a consequence, many entrepreneurs even resort to ﬁnancing projects with credit cards, which may charge a thousand basis points above Treasury bonds. These high borrowing costs can thus prevent rational entrepreneurs from taking many projects that they would undertake if they had the money on hand. It also means that more established ﬁrms or richer entrepreneurs should optimally take more projects than poorer entrepreneurs.
But be careful in the real world before you conclude this to be the case: Entrepreneurs tend to have notoriously over-optimistic views of their prospects. (Even venture capitalists, the ﬁnancing vehicle for many high-tech entrepreneurial ventures, which advertise returns of 30%/year or more seem to have managed to return only a couple of percentage points above the riskfree rate over the last thirty years.) This may actually mean that entrepreneurs face only high promised borrowing costs, not high expected borrowing costs. Thus, the quoted spread between their borrowing and lending rates, which is really all that you can easily observe, likelyhas a large component that is due not to information disagreements but simply due to credit risk.

Expected Return Diﬀerences vs. Promised Return Diﬀerences

admin — Sat, 23 May 2009 10:49:09 +0000

The most obvious cause for diﬀerent borrowing and lending rates are diﬀerences in opinion between the lender and borrower. To think about this particular assumption violation, we must work in a world of uncertainty—it would be absurd to believe that such diﬀerences in opinion could exist if there is no uncertainty. So, what happens if the lender and borrower have diﬀerent information or diﬀerent judgment about the same information? Most prominently, they could disagree about the default risk! For example, if you have no credit history, then a lender who does not know you might be especially afraid of not receiving promised repayments from you—from the perspective of such a lender, you would be extremely high-risk. Your lender might estimate your appropriate default probability to be 20% and thus may demand an appropriate default premium from you of, say, 8% above the risk-free yield. On the other hand, you may know that you will indeed return the lender’s money, because you know you will work hard and that you will have the money for sure. In your opinion, a fair and appropriate default premium should therefore be only 0-1%.
When your potential lenders and you have diﬀerent opinions, you then face diﬀerent expected savings interest rates and borrowing costs of capital. That is, if you know that you are a low risk, then your borrowing cost of capital (the expected interest rate) would not only be much higher than the lender perceives it to be, but it would also be the case that your borrowing expected cost of capital is much higher than your savings expected rate of return that you would earn if you deposited your money in the bank. You might be able to borrow at a cost of capital (expected rate of return) of 12%, but save only at an expected rate of return of 5%.
It is not just that you must oﬀer a higher promised rate of return than what you expect to repay. Instead, you must now oﬀer a higher expected rate of return when you want to borrow, compared with the expected rate of return that you could earn if you deposited money in the bank. (The bank is unlikely to go bankrupt, and your deposit is probably insured by the government, which means that the bank may pay not more interest than the equivalent short-term Treasury. The bank’s promised rate of return is almost the same as the expected rate of return.) The diﬀerence in stated borrowing interest rates and stated saving interest rates at your local bank could just as well be the default premium—the diﬀerence in the returns you promise and which you expect to pay, although in a diﬀerent guise. The bank quoting you a lower savings deposit interest rate than borrowing loan interest rate would just compare promised interest rates, not expected interest rates. Instead, the novel issue discussed in our blog is that disagreements and information diﬀerences are now causing diﬀerences in expected returns. The borrowing and lending expected rates of return are no longer the same.Perfect Market Default Spread Assume you have a 5% objective probability of total default. In this case, a risk-neutral bank would ask you for a return of 5% · 0 + 95% · x = (1 + 10%) · $1, 000 ⇒ x ≈ $1, 158 . (6.1)
This 15.8% interest rate is not a market imperfection. It is merely compensation for your probability of defaulting. Both you and and the bank would realize that you are paying a 10% cost of capital.
Imperfect Market Credit Spread Now assume that you believe you have a 3% objective probability of total default, and the bank believes you have a 9% objective probability of default. In this case, the bank would quote you an interest rate of 20.9%. You, in turn, would consider this $1,209 in payment to be equivalent not to the 10% expected rate of return that the bank believes it is, but equivalent to a 97% · $1, 209/$1, 000 ≈ 17.3% interest rate.
You would consider the 7.3% to be the extra spread due to friction—but, of course, who says you are right and the bank is wrong?