GAIM 2010 Day1 Investing in an Era of Sovereign Risk D

8/9/2019 GAIM 2010 Day1 Investing in an Era of Sovereign Risk D

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Investing in an Era of overe gn s

GAIM International 2010

onaco, une ,

Dino Sola, [email protected]


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,

cases have involved emerging economies, not developed ones.(This time is different!)

A default by Greece might cause contagion and trigger a wave

o e a u t s.

nves or ec s on w e ase no on y on macroeconom canalysis, but also on animal spirits.

A behavioral interpretation of the sovereign debt crisis and ofthe chance of contagion will be useful.

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, -

Algeria

Angola

r ca

ChinaHon Kon *

s aAustria

Belgium*

uropeArgentina

Bolivia

a n mer ca

Central Af.Rep.

Cote DIvoire

India

Indonesia

Japan

Denmark*

Finland

France

Germany

Brazil

Chile

Colombia

KenyaMauritius*

Nigeria

Korea*Malaysia*

Myanmar

GreeceHungary

Italy

Netherlands*

osta ca

Ecuador

El Salvador

South Africa

Tunisia

Zambia

Philippines

Singapore*

Taiwan*

Norway*

Poland

Portugal

Honduras

Mexico

Nicaragua

m a we Thailand*Russia

Spain

Sweden

Panama

Paraguay

PeruNorth America Oceania

Source: TTID 2008 paper

Turkey

UK*

Uruguay

VenezuelaCanada*United States*

Australia*

New Zealand* * :default virgins


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e osts o overe gn e au t , y uar o orenszte n an

Ugo Panizza. IMF working paper, October 2008,via The Economist. 4


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Source: TTID 2008 paper5


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Source: TTID 2008 paper 6


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7Source: TTID 2008 paper


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Source: TTID 2008 paper, Figure 18


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,

Source: Credit Suisse, 20099


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en ogo oom erg.com, e ruary , :

Following banking crises, we usually see a bunch of sovereign

defaults, sa in a few ears.

We almost always have sovereign risk crises in the wake of

an international banking crisis, usually in a few years, and

thats happening, he said. Greece is just the beginning.In rich countries Germany, the United States and maybe Japan we

.

problem hits with interest rates.

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or financial disruptions.

Contagion can arise through direct linkages among countries withcommon internal macroeconomic fundamentals and circumstances:

Capital inflow bonanzas, increases in private or public leveraging, housing

, , .

Example: the 2007-2008 US financial crisis spread globally through directlinkages, via investment in toxic securitized products. (TTID, p. 242).

ontag on can a so e cause y externa nternat ona s oc s:

Changes in interest rates, changes in oil prices and other commodity prices,

inflation, etc. Example: the Latin American debt crisis (or LDC debt crisis ) of 1980s.

Commodity prices fell 40% from 1979 to 1982. Real interest rates in the US hit

6%, highest reading since 1933 (TTID, p. 243).

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one economy to countries with apparently healthy fundamentals

and no clear linkages with the originator.

The international transmission of financial shocks is not a new. , ,

originating in a particular country affect, in a very severe andunexpected way, nations that are very distant and that appear tobe largely unrelated to the shock originator.

Examples of this type of situation include, among other, the

transmission of turmoil from Hon Kon to Mexico and Chile in 1997and the dramatic spillover of the Russian crisis of August 1998 intoMexico and other Latin American countries.

, , .

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evera e av ora exp ana ons ave een propose :

Asymmetric information and herding behavior ,may sell first and ask questions later, and others may follow.

Examples: Lehman, Greece.

Macroeconomic or financial feedback loopsExample: The concern that Italy might go the way of Greece might

cause nves ors o se a an on s, w c wou cause nanc ng cos s

for the Italian government to go up, making a default more likely.

Bank run mechanisms and self-fulfillin ro heciesIf some depositors run, it is optimal for others to run too. In the analogue

for sovereigns, a lack of lenders might cause a bond auction to fail.

See Contagion of Financial Crisis, Hong Kong Monetary Authority, 2009.

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am ns y, ogo an g e n o y r n y o nanc a

Contagion, 2003) distinguish two types of contagion:

High-velocity or fast and furious transmissions:

We refer to contagion as an episode in which there are significantimmediate effects in a number of countries following an event that is,

of hours or days. (TTID, p. 241).

Low-velocity or slow-burn contagions or spillovers that spreadslowly and initially have a muted reaction.

Example: The Argentina default in December 2001.

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.e a ove s nc on can e m s ea ng

A slow-burn contagion can become fast and furious if. .

This is the sudden realization that If something cannot go on forever,

it will stop (Steins Law).

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GREEK GOVT BOND HELLENIC REP2Y (GGGB2YR:IND)

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,

trigger is a sense of mistrust or lack of confidence.

Im erfect informationThe lack of sufficient information dents confidence.

Feedback loops

Lack of confidence causes selling, which causes a dropin prices, which causes a further loss of confidence.

A run on a country occurs when that country cannot refinance itsdebt: new debt auctions fail. If current bond investor sell or run,

debts and will desert new auctions.

Confidence might wane gradually or fall off a cliff

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in a Wile E. Coyote moment.


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rational. Indeed the truly trusting person often discards

or discounts certain information. She may not evenprocess t e n ormat on t at s ava a e to er

rationally; even if she hasprocessedit rationally, she

still may not acton it rationally. She acts according to

what she trusts to be true. The very term confidence implying behavior that

indicates why it plays a major role in macroeconomics.

When people are confident they go out and buy; when

, .

Animal Spirits, Chapter 1 (pages 12-13).

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The cornerstone of our theory is confidence and the feedback

mechanisms between it and the economy that amplify disturbances.

Confidence and the confidence multiplier can

(page 5)

, ,

indicators are being developed.Some of these indicators are market based (e.g.

VIX, TED spread).

The media provides an excellent testing

groun or e eve o con ence n e

markets.

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January 13


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WSJ.LAW MARCH11 2010Exam iner: Lehm an Torpedoed Lehm an

n t e report, r. a u as eta e a mater a y m s ea ng approac e man tooto representing its financial conditionLehman chose to "disregard or overrule the firm's risk controls on a regular basis "

The examiner said that Lehmananxious to maintain favorable credit ratingsengaged in an accounting device known within the firm as "Repo 105" to essentially

' .helped Lehman look like it had less debt on its books."In this way, unbeknownst to the investing public, rating agencies, Government

' ', ,net leverage ratio for public consumption," says the report. the transactions posed "reputational risk" to Lehman if their use became publicly

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See: Funny swaps at

www.market-melange.com

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,THERE comes a moment in man debt crises when events s iralout of control. As panic sets in, bond yields lurch sickeninglyupwards and fear spreads to shares and currencies. In September

2008 the failure of once-stellar Lehman Brothers almost broughtdown the worlds bankin s stem. A decade earlier, Russiaschaotic default on its sovereign debt rocked the credit markets,felling Long Term Capital Management, a hugely profitableAmerican hedge fund. When the unthinkable suddenly becomesthe inevitable, without pausing in the realm of the improbable,then you have contagion.

The Greek crisisor more properly Europes sovereign-debtcrisislooks dangerously close to that (see article). Even asne otiators from the Euro ean Union and the IMF are ha linwith the Greek government over an ever-growing bail-outpackage, the yield on Greek debt has ballooned: two-year bondssoared towards 20% this week. Portugals borrowing costs

jumped. Spains debt was downgraded, along with Portugals and stGreeces, and Italy came worryingly close to a failed debtauction. European stock markets have slumped and the euro itselffell to its lowest level in a year against the dollar.

,

From: Acropolis Now, The Economist, May 1st, 2010.

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Doubts on ECB bond bu inByDavid Oakley andRalph Atkins June 8 2010

It is one month since the announcement ofthe 750bn shock and awe international rescue

acka e to save Euro es overnment bond markets from im lodin and the results so far are

not encouraging. A key part of the plan was the European Central Banks decision to buy

eurozone government bonds to stop the relentless rise in government bond yields of the weaker

economies on the monetar union eri her . Yet the bond ields of Ital and S ain, which hit

fresh peaks on Monday, are higher than they were before the emergency rescue plan wasannounced.

Ralf Preusser, head of European rates research at BofA Merrill Lynch Global Research, adds:

We are at a critical stage for the eurozone. There are very few buyers of eurozone bonds, except

for the most liquid markets.

Source: FT.com

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Life occasionally has its revelatory moments. In Henry

James The Golden Bowl, it was just a glance and then

accurate: her husband and her fathers wife were intimate.

For the worlds economy, September 29, 2008, was such a

e n ng momen . e . . ongress a re use a oug

it later reversed itself) to pass the $700 billion bailout planproposed by Treasury Secretary Henry Paulson. The Dow

Jones stock market index dropped 778 points. Stock

markets fell throughout the world. Suddenly what had

seemed only a remote possibility a repeat of the Great

Animal S irits Preface a e vii .

Depression was now a real prospect.

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AHEADOFTHETAPE JUNE9,2010Cloudy W ith a Strong Chance of ECB FogB BRIAN BLACKSTONE

Details, details. That is what investors crave from Europe this week as theycontinue to fret over just how far and wide the crisis on the Continent will reach.Too bad the European Central Bank isn't likely to appease them when it

meets Thursday. That could leave European bond markets and the eurounder pressure. Investors may get an early glimpse Wednesday of just howon ed e markets are when Portu al looks to sell 1 billion to 1. billion($1.19 billion to $1.79 billion) of bonds.So what do investors want? More information as to how much the centralbank will spend on a controversial government-debt-purchase program, the

' ,ECB's views on the euro's steep slide.They aren't alone in thirsting for clarity. Financial-market fears have drivenovernight deposits at the ECB to records, showing banks figure it is better

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o accep a pa ry 0.25 n eres ra e an en o o er an s.


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n urs ay ay ean- au e unc er, ea o e

eurogroup of finance ministers, said he did not think markets

Hungary spent Monday trying to undo the damage from its

new overnments warnin that it mi ht be the next Greece.

France, meanwhile, is suffering from unwise words byFrancois Baroin, budget minister. He said it would be a

stretch to keep the countrys triple A credit rating. After

looking at the numbers, investors seem to have concluded he is

r g .

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Strong euro hid crisis, says EU chief

By Tony Barberin Brussels June 13 2010

Herman Van Rompuy, president of the European Union,has blamed the strength of the euro in recent years for

blinding the eurozone to its underlying fiscal problems.

He also criticised financial markets for overreacting to

influenced by rumours and prejudices.He said: The markets were too indulgent in the first

decade, but now they overreact a lot of the time to small

incidents.

What went wrong wasnt what happened this year.

What went wrong was what happened in the first 11

.victims of our success.

The euro became a strong currency with very small

interest rate spreads [on government bonds]. It was like

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some kind of sleeping pill, some kind of drug. We

werent aware of the underlying problems.Source: FT.com


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120

200 pr

110

160

S&P 500

100

140

90

120

80

100

60

70

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80

12/31/2009 1/31/2010 2/28/2010 3/31/2010 4/30/2010 5/31/201050


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12.00%

10.00%

11.00%

Exp return As risk aversion

increases, ALL risky

9.00%

7.00%

8.00%

Optimal risky portfolio

5.00%

6.00%

Risk- ree

Optimal

3.00%

4.00%asset

portfolio

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2.00%

0.00% 5.00% 10.00% 15.00% 20.00% 25.00% 30.00%

Risk


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12.00%

10.00%

11.00%

Exp return Plenty of opportunities

to short

9.00%

7.00%

8.00%

Optimal risky portfolio

5.00%

6.00%

OptimalRisk-free

3.00%

4.00%

complete

portfolioasset

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2.00%

0.00% 5.00% 10.00% 15.00% 20.00% 25.00% 30.00%

Risk


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32Source: Bonds, why bother. Robert Arnott. May 2009


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12.00%

11.00%

Exp return at ere s no

risk-free asset?9.00%

.

7.00%

8.00%

Optimal risky portfolios

5.00%

6.00%

4.00%

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2.00%

.

0.00% 5.00% 10.00% 15.00% 20.00% 25.00% 30.00%

Risk


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o s no a r s - ree asse u means many ngs o many

people. Here are some of the attributes of gold as an

Gold provides diversification away from globalization

Gold is a form of insurance against panic in the financial markets

Gold is an inflation hedge which does not deflate Gold is a vote of no confidence on governments and their

currencies

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The markets are moved byanimal spirits, and not by

reason.

uccess u nvest ng s

anticipating the anticipationsof others.

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GAIM 2010 Day1 Investing in an Era of Sovereign Risk D

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