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Book summary: The Asian Financial Crisis by Shalendra Sharma

This book describes how the 1997 Asian Financial Crisis transpired.

Impacted countries

  • South Korean
  • Indonesia
  • Thailand
  • Malaysia
  • Singapore
  • Hong Kong
  • China

Key lessons

  • Only 2 of these three conditions can be allowed to be true without causing inflationary recession
    • Fixing the currency exchange rates against other reserve currencies
    • Control over domestic interest rates
    • Control over capital inflow
  • On foreign capital flows
    • huge volume of foreign capital flows into a country
      • economic growth rate increases
      • inflation rate stays low
    • huge volume of foreign capital flows out of country
      • economic growth rate decreases
      • inflation rate goes up

Common pattern across countries

The build up

  • Long periods of high export lead GDP growth attracts high levels of foreign investments. Huge volume of foreign funds originated from Japan which was having a very loose monetary policy
  • Countries peg their exchange rates to reserve currency to ensure stable prices for both imports of raw materials and exports value added products
  • Countries currencies are not reserve currency, hence foreign loans were denominated in foreign currency
  • Excessive leverage within the country by domestic parties who take on short term loans denominated in foreign currencies at lower interest rates to finance long term projects that generate returns in domestic currencies
    • Stocks are purchased with borrowed money. These stocks are then further used as collaterals to borrow more money
    • Real estate are purchased with borrowed money. These real estates are then further used as collaterals to borrow more money
  • Moral hazard due to corruption of financial system
    • banks are arm twisted to finance projects that are not financially viable by governments and politicians

The economic headwinds

  • countries face increasing export market pressure
    • Competition at the low end of the export markets from China
    • Competition at the high end of the export markets from Japan
  • Japanese government instructs central bank to tighten monetary policy to reduce real estate. This severely restricted liquidity from Japan and reduced availability of short term foreign loans to affected countries

The crash

  • Borrowers within these countries increasingly experienced difficulties rolling over their foreign denominated short term loans to finance their long term illiquid domestic projects
  • Many of them started defaulting on their loans
  • Foreign investors started getting spooked and started withdrawing their funds or refusing to allow their loans to roll over
  • Non-performing loans builds up amongst banks within these countries
  • Capital flight continues causing downward pressure on the exchange rates of these countries
  • Countries continued defending their exchanges rates by buying up their own currency and selling off foreign reserves (assets held in foreign currencies)
  • Countries deplete their foreign reserves and are unable to uphold their exchange rates. Since most debts are denominated in foreign currencies, they are not able to print money to pay off these loans.
  • The economy grinds to a halt and hyper-inflation occurs within their financial system at this point
    • domestic production stops and locally produce foods is no longer available for sale
    • due to shortage of foreign reserves imported products become very expensive in local currency
  • Countries approach IMF for loans to tide through this liquidity crunch.
  • IMF steps in and with a lack of understanding of the economic patterns imposes these requirements:
    • Countries required to impose high domestic interest rate. It has the effect of further reducing the money supply within these countries causing more defaults domestically.
    • Countries will reform the financial systems to remove cronyism lead financing
  • Riots ensures and Anti-establishment governments get elected in some countries

The recovery

  • IMF releases the misstep in policies and relents
    • Countries lower their domestic interest rates to increase liquidity within their financial system
    • Countries allow their exchange rates to float freely
  • Relatively cheap asset prices within these countries starts attracting foreign investments again
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Afternoon with Tomasso on the limitations of Artificial intelligence’s application

For us to be able to successfully apply artificial intelligence on any domain, the following needs to be true

  • The behavior the system to be modeled must not be stochastic
  • The state of the system must be decipherable by the data scientist
    • it should be possible to understand the state in which the system is at through interpretation of data gathered
  • The domain can be modeled
    • the parameters for modeling the domain must be well defined

Only when all three premise are true can we determine where the adjustment should be made when a model fails to predict an outcome

The financial markets is stochastic  in the short run.

The underlying parameters are constantly changing and thus hard to model due to the emergent nature of impacts caused by human activities. The data is qualitative and thus hard to convert into clean quantitative datasets.

While the price movements are obvious it is hard, it is hard to attribute impact to the various parameters.

As such, it requires human neural networks that consumed all these qualitative data to perform the prediction/decision making.

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Why banks are trading at or below net book value

After the 2008 financial crisis, legislations like the Volcker Rules to inhibit big banks from behaving like hedge funds. They are no longer allowed to engage in any forms of trading or financial innovation which leads to excessive multiplying of money supply leading and excessive leveraging within the banking systems.

Their income is thus restricted to investment banking commissions and net interest incomes.

Related references

Long-Sought Volcker Rule Revisions Land on a Changed Wall Street

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Book summary: The Savings and Loan Crisis – Lessons from a regulatory failure

This book documents the series of regulatory missteps from the 1980s to the 1990s that lead 50% of savings and loans in the US to insolvency. During this period the total number of savings and loans decreased from 3,234 to 1,645.

Operating mechanism

The savings and loans are a special group of banks that are encourage to grow by the US government to enable affordable housing after the world depression.

They take in short term savings deposits at lower interest rates and lend out long term mortgages at higher interest rates. They profit through the net interest income generated between the short term interest rates and the long term interest rates. If you think you’ve become a victim to such practice, then you can always get help here in order to extricate yourself from the situation.

Events leading to massive failure

  • During the Vietnam war, inflation which drove short term interest rates increase. This cannibalized SnLs’ profit margins.
  • De-regulation of short term interest rates which lead to increased competition by other banks for deposits.  This lead to the inability to attract deposits at feasible rates to finance SnL’s long term illiquid mortgage loans.
  • The US government instead of recapitalizing these insolvent SnLs opted to de-regulate by allowing them to enter into other high yield investment instruments. This is in hopes of they will be able to rebuild the capital and thus minimize the amount of burden to be imposed on tax payers
  • Entrance of new entities
    • mutual funds competed for deposits
    • Freddie Mae and Freddie Mac competed for mortgages
  • SnLs ventured out of their areas of expertise and started buying into high yield corporate junk bonds and unsecured commercial loans.
  • With minimal equity stake in the game due to years of erosion and an implied government guarantee for a bail out in case things go south, SnLs began aggressive leveraged into these positions.
  • The US government reversed it stance and past regulation against SnLs holding high yield investment instruments. The forced liquidation of relatively illiquid positions further exacerbated the situation.

Lessons learned

  • Government meddling in market mechanism to further political agenda is generally a recipe for disaster
  • Venturing beyond circle of competence in search of high yield is generally a recipe for disaster
  • Overt or implied guarantee of government bail out is a source of moral hazard that leads to excessive leverage by operators which is definitely a recipe for disaster
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Book summary: Barbarians at the gate by Bryan Burrough and John Helyar

This book documents the series of events leading up to the successful leverage buyout (LBO) of RJR Nabisco.

Mechanism of an LBO exercise

  • Figure out the cheapest possible price to acquire the asset and its future cashflows while keeping transaction costs low
  • The acquisition team access the business to decipher potential cashflow, areas for cost savings and parts that could be sold off
  • The acquisition team raises private money to do the acquisition
  • During this period of time bandwidth of law firms and banks are fully engaged
  • Competing offers should be expected once a public announcement of an LBO buyout is made
  • Law firms and investment banks will charge fees even if the hiring party does not win the bid

Methods for financing an LBO exercise

  • issue of junk bonds
  • raising from private investors
  • issue of shares to directors to drive down level of cash required for the purchase
  • payment through cash
  • utilization of legal loop holes to reduce taxation on the LBO transaction

Motivations for an LBO exercise

  • The management team:
    • a option to exercise when the market is persistently undervaluing the shares of the business
    • free up value to reward themselves and their share holders
    • the CEO being the typical Type A personality got bored and restless from running his day to day business
  • The investment banks:
    • when the market is down but they still need to figure out ways to make money through business transactions
    • some needed an opportunity to enhance their prestige so as to attract future opportunities. Securing a prominent position in the transaction has that effect

Lessons from the LBO exercise

  • The inability to sit in a room and doing nothing is the source of most trouble.
    • The CEO ended off worst off than he did before the LBO event
  • Having inside support matters
    • Having support of the management team provides knowledge of where cost savings could be had in the operations
  • Just when you think shit will not happen, it usually does.
    • The management team was expecting an uneventful transaction. Unfortunately, the operation quickly escalated out of control when competing bids surfaced.
  • When money is cheap, Wall street gets creative
    • the Federal reserve provides cheap money which cannot be put to real economic use, LBO is just another method Wall Street utilizes to make a profit from this cheap money
  • When egos start getting involved, its no longer about making a profit
    • the successful acquirer ended up defaulting on a lot of the junk bonds issue
    • what started as an initial USD76/share bid quickly escalated to USD106/share
  • When an opportunity as large as this becomes available, the services of lawyer firms and bank credit becomes scarce and it is hard to gain access to such facilities as a new comer to the table
  • Companies actively manage Wall Street expectation
    • RJR Nabisco actively engaged in wasteful activities to project a steadily advancing year over year profitability and thus share price. It could have operated efficiently and have the share price reflect the actual value on day one
  • The core business will falter overtime when the operators get distracted by other activities and are no longer engaged and connoisseur of their own products
    • early employees of Reynolds cigarettes are themselves enthusiast smokers. They released a new product only when it passes their own taste test
    • later management were focused on milking the cash cow and started changing the culture as such
  • Negotiation dynamics
    • the senior financiers will generally play the diplomat (good cop)
    • the junior and middle level financiers will be in charge of hashing out the details (bad cop)

 

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Key lessons from When Genius Failed by Roger Lowenstein

When Genius Failed
When Genius Failed, Roger Lowenstein

Overview

This book documents the rise and fall of Long Term Capital Management. A hedge fund that specializes in government arbitrage

LTCM’s trading methodology

  • Yield for bonds of the same length of maturity with the different maturity dates issued by the US treasure will tend towards each other over time.
  • Bond’s past a specific time frame becomes less liquid hence gets discounted by fund managers
  • leverage up to 30X capital to short the over bought bond and long the over sold bond, essentially making the difference with little capital employed

Causes for LTCM’s failure

  • becoming overly reliant on their models
    • a period of continuous credit spread widening was followed by the Russian government bond default. LTMC continuously doubled down on their position assuming the trend would eventually reverse
  • not taking into account that unlikely long tail negative events. When they occur the impact tend to be very large
  • Excessive use of leverage
    • up to 30X as compared to 20X employed by most hedge funds
    • made possible by FOMO of all banks who were eager to profit by extending credit lines
    • partners borrowed money from banks using securities they own within the firm as collateral
  • The margins of any profitable trading methodology will tend to get eroded overtime as big banks start tapping into the same opportunities
  • Stepping beyond their circle of competence and expecting the same methodology to still work with international bonds
    • assuming political dynamics overseas (Russia) will be the same as within the US
  • banks unloading sections of their portfolio likely to be impacted by LTCM’s position after news of LTCM’s funds and positions they hold further exacerbated their problem
  • Winding an extremely large position is extremely difficult
    • not enough liquidity
    • will negatively impact price

Lessons for LTCM’s failure

  • guard against hubris / overconfidence
  • be self aware of your circle of confidence and staying within it
  • always check for faulty assumptions in your reasoning
  • avoid excessive use of leverage
  • monitor for long tail events that are emergent by nature
  • do not double down on any positions that did not performed up to expectation
  • guard information about your trades tightly
  • be wary of entering into positions with little liquidity
  • If your fund gets into trouble and you owe the bank a small amount of money its your problem, but when it is an extremely large amount of money it becomes their problem
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Federal Chairman Jerome Powell on 0.25% interest rate cuts

Overview

  • Outlook for the US economy is favorable but
    • core inflation is only at 1.6% instead of 2%
    • cutting interest rate by 0.25% from 2.5% to 2.25%
  • insurance against downside risk
    • global growth is slowing
    • trade policy tension is a new stimulus to the equation and it is a concern
  • key objectives
    • strong job economy
    • 2% inflation rate
  • adopt an iterative approach by observing how economy reacts to policy changes

Key areas of concern

global growth slow down

  • US core inflation rate is at 1.6% – excludes food and energy inflation which are cyclical
    • US GDP sustained
  • US manufacturing declined in 2019Q1 and 2019Q2
  • US business fixed investment slowed in 2019Q1 and fell in 2019Q2
    • companies uncertain about investment spending
    • not seeing additional demand for products
  • June US job growth slowed in 2019Q2
  • disinflation rates observed in other countries
    • manufacturing in rural China and the EU are slowing

highly leverage business sector within the US

  • Business borrowings are excessive
  • loans have moved off balance sheet of banks to market based vehicles

Positive signals of sustained US economy

  • rising household income drives confidence
  • no booming sectors observed hence no concerns for busts

Federal Reserves framework for monitoring risks

  • Excessive leverage in the Financial sector
  • Excessive asset valuations
  • Excessive debt loads in households and business
  • Funding risks that could result in sudden shortfall of liquidity

Structure of the US economy

  • US capital requirements within banks are at 2X of what is required to tide through tough times
  • Allocations
    • 70% consumer
    • 30% investments and manufacturing
      • not growing
      • remains healthy

Related references

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Manias, Panics and Crashes – balance of trade mechanism

In a world where currencies are not pegged to gold or other currencies price stability is achieved when major trading partners all target the same inflation rates. Otherwise wild fluctuations in rear asset prices and exchange rates will likely occur.

We should expect the following loops to occur.

Loop #1 – When central bank pursues expansionary monetary policy

  1. Central bank pursues an expansionary monetary policy
  2. investors expect inflation rates to go up
  3. investors expect currency value to drop in overseas market
  4. investors sell off real assets within country and exit funds out of country to other countries
  5. due to decreased demand, stocks, real estates and commodity drops in value.
  6. Exports become more competitive and balance of trade surplus results.

Loop #2 – When central bank pursues deflationary monetary policy

  1. Central bank pursues deflationary monetary policy
  2. investors expect inflation rates to go down
  3. investors expects currency values to increase in overseas market
  4. investors move funds into country to buy up real assets
  5. Due to increased demand, stocks, real estate and commodities within the country appreciates in value
  6. Exports become less competitive overseas and trade deficit results

Key insights

US has been experiencing a balance of trade deficit since 1980. This is partially due to the result of going off the gold standard.

While it did not actively pursued a deflationary monetary policy, it’s stable politic system and high level of technology innovation, relative to other countries, has an overall deflationary effect on its economy.

The net effect is the same as if the central bank pursues a deflationary policy.

Related readings

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Book summary – The Bank Credit Analysis Handbook by Jonathan Golin and Philippe Delhaise

“Panics do not destroy capital, they merely reveal the extent to which it has been previously destroyed by its betrayal into hopelessly unproductive works”, John Stuart Mill

Overviews on crisis

Crisis tends to only be obvious in hindsight. People tend to be biased towards optimism even in the darkest times.

Crisis are generally triggered by a momentary lack of liquidity which leads to  a whole cascade of events. This sends the entire system into a negative tail spin. A loss of trust in the system is the fundamental problem.

Types of crisis

  • Banking crisis:
    • usually triggered by rapid deregulation leading to excessive levels of volatility within system
    • A single bank or the entire banking system experiencing a shortfall of liquidity which deteriorates into a massive bank run.
    • takes place before financial crisis
    • reaches highest point after financial crisis
  • Financial crisis
    • country whose currency is not a reserve currency experiencing a shortfall of liquidity triggering off rapid exit of funds trying to avoid the negative currency exchange dip
  • Twin crisis
    • when both bank crisis and financial crisis occur together resulting in cross feeding.
    • economic fundamentals are deteriorating in periods preceding twin crisis

Bank failure cause by banking crisis

  • Quality of management plays a very important role in averting such crisis
  • If bank is too big to fail
    • government will attempt to step in.
    • To restore trust
    • Relatively rare
  • Smaller banks
    • will get absorbed by larger banks
  • government interventions
    • when seen as too ready to step in will encourage moral hazard
    • results in banks taking excessive risk
    • want the funds to restore liquidity to come as much as possible from the private

Indicators for banking crisis

It is generally difficult to assess banks due to information asymmetry. Banks and government will want to delay the release of bad news to prevent deterioration of an already bad condition

Spreading the financial statements across different banks will help analysis risk

  • Leading indicator:
    • Non-performing loans/assets as a percentage to total loans/assets
    • Non-performing loans as ratio to loan-loss reserves
  • Lagging indicator: net interest income falls

Risk assessment method

  • CAMEL model
    • Capital
    • Asset quality
    • Management
    • Earnings
    • Liquidity

Roles of Banks

Generalfunctions
  • Hubs of financial networks that connect supply and demand for money
  • Intermediary to smooth out friction in the flow of money
  • Spread risk of loaning money
  • Ease of liquidity
  • Securitization to move loans off balance sheets
  • Underwriting
Special functions
  • Support national payment system
  • Providing backup liquidity to non-banks
  • transmission belt for monetary policy

Types of Banks

  • Large banks – extensive network able to pull in consumer deposits at relatively low cost
  • regional banks – has deep relationships with local territory and is able to meet the needs of local business better than large banks

Types of capital

  • Consumer deposits – very sticky but small in amount
  • Commercial deposits – very volatile but large in amount

Types of banking instruments

  • Negotiable Certificate of Deposits
  • Letters of Credit
  • Derivatives
  • Futures

Credit risk

The possibility of not getting the loan and interest back due to inability or unwillingness of the borrower. Assessed qualitative and quantitative elements

external factors

  • sovereign risk
  • cyclical risk

Components to model credit risk, a.k.a. Expected Loss

  • PD – probability of default
  • EAD – exposure at default: percentage of the amount of loan that will be affected by a default event
  • LDG – loss given default
  • Time horizon – the longer the time horizon the more likely the default

Risk assessment method

  • general – Value at Risk (VaR) model
  • fixed income analysis – fundamental and technical analysis

Currency risks triggered by sovereign/country risk

  • policy lending – subsidizing industries through banking industry
  • state-owned enterprises – encourages inefficiency

Components to consider

  • GDP growth – a growing GDP will help buffer shocks to the system
  • Fiscal deficit
  • Monetary conditions
  • Balance of trade

leading Indicators

  • consumer confidence index
  • manufacturers index
  • money supply
  • yield curve

lagging Indicators

  • unemployment rate
  • inventories to sale
  • consumer credit to personal income

Risk management

  • liquidity risk
  • solvency risk
  • market risk
  • credit risk
  • credit spread risk
  • currency risk
  • operational risk

Risk assessment method

  • general – Value at Risk (VaR) model
  • Stress test

Further Readings

  • Managing banking risk, Eddie Cade
  • The dollar crisis, Richard Duncan
  • A failure of capitalism, Richard A Posner
  • Bank restructuring, Andrew Sheng
  • When genius failed, Roger Lowenstein
  • Manias, panics and crashes, Charles P. Kindleberger and Robert Aliber
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Thoughts on avoiding the greater fool theory

Once a project’s mission statement is defined, it becomes easy to determine when to stop further iterations. 

Below are the listed of statements I periodically revisit when pursuing GetData.IO’s mission to help people make good decisions by making data gathering simple and affordable. 

Hypothesis 1: People no longer need make good decisions.

Hypothesis 2: People no longer need data to make good decisions.

Hypothesis 3: People no longer find it hard to get data.

Hypothesis 4: We have exhausted all known approaches to lower the cost of data gathering to an affordable range. 

Hypothesis 5: We have exhausted all viable approaches to reach people who need to make good decisions.

Hypothesis 1 and 2 are existential questions, while hypothesis 3 focuses on substitute availability. These are out of our control. The only thing we could do is monitor for changes.

Hypothesis 4 and 5 focuses on economic feasibility. These we will fully focus our efforts on. Once we eliminate all none viable options, whatever remains will be the limitations we must accept and live with. 

It is useful to note the lack of any mention on funding. The underlying assumption is that every successful iteration necessarily unlocks resources from the environment which is then fed back to further the compounding process. The discipline is to minimize wastage. 

Relying on external funding is like utilizing margins during day trading. While earnings get amplified, failures tend to be really spectacular. One additional drawback is that they tend to mask critical flaws in the short run leading to the commonly observed greater fool phenomena in the financial markets.

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