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

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

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.

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

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

Macro economic extension to loss aversion reversion to mean trading methodology – Government versus Government scenario

Trading Heuristics

Chain of events and decision making

The decision making processes from June 2019 after the federal reserve signal likelihood of cutting interest rate leading up to the 2019 August downward mean reversion of the SnP.

19th June 2019, Federal Reserve signals for first time likely decrease of interest rates

Federal Chairman expresses concerns about potential cross winds caused by US trade policies and its impact on their dual mandate.

10th July 2019, news paper reports SnP reaches all time high

SnP on the cusp of crossing 3000 threshold for the first time to an all time high. Market is euphoric. Trade issue between US/China yet resolved but discussions are underway.

Short positions SQQQ and SRTY were utilized as hedges against downward macro environment reversion risk when the SnP extended beyond 3000 to reach an all time high

1st August 2019, US announcement of 10% tariffs on US300 billion imports from China starting September 2019

on 1st August, 24 hours after actual interest rates cut, Trump signaled 10% tariffs on USD300 billion Chinese import. SnP dropped.

Exited SQQQ and SRTY for 10% capital gain after reaching 30SMA and 50SMA range. Net combined loss to portfolio was 0.5%.  Left remaining long positions open.

4th August 2019, Chinese response

On 4th Aug 2019, China’s exchange rate dropped for the first time below 7RMB/1USD.

5th Aug 2019 trading day

On 5th Aug 2019, China announced they will halt all imports of agricultural goods from US.

Portfolio continued declining an additional 2% on the trading day of 5th August 2019.

Closed all long positions with the exception of REITs

Decline overview

  • SnP
  • REITs
  • Value shares
  • Growth shares

6th Aug 2019 trading day

On the evening of 6th Aug 2019, China announced decision to control fluctuation of RMB exchange rates to USD

Bought into TQQQ and URTY at below 30SMA and 50SMA

7th Aug 2019 trading day

TQQQ and URTY automatically exited at the mid point between the two following highs and lows:

  • highest point  before Trump’s tariff announcement came into effect
  • lowest point after China’s halt on US agricultural imports and RMB/USD breaking 7 came into effect

Related readings

Donald Trump’s August 1st 2019 tweet on additional tariffs

Highlights

  • The effect of a negative shock is 3X worst that the effect of a disappointment
  • The effect of a negative shock is longer lasting than the effect of a disappointment
  • The market does retain memory of prior states
  • Seems like each negative political macro event has approximately negative 3% impact on the SnP

Series of events

Wednesday, 31st July 2019, 2pm, US Federal Reserve’s disappointment

  • Federal Reserve announced an interest rate cut of 0.25% from 2.5% to 2.25%
    • no hints of further cuts
    • before announcement SPY price 300.04
    • after announcement SPY price 296.98
    • net effect on SPY -1.02%

Thursday, 1st Aug 2019, 10.26am, US President’s negative shock

  • President Donald Trump announced additional 10% tariffs on remaining 300 billion imports from China on Twitter.
    • before announcement SPY price 300.45
    • after announcement SPY price 291.02
    • net effect on SPY -3.14%
    • SPY price still above the 7th June 2019 price of 288.97 when the effect of Fed’s hint to adjust interest rate cuts has been priced in.

Sunday, 4th Aug 2019, 6.20pm PST, China exchange rate sinks below 7CNY/1USD for the first time

Monday, 5th Aug 2019, 9.58am PST, China suspends purchases of US farm products

  • US Market takes a sharp dip on Monday
    • SPY price 281.90 at lowest point
    • net effect on SPY -3.13%

Monday, 5th Aug 2019, 5.27pm PST, China announces fix to prevent further RMB depreciations against the USD

  • US market rebounds
    • SPY price 293.55 at highest point
    • net effect on SPY 4.13%

13th Aug 2019 Trump announces delay of tariff

  • US market rebounds
    • SPY price 292.32 at highest point
    • net effect on SPY 1.91%

14th Aug 2019 UK and US 2 years / 10years yield curve inverts. Germany reports GDP shrinkage for 2019Q2

  • US Market takes a sharp dip
    • SPY price 284.20 at lowest point
    • net effect on SPY -2.77%

Related artifacts

Trump’s tweet on additional 10% tariffs at 1st Aug 2019, 10.26am PST
Chinese RMB crosses 7RMB/1USD for the first time on 4th Aug 2019, 640pm PST

Related readings

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

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

Effects of Trump administration and Federal Reserve fiscal policy on the S&P index

2018 Oct / Dec SPY decline

During the period of Dec 2019, the SPY index ranged between

  • 3rd Oct 2019 – USD 291.72
  • 24th Dec 2019 – USD 234.34

The steep decline in share price can be attributed to the ongoing trade war wage by the Trump administration and the expected Federal Reserve rate hike. The decline attributions are as follows:

  • Trump administration
    • USD 291.72 – USD265.37
    • 3rd Oct 2019 – 13th Dec 2019
    • decline of 9.03% off of USD291.72
  • Federal reserve rate hike
    • USD265.37 – USD234.34
    • 13th Dec 2019 – 24th Dec 2019
    • decline of 10.63% off of USD291.72

2019 May / June SPY decline

During the period of May and June 2019, the SPY index ranged between

  • 3rd May 2019 – USD 294.03
  • 3rd June 2019 – USD 274.57

The steep decline in share price can be attributed to the two front trade war wage by the Trump administration which caused a 6.61% price decline

Of the recovery that occurred after 3rd June 2019, the following parties could be attributed

  • Federal reserve
    • USD274.57 – USD 287.65
    • June 3  2019 – June 7 2019
    • 4.76% recovery off of USD274.57
  • Trump administration
    • USD 287.65 – USD 292.32
    • June 10th 2019 – June 18th 2019
    • 1.70% recovery off of USD274.57

Conclusion

While both the Government administration and the Federal reserve have observed impact on the SnP index, it is observed the Federal reserve has a slightly higher level of impact.

  • Oct/Dec 2019: 10.63% versus 9.0%
  • May/June 2019: 4.76% versus 1.70%

 

Macro-economics negative spiral leading indicator

Overview

This post documents how we identify negative macro downtown.

Heurisitics

  • When more than 20 companies within the mega cap area experience large dip within a week, it is a good indication that macro economics trend has shift
  • Verify by cross referencing with SQP, QQQ and ^RUT
  • During this scenario, it might make sense to shift position into SRTY

Related references