Flash crash

Dow Jones index had today its biggest intraday drop in history. It was down almost 1000 points/10%, but managed to close "just" with loss of 3,24%.

There are various reasons circulating what caused the crash... I think that the market was ready for a correction for a long time, but buyers were still stepping in (when I say buyers, think about investment banks and hedge funds). The risk of spread of contagion from Greece to other countries not just in Eurozone is clearly visible, but Wall Street was pretty immune. But nothing last forever and this week investors realized that the risk is very clear and pretty high. Plus Trichet was extremely passive on the ECB conference and he even said that they didn't consider buying bonds. Well, markets didn't like it. What we saw was a panic which was then amplified by maybe a crash of a HFT system or something like that.

Lets see how this continues... But my guess is that this can go further.

Various comments about the crash from other bloggers:

Carry Unwind Magnifying Moves? - UrbanDigs

A: Tons of talk about this threat since middle of 2009. Has The Search For Yield ended with a fierce carry trade unwind?

When asked in November about what signs would indicate an that a carry trade unwind might be happening (5th comment), the response was:

Danny: Noah, what are some of the initial signs that may indicate the positive carry trade unwind is upon us?

Noah: the main sign will be a sharp, fierce rally in the US dollar and likely a similar fall in commodities/stocks. I wonder how metals will react as they may disconnect a bit given the nature of the crisis and actions taken across the world to stem it.

In Debt We Trust: The warning sign will be a jump in options volume for vix call futures.

So lets see here:

1. Sharp/Fierce rally in US Dollar - check!

2. Selloff in Equities/Commodities - check

3. Disconnect in Metals/Gold - check!

4. Jump in options volume for VIX calls - check!

Eurodollar futures plunging which will reflect a rising LIBOR rate. HY/IG getting hit. These are all clear signs of stress. Sometimes the best discussions on this site occur in the comment threads! Hopefully that continues and reader participation and opinions only grow from here!

PLUNGE! 1987 Style - Sudden Drop in US Stocks Driven by Program Trading and a Ponzi Market Structure - Jesse
US equities were gripped by panic selling as the Dow plunged almost 1,000 points driven by a cascade of 100 share high frequency program trading, estimated to have been about 80% of volume. Gold rocketed higher to $1,210. The stock exchange circuit breakers do not apply after 2:30 PM NY time.
This was highly reminiscent of the 1987 crash driven by a flawed market structure based on automated trading and bad theories.
The entire stock market rally which we have seen this year off the February lows resembles a low volume Ponzi scheme, and formed a huge air pocket under prices.
This US equity rally was driven by technically oriented buying from the Banks and the hedge funds. There was and still is a lack of legitimate institutional buying at these price levels. This was machine driven speculation enabled by the lack of reform in a system riddled with corruption, from the bottom to the top.
This is yet another indication that the US regulatory and market oversight organizations, especially the SEC and CFTC, continue to be disconnected from and remarkably ineffective in their responsibilities in guarding the public against gross market abuse, price manipulation, and insiders playing games with cheap money supplied by the NY Fed.
And as you might expect, the anchors on financial television are trying to excuse and blame the sell off on a 'fat finger' order that caused Proctor and Gamble to drop 20 points in 45 seconds. Or a typist inputting an order to sell 16 million e-mini SP futures, and typing "B" instead of "M." Oops. Crashed the free world.

"Ordinarily, the financial risk in a market, and hence the risk to the economy at large, is limited because the assets traded are finite. There are only so many houses, mortgages, shares of stock, bushels of corn, [bars of silver], or barrels of oil in which to invest.

But a synthetic instrument has no real assets. It is simply a bet on the performance of the assets it references. That means the number of synthetic instruments is limitless, and so is the risk they present to the economy...

Increasingly, synthetics became bets made by people who had no interest in the referenced assets. Synthetics became the chips in a giant casino, one that created no economic growth even when it thrived, and then helped throttle the economy when the casino collapsed."

US Congressman Carl Levin

Even if any of this was true, it was just the spark that caused the market to plummet because of its highly unstable and artificial technical underpinnings. There is no longer any legitimate price discovery. The US financial system is a casino, dominated by a few big Banks and hedge funds, the gangs of New York.
They'll never learn. Or is it 'we?' They may not really care.

WHAT CAUSED THE CRASH TODAY? - Pragmatic Capitalism

There’s all sorts of speculation over what caused the crash today.  The answer is simple.  Pure unadulterated fear.   Everyone is looking for someone to blame, but we’ve seen this happen in markets for hundreds of years.  It happened before there were computers and it now happens that there are computers.  Today was a classic fear filled day.  We saw huge downside in many debt and forex instruments before the crash and the equity markets were the last to capitulate.  The bids fell off the board and the sellers just continued to hit the bids.  There might have been some “fat finger” trades or some electronic trading that contributed, but this was primarily fear.  Good old fashioned fear.  This has always happened in markets and will always happen in markets.  It’s as simple as that as far as I’m concerned.

Investors are scared out of their minds as China looks like it is slowing substantially and Greece and the EMU appear to be on the brink.  There are real fundamental reasons for the recent declines in stocks.  In addition, it’s important to remember that there are a mountain of longs that have piled into the market in recent weeks and months with the expectation of a nice easy recovery trade.  That is clearly off the table and there is a huge trade being unwound here.  Greed has quickly turned to fear.

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Mean Street: Crash — The Machines Are in Control Now - WSJ Deal Journal

If you’re a Merrill Lynch broker, you better be praying that none of your clients were watching CNBC between 2 and 3 p.m. this afternoon.

Anyone who saw the Dow freefall 7% in a matter of minutes is going to require some convincing to hang onto any stocks. The Dow’s intraday drop of 998 points was its largest ever one-day point decline.

The early talk is that it was a trading error at Citi that got the panic going. Poor guy. He’ll be unemployed and in front of Carl Levin’s committee within a week. Then again, he works at a state-owned bank, so at least he’ll be better treated than Goldman Sachs’ “Fabulous” Fabrice Tourre.

Of course, it’s not just one guy’s fault. A panic is a collective undertaking and today there were plenty of reasons to freak out: the rioting in Athens, the impending collapse of the euro, more financial regulations down in D.C.

But please, why make excuses? Why do we pretend that people are in control, when they’re really not? The machines are.

We’ll have to wait for a full autopsy of today’s trading day. But it’s a safe bet that after the trader’s initial error, high-frequency trading computers remorselessly running their algorithms took over.

I’d be amazed if “high-frequency trades” don’t account for the vast majority of the executions that took place between 2:15 and 3 pm at the NYSE.

Of course, the bigger question will be not what caused the panic – but what, if anything, should be done about it.

As a believer in free markets, I think it is both useless and harmful to constrict computerized trading. But on days like today, it really puts that belief to the test.

The purpose of a stock market is to provide an orderly and efficient market for the free exchange of equity securities. At the core of the market, there must be a belief that the market is trustworthy, that it can match buyers and sellers, bids and asks.

Today’s market was neither orderly nor efficient nor trustworthy. It was just a bunch of computers making ugly, messy love with each other . And your money hung in the balance.

Europe finds the old rule still apply

Kenneth Rogoff for FT:

The cruel irony of the euro area's predicament is that, in many ways, the whole exercise was designed to produce the very credit explosion that bedevils it today.After all, one of the driving motivations of the euro was to enable member states to compete with the US for a share of the global reserve currency business. Reserve currency status, in turn, is the essence of America's “exorbitant privilege” (a term coined by Valéry Giscard d'Estaing, the former French president). The most important perk the US gets is the ability to issue debt at a lower interest rate than would otherwise be the case. Indeed, recent research suggests that simply by enhancing the size and liquidity of financial markets, the euro may have helped to lower real interest rates across Europe, and not just for government borrowers.

Lower interest rates, in turn, helped fuel greater borrowing, especially in the countries of the eurozone periphery. Thus, the spreading debt crisis is as much a product of the “success” of the euro as of its failure. The euro was designed to be a superior debt financing machine and, to a considerable extent, it has delivered.Unfortunately, it should have come with a warning sign: Europe's leaders were far too quick to admit members who might have been better served with a much longer probation period. The Maastricht treaty and, more importantly its implementation, was simply too forgiving, especially for countries with chequered financial histories.

A recurring theme of my academic research with Carmen Reinhart is that “graduation” from emerging market status is a long, painful process that can take 75 years or more to complete. Twenty years without, say, a sovereign debt crisis is significant, but hardly enough definitively to declare a country a “graduate”. Greece resolved its last sovereign default only in the mid-1960s and Portugal had an International Monetary Fund programme as recently as 1984. ( Spain 's modern history is much better, despite holding the record – more than 12 – for most independent sovereign default episodes.)

The eurozone experiment was, in effect, an attempt to speed up the graduation process through the carrot of the single currency and the stick of harsher bail-out rules. Instead of having to demonstrate fortitude and commitment through decades of surpluses and declining public debt levels (as for example, Chile has done), euro members were allowed to have their cake and eat it, too. Instead of starting to hit a ceiling at 90 per cent of gross domestic product as might a “normal” emerging market country, Greece could run up its public debt to more than 115 per cent of GDP. Even more stunning a figure is Greece's total external debt to GDP, which is more than 170 per cent, counting both public and private debt. Prof Reinhart and I find that most emerging markets run into trouble at external debt levels of merely 60 per cent of GDP. Indeed, the external debt levels of Spain, Portugal and Ireland are all sky high if one were to judge them by emerging-market standards.

Is it realistic for the IMF and Europe to hope that Greece (and other struggling euro members) will survive without an eventual default? It can happen but it is not easy.In recent years, South Korea, Turkey and Mexico have all skirted sovereign default thanks to massive external assistance, albeit with significant private sector external defaults. Unfortunately, “near misses” are the exception, not the rule.Indeed, there are many cases where even an IMF programme is not enough to solve the problem. Argentina, Indonesia, Uruguay and the Dominican Republic all provide very recent examples where a government adopted an IMF programme but defaulted eventually anyway.

Will Europe's crisis end only in “near misses” rather than outright defaults or reschedulings? The answer involves a range of political, social and economic questions that are not easily quantifiable. Economists have only a limited understanding of why sovereign nations ever repay their external debt, given the lack of any supranational legal authority that might force them to do so. It is very rare for a country to default because it literally cannot pay. In most cases, and certainly in southern Europe today, the issue is willingness to pay. Romanian dictator Nicolae Ceausescu famously forced his people to endure cold winters with minimal heat to help his country repay $9bn owed to foreign banks in the 1980s.Had he been able to wait a few years, Romania would probably have enjoyed the same kind of partial debt forgiveness extended to many others at the end of that decade. The fact that a country can repay its debt does not necessarily mean it should choose to do so.

In the case of Europe, the decision to repay involves not only the usual costs and benefits, but also the added question of how a nation's status in the European Union will be affected. Is Europe prepared to go to great pains to punish Greece if it defaults, imposing costs much higher than those a non-euro country would face?If not, how can it seriously expect Greece to pay down debt levels far in excess of those navigated by almost any other large emerging market?

In our book on financial history, Prof Reinhart and I find that international banking crises are almost invariably followed by sovereign debt crises. Will the euro prove to be a firewall against this process, or a debt machine that fuels it? It is going to be extremely difficult for some of the peripheral eurozone economies to escape without large-scale defaults on their massive private external debts, public external debts, or both.

A glimpse into financial hell

FT Alphaville:

Posted by Neil Hume on May 04 14:40.

Alan Ruskin has peered into the abyss of a US sovereign debt crisis to see what the world might look like. Unsurprisingly, it’s not a nice place.

Food commodities would be about the only thing left worth owning, according to the RBS strategist.

Now, Ruskin is not forecasting a 70’s style Treasuries sell-off, but he reckons this is a fat tail risk worthy of serious consideration given that politicians will need to have their feet raked over coals before behaving responsibly.

Welcome to financial hell:

The US Treasury market is large, but by the size of global financial assets it is still surprisingly small. If we use end 2008 IMF data (because this data is complete and the last year will not have changed the big picture) US treasuries make up 25% of global public sector debt securities; 9.5% of public plus private sector debt securities; 7.5% of bank assets; and a modest 3.5% of all private & public sector debt plus equity plus bank assets. In other words there are plenty of other assets to own in the world. However, that would not help much if there was a run on US treasuries.

The first problem is simply one of correlation. Almost all the above assets, private debt, bank assets and equities will be especially highly correlated with US Treasuries in a crisis. The second problem is that Treasuries, even if they stand at the epicenter of the crisis, are likely to be the low beta asset. The majority of the $220+ trillion in global bond, equity and bank assets would be leveraged off global growth and remain high beta relative to Treasuries, losing even more value were Treasuries to collapse. This probably also applies to many real assets in the short-term, especially those that are interest rate sensitive.

A Treasury collapse story presumably would very quickly evolve into too many risky assets chasing far too few ‘risk free’ assets. What are the risk free assets they would choose? Gold, the barbaric metal, would presumably feed handsomely off such sovereign risk savagery! But the total gold market is estimated to be only about $6.5trillion, or smaller than the Treasury bond market, of which only a little over $5 trillion is in private hands. Worse still, the daily gold turnover is only 2% of major currencies! Such a slow churn, coupled with fixed supply, would drive prices parabolic, and the choice of buying gold would quickly start to feel like it did to the average Dutchman in the 17th century, when a single tulip rose to an average of 10 times annual income.

Foreign bond markets could provide an alternative, if tax revenues could hold up somewhere in the world, but all debt markets outside the G3 are tiny relative to global assets. For example even the German Bund market makes up less than 2% of global debt securities, and this is roughly three times all of Asia NIC public debt if you were looking for an emerging market ’safe haven’. In a topsy-turvy world where the risk pyramid inverts, and the developing world risk converges further versus the developed world, emerging economy bonds, equities and bank assets still provided limited opportunities, making up a mere 14% of these same developed world assets.

And here is Ruskin’s conclusion:

The above clipped analysis tends to lead to an unlikely conclusion: One of the unique sources of Treasury value, is that as it goes down, it destroys more value in most substitutable assets than it loses itself, which perversely then provides some support! Put another way, one of the sources of Treasury ‘quality’ is precisely its ability to destroy value (quality) in competing assets! In the hierarchy of assets it makes a difference whether assets are dependent on other assets, or whether they lead other assets, as the Treasury market does. It is also doubtful whether another benchmark sits in the wings, for no other economy is big enough and has the global interconnectivity whereby changes in the long-term price of money reverberate around the world the way US treasuries do.

Now a US Treasury crisis should also never have to extend to default, as long as the Fed is willing to buy US Treasury debt, and deliver the haircuts to investors through inflation rather than direct restructuring – which may be preferable for reputational interests. Unfortunately the inflation route is still desperately painful, not least because it drives up nominal yields and delivers the pain incrementally through bond and currency losses, rather than all upfront as a restructuring. Such bond losses are indicative of how a fiscal funding crisis quickly ends up as a monetary policy crisis, and a collapse in central bank control across the curve.

Although this all feels like jumping deep into the land of the hypothetical, the above scenario is not too far removed from the late 1970s period of stagflation. I have gone back a good deal further, to the start of the 20th century to see how assets coped with stagflation (a relatively rare phenomenon) which would be the likely backdrop to (or outcrop of) a US sovereign crisis. The conclusions are not pretty.
As feared there have been very few places to hide outside commodities when US growth is very soft and inflation is above a 5% threshold. Sell, equities, be a big seller of BAA then AAA bonds and yes buy FOOD commodities. Food commodities have been up as much as 30% y/y in years since 1900 when US per capita income was negative and inflation is above 5%, perhaps because these conditions are also accompanied by energy shocks or war, that are among the other darkest channels to financial blight.

Europe's Web of Debt

Mish's Global Economic Trend Analysis:

In a move that is supposed to stop contagion and inspire confidence, the ECB Comes to Greece’s Aid by Waiving Collateral Rules

The European Central Bank joined the international rescue of Greece, saying it would indefinitely accept the country’s debt as collateral regardless of its country’s credit rating, underpinning gains in the bond market.

The decision came less than a day after Greece agreed to a 110 billion-euro ($145 billion) package of emergency loans from the International Monetary Fund and its euro-region allies. Under the plan backed by the ECB, Greece pledged 30 billion euros in budget cuts to bring a deficit of 13.6 percent of gross domestic product within the EU limit of 3 percent in 2014.

Further downgrades from credit-rating companies had threatened to render Greek bonds ineligible for collateral for ECB loans after Standard & Poor’s last week cut the nation to junk status. Had Moody’s Investors Service and Fitch Ratings followed suit, Greece’s debt would have no longer been accepted under the previous rules, threatening to inflict further pain on the economy and its banks.

Today’s decision was a reversal for ECB President Jean-Claude Trichet, who began the year saying the ECB would not change its “collateral policy for the sake of any particular country.”

ECB Plays With Fire

The ECB is foolish. Greece may default a couple years down the road. In the meantime, banks can swap Greek risk straight on to the ECB in exchange for Euros.

What the ECB does for Greece, it may now feel obliged to do for Portugal and Spain.

This is a dangerous precedent that challenges the credibility of both the ECB and Jean-Claude Trichet.

Intermediate-term, the ECB's actions add more tinder to the woodpile. Spain and Portugal are the matches.

Europe's Web of Debt

The New York times has a nice European Web of Debt graphic worth a good look.



click on graph for sharper image

For the related story please see In and Out of Each Other’s European Wallets

The chart and story show some interesting facts

• Italy owes France $511 Billion (20% of French GDP)
• Portugal owes Spain a net a net of $58 billion
• Spain holds nearly a third of Portugal's debt
• Spain owes France $220 Billion
• Spain owes Germany $238 billion
• Spain owes the UK $114 billion

Does anyone seriously think this debt can be paid back? If so, how? Instead, I suggest this is another clear sign of just how insolvent the global banking system is.

Misguided US-Centric hyperinflationists who tend to only see US problems clearly have something else to think about.

Mike 'Mish' Shedlock
http://globaleconomicanalysis.blogspot.com

The arithmetic of bank solvency

Bronte Capital:

This is a post driven by Krugman’s many debates on bank profitability. In particular, a post from Krugman – about why banks are suddenly profitable – and the debates it engendered amongst my friends is the origin of this post. Long-time readers of my blog will know I have explored these ideas before.

First observation: at zero interest rates almost any bank can recapitalize and become solvent if it has enough time.

Imagine a bank which has 100 in assets and 90 in liabilities. Shareholder equity is 10. The only problem with this bank is that 30 percent of its assets are actually worthless and will never yield a penny. [This is considerably worse than any major US bank got or for that matter any major Japanese bank in their crisis.]

Now what the bank really has is 70 in assets, 90 in liabilities and a shareholder deficit of 20. However that is not what is shown in their accounts – they are playing the game of “extend and pretend”.

Now suppose the cost of borrowing is 0 percent and the yield on the assets is 2 percent. [We will ignore operating costs here though we could reintroduce them and make the spread wider.]

This bank will earn 1.4 in interest (2 percent of 70) and pay 0 in funding cost (0 percent of 90). It will be cash-flow-positive to the tune of 1.4 per annum and in will slowly recapitalize. Moreover provided it can maintain even the existing level of funding it will be cash-flow-positive and will have no liquidity event. (It does however need to be protected from runs by a credible government guarantee.)

Now lets put the same bank in a high interest rate environment. Assume funding costs are 10 percent and loans yield 12 percent.

In this case the bank earns 8.4 per year in interest (12 percent of 70) and pays 9 per year in funding (10 percent of 90). The same bank with the same spread is cash flow negative.

This is an important observation – because – absent another wave of credit losses – a marginally insolvent bank with a government guarantee will certainly recapitalize over time provided its funding costs are pinned somewhere near zero. The pinning of the funding costs near zero is not a subsidy (except in-as-much-as the government guarantee is a subsidy). Both these banks have the same spread and have the same profitability. The answer depends criticially on whether you can pin the funding to a low interest rate.

Banks and sovereign solvency

All banks more or less anywhere get their finances entwined with the finances of the sovereign. No sovereign will (or in my opinion should) allow a mass run on banks but they can only stop such a run if their own credit is good. But this link between sovereign solvency and bank-system solvency means that bank funding costs at a minimum are bounded at the lower end by sovereign borrowing costs.

It was pretty clear in the crisis where the US Sovereign borrowing costs were pinned. I barely cared whether BofA was solvent when I purchased it (but I was pretty sure it was). I cared that the US government was going to pin its funding costs. Buying BofA at low single digits was – in the end – a bet on US Government solvency.

On the same token Spanish banks may go the way of Greek banks. They can’t control their funding costs because the Spanish sovereign cannot control their funding costs. The idea that European sovereigns can default is now front-and-center. And the Spanish banks can’t control that either.

Extend-and-pretend (what Felix Salmon crudely deigned to be the Hempton plan) worked well in America. It won’t work in Spain because you can’t pin rates at zero even with a government guarantee. The scale of financial restraint needed to solve this problem is enormous. But the alternatives are worse.

John

More posts to follow here

David Rosenberg: Get Over It, Greece Is Going To Default

Clusterstock:

We're guessing that a lot of folks share David Rosenberg's sentiment on this one, that it's time to ban the bailouts, and forget the idea that a Greece "default" would be tantamount to failure.

BAN THE BAILOUT
First we have governments bailing out banks (and auto companies and mortgage providers), homeowner debtors, and now we have governments bailing out governments. When does someone finally say — enough is enough! Oh no — bank ABC is too big to fail. Company XYZ is too complex to fail. And now country GRK is too interconnected to fail. Give me a giant break.

Look, Greece is not going to “fail”. They are going to default. There will be a debt restructuring. And there will be some recovery. Bondholders will take a haircut — why shouldn’t they? Why should Angela Merkel care if German banks own Greek bonds? Greece has been in default in its recent 200-year history almost half the time. So has most of Latin America come to think of it. What about Russia? So Greece defaults, bondholders who knowingly bought these instruments knowing the historical record went for the yield and simply do not deserve a taxpayer-supported bailout of any kind. To actually come to the aid of Greece (especially after all the accounting gimmickry) would send a signal to investors that the best way to make money is buy the debt of the most risky and highest yielding enterprise because there will always be a bailout. Rewarding bad investment decisions is a huge mistake, in my opinion.

Let Greece default, the world will not come to an end, and whether or not the country gets a “bailout”, the fiscal drain is going be a pervasive drag on economic activity for at least the next five years. While there may be contagion risks — same deal. Investors who bought Club Med bonds with their stretched government balance sheets in order to stretch for yield don't deserve to be bailed out either. Taxpayers unite, wherever you live (because you too support the IMF). These are solvency issues we are talking about, not liquidity issues. This is about bad decisions, not market failure.

The U.S.’s Least Capitalized Big Bank: The Fed

WSJ.com: Real Time Economics:

Last year the Federal Reserve pushed the nation’s biggest banks to beef up their capital levels to ensure that they could escape a worsening crisis with common equity of at least 4% of their total assets. Today, the Fed put out financial statements on itself and revealed that its own capital level is below that stress-test level.

At the end of 2009 the Fed had $51.3 billion in total capital on $2.3 trillion of assets, for a capital ratio of 2.3%. Is this something to be alarmed about? The answer is yes and no. It’s not, because the Fed makes plenty of profits on the loans it makes to banks and the securities it holds. (Its cost of funds is now close to zero.) In a normal year its profits are around $25 billion. Last year, its net income was a record $53.4 billion, enough to double its capital in a year.

Capital was up from $42.2 billion, or 1.9% of assets, in 2008. The Fed turned 89% of its 2009 profits over to the U.S. Treasury, a rather hefty dividend yield for U.S. taxpayers, thanks in part to the Fed’s controversial role in financial crisis rescues. One bright spot was the performance of its Maiden Lane portfolios which hold assets from the bailouts of American International Group Inc. and Bear Stearns; they recorded gains in 2009 instead of losses in 2008. Ironically, much of the income turned over to the Treasury was generated from Treasury bonds owned by the Fed and government sponsored enterprises controlled by Treasury.

Still there are reasons to be concerned about the Fed’s paper-thin capital position. It has a more risky portfolio than it’s ever had before, including $1.25 trillion in mortgage securities that could lose market value if interest rates rise or if it has to sell them quickly. A 4% loss on that portfolio would equal almost all of its capital.

Of course the Fed can print money itself. (As opposed to a bank, which depends on the backing of depositors and other creditors to fund its operations.) Thus, as a Fed official notes, on condition of anonymity, it would be able to continue operating even if its capital becomes depleted. The official adds that the Fed is in fact expecting to continue its run of big profits. Moreover, the Treasury would stand behind it in a crisis. Still, if its fortunes take a turn for the worse and its capital disappears, it would be a mighty embarrassing turn for the world’s most powerful central bank.

Cognitive Biases - A Visual Study Guide

If you have read paper about Cognitive biases I posted recently, then you will like also this presentation.
Cognitive Biases - A Visual Study Guide by the Royal Society of Account Planning