The Insightful Trader

Archive for October, 2011

Sovereign CDS: Goodbye to All That

by on Oct.31, 2011, under Editorials

by Jonathan Bernstein


In my view, it’s a good thing that the recent Eurozone deal has basically ended the issuance of CDS on sovereign credits. Why shouldn’t big banks and insurers bring back the forgotten art of credit analysis, and look carefully at what they buy?

I know, there is an argument that CDS allow some borrowers who might not otherwise be able to obtain funds, to issue bonds. But in the end, lending money to debtors who can’t repay ends badly for all concerned.

Sovereign CDS Exist to Make Possible Loans that Really Shouldn’t Be Made

If the Eurozone wants to help its poorer members, it should do so with outright grants or other funding that is workable longterm, rather than go through a lending charade. If it doesn’t, tell the truth and move on.

As many readers know, the Eurozone structured Greece’s 50% haircut as “voluntary” so that banks writing CDS on Greek bonds would not have to pay off. Having seen that, investors won’t bother buying worthless CDS “protection” for sovereign bonds going forward. Therefore sovereign issuers who can’t sell bonds on the strength of their own creditworthiness, won’t be able to scrape through by having underwriters issue CDS to cover the risk.

 A centralized CDS Exchange Would Be More Transparent But Market Size Would Have to Be Limited

Writers such as John Mauldin and Barry Ritholtz, to name two, say that we could reform the CDS market by requiring that all CDS be traded on a centralized exchange. They make a good point – an exchange traded market would be safer than the current system — but I have difficulty envisioning a deep and liquid market for exchange traded CDS. I’d rather explore ways to wind down existing CDS and ultimately ban them, but if you are going to keep them, I think the exchange traded model is the best choice.

Of course if all CDS traded on one centralized exchange, risk would be decidedly lower than in the current model. CDS writers would have only one counter party, the new CDS exchange, whereas banks now hedge by making canceling trades with other banks. This exchange traded model would also increase transparency, since the exchange and financial regulators could monitor CDS writers’ exposure in real time. The trouble is, that such an exchange could not easily protect itself from default risk in size. Let’s see how this would have to work.

Suppose you are chief risk management officer of this exchange, call it the CDSE. You’ve lived through the AIG fiasco and the Greek restructuring, so you know this much: if a large asset class gets unglued (MBS in the case of AIG, or PIIGS sovereign debt) many of the banks exposed will all experience liquidity issues, simultaneously. Lending would slow down and a systemic crisis would result.

Therefore, as the CDSE’s CRO, what would you do? You would make sure that the exchange traded CDS contract allows for very strict position limits, not only by each credit, but by asset class being protected. In this example, you would probably limit CDS writing on, let’s say, all sovereign credits that are not backed by a printing press, rather than just Greece, or even just the PIIGS countries.  And these limits would stand in addition to the more traditional position limits for each contract that each CDS writer would have to abide by. The maximum hedgeable size of the sovereign CDS market might well be smaller than the current outstandings.

Without strict position limits, the CDSE couldn’t count on the ability of the CDS writer to buy back the CDS he wrote, or to post adequate collateral, during a systemic crisis; unlimited position sizes could get unmanageable. In crisis mode the cost of the protection would skyrocket to some amount commensurate with the expected bondholder haircut. Buybacks would be prohibitive if they could be accomplished at all.

Furthermore, in a banking crisis, you might have to jostle with bank regulators (like the FDIC and its foreign equivalents) to get your mitts on the amount of cash collateral you would need to feel comfortable. Therefore you’d have your own, independent credit analysts monitoring the exchange traded credits, and you would be raising margin requirements rapidly at the first hint of trouble. You can’t afford to be unprepared when real trouble hits, and your margin policy would have to be aggressively pro-active in order to protect the market before a crisis broke.

In this your model would be the way Goldman Sachs (GS) demanded collateral from AIG before the 2008 crisis was obvious to everyone. And like GS, you wouldn’t wait for S&P or Moody’s to downgrade anyone you are exposed to.

I don’t want to overdo the dark side, but I’m harping on crisis conditions for a reason. That’s when sovereign credits often go bad, and in the last 30 years, we have had three such instances: Latin America in the early 80s, Asia in 1998, and now Europe. If you are planning a CDS product to insure against sovereign risk you have to think about crisis conditions before product launch, not after.

Banks Like CDS Writing When they Can Shift the Risk

Banks don’t like the idea of exchange traded product, because it is commoditized and commands lower profit margins than the current model of over the counter, custom product. Nor would banks like the idea of tying up large amounts of cash collateral when writing the CDS under a risk regime that would work for any rational exchange.

In other words, the obvious way to make CDS profitable for the bank – or at least as profitable as banks would prefer — is to shift much of the risk onto someone outside the banking system. In the cases of AIG (and probably the PIIGS), that “someone else” turned out to be the nearest taxpayer.

Which brings me back to my opening statement. If you are going to buy bonds, know what you are buying, because in the event of systemic trouble, credit enhancement may itself become as worthless as the bonds being insured. GS and its ilk were lucky and got bailed out in 2008 when AIG failed. On the face of it the European sovereign bondholders were less lucky, and while they might get bailed out too if the coming European bank recapitalization turns out to be favorable, we don’t know yet how that will turn out.




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China Trade Bill: We’ve Met the Enemy and He is Us

by on Oct.20, 2011, under Editorials

by Jonathan Bernstein

China Trade Bill

 The China Trade Bill would impose a tariff on Chinese imports to the US in an effort to get China to revalue the yuan. The purpose of the bill is to reduce the US bilateral trade deficit with China. Its boosters, including Senate Majority Leader Harry Reid, say the bill could create 2 million American jobs it if it becomes law.

The China Trade Bill sailed through the Senate but its prospects in the House are doubtful. Speaker Boehner has said he won’t allow it to come to the floor for a vote – because he knows it would pass easily if it did. (Ironically the House passed the bill in 2010 but the Senate did not.)

While I think it’s a poor solution, the China Trade Bill addresses a real issue. The Sino-American trade imbalance can’t go on forever. At some point – when China is less dependent on the US market – China will be less willing to accept US paper in exchange for Chinese goods. If we let the situation go, eventually China will “fix” it, and do so on China’s terms.

Having said that, the bill highlights a major fallacy in how America approaches the rest of the world. The China Trade Bill would in effect tell China to revalue its currency at America’s pleasure. Not a great idea, because the Chinese can peg their currency wherever they want to, and they don’t care to be pushed around by other countries. The bill represents a swell idea for Chinese politicians to stoke nationalistic fervor at America’s expense. China has also threatened a “trade war” if the bill passes.

On the one hand, China’s threat of a trade war is less fearsome than it may sound. If trade between the US and China fell to zero, China, which runs a big trade surplus with the US, would lose far more in exports to the US than America would lose in sales to China. America might lose access to some goods it no longer produces, but eventually America could rebuild the manufacturing infrastructure it has lost and would come out stronger after doing that. China might buy less US treasury bonds but then again – there would be no bilateral trade deficit to finance, and the dollar would be the stronger for that as well.

What We Can Do:

On the other hand, America could — theoretically at least  —  do much more for our trade balance, and our economy, without provoking a high profile confrontation with China. In my view, the problem is twofold.

First, we must support the industries that are important to our future, rather than let China pick off its American competitors. We have to care about what industries America will be in, or we won’t be in them anymore. For example, Evergreen Solar set up its manufacturing facility in Devens, MA, aided by a $43 million incentive package it received from Massachusetts in 2008. In 2009 the company started shifting production to China, and shuttered the plant earlier this year. Evergreen CEO Michael El-Hillow stated that Chinese state-owned banks and municipalities had offered unbeatable assistance. Even though labor is far cheaper in China, labor accounts for only a small percentage of total cost, El-Hillow said. The partnerships with banks and municipalities actually outweighed the labor cost differential.

In addition, Evergreen said that while it cut its cost per watt of solar capacity from $3.39/watt in 2009 to $1.90 in the fourth quarter of 2010. Yet the Chinese undercut Evergreen further and were selling panels at $1.60 by then, and could produce them for a cost of $1.35.

Now, some  companies – think SolarWorld, which filed antidumping complaints yesterday, October 19, against China – believe that China gives its solar firms incentives that violate WTO rules. In their view, illegal Chinese subsidies are decisive in helping the Chinese companies cut their cost so much. Maybe they are right, and sometime within the next year US agencies will decide whether countervailing import duties are in order.

My feeling is, who cares? A year is an eon in internet time, and by then the Chinese will have solidified their advantages even more. In any event, Massachusetts could only do so much to hold onto Evergreen, and without Federal help, efforts at the state level were doomed to failure. With the concomitant departure of First Solar (FSLR) to China, anything the US eventually elects to do will be in the realm of playing catch-up.

I could give lots more examples, but perhaps one of the most egregious is that Pfizer shut its famed R&D laboratory in Groton, Connecticut this year, along with its equally distinguished British lab, and will shift much of its R&D to Shanghai. For many years, outsourcing advocates have maintained that America will not suffer much if “low level” assembly and manufacturing work shift abroad, as long as the “knowledge work” stays here. Well, now the knowledge work is leaving too.  What has the Obama Administration done about this? Well, not a whole lot.

Closing the Groton lab will do more than harm American competitiveness. According to Medpage, Today, the abrupt lab closure will in effect throw away irreplaceable knowledge and expertise in the area of antibiotics and other treatments to fight infectious disease. While this move might improve Pfizer’s short term profits, just how wise is it, given the increasingly serious problem posed by drug resistant “superbugs?”

My point is, tariffs can only do so much, if we have not identified and nurtured our key national assets before the fact.  Yes, that is protectionism, but then again, protectionism is what nearly all governments do these days. Leaving US firms to compete individually against China in an industry that China wants to dominate, is tantamount to kissing the US firms goodbye.

I don’t know what the solution is to what I see as the second part of our difficulty: US managements, in many instances, simply favor outsourcing rather than producing in the US, even when US production costs are comparable to costs to produce elsewhere.  For example in mid-2009, when GE needed wind turbine parts, a company named ATI arranged a deal to set up a plant in Michigan to make them. When Chinese companies made a counteroffer to GE, ATI was able to match the China price. Yet GE decided to source the parts in China despite this. Similarly, a quick search online will yield plenty of results where consulting firms will tell companies how to get their “globalization policy” up to snuff and where the opportunities are to outsource various corporate functions. As anyone who has spent any time in the corporate world can tell you, consultants dream up solutions that “confirm” the existing biases of their clientele.

Even more importantly, in the early 1980s, key business lobbies such as the Business Roundtable and the US Chamber of Commerce, shifted their opinions from favoring US operations to favoring outsourcing. And after they did so, US policy shifted that way too, resulting in such agreements as NAFTA and the WTO. It was this rewriting of trade rules that made outsourcing workable. If Corporate America hadn’t wanted outsourcing, it simply wouldn’t have happened.

The contrast with Germany and Japan is striking. Both countries remain export powers even though their labor is far more expensive than is labor in China. The difference? Again, I would submit, is that Corporate Germany and Japan, Inc. care about maintaining employment in their home countries, while Corporate America does not.

In other words, if Corporate America wanted to produce here, we still would be, and we wouldn’t need a China Trade Bill.  And because Corporate America does not want it, the bill will almost  certainly not become law — neither the Republican leadership in the House nor President Obama would dare offend campaign contributors that way. The bill simply gave Reid a chance to grandstand, before going about the business of enacting more job export measures such as the “free trade agreements” with Colombia and South Korea.

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