"Hope, the best comfort of our imperfect condition." - Edward Gibbon, English historian
"We already touched on the subject of "Rogue Waves" in our conversation "the Italian Peregrine soliton", being an analytical solution to the nonlinear Schrödinger equation (which was proposed by Howell Peregrine in 1983), and being as well "an attractive hypothesis" to explain the formation of those waves which have a high amplitude and may appear from nowhere and disappear without a trace, the latest surge in Spanish Nonperforming loans to a record 10.51% and the unfortunate Sandy Hurricane have drawn us towards the analogy of the 1991 "Perfect Storm".
Generally rogues waves require longer time to form, as their growth rate has a power law rather than an exponential one. They also need special conditions to be created such as powerful hurricanes or in the case of Spain, tremendous deflationary forces at play when it comes to the very significant surge in nonperforming loans.", source Macronomics, October 2012
"LTCM's trading strategies generally showed no or almost very little correlation. In normal times or even in crises that are limited to a specific segment, LTCM benefited from this high degree of diversification. Nevertheless, the general flight to liquidity in 1998 caused a jump in global risk premiums, hitting the same direction. All (in normal times less-correlated) positions moved in the same direction. Finally, it is all about correlation! Rising correlations reduces the benefit from diversification, in the end hitting the fund's equity directly. This is similar with CDO investments (ie, mezzanine pieces in CDOs), which also suffer from a high (default) correlation between the underlying assets. Consequently, a major lesson of the LTCM crisis was that the underlying Covariance matrix used in Value-at-Risk (VaR) analysis is not static but changes over time." - source Credit Crises, published in 2008, authored by Dr Jochen Felsenheimer and Philip Gisdakis
"The issue with so many pundits following "similar strategies" and chasing the "same assets" in a growing "illiquid" fixed income world is a Cushing's syndrome impact. Excess stimulants have compressed yield spreads too fast leading to "unhealthy" rapid bond prices gain.
The growing issue with VaR (Value at risk) and bond volatility is that it has risen sharply from a risk management perspective. This could lead to a sell-fulfilling "sell-off" prophecy of having too many pundits looking for the exit as the same time, namely "de-risking".
To that effect and in continuation to Martin Hutchinson's LTCM reference, we would like to repeat the quote used in the conversation "The Unbearable Lightness of Credit":
Today investors face the same "optimism bias" namely that they overstate their ability to exit.
“Liquidity is a backward-looking yardstick. If anything, it’s an indicator of potential risk, because in “liquid” markets traders forego trying to determine an asset’s underlying worth – - they trust, instead, on their supposed ability to exit.” - Roger Lowenstein, author of “When Genius Failed: The Rise and Fall of Long-Term Capital Management.” – “Corzine Forgot Lessons of Long-Term Capital“
"On a side note while enjoying a lunch with a quant fund manager friend of ours, we mused around the ineptness of VaR as a risk model. When interviewing fellow quants for a position within his fund, he has always asked the same question: What does VaR measures? He always get the same answer, namely that VaR measures the maximum loss at any point during the period. VaR is like liquidity, it is a backward-looking yardstick. It does not measure your maximum loss at any point during the period but, in today "positively correlated markets" we think it measures your "minimum loss" at any point during the period as it assumes "normal" markets. We are not in "normal" markets anymore rest assured." - source Macronomics, May 2015
- Credit - The different types of credit crises and where do we stand
- A couple of illustrations of on-going nonlinear "Rogue Waves" in the financial world of today
- The overshooting phenomenon
- The Yuan Hedge Fund attack through the lense of the Nash Equilibrium Concept
- Credit - The different types of credit crises and where do we stand
"When it comes to a macro-driven market as "central banks' put" are losing their "magic", correlations unfortunately are still moving higher, which, we think is a sign of great instability brewing.The correlation between macro variables such as bund yields, FX and oil and equity market factors (Momentum, Value, Growth, Risk) is now higher than the correlation between macro variables and the market. There lies the crux of central banks interventions. There is now deeper inter-linkages in the macro economy as well as financial markets globally post crisis." - source Macronomics, January 2016
- "Currency crisis: A speculative attack on the exchange rate of a currency which results in a sharp devaluation of the currency; or it forces monetary authorities to intervene in currency markets to defend the currency (eg. by sharply hiking interest rates).
- Foreign Debt Crisis: a situation where a country is not able to service its foreign debt.
- Banking crisis: Actual or potential bank runs. Banks start to suspend the internal convertibility of their liabilities or the government has to bail out the banks.
- Systemic Financial crisis: Severe disruptions of the financial system, including a malfunctioning of financial markets, with large adverse effect on the real economy. It may involves a currency crisis and also a banking crisis, although this is not necessarily true the other way around.
In many cases, a crisis is characterized by more than one type, meaning we often see a combination of at least two crises. These involve strong declines in asset values, accompanied by defaults, in the non-financials but also in the financials universe. The effectiveness of government support or even bailout measures combined with the robustness of the economy are the most important determinants of the economy's vulneability, and they therefore have a significant impact on the severity of the crisis. In addition, a crucial factor is obviously the amplitude of asset price inflation that preceded the crisis.Depending on the type of crisis, there are different warning signals, such as significant current account imbalances (foreign debt crisis), inefficient currency pegs (currency crisis), excessive lending behavior (banking crisis), and a combination of excessive risk taking and asset price inflation (systemic financial crisis). A financial crisis is costly, as they are fiscal costs to restructure the financial system. There is also a tremendous loss from asset devaluation, and there can be a misallocation of resources, which in the end, depresses growth. A banking crisis is considered to be very costly compared with, for example, a currency crisis.We classify a credit crisis as something between a banking crisis and a systematic financial crisis. A credit crisis affects the banking system or arises in the financial system; the huge importance of credit risk for the functioning of the financial system as a whole bears also a systematic component. The trigger event is often an exogenous shock, while the pre-credit crisis situation is characterized by excessive lending, excessive leverage, excessive risk taking, and lax lending standards. Such crises emerge in periods of very high expectations on economic development, which in turns boosts loan demand and leverage in the system. When an exogenous shock hits the market, it triggers an immediate repricing of the whole spectrum of credit-risky assets, increasing the funding costs of borrowers while causing an immense drop in the asset value of credit portfolios.
A so-called credit crunch scenario is the ugliest outcome of a credit crisis. It is characterized by a sharp reduction of lending activities by the banking sector. A credit crunch has a severe impact on the real economy, as the basic transmission mechanism of liquidity (from central banks over the banking sector to non-financial corporations) is distorted by the fact that banks do a liquidity squeeze, finally resulting in rising default rates. A credit crunch is a full-fledged credit crisis, which includes all major ingredients for a banking and a systemic crisis spilling over onto several parts of the financial market and onto the real economy. A credit crunch is probably the most costly type of financial crisis, also depending on the efficiency of regulatory bodies, the shape of the economy as a whole, and the health of the banking sector itself." - source Credit Crises, published in 2008, authored by Dr Jochen Felsenheimer and Philip GisdakisThe exogenous shock started in earnest in mid-2014 which saw a conjunction of factors, a significant rise in the US dollar that triggered the fall in oil prices, the unabated rise in the cost of capital.
If we were to build another schematic of the current market environment, here what we think it should look like to name a few of the issues worth looking at:
"Even if there are arbitrage opportunities in the sense that two positions that trade at different prices right now will definitely converge at a point in the future, there is a risk that the anomaly will become even bigger. However typically a high leverage is used for positions that have a skewed risk-return profile, or a high likelihood of a small profit but a very low risk of a large loss. This equals the risk-and-return profile of credit investments but also the risk that selling far-out-of-the-money puts on equities. In case of a tail event occurs, all risk parameters to manage the overall portfolio are probably worthless, as correlation patterns change dramatically during a crisis. That said, arbitrage trades are not under fire because the crisis has an impact on the long-term-risk-and-return profile of the position. However, a crisis might cause a short-term distortion of capital market leading to immense mark-to-market losses. If the capital adequacy is not strong enough to offset the mark-to-market losses, forced unwinding triggers significant losses in arbitrage portfolios. The same was true for many asset classes during the summer of 2007, when high-quality structures came under pressure, causing significant mark-to-market losses. Many of these structures did not bear default risk but a huge liquidity risk, and therefore many investors were forced to sell." - source Credit Crises, published in 2008, authored by Dr Jochen Felsenheimer and Philip Gisdakis
The big question is not if we are in a bubble again but if this "time it's different". It is not. It's worse, because you have all the four types of crisis evolving at the same time.
Here is what Chapter 5 of "Credit Crisis" is telling us about the causes of the bubble:
"A mainstream argument is that the cause of the bubbles is excessive monetary liquidity in the financial system. Central banks flood the market with liquidity to support economic growth, also triggering rising demand for risky assets, causing both good assets and bad assets to appreciate excessively beyond their fundamentally fair valuation. In the long run, this level is not sustainable, while the trigger of the burst of the bubble is again policy shifts of central banks. The bubble will burst when central banks enter a more restrictive monetary policy, removing excess liquidity and consequently causing investors to get rid of risky assets given the rise in borrowing costs on the back of higher interest rates.
This is the theory, but what about the practice? The resurfacing discussion about rate cuts in the United States and in the Euroland in mid-2005 was accompanied by expectations that inflation will remain subdued. Following this discussion, the impact of inflation on credit spreads returned to the spotlight. An additional topic regarding inflation worth mentioning is that if excess liquidity flows into assets rather than into consumer goods, this argues for low consumer price inflation but rising asset price inflation. In late 2000, the Fed and the European Central Banks (ECB) started down a monetary easing path, which was boosted by external shocks (9/11 and the Enron scandal), when central banks flooded the market with additional liquidity to avoid a credit crunch. Financial markets benefited in general from this excess liquidity, as reflected in the positive performance of almost all asset classes in 2004, 2005, and 2006, which argued for overall liquidity inflows but not for allocation shifts. It is not only excess liquidity held by investors and companies that underpins strong performing assets in general, but also the pro-cyclical nature of banking. In a low default rate environment, lending activities accelerate, which might contribute to an overheating of the economy accompanied by rising inflation. From a purely macroeconomic viewpoint, private households have two alternatives to allocate liquidity: consuming or saving. The former leads to rising price inflation, whereas the latter leads to asset price inflation." - source Credit Crises, published in 2008, authored by Dr Jochen Felsenheimer and Philip Gisdakis
"The core objection to this view is that it arguably conflates “financing” with “saving” –two notions that coincide only in non-monetary economies. Financing is a gross cash-flow concept, and denotes access to purchasing power in the form of an accepted settlement medium (money), including through borrowing. Saving, as defined in the national accounts, is simply income (output) not consumed. Expenditures require financing, not saving. The expression “wall of saving” is, in fact, misleading: saving is more like a “hole” in aggregate expenditures – the hole that makes room for investment to take place. … In fact, the link between saving and credit is very loose. For instance, we saw earlier that during financial booms the credit-to-GDP gap tends to rise substantially. This means that the net change in the credit stock exceeds income by a considerable margin, and hence saving by an even larger one, as saving is only a small portion of that income." - source BIS paper, December 2012
"Asset price inflation in general, is not a phenomenon which is limited to one specific market but rather has a global impact. However, there are some specific developments in certain segments of the market, as specific segments are more vulnerable against overshooting than others. Therefore, a strong decline in asset prices effects on all risky asset classes due to the reduction of liquidity.
This is a very important finding, as it explains the mechanism behind a global crisis. Spillover effects are liquidity-driven and liquidity is a global phenomenon. Against the background of the ongoing integration of the financial markets, spillover effects are inescapable, even in the case there is no fundamental link between specific market segments. How can we explain decoupling between asset classes during financial crises? During the subprime turmoil in 2007, equity markets held up pretty well, although credit markets go hit hard." - source Credit Crises, published in 2008, authored by Dr Jochen Felsenheimer and Philip Gisdakis
- A couple of illustrations of on-going nonlinear "Rogue Waves" in the financial world of today
- graph source Barclays (H/T TraderStef on Twitter)When it comes to the unfortunate truth about wider spreads, what the flattening of German banking giant Deutsche bank is telling you is that it's cost of capital is going up, this is what a flattening of credit curve is telling you:
- source Thomson Reuters Datastream (H/T Eric Burroughs on Twitter)Also the percentage of High Yield bonds trading at Distressed levels is at the highest level since 2009 according to S&P data:
- 2015: 20.1%*
- source H/T - Lawrence McDonald - Twitter feed
• We anticipate that spread volatility, liquidity stress and credit tightening will persist. Look for wider conduit spreads.
• While CMBX.BBB- tranche prices fell sharply this week we think further downside exists, particularly in series 6&7.
As investors ponder the likelihood that economic growth may slow and that CRE prices may have risen too quickly (Chart 3), recent CMBX price action indicates that a growing number of investors may have begun to short it since it is a liquid, levered way to voice the opinion that CRE is considered to be a good proxy for the state of the economy.
In the past, this type of activity began by investors shorting tranches that were most highly levered to a deteriorating economy and could fall the most if fundamentals eroded. This includes the lower rated tranches of CMBX.6-8, which, as of last night’s close, have seen the prices for their respective BBB-minus and BB tranches fall by 13-17 points for CMBX.6 (Chart 4), 14-20 points for CMBX.7 (Chart 5) and 17-19 points for CMBX.8 (Chart 6) since the beginning of the year.
We agree that underwriting standards loosened over the past few years, which, all else equal, could imply loans in CMBX.8 have worse credit metrics compared to either the CMBX.6 or CMBX.7 series. Despite this, and although prices have already fallen considerably, for several reasons we think it makes sense to short the BBBminus tranche from either CMBX.6 or CMBX.7 instead of the CMBX.8. First, the dollar price of the BBB-minus tranche from CMBX.6 and CMBX.7 is materially higher that of CMBX.8 (Chart 7).
Additionally, although the CMBX.8 does have more loans with IO exposure than series 6 or 7 do, we think this becomes more meaningful when considering maturity defaults. By contrast, the earlier series not only have lower subordination attachment points at the BBB-minus tranche, but they also have more exposure to the retail sector, which could realize faster fundamental deterioration if the economy does contract." - source Bank of America Merrill Lynch
"To this point, Sears’s management announced this week that revenues for the year ending January 31, 2016, decreased to about $25.1 billion (Chart 8) and that the company would accelerate the pace of store closings, sell assets and cut costs.
Why could CMBX.6 be more negatively impacted by the negative Sears news than some of the other CMBX series? Among the more recently issued CMBX series (6-9), CMBX.6 has the highest percentage of retail exposure. When we focus solely on CMBX.6 and CMBX.7, which have the highest percentage exposure to retail among the postcrisis series, we see that although the headline exposure to retail properties is similar, CMBX.6 has considerably more exposure to B/C quality malls than CMBX.7 does" - source Bank of America Merrill Lynch
- The overshooting phenomenon
"Closely linked to the bubble theory, Rudiger Dornbusch's famous overshooting paper set a milestone for explaining "irrational" exchange rate swings and shed some light on the mechanism behind currency crises. This paper is one of the most influential papers writtten in the field of international economics, while it marks the birth of modern international macroeconomics. Can we apply some of the ideas to credit markets? The major input from the Dornbusch model is not only to better understand exchange rate moves; it also provides a framework for policymakers. This allow us to review the policy actions we have seen during the subprime turmoil of 2007.
The background of the model is the transition from fix to flexible exchange rates, while changes in exchange rates did not simply follow the inflation differentials as previous theories suggest. On the contrary, they proved more volatile than most experts expected they would be. Dornsbusch explained this behavior of exchange rates with sticky prices and an instable monetary policy, showing that overshooting of exchange rates is not necessarily linked to irrational behavior of investors ("herding"). Volatility in FX markets is a necessary adjustment path towards a new equilibrium in the market as a response to exogenous shocks, as the price of adjustment in the domestic markets is too slow.
The basic idea behind the overshooting model is based on two major assumptions. First, the "uncovered interest parity" holds. Assuming that domestic and foreign bonds are perfect substitutes, while international capital is fully mobile (and capital markets are fully integrated), two bonds (a domestic and a foreign one) can only pay different interest rates if investors expect compensating movement in exchange rates. Moreover, the home country is small in world capital markets, which means that the foreign interest rate can be taken as exogenous. The model assumes "perfect foresight", which argues against traditional bubble theory. The second major equation in the model is the domestic demand for money. Higher interest rates trigger rising opportunity costs of holding money, and hence lower demand for money. In the contrary, an increase in output raises demand for money while demand for money is proportional to the price level.
In order to explain what overshooting means in this context, we have to introduce additional assumptions. First of all, domestic prices do not immediately follow any impulses from the monetary side, while they adjust only slower over time, which is a very realistic assumption. Moreover, output is assumed to be exogenous, while in the long run, a permanent rise in money supply causes a proportional rise in prices and in exchange rates. The exogenous shock to the system is now defined as unexpected permanent increase in money supply, while prices are sticky in the short term. And as also output is fixed, interest rates (on domestic bonds) have to fall to equilibrate the system. As interest-rate parity holds, interest rates can only fall if the domestic currency is expected to appreciate. As the assumption of the model is that in the long run rising money supply must be accompanied by a proportional depreciation in the exchange rate must be larger than the long term depreciation! That said the exchange rate must overshoot the long-term equilibrium level. The idea of sticky prices is in the current macroeconomic discussion fully accepted, as it is a necessary assumption to explain many real-world data.
This is exactly what we need to explain the link to the credit market. The basic assumption of the majority of buy-and-hold investors is that credit spreads are mean reverting. Ignoring default risk, spreads are moving around their fair value through the cycle. Overshooting is only a short-term phenomenon and it can be seen as a buying opportunity rather than the establishment of a lasting trend. This is true, but one should not forget that this is only true if we ignore default risk. This might be a calamitous assumption. Transferring this logic to the first subprime shock in 2007, it is exactly what happened as an initial reaction regarding structured credit investments. For example, investment banks booked structured credit investments in marked-to-model buckets (Level 3 accounting) to avoid mark-to-market losses.
A credit crisis can be the trigger point of overshooting in other markets. This is exactly what we have observed during the subprime turmoil of 2007.
This is a crucial point, especially from the perspective of monetary policy makers. Providing additional liquidity would mean that there will be further distortions. Healing a credit crunch at the cost of overshooting in other markets. Consequently liquidity injections can be understood as a final hope rather than the "silver bullet" in combating crises. In the context of the overshooting approach, liquidity injections could help to limit some direct effects from credit crises, but they will definitely trigger spillover effects onto other markets. In the end, the efficiency of liquidity injections by central banks depends on the benefit on the credit side compared to the cost in other markets. In any case, it proved not to be the appropriate instrument as a reaction to the subprime crisis in 2007" - source Credit Crises, published in 2008, authored by Dr Jochen Felsenheimer and Philip Gisdakis
"As spreads widened over the past few weeks, a significant number of conversations we’ve had with investors have revolved around the concern that the recent spread widening may not represent a transient opportunity to add risk at wider levels, but instead could represent a new reality earmarked by tighter credit standards, lower liquidity and higher required returns for a given level of risk. While it may be easy to look at CRE fundamentals and dismiss the recent spread widening as being due to market technicals, it is important to realize that while that may be true today, if investors are pricing in what they expect could occur in the future, there may be some validity to the recent spread moves. As a case in point, given the recent new issue CMBS spread widening, breakeven whole loan spreads have widened substantially over the past two months (Chart 16).
Not only do wider whole loan breakeven spreads result in higher coupons to CMBS borrowers, which, effectively tightens credit standards, but it also can reduce the profitability of CMBS originators, which may cause some of them to exit the business. As a case in point, this week Redwood Trust, Inc. announced it is repositioning its commercial business to focus solely on investing activities and will discontinue commercial loan originations for CMBS distribution. Marty Hughes, the CEO of Redwood said:
"We have concluded that the challenging market conditions our CMBS conduit has faced over the past few quarters are worsening and are not likely to improve for the foreseeable future. The escalation in the risks to both source and distribute loans through CMBS, as well as the diminished economic opportunity for this activity, no longer make our commercial conduit activities an accretive use of capital."
If, as we wrote last week, CRE portfolio lenders also tighten credit standards, it stands to reason that some proportion of borrowers that would have previously been able to successfully refinance may no longer be able to do so. The upshot is that it appears that we have entered into a phase where it becomes increasingly possible that negative market technicals and less credit availability form a feedback loop that negatively affects CRE fundamentals.This is another sign that credit will no doubt overshoot to the wide side and that you will, rest assured see more spillover in other asset classes. Given credit leads equities, you can expect equities to trade "lower" for "longer" we think.
To this point, although a continued influx of foreign capital into trophy assets in gateway markets can support CRE prices in certain locations, it won’t help CRE prices for properties located in many secondary or tertiary markets. If borrowers with “average” quality properties located away from gateway markets are faced with higher borrowing costs and more stringent underwriting standards, the result may be fewer available proceeds and wider cap rates." - source Bank of America Merrill Lynch
Furthermore, Janet Yellen's recent performance is confirming indeed the significant weakening of the Fed "put" as described in Bank of America Merrill Lynch's note:
"With Fed Chair Yellen’s Humphry Hawkins testimony, in which she stressed the notion that the Fed’s decision to raise rates is not on a predetermined course, the probability that the Fed would raise interest rates at its March 2016 plummeted as did the probability of rate hikes over the next year. During her testimony, however, the Fed Chair mentioned that the current global turmoil could cause the Fed to alter the timing of upcoming rate hikes, not abandon them.
As a result, risky asset prices broadly fell and a flight to quality ensued due to the uncertainty of the timing of future rate hikes, the notion that the Fed put may be further out of the money than was previously anticipated and the prospect that a growing policy divergence among global central banks could contribute to a U.S. recession. While delaying the next rate hike may be viewed positively in the sense that it could help keep risk free rates low, which would allow a greater number of borrowers to either refinance or acquire new properties, we think it is likely that many investors will view it as a canary in the coalmine that presages slower economic growth, more capital market volatility, wider credit spreads and lower asset prices.
Ultimately, the framework that has been put in place by regulators over the past few years effectively severely limits banks’ collective abilities to provide liquidity during periods of stress. As global economic concerns have increased, investors and dealers alike have become increasingly aware of the extremely limited amount of liquidityavailable, which has manifested through a surge in liquidity stress measures (Chart 21) and wider spreads across risky asset classes.
- source Bank of America Merrill LynchWhen it comes to rising risk, it certainly looks to us through the "credit lense" that indeed it certainly feels like 2007 and that once again we are heading towards a Great Financial Crisis version 2.0. For us, it's a given.
When it comes to the much talked about Kyle Bass significant "short yuan" case, we would like to offer our views through the lens of the Nash Equilibrium Concept in our next point.
- The Yuan Hedge Fund attack through the lense of the Nash Equilibrium Concept
"Financial panic models are based on the idea of a principle-agent: There is a government which is willing to maintain the current exchange rate using its currency reserves. Investors or speculators are building expectations regarding the ability of the government to maintain the current exchange-rate level. An as answer to a speculative attack on the currency, the government will buy its own currency using its currency reserves. There are three possible outcomes in this situation. First, currency reserves are big enough to combat the speculative attack successfully, and the government is able to keep the current exchange rate. In this case there will be no attack as speculators are rational and able to anticipate the outcome. Second, the reserves of central banks are not large enough to successfully avert the speculative attack, even if only one speculator is starting the attack. Thus, the attack will occur and will be successful. The government has to adjust the exchange rate. Third, the attack will only be successful if speculators join forces and start to attack the currency simultaneously. In this case, there are two possible equilibriums, a "good one" and a "bad one". The good one means the government is able to defend the currency peg, while the bad one means that the speculators are able to force the government to adjust the exchange rate. In this simple approach, the amount of currency reserves is obviously the crucial parameter to determine the outcome, as a low reserve leads to a speculative attack while a high reserve prevents attacks. However, the case of medium reserves, in which a concerted action of speculators is needed is the most interesting case. In this case, there are two equilibriums (based on the concept of the Nash equilibrium): independent from the fundamental environment, both outcomes are possible. If both speculators believe in the success of the attack, and consequently both attack the currency, the government has to abandon the currency peg. The speculative attack would be self-fulfilling. If at least one speculator does not believe in the success, the attack (if there is one) will not be successful. Again, this outcome is also self-fulfilling. Both outcomes are equivalent in the sense of our basic equilibrium assumption (Nash). It also means that the success of an attack depends not only on the currency reserves of the government, but also on the assumption what the other speculator is doing. This is interesting idea behind this concept: A speculative attack can happen independent from the fundamental situation. In this framework, any policy actions which refer to fundamentals are not the appropriate tool to avoid a crisis. " - source Credit Crises, published in 2008, authored by Dr Jochen Felsenheimer and Philip Gisdakis
"The absence of new news has helped divert attention away from China – but the underlying problem remains unresolved
- After surprise devaluation in early January, China has stopped being a source of new bad news
- Currency stable since, though authorities no longer taking cues from market close to set yuan level*
- Macro data soft as expected, pointing to a gradual deceleration not a sharp slowdown
- Underlying issue of an overvalued yuan remains unresolved, current policy unsustainable long-term
−At over 2x nominal GDP growth, credit growth remains too high
−FX intervention to counter capital outflows – at the expense of foreign reserves
- source Deutsche Bank
"Self-fulfilling processes are a major characteristics of credit crises and we can learn a lot from the idea presented above. The self-fulfilling process of a credit crisis is that short-term overshooting might end up in a long-lasting credit crunch - assuming that spreads jump initially above the level that we would consider "fundamentally justified; for instance reflected in the current expected loss assumption. That said, the implied default rate is by far higher than the current one (e.g., the current forecast of the future default rate from rating agencies or from market participants in general). However the longer the spreads remains at an "overshooting level", the higher the risk that lower quality companies will encounter funding problems, as liquidity becomes more expensive for them. this can ultimately cause rising default rate at the beginning of the crisis; a majority of market participants refer to it as short-term overshooting. Self fulfilling processes are major threat in a credit crisis, as was also the case during the subprime meltdown. If investors think that higher default rates are justified, they can trigger rising default rates just by selling credit-risky assets and causing wider spreads. This is independent from what we could call the fundamentally justified level!
The other interesting point is that the assumption of concerted action is not necessary in credit markets to trigger a severe action. If we translate the role of the government (defending a currency peg) into credit markets, we can define a company facing some aggressive investors who can send the company into default. Buying protection on an issuer via Credit Default Swaps (CDS) leads to wider credit spreads of the company, which can be seen as an impulse for the self-fulfilling process described above. If some players are forced to hedge their exposure against a company by buying protection on the name, the same mechanism might be put to work." - source Credit Crises, published in 2008, authored by Dr Jochen Felsenheimer and Philip GisdakisAs we highlighted above with the flattening of MS München and/or Deutsche Bank and the flattening of the CDX HY curve, the flattening trend means that the funding costs for many companies is rising across all maturities:
"Such a technically driven concerted action of many players, consequently can also cause an impulse for a crisis scenario, as in the case for currency markets in financial panic models" - source Credit Crises, published in 2008, authored by Dr Jochen Felsenheimer and Philip Gisdakis
And this dear readers is the story of VaR in a world of rising "positive correlations" but we are ranting again...
"The laws of probability, so true in general, so fallacious in particular." - Edward Gibbon, English historian