Will Third Generation BASEL make any difference?

Recently, a reputed training institute based in Europe sent me details of training program for Basel III. They said that their training course provides helpful details of Basel III that will be rolled out soon across financial sector of various nations across the world and will strengthen the various players in the financial sector, mainly banks.

Let us see what the first and second generations of Basel has done for the global economy. The declared aim of these systems is to bring in stability in financial system and minimize banking problems and banking collapse.

Basel 1 -first generation- was rolled out soon after the collapse of Baring Banks by the aggressive risk taking by Nick Leeson. After selling straddles on Japanese Nikkei index successful over some years, Nick Leeson licked dust the day when an earthquake hit the city of Kobe in Japan in 1992. The straddles Nick Leeson shorted in derivatives market went against Baring Bank, which witnessed massive losses. Unable to meet the obligations, the bank went bankrupt and Nick Leeson went to jail.

Then they rolled out Basel 1, which I met during my early part of the career and remember doing the Risk Weighted Asset calculation and applying the appropriate capital adequacy ratio and finding out the risk/reward pattern for each asset and portfolio in general. Several accounting firms, consulting companies and IT firms had a field day as they delivered beautiful and elegant systems that captured various risks under Basel 1 in comprehensive manner but in an incomprehensible way.

However, soon criticisms were paraded against this system and intellectuals and academicians began to devote time for an improved version. The new systems gave undue importance to risk models and opinions of rating agencies. As the new system was being formed, another near disaster hit the global economy in the form of Long-Term Capital Management or LTCM.

The collapse of LTCM in 1998 showed the weakness of the risk models which was the basis for advanced IRB models in Basel II. It is interesting to note that two co-founders of LTCM (Myron Scholes and Robert Merton) won Nobel Prize in 1997 just one year before LTCM went bankrupt. Their convergence strategy and long/short strategy that delivered excellent returns (even up to c.45% p.a) for a few years turned against the firm when Russians decided not pay its sovereign debt in 1998. Entire capital of LTCM -one of the financial giants in the Wall Street - was wiped out resulting in a financial panic. Default by LTCM loomed large giving sleepless nights to various lending banks/FIs. A default would have caused a chain reaction of defaults across US banking system and possibly in other countries which were linked to US. The fear who else is insolvent froze the financial system. Thankfully, Allan Greenspan brought together the creditor banks of LTCM who bought into the equity of LTCM and took control and avoided the crisis. Despite all the mudslinging against Allan Greenspan in the recent times, we need to praise his steadfastedness to salvage US banking system and hence the economy, without tapping into Govt support.

Despite defusing a massive financial nuclear bomb well in time, the lessons learnt in LTCM was forgotten quickly. One of the chief culprits of LTCM collapse was its reliance on financial models, especially Var (Value at Risk) which assumed normal distribution in financial markets. In fact financial and credit markets are anything but normal and there were several evidence and academic criticisms against Var and similar models. Among the leading critics was Nassim Taleb while the die-hard supporters included the Quants in JP Morgan who originally brought out this beast into the financial markets.

During the later part of career again I had to get in touch with second generation Basel and its modelling systems. I often wondered alongwith some of my colleagues that the second generation was an excellent example of making simple concepts into beautifully carved complex and complicated systems of dubious quality. Again a bunch of accounting firms, consultants and IT firms won lot of business.

As the second generation was rolled out with its heavy reliance on models, Lehman crashed spectacularly in 2008, ten years after LTCM. No one was around to save Lehman or most of its creditors and its collapse exactly did opposite what Basel-1 and Basel II was originally rolled out for. They were supposed to protect banking and financial sectors or the nations. They did everything but that. Hundreds of banks have shutdown across the world or merged with others to avoid collapse. Many banks are still alive on Govt support.

Hold your breath. Now they are rolling out the third generation!! See you in 2018 or 2019, when another spectacular financial fireworks is possible, based on the track record we just discussed.

Someone told me that Einstein had said that 'there is nothing like simplicity'. It seems that sometimes he is right!!.

Great Chinese Property Bubble

No doubt China is a great country and civilization with a history going back to several millenniums comparable to India, Egypt, Mesopotamia, etc. However, recently, China is hitting headlines for some wrong reasons. (I am not sure my colleague who is of Chinese origin, but an UK Citizen, will agree with my view. He often argues that China is hitting the headlines for all right reasons.)

As China made its massive population the cheapest hardworking labour in the world, the greedy corporates of USA decided to dump the blue collar labour in their own country and exported those jobs to China. This still is one of the core reasons for record US unemployment, highest in the recent history of USA. Chinese labourers are working in poor labour (near slavery?) conditions and humanitarian track record of China is among the worst in the world. However these issues do not bother US Corporates, if money can be made cheap. Remember the recent news of suicides in several Chinese factories.

Cheap (and often stated to be of low quality) Chinese goods are flooding global markets and have created havoc in many countries resulting in closure of several industries in those countries. Recently, China won and half completed a metro railway project in Saudi Arabia undercutting several other competitors. It is reported that China is losing money in this project but happy and it means that they have now taken the undercutting abroad.

Both Saudi and China are totalitarian regimes and intolerant. One is based on communism and doesn't like religion and claims there is no God. Another one is based on extreme form of religion and insists that their way of viewing God is the only right way. It is a paradox that Saudi relies on skill set of expatriates of different religions such as Hindus, Christians, Parsis, Buddhists, Jains, etc but no religious freedom. Saudi beheads its criminals and does not allow women to drive or has any theatres. Saudi follows their religious law and restricts freedom of speech and expression, which has similarities to Chinese communism, where also both are denied. A chinese citizen -Liu Xiaobo- was awarded 2010 Nobel Peace Prize but he is in prision for the criminal offence of working for fundamental human rights in China. Whilst violent 'Communism' was exported all over the world by Soviet Union in early 20th century, now-a-days it is violent religious 'Terrorism' that is being exported around.

Now the million dollar question is whether Chinese Property Bubble will burst in 2011. It is widely acknowledged that the Property Bubble in China is much worse than that of US in 2007/08. The average price to rent ratio in China now stands at 40x vs. 23x of USA just before the onset of 2008 crisis. The main reason is that the government owned companies / banks driving up the investments to support GDP growth, even during the financial crisis. Artificially suppressed exchange rates also contributed to the growth of Great Chinese Bubble.

As in the Japan of 1990 and USA in 2008, the Chinese banks have exposure to the property market and any crash will then will result in banking crisis. A banking crisis will soon turn into a credit crisis and then economic crisis. So, if the Chinese property bubble bursts, definitely the global problems would multiply.

However, there are many who dismiss the above views saying China is different and they can control these issues. Well, that is what I also want so that the predictable 2011 is good for investing. My portfolio would not show much fluctuations and that is good. However, it is worrying that such complacency was exhibited prior to the United States sub-prime crisis and European sovereign debt crisis as well.

If China Property Bubble bursts the initial casualty will be drying up of demand for Raw materials. China is currently the global leader in consuming major commodities such as copper, steel, cement, etc. As the commodities take the southward direction, the mining companies and mining equipment manufacturers would follow. Investor sentiment would be affected and the global stock markets may test new lows. Bears would be happiest persons.

Let us hope that as China lovers say that the Chinese government has "ample resources" to bail out its banks and other sectors, in case of a crisis, which would prevent any exacerbation of the problem.

Will 2012 be similar to 1932? Or Japan in 1990s ? - Part 2

This is in continuation of the article published (in this blog) couple of weeks ago titled "Will 2012 be similar to 1932? Japan in 1990s?" We discussed about the parallels between 1929 Crash and 2009 Crash and discussed some of the common reasons behind both downturns i.e. - the structural weaknesses, reckless lending, high leverage, speculation, asset bubbles, massive bank failures, stock market crash, etc were some of them.

We had also discussed about the parallels of 2009 Crash to the Collapse of Japanese economy after their fantastic economic growth in the 1970s and 1980s, where Japan witnessed fast rise in real estate, stock market and all asset classes fuelled by cheap credit policy. But mainly due to mismanagement of the interest policy regime, the stock market crashed, debt crisis followed, banks collapsed, triggering bailouts by Japanese Govt, which sound so similar to the US story of 2008 end/early 2009.

What did Japan do during the 1990s after the gigantic economic shock? Among the steps by Japan, zero interest rate regime was the most famous to create demand. But deflation set in Japan creating lot more problems. Stock market index (Nikkei) that touched 38,957 in Dec 1989 is still hovering around 9000 levels today. The real estate prices are now going at the fraction of bubble times. Why did the deflation set in the Japan? Many reasons are highlighted by various authorities.

a) Sharp drop in post bubble asset prices. It is partly emotional. After burning the fingers in the crash, many investors (including retail investors) won't touch the same asset class and may even warn their children.
b) Risk averse banks: Post bubble, many banks were literally destroyed by the large percentage "non-performing" credit assets(i.e.loans that had to be written off). This reduced the credit risk appetite of banks.
c) Businessmen, who recently experienced the trauma of economic collapse and witnessed drying up of demand and non-payment by debtors did not take risky decisions. They were reluctant to borrow and expand questioning whether the hard pressed consumers will buy more.
d) Japanese people became fearful of banks' collapse. They bought gold or invested in United States/Japanese Treasury securities instead of bank deposits, reducing the funds available with banks.

A university professor at Tokyo University in a recent research of young adults stated that "the lost decade made young people timid and afraid of what to do; it is made them even more risk averse". It is not good news for Japanese, who are famous for their hard work and astonishing growth from the shambles of Second World War.

Against this background, it is understandable why Ben Bernanke is pumping money into the US Economy through Quantitative Easing. Deflation should never be allowed to lift its ugly head. Deflation was the major problem in post 1929 crash also. As we mentioned earlier in this blog, the Governor of the Fed had studied the 1929 US depression (and got PhD). Those days the dollar was pegged to gold. Because of this peg, the Fed in 1920s couldn’t just print dollars to counter deflation. Thank God, there are no more gold standards out there.

Let us hope USA won’t witness a lost decade. USA has a more dynamic economy than Japan with greater employment mobility and entrepreneurial energy. The working age of Americans is not shrinking unlike Japan. Moreover, USA has sprung back from its previous recessions since the Second World War smartly because its free economy allowed the economic agents greater flexibility to cut costs or lay off or recruit resources. Let us hope this dynamism will ensure that there is no lost decade for the USA, which will benefit the world, since US is still the biggest economic player in the world. Let us also hope China will not play a spoil sport in this great recovery game.

What this mean to you and me? Well Be on Guard. Your hard earned money is always at risk of a possible economic upheaval. Remember the best two principles of Warren Buffet (a) Never lose money in investments/savings (b) Always remember the first rule. As you know, it is not an easy job; but very little alternatives.

Nasty Experiment called EURO

Sorry if it is offending to anyone to call Euro nasty. But that is true. Because of Euro, many fund / portfolio managers and investors get sleepless nights. Who knows? Someone may even be getting heart attacks.

Second time this year (2010) the world's markets are rattled by Euro problems. Consequently, the values of stock and portfolios plunge, causing numerous issues of margin calls, leverage problems and crystallisation of derivatives. No wonder several portfolio managers and bankers watchover Euro with little bit of fear. A loss of confidence in Euro impacts liquidity and all risk assets. No one can rule out European (British banks are not immune) banks facing pressure.

First, it was Greece, who almost defaulted in April/May 2010. Greece is a very small player in the global economic scenario and its crisis would not have been of any major global impact. (Zimbabawe was in economic crisis, but hardly anyone noticed!!) Why did Greece issue become so magnified? Because of Euro. Media, investors, governments, bankers and across the world feared collapse of Euro. If it is the problem of Euro, it impacts entire Eurozone. And Eurozone economy is globally siginificant.

Second instance is now - Ireland in Nov 2010. Again Irish problems impact Euro and the global investors are worried. On a stand alone basis, Ireland is a very small player. But its problems are magnified through Euro. Markets get 'concerned' about these small Euro countries and fear the possibility of contagion and their impact on Euro and global markets.

Global investors, please brace up for more Eurozone problems. Your portfolio of stocks and commodities are at their mercy. Portugal, Spain and probably Poland are waiting in line to repeat the actions of Ireland or Greece.

Economic crisis due to heavy external debt sometimes happens and the best way to overcome is to depreciate its currency to encourage exports and earn enough foreign currency. For example, this was adopted by India in early 1990s and Brazil in 1980s. Had Greece had an independent currency, it could have devalued its currency. (Euro is not controlled by Greece but by Brussels, mostly influenced by Germany and France) This would have resulted in more export earnings through massive boom in tourism and exports through goods and services. In turn, this would have created more employment in the country.

Of the two choices, Greece was forced to have the German medicine of austerity instead of devaluation. Austerity also includes retrenchment, which means more unemployment. Latest press reports indicate that Greece is falling behind on its austerity promises and hence there is all likelihood that Greece problems may return in the future with vengenance. Bad news for global stock and finance markets.

As long as Euro exists, be ready for more problems ....

Let us hope for the best; but prepare for the worst.

Post QE2 Developments

As expected, after the announcement of the Fed’s new $600 billion bond purchase plan to boost the U.S. economy, the stocks and commodities were driven higher while Euro appreciated further partly reflecting European Central Bank decision to keep the interest rate unchanged. In fact the global stock indexes touched two-year highs while crude oil almost kissed $90/- per barrel and gold zoomed to record highs. Overall, the investors rejoiced the extra liquidity in the system.

And the dollar touched its 11 month low. Wow! that was too much, for China, who views the depreciation of dollar as indirect yuan appreciation. China came out with the most severe criticism and its 'government sponsored' rating agency downgraded US rating. That is China's way of thanking US companies who exported most of the manufacturing jobs to China, making millions of Americans unemployed.

But within a week's time, the dollar began to strengthen while commodities stagnated or dropped. Why? The major reasons are:

1. The market might have over adjusted to the anticipated announcement and now correcting itself.
2. One of the trader’s rules "Buy on rumour and sell on news" may be playing out.
3. Dollar is not only the currency of the US, but also the reserve currency of the world.
4. Many emerging economies have conducted studies and taking steps to control the dollar flow into their economies.
5. Unwinding of a portion of the USD based carry trade after the stock markets touched recent two year high.

However, in the long run, as more and more tranche of USD 600 bn hit the market, the possibility of depreciation of USD cannot be ruled out. One of the studies has indicated that over the next one year dollar can lose as much as 20% of its value.

But as economists say, this will happen ‘only if other things remain the same’. In this current volatile environment, we have to wait the reactions of other nations, who may view this as a step to weaken dollar. Moreover, the bad experiment called Euro is at the mercy of several fringe nations of the European Union. Any crisis for Euro will cause flight to safety causing USD to appreciate.

Will 1932 be repeated in 2012? or Japan in 1990s?

Everyone knows that there are some parellels between 1929 Crash and 2009 Crash. While the stock market touched its low in 1929 Oct, 2009 Mar was the lowest point of Dow in the US market in the recent years.

What caused these downturns? A lot of reasons are similar. The downturn in 1929 and 2008/2009 have common features such as -the structural weaknesses, reckless lending, high leverage, speculation, asset bubbles, massive bank failures, stock market crash, etc were some of them.

The US Govt did not sit idle in 1929. They took steps and as a result the stock market moved up in 1930. But consumer spending dropped due to deleveraging, unemployment, erosion in networth due to fall in asset values, which in turn was due to the stock market crash / real estate crash. Lower consumer spending meant lower demand for goods and services. Business dropped leading to more shutdowns and more unemployment, which reached 25% in early 1930s. Stock market crashed below 1929 levels.

Linked to gold standard, the dollar printing was restricted and US Govt/Fed did not inject liquidity into the economy in 1930s. International trade dropped due to protectionism. Overall, the deflation set in causing drop in prices, translating into losses for businesses, that managed to survive. More unemployment. And for some weird reason, Fed kept interest rates high. All of the above ensured the recession continued into a decade.

As a student (got PhD) of 1929 rececession, Ben Benarke is trying to avoid deflation at all costs. Hence, he plans more quantitative easing in the US economy which will pump up to USD 2 trillion dollars (or USD 2000,000,000,000/- dollars).

Ben Benarke should have taken a PhD on Japan's lost decade as well.

Japan after the envious economic growth in the 1970s and 1980s, witnessed fast rise in real estate, stock market and all asset classes fuelled by cheap credit policy of the Central Bank (CB). Panicing one day, CB increased the interest rates (this reminds the action of Ben Benarke in 2006/07 where he constantly pushed up the interest rates till economy collapsed). What followed is well documented in the history. The asset bubbles got pricked, stock market crashed, bad debts zoomed, debt crisis followed, banks collapsed, triggering bailouts by Japanese Govt. It is clear that US did not learn from Japanese folly.

What is the conclusion from the above? History repeats itself and P.hDs do not help always; but common sense will; however common sense is not very common.

Let us hope the future will be rosy and everything will be fine. But also be prepared for 1932 in 2012 or a lost decade in 2010s. G20 is meeting to avert mistakes of 1929 but the looming currency war between China/Japan/US/other countries does not have appropriate historical parallels and may make a history of its own for future generations.

What this mean to you and me? Well Be on Guard. Your hard earned money could be under attack. Remember the best two principles of Warren Buffet (a) Never lose money in investments/savings (b) Always remember the first rule. It is a tough job; but very little alternatives.

Why Commodity / Mining Stocks may be added into your portfolio

In order to further boost US Economy, the vast majority of Analysts expect an announcement on Quantitative Easing (QE) at the US Fed's policy meeting in November.

QE2 in November is all but certain. The only issue is the details of its implementation. The forecasts show that the next round of asset purchases would be c.$500 billion. Estimates ranged from $500 billion to $1.25 trillion (source Reuters).

Mr. Beranake needs this cash to filter into the private sector. This is expected to create jobs in the US.

Well most investors are probably happy to see another round of QE. Why? The stocks may benefit. But BE CAREFUL. Not all sectors are going to reap advantages. How can it happen when economic uncertainties prevail in many sectors. But there is one sector that could still benefit - even if the QE plan fails.

Years of cheap credit and reckless spending by US governments has taken the toll. Pumping more cash into the US economy and hope that things will improve is a doubtful idea. If the economy wants to sustain genuine growth , then the unviable businesses should be closed while US should become more competitive to China

Unfortunately, it appears that the US government wants an easy route. They try to the avoid the pain of economic adjustments with second round of QE.

May be Bernanke is right. The Governor of the Fed studied the 1929 US depression – when the dollar was pegged to gold. Because of this peg, the Fed in 1920s couldn’t just print dollars to counter deflation.

But it is quite different in 2010. Now Mr Bernanke can create all the cash or dollars. He hopes this will work miracles and will get the US out of economic trouble – be it deflation or not. Following are some of the thoughts on QE in November:

1) It may set off some inflation. Commodities should provide an inflation hedge. Invest in commodities.
2) US dollar could depreciate. This is good for commodities. But other export oriented nations could devalue their currencies against USD to keep their competitiveness.
3) QE funds channels into the emerging markets creating some growth in the developing economies. This will also result in more demand for commodities. Commodities should benefit.

If commodities do well, then mining sector should do well.

Do you want to know more about the mining stocks that could gain? Google is selectively placing advertisements in the blog related to this topic. You may click one of them and try your luck at your own risk.

The above content is for information purposes only and not intended to be relied upon for investment decisions. Appropriate independent advice should be obtained before making any such decision. Investing is risky and can lose money. Always seek expert advice before investing.