Last night's post talked about the precarious nature of the ECB's balance sheet, based on a paper by a Columbia Business School professor. I just saw this discussion in today's online Wall Street Journal:
"The reality is that efforts to leverage the European Financial Stability Facility are in disarray – and will remain so until the current political uncertainty over Greece, and maybe now Italy, has passed. And the bank recapitalizations are not due to be completed until June 2012. The only contagion defence available to the euro zone is the European Central Bank which may be reluctant to step into the breach. After all, if Greece is forced into a disorderly default, it would likely repudiate all its debt, including that held by the ECB. That would blow a €50 billion hole in the ECB’s balance sheet and destroy the credibility of its Securities Markets Program."
The balance sheet of a traditional central bank has to be above reproach. The ECB may have short-term issues, and for it to be a factor in a longer-term working out of the Euro crisis it's balance sheet will have to undergo a wholesale swapping out for multinational, EU guaranteed bonds. Can we get there from here?
Thursday, November 3, 2011
Wednesday, November 2, 2011
Papendreou Agonistes: Greece Throws Down The Gauntlet
For all the hectoring that Greek Prime Minister Papendreou may soon face from the German Chancellor and French Prime Minister, his gambit of calling for a referendum seems politically and economically rational. Under a scenario of further fiscal discipline mandated by the EU, economic growth prospects are dismal which means growing political unrest and instability in Greece. The Greek political leadership will not be able to influence the path of future events, other than to be reacting to serial crises.
If, on the other hand, a referendum goes were to go forward and pass, Greece could resurrect the drachma, gain control over its future monetary policy and have an exchange rate to adjust for differential inflation levels with the rest of the EU and for payment imbalances. A run on the banks would have to be forestalled, but Argentina suffered through a bank run in 2001 and reemerged healthier five years later.
Asset markets would be thrown into turmoil, but everything would eventually be remeasured, and life would go on, with limited access to the capital markets for some time. However, from the political standpoint, Greece would be in charge of its monetary and fiscal policies, as opposed to the popular perception that the country is at the mercy of Germany and France. Short-run economic growth prospects in this scenario shouldn't be much worse than under the current euro structure, assuming that fiscal discipline continues and revenues are eventually raised through higher taxes and better collections.
The important element for a politician is that Greece is in charge of its own destiny, even if that means being a pariah for a few years.
Back in July, we wrote about the limited options for the European Central Bank. We focused on " the fundamental problem of economic imbalances within the European Union." Professor David Beim of the Columbia University School of Business puts forward a cogent analysis in his October 9 paper, "Can the Euro Be Saved?"
The seminal formulations of the economic and currency union idea were put forward by Robert Mundell, Roland McKinnon, Peter Kenen, Douglas Dosser and others in the 1960s. As Beim rightly points out, these models were predicated on the countries being broadly similar, especially as regards having common or similar rates of inflation. If they were not, a currency union must inevitably end in a debt crisis, driven by persistent payments imbalances. That's where the EU is today.
We've said from the beginning that no politician on our planet will willingly cede national sovereignty over fiscal policy, because that would be either a literal or political death sentence. We've written earlier, "we are moving, like a slow motion train wreck, towards a default of some kind, semantically within or outside the euro."
Professor Beim agrees, "Greek debt restructuring and exit from the euro needs to happen in the near future and will happen with certainty in the medium future."
Professor Beim raises a really important point, which has been glossed over in all the focus on Greece, and that is the balance sheet of the European Central Bank. He reads the September 30, 2011 balance sheet showing 2.3 trillion euros of assets, composed of 1.14 trillion of bank loans and distressed sovereign debt!
As he says, "The ECB itself needs to be bailed out, replacing its risking assets with European Financial Stabilisation Mechanism (EFSM) euro-bonds, to the extent that this can be done at this late stage."
This recapitalisation itself will be a Herculean undertaking.
If, on the other hand, a referendum goes were to go forward and pass, Greece could resurrect the drachma, gain control over its future monetary policy and have an exchange rate to adjust for differential inflation levels with the rest of the EU and for payment imbalances. A run on the banks would have to be forestalled, but Argentina suffered through a bank run in 2001 and reemerged healthier five years later.
Asset markets would be thrown into turmoil, but everything would eventually be remeasured, and life would go on, with limited access to the capital markets for some time. However, from the political standpoint, Greece would be in charge of its monetary and fiscal policies, as opposed to the popular perception that the country is at the mercy of Germany and France. Short-run economic growth prospects in this scenario shouldn't be much worse than under the current euro structure, assuming that fiscal discipline continues and revenues are eventually raised through higher taxes and better collections.
The important element for a politician is that Greece is in charge of its own destiny, even if that means being a pariah for a few years.
Back in July, we wrote about the limited options for the European Central Bank. We focused on " the fundamental problem of economic imbalances within the European Union." Professor David Beim of the Columbia University School of Business puts forward a cogent analysis in his October 9 paper, "Can the Euro Be Saved?"
The seminal formulations of the economic and currency union idea were put forward by Robert Mundell, Roland McKinnon, Peter Kenen, Douglas Dosser and others in the 1960s. As Beim rightly points out, these models were predicated on the countries being broadly similar, especially as regards having common or similar rates of inflation. If they were not, a currency union must inevitably end in a debt crisis, driven by persistent payments imbalances. That's where the EU is today.
We've said from the beginning that no politician on our planet will willingly cede national sovereignty over fiscal policy, because that would be either a literal or political death sentence. We've written earlier, "we are moving, like a slow motion train wreck, towards a default of some kind, semantically within or outside the euro."
Professor Beim agrees, "Greek debt restructuring and exit from the euro needs to happen in the near future and will happen with certainty in the medium future."
Professor Beim raises a really important point, which has been glossed over in all the focus on Greece, and that is the balance sheet of the European Central Bank. He reads the September 30, 2011 balance sheet showing 2.3 trillion euros of assets, composed of 1.14 trillion of bank loans and distressed sovereign debt!
As he says, "The ECB itself needs to be bailed out, replacing its risking assets with European Financial Stabilisation Mechanism (EFSM) euro-bonds, to the extent that this can be done at this late stage."
This recapitalisation itself will be a Herculean undertaking.
Friday, October 28, 2011
Algae Factories In Our Future?
There have been some interesting meetings about using algae as a renewable fuel source, which motivated a quick review of what's been happening with alternative fuels. As corn-based ethanol has rightly been fading as a meaningful solution for our hydrocarbon dependency, cellulosic ethanol once seemed extremely promising.
One of the emerging leaders was Iogen Corporation in Canada (http://www.iogen.ca/). Goldman Sachs was an early investor in the company. Pilot plant results using wheat straw were very promising, and the energy balance for cellulosic ethanol looked a lot better than that of corn-based feedstock. In 2011, Goldman Sachs was hired to look at strategic alternatives.
The company formed Iogen Energy, which is 50/50 percent owned by Iogen and by Royal Dutch Shell plc. Plans for a full scale commercial plant in Canada are taking longer than planned for "technical design and feasibility" issues. Abstracting from the technical process issues, the other big issue for plant economics will minimizing transportation costs for the low value per unit volume feedstock while also getting the fuel efficiently to a wholesale distribution point. Things still look promising for this fuel, but it will be part of a portfolio of transportation fuels.
Several industry experts have pointed out that naturally occurring algae won't be able to produce on a large enough scale without having uneconomically large areas devoted to production. Renewable biofuels fron algae will almost certainly require synthesizing some specialized organisms which produce the fuel in a manner in which it can be easily "skimmed" or recovered without necessarily breaking apart the producer organisms themselves. This has been described by Craig Venter as requiring the "invention of a new agriculture." Since ExxonMobil has committed to researching algae-based biofuels, there is optimism for the future.
A large NSF research grant led by investigators from Penn State University aims at developing genetically engineered bacteria for production of liquid fuels will be completed in early 2012. This has been a four year effort and hopefully, it will advance the renewable fuels effort forward.
While this area continues to show promise and leverages our scientific, engineering and production expertise as a nation, renewables as a class of fuels will be a part of a fuel portfolio that will be dominated by hydrocarbons for decades to come.
One of the emerging leaders was Iogen Corporation in Canada (http://www.iogen.ca/). Goldman Sachs was an early investor in the company. Pilot plant results using wheat straw were very promising, and the energy balance for cellulosic ethanol looked a lot better than that of corn-based feedstock. In 2011, Goldman Sachs was hired to look at strategic alternatives.
The company formed Iogen Energy, which is 50/50 percent owned by Iogen and by Royal Dutch Shell plc. Plans for a full scale commercial plant in Canada are taking longer than planned for "technical design and feasibility" issues. Abstracting from the technical process issues, the other big issue for plant economics will minimizing transportation costs for the low value per unit volume feedstock while also getting the fuel efficiently to a wholesale distribution point. Things still look promising for this fuel, but it will be part of a portfolio of transportation fuels.
Several industry experts have pointed out that naturally occurring algae won't be able to produce on a large enough scale without having uneconomically large areas devoted to production. Renewable biofuels fron algae will almost certainly require synthesizing some specialized organisms which produce the fuel in a manner in which it can be easily "skimmed" or recovered without necessarily breaking apart the producer organisms themselves. This has been described by Craig Venter as requiring the "invention of a new agriculture." Since ExxonMobil has committed to researching algae-based biofuels, there is optimism for the future.
A large NSF research grant led by investigators from Penn State University aims at developing genetically engineered bacteria for production of liquid fuels will be completed in early 2012. This has been a four year effort and hopefully, it will advance the renewable fuels effort forward.
While this area continues to show promise and leverages our scientific, engineering and production expertise as a nation, renewables as a class of fuels will be a part of a fuel portfolio that will be dominated by hydrocarbons for decades to come.
Tuesday, October 25, 2011
Pandora's Risk: Goodbye to Efficient Markets
Kent Osband's book, Pandora's Risk from Columbia University Press is the best book on financial markets I've read this year. It's not an easy read, but stimulating and worthwhile. He made a related presentation in 2005 to the Irish Society of Actuaries titled, "How to Mismanage Portfolio Risk: A Guide for the Fiducially Challenged." I can't find a link to the slides on the Web, but it's got the same tongue-in-cheek style.
In Osband's view, one of the strangest features of financial markets is their self-absorption. In the continuous experiment that is a trading session, the actors are also observers. Invoking Keynes, a financial market is not like a beauty contest aiming to pick out the greatest beauty, but it's aimed at finding out which contestant the other judges would pick as the best.
As each piece of new information comes in, including about the previous trade, market participants make adjustments in a never ending process, until the bell rings and the market closes.
When thinking about the CAPM formulation, the intrinsic value of an equity is like a port into which the market eventually puts in, through fundamental valuation and incorporation of all relevant information. In the weaker formulations, it may zigzag its way into port, overshooting and undershooting, but the ship puts in. In Osband's world, he models us away from the nice Gaussian distribution and takes us into beta and gamma distributions, where risk is not so neat and where uncertainty abounds. Volatility is high, trading volumes are high, and buy and hold strategies are not value producing.
He doesn't have kind words for pension consultants who focus on tracking error to evaluate mutual fund managers. Tracking errors, he shows, are good for fund managers' job security, but not for their clients. Conventional indexes contain most of the market risk and reward, so clients should be taking MORE risk on the residual element not less. His preferred model for a typical investor would be an index fund combined with a delevered hedge fund vehicle to produce superior returns.
Most mutual funds diversify TOO much given their investment profiles, where the benefits of risk reduction are quickly outweighed by mediocre holdings and inability to monitor the portfolio quality, which means defaulting to tracking error.
Talking about the melting of the global financial ice cap, he poses and answers the following questions:
In my continuing search to understand what we really know about enterprise risk management, I found this comment particularly insightful: "Most risk managers have detailed knowledge of individual trade exposures, largely redundant with that of the traders they're checking on." What the risk manager doesn't know, both for model limitations and data limitations, are how these individual risks fit together. Given mark-to-market and Osband's model for market price behavior, the possibility of a nuclear portfolio event is never far away. As he writes, "Mankind can aspire to mastery of the universe but never achieve it. To err big is human."
He doesn't have kind things to say about US monetary and fiscal policies, and in particular the endless rolling over of public debt. We have seen the sovereign downgrade of US debt come and go. However, domestic sovereign default is the biggest risk facing the global system, Osband says.
Although he doesn't write about this, the second biggest risk is probably the slow unwinding or collapse of the Euro.
For state and local pension funds, his outlook is red on the Uncertainty Meter. We should "stop exempting public agencies from private sector standards for estimating the NPV of future (pension and bonding) obligations." Amen to that, and it's something that could be easily enacted although there might be casualties among the stampede of lobbyists in opposition.
And so it goes. Have a peek into Pandora's box with Osband.
In Osband's view, one of the strangest features of financial markets is their self-absorption. In the continuous experiment that is a trading session, the actors are also observers. Invoking Keynes, a financial market is not like a beauty contest aiming to pick out the greatest beauty, but it's aimed at finding out which contestant the other judges would pick as the best.
As each piece of new information comes in, including about the previous trade, market participants make adjustments in a never ending process, until the bell rings and the market closes.
When thinking about the CAPM formulation, the intrinsic value of an equity is like a port into which the market eventually puts in, through fundamental valuation and incorporation of all relevant information. In the weaker formulations, it may zigzag its way into port, overshooting and undershooting, but the ship puts in. In Osband's world, he models us away from the nice Gaussian distribution and takes us into beta and gamma distributions, where risk is not so neat and where uncertainty abounds. Volatility is high, trading volumes are high, and buy and hold strategies are not value producing.
He doesn't have kind words for pension consultants who focus on tracking error to evaluate mutual fund managers. Tracking errors, he shows, are good for fund managers' job security, but not for their clients. Conventional indexes contain most of the market risk and reward, so clients should be taking MORE risk on the residual element not less. His preferred model for a typical investor would be an index fund combined with a delevered hedge fund vehicle to produce superior returns.
Most mutual funds diversify TOO much given their investment profiles, where the benefits of risk reduction are quickly outweighed by mediocre holdings and inability to monitor the portfolio quality, which means defaulting to tracking error.
Talking about the melting of the global financial ice cap, he poses and answers the following questions:
- "Did we measure risk incorrectly?" Answer: Yes
- "Did we measure the wrong risk?" Answer: Yes
- Did we wrongly expect too much from our risk measures?" Answer: Yes
In my continuing search to understand what we really know about enterprise risk management, I found this comment particularly insightful: "Most risk managers have detailed knowledge of individual trade exposures, largely redundant with that of the traders they're checking on." What the risk manager doesn't know, both for model limitations and data limitations, are how these individual risks fit together. Given mark-to-market and Osband's model for market price behavior, the possibility of a nuclear portfolio event is never far away. As he writes, "Mankind can aspire to mastery of the universe but never achieve it. To err big is human."
He doesn't have kind things to say about US monetary and fiscal policies, and in particular the endless rolling over of public debt. We have seen the sovereign downgrade of US debt come and go. However, domestic sovereign default is the biggest risk facing the global system, Osband says.
Although he doesn't write about this, the second biggest risk is probably the slow unwinding or collapse of the Euro.
For state and local pension funds, his outlook is red on the Uncertainty Meter. We should "stop exempting public agencies from private sector standards for estimating the NPV of future (pension and bonding) obligations." Amen to that, and it's something that could be easily enacted although there might be casualties among the stampede of lobbyists in opposition.
And so it goes. Have a peek into Pandora's box with Osband.
Monday, October 24, 2011
Arab Spring's Prescursor: Algeria
I just finished John Kiser's fine book, "The Monks of Tibhirine," which provided the basis for the screenplay of Xavier Beauvois' wonderful movie, "Of Gods and Men." Kiser's deft treatment of Christian-Muslim relations is depicted against the violent background of French colonialism in Algeria.
The Western press has romanticized the so called "Arab Spring," as a prelude to a golden age of Western democracy and modernity in Middle East nations oppressed by their own dictators. Some of this is wearing off as the reality is showing something different.
In Kiser's book, Ali Benhadj, a popular preacher who resonated with disaffected Algerian youth says,"For Muslims liberty is constrained by the law of God, not by the rights of others....rights change, and liberty is an illusion that can be trampled by the state. True liberty comes from submission to God." Benhadj wrote this in the newspaper El Munguid ("The Deliverer") around 1988.
So the Western concept of a secular, political democracy in which the state regulates religion to being a solely private matter, is anathema to the population in the Middle East. It's interesting to read about the commonality of ideas and mutual respect between the local Algerian Muslim population and the Cistercian monks, who are People of the Book.
In a speech at the Es Summa mosque in November 1989, Kiser writes that Ali Benhadj said, "They (the Algerian ruling elites) are just like the French before them. They believe that God can be separated from life, visited perhaps once a week in a mosque. They have adopted the so-called Enlightenment thinking of the French, which is at the root Greek, an insolent idea that man is the measure of all things. Everything comes from God. Secular thinking separates man's spirit from God. Islam teaches that it is man's duty to be humble and to serve God in accordance with his commandments."
The Syrian, Tunisian, Egyptian and other elites bring their own philosophical, political and economic baggage to the discussion about the future of the Arab Spring. Reading about Algeria's history through Kiser's book was very instructive in thinking about the future of the countries which are trying to throw off the shackles of authoritarianism. It will not be a short struggle.
The Western press has romanticized the so called "Arab Spring," as a prelude to a golden age of Western democracy and modernity in Middle East nations oppressed by their own dictators. Some of this is wearing off as the reality is showing something different.
In Kiser's book, Ali Benhadj, a popular preacher who resonated with disaffected Algerian youth says,"For Muslims liberty is constrained by the law of God, not by the rights of others....rights change, and liberty is an illusion that can be trampled by the state. True liberty comes from submission to God." Benhadj wrote this in the newspaper El Munguid ("The Deliverer") around 1988.
So the Western concept of a secular, political democracy in which the state regulates religion to being a solely private matter, is anathema to the population in the Middle East. It's interesting to read about the commonality of ideas and mutual respect between the local Algerian Muslim population and the Cistercian monks, who are People of the Book.
In a speech at the Es Summa mosque in November 1989, Kiser writes that Ali Benhadj said, "They (the Algerian ruling elites) are just like the French before them. They believe that God can be separated from life, visited perhaps once a week in a mosque. They have adopted the so-called Enlightenment thinking of the French, which is at the root Greek, an insolent idea that man is the measure of all things. Everything comes from God. Secular thinking separates man's spirit from God. Islam teaches that it is man's duty to be humble and to serve God in accordance with his commandments."
The Syrian, Tunisian, Egyptian and other elites bring their own philosophical, political and economic baggage to the discussion about the future of the Arab Spring. Reading about Algeria's history through Kiser's book was very instructive in thinking about the future of the countries which are trying to throw off the shackles of authoritarianism. It will not be a short struggle.
Thursday, October 20, 2011
A Coupon For The Groupon IPO
What could be better than daily deal coupon issuer Groupon giving a rebate on itself? Back in June, we posted on the absurd $15-20 billion valuation range being suggested for Groupon. Many investment bankers are probably poker wizards with the requisite "poker face," which allows them to make the most ridiculous statements without blushing or bursting out laughing.
In today's Wall Street Journal, we see that investors can get a coupon on Groupon:
In today's Wall Street Journal, we see that investors can get a coupon on Groupon:
"In a stark comedown for what was expected to be one of the hottest stock offerings of the year, Groupon Inc. is scaling back plans for its public debut. The Chicago company and its bankers will begin meeting with investors in the next few days to sell them on a deal that values the daily deals pioneer at less than $12 billion, according to people familiar with the matter. While that would still mark one of the biggest Internet IPOs since Google Inc. in 2004, it is well below the valuations that were bandied about when the company filed to go public in June. Groupon's IPO was originally expected to value the three-year-old company at between $15 billion and $20 billion, according to people familiar with the matter"
In the meantime, we've had IPO metrics blessed by the company and its auditors, and then the same metrics were withdrawn. An email from the CEO suggests that investors should ignore marketing costs because they can be scaled back at any time, which could sound like "managing earnings," assuming that Groupon had earnings.
With the powerhouse banks behind the deal, a deal will get done. Lucky flippers will have a nice payday. The Groupon model is not healthy for most restaurant businesses, but if this industry manages to get a footing, then it will take its profits out of the hides of their small business customers. In the meantime, I can't wait to see which mutual funds wind up listing Groupon as 2% of their fund assets. An absurd valuation is now merely ridiculous. Caveat emptor!
Wednesday, October 19, 2011
Auditor Term Limits: Another Irrelevant Idea
Arthur Levitt, former SEC Commissioner, has weighed in favor of "auditor term limits." This will do nothing but impose costs on companies, and, as usual, those costs will fall disproportionately on smaller companies which don't have armies of people in finance, tax, treasury and accounting. As a stockholder, already facing meager returns, I wouldn't get excited by this proposal.
It will also add to SOX expenses for no value-added, as auditors will not agree on the identity and number of key controls, which in turn will lengthen audit committee deliberations, particularly for companies which are trying to remediate already existing weaknesses and deficiencies.
This foolish idea will not:
It will also add to SOX expenses for no value-added, as auditors will not agree on the identity and number of key controls, which in turn will lengthen audit committee deliberations, particularly for companies which are trying to remediate already existing weaknesses and deficiencies.
This foolish idea will not:
- Result in higher quality audits
- Reduce risk for institutional investors.
- Improve transparency or utility of financial statements produced by issuers.
- Make auditors work harder on existing engagements.
- Have any economic benefit beyond political window dressing.
Expect to see board expenses go up because of more audit committee meetings, legal fees go up for outside counsel reviews, and watch audit fees and SOX consulting fees rise also.
As we enter the campaign season, it makes for good headlines, though.
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