Have mentioned a few times that CDS spreads are a lot quicker to react than rating agencies. I read this article a while back in Bloomberg magazine, but couldn't find it on the internet.

http://www.bloomberg.com/apps/news?pid=20601087&sid=a0tWb0sTTgu8&refer=home

original post

http://www.noelwatson.com/blog/PermaLink,guid,e3de871d-7c56-437d-bd33-239b97de44e8.aspx

and some more

http://www.cnbc.com/id/15840232?video=921233906

follows on from similar article from DTCC

http://www.noelwatson.com/blog/PermaLink,guid,cbbb4a7a-4a20-4de9-9f1f-d458f483c938.aspx

the only thing I would point out is

"Perhaps the biggest misperception about the CDS sector is its role in today's financial crisis. The root cause of the financial sector's woes is too many bad mortgage loans. While some observers point to AIG's use of CDS as contributing to its downfall, the truth is that the company, like others, took on the risk of too many defaulting mortgages and troubled loans."

as pointed out yesterday,

http://www.noelwatson.com/blog/PermaLink,guid,19e80fd2-0f61-4650-8afe-142458df673b.aspx

AIG may be getting hit by writedowns on super senior protection on corporate bond backed CDO, in addition to all the mortgage woes. There is an article talking about AIG in the NYT today.

http://www.nytimes.com/2008/10/30/business/30aig.html

Tavakoli is mentioned, again!

I've spoken about the CPI target in the past

http://www.noelwatson.com/blog/PermaLink,guid,3f7c123f-446d-4e2a-8c96-c9d104c29373.aspx

but thought I would investigate further. The CPI was introduced in December 2003

http://www.hm-treasury.gov.uk/monetary_policy_uk.htm

replacing the RPIX. The new target was 2% vs 2.5% for the old. It follows that the historical gap of RPIX vs CPI should be 0.5% if we are to avoid monetary easing/tightening due to the new target. The average difference between the two from 31/03/1989 to 30/11/03 is 0.7%. However, at the extremes, the highest RPIX is 1% greater than CPI (9.5% vs 8.5%, 1.5% vs 0.5%), so it would appear CPI tends to underestimate the further we are from trend. Furthermore, at the time of introduction, there was 1.2% difference between the two.

CPI

RPIX

We can see the same info here. Note median of 0.9

I picked 31/03/1989 as the start date as it was the earliest that CPI went back. If we cut our filter to 30/11/93, we see a mean of 0.85. Maybe the period in 1991 when CPI was above RPIX was an anomoly.

If we look at the period since CPI was introduced, we see a mean of 0.7, and median of 0.8

So assuming we were forced to stick with CPI, one could argue that a target of 1.75% would reflect an RPIX of 2.5% more accurately. This would've set the alarm bells off slightly quicker, but maybe CPI is the wrong measure completely. Maybe RPI (not RPIX) with a target of 2% would've prevented this unprecendented boom

The problem here is that it is targeting mortgage repayment, and not asset prices. So for example

Using FSA calculator

http://www.moneymadeclear.fsa.gov.uk/tools.aspx?To...

Mortgage: £200000
Repayment period: 25
Interest rate: 7%

Monthly repayments: £1413

Cut rates to 3%, and the same person can now borrow £300000 and his monthly payments are still the same, yet his debt levels are 50% higher, and need to be repaid at some point. The problem here is, either:

a). We are in a new paradigm, and inflation is permanently low. This means that interest rates can stay at the low 3%. Unfortunately, wage deals tend to be closely related to inflation, so our man is getting 3% pa wage increases. The debt burden will be hanging round his neck for many years to come (unlike people in the late 80s/early 90s where wage increases peaked at 10%)
b). Alternatively, interest rates go back to 7%, and our man finds payments impossible.

From the above we need to have some way of monitoring debt levels as opposed to merely monitoring the cost of servicing the debt.

I briefly looked at single name CDS vs. share price,

http://www.noelwatson.com/blog/PermaLink,guid,27af9f1a-63b5-4e47-88a9-59d03ed7f90d.aspx

but today want to look at the credit and equity indices, and in particular, why the equity market has taken so long to price in the upcoming downturn. Way back in August 2007, the ITRAXX spiked from 20 to 60bps, and in March of this year was at 160bps, yet the FTSE was still over 6000 in April, compared to ~4000 today

One reason could be that equity analysts are a lagging indicator

http://ftalphaville.ft.com/blog/2008/10/22/17316/montier-analysts-are-rubbish/

yet people still take note of what they say. Earnings per share is still expected to rise according to the analysts

So on paper, the FTSE appears to good value relative to historic averages

with a yield of over 6% and P/E under 8. However, how much will earnings and yield be cut in the upcoming recession? Furthermore, while the market may be cheap, it can get a lot cheaper - FTSE All Share was yielding 10% in 1974.

http://www.thisislondon.co.uk/standard-business/article-23569535-details/It's+got+so+bad+that+even+the+bears+are+buying/article.do

now it could be the turn of corporate backed CDOs

http://ftalphaville.ft.com/blog/2008/10/23/17365/the-cdo-unwind-waiting-to-happen/

I have spoken in the past about models struggling to value AAA tranches

http://www.noelwatson.com/blog/PermaLink,guid,7a0b0ec8-475e-4359-b2a7-06dc3e46801f.aspx

and as spreads have continued to widen, this has become more difficult. Tavakoli's recently released book

http://www.amazon.co.uk/Structured-Finance-Collateralized-Debt-Obligations/dp/0470288949/ref=sr_1_1?ie=UTF8&s=books&qid=1225267106&sr=1-1

talks about the super senior tranche (pg 331)

As you can see from the above, the super senior tranche is much cheaper than AAA to issue.

For a super senior tranche of $1 billion, the capital charge would be $80million (see 8% total risk weighted assets http://en.wikipedia.org/wiki/Bank_for_International_Settlements). If the tranche pays 10bps (retained on banks books), return on regulatory capital is 1.25% (10bps/0.08). Furthermore, the Fed recognises a 20% risk weight for super senior risk, and Basel II guidelines allow AAA to  get 20% BIS risk weighted treatment, giving a 6.25% return. Banks may also be able to use model-based capital treatment, further improving returns.

Super senior tranches make up a large percentage of total CDO issuance, yet there is no standard definition of pricing super senior risk.

Monolines are one of the insurers of super senior risk, and it would appear that AIG are spending most of their loan on posting additional collateral as the spreads widen on these these tranches

The article mentions super senior - see attached

levsupseniorCDO_082205.pdf (659.25 KB)

UPDATE:

The original Bloomberg article was a bit misleading

http://www.bloomberg.com/apps/news?pid=20601087&refer=home&sid=a5x0jMKZf4yc

According to CreditFlux, there is ~1.5trn USD notional on synthetic CDO (CSO). So where does the

"Investors are taking losses of up to 90 percent in the $1.2 trillion market"

come from?

• If it refers to the 1.5trn being marked down by 90%, this is incorrect.

~65% of CSO volume is super senior risk - marked at 80%

25% is mezz/senior risk - marked at 40%

10% is equity - marked at 10%

This equates to a markdown around 37%, so 450bn (if we assume market size of 1.2trn and not 1.5trn). Note that this is a mark to market loss - it is unlikely that super seniors will be impaired (barring disaster), and mezzanine CSO tends to be held until maturity, so MTM is not important.

• It could be that they are referring only to the mezzanine tranches, but the notional is unlikely to be 1.2trn, and they are not all trading at 10%.
• Alternatively, it could refer to the CDS risk (leveraged around 3-4 times for mezz) of the mezzanine tranche, but assuming the ITRAXX and CDX IG have widened by around 200bps, this translates into a markdown of 8-15%, not 90%.

I have commented on this in the past

http://www.noelwatson.com/blog/PermaLink,guid,2060fb25-5d11-4a30-93b1-9c257651b104.aspx

Stephen Bland no longer writes for the Motley Fool and instead writes a subscription newsletter for MoneyWeek

http://www.moneyweek.com/about-us/the-moneyweek-team/stephen-bland.aspx

Before he left Fool, he gave an example portfolio for troubled times

http://www.fool.co.uk/news/investing/high-yield/2007/11/20/high-yield-picks-in-a-troubled-market.aspx

Bland's belief was that the best time to invest is now, and you shouldn't think you know what the future holds. Furthermore, the portfolio should be held indefinitely, as you are unable to predict the future. The portfolio is now almost a year old, so I thought I would do a little analysis. The HYP has fallen slightly more than the FTSE (-39.76% vs -38.14%). Certain shares have fallen more than others. For example, Taylor Wimpey is worth 5% of purchase price.

Were there any warning signs that could have told us that maybe we should sell? I decided to look at the CDS spreads (credit markets are notoriously slow to react). Unfortunately, Taylor Wimpey doesn't have an active CDS market, so onto another big faller.

I didn't pick RBS as its spread has been influenced by the BOE bail out, so instead will pick DSGI. Downgraded by Moody to speculative grade in May, by this point the stock had almost halved. So what did the CDS market show us? Soon after Christmas, DSGI started to move out, from around 100bps to 450 in mid Feb.

compared with the ITRAXX Europe which jumpled from 50bps to 160bps in the same period

So the first question could be, "Should be have a ratio of single name spread change to index spread change, and if our entity breaches it, we sell?"

I'm not sure it is as simple as this, as Rexam's CDS spread has gone from 60bps to 380bps, yet its share price has outperformed the market

and even Glaxo's CDS spread (the best performer) has gone from 27 to 110. So maybe we could have a rule that says if spread > MIN (500, ITRAXX Europe*2.5) sell. Furthermore, we could exclude names for which there is no CDS spread. of course, we cannot get excess return without taking risk, but maybe we can mitigate some of the risk by applying mechanical rules.

Here are my initial suggestions

Purchase

• Entity must be BBB rated or above when purchased
• Entity must have liquid CDS spread (tricky in current market!), and this must be no greater than 1.5*ITRAXX Europe
• Entity must not be in ITRAXX XOver (DSGI is in this list)

Reasons to sell

• Entity gets downgraded below BBB (probably too late to save majority of the fall in share price)
• CDS spread is greater than 2.5 times ITRAXX, or spreads goes above 500bps.
• Entity gets included in XOver on index roll

Research has been done into the link between credit spreads and stock prices

http://thesis.haverford.edu/dspace/bitstream/10066/1447/1/2008HaferS.pdf

but no link was found between the two that could be used to make excess return.

Attcahed is spreadsheet with working

HYP.xls (26 KB)

Will update at a future date

CDS spreads on Sovereign debt have been in the news a lot recently. There was the story about the U.S. Government being riskier than McDonald

http://ftalphaville.ft.com/blog/2008/09/26/16386/what-mcdonalds-can-teach-you-about-finance/

and with Iceland struggling, spreads in most countries have widened. I thought I would look at some of the spreads and what the market think their chances of default are. Starting with the U.S. Since the link above was written, 10 year (I will use 10 year for all sovereigns) have continued to widen
 

 
and the probability of default at ~3% in the next five years (note that I am using mid spreads and an assumed recovery of 0.4 (originally thought that all sovereigns recover at 25%, but Markit/Bloomberg show otherwise). I use this nearest roll date to five years from now, which in this case is 20/12/2013)

 
the UK is looking more risky than the U.S.

 
with >5% chance of defaulting in the next five years
 

 
Some other sovereigns, and their chance of default in next five years

• Iceland (40% recovery): 56%
• Pakistan (40% recovery): 89%
• Argentina (25% recovery): 92%

 
Bloomberg CDSW calcs here

http://www.noelwatson.com/blog/PermaLink,guid,fa4d8579-f754-48e0-a485-dc7c6850405f.aspx

Markit will be showing Sovereign CDS on the internet

http://us.ft.com/ftgateway/superpage.ft?news_id=fto102320081726108049

Now it could be that the current CDS spreads don't reflect the real risk of default

• The markets may be overreacting to the current market turmoil
• Protection sellers may be asking for extra premium for tail risk. Say for example a bank sells 10mm 5 year protection on UK for 62bps. They will receive 15.5k every quarter ((1/4)*10000000*(62/10000)), but if UK defaults, they pay out 6mm (assuming recovery of 40% and ignoring discounting for present value). This is similar to someone being asked to underwrite a £1m lottery where the chance of a payout being 1 in a million. In theory, you would say that £1 is fair value for the risk you are taking on, but how many would take on this underwriting?

http://www.hedgeweek.com/articles/detail.jsp?content_id=48740

Index was launched in 2007

"According to Merrill Lynch, simulated back testing of the Equity Volatility Arbitrage Index has outperformed most major global broad-based investible and non-investible hedge fund benchmark indices.

Moreover, the firm says, the strategy returns were negative in only three quarters over the past 18 years. The source of this strong performance is the high demand for S&P 500 index volatility relative to supply, a structural imbalance that has persisted for decades"

Looking at the price graph, it would appear that the index has indeed given strong performance

But if we look at the last few weeks...

The perils of backtesting.....

I have talked about CPDOs in the past

http://www.noelwatson.com/blog/SearchView.aspx?q=CPDO

last week the very first CPDO unwound

http://ftalphaville.ft.com/blog/2008/10/17/17193/requiem-for-the-cpdo/

Note details here

http://www.financialregulator.ie/data/in_mark_prosp/4712%20FinalProspectusChess%20II.pdf

http://www.financialregulator.ie/data/in_mark_prosp/4712%20FinalProspectusChess%20II.pdf

Looks like 200ps over risk free was too good to be true. Ironically, if it were launched today when spreads are much wider, they would have less chance of blowing up

FT:

• Pensions have billions in toxic assets

http://us.ft.com/ftgateway/superpage.ft?news_id=fto101920081613587193

Looks like the U.K. funds may be O.K.

"However, the UK appears to have escaped relatively unscathed. David Norgrove, chairman of the Pensions Regulator, said a survey of the UK's 80 largest schemes found "relatively limited exposure" to toxic assets.

• UK pensions beat the crash

http://us.ft.com/ftgateway/superpage.ft?news_id=fto101920081613587192

        Good to see a surplus even in troubled times.

• Trustees should take asset allocation advice

John Redwood (I mentioned his blog a few posts back) makes the point that as it is almost impossible to pick shares that beat the index, instead they should be selecting the correct mix of assets to outperform. I'm not sure how it will be any easier to do the latter then the former

• Only the brave buying up junk

http://us.ft.com/ftgateway/superpage.ft?news_id=fto101920081613597200

It will be interesting to see how these funds perform with the level of corporate defaults expected to rocket

• How to save a column from Armageddon

http://www.ft.com/cms/s/0/822be2cc-9c6d-11dd-a42e-000077b07658.html

"I have just been listening to someone who worked on Wall Street in 1929, and it seems it isn’t. Irving Kahn, now 102, was last week interviewed on the BBC World Service and crisply said that today “things are a great deal better. People are spoiled”. The main villains, he said, were the journalists – “the reporters who want to get attention writing up headlines saying how bad it is"

• Lamppost in the dark mathematics:

http://www.ft.com/cms/s/0/eb87dcda-9e3e-11dd-bdde-000077b07658.html

The author of this letter proposes that normal distribution is hopeless. he then goes on to mention alternatives such as Mandelbrot's fractal work. The problem with this is that Mandelbrot does not propose a system that can be implemented - maybe this is not possible

http://www.amazon.co.uk/Mis-Behaviour-Markets-Benoit-Mandelbrot/dp/product-description/1861977654

• A long way down

http://us.ft.com/ftgateway/superpage.ft?news_id=fto101920081602167168&page=2

Bubbles are getting much easier to identify (admittedly in hindsight). Maybe this is because there has been some much money sloshing round the system due to central banks that we are getting more experienced at seeing the warning signs. We have seen housing pop, oil at $140 was (IMO) a bubble, and commodities are plummeting. Will Dubai be next?

• Nervous times for investors in loan markets

http://us.ft.com/ftgateway/superpage.ft?news_id=fto101920081750287216

It was my understanding that LCDS always traded tighter than CDS due to expected greater recovery rate

http://www.fitchratings.com/dtp/pdf1-08/ibas0110.pdf

"What then of the spread relationship between CDS and LCDS? Theoretically, players in
both structures generally face the same risk of a credit event being called, therefore,
besides market technicals (a very significant consideration), recovery expectations should
really be the primary driver of differences in trading levels. Making this assumption,
what is commonly done is to compare the ratio of the LCDS spread to the CDS spread, and
relate that to the ratio of their respective expected recovery rates"

Maybe the LevX/LCDX are suffering illiquidity in the indices, much like ABX a while back

• The view isn’t pretty as the banking crisis dust settles

http://www.ft.com/cms/s/0/30645a4e-9df5-11dd-bdde-000077b07658.html

"All this has not been lost on the equity markets. The yield on European non-financial stocks, according to Citigroup, is now higher than that on a basket of European sovereign bonds. This is unprecedented, at least in the 45 years Citi has looked at the data.

For the entire European market including financials, Merrill Lynch says, the yield is now the highest since 1975. Put those together, and the market plainly expects sweeping dividend cuts.

Merrill calculates that in the three last recessions dividends were only cut by 8 per cent on average, against falls in earnings of 35-40 per cent. And bank dividends only fell by 7 per cent."

Could now be the perfect time to buy into the indices? Buffett seems to think so.

http://www.guardian.co.uk/business/2008/oct/17/warren-buffett-shares-markets

 

Telegraph:

• House prices are close to affordable levels, reveals survey

"Diana Choyleva, director of Lombard Street Research, said prices were unlikely to fall much more than 20pc, and should stop falling by mid to late next year"

Not sure where they are getting their information from. If only these people would accept a small wager!

A CDPC is a special purpose entity that writes unfunded credit protection of a notional many times the amount of capital it holds. It is a ‘continuation vehicle’ in that it has no wind up date and has a counterparty rating of triple ‘A’. Capital comes in the form of equity and debt which are both subordinate to the claims of any counterparty. CDS written by a CDPC do not need to be collateralised. Estimated total notional of protection written by CDPCs is in the region of USD 100bn.

Some more info

http://www.creditflux.com/files/8490.0.aspx

"Most basically, CDPCs support effective risk transfer. By trading with triple A CDPCs, counterparties can achieve capital relief relativeto their internal economic capital models and to the regulators. In addition, credit derivative traders are exposed to Gaap mark-to-market volatility arising from their credit derivative positions. In a large, complex, opaque financial institution, a sudden negative mark-tomarket can translate into a big impact on the
stock price."

Now where have I seen that before?

http://ftalphaville.ft.com/blog/2008/10/01/16559/aig-and-an-overlevered-europe/?source=rss

Current rated CPDCs

Primus Financial Products
Athilon Asset Acceptance Corp
Invicta Capital
Cournot Financial Products
Newlands Financial
Channel Capital
Koch Financial Products
Aladdin Financial Products
Satago Financial Products
Quadrant Structured Credit Products

Athilon has recently been downgraded

http://www.marketwatch.com/news/story/fitch-downgrades-athilon-off-rating/story.aspx?guid=%7B50405484-B24D-4C36-8E3D-00B67D1E17F7%7D&dist=hppr

iI would appear that Gordon has done a good job convincing the public that the current crisis wasn't his fault

I disagree

http://www.noelwatson.com/blog/PermaLink,guid,bc024a3b-6d2a-4ea1-bd0e-052811080655.aspx

http://www.dtcc.com/news/press/releases/2008/tiw.php

"The payment calculations so far performed by the DTCC Trade Information Warehouse relating to the Lehman Brothers bankruptcy indicate that the net funds transfers from net sellers of protection to net buyers of protection are expected to be in the $6 billion range (in U.S. dollar equivalents)."

So a smaller value than was being banded about by the press last week

http://www.straitstimes.com/Breaking%2BNews/Money/Story/STIStory_289276.html

"Lehman CDS sellers lose US$365b"

Article in Independent

MorganStanleyFutureOfTheCDSMarket.pdf (121.7 KB)

related BIS document - central counterparties

http://www.bis.org/publ/cpss64.pdf?noframes=1

at current risk models being used, and people who think they can model events accurately

http://www.youtube.com/watch?v=ABXPICWjFIo

related article

http://online.wsj.com/article/SB122385689217827341.html

and this is the kind of person that Taleb talks about

"Nigel Marriott thinks it is a genuine Black Swan event, "a one-in billions" chance"

http://www.bloomberg.com/apps/news?pid=20601109&sid=acw1G8iS8oXc&refer=home

Note that their data only when back to 1992 (so missed the 1987 crash), and also note that these banking disasters tend to happen with regular frequency (admittedly not of this magnitude)

UPDATE:

Taleb's clients have benefitted from market turbulence

http://www.bloomberg.com/apps/news?pid=20601087&sid=aDVgqxiT9RSg&refer=home

Gordon Brown is angry with the bankers for causing the the current crisis.

http://www.thisislondon.co.uk/standard/article-23569789-details/Brown+at+war+with+the+City/article.do

His anger with the bankers is second only to his fury at the Americans for creating this mess. If it wasn't for these two groups the UK would allegedly be in fine fettle. The scary thing is, the UK population are starting to believe this.

Now Gordon Brown must be right, as he has the astonishing ability to eliminate the economic cycle

http://www.guardian.co.uk/politics/2000/sep/25/labourconference.labour6

"We will not put hard won economic stability at risk. No return to short-termism. No return to Tory boom and bust."

When a politician makes these claims, it is always good to look at facts to see how much they are lying. Did the bankers cause these problems? Did America cause this, and if so, why are they different from the UK?

First the U.S.

• In 1999, the Clinton Administration encouraged low and moderate income people to buy housing

http://query.nytimes.com/gst/fullpage.html?res=9C0DE7DB153EF933A0575AC0A96F958260&sec=&spon=&partner=permalink&exprod=permalink

• Alan Greenspan famously said he couldn't identify a bubble until it had burst

http://en.wikiquote.org/wiki/Alan_Greenspan#Quotes_on_the_Housing_Bubble

Look at the graph below, why would interest rates be cut to 1% when housing was looking increasingly overvalued.

So, Brown may have been right about America causing this mess, but could it be just bad luck that the US bubble burst before the UK one?

In 1997, the Bank of England were granted operational independence over monetary policy

http://en.wikipedia.org/wiki/Bank_of_England

this sounds all well and good, but depends on what inflation target the BOE is given.

http://en.wikipedia.org/wiki/Consumer_price_index_by_country#United_Kingdom

In my opinion, the CPI is flawed - look at the Halifax house prices below - why were house prices going up at such a rate when inflation was at or near target?

Furthermore, in 1997, the Government gave responsibility for managing debt to the FSA

"Concurrent with assuming control of the interest rate in 1997, the bank transferred the duty of managing the government's debt to the Treasury Department and its regulatory functions were assumed by the Financial Services Authority ("FSA"). "

http://www.gocurrency.com/articles/england-bank.htm

Appointments to the MPC committee seem somewhat dubious (article below is admittedly not the most impartial!!)

http://www.johnredwoodsdiary.com/2008/05/17/why-has-the-government-and-the-bank-of-england-failed-us-on-inflation/

So where does this now leave us?

• We have unprecedented levels of personal debt

http://www.independent.co.uk/money/loans-credit/for-the-first-time-britons-personal-debt-exceeds-britains-gdp-462825.html

• Negative savings rate

http://business.timesonline.co.uk/tol/business/economics/article4854282.ece

and negative real interest rates meaning that people are unlikely to start saving anytime soon

http://www.telegraph.co.uk/finance/personalfinance/savings/3166408/Financial-crisis-UK-savers-lose-out-with-negative-real-interest-for-first-time-in-27-years.html

(I mentioned this previously)

http://www.noelwatson.com/blog/PermaLink,guid,ac794dad-98e0-4bde-b5b0-d05409bea9fa.aspx

• The less said about public sector debt the better (Private Eye are good for this)
• Housing is now more overvalued than the U.S.

http://www.reuters.com/article/ousiv/idUSTRE49767320081008

Jeff Randall sums it up well

http://www.telegraph.co.uk/finance/comment/jeffrandall/3168301/Debris-from-the-City-and-Wall-Street-will-destroy-innocent-lives.html

To conclude, the bankers must share the blame, but I believe the central banks (partly through constraints placed upon them) should take most of the blame. If you look at the economic problems in the last century, the central banks, in hindsight, have made the problem worse. Take the Great Depression

http://en.wikipedia.org/wiki/Great_depression

"Monetarists, including Milton Friedman and current Federal Reserve System chairman Ben Bernanke, argue that the Great Depression was caused by monetary contraction, the consequence of poor policymaking by the American Federal Reserve System and continuous crisis in the banking system"

Brown may gloat at the current U.S problems, but I am certain that the UK are only 12-18 months behind in the slide into recession.

It is all well and good to criticise without offering a better solution - here is mine.

• An inflation measure must be chosen that has asset prices as an input. Using the CPI measure is flawed (it is flawed even for the EU - one size does not fit all - see Ireland and Spain).
• House prices must form a large part of this measure. We should take the long term trend (e.g. 2% pa over wage increases). Whenever it deviates +/-2% from this target, the input into the overall inflation target will change
• Money supply needs to be targeted. Mervyn King said that inflation and money supply are strongly correlated - yet we ignore M4 numbers.
• Members of the MPC must be selected by an independent committee.
• The Government debt controls should be placed back under control of the BOE
• The rating agencies need to be improved. They, along with the FSA need to recruit the best people that would otherwise go into banking. For this, they must pay top rates.
• The banks may need to be better regulated - this is a tricky one

UPDATE 1:

• Brown says no return to boom and bust

         http://www.youtube.com/watch?v=E5UILQzJgCA

http://www.youtube.com/watch?v=aCQREoAmsu0

 

• Greenspan talk about subprime in 2005

http://www.federalreserve.gov/BoardDocs/speeches/2005/20050408/default.htm

"With these advances in technology, lenders have taken advantage of credit-scoring models and other techniques for efficiently extending credit to a broader spectrum of consumers. The widespread adoption of these models has reduced the costs of evaluating the creditworthiness of borrowers, and in competitive markets cost reductions tend to be passed through to borrowers. Where once more-marginal applicants would simply have been denied credit, lenders are now able to quite efficiently judge the risk posed by individual applicants and to price that risk appropriately. These improvements have led to rapid growth in subprime mortgage lending; indeed, today subprime mortgages account for roughly 10 percent of the number of all mortgages outstanding, up from just 1 or 2 percent in the early 1990s."

I posted some housing advice by a U.S. realtor and promised to revisit the post a year later

http://www.noelwatson.com/blog/PermaLink,guid,70afcbb4-dfc0-49e5-8e5d-38e55fa3568c.aspx

Surprisingly, the U.S housing market has been decimated since. I came across some similar advice from a UK unbiased source (see below). Again, I will revist in a year and see how much of a good idea it turned out to be....

THE BANKING SYSTEM
The banking system is in chaos and any
bank deposit over £50,000 from today,
according to government statements,
is not guaranteed to be returned.

The government has stated that 98% of those
with bank accounts will be covered by this
guarantee but the government does not state
that the other 2% who own 50% of the deposits
will not so this money needs to be protected.

Have you seen with your own eyes, seen on
the television or read in the newspapers
the fact that English banks and building
societies are being inundated by investors
wanting their monies returned so that
they may place them in Irish banks as
the Irish government has guaranteed the
accounts to 100% of the sum deposited.

Are you aware that some people are so
desperate to protect their money that they are
transferring it from one account to another, they
are seeking to buy gold, which itself is subject
to fluctuation, they are investing in foreign
currencies, which is also subject to fluctuation
and probably some are storing their money
under the bed as being the least risky option.

The question is as to the best method of
protecting money in the current climate and
the simple answer is to invest in property.

Property prices are at their lowest
for a considerable time and there are
many good deals to be had. Mortgages
are available particularly for those
with a reasonable financial record.

Property has for the last 50 to 60 years shown
itself to be one of the best ways of protecting
money and the number of blips in the market
over these years have been very few and only
severe on those who were so imprudent as
to borrow at a level beyond their means.

For those who wish to protect their
money xxxx offers a wide range
of investment properties.
Yours faithfully
xxxxxx   xxxxxx
Director

There have been a lot of people on various forums expressing surprise about the events unfolding in Iceland. Some are saying that there was no warning.

(I discussed this on another forum back in April)

http://www.pistonheads.co.uk/gassing/topic.asp?h=0&t=518561

People are upset at Martin Lewis on MoneySavingExpert

http://blog.moneysavingexpert.com/2008/04/01/icesave-how-safe-are-your-savings-facts-and-myths/

"Icesave has high interest rate accounts, and is a best buy in certain categories. That makes it an attractive account. The risk of it going bust, doesn’t seem to be very substantively more than any other top savings account bank and this is unlikely to happen (though nothing’s impossible)".

I don't agree with the above. I used to look at the CDS spreads in our flow desk blotters and the Icelandic banks (Glitnir, Kaupthing, Landsbanki) were always in the top 10 highest CDS spreads over the last year or so.

(note that I haven't included the last month's data as it compressed the y axis too much)

Compare this (Landsbanki) with Abbey (part of Santander, so they trade approximately the same CDS levels). Now I'm not sure what rate Abbey were offering at the time, but seeing a CDS spike above 800bps sets alarm bells ringing.

There has been lots of debating as to whether these spreads have been justified - they are illiquid in the CDS market (typically 850/950 bps), so hedge funds were rumoured to be pushing them wide

http://www.efinancialnews.com/assetmanagement/index/content/2450194340

http://www.moneysupermarket.com/community/forums/t/turnaround-in-icelandic-cds-levels-signals-end-of-20926.aspx

I have also read research pieces saying that there were forced protection buyers at the short end of the curve pushing the curve wider.

I am a believer that certain markets (maybe not credit) are reasonably efficient, so while the market may not be right all the time, it would be foolish to ignore them.

The same goes for the betting exchanges (Spreadfair etc) that were showing falls before the general population cottoned on.

Lots of people in the city are getting annoyed with Peston - as one trader to me said, "If I was doing that I would be in serious trouble. He is mentioned on the Guido blog

http://www.order-order.com/2008/10/pesto-wire-causes-more-misery.html

and has a fan club

http://robertpestonmustdie.blogspot.com/

EDIT:

Michael Howard has asked the FSA to investigate

http://www.order-order.com/2008/10/exclusive-michael-howard-complains-to.html

I wonder what the outcome will be (can't be hard to guess)

I was originally going to write something about the Icelandic banks and how the CDS market had been pricing in pain for years, but recent events have overtake me. Instead I will look at what I believe will be property's LTCM. All the ingredients are there, leverage, not just being in the market, but being the market, and the rest of the market knowing what you are up to.

But first, LTCM. There have been several books written about LTCM, When Genius Failed" being a good example

http://www.amazon.co.uk/When-Genius-Failed-Capital-Management/dp/1841155047/ref=sr_1_1?ie=UTF8&s=books&qid=1223365713&sr=8-1

the Wikipedia article is also very good

There are a couple of property investors that I elieve are going to suffer the same fate

• Leverage

"Fergus is cautious about precise figures, but reckons his properties are worth "around £250m" and that the typical loan-to-value is around 65%"

With house prices plummeting, how long with this equity cushion, and therefore funding last?

• They are the market

By concentrating on two and three bed houses in Ashford and Kent, they make up a large percentage of the market

• They have made their intentions known

I'm not sure why they did this (maybe they love the publicity), but by doing this they are letting everyone know that they are selling up, so people will be targetting them with low bids.

The greatest bubble in UK history is now bursting. To me, the fact that the market was a bubble was pretty obvious, but identifying when it was going to go pop, was nigh on impossible (as is the case with all bubbles). I have been blogging on both the UK and US housing market for a couple of years

and it is interesting to go back and see how accurate the betting exchanges such as Spreadfair have been - these were pricing in falls well before an incredulous general public realised what was about to happen.

http://www.noelwatson.com/blog/CategoryView,category,Housing%2Bmarket.aspx

The latest Nationwide numbers came out yesterday showing the (now expected) falls.

http://www.nationwide.co.uk/hpi/historical/Sep_2008.pdf

The thing that interested me was on page three - "Long Term Real House Price Trend". It shows that after the recent falls we have been having, we are almost back to the long term mean, so on first impression this would imply that we haven't got much further to fall. However, this ignores two key points. Firstly, house prices are cyclical, and secondly, I believe the long term trend of 2.9% over RPI has been dragged up by recent rises.

So, how much further have house prices to fall. Up until now I have been reluctant to give predictions, feeling that the betting exchanges (Spreadfair) and property derivative sites were the best way forward

http://www.tfspropertyderivatives.com/pdf/RISK&MANAGE/2008/Sep-08.pdf

but I thought that it would be fun to have a punt and see how it turns out in a couple of years

The most recent graph can be found here (doesn't include Q3, but we can fix this)

http://www.nationwide.co.uk/hpi/downloads/UK_house_prices_adjusted_for_inflation.xls

We can get our Q3 number from the latest report £165,188

http://www.nationwide.co.uk/hpi/historical/Q3_2008.pdf

next we need to decide what is a more accurate real rate of return. For this we can look at the Nationwide archive

http://www.nationwide.co.uk/hpi/archive.htm

and in particular April 2000, as the figure of 1.5% p.a. reflects (in my opinion) a more accurate reflection of growth, as it occurs soon after a big fall preceded by an equally big rise

Comparing the two graphs, it is interesting to see the trend line for Q1 2000 is around £25k lower than for Q2 2008.

We can easily extend the current 2.9% trend into the future (each cell in column D is 1.007 larger than the one above - 2.84pa - this doesn't include the Q3 numbers to make it 2.9%, but it is close enough)

Next we add our own 1.5% trend. For this, we add multiply each cell in column E by 1.00375 multiplied by the cell above. Note that our starting figure for the 1975 Q1 1.5% trendline is not the same as that for the 2.9% trendline - we need to adjust for the fact that the data series started before 1975. Note how our modified trendline now crosses at around £75000 for Q1 2000, as it did with the April 2000 report

Next is the tricky part. We have to discount our house prices for inflation. The calculations are shown in the spreadsheet. I am assuming an inflation rate of 1.2% a quarter which gives 4.7% per year.

To attempt an accurare looking graph, I have included two variables, initial quarterly fall and decrease on the quarterly fall per quarter. I have estimated these at 10500 and 700 respectivelly.

So, what is the fall from peak to trough. The peak was round £185k, the low on my graph is £83k (2013 Q1) - so we are looking at falls of around 55% - so around 45% to go (from peak).

This may seem like an extreme few, and I may have made a fundamental error in my calculations. However, in the latest nationwide report, it states

“House prices now are over 60% higher in real terms than they were at the start of the decade, even taking into
account the falls since last October"

So if we are around 165k now, this would take us down to 100k. As I said earlier, these things tend to undershoot, so maybe 83k doesn't look so unrealistic.

Spreadsheet attached:

Nationwide2008Q2.xls (121.5 KB)

EDIT: There are still some areas of concern

1. Trend line start dates differ

2. Real house prices are discounted from the present time - therefore they are not comparable for different time periods

Attempt 2:

Changes

1. Trendline starts at same point

2. Monthly trend increased to 1.005 (2% pa)

3. Starting quarterly fall 10000

4. Quarterly decrease 800

We now have a bottom of £97588 in 2011 Q4

Note that this is effectively a hack of a hack, but it is best guess so far.

Spreadsheet attached:

http://www.creditfixings.com/information/affiliations/fixings/auctions/current.html

Tembec - 2nd October 2008

Fannie Mae Senior - 6th October 2008

Fannie Mae Subordinated - 6th October 2008

Freddie Mac Senior - 6th October 2008

Freddie Mac Subordinated - 6th October 2008

Lehman Brothers - 10th October 2008 (TBC)

Peston is saying the HBOS deal will go through

http://www.bbc.co.uk/blogs/thereporters/robertpeston/2008/10/insane_markets_and_hbos.html

The credit markets show

LLOY 185/200

HBOS 315/345

Which will be right?