The Bank for International Settlements Annual Report is well worth dipping into. It provides another detailed analysis of the factors and events behind the unraveling of financial markets following the subprime meltdown, which all seems so obvious in hindsight.
In addition to a generally gloomy outlook for the world economy, it provides a thorough critique of the “originate-to- distribute” model, which began with mortgage-backed securities and led to specialized investment vehicles and other esoteric and poorly understood derivate instruments.
The report does not lay blame on any one party but rather stresses the interdependence of all involved:
“A general lesson derived from the financial turmoil is the close interdependence of markets and institutions in the functioning and resilience of the financial system. The OTD model of financial intermediation is based on the premise that risk is ultimately shifted to the investors through market transactions. However, as the events during the period under reviewdemonstrated, it is the capital of financial institutions that in the end underpins the stability of all these transactions.”
“From a policy point of view, this interdependence between financial institutions and markets argues in favour of strengthening the macroprudential elements in the design of the framework and the calibration of its instruments.”
The shortcomings of the originate-to-distribute model can be attributed mainly to the failure of individual players to develop a holistic view on the risks due to excessive focus on their narrow, individual perspective, losing sight of systemwide drivers of risk and interdependencies.
“Policy that has a similarly narrow focus can also fail to take ex ante preventive action as the risks of disruptiveinteractions build up, ” the BIS says. ” At the same time, the management of the period of stress has already shown that, to be effective, policy responses may entail interventions aimed at easing the strain in the markets while at the same time helping institutions to cope with distress.”
In his latest Chairman’s Corner letter, Audit Integrity Chairman Jim Kaplan elaborates on his recent report on credit default swaps.
In that report, posted on Research Recap on June 18, Kaplan argued that credit default swaps are adding risk to financial markets, rather than mitigating it as they are designed to do.
Kaplan says “the article’s intent was to focus on the largest capitalized companies that had (have) substantial exposure to the CDS market.” This focus was entirely independent of the company’s AGR® rating, which Audit Integrity uses to measure corporate governance. “However, it is interesting to note that the majority of the big-cap companies that have CDS exposure are rated Very Aggressive by our rating model. I doubt this is merely a coincidence; rather, it is an indication that many of these companies are taking substantial — and often, undisclosed – risk. Of course, not all the companies listed are using CDS in a speculative manner; unfortunately, the lack of detailed disclosure of their positions does not allow me to make that judgment.”
Kaplan notes the Audit Integrity rating is based on forensic analysis of data that is gleaned from multiple governance and accounting metrics. “Exposure to derivatives, including CDS, is not one of the specific metrics utilized, but their exposure is captured in part in the Interest Expense and Interest Income metrics used in the AGR analysis.”
Kaplan is particurly concerned about the potential “time-bomb” of litigation as the losses of financial institutions mount. “When you include Hedge funds, you can double the time-bomb factor, as they account for over 50% of the trading in CDS” and are not required to report financial positions. “Large Hedge funds, including D.E. Shaw and Citadel, are major players. Stakeholders in these particular funds, as well as many other funds, are most likely unaware they are bearing unusual levels of risk.”
A meltdown, which I fully expect, will not only implicate the sellers of CDS but also the buyers.
In recent litigation against UBS (NYSE: UBS) and Wachovia (NTSE: WB), VCG Special Opportunities Fund has sued both companies claiming breach of contract and unjust enrichment.
“The interesting part of both suits is not the claim itself, but the fact that both UBS and Wachovia, two very sophisticated financial companies, purchased insurance from a pocket portfolio very thinly capitalized in the Channel Islands. I can reach only two possible conclusions: (1) these big, sophisticated financial companies don’t know what they are doing, or (2) they were unable to purchase insurance for the low-quality debt they wanted to insure, and were forced to turn to a third-tier provider.”
“If the latter is true, UBS and Wachovia purchased the insurance not to protect their debt, but to eliminate the need to mark the debt to market – thereby masking a serious problem. In either case, the stakeholders are the last to know, unless they demand transparency.”
Major integrated oil companies should continue to perform strongly even if oil prices drop back from current record highs, according to a new industry analysis from Moody’s. However, the majors still face formidable long term challenges.
Moody’s outlook for the global integrated oil industry is stable, reflecting prospects that companies will continue to generate strong free cash flow and maintain relatively modest financial leverage, even if oil and natural gas prices retreat from recent high trading ranges.
These positive factors support the industry’s almost uniquely strong financial profile, but they are tempered by formidable reserves replacement, production growth, cost structure and political risk challenges, Moody’s says.
The report covers ExxonMobil (NYSE: XOM), BP (NYSE: BP), Chevron (NYSE: CVX), Royal Dutch Shell (NYSE: RDS.A), TOTAL (NYSE: TOT), ENI (NYSE: E), StatoilHydro (NYSE: STO), BG Energy, Marathon Oil (NYSE: USX) and Repsol (NYSE: REP).
Price increases have outstripped rising costs, supporting a period of expanding unit cash margins and markedly higher cash returns for the majors, Moody’s says. Between 2004 and 2006, revenues increased on average by 60% and generally at a higher relative rate than full cycle costs. Unit cash margins per BOE were up significantly, almost doubling over the four years, and averaging above $27/BOE in 2006, with the greatest relative margin expansion exhibited by Royal Dutch Shell, ExxonMobil and ENI.
In contrast to the expanding cash margins, the leveraged full cycle ratio has not increased consistently for any company except ExxonMobil and Royal Dutch Shell (the latter from less than 1X in 2004). The full cycle ratio is a cash return measure that indicates the amount of cash generated by a company for each dollar invested
over the cycle.
Oxford Analytica analyzes the risks associated with credit default swaps in a new report and warns that counterparty risks could worsen or spread to other markets, such as energy derivatives.
Participants in modern derivatives markets may not have devoted sufficient time, resources and systematic thought to the subtleties of the theory of counterparty credit risk, OxAn says
“The concept of ‘wrong-way risk’ is as old as the modern derivatives market. Yet in part because its systemic effects are relatively difficult to model, the threat it poses in particular derivatives transactions — and to the financial system more generally — is often overlooked.”
Over the past year, wrong-way risk has chiefly been a problem on credit derivatives markets. However, it could easily worsen, or spread to other markets — such as energy derivatives.
This variety of counterparty risk can be effectively priced and modelled, but this is very time consuming, expensive and often does not fit well with other forms of mathematical risk modelling, OxAn says. The risks associated with wrong-way risk have not been dealt with effectively, and are increasing.
Moreover, the most pernicious type of counterparty risk — the danger that counterparty transaction risk might increase for all counterparties, simultaneously — has become systemic. This threat, known as ‘wrong-way risk’, has become a chronic problem in the developed world.
This situation represents both a failure of risk management modelling and a failure of imagination.
The trouble with credit derivative hedges emerged due to the parlous financial health of some derivative dealers and the monoline insurers that, in effect, act as credit insurers. Dealers and banks are facing the unsettling thought that the credit default swap (CDS) hedges that they had entered into with monolines to help manage risk on their structured credit origination activities will become worthless if these troubled counterparties themselves lurch into bankruptcy.
OxAn says the key to quantifying wrong-way risk is to model correlation between contract values (across a portfolio of derivatives) and counterparty credit quality. The most common generic theoretical approaches include :
- simulation of counterparty default and exposure jointly;
- simulation of exposure conditional on counterparty default; and
- adjusting the expectation of (unconditional) exposure in order to approximate the risk expectation conditional on default.
Significantly, when wrong-way risk is modelled, it is often done via the last approach, due to the fact that it is less computationally expensive and time consuming, and it generates measures of exposure that risk managers find easier to incorporate into their overall risk management framework. However, given the gravity of the crisis, this approach may have been insufficient, OxAn says.
More details are available in the full report, Wrong-way risk’ could exact heavy toll.
Guest Post by Fred Wilson, Union Square Ventures.
This morning I was reading a CIBC research report called Heading for the Exit Lane and I’ve been thinking about it for most of the day.
This oil thing sure has legs. Even if we aren’t in a “peak oil” situation (and even the Saudis can’t agree about that), we’ve gotten to a price point where consumer behavior is going to change significantly over the next few years. Over the long term, that’s a good thing. The world economy is addicted to oil, largely because it’s been so cheap for so long. But it’s not cheap anymore and given the pace at which the rest of the world is developing these days, it’s not going to be cheap ever again. Unless we find another source of energy that is a lot cheaper than oil and I am not aware of any developments that will get us there soon.
This has bigtime ramifications for slowing growth and rising prices (inflation). And these impacts will not be limited to the US economy. They will be felt worldwide. The hypergrowth economies of China, India, Brazil, Russia, and other developing economies may not be impacted as much as the more mature economies like Japan, Europe, and most of all the US. Russia, in particular, stands to benefit greatly from the spike in oil prices.
Slower growth and rising prices (inflation) cannot be good for equities. Rising rates, which is what will have to come, will not be good for any kind of financial assets.
Which, of course, leads me to venture capital. The value of your equity in a startup company is a financial asset. It may not be publicly traded but like all other financial assets it is ultimately worth the present value of future cash flows discounted at an interest rate that takes into account market rates of interest plus a risk premium.
We’ve been operating in a world where real interest rates have been hovering around zero (at least in the US). And that has propped up the value of equities and venture capital assets have been part of that prop-up.
All we have to do is look at the 70s to see the effect of low growth and high inflation (stagflation). Here is a chart of the Dow Jones Industrial Average during the 1970s.
Yes, that’s right, the Dow Jones Industrial Average ended the 1970s right about where it started.
I wasn’t in the venture capital business in the 1970s. I was a teenager that decade. I remember Vietnam, Watergate, the oil shocks, the gas lines, Gerald Ford, whip inflation now, Jimmy Carter, the Iran hostage crisis, and Paul Volcker and Ronald Reagan.
The first venture capital firm I worked for, Euclid Partners, was formed in 1971. The two founding partners, Milton and Bliss, raised about $4.5mm in 1971. They didn’t raise another fund until 1983. They strugggled mightily during the 1970s with their portfolio and ultimately made it work when the technology market took off in the early 80s. I heard a bunch of stories from them about that time and it was not an easy time to be an entrepreneur or a VC.
Surely the next 10 years won’t be identical to the 1970s. A lot has changed, particularly the global economic environment. But it’s also clear that the economy we are in (and maybe have been in for the past 18 months) is going to be tougher for owners of financial assets than the past 20 years have been. And I don’t think the startup economy and venture capital is immune to this new reality.
So what should we do about it? Well first, we need to be careful with valuations. If financial assets are going to be subject to downward pressure then inflated valuations will not be sustainable. We need to be careful with the amount of money we invest and burn. Companies that are capital efficient and cash flow positive will fare better in this environment. And we need to be prepared to wait a long time for liquidity.
It’s ironic that the title of the CIBC report is “Heading For The Exit Lane” because I think the exit lane will take longer to find and possibly be less rewarding in the coming years.
A Final Thought: This may mostly be good news for cleantech investors. As oil gets more expensive, cleantech and alt energy technologies can become commercially viable more quickly. But it takes a lot of money, biotech-like capital investments, to get most cleantech investments to profitability. So if the capital markets are going to be more difficult, it’s not all good news for cleantech. And the web clearly has a role to play in all of this too. More on that later.
A lot of people must be sticking pins in their Goldman Sachs voodoo dolls these days.
First, Goldman was responsible for the $200 Oil Price Spike forecast that helped fuel the oil price runup. Then Goldman analysts put the boot in on General Motors and Citigroup with “sell” recommendations, helping send the market into a tailspin late this week.
The fact that Goldman has so far survived the financial turmoil far better than the (below) average Bear, just rubs salt into the wounds of its Wall Street competitiors.
Speaking of oil, it’s hard to know exactly what to make of the Energy Information Agency’s annual Energy Outlook in the context of current oil prices. The EIA projects an increase of over 50% in world energy consumption by 2030, but this scenario was based on last summer’s energy prices. The EIA also projects that “in nominal terms, world oil prices in the IEO2008 reference case decline from current high levels to around $70 per barrel in 2015, then rise steadily to $113 per barrel in 2030.” That looks like a pretty attractive scenario these days.
If we can afford the utilities bills, by that time we’ll be spending much of our waking hours watching video, judging from Research Recap’s most popular post this week. Forrester Research outlines a world in which every surface -including the bottom of our cereal bowls- becomes a video outlet for beaming video signals into our receptive brains.
Back to the present, Standard & Poor’s analysis that the CMBX Index has contributed to capital drying up in the commercial real estate market was popular, as was the older multi-source post arguing that credit default swaps may be contributing to financial risk, rather than mitigating it as it is supposed to do.
Research Recap Quote of the Week:
Marketers no longer dismiss blogs as irrelevant ramblings of pajama-clad geeks. -Forrester Research analyst Peter Kim.
A new analysis from Fitch Ratings finds that increased disclosures under “fair value” accounting standards are helpful, but more extensive disclosure is needed for a fuller understanding of the true worth of today’s complex financial instruments.
In particular Fitch advocates greater transparency around banks’ Level 2 assets and liabilities, which are moderately difficult to accurately price. “Most of the financial assets and liabilities reported at fair value for the banking groups reviewed fall into Level 2. Given this, along with the range of measurements that fall into Level 2, Fitch would like to see more information about Level 2 measurements.”
It would be particularly informative for users of the accounts to have the most reliable and least reliable Level 2 measurements reported separately, potentially introducing Level 2A and 2B categories.
Fitch’s analysis was based upon a review of 2007 annual reports and 10-Ks of the world’s largest banking groups. In particular, Fitch reviewed notes to the financial statements and critical accounting policies relevant to fair value measurements.
The report highlights specific disclosures that Fitch considers helpful to credit analysis in evaluating fair value measurements, and identifies areas where more extensive disclosure would assist the reader in understanding the results.
‘The new fair value disclosures are obvious improvements compared to prior disclosures but do not go far enough – Olu Sonola, Director, Fitch Ratings Credit Policy Group. ‘Investors and analysts need better and more extensive disclosure around fair value measurements.’
The tabular format required by Statement of Accounting Standards (SFAS) 157, distinguishing between level 1, 2 and 3 valuations, is clear and easy for readers to understand. This disclosure format is not yet required under International Financial Reporting Standards (IFRS), but Fitch found it encouraging that most of the IFRS reports reviewed used the format anyway.
Fitch notes, however, that information about fair value measurement in IFRS reports outside the group of institutions it reviewed is limited. The SFAS 157 tabular format would be a helpful way to disclose information for any company with a high proportion of assets/liabilities at fair value.
The full report, titled Fair Value Disclosures: A Reality Check, includes detailed analysis of disclosures by Merrill Lynch, Royal Bank of Scotalnd Group, BNP Paribas, Credit Suisse, HSBC Holdings, Goldman Sachs, JP Morgan Chase, Cititgroup and Barclays.
Audit Integrity identifies potential losers and winners in a transportation industry suffering the impact of record high oil prices in a new report.
Individual sectors have varying levels of cost absorption and pass through structure, resulting in differing levels of cost offset and impact to profitability, the report says.
Audit Integrity looks at companies through the lens of how they rank in corporate governance, using its Accounting and Governance Risk (AGR) and AGR Equity Factor rankings.
One airline in the bottom-ranked Very Aggressive AGR category is Delta Air Lines (NYSE: DAL) . Its stock is downn 73% from a year ago.
Rising oil prices also affect the shipping lines, and have made transportation costs significantly more expensive, especially for products with a high freight cost-to-value ratio.
Among shipping companies Genco Shipping & Trading (NYSE: GNK) has a low Very Aggressive AGR ranking, while Brazilian shipper Ultrapetrol (Bahamas) Limited (NASD: ULTR) is in the top-ranked Conservative AGR category.
Railroads are also dependent on deiesel but are relatively more efficient than trucking companies, so stand to benefit from increasing demand. Burlington Norther Santa Fe (NYSE: BNI) is in Audit Integrity’s top ranked category and also benefits from being the second-largest railroad operator in the US with the advantage of a substantial amount of railroad tracks.
The report, available here, details the 11 transportation companies with Audit Integrity’s highest AGR rankings and the 11 with the lowest.
Capgemeni and Merrill Lynch’s new World Wealth Report finds that green investment activity among High Net Worth Individuals (HNWI) grew substantially in 2007. “In much greater size and proportion than in recent years, investors have been supporting innovative research and development initiatives in search of alternative fuels, renewable energy and other advanced technologies.”
Wind and solar were particularly strong sectors. “In fact, in the three years ending November 2007, gains in the wind segment exceeded 300%, while solar posted the highest growth in 2007, roughly 150%.” Additionally, the solar energy sector saw the greatest IPO activity in any green sector.
By the end of the year, however, the green energy sector was, like virtually every other part of the economy, “burdened by poor overall market conditions.”
Noting that, “Governments across the globe have played an active role in stimulating the growth of green initiatives, paving the way for lucrative market opportunities,” the report concludes that future investment opportunities will likely grow at a rapid pace.
Forrester Research highlights the growing importance of bloggers in influencing consumer behavior in a new report advising businesses on How to Connect With Bloggers.
Forrester analyst Peter Kim notes that “Marketers no longer dismiss blogs as irrelevant ramblings of pajama-clad geeks. Brands such as OﬃceMax and Unilever’s Dove have experienced business lift generated by online chatter.1 On the opposite end of the spectrum, some brands, including Dell and Wal-Mart, have felt the sting of negative blog sentiment.”
Kim says marketers need to formulate a strategy to connect with bloggers because:
- Consumers trust individual opinions over mass advertising.
- Bloggers talk more than their peers about products and purchases.
- Bloggers — especially youth — have money to burn.
Brands desiring to build relationships with bloggers must create personal connections through interpersonal communications — the exact opposite of “one size ﬁts all” mass media techniques used to build brands for the past two centuries, Kim says.
Making personal connections requires that marketers understand blogger motivations, which can lead to successful participation in a digital dialogue.
Kim recommends marketers who intend to connect with bloggers must implement tactical guidelines to guide their outreach strategy.
These “rules of blogger engagement” will help individuals know how to represent their brand transparently and accurately, he says. “The rules should be accompanied by plenty of examples to illustrate the practices in action.” A good blogger outreach policy should answer the following key questions about engagement:
- Who is permitted to “oﬃcially” represent our brand?
- What if bloggers don’t want to hear from me?
- How do I deal with conﬂict?