Stat Arbitrageurs: Merchants of Volatility

Neil OHara

Statistical arbitrageurs have demonstrated the ability to make money during tough times. “Stat arb tries to remove market risk to a degree that you really don’t see in any other strategy,” says Alain Sunier, portfolio manager of Highbridge Capital.

Like many hedge fund firms, Highbridge Capital Management had an absolutely miserable year in 2008. Its flagship Highbridge Capital Corp. multistrategy fund, which previously had experienced only one down year since Highbridge co-founders Glenn Dubin and Henry Swieca launched it in 1992, fell by more than 27 percent. Its convertible arbitrage portfolios, long a strength of the New York–based multistrategy powerhouse, did even worse, dropping about 45 percent. Between the losses and investor redemptions, the firm saw its hedge fund assets under management plummet from $27.8 billion at the start of 2008 to $17.3 billion when this year began. 

Highbridge, which is majority-owned by banking giant JPMorgan Chase & Co., had one bright spot, however. Its statistical arbitrage hedge fund was up more than 22 percent in 2008, taking advantage of some of the same forces that sent its other funds tumbling. As Highbridge portfolio manager Alain Sunier explains, statistical arbitrage funds profited last year from equity price distortions caused by sudden drops in liquidity and the spikes in volatility that typically accompany them. 

“Stat arbs take the other side of a move,” Sunier says. “We provide liquidity. If it’s a good time to do that, we earn an economic rent as prices return to normal.” 

In a world as desperate for liquidity as most equity markets were in 2008, rents soared for anyone willing to supply it — stat arbs included. And with no sign that equity markets will settle down anytime soon, stat arb funds look poised to enjoy success through 2009 and perhaps beyond. 

Statistical arbitrageurs employ a quantitative rapid-fire trading technique that relies on computer models to detect anomalous price movements among equity securities that normally trade in tandem. Although stat arbs as a group didn’t come close to matching Highbridge’s performance — Morningstar’s statistical arbitrage index fell 6.21 percent in 2008 — they did well in a year when the Morningstar 1000 hedge fund index dropped 22.41 percent and the Standard & Poor’s 500 index declined by 38.5 percent. And though most hedge fund managers suffered their worst losses in the fourth quarter, stat arbs managed to deliver positive returns as the year came to a close: The Morningstar statistical arbitrage index was up 1.44 percent in the final three months of 2008, compared with a 10.62 percent loss for the broader Morningstar 1000. 

It’s a dramatic turnaround for a strategy that had been all but left for dead after the summer of 2007. During the first two weeks of August that year, statistical arbitrageurs — including major players like AQR Capital Management, D.E. Shaw & Co., Goldman Sachs Asset Management and Renaissance Technologies Corp. — suffered huge losses. Goldman’s once–$5 billion Global Equity Opportunities Fund, for example, was down 30 percent; the then–$1.7 billion Highbridge Statistical Opportunities Fund fell 18 percent. For managers like Goldman and Highbridge that were able to hold on, performance snapped back later that month, but those that were forced to liquidate missed the rebound. In retrospect the crippling losses were more the result of margin calls that originated in the credit markets than of any flaw in statistical arbitrage theory, according to Andrew Lo, a finance professor at the MIT Sloan School of Management. 

“There was some kind of unwinding, most likely due to a multistrategy fund that needed to raise cash to meet margin calls for other investments,” says Lo. 

Investors nonetheless were spooked and took flight. Judith Posnikoff, a managing director and co-founder of Pacific Alternative Asset Management Co., an Irvine, California–based firm that manages about $9 billion in funds of hedge funds, estimates that between one third and one half of the hedge fund capital dedicated to statistical arbitrage had fled the strategy by early last year. At the same time, proprietary trading desks at many of the big investment banks also got out of the game. The exodus set the stage for a rebound in 2008. Lo points out that stat arbs tend to be long volatility, which shot up to record levels in the fourth quarter of 2008. 

“Spreads widened, volatility increased, and as a result, the profitability of these strategies grew,” says Lo, who is also founder, chairman and chief scientific officer of Cambridge, Massachusetts–based AlphaSimplex Group, a $700 million quantitative hedge fund manager. “Those were ideal conditions for stat arb.” 

Stastical arbitrageurs behave like quasi–market makers — buying stock at the bid price or selling it at the offer, but not doing both at the same time. True market makers, of course, have an obligation to do both. That makes them vulnerable when stocks are moving quickly; they can end up short in a rising market or long in a falling market. To compensate for that risk — known as being “short gamma” in traders’ lingo — market makers widen bid-offer spreads in volatile markets. Although stat arbs are not required to make a two-way price, they still benefit from the wider spreads. 

“The strategy makes money by providing structured liquidity to the market,” explains Paul Simpson, who co-manages two statistical arbitrage funds for Old Mutual Asset Managers in London. “As volatility increases, so does the opportunity to profit from more extreme price action.” 

Managers credit their fancy computer models rather than market structure as the source of their alpha. Every stat arb fund has a different model — often more than one — but Simpson says the models typically track the relationship between either stocks that normally move in the same direction at the same time (correlation) or stocks that don’t always move in the same direction but fluctuate over time around an observable constant such as a dollar spread or a price ratio (co-integration). 

Simpson knows whereof he speaks. After starting his career in the late 1980s in risk management, he worked as a proprietary trader doing equity arbitrage at several major securities houses, including Deutsche Bank and UBS. He eventually ended up at hedge fund Millennium Capital Management in London, where he and colleague John Dow jointly managed the statistical arbitrage program. In January 2006, Old Mutual hired Simpson and Dow, who together run about $320 million in two statistical arbitrage funds using models they built about seven years ago and continue to refine. Their flagship fund returned 18 percent in 2008. 

Like almost all stat arb funds, the Old Mutual portfolio is market-neutral — meaning its returns owe nothing to movements of the market as a whole. Although some stat arbs may use fundamental information about equities, such as price-earnings ratios, in their models, most — including Simpson and Dow — do not. 

“Our model is entirely driven by relative price evolution,” Simpson notes. “Mean reversion is a well-observed phenomenon in equity markets that exists at every time interval from a few minutes out to several years.” Simpson and Dow’s flagship fund trades large liquid equities on a global basis; the average holding period for each position is typically measured in days, not weeks. 

Old Mutual’s average holding period, in fact, is shorter than that of many stat arbs (Paamco’s Posnikoff estimates the industry average to be two to three weeks). But even a week is practically an eternity for Marek Fludzinski, whose New York–based Thales Fund Management turns over 10 to 40 percent of its $1.2 billion portfolio every day. Flud­zinski, who has a Ph.D. in theoretical physics from Prince ton University, applies mathematical principles to extract tiny distortions from mountains of data and thereby predict market market moves that may last for a few hours at most. 

He has been doing statistical arbitrage since the early 1990s, first at D.E. Shaw and then at Swiss Bank Corp. In 1994 he started Thales Financial Group with seed money from Paloma Partners Management Co., the now–$2 billion Greenwich, Connecticut–based investment firm founded by Donald Sussman. In January 1999, Fludzinski launched the Thales Fund, which had a largely successful run until it hit the skids in August 2007. Thales finished that year down 8 percent and suffered significant withdrawals as a result. Instead of soldiering on with a model that was no longer delivering the goods (it looked for trends that would play out over three to ten days), Fludzinski elected to return investors’ money. He launched a new fund last May using what he says iss an improved model. He shortened the average duration of the trends he looks for and built in an optimization routine that chooses the best time scale for each trade. 

Thales wasn’t the only shop to experience redemptions after the 2007 carnage. In fact, even managers who did well suffered withdrawals, not only at the end of 2007 but all through 2008. Paamco’s Posnikoff says stat arbs offer investors better liquidity than most hedge fund strategies do — they can’t justify long lockups for portfolios that turn over every week or two — so investors who needed cash dipped into stat arb funds as if they were ATMs. 

The credit crunch exacerbated the pressure on stat arb managers, as those who stayed in the game had to cut back their leverage too. Before August 2007 it was not unusual for statistical arbitrage funds to use as much as eight times leverage, says MIT’s Lo. “Nowadays leverage has come down dramatically,” he notes. “You would be hard pressed to find a stat arb manager getting more than five to six times leverage, and the typical leverage being used is probably three to four times.” 

Highbridge’s Sunier says that as a result stat arb was better placed than many other strategies to weather the market storms in 2008. “The supply-demand balance has been quite favorable for the short-term forecasts that lie at the heart of stat arb profitability,” he explains. “I do feel that those conditions will remain with us for some time.” 

Sunier is not alone. Posnikoff projects that the CBOE volatility index, or VIX, a key measure of the U.S. equity market’s expected near-term volatility as expressed by the prices of S&P 500 index options, will remain high through the end of this year, trading between 40 and 60. To protect against the eventual decline in volatility, she favors high-frequency statistical arbitrage funds that turn over their portfolios every two or three days. “The short time frame adapts to changes in volatility more quickly,” Posnikoff explains. She expects these funds to thrive even when the markets calm down and volatility recedes to a more normal range — a VIX of 20 to 35. Her biggest challenge is to find capacity; managers who trade like whirling dervishes can handle only a limited amount of assets. 

Fludzinski, for his part, intends to cap Thales’s gross assets — its longs plus its shorts — at about $2.5 billion. He is almost halfway there, having raised some $300 million in capital for the new fund, which has a leverage target of four to one. “The limitation is liquidity, the need to trade in and out of stocks quickly,” says Fludzinski, whose fund was up about 13 percent last year in just eight months of operation. Thales’s positions tend to be in large- and midcap stocks that can accommodate the frenetic pace of trading. 

Although high volatility usually boosts returns for stat arbs, too much of a good thing can be harmful. In extreme market conditions indiscriminate forced selling overwhelms normal trading relationships and the models stat arbs use don’t work. Jaeson Dubrovay, senior consultant for hedge funds at Cambridge, Massachusetts–based investment consulting firm NEPC, sees the sweet spot for stat arbs in a VIX range of 20 to 40. “Below 20 nothing is moving, and above 40 everything is moving either up or down together,” he says. “Stat arbs need dispersion, where the best stocks outperform the worst stocks.” Dubrovay expects volatility to slide toward that sweet spot later this year and foresees an increase in dispersion too. Not surprisingly, he favors an allocation to statistical arbitrage at the moment as part of a diversified portfolio for clients who invest in hedge funds. 

At a time when investor confidence is low, liquidity is scarce and market volatility remains high — albeit lower than the record levels seen last fall — stat arbs are likely to enjoy a benign environment for some time to come. But in theory, statistical arbitrage is a strategy for all seasons because it depends on short-term relative price movements, not the intrinsic value of securities. The returns it generates are particularly attractive on a risk-adjusted basis even when market conditions are not so favorable. 

“Stat arb tries to remove market risk to a degree that you really don’t see in any other strategy,” says Highbridge’s Sunier.

Aud... The only one that i like for the time being

A recently released report from Goldman is making the rounds and is amping up the buying temperature for a perennial institutional favorite, the carry trade. Even Bloomberg has picked up the story and is running with the theme. They specifically call out two ZH favorites, the BRL and the AUD - however we think this move is really too early/too late, depending on how you look at it. 

As seen below, the BRL would have been a great buy right after our last post on it. However, we now expect a major turn around after the current market situation "resolves" itself and investors return to their bunkers. As we have posted extensively on the reasons why we see the market correcting in the near term, we won't rehash the details but suffice to say that you don't want to be caught short on the unwind. If not a direct directional bet, going long vol on the BRL in particular and EM baskets in general seems the smartest play in currency right now. Additionally, look for unrelated casualties (GBP) as the US equity correlation across some of the majors brings down some of the recent gainers.

1. AUDJPY - Will post a bearish key day from the 200-dma with a close below 72.08 today

 

- This would be the first such pattern since the market based at 55.51 on 2nd February

- This comes as the market hits the 200-dma at 73.26 (today's high 73.47)

- This doesn't mean the market has to collapse or start a sustained downtrend

- But, a correction to the 21-dma at 69.13 as happened on 30th March is very possible

 

Chart Source: Aspen Graphics     Data Source: Reuters

 

 

2. AUDJPY 1-month 25-delta Risk Reversals - Short-dated risk reversals appear an attractive way to hedge an underlying long position

 

- The chart below shows AUDJPY 1-month 25-delta risk reversals back to 2004

- The market has now moved back to pre-crisis levels not seen since July '07

- With this in mind, using short-dated risk-reversals as an overlay on an underlying long-cash position looks attractive (short-dated protection and just a natural T/P if the trend does continue)

- It's also a reminder of how much sentiment has swung since the extremes back in late-'08/early-'09

 

Chart Source: Bloomberg      Data Source: Bloomberg 

 

 

3. AUDCAD - Also looking tired on the daily charts

 

- Given USDCAD has only just broken down from it's recent consolidation, CAD looks less susceptible to a positional clearout than AUD

- AUDCAD spot has just hit and held the prior high from 2nd April at 0.8933, it's also hit the trend across the last two notable highs from October and January

- It will post a bearish key day with a close below 0.8822

- The daily momentum setup is very poor, with extremely clear negative momentum divergence developing

- ST double top targets 0.8516

 

Chart Source: Aspen Graphics     Data Source: Reuters

 

 

4. AUDCAD 1-month Vol - Towards the base of the range

 

- 1-month implied AUDCAD vol has also corrected back to near pre-crisis levels

- Downside on AUDCAD should be an attractive way to hedge a long-risk portfolio

- If you do believe there is risk of a pull back in recent trends it also looks an attractive way to position

 

Chart Source: Bloomberg      Data Source: Bloomberg 

Time to wise up from FT

By John Authers

This has not been a good year for conventional wisdom.

Of course, “conventional wisdom” is rarely cited as anything other than a whipping boy – something we can expect to be wrong. But markets might be considered to be different, because conventional wisdom can be self-fulfilling. If everyone believes a stock is worth $20, then it will trade for $20.

But some of the smartest investment ideas offered to the wealthy have begun to look very bad indeed of late.

It is now almost a year since a cataclysmic week for quantitative funds heralded the beginning of the credit crisis. The quant funds made their money with a highly sophisticated “market-neutral” strategy, in which they bet on equal numbers of stocks to go up and down, exploiting subtle differences in their valuations. They found that many had made the same bets. As soon as a few fund managers started getting out of the market, suddenly all of them suffered huge losses. This had been hailed as a “low-risk” strategy uncorrelated to the markets, but some of the most prestigious funds in finance saw one-third of their value wiped out in a week.

Another bright new orthodoxy was: “commodities are good for you”. Academic studies demonstrated that investing in commodities via futures as part of a broader portfolio could give you the investor's holy grail – higher returns for no greater risk. Investment banks put together commodity indices, based on futures, providing products for private bankers to sell to their clients.

The problem is that many now claim that the money this attracted into commodities helped push up prices artificially. There have even been hearings in Congress over the claims. Debate rages over that topic but the experience of the past few weeks, with almost all commodity indices now down more than 20 per cent from their highs, has been unpleasant.

More apparent wisdom, offered to high net worth investors, was that macro hedge funds, which make big international bets on asset allocation, were the way to conserve wealth. There have certainly been trends to exploit in the financial upheaval since last summer. For many months, betting on commodities, while betting against the US dollar and the stock of US banks, was a great way to keep your head above water.

But in the middle of the market panic of mid-July, both sides of the trade suddenly went into reverse. Hedge funds that had funded investments in oil futures by selling short on bank shares were caught in a vicious squeeze, as this strategy lost more than 40 per cent in a matter of weeks.

A spoof “Dear Investor” letter from a macro hedge fund manager to his clients is currently doing the rounds on the internet. It captures nicely enough what went on. “We have no explanation, since our trades are systematically based upon doing what others are doing (only, hopefully, faster ... though, in this instance, not fast enough). Nor do we offer you apologies. You [presumably] knew the risks, and felt the glory (if only for a while).”

Again, a strategy widely offered to wealthy investors to enable them to make money during the carnage had come a cropper.

It is popular to blame complicated investments such as this for the market's problems. Excessive use of leverage, derivatives or short-selling have all helped amplify market chaos in the past year. It is supposedly good for the rich that they can take advantage of such strategies, but that is beginning to look questionable.

And conventional wisdom seems to be taking a new beating on another front. For years, that wisdom has held that for most people, index funds make sense. Passive investing keeps costs low, and avoids wasting money on trying to do what most active managers seem to find impossible – beating the market consistently.

Yet there is a problem: index funds are dumb. They cannot be contrarian. Once a trend gets going, they have no choice but to follow it, thus making that trend even stronger. Index funds arose, logically, out of the theory of efficient markets. Put very crudely, markets are efficient, so it is impossible to beat them and you should just join them. But the very existence of index funds helps make markets more inefficient and more prone to bubbles.

Experience, and not just logic, backs this argument. Indexation began to become an orthodoxy for retail investors and for big institutions about a decade ago. And in that decade, markets have grown ever more prone to bubbles – from the tech bubble to housing stocks, to China.

The logic of indexing has not gone away. It makes more sense to pay a small fee for an index return than to pay much more to an active manager who will be lucky to do even that well.

But the conventional wisdom is starting to shift against indexing. And while it is still fashionable to blame the esoteric investments of the rich, there is a good argument that index funds, the investment of the masses, have also exacerbated the world's financial problems.

Why I wanna keep my Short in Eur/Usd

Europe On the RopesThe Absolute Return Letter March 2009
"Many of today's policy proposals start from the view that "greed" and "incompetence" and "poor risk assessment" are the ultimate source of what went wrong. In fact, they were not the true cause at all. Moreover, even if they had been, it is fatuous to think that we will now create a post-crash generation of bankers and traders who are not greedy, much less a new generation of quants who will be able to assess and manage risks much better than "the idiots" who have brought us to the current abyss. Greed cannot be exorcised. Nor can the inherent inability of any quants to determine the "true" probability distributions of all-important events whose true probabilities of occurrence can never be assessed in the first place."
Woody Brock, SED Profile, December 2008
Policy mistakes 'en masse'
The last few weeks have had a profound effect on my view of politicians (as if it wasn't already dented). All this talk about capping salaries for senior bank executives is quite frankly ridiculous. It is Neanderthal politics performed by populist leaders. That Gordon Brown has fallen for it is hardly surprising but I am disappointed to see that Barack Obama couldn't resist the temptation. The mob wants blood and our leaders are delivering in spades. The stark reality is that we are all guilty of the mess we are now in. For a while we were allowed to live out our dreams and who was there to stop us? Policy mistakes – very grave mistakes – permitted the situation to spin out of control. From the U.S. Federal Reserve Bank under the stewardship of Alan Greenspan being far too generous on interest rates to the British Chancellor of the Exchequer -who now happens to be our Prime Minister - advocating 'Regulation Light'.
Policing must improve
If you really want to prevent a banking crisis of this magnitude from ever happening again, the focus should be on the way banks operate and not on how much they pay their staff. And, within that context, any discussion must start and end with how much leverage should be permitted. The French have actually caught onto that, but their narrow-mindedness has driven them to focus on hedge funds' use of leverage which is only a tiny part of the problem. It is the gung ho strategy of banks which brought us down and which must be better policed. And guess what; if banks were better policed - and leverage restricted - then profits, even at the best of times, would be much smaller and there would be no need to regulate bankers' compensation packages.
It is pathetic to watch our prime minister attacking the bonus arrangements of our banks when the UK Treasury, on his watch, spent £27 million pounds on bonuses last year as reward for delivering a public spending deficit of 4.5% of GDP at the peak of the economic cycle. Even my old mother understands that governments must deliver budget surpluses in good times, allowing them more flexibility to stimulate when the economy hits the wall. What Gordon Brown has done to UK public finances in recent years is nothing short of criminal.
So, with that in mind, let's take a closer look at the European banking industry. The following is not pretty reading. I have rarely, if ever, felt this apprehensive about the outlook. So, if the crisis has made you depressed already, don't read any further. What is about to come, will make your heart sink.
More leverage in Europe
Let's begin our journey by pointing out a regulatory 'anomaly' which has allowed European banks to take on much more leverage than their American colleagues and which now makes them far more vulnerable. In Europe, unlike in the US, it is only risk-weighted assets which matter to the regulators, not the total leverage ratio. European banks can therefore apply a lot more leverage than their US counterparties, provided they load their balance sheets with higher rated assets, and that is precisely what they have been doing.
That is fine as long as you buy what it says on the tin. But AAA is not always AAA as we have learned over the past 18 months. Asset securitisations such as CLOs proved very popular amongst European banks, partly because they offered very attractive returns and partly because Standard & Poors and Moodys were kind enough to rate many of them AAA despite the questionable quality of the underlying assets.
Now, as long as the economy chugs along, everything is dandy and the AAA-rated assets turn out to be precisely that. But we are not in dandy territory. Many asset securitisation programmes are in horse manure to their necks, so don't be at all surprised if European banks have to swallow further losses once the full effect of the recession is felt across Europe. The two largest sources of asset securitisation programmes are corporate loans and credit cards. Senior secured loans are still marked at or close to par on many balance sheets despite the fact they trade around 70 in the markets. The credit card cycle is only beginning to turn now with significant losses expected later this year and in 2010-11.
Not much of a cushion left
Citibank has calculated that it would only take a cumulative increase in bad debts of 3.8% in 2009-10 to take the core equity tier 1 ratio of the European banking industry down to the bare minimum of 4.5%1. By comparison, bad debts rose by a cumulative 7% in Japan in 1997-98. One can only conclude that European banks are very poorly equipped to withstand a severe recession. Seeing the writing on the wall, they are left with no option but to shrink their balance sheets. Despite talking the talk, banks will use every trick at their disposal to reduce the loan book. No prize for guessing what that will do to economic activity.
The wheels are coming off
But that is not the whole story. It is not even the most worrying part of the story. For the true horror to emerge, we need to turn to Eastern Europe for a minute or two. Nowhere has the credit boom been more pronounced than in Eastern Europe. And nowhere is the pain felt more now that credit has all but dried up. One measure of the credit fuelled bonanza is the deterioration of the current account across the region. Credit Suisse has calculated that in four short years, from 2004 to 2008, Eastern Europe's current account went from +6% to -6% of GDP2. That is a frightening development and is likely to cause all sorts of problems over the next few years.
Meanwhile Western European banks, eager to milk the opportunities in the East after the iron curtain came down, have acquired many of the region's banks (see chart 1). Now, with many Eastern European countries in free fall, ownership could prove disastrous for an already weakened banking industry in the West.


The problem is widespread
To make matters worse, the problems in the East are beginning to look systemic. Credit Suisse has produced an interesting scorecard where they rank a number of countries around the world on factors usually taken into consideration when assessing the credit quality of sovereign debt (see chart 2). At the top of the tree (i.e. the worst credit score) you find Iceland – hardly surprising considering their current predicament. More importantly though, of the next 14 countries on the list, 8 are Eastern European – not what you want to hear if you are an already undercapitalised European bank with huge exposure to Eastern Europe.
Swedish banks are already reeling from their exposure to the Baltic countries. Austrian banks are in even worse shape, having been the most acquisitive of any European banks. Some Italian banks could be dragged under by their Eastern European exposure and even the conservative banking sector in Switzerland doesn't look like it can escape the mayhem.
Worst of all, the problems in the East are just about to unfold at a point in time where the European banking industry is bleeding heavily from massive losses already incurred in other areas. With no access to private funding, banks find it virtually impossible to re-build their capital base with anything but tax payers' money.
US banks are better off
US banks are in less of a pickle. Unlike the subprime debacle which hit both the US and the European banks hard, US banks have little exposure to Eastern Europe. To prove my point, according to the IMF, European banks have 75% as much exposure to US toxic debt as American banks, but 90% of all cross border loans to Eastern Europe originate from Western European banks. And, to add insult to injury, European banks have been much slower than US banks in terms of recognising their losses. Write-offs now total about $750 billion in the US and only about $325 billion in Europe.
 
The great mortgage show
The problems in Eastern Europe begin and end with their large external debts. In recent years, ordinary people all over the region have converted their traditional mortgages to EUR- or CHF-denominated mortgages. Some have even switched to JPY mortgages. Who can possibly resist 3% mortgages? Didn't anyone inform them of the risk? As currencies across the region have fallen out of bed in recent months, these mortgages have suddenly become 30-50% more expensive. No wonder the local economy is suddenly tanking.


Credit Suisse has calculated that net foreign liabilities (as a % of GDP) have risen from 47% to 65% in recent months as a direct result of the loss of local currency values (see chart 3 – and don't ask me why Credit Suisse has included South Africa in Eastern Europe!).
Chart 4: Eastern European vs. Asian Crisis
 Source: Wall Street Journal
Back in 1997-98 Asia went through a similar currency crisis. However, as you can see from chart 4, Asian current account deficits were much smaller than Eastern European deficits are now. So were debt levels. Despite that, the Asian crisis did enormous damage to the local economy. Eventually Asia came good, primarily because the devalued currencies allowed the Asian countries to export more. Eastern Europe does not share this luxury. With over 90% of the world's GDP in recession, who are they going to export to anytime soon?
Austria is in greatest trouble
According to the latest estimates from BIS, Eastern European countries currently borrow $1,656 billion from abroad, three times more than in 2005 and mostly denominated in foreign currencies (ouch!). 90% of that can be traced to Western European banks. About $350 billion must be repaid or rolled over this year. Not an easy task in these markets. Austrian banks alone have lent about $300 billion to the region, equivalent to 68% of its GDP according to the Financial Times. A default rate of 10% on its Eastern European loans is considered enough to wipe out the entire Austrian banking system. EBRD has gone on record stating that defaults in Eastern Europe could end up as high as 20%3.
An extra $250bn to the IMF
Hungary, Latvia and Ukraine have already received emergency loans from the IMF and both Serbia and Romania are reportedly considering asking for help. Meanwhile the IMF's coffers are draining quickly and it has asked leading industrial nations for new funding. At their summit a week ago, EU leaders coughed up an extra $250 billion but nobody said where the money is going to come from. Even if they find the money, it is likely to prove hopelessly inadequate. Our leaders must grow up. Measuring everything in billions is so yesterday. Trillions are the new billions, like it or not.
Conspiracy or...?
On the 11th February the Daily Telegraph's Brussels correspondent Bruno Waterfield wrote an article under the header: "European banks may need £16.3 trillion bail out, EC document warns." In the article, the reporter revealed that he has seen a secret document produced by the EU Commission which briefed the union's finance ministers on the true extent of the banking crisis. Less than 24 hours later, the article's header was changed to "European bank bail-out could push EU into crisis" and two paragraphs had mysteriously disappeared. Here they are:
"European Commission officials have estimated that "impaired assets" may amount to 44pc of EU bank balance sheets. The Commission estimates that so-called financial instruments in the 'trading book' total £12.3 trillion (13.7 trillion euros), equivalent to about 33pc of EU bank balance sheets.
In addition, so-called 'available for sale instruments' worth £4trillion (4.5 trillion euros), or 11pc of balance sheets, are also added by the Commission to arrive at the headline figure of £16.3 trillion."
Do yourself a favour - read those two paragraphs again. Newspaper editors do not change content light-heartedly. Did the Telegraph editor receive a call from Downing Street? Or Brussels? Did he have second thoughts about the avalanche that he could possibly instigate? I don't know and I probably never will. But one thing is certain. If the EU Commission's estimate of £16.3 trillion of impaired assets is correct, then the crisis is far worse than any of us could ever imagine. Not only would we have to get used to the prospects of a systemic meltdown of our banking system, but entire nations may go down as well.
Public debt to rise and rise
Even if actual losses prove to be much, much smaller (and I sincerely hope so), the banking sector cannot, in the current environment at least, raise sufficient capital to stay afloat, so more, possibly a lot more, tax payers' money will have to be put forward. This can only mean one thing. Public debt will rise and rise. The official estimate for the UK for next year is already approaching 10% of GDP, an estimate which will almost certainly rise further. We probably have to get used to running 10-15% deficits for a few years, a fact which seriously undermines the notion of government bonds being next to risk-free.
BCA Research has calculated the effect on public debt in a number of countries, as a result of further bank losses being underwritten by tax payers. Obviously, those countries with the largest banking industries (as a % of GDP) will be hit the hardest (see charts 5a and 5b).


For that very reason, and as pointed out in last month's Absolute Return Letter, there is a real risk that investors will demand much higher risk premiums on government debt. Only a few days ago, Ireland issued 3-year bonds at almost 250 basis points over corresponding Bunds. As more and more debt is transferred to sovereign balance sheets, we will likely see the spreads between good and bad paper rise further but we will also witness increasingly desperate measures being applied by the men in power. If they could prohibit short-selling of banks on the stock exchange (which didn't work), why wouldn't they consider prohibiting short-selling of government bonds? Not that it would necessarily work any better, but desperate people do desperate things.
Can Germany rescue us?
Most investors remain convinced that Germany will come to the rescue - in my opinion not as simple a solution as widely perceived given the enormity of the crisis. One possible solution which has been mentioned frequently in recent weeks is for all the eurozone nations to get together and start issuing joint bonds. This would undoubtedly help the weaker nations, but the idea was shot down by the German Finance Minister only a few days ago when he said that closer economic harmony across the eurozone would be needed before Germany would be prepared to entertain such an idea.
The most obvious trick left in the book, therefore, is to inflate us out of this mess. With the enormous amounts of public debt being created at the moment, years of deflation a la Japan would be catastrophic. You will never get a central banker to admit to it, but a healthy dose of inflation is probably our best prospect of surviving this crisis.
Given this outlook, do you really want to be long euros?
Niels C. Jensen © 2002-2009 Absolute Return Partners LLP. All rights reserved.