Canada Day: A celebration of up-side risk

by Michael Arbow, MBA

Partner, RSD Solutions Inc.

www.RSDsolutions.com

info@RSDsolutions.com

 

Today (July 1^st) is Canada’s 144^th birthday and I like many other Canadian’s and those who endorse what Canada represents will be celebrating across the world.  We celebrate a great country that is currently and for the foreseeable future in a “sweet spot”; Canada has a stable government, banking and legal system which immigrants and investors love.  As a country we are also lucky to have food, energy and fresh water all in quantities greater than our 33 million or so people can consume. 

 

While we celebrate all those benefits; we are also celebrating up-side risk.  John A MacDonald and his contemporaries, who created Canada, surely saw downside risk in creating a country as vast and under-populated as Canada was in the agrarian nineteenth century but they didn’t let this over-ride their belief in the benefits of one Dominion.  By clinging to their convictions of the up-side risk, Canada was born and happily their vision continues to live on, grow and prosper.

 

Happy Birthday Canada and to our readers in Canada – have a great long weekend.

Which side of the ring-fence are you on?

by Stephen McPhie, CA

Partner RSD Solutions Inc.

www.RSDsolutions.com

info@RSDsolutions.com 

 

The UK government recently announced proposals to “ring-fence” bank’s retail from their investment banking operations.  The underlying idea is that the government would allow investment banks to fail in the event of a future financial crisis and that retail banks would be safer.  Presumably investors would believe that retail banks could be bailed out. 

 

Moody’s warned that this is a credit negative event making bank downgrades more likely.  And others have warned that it will raise costs for consumers and small businesses.

 

We actually need to see the mechanics of such a scheme.  Many operations are obviously retail or investment banking but there are grey areas, e.g. structured products and the cut off point between small and large corporate business, so where would they be put?  Importantly, how would the existing capital be allocated to each operation? 

 

A lot of smart people have been very skilled at peering round Chinese walls and reclassifying one type of asset to look like another.  Would the proposed ring-fencing be different this time?

 

And of course, the major UK bank failures had little to do with investment banking operations and lots to do with retail banking.  Furthermore, Lehman Brothers, which started a lot of dominos falling, had no retail banking operations.  So what benefit would ring fencing have brought if it had been in place for the last few years?

 

Is it a well-conceived way to protect peoples’ businesses and the economy?  Or is it a political response to an inability to institute effective corporate governance and regulatory oversight?

Sovereign Risk and Unintended Consequences

by Don Alexander, MBA

Associate, RSD Solutions Inc.

www.RSDsolutions.com

info@RSDsolutions.com

 

(Fiscal Monitor – Staying the Course on Fiscal Adjustment, IMF, June 2011) The IMF noted in its latest interim Fiscal Monitor that government actions to address budget deficits continue to make progress in the advanced economies – especially in core Europe, Australia and Canada.  This improvement is driven by recovering activity and higher revenues.

Despite the good news, there remains some doubt about debt sustainability and the political will to maintain austerity programs in countries like Greece.  Credit default spreads (CDS) are at new highs for Greece as investors worry about contagion.

Elsewhere, the US and Japan are slow to implement plans to control budget deficits and rising debt levels.  However, the US deficit for 2011 will be lower than earlier forecasts and similar to 2010 on a cyclically adjusted basis.  Policymakers urgently need to reach a consensus medium-term adjustment plan to avoid potential market distress.  Japan lacks a specific plan to address rising debt and contingent liabilities of an aging population.  There is a rising risk perception in peripheral Europe led by Greece, Ireland and Portugal followed by some concern about Spain.  Downward revisions for growth in Greece and Portugal have created more urgency. This underscores urgency for these countries to implement an adjustment program and develop a comprehensive and consistent approach for crisis management and adherence to Eurozone policies.  The record for emerging economies remains mixed as a number of countries are implementing fiscal consolidation at an appropriate pace.  In others, fiscal policy must be tightened quicker to avoid the potential risk of overheating.  Long-term, countries must implement policies to reduce imbalances and government market intervention.

The improvement in the outlook for government finances in a number of countries is overshadowed by recent events.  The surge in the CDS premiums for Greece raises a few questions – is the CDS exposure held by a few institutions or widely dispersed?  Can the institutions payout the billions required in a default?  Do we have concentrated risk such as AIG?  This is something that policymakers or regulators cannot answer.  

 

“Medicine approvals slump to lowest in decade”: It’s pay-up time for downside risk protection

by Michael Arbow, MBA

Partner, RSD Solutions Inc.

www.RSDsolutions.com

info@RSDsolutions.com

 

 

A while ago a tech oriented friend (jeffroach.ca) commented on the effect of the bursting of the dot-com bubble between March 2000 and 2001: his observation was that tech advancements from Silicon Valley were pushed back by 3 or so years.  On a related note, in a Globe and Mail article today, it was pointed out that new medicine approvals have slumped to the lowest level in a decade.  How is this related?  When the tech bubble burst, the flow of angel, private and corporate venture capital dried up in all sectors, including the search for new medicines.  With the lead time from inception to commercial launch of pharmaceuticals for human use being an average of 7 to 10 years, we are now witnessing the demise of that new venture funding 10 years ago.

 

So what does this have to do with risk management?  The collapse of the tech bubble caused a sweeping focus on downside risk (understandably as USD $1 trillion was wiped from the US equity markets) with perhaps little thought to the cost this would have on reducing upside risk – especially in the longer term.  Limiting all corporate activities to reduce downside expose does have a cost; in this particular instance pharmaceutical firms and the greater human populace are about to begin paying for it now.  Firms must be more selective in deciding which downside risk to address and at what cost now and in the future. 

 

For more on medicine approvals click on the link to a Globe and Mail article:

http://tinyurl.com/6aajlyu

Dazed and Confused - Managing Foreign Exchange Risk & the Greek Debt Crisis

by Don Alexander, MBA

Associate, RSD Solutions Inc.

www.RSDsolutions.com

info@RSDsolutions.com

 

The stakes continue to remain high in Athens as Greece’s economic rescuers attempt to craft another bailout facility.  Demonstrators, while angry, continue to be dazed and confused, and so are investors.  However, if talks breakdown it can have catastrophic consequences for Greece, the euro and the financial system.  The Greek banks and government would run out of money, cause a sharp euro downdraft and severe financial contagion.  The addition of another liquidity facility only postpones the day of reckoning.  Even if the new facility appeases the bears, the fundamental problem remains is that the country remains uncompetitive in global markets.  It will take years of painful structural reforms to restore competitiveness.  Investors with Greek or euro exposure may have to take a painful haircut much as investors in Argentina did in 2001.      

Despite the confusion in the streets, there remains a number of questions about the size of the package, of euro 119 billion (about US $120 billion) and the future viability of the Greek economy in its current state.   There seems to be a mistaken belief by Greek politicians, that the would be rescuers, would make available another euro 120 billion (or more) in 2012 to provide relief through 2014.  This would allow the new EU stability mechanism an opportunity to provide needed relief.  However, it seems to ignore the view of investors, the need for assistance to other countries and the recapitalization/restructuring of European banks. 

In addition, there are a number of challenges in German courts that the facility is “bridge-financing” and does not violate the “non-bailout” clause in the German and European Constitution.  However, analysts do not expect the court to rule the bailouts as unconstitutional, but the uncertainty surrounding the situation adds to potential risks.

In addition while Greek CDS spreads are near record levels, there seems to be further confusion as to what constitutes a default.  Rating agencies consider any type of debt restructuring, reprofiling, or even a voluntary rollover of maturing debt as a potential default.  However, a rollover according to the International Swap Dealers Assn. (ISDA) may not trigger a credit event.  European officials are trying to get around rating agencies’ reservations about a rollover so as to not to trigger a default or credit event.

The depth of the recession is taking a severe toll on the Greek economy as the economy could shrink by 4% in 2011, after falling over 4.5% in 2010.  The politicians continue to defend the welfare state and admit the medium-term budget targets are not achievable.  There is a growing concern that if the fractious politicians cannot make unpopular decisions – how can they avoid bankruptcy?  Dazed and confused - do you know your potential risk exposure?  

Systemic Risks Remain Elevated According to the IMF

by Don Alexander, MBA

Associate, RSD Solutions Inc.

www.RSDsolutions.com

info@RSDsolutions.com

 

(Global Financial Stability Report – Market Update, IMF, June 2011)  Since the publication of the semi-annual Global Financial Stability Report (GSFR) in April, financial risks have increased, particularly systemic risk.  The Market Update offered three reasons. First, the multi-speed recovery remains intact as the base case, but growth could become more fragile during the second half and certain downside risks have emerged for some countries.  Second, the concern about debt sustainability and lack of political support for adjustment efforts in Europe’s periphery has increased market pressure and contagion risk. European policymakers continue to avoid making the necessary political decisions about debt restructuring (including bank balance sheet restructuring and recapitalization) and hope the problem will evaporate with another liquidity facility.  Elsewhere, certain advanced countries such as the US and Japan remain in political gridlock about how to deal with growing budget deficits. Third, despite a recent pullback from risk taking, a prolonged period of low rates could see a reversal of this view as investors search for yield. This trend could contribute to financial imbalances, particularly in emerging markets. 

 

Policymakers continue to face increased vulnerability to future shocks to the financial system, as rising systemic risk and market volatility add to existing concerns. Against these risks, a number of challenges remain.  This includes challenges on budget deficits, debt sustainability, system vulnerabilities and financial sector reforms.  Reforms are moving in the right direction, but the progress is slow and insufficient. Markets may lose patience if political developments and vested interests derail momentum on fiscal consolidation and financial repair/reform. Policy makers face a number of challenges to reduce systemic risk before the window closes.