Italy – Systemic Risk or Self Inflicted

by Don Alexander, MBA

Associate, RSD Solutions Inc.

www.RSDsolutions.com

info@RSDsolutions.com

 

The sudden surge in Italian debt yields raise questions about whether Italy has become a victim of European contagion or are the wounds self-inflicted?  This question is raised by Paolo Manasse and Guilio Trigilia in a recent paper Little time for Italy (VOXEU, Manasse & Trigilia, July 19^th).  The rise in unanticipated risk may prove costly.

The Eurozone crisis now extends to Italy.  The authors analyze 5-year credit-default-swaps (CDS) data and reach two conclusions: that Italy’s troubles are home-grown and the default risk is concentrated in the short run.

A number of well known factors contribute to Italy’s vulnerability: large deficits and surging debt levels, low productivity, an aging population and a large corrupt, inefficient bureaucracy.  This situation is aggravated by minimal fiscal reforms, a new budget of smoke and mirrors where most spending cuts are not implemented till 2013-2014. 

The authors ask three questions:  the first question is breaking the CDS spread component into euro-wide and country specific factors to obtain the country’s contribution to a European rather than country specific risks.  The findings suggest the Italy’s coefficient is near one indicating that spreads are more closely linked to the Eurozone than being country specific.  The second question is how much the euro-dimension explains Italy’s credit-default-swap premium.  The findings suggest Italy’s spread variance is less attributable to the euro component and most recently explained by country specific factors as the markets judge Italy on its own merits.  Lastly, what is the perceived risk of Italian debt at different time horizons?   The authors calculate the hazard rate of default (instantaneous probability) for bonds of different maturities (starting daily in 2007) to see the market view of the timing of the default.  The hazard rates are calculated daily for bond maturities of 1-10 years and plotted in a slope.  A positive slope means that the default rate is higher in the future.  The results show a sharp negative slope indicating the highest risks are concentrated in the short term, especially as the slope turned sharply negative over the last couple of weeks.

The verdict on Italy has not fully emerged yet, but the jury is still out as risks are concentrated in the very short run.  Italian leaders such as Mr. Berlusconi and Mr. Tremonti should take note as well as European leaders.  Do you have exposure to unanticipated risk?

 

For more on this story and the work of Mr. Manasse and Mr. Trigilia click on the link: http://tinyurl.com/45yoxmy

Continuing uncertainty and volatility – are you immune?

by Stephen McPhie, CA

Partner, RSD Solutions Inc.

www.RSDsolutions.com

info@RSDsolutions.com 

 

Moody’s has placed its Aaa U.S. government bond rating on review for possible downgrade.  Financial institutions linked to the government rating such as Fannie Mae and Freddie Mac are also placed on review.  This is because the federal debt limit may not be raised in time leading to default because of a late interest or principal payment.  Most assume default would be of short duration but such talk would have been unthinkable until very recently.

 

Across the pond, it was assumed that markets would move their attention from Greece onto Portugal and Ireland.  However, the focus has shifted to the much bigger fish of Spain and Italy with sharp increases in their debt yields.  European politicians are still muddling around trying to find a way to get out of the mess without creating a formal default on debt where there is no foreseeable means of repayment – at least for Greece and likely Portugal.  But there is stiff resistance in Germany in particular to bail out private investors in the troubled sovereigns at the expense of domestic taxpayers.  Of course politicians everywhere usually want to win the next election above all else so they have one eye on how to fix the unthinkable and the other on opinion polls.

 

Whatever happens, we have the recipe for a degree of turmoil.  Not just for the countries directly involved but turmoil which could easily spread to exchange rates, interest rates, commodity prices and the global economic outlook generally.  So if you have exposures in any of these areas have you identified, quantified and instituted robust risk management strategies?  Have you evaluated and updated your existing risk management processes recently, possibly with an independent external evaluation?  Isn’t it better, cheaper and more comforting to fix the roof before the storm?

 

Driving Miss Meaghan

 by Rick Nason, PhD, CFA

Partner, RSD Solutions Inc

www.RSDsolutions.com

info@RSDsolutions.com 

 

Late last week I drove my teenage daughter Meaghan to the dealer so she could pick up her car after having it serviced.  Starting off on the 20 minute drive I realized that either I could listen to her favorite pop music radio station (instead of my favorite classical or hard rock stations) or start a conversation.  I chose to start a conversation – and those of you with teenagers are now rolling your eyes and calling me a fool.

 

As most conversations with teenagers go this started off in a rather predictable fashion;  “How was your day?”  “Boring.”  “What did you do?”  “Nothing.”  …  I think you get the pattern of the conversation; question, followed by a mono-word answer that signals the value that teenagers place on “conversing” with their parents.  As it is the middle of summer, and all her friends were working while she had the day off, I suspect that my daughter did indeed have a relatively uneventful day.  However we still had 18 minutes to go until we would be at the car dealer.

 

I started to ask questions that could not be answered by mono-word answers.  “What was the funniest thing you did today?”  “What was the single most fantastic moment of the day?” etc.  Of course these questions (positive in focus) just gained me a weird look and an attempt to put a CD into the player.  However I persisted and a funny thing happened.  The more I focused on the positive aspects of the day (“well you are breathing, correct?  Isn’t that a good thing?”), the more my daughter opened up.  By the time we got to the dealership I could not shut her up.  She was going on about this great thing, and that great thing.

 

In risk we often focus on facts – particularly the facts of the downside.  How interesting is that?  How engaging is that?  Perhaps if we focused more on the upside of things, and focus on them in a qualitative manner, then the risk conversation as well would become richer and much more engaging.

 

P.S.  On the drive back home by myself, I listened to a Headstones CD.

A Square Peg in a Round Hole – Politicians Create Risk

by Don Alexander, MBA

Associate, RSD Solutions Inc.

www.RSDsolutions.com

info@RSDsolutions.com 

 

European politicians, in their attempt to create the euro, did so with the view that one size fits all.  In this case, they overlooked basic economic fundamentals such as competitiveness, labour productivity and assumed a uniform monetary policy should be the same for all countries.  They did not think to establish guidelines to monitor potential risks.  This question is now being asked.

 

Is Europe an optimal currency area? Is the euro doomed?  The author, Carlo Faverro, argues that economic differences within Europe, exposed by the current crisis, are reasons to doubt the sustainability of the single currency.  One element is an optimal currency is an area-wide monetary policy associated with country-specific and very heterogeneous nominal and real long-term rates. 

 

The author looks at the relationship between long-term rates from the pre-EMU period through the next 10-11 years after EMU formation in 1998 and the subprime financial and euro debt crises.  The first period showed nominal yield differentials associated with inflation differentials.  After the euro introduction, nominal and real long-term rates converged as inflation differentials disappeared.  However, in the crisis period, long-term rates have diverged as long-term real rate spreads have gapped higher, despite minimal inflation differentials. 

 

The ECB’s common monetary policy controls short-term policy rates, but does not control investment and consumption -- key components of growth that depend on real bond yields.  High real long-term rates negatively impact consumption and investment, especially in peripheral countries where growth is needed to help fiscal stabilization.  The common currency has prevented exchange rate movements that normally offset emerging growth differentials.  The peripheral countries are experiencing higher labour costs, loss of competitiveness and surging deficits: factors that could dampen growth prospects.  The inability to reduce fiscal deficits may not be enough to restore real long-term yield convergence.  The doubtful attempt to sustain a common monetary policy with differential economic impacts casts doubt on the sustainability of the euro as a common currency area.  However, it might be reduced to a smaller area.

 

Do you know your potential exposures and risks?

 

For more on the Euro’s current issues, click on the link:  http://tinyurl.com/42c23vj  

 

If Rodney Dangerfield was a Risk Manager today, he is now finally getting respect

by Michael Arbow, MBA

Partner, RSD Solutions Inc.

www.RSDsolutions.com

info@RSDsolutions.com

 

Before: 

“The risk chief used to be like the human resources leader. You had to have one, but generally speaking, the risk guy was never going to be CEO of the company,” Tom Flannery, managing director for the Pittsburgh office of executive search company Boyden said.

 

After: 

“The value of the job has gone up because people have seen how badly things can go if you aren’t paying attention,” said Kevin Blakely, chief risk officer at Huntington Bancshares Inc. 

 

A few months ago I wrote a blog entitled “Was Rodney Dangerfield once a Risk Management Consultant?” in response to some research I did surrounding the US government’s job title classification list which in its over 250,000 words excludes the work risk.  Well perhaps that will change now that some risk managers on Wall Street are pulling in 7 figure incomes and at least one topping out at $10,000,000.  To me this is a sign that risk management and managers is coming of age, pity it took the financial collapse of the Western economies through the Great Recession to make it so.

 

So has your firm brought on a risk manager or risk consultant yet?  It is only a matter of time,… for as I like to say, “The train has left the station”. 

 

For more on this subject, click on this link to Bloomberg: http://tinyurl.com/6b7uxcf 

To see my original blog of April 3, 2011 click on the link: http://tinyurl.com/626aqvo

What goes up must come down (please, please, please)

by Michael Arbow, MBA

Partner, RSD Solutions Inc.

www.RSDsolutions.com

info@RSDsolutions.com

 

Over the centuries, our world has experienced many financial bubbles, most recently from real estate.  Most of these bubbles have been burst in large part by some increase in supply, either through improved crop yields or just building more homes or silicon chip factories.  However, as the emerging economies become wealthier, their populations healthier, the ability to continue to limit price increases by upping supply has diminished.  This is particularly so in the world of finite commodities and even more so in oil.  Recently, the International Energy Agency stated that even with soft global economic growth, the oil producing nations will find it difficult to meet the world’s demand requirements of 89 million barrels a day in the second half of 2011.

 

The result of this supply constraint – which cannot be remedied in weeks will be the pushing up of oil prices (Brent crude has been trading at triple digits for almost the entire year).  Motorist will feel the pinch immediately and the rest of society will feel it in the following months as wheat prices (50% of which is derived from the price of oil), transportation etc. move up or possibly down in the case of houses in the exurbs.  For those living in the risk world the demands for hedging will possibly move from idea to necessity as business’s struggle to lessen the pace and impact of another wave of commodity price increases.  I believe that it will be the pro-active risk managers that are acting now that will survive and possibly thrive in this new environment.  Hopefully you will be one of them.

 

For more Jeff Rubin’s thoughts on oil prices, click on the link:

http://tinyurl.com/5wnlwdb