International Bond Markets Since the Global Financial Crisis - Essay Example

?International Financial Markets Question a) Issues that have affected the international bond markets since the start of the global financial crisis. Sovereign debt, otherwise known as public debt, is borrowing incurred by governments. This figure has risen significantly and become unsustainable for at least three Eurozone countries, namely Greece, Ireland, and Portugal, which have all turned to the International Monetary Fund (IMF) and other Eurozone member states for financial assistance. Japan has also incurred high public debt for which its credit rating has been downgraded by Standard and Poor’s (S&P) in January 2011. In August of the same year, S&P downgraded long-term U.S. sovereign debt from the highest possible rating, AAA, to AA+. Reasons for this trend are the fiscal stimulus packages, nationalization of private-sector debt, and reduction in tax revenues (Nelson, 2012). While government securities are considered close to risk-free, there have however been worries in 2010 that U.S. municipal bonds may default because of lack of liquidity, a fear which proved unfounded (MeritWealth, 2011). When the government requires high levels of borrowing, it tends to raise the yield on its bonds in order to attract investors. In a low interest environment, high-yield bonds become attractive to investors because the present value of high-yielding bonds makes the bonds more valuable when traded in the open market. However, by increasing the yield on its bonds the government crowds out private business and credit tends to become more costly – that is, added risk premiums increase interest rates over that offered by the government, discouraging private borrowers from resorting to bond financing because of the higher default risk involved. The result is a credit crunch that reduces funding to business and slows down productive activity, eventually causing downsizing, lay-offs and company closures. The central bank resorts to quantitative easing to introduce liquidity in the economy to spur nominal spending; this is done by purchasing financial assets from the private sector. The new central bank money used to pay for the assets increases the money held by banks and increases the level of deposits held by private parties. Quantitative easing is seen to help restore the inflation rate to positive levels when the economy is too weak that deflation (negative inflation) threatens to set in (Benford, et al, 2009). As for other developments, retail bond trading (lower-denominated bonds offered to individual investors) is seen as the better alternative to institutional bond trading. Retail had been growing when institutional was shrinking in the past crisis, due to its lower risk (Kite, 2008). Furthermore, emerging market dollar bond issuance has surged to $100 billion in 2012, as investment funds found safer markets in emerging economies little affected by the subprime financial crisis (Natarajan, 2012). Another alternative is sukuk bonds, which are Islamic financial instruments resembling conventional bonds but, consistent with Shariah law, are not debt instruments and do not pay interest. Instead, sukuk are ownership investments representing “legal/beneficial interest in specified tangible assets and/or services and/or projects.” Sukuk investments yield pre-determined returns, and specifies profit-and-loss sharing between fund user and provider (Adam & Thomas, 2004, p. 54-55). Contingent convertible bonds, also known as CoCo bonds, are a novel way by which banks may raise capital. These are bonds that automatically convert to equity when a particular trigger takes place, such as when the issuer needs money (Pietersz, 2012; . The CoCo mechanism quickly converts temporary capital (debt capital, which must be paid back) to permanent capital (equity, which however tends to dilute shareholdings). As for the future of securitisation, there is still a great need for developing securities which businesses resort to for hedging and risk management. However, new regulations have been adopted to ensure that the framework (regulators, ratings agencies, etc.) are working as expected, and that officials of financial institutions are acting ethically, observing good governance, and prioritizing the best interests of their clients and depositors. (b) How asset securitisation contributed to the global financial crisis. Housing subsidy and mortgage credit was provided by Fannie Mae, Freddie Mac, and the Veterans’ Administration. Fannie Mae and Freddie Mac, both government sponsored enterprises (GSE) operate under congressionally conferred charters, and as such were obligated to comply with government policy. The Federal Housing Authority (FHA) policies specified the extension of mortgages with the aim of providing housing for the poor (thus, “subprime”). The mortgages were pooled and bundled, and the interest in these bundles, known as mortgaged-backed securities (MBS) were sold to investors. The default risks on the MBSs were guaranteed by Freddie Mac, which risk in turn is implicitly guaranteed, together with that of Fannie Mae, by the Federal government. Because of the implicit guarantee, a moral hazard was created, in the sense that Fannie Mae and Freddie Mac, and the various investment banks which extended mortgages without ascertaining the ability of the borrowers to pay back. By moral hazard is meant the assumption of risk without exercising due care in assessing and lessening risk, because someone else assumes the risk. The credit default swap (CDS) was actually an invention of the global investment bank, JP Morgan. The bank’s books were encumbered with loans in the tens of billions of dollars, for which it was required to maintain a certain amount of reserve capital to serve as security in case of default. To free up the reserves and improve the bank’s liquidity, JP Morgan, as originating bank, bundled these loans into securities – CDSs – and sold them, making the buyer the insurer of the security against default. Since the risk is no longer with the bank but with the CDS buyer, the bank’s reserves were freed up, allowing the banks to give out more loans and gain more commissions (Philips, 2008). Credit ratings agencies also contributed to the accumulation of systemic risk. Charged with the duties of “arbiters of investment value” that gauged the safety of investments (Sack & Juris, 2007), Moody’s, Standard & Poor’s, and Fitch issued recommendations relied upon by investors in securities. Originally, the agencies were compensated through subscriptions bought be interested investors. In the seventies, however, the agencies switched from the “investors pay” to “issuers pay” model. This created the conflict-of-interest situation wherein the agencies were compensated by the parties whose issues they were supposed to regulate. As a result, even risky securities were rated investment-grade (“AAA”) which the issuers paid handsomely for (White, 2007). The resulting advisories misled the investing public, and allowed for the massive accumulation of highly risky securities, in financial institutions. Question 2: Factors driving the bull phase of the commodities super-cycle Investing in commodities is different from investing in other markets. The nature of commodities is that they are real assets, primarily consumables and not investment goods. Their value is in their utility, for use either in industrial manufacture or in consumption. Because their value is in their physical possession, the limited availability of such goods limits the supply and, with unchanged or increasing demand, increases the value of the commodity. Another consideration is that as an asset class, it must be kept in mind that commodities are heterogeneous, each commodity having its own characteristic properties. They may be classified according to hard (energy and metals), pertaining to the durables, versus soft (livestock and agriculture), which refers to the perishables. The categories are shown below. Even among commodities in the same classification, the rise and falls in prices cannot be generalized over all of them, and the increase or decrease in their prices is strongly influenced by the particular factors which influence their specific properties. A graph of commodity food prices is shown in the following figure, which depicts each commodity displaying its own price patterns. Commodity prices are not capital assets (e.g. stocks and bonds) or long-term stores of value (e.g. works or art or foreign exchange); Therefore, interest rates have little effect on their value. The price of commodities is determined by the interaction of supply and demand. Therefore, if pressures on either of these factors could be identified beforehand, then it may be possible to speculate on the future value of a particular commodity. Bull markets typically run for twenty year time periods, with none of them running for less than fifteen years. This particular bull run began in 2000, therefore on the average it is only past halfway through the twenty-year expected duration (Herold, 2011). For this particular bull run, analysts believe that it will continue for at least another five years (Global Investor, 2011). Advocates of a continued bull run include Dighton Capital Management, whose chief investment officer believes that commodities continue to offer the only viable investment option now because investors continue to harbour fears of the real value of money and volatility in foreign exchange rates. As a result of monetary policy uncertainties, investors will continue to seek a safe haven in precious metals because of their intrinsic value (Global Investor, 2011). Furthermore, the growing prosperity and lifestyle changes of emerging markets and their demand particularly for oil, soft commodities and base metals will continue to push oil prices up and sustain the bull run (Fisher, 2008). Other analysts tend to differ, however. Many place the end of the bull run at around 2015, much sooner than the forecasted ten years into the future. The price of copper and other base metals are seen to be the biggest casualties when prices begin to come down, because they were the stellar performers on the way up (Burton, 2011). The key argument of these analysts is that the growth in China relied upon by bull market proponents is unlikely to be sustained. The thinking is that if China grows, its demand for base metals will grow proportionally as the country builds its industrial sector. The contrarian opinion is that as China becomes a developed economy, its demand for base metals will taper off because the economy will gradually shift to demand for services, consistent with other developed countries, thus the growth in emerging markets will cease to be a factor in the movement of metal prices (Burton, 2011; Trends E-Magazine, 2011). Aside lower than expected demand, the top 10 publicly listed copper mining companies are expected to increase production by more than 9% over the next four years, with most of the increase materializing by 2013-2014, further dampening expectations for copper price increases (Trends E-Magazine, 2011). As for oil, analysts who predicted its continued rise based their forecast on expectations that: (1) new oil discoveries have been tapering off in the past two decades; (2) OPEC continues to monopolize the industry; and (3) the growth in automobiles in China will push demand for oil. Trends E-Magazine analysts, however, note that due to the decades-long one child per family policy in China, its population is actually experiencing negative growth which will slow down consumption, even of oil. That aside, there is also a substantial shift to alternative sources of energy, natural gas in particular, to generate electricity, and more sustainable fuels for transportation due to hybrid and clean technology (Trends E-Magazine, 2011). As for soft commodities, the table below shows the comparative figures drawn from Organisation for Economic Cooperation and Development –Food Agricultural Association (OECD-FAO), the Food and Agricultural Policy Research Institute (FAPRI) and US Department of Agriculture (USDA) showing consumption and production trends for two decades. According to Euromoney (2007), the soft commodities market appears to be on a long-term bull run based on an annual increase of 80 million in the world population, and a continued decline in agricultural stocks as well as coffee, wheat, corn, rice and cotton since 2000. Updating from 2007 to 2011, however, From the forecasts shown, it is evident that for some commodities (such as oilseeds, rice and sugar), consumption exceeds production, and vice versa for other commodities (such as wheat, butter and vegetable oil). For others (cheese, pigmeat and poultry meat), they are about the same. What is clearly evident is that the rate of growth for both consumption and production has considerably slowed within one decade, such that discrepancies in consumption and production rates will not likely be significant enough to prolong the bull run. Question 3: Changes made to the regulation of international financial markets in response to the financial crisis of 2008. 3.1 Increased capital and liquidity requirements - Basel 3 and Solvency 2. Among the new regulatory measures introduced, Basel III specifies new capital and liquidity rules for banks, while Solvency II sets new capital requirements for insurance companies; both these regulations will take effect in January 2013 (Zahres, 2011). Because insurers are principal institutional investors, particularly in bank bonds, the new measures imposed on insurance companies will create reciprocal effects between Basel III and Solvency II. Conflicts tend to arise: for instance, solvency II favours bonds with short-term maturities, while Basel III requires that banks establish long-term funding sources, and so will issue longer-term bonds (Zahres, 2011). Such reciprocal effects, it is feared, may deter insurers from maintaining significant exposure in banks, causing cost of bank capital to rise, “dampening bank global economic well-being” (Standard & Poor’s, 2012). Furthermore, while group supervision appears to be strengthened by both measures, there are concerns that Solvency II is restricted in its geographical application, and therefore may cause leakages in the potential resort to non-equivalent jurisdictions for reinsurance, as well as the adequacy of much-needed safety nets (Al-Darwish, et al., 2011). Likewise, corporate funding conditions may be expected to tighten, because of still unknown effects in pricing and risk-taking behaviour between insurers and banks (Standard & Poor’s, 2011), which may be evidenced in the following table. 3.2 FSA in the UK to close and new Prudential Regulation Authority (Bank of England) and Financial Conduct Authority. The Prudential Regulation Authority is a future agency to be created by the end of 2012, as a subsidiary to the Bank of England. The PRA’s responsibility is to supervise both insurance companies and deposit-takers, as well as a small number of investment firms which may pose significant risk to the financial system’s stability. PRA’s supervision will include three elements: policies and rules on firms’ resilience (e.g. requirements for capital, liquidity and leverage); supervisory assessments and interventions, and policies and mechanisms to support resolution (BoE, 2011). The PRA’s risk assessment framework is depicted as follows: At this point in time, however, it is not clear how exactly the PRA intends to regulate the risks of deposit-takers, insurers, and investment firms since they have divergent types of risks and concerns. Its stated direction – that of being market-based and forward-looking (FSA, 2011) – is however favourable, assuming that these are translated into effective regulatory guidelines. 3.3 Regulating compensation. In 2009 the Economist reported on weaknesses in the UK financial system that contributed to the crisis. Among these were “the pay culture that rewards bank bosses for short-term risk-taking” and traces these to the “bonus pools” which is a remnant from when private finance houses required partners to share losses as well as gains (The Economist, 2009). Today, while losses are no longer shared by top executives, the bonus pool has however remained and sometimes amount to 50% of trading revenues (note, not net profits). It has therefore been possible that executives reaped extremely high bonuses despite the fact that the bank declared losses for that year. For this reason, the FSA has issued a policy statement entitled “Reforming remuneration practices in financial services” which embodied the final rules (the Code of practice) on remuneration policies which will form part of the FSA Handbook. The new rules require the 26 largest UK banks and financial institutions to establish compensation committees, as well as non-UK firms that have total regulatory capital in excess of ?1 billion. The Code requires the compensation committees to comply with the new rules for determining compensation packages for senior level executives and employees. Future remuneration packages could no longer pay out cash bonuses immediately, but must take into account the firm’s current and future risk analysis, and must integrate deferred payment bonus schemes, e.g. stock option plans that vest only after 3 or 5 years (O’Connell, 2009). 3.4 The Volcker rule on proprietary trading, hedge funds and private equity. The Volcker rule is contained in Title VI of the Dodd-Frank Act, and is named after former Federal Reserve Chairman Paul Volcker. Its purpose is to re-erect the essential demarcations between commercial and investment banking which were initially established in 1933 by the Glass-Steagall Act, taken down by the Gramm-Leach-Bliley Act, and now reinstated by the Dodd-Frank Act. The Volcker rule prohibits any insured depository institution and its affiliates from – (1) engaging in ‘proprietary trading’ (trading as a principal) of debt and equity securities, commodities, derivatives, or other financial instruments; (2) holding any equity, partnership, or other ownership interest in a hedge fund or private equity fund, and (3) sponsoring a hedge fund or a private equity fund (Sweet & Christiansen, 2012). In effect, the goal of the rule is to deter the banks from using their clients’ deposits in speculative activity, where those deposits are insured by the Federal Deposit Insurance Corporation (FDIC) (Tropeano, 2011). There are other regulations that have to do with the procedures for reporting and trading derivatives and exotic assets which aim to impose more accountability on the financial institution or investment firm and to reduce speculative practices. These are secondary, however, to the fundamental reforms mentioned above that are sought to be applied to the entire system. It is to the credit of financial regulators that the measures impose stricter measures on the executive management of the financial firms while trying to allow for the possibility that creative instruments could be proposed in order to better manage risks. The current reforms are not yet too little too late, as long as they are consistently applied and substantially complied with. Bibliography: Adam, N J & Thomas, A 2004 Islamic Bonds: Your Guide to Issuing, Structuring, and Investing in Sukuk. 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