A Global Boom Is Facing the End of Easy Lending

New York Times

August 20, 2013

A Global Boom Is Facing the End of Easy Lending


In a city where skyscrapers sprout like weeds, none grew as high as the Sapphire tower in Istanbul.

Today, it stands as a symbol of how far the mighty may fall.

Like a vast majority of new buildings that have blanketed the Istanbul hills in recent years, the Sapphire — at 856 feet it is the tallest in Turkey and among the loftiest in Europe — was built on the back of cheap loans, in dollars, that have flooded Turkey and other fast-growing markets like Brazil, India and South Korea. The money began to flow when the Federal Reserve and other major central banks cut interest rates to the bone in 2009 and cranked up the printing presses in a bid to spur recovery in the United States and other advanced industrial nations.

But now, with expectations mounting that the Federal Reserve, led by its departing chairman Ben S. Bernanke, may soon begin to tighten its monetary spigot, Istanbul’s skyline could well be a harbinger of an emerging-market bust brought on by unpaid loans, weakening currencies, and, eventually, the possible failure of developers and banks.

This week, stocks and currencies in several developing Asian markets, including India, Indonesia and Thailand, have been hit hard. Global investors continued to withdraw funds from emerging markets, as interest rates edge up in anticipation of the Fed’s move to reduce its stimulus efforts in the United States. Indonesia’s benchmark index, which fell 5 percent on Monday, dropped 3.2 percent more on Tuesday. India’s stock market fell 0.3 percent after sliding 5.6 percent in the previous two trading sessions.

Some analysts see it as the markets reacting to an end — real or perceived — of the Bernanke boom. “What we are witnessing is a huge bubble, a Bernanke bubble if you will,” said Tim Lee of Pi Economics, an independent consultancy based in Greenwich, Conn.

Not everybody is as alarmed as Mr. Lee. Still, 16 years after emerging markets in Asia imploded after local currencies collapsed, even optimists are starting to grow nervous over the rapid accumulation of dollar-denominated debt not just in Turkey but in other now-struggling economies like Brazil, India and South Korea.

As it turned out, some of the biggest beneficiaries of the Fed’s largess were not so much in the developed world, but among the politically connected elite in emerging nations like Turkey, where vanity towers, glitzy shopping malls and even grander projects to come — a third bridge across the Bosporus and a vast new airport — have become representative of the nation’s new dynamism, economic as well as geopolitical.

What these elites have so far ignored, Mr. Lee warns, is that their obligations carry with them a significant and pressing danger: currency risk.

Unlike the risky loans made to subprime borrowers in the United States or Irish real estate developers in the euro zone, dollar debts taken on by companies erecting skyscrapers in Istanbul, manufacturing steel in India and prospecting for oil in Brazil, need to be largely paid back in dollars by entities that earn most of their revenues in their home currency.

When the Turkish lira or the rupee in India was strong — as these currencies were until recently — local companies had every incentive to borrow in dollars at comparatively lower interest rates.

But when local currencies start to weaken, in line with diminished economic prospects, then the effect is twofold: paying off dollar loans becomes more costly for the borrower, and the lender becomes increasingly skittish about his exposure to a fragile currency and may move to reduce or even slash credit lines.

While Brazil has the largest amount of dollar loans outstanding at $287 billion, few countries have relied on this source of money as much as Turkey, where dollar loans of around $172 billion represent 22 percent of the overall economy.

In recent months, the Turkish lira has lost 4.5 percent of its value against the dollar. Adding to this, protests have hit Istanbul’s main public square over an unpopular building sponsored by a developer with close political and cultural ties to the prime minister, Recep Tayyip Erdogan.

Goldman Sachs is forecasting a dollar-lira rate of 2.2, representing a 15 percent mini-devaluation from the current level of 1.95. “The Turkish economic miracle was built on liquidity and a massive appreciation of the Turkish lira,” said Atilla Yesilada, an economist at Global Source partners in Istanbul, who has lived through Turkey’s previous financial crashes in 1994 and 2001.

These loans — many of them relatively short term — also highlight a recurring characteristic of the emerging-market growth boom: the powerful nexus between ambitious governments eager to promote high-profile investments and politically connected business groups ready to take on such projects.

The Sapphire tower in Turkey is a perfect example in this regard.

The 54-floor tower, which received a ceremonial baptism from Prime Minister Erdogan when it opened in early 2011, is the signature property of the Kiler Group, one of the many construction-themed conglomerates that have achieved extraordinary success since Mr. Erdogan came to power in 2003. Like Mr. Erdogan, whose family comes from the northern Black Sea region, these businessmen hail from Turkey’s conservative Islamist provinces.

According to regulatory filings, 154 million liras of the group’s total 164 million liras in debt is denominated in dollars — about $79 million using current exchange rates. Of that figure, $25 million is related to the Sapphire tower, company officials say. Most of the group’s debt is short term, and in a reflection of the project’s risk, regulatory documents show that the cash generated by the property goes directly to the project’s primary creditor, Akbank, the fourth-largest bank in Turkey.

Given the differential between dollar loans at 6.5 percent and lira credit costing 11.5 percent, it was no surprise that the Kiler Group and others chose to borrow in dollars. The company, in its most recent filings, acknowledged this risk: if the American dollar gains 10 percent against the Turkish currency, the loss to the company would be 11.8 million Turkish liras.

According to Rasim Kaan Aytogu, chief financial officer for the Kiler Group, the Sapphire tower’s share of that total is $25 million. He contends that because the project books its revenue in dollars it is not exposed to currency fluctuations. He also says that demand for apartment units is strong, with 66 percent of them sold.

“This is a unique property in all of Europe,” he said. “And it is becoming a travel destination.”

But Turkish real estate experts say that sales of the apartments, which cost from $1 million to $10 million, have lagged and that the tower does not have the prestige of rival properties, including towers built by Trump and Zorlu. And according to company filings, revenue from visitors ogling the view from the tower’s observation deck have undershot targets from the outset.

The Kilers are not alone in their ability to make a big splash in Istanbul by deploying dollar debt and political muscle.

Even more influential has been the Kalyon Group, another real estate conglomerate with close ties to Mr. Erdogan. Kalyon is the main developer behind Mr. Erdogan’s controversial effort to build a replica of Ottoman-era army barracks as a shopping mall near Taksim Square.

As troubles were beginning to brew in Turkey, the leader of the Kalyon Group, Cemal Kalyoncu, remained confident that nothing would change. Asked in an interview with a local paper how the consortium of companies that won the tender for the airport would obtain the money, Mr. Kalyoncu said the group would look for loans outside Turkey.

“Financing this should be no problem at all,” he said.

Companies Shift Cash Out of Treasurys as Fears Subside

August 7, 2013, 1:28 PM ET

Companies Shift Cash Out of Treasurys as Fears Subside

Companies moved money out of government debt and into commercial paper and corporate debt, as worries over Federal Reserve policy faded and treasurers showed a willingness to take on some risk to gain yield.

Click on the image above to view an interactive chart of corporate cash allocations.

U.S. Treasurys ended a three-month streak of increases in their share of corporate cash allocations, falling by 0.85 percentage point to represent 26.5% of corporate cash on August 1, according to data from Clearwater Analytics.

Corporate debt and commercial paper grew by .55 and .32 percentage point, respectively. Corporate debt remains the largest asset class among cash allocations, representing one-third of the total.

Worries that the Fed would reduce its bond-buying program prompted credit spreads to widen in May and June, said Rhet Hulbert, a portfolio manager at Clearwater Advisors LLC. But last month, he said, “the market settled, recognizing an over-reaction.”

Mortage-backed securities grew by .21 percentage point to 3.5% of all cash allocations.

“Mortgages had been underperforming other asset classes recently,” Mr. Hulbert said, “but investors in July moderated their views on risk and interest rates and moved some assets back into the space.”

Other asset types were mostly stable last month. Both agency bonds and CDs sank by 0.16 percentage point, but all other asset classes shifted less than 0.1 percentage point in July.

The 3 Ms of Risk Management

The 3 Ms of Risk Management




Recent market event have pointed to increasing volatility. As has happened all too many times in the past, risk management disasters continue to plague the industry and show up on the front page of the newspapers. Given the potential for these disasters to occur, lets discuss some required risk management capabilities.


Consider the following scenarios:


A major market move occurs. The Chief Risk Officer (“CRO”) of a broker/dealer wants to know right now what effect this has on the firm. Are they better or worse off? What actions should be taken? To determine the best course of action the CRO needs to know real-time what the positions are and the potential P&L effect. The CRO must also be able to perform a risk analysis immediately. As we have seen, inability to do this will consume resources, raise the firm’s risk profile and possibly cause losses as a result of the market move.


A major firm announces a significant profit restatement. The CRO of a major retail brokerage wants to know which accounts will be affected the most. The CRO needs to know real-time which accounts have concentrations in that industry and SIC code. Since it isn’t clear yet what the full effect of the restatement will be on security prices, can the CRO perform a what-if analysis on specific accounts to determine the potential effects on the firm and the accounts so that proper actions can be taken? Inability to do this real-time will consume resources and increase the risk profile of the firm and the accounts.


In both cases, could the CRO have set up early warnings so that the risk systems would have generated alerts as to problem positions or accounts when specific actions occur so that the CRO can spend less time finding risks and more time managing risks?


The industry has spent many dollars effecting comprehensive risk management capabilities. Ultimately risk management is, however, a process that requires tools and the right mindset, not just a system that measures risk. The purpose of risk management is the following: minimize the probability that an error occurs AND that it goes unnoticed. To do that, a firm must have all the components of effective risk management. The firm must have the ability to perform the 3 Ms of Risk Management: Measurement, Monitoring and Management of risk. In this paper, we will outline the basic capabilities of each of the three areas.



Risk Measurement


All firms must have the capability to measure their risks. Most firms have risk measurement systems. However, there is a lot more to it than that. Risk measurement involves ALL aspects of the capability to measure risk, not just having systems. To measure risk effectively and accurately, the firm must have accurate and timely information as to its positions, its counterparties and all relevant information regarding its positions and counterparties. This information should ideally be available on a real-time basis as markets move very rapidly and soon the risk analysis may no longer be valid. Measuring this information solely on an overnight (or end of day) basis will not be sufficient as market conditions change during the day, and customer and counterparty activity changes the firm’s risk profile constantly. It is also not sufficient to simply do this several times a day. As market conditions change, the value of the firm’s and its customers’ positions changes accordingly, either favorably or unfavorably. In addition, as customers do trades during the day the firm must be able to track its customers’ accounts as they transact business. This information must be accurate, accessible in a timely manner and able to be retrieved from the firm’s computers and sent to the relevant analytical models for risk evaluation. During some recent risk events, many firms learned that they could not do this effectively, much to their dismay.


So what does effective risk measurement entail? Several key components are required:


The risk measurement methodologies used must accurately measure the risks. There are many different ways to measure risks and firms use most of them. The two basic necessities for a risk measurement methodology to be effective are that they must reflect the risks they measure and all relevant parties must understand them.


Different kinds of firms will require different kinds of risk measures. The measures needed for a portfolio-based approach to risk measurement are not exactly the ones needed for a retail operation. The portfolio approach requires position, position attribute, counterparty and counterparty attribute data. A retail operation will require all that and extensive information at the account level so it can see what individual accounts are doing real-time.


The firm must be able to examine its risks at any level and aggregate up or drill down to any desired degree. For example, a broker dealer must be able to measure risk by security, security type, counterparty and type, industry or SIC classification, currency, geographical location, etc. The B/D should then be able to aggregate up or drill down in any direction (for example by country by currency or vice versa). A retail brokerage should be able to measure risk by account, by account type, by industry, SIC code, etc, and aggregate up. They should also be able to drill down to the account level after starting with a portfolio approach. In addition, a retail brokerage needs to perform sophisticated margin calculations on a wide variety of products. Also, they would need to be alerted when specific activities occur in selected accounts, e.g., large trades or prohibited activities.


The firm must be able to perform scenario and what if analysis on a real time basis for any of its risk measurement categories. For a retail operation, this means even at the account level.


The analytical models used to measure risk must be accurate and measure the right risks. The models must be appropriate to the business and the products. Different products may require different kinds of models and there is nothing wrong with that. Use as many models as is necessary and no more.

The inputs to the models must be accurate. Many firms have a problem with their data and getting it to the right system at the right time. The data must be accurate, clean, and timely. This applies to model-generated data (including the results of risk analysis) as well as historical market data. Without accurate inputs, the model will give misleading results, leading to inaccurate decision-making.


The connections between the systems must be accurate. Feeder systems must feed the inputs to the risk model on a timely and accurate basis, just as the risk system must feed other systems in the same manner.


The systems must work automatically. You should not have to do anything extra for the system to be measuring risk accurately and timely.


The firm should periodically assess its systems and their ability to perform, effecting updated capabilities when necessary.



Risk Monitoring


For effective risk management to take place, risks must be monitored. A firm that simply measures risk three thousand ways but does not monitor it on a timely basis will likely suffer at some point. Risk monitoring includes all aspects of ensuring that accurate risk measurement information is available to the right people on a timely and accurate basis. What does effective risk monitoring entail? Several key capabilities are required.


The firm must have timely and accurate risk information available to the right people at the right time.

The firm must have a set of comprehensive risk reports generated during the day. The reason that a set of reports is necessary is that different levels of management require different levels of risk information. The key criterion is that the reports reflect the degree of granularity and breadth of information required to optimize the decision-making capabilities of the party that gets the reports.

The firm must also have this information available on a real-time basis. This means that it must be available online for the parties that require it so they can see what is going on at all times. The same issues of granularity and breadth apply here.


The risk systems should have the capability to alert the proper manager when preset conditions occur so that proactive risk management can occur. The firm should set up a variety (as many as needed) of risk conditions that different managers are concerned with. These conditions should also be set in a variety of ways. The parties could set up criteria that will generate alerts. The relevant manager could then drill down into the alert to investigate further. The proper action could be taken.

For example, a B/D could set these alerts to show limit utilization above a certain level (e.g., 75%) and by security, currency, counterparty, trading ledger, industry or geographic location. The system alerts the appropriate level(s) of management when the condition is met. The alerts should also happen as a result of a what-if or scenario analysis, alerting the appropriate party to what could happen under certain conditions. For example, an alert could occur if a major market move would cause an X% loss in a particular security. Management can then examine the alert and take appropriate action, if any. These alerts are set by management and should reflect the conditions with which management is currently concerned.

For a retail operation, this would include all the above. It would also need to include alerts at the account level such as a big trade or an account that is utilizing an increasing portion of its credit and is heading toward a potential margin call. For example, an alert could occur if an X% market move would cause a margin call in a large (or small) account(s). Management can set up appropriate conditions for accounts it wishes to monitor and be alerted when those conditions are met. Management can then examine further and take the appropriate action, if any.

In addition to all the reports and alerts, managers must effectively communicate with each other so that they are aware of current conditions.



Risk Management


The first two steps in the process provide the analytics and the tools that managers at all levels must have in order to make effective decisions regarding risks. The final step in the process may be the simplest to explain. After all the risks that can be measured are monitored (those that can be measured. Not all risks can be measured and you should not try!), and after the correct monitoring systems and procedures are in place, the final step in the process is actually managing the risk. This simply means management decision-making when called for, based on the information that is available. Managers at every level must be ready to take appropriate actions when a condition exists that warrants attention. This means proactive actions. Remember that not every risk condition or situation requires action. It possible that, for example, that a limit is exceeded on a trading floor and management becomes aware of it. After reviewing the excess, determining the cause and discussing the possible harm, the appropriate managers may let it stand and take no action. Or, an alert can be generated on a specific account. After drill down and review, management decides no action is called for.


Some of the critical aspects of managing risk effectively are:


The proper analytical tools must be used so that the information to decide possible courses of action is reliable

The proper risk monitoring capabilities, including alerting capabilities that provide this information on a real time basis, must be in place

A risk-oriented mindset must exist in all employees. Senior management must drive this mindset from the top down. Everyone bears some of the responsibility, not just management and risk managers

A willingness to be proactive regarding risk management, treating risk management as a business partner, not simply part of a compliance function




As we all know, there are many crucial aspects to implementing effective risk management capabilities at a firm. It is critical that each phase be implemented at any firm that wishes to effectively manage its risks. This can be summarized relatively simply. The tools for measuring risk must be accurate as must be the inputs to those tools. This means models must be accurate. Data must be clean. The technology behind the system should help the risk management process by identifying risk so that managers gave increased resources for managing risks. Real-time capability is required; batch processes won’t cut it any more. The outputs of the risk measurement process must be available on a real time basis so that managers understand what is happening as it is happening and can take appropriate action. This means everyone gets the info when they need it. Systems that inform management of current conditions go a long way to helping the process. Finally, everyone should consider risk management as part of his or her job. Effective risk management is possible when these conditions are met.



New FX Volatility Likely (Stay Tuned)

Some Comments on Recent Exchange Rate Activity 

The FX markets are critical to smooth functioning markets. Sooner or later EVERY piece of international trade will involve a foreign exchange transaction. That is one reason the FX market is by far the largest market in the world. Another factor is the amount of currency speculation that occurs. Here we simply have those buying and selling solely to try to benefit from anticipated price movement. Finally we have hedging activities, those taking offsetting positions to reduce the overall volatility in a firm or trader’s P&L. These are just some of the factors that affect the FX market, which includes currencies and derivatives.

Some recent actions point to the possibility of increasing exchange rate volatility in the near future.

  1. Japan has recently begun a change in their macroeconomic management of the Japanese economy. Their desire to cure the deflation which has been hurting the Japanese economy is likely to cause an increase in the inflation rate. This can cause a weakening of the Yen relative to other currencies
  2.  Thailand is considering capital controls and interest rate actions to cool the rise in the Baht
  3. The US has had very low interest rates for several years as the Fed has been trying to manage the economy back to health. At some point interest rates in the US are likely to rise from their current levels. This will likely cause some increase in exchange rate volatility.
  4. Problems with the Euro have been plaguing the world, although based on member country interest rates, it appears that markets have calmed down a great deal

While many factors affect currency markets, here is a quick overview of three key relationships affecting exchange rates. We are describing each factor independently even though they are interactive and NOT the only factors affecting exchange rates.

  1. Interest rate differentials between two countries can affect exchange rates by making investments in the higher interest rate country relatively attractive. This comes from two potential sources. First, the higher interest rate can potentially offer a more attractive rate of return. Second, if the rate is believed to be ‘high’ and likely to come down, there will be a potential capital gain earned should rates decrease. This can translate into an enhanced rate of return for the investor.
  2. Inflation rate differentials can affect exchange rate by causing a devaluing of one currency relative to another. Generally speaking, the exchange rate between two currencies will depreciate relative to the difference in the inflation rates between the currencies. Inflation tends to weaken a currency and so we could expect the inflation rate differentials to drive a wedge into the exchange rate
  3. The Fischer effect (named after Irving Fisher) states the nominal rate of interest is related to the sum of the real rate of interest and the expected inflation rate (while this is not literally the relationship, it is close enough for what we are discussing here). As inflation rates rise nominal interest rates should tend to rise with them, although there is often a time lag. If inflation rates rise (as some think likely) expect nominal rates to rise.

In general, an increase in the level of rates tends to raise the measured volatility of those rates. In other words, volatility tends to be higher as the LEVEL of rates gets higher. So if rates go up in the near future (for any reason – inflation, commodity prices, etc) we can expect a corresponding increase in exchange rate volatility.