Betting on the Wrong Side of the Market

By Simon Grey, on January 5th, 2012
Here’s some bad advice:

You don’t have to shell out hundreds of dollars every year to watch your favorite shows. This year, consider canceling your cable and taking advantage of several free and low-cost entertainment services. The website Hulu, for instance, lets you watch a variety of hit shows for free such as Glee, The Office and Modern Family, plus movies and documentaries. Or for $7.99 a month, you can take advantage of Hulu Plus, which gives you access to all of the selections on regular Hulu, plus more shows and movies.

You can also watch many shows for free on the network’s website, or pay $7.99 for Netflix, which provides access to unlimited movies and TV episodes.

The reason why cable is so expensive is because ad revenue alone is insufficient to cover both production costs and distribution costs. Cable and satellite networks are expensive to build and maintain, and content creation can often be pricey. As such, cable providers have to charge customers in order to be profitable.

The problem internet-based entertainment services face is that they are causing a significant portion of data transfer (i.e. the amount of data transmitted across the various data networks) but aren’t paying for any of the network upkeep and maintenance. Essentially they are paying only for content creation and distribution rights. This, incidentally, is why Hulu+ and Netflix subscriptions are so cheap (that, and Hulu is pretty well-connected to the NBC and Fox family of networks).

More importantly, it is the data service providers who have to pay for the creation and upkeep of data networks, and these networks have data transfer limits known as bandwidth. Essentially, there are limits to how much data can be transferred across a network at any given time. As more and more people begin to use online video content providers, there will be even more at being transferred at any given time, pushing up against physical network limits.

Data service providers will then have two options when this inevitably happens: increase bandwidth or cap data transfers. Most data transfer providers have relatively tight margins, so upgrading a network is not particularly feasible, nor will it be particularly widespread. Thus, the more common choice will be to cap data. Data caps (whether in terms of bandwidth usage or total data downloaded) will significantly curtail entertainment options, and so whatever profitability online video sites may have now will be either significantly reduced or completely eliminated, unless they decide to raise their fees.

Quite simply, the internet is not yet ready to replace cable. The network is not sufficiently built up. More importantly, the producers and aggregators of online content are not paying for the distribution of their content, and those who distribute content (data service providers) don’t have much reason to upgrade their network.

Ultimately, there is a strong chance that the market for online videos will eventually come to resemble the subscription television market. The separation of content providers and content distributors provides a problematic incentive structure that won’t be easily remedies unless content aggregators/producers have a financial stake in distribution, and vice versa.

Note: one thing that complicates this discussion immensely is the role of IP. If there were no IP, there would be many more aggregators of videos, and their subscription costs, if any, would be minimal since it would be considerably easier to find advertisers for pre-existing content, thus leading to an easy method of third-party funding. On the other hand, the amount of original content would diminish, and would probably become more low-brow.



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ECB/Fed Support for the European Banking System - 750 billion USD, and counting ...

By Claus Vistesen, on January 5th, 2012

One point that I have been shouting from the proverbial roof tops in my research, to partners and colleagues is that 2012 may well be the year when all major central banks will be conducting both conventional and unconventional monetary easing at the same time. I think this is a very strong testament not only to the severity of the ongoing debt crisis in the developed world, but also to the propensity of central banks to choose inflation as the  desired route to recovery. We need not initially discuss whether they are deploying the proper set of policies or even whether such policies represent moral hazard or a ponzi scheme on government debt.

The main thing is to realise that this is an unprecedented global monetary experiment.

My message to investors in 2012 would then be not to underestimate this inflation bias by part of global central banks. Inflating your way out of too much debt won’t work in the long run without considerable defaults and/or economic stress (hyper inflation). Events since 2008 are ample evidence of this, but the simultaneous inclination to create inflation and debase your currency (to generate more inflation and exports) by all major central banks will continue to exert a profound effect on asset prices and the global economy.

In so far as goes the idea that an investors’ interest in asset prices is conditioned on return and volatility we can say that central bank policy will affect both. Financial assets will certainly benefit from excess liquidity, but the unravelling of too much debt through inevitable defaults and the central bank policies themselves will generate volatility. Whether the combination of such volatility and return means that you should stay out of the market entirely is a question for the individual investor. I believe that

From a macroeconomic point of view, the downbeat assessment remains however that it is difficult if not impossible to paint a picture of where sufficient growth is going to come from and on the investment side of things, the higher level of volatility will tend to shake the foundation of investors even if money is to be made for short periods of time.

Most attention has been centered on the ECB, whether the 3y LTRO represent QE and whether the continuing rejection to buy government bonds outright means that the ECB is a laggard among global central banks (see this excellent report by Hinde Capital for additional analysis relative to the points below).

750 Billion USD,  and counting …

Europe remains the center of the global debt crisis, a role the continent has now decisively taken over from the US which stood at the forefront in the initial phases of the crisis in 2008. Apart from the almost endless summits and meetings among government officials the significant measures continue to be the ones coming from the ECB.

In my view, the European interbank market is virtually dead and dusted, and the ECB and the Fed are now effectively the only thing between Europe’s banks and large scale failures. Since early September 750 billion USD worth of liquidity has been provided to the European banking system of which 100 billion sits on the Fed balance sheet through USD swap lines.

Who will bet against the final 3y LTRO auction to take this beyond one trillion USD?

Spanish and Italian curves are now nicely steep again after a brush with inversion which obviously was one of the main objectives even if it was always debatable whether banks would buy government bonds with the liquidity taken up at the ECB.

The question is; how do you unwind all this? 750 billion USD to roll short term liabilities with the ECB and the Fed seems to me to be one of the biggest gamble in monetary history.

While the BOE and the Fed have been transparent in their QE efforts and the BOJ never really having left the zero bound the ECB has been more covert. However, it is my contention that with the expansion of the securities market programme (SMP) in 2011 to buy considerable amounts of government bonds (1) as well as the 3y LTRO the ECB is now fully engaged in quantitative easing.

I base this on two points.

  • The ECB has acted as a sovereign debt buyer of last resort in times of crisis. It is common knowledge in the market that the ECB has been Italian and Spanish bonds in times of particular stress on the notion that these two economies in particular could not be allowed to fatally succumb to the debt snowball dynamics.
  • ECB support for the banking system in the form of collateralised liquidity and wholesale funding is not temporary but structural and permanent in nature. The interbank market in Europe is not working and has not been working since the crisis started in 2008.

    The ECB will of course vehemently deny this but investors should understand that such denial is mainly out of political reasons.  When Draghi unveiled the ECB’s attempt to backstop the crisis in Europe by offering full allotment liquidity on a 3y basis, the market was disappointed because the central bank president also reiterated that the ECB would not step up its purchases of government bonds.

    I think that the ECB will be forced into a much more direct and active role where unsterilized purchases in the primary market (monetisation) will be needed, but I fully appreciate the political issues. We are currently in a delicate situation where new governments in most of the involved countries are saddled with forced mandates to impose austerity. It is very difficult for all parties involved to push this agenda if the ECB had stepped up a full backstop. Moral hazard risks are consequently paramount here.

    As such, investors must content with the ECB’s attempt to shore up the European banking system which is no little feat given the bank rollover schedule in 2012  as well as new Basel II regulation which will further impair already shaken balance sheets. The ECB’s initiatives then follows the steady deterioration of conditions in the European (indeed global) banking system which initially culminated in the coordinated action by global central banks to supply dollars through Fed swap lines and which found its European answer in the ECB’s decision to provide unlimited liquidity yet again.

    The problems look ominous for European banks and the global financial system in general. No matter what, European financial institutions will have to delever significantly which will spread its tentacles wide and far due to the high penetration by European banks in emerging markets (Eastern Europe in particular).

    Behind the scenes however, significant ink has been spilled to debate and speculate on to the exact significance of the ECB’s liquidity operations.

    John Hempton for example suggests that the ECB’s policy move is an open invitation to play the carry trade game using almost free liquidity to buy higher yielding government bonds.

    Well the Euro fix is in. Whether it works – that is another question. But the fix is this: European banks can borrow unlimited amounts for three years to buy Euro government debt. The debt often yields 5 percent. The money costs 1 percent.

    I agree that the incentives are certainly there for the banks to play this game especially in the context of government bonds as zero risk weighted assets. The problem is that many European banks have spent more than a year and two stress tests to get rid of substantial amount of peripheral government debt (which do not count as zero risk weighted assets according to Basel III) and as such weak governments are unlikely to benefit from this.

    The flip side of this is that most of the liquidity taken up by banks go straight back to the ECB at the deposit facility which is now standing higher than at any time between 2008 and 2010.

    Quote Reuters

    The euro zone banking system starts the new year awash with record levels of liquidity but few signs that institutions are prepared to lend to each other, leaving money markets frozen.Most of the near half trillion euros of three-year funds borrowed from the European Central Bank in the last week of 2011 have made their way back to the ECB’s overnight deposit account.

    The Reuters piece goes on to argue that most of the liquidity will probably go to aid the large refinancing need banks face in 2012 and thus effectively as a replacement for a non-functioning interbank market that would normally be able to roll this financing. If this does nothing to solve the problem of sovereign insolvency and illiquidity it will work wonders through the fact that banks won’t act as a drag on their respective sovereign’s balance sheet as long as the ECB is involved.

    I would note though that even though the liquidity is mainly reflected in reserves held at the ECB, it still represents excess liquidity as noted by Danske Bank.

    Some market commentators have argued that the first 36 months long-term refinancing operation (LTRO), in which banks took EUR490bn in total, has so far not worked as planned because the extra liquidity has simply been placed on the deposit facility at the ECB. However, this argument is false.The sharp increase in outstanding open market operations (MRO+LTRO) increases excess liquidity (defined as open market operations plus recourse to the marginal lending facility minus autonomous liquidity factors minus reserve requirements) and this excess liquidity shows up as deposits at the ECB in just the same way as it did in 2008-10.

    However, nothing is easy and despite the fact that collateral can be posted for liquidity the sovereign is still on the hook as my friend Edward Hugh points out.

    Banks are being encouraged to keep rolling over what are basically NPLs by financing them at 1% at the ECB (foreclosing on them in Spain and keeping the property on the books may cost something like 8% in comparison). But the ECB isn’t assuming the risk here, the national sovereign implicitly is, and is getting in deeper by the day.

    This is certainly true by the letter of the law but one has to wonder whether the ECB will ever get paid back here. I mean 3 years is an awful lot of time. The ECB can roll these loans as long as need be (it has already effectively been rolling bank funding since 2008) while maintaining the figue leaf that it is not funding sovereigns. This may be true, but it is effectively funding the sovereign’s banks and postponing the day of reckoning which is bank failures or nationalisation or both.

    If the ECB is then forced take a hit on the collateral or the loans themselves, it will need to create the money to pay for these loans by printing euros. This sounds as a plan to me except that it does not solve the funding risks of governments which may or may not be able to ask their banks for help. The likely answer is that they won’t be unless the ECB and EU decide to wield the ultimate weapon of financial oppression which would be to penalise reserves over a given level with negative interest rates at the same time as banks would be forced, through regulation, to hold government bonds.

    But Edward makes another interesting point;

    Looking at the Greek PSI, what they would try and do (if all this gets that far, I mean if the Euro holds together long enough in this Byzantine world) ) is load up the private sector share of the haircut, and keep the ECB as untouchable official sector. At the limit they can use ELA to keep the banks afloat while the sovereign restructures and then recapitalises.

    (…)

    Why would any ex Eurozone third party want to be counterparty to anything which might end up being subordinated to ECB exposure later on down the line. The more I think about it the more it seems to me that the 3 yr LTROs might end up choking the European banking system to death.

    It is difficult to disagree on the gist of this point, namely that the ECB is digging itself a very big hole. If banks can exchange under water assets at the ECB for a deposit asset at the ECB (albeit with a negative carry) the ECB is running the risk that it becomes the sole counterparty of bad assets in the euro zone in which case seniority will mean very little.

    The Greek situation is a good example. Private creditors face an almost certain 100% wipeout exactly because they represent such a small tranche of the total stock of debt. In such a situation the asymmetric relationship between subordinate and senior debt holders mean that the latter essentially become equity holders. But once subordinate creditors are wiped out the turn comes to the senior debt tranches and the further the ECB goes along the road of providing full allotment liquidity the higher will be its implicit direct claim on assets of all sorts of qualities.

    In conclusion, it is my view that the ECB is now the only thing between the economy and widespread bank failures, but I also concur that the consequence of this is a permanent outsourcing of the interbank market in Europe to the ECB’s balance sheet and, quite possibly, Fed’s USD swap lines.

    –

    (1) – Even if such purchases have been fully sterilised.



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    The first PISA results for India: The end of the beginning

    By Ajay Shah, on January 5th, 2012

    The PISA 2009+ results are the end of the beginning. For the last decade there has been a debate. Some argued the levels of learning inside Indian elementary schools (primary and upper primary) are a national scandal and a threat to the future of India’s society, polity, and economy. Others appeared to believe that the main, if not only, problem with Indian schools was that not enough children attend them and that with more money and more of the same, all would be well. The last five years saw a relentless accumulation of evidence about the crisis of learning. The establishment has tried to deny, deflect, and dismiss the evidence on learning. Eventually the Government of India agreed to participate in the PISA (Programme for International Student Assessment) – but only for two states, Tamil Nadu and Himachal Pradesh – and both sides agreed PISA was the litmus test. The PISA 2009+ results, which are both official and are beyond gain-saying are unspeakably bad. They confirm the worst of what anyone has been saying about the levels of learning in India elementary education.

    • In reading of the 74 regions participating in PISA 2009 or 2009+ these two states beat out only Kyrgyzstan.
    • In mathematics of the 74 regions participating the two states finished again, second and third to last, again beating only Kyrgyzstan.
    • In science the results were even worse, Himachal Pradesh came in dead last, behind Kyrgyzstan, while Tamil Nadu inched ahead to finish 72nd of 74.

    But just coming in last (if we can dismiss as a relevant comparator for India a tiny Central Asian state) does not convey the enormity of how bad these results were, as not only was India last, it was far, far, behind its aspirations, both at the bottom and at the top levels of performance.

    PISA expresses the levels of performance in two ways, an overall index number and the fraction of students achieving various “levels” of achievement. The PISA index numbers for each subject are scaled so that the typical OECD student is at 500 and the standard deviation across OECD students is 100. The testing of thousands of students allows the results to present not only the average but also the worst (5th percentile) and best (95th percentile) students do in each country/region. PISA also classifies student performance into “levels” that represent different degrees of mastery of the material.

    Table 1 compares India’s performance to three groups of countries. The economic superstars have successfully completed the transition from poor to rich economies in just two generations – Singapore, Hong Kong, Korea (China’s only results are just for the city of Shanghai, which are the highest scores of any region tested, but this is too a typical to really be comparable) and India aspires to their sustained success economically. The current super powers are represented by the USA and the OECD average reflects India’s aspirations as a superpower. The rising powers are represented by the BRIC countries of Russia and Brazil which reflect the rise of the emerging markets.

    Compared to the economic superstars India is almost unfathomably far behind. The TN/HP average 15 year old is over 200 points behind. If a typical grade gain is 40 points a year Indian eighth graders are at the level of Korea third graders in their mathematics mastery. In fact the average TN/HP child is 40 to 50 points behind the worst students in the economic superstars. Equally worrisome is that the best performers in TN/HP – the top 5 percent who India will need in science and technology to complete globally – were almost 100 points behind the average child in Singapore and 83 points behind the average Korean – and a staggering 250 points behind the best in the best.

    As the current superpowers are behind the East Asian economic superstars in learning performance the distance to India is not quite as far, but still the average TN/HP child is right at the level of the worst OECD or American students (only 1.5 or 7.5 points ahead). Indians often deride America’s schools but the average child placed in an American school would be among the weakest students. Indians might have believed, with President Obama, that American schools were under threat from India but the best TN/HP students are 24 points behind the average American 15 year old.

    Even among other “developing” nations that make up the BRICs India lags – from Russia by almost as much as the USA and only for Brazil, which like the rest of Latin America is infamous for lagging education performance does India even come close – and then not even that close.

    To put these results in perspective, in the USA there has been huge and continuous concern that has caused seismic shifts in the discourse about education driven, in part, by the fact that the USA is lagging the economic superstars like Korea. But the average US 15 year old is 59 points behind Koreans. TN/HP students are 41.5 points behind Brazil, and twice as far behind Russia (123.5 points) as the US is Korea, and almost four times further behind Singapore (217.5 vs 59) that the US is behind Korea. Yet so far this disastrous performance has yet to occasion a ripple in the education establishment.

    Table 1: Comparing Indian (Tamil Nadu and Himachal Pradesh) students mastery of mathematics to economic superstars, current superpowers, and rising superpowers
    Country/Region 5th mean 95th HP+TN average to comparator average HP+TN average to comparator 5th percentile HP+TN best (95th) to comparator’s average HP+TN best (95th) to comparator’s 95th
    Points TN/HP is behind (-)/ahead(+)
    Economic Superstars
    Singapore 383 562 725 -217.5 -38.5 -99 -262
    Hong Kong 390 555 703 -210.5 -45.5 -92 -240
    Korea 397 546 689 -201.5 -52.5 -83 -226
    Current Superpower
    OECD avg. 343 496 643 -151.5 1.5 -33 -180
    USA 337 487 637 -142.5 7.5 -24 -174
    Rising Superpowers
    Russia 329 468 609 -123.5 15.5 -5 -146
    Brazil 261 386 531 -41.5 83.5 77 -68
    Indian States
    Tamil Nadu 241 351 468
    Himachal Pradesh 223 338 458
    Average of TN and HP 232 344.5 463
    Source: PISA 2009 Plus Results, Table B.3.1 for first three columns and author’s calculations.

    I have emphasised Mathematics because many believed math was an Indian strong suit. The results for reading and science are similarly bad. Table 2 shows science results in a different format, which shows the proportion of children in various categories of performance. There are three points:

    1. “Below level 1″ doesn’t even have a description as it implies  that so little proficiency is demonstrated it is impossible to
      distinguish from not knowing anything at all. In the USA, even with its socio-economic and racial inequalities and language inequalities and its failing inner city schools, only 4.2 percent are in this category. In HP 57.9 percent of 15 year olds in school cannot be distinguished from not having learned any science at all and in TN 43.6 percent all in this category – ten times as many as the USA.
    2. PISA considers “level 2″ as the minimum level that provides the science competencies that will enable them to participate actively in life situations related to science and technology. Since more than 80 percent of students in both HP and TN
      are level 1 or below this most students in these states have reached age 15 ill-equipped for the century they will face.
    3. While a thin elite that competes for the few highly selective technical institutes are globally competitive, this is a tiny fraction of the population. The estimate of the fraction of TN or HP students at level 6 in science proficiency was zero. Their estimate of the fraction at level 5: also zero. Of course this does not mean there are not such students in these states, of course there are, just that from the samples available in the study the best estimate was so small as to be indistinguishable from zero.
    Table 2: Comparison of science proficiency in Tamil Nadu
    and Himachal Pradesh to India’s aspirations
    Country/Region Below level 1 Level 1 1 Level 5 5 Level 6 6
    Singapore 2.8 8.7 15.3 4.6
    Hong Kong 1.4 5.2 14.2 2
    Korea 1.1 5.2 10.5 1.1
    OECD avg. 5 13 7.4 1.2
    USA 4.2 13.9 7.9 1.3
    Russia 5.5 16.5 3.9 0.4
    Brazil 19.7 34.5 0.6 0
    Tamil Nadu 43.6 40.9 0a 0a
    Himachal Pradesh 57.9 30.9 0a 0a
    Source: PISA 2009 Plus Results. Description of levels Table 3.2, percentages Table B.3.4.

    1) At Level 1, students have such a limited scientific knowledge that it can only be applied to a few, familiar situations. They can present scientific explanations that are obvious and follow explicitly from given evidence.

    5) At Level 5, students can identify the scientific components of many complex life situations, apply both scientific concepts and knowledge about science to these situations, and can compare, select and evaluate appropriate scientific evidence for responding to life situations. Students at this level can use well-developed inquiry abilities, link knowledge appropriately and bring critical insights to situations. They can construct explanations based on evidence and arguments based on their critical analysis.

    6) At Level 6, students can consistently identify, explain and apply scientific knowledge and knowledge about science in a variety of complex life situations. They can link different information sources and explanations and use evidence from those sources to justify decisions. They clearly and consistently demonstrate advanced scientific thinking and reasoning, and they demonstrate willingness to use their scientific understanding in support of solutions to unfamiliar scientific and technological situations. Students at this level can use scientific knowledge and develop arguments in support of recommendations and decisions that centre on personal, social or global situations.

    a) In Table B.3.4 these are reported as blank but the estimated percentages in below 1 to level 4 sum to exactly 100 percent. Obviously this not imply that there are exactly zero students in all of these two states meeting these levels but that with the sample sizes assess students of 1616 in HP and 3210 in TN there was insufficient information to create a non-zero estimate.

    These results on PISA 2009+, while tragic for what they imply for Indian youth and perhaps shocking to newcomers to this subject, come as no surprise to those who have been working on basic education in India:

    • Das and Zajonc (2008) used results from Orissa and Rajasthan to create indices on mathematics performance similar to those of TIMSS (Trends in Mathematics and Science Study) and found these states near the bottom of the global rankings.
    • Educational Initiatives carried out an 18 state study using sophisticated testing instruments and found levels of performance on TIMSS comparable items that were stunningly lower. For instance on the open ended question “Write a fraction larger than 2/7″ less than 30 percent of Indian students in standard 8 could answer correctly compared to more than 70 percent internationally.
    • The APRest study led by Karthik Muralidharan and Venkatesh Sundararaman in rural AP asked the same questions of students in grades 2 to 5 and found very slow rates of learning progress.
    • The results year after year from the ASER [2010 2009] study supported by Pratham find that significant fractions of students in Standard 8 cannot master even Standard 2 curricular basics. In rural areas nationwide a third of children in grade 8 could not do a simple division problem and almost 20 percent could not read a level 2 text. The 2011 results, due out in a few weeks will show continued stagnation or even retrogress in learning.
    • Numerous studies by MIT’s JPAL, World Bank, NCAER/University of Maryland and other researchers found levels of performance that were shockingly low compared to curricular expectations.

    These PISA 2009+ results are the end of the beginning. The debate is over. No one can still deny there is a deep crisis in the ability of the existing education system to produce child learning. India’s education system is undermining India’s legitimate aspirations to be at the global forefront as a prosperous economy, as a global great power, as an emulated polity, and as a fair and just society. As the beginning ends, the question now is: what is to be done?



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    Economic Events on January 5, 2012

    By B.P.T., on January 5th, 2012

    The monthly Chain Store Sales report will be released today.  This report on sales in chain stores gives a look at the health of stores that make up about 10% of all retail sales.

    The Challenger Job-Cut Report will be released at 7:30 AM Eastern time, providing an estimate of the number of layoffs in December.

    At 8:15 AM Eastern time, the monthly ADP Employment Report will be released.  Investors will be watching this number to get advance notice on the state of the job market in advance of the government’s report on Friday.

    At 8:30 AM Eastern time, the U.S. government will release its weekly Jobless Claims report. The consensus is that there were 375,000 new jobless claims last week, which would would be 6,000 less than the previous week.

    At 9:45 AM Eastern time, the weekly Bloomberg Consumer Comfort Index will be released, providing an update on Americans’ views of the U.S. economy, their personal finances and the buying climate.

    At 10:00 AM Eastern time, the ISM non-manufacturing index for December will be released.  The consensus estimate is that increased by 1.4 points to a value of 53.4, and will continue to signal economic growth as it remains above the mid-point of 50.

    At 10:30 AM Eastern time, the weekly Energy Information Administration Natural Gas Report will be released, giving an update on natural gas inventories in the United States.

    At 11:00 AM Eastern time, the weekly Energy Information Administration Petroleum Status Report will be released, giving investors an update on oil inventories in the United States.

    At 4:30 PM Eastern time, the Federal Reserve will release its Money Supply report, showing the amount of liquidity available in the U.S. economy.

    Also at 4:30 PM Eastern time, the Federal Reserve will release its Balance Sheet report, showing the amount of liquidity the Fed has injected into the economy by adding or removing reserves.



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