introduce the russian crisis historical context – weathered the asian crisis much better than...

Introduce the Russian CrisisIntroduce the Russian Crisis

Historical context – weathered the Asian Crisis much better than expected

Discuss the Fed’s outlook at the timeThe 180 degree turnaround

The Russian CrisisThe Russian Crisis

“You had an immediate and substantial collapse in risk appetite. Holders began selling bonds from South Korea, Greece, Turkey, Mexico, Brazil.”

If you had a collapse in risk appetite and you were an investor, where would you invest???

US 3-Month T-BillUS 3-Month T-Bill

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September 22, 1998 – From the September 22, 1998 – From the WSJWSJ

Why a World-Wide Chain Reaction

Set Financial Markets Into a Spin

This time, it isn’t some ill-starred military adventure. Instead, the world is blaming Russia for the chaos sweeping through financial markets over the past month. Russia’s abrupt decision in mid-August to let the ruble’s value fall and default on part of its debt is widely viewed as the reason for widespread selling in everything from Brazilian bonds to U.S. stocks.

What the virtual collapse of Russia’s markets did was touch off a global flight from financial risk of all kinds. Russia’s actions were the trigger for that panicked flight, but once started, it behaved like a chain reaction.

Big bets by sophisticated investors, many made with borrowed dollars and many having nothing to do with Russia, suddenly went bad.

Discuss LTCM and their bets

In a scramble to shore up their crumbling finances and meet lenders’ demands for more

collateral, those investors were forced to sell out of other, safer investments. And as these investments in turn tumbled under the selling pressure, the urge to flee became contagious, spreading quickly until it hammered just about every financial instrument except super-safe U.S. Treasury securities and German government bonds—which soared.

“Russia was the match, but the markets were ripe for dislocation,” Mr. Dimon says.

And they haven’t settled down yet. The scramble to unload almost any kind of risky investment has been so urgent that some markets, particularly for riskier bonds, are paralyzed, leaving firms holding far more of them than they want. The firms’ continuing efforts to cut their holdings suggest more declines ahead.

Beyond that are fears that other nations will follow Russia’s lead. Already, Malaysia has applied rigid controls that limit foreign investors’ ability to get their money out. Stock markets around the world remain volatile as investors worry about a crisis of confidence erupting in another developing nation.

Until this summer, Russia made some sense as a place to invest. The Asian turmoil that began with a mid-1997 devaluation of the Thai baht hadn’t reached Moscow. Yields on Russia’s government debt were high. Major firms such as Goldman, Sachs & Co. and Chase Manhattan Corp. were competing to underwrite government bonds and lead syndicated loans to Russian companies, while hedge-fund investors such as George Soros and Leon Cooperman were there, too.

With such stars paving the way, other investors felt comfortable in the Russian market. Some Wall Street traders bought Russian bonds for their personal accounts.

“Interest rates were so high it was almost as if they were giving money away,” says Dana McGinnis, a San Antonio manager of three emerging-market hedge funds. His McGinnis Advisors invested a large chunk of its $200 million in Russia.

Marc Hotimsky, global-bond chief for Credit Suisse First Boston, met with officials in Moscow and was assured that Russia would meet its obligations and wanted a stable ruble. Leaving the country on Friday, Aug. 14, he says, he “had a sense the situation in Russia was critical, but I didn’t think they would default.”

Trust me

On Monday, they did. Although Russia didn’t tamper with the government’s foreign-currency debt, it announced it would restructure its treasury bills and impose a moratorium on repayment of $40 billion in corporate and bank debt to foreign creditors. It said it would let the ruble’s value against the dollar fall by up to 34%. (The ruble didn’t stop where it was supposed to, as devalued currencies often don’t.)

Awakened at 3 a.m. by the news, he dashed to the office to warn others of the danger, the traders say. Then he boarded a plane back to Russia to try to sort out the mess.

The bills were supposedly protected by forward currency contracts entered into with big Russian banks. But Russia’s debt moratorium apparently allows its banks to ignore their forward-contract obligations for 90 days; terms of the freeze are so confused that parties are still haggling over what they mean.

Those holding Russian securities were stuck. There was no trading. No bids, no offers. A trading strategy that had been profitable—Nomura’s New York unit had made a total of about $100 million in Russia in the prior three years, the traders say—suddenly was destroyed. Nomura ended up with Russia-related pretax losses totaling $350 million, including $125 million in Mr. Amoresano’s “book.”

Investors in Russian securities weren’t the only ones affected; so were those who had lent to such investors. Creditors of hedge funds, convinced the funds wouldn’t get back all the money they had put into Russia, issued demands for more collateral, known as margin calls.

The funds had to raise capital to meet the calls, but they couldn’t do so by selling Russian securities, with those markets paralyzed. So they began selling other assets, including U.S. stocks.

One who got a margin call was Mr. McGinnis in San Antonio. His funds had $100 million of Russian bonds, bought with leverage; he, too, found that his currency contracts didn’t protect him when Russia defaulted. He says Citicorp, First Boston and Lehman Brothers Holdings Inc. demanded more collateral. To raise it, he says, he began dumping “everything else.”

Contagion!Contagion!

Talk spread that Russian treasury bills might be worth only 10 cents on the dollar. “The second you hear that, you’re feeling, ‘I don’t want to hold any other similar emerging-market debt,’ “ says Philipp Hildebrand, a strategist for the British affiliate of Moore Capital Management, a New York hedge fund. “You had an immediate and substantial collapse in risk appetite.” Holders began selling bonds from South Korea, Greece, Turkey, Mexico, Brazil.

Bonds Diverge Now, as investors rushed for the sanctuary of

U.S. Treasurys, the value of those bonds began to soar. Monday the 30-year bond’s yield got as low as 5.05% before late trading pushed it back up to a still-ultralow 5.124%. But the same thirst for safety caused investors to flee from riskier bonds, including those of emerging markets, U.S. mortgage-backed securities, high-yield “junk” bonds and even investment-grade corporate bonds.

“The whole world was on one side of the ship for three years, and now they wanted to go to the other side of the ship all at once,” says Greg Hopper, a portfolio manager at Bankers Trust Global Investment Management.

Many hedge funds and investment banks had wagered that growing demand for riskier bonds around the world would cause these bonds’ prices to rise and their yields to fall, but that yields would rise on the safest government bonds. The flight to safety caused the reverse to happen.

Nor was Merrill Lynch spared. In the wholesale flight to safety, even U.S. corporate bonds got slammed, and Merrill Lynch, as a leading underwriter and market maker, owned a $5 billion portfolio of them. Making matters worse was that one way Merrill had tried to protect itself from such a decline was by selling U.S. Treasurys short, figuring that if corporate bonds fell, so would Treasurys; when they soared, this bet only worsened Merrill’s losses.

A broader concern in the bond market has been gridlock. In recent weeks, buyers have simply shunned a broad range of bonds, from U.S. junk bonds to any emerging-market debt.

How the Fed Fumbled and How the Fed Fumbled and ThenThen

Recovered in Making Policy Recovered in Making Policy ShiftShift

By DAVID WESSEL Staff Reporter of THE WALL STREET

JOURNAL

WASHINGTON—Shortly after the Federal Reserve announced early in the afternoon on Sept. 29 that it was cutting interest rates, top Fed officials realized they had made a mistake.

They had hoped their first rate cut in nearly three years would reassure financial markets that the world’s most powerful central bank was prepared to do what was needed to avoid a global economic meltdown.

But Fed Chairman Alan Greenspan, known for often-obscure pronouncements, had sounded a clear alert that a rate cut was imminent, and the markets shrugged when the Fed trimmed just a quarter percentage point off its key short-term interest rate.

Edward Boehne, president of the Philadelphia Federal Reserve Bank, says he knew a few days later that the Fed had goofed. When he checked into a hotel in a small town in Pennsylvania, the clerk looked at his title and said, “You didn’t do enough.”

“You don’t usually get that from a hotel clerk,” Mr. Boehne says.

Discuss Fed Fumble articleDiscuss Fed Fumble article

What was the Fumble and what was the recovery? The handful of Fed policy makers who had

argued for a more dramatic half-percentage-point rate cut felt vindicated. Officials at the Federal Reserve Bank of New York worried that the rate cut had done little to reverse a stampede away from risky, and even not-so-risky, bonds.

Fed Fumble Article - Fed Fumble Article - continuedcontinued

– I thought the amount was irrelevant,” says Mr. Boehne, the Philadelphia Fed president. “The problem with 50 basis points”-jargon for a half percentage point-“was that people could have inferred that we knew more bad things than we did.” Mr. Greenspan made the same argument internally.

Fed Fumble - contFed Fumble - cont

– But after the Fed’s Sept. 29 announcement, the stock market sagged, and the worrisome spreads in the bond market widened.

A week later, Mr. Greenspan delivered a rambling, off-the-cuff early morning speech to the National Association for Business Economics. He had two goals. The first was to dispel the sense of doom and gloom that had descended.

Fed Fumble - cont’dFed Fumble - cont’d

The second goal, somewhat at odds with the first, was to lay the foundation for another rate cut by detailing the evidence that uncertainty and fear were causing investors to, as he put it, “disengage.”

Fed Fumble - contFed Fumble - cont

– By Thursday, Oct. 15, Mr. Greenspan figured the spreads in the bond market he had been tracking had grown so wide that they were bound to begin to narrow soon. It was time. He convened a telephone conference call of the FOMC.

Fed FumbleFed Fumble

– On their TV sets and computer screens, Fed officials watched the instant analysis with a bit of trepidation. But the reaction was almost universally favorable, and the intended message was received: The Fed was prepared to do what was necessary. “Yes!” one Fed governor said late that afternoon after listening to a Wall Street pundit on CNBC, the business cable channel. “They got it right.”

What is a spread?What is a spread?

In the context of the Russian Crisis, people were very interested in the movements of the commercial paper – US T-bill spread (paper – bill spread for short)

Why is there a spread?Which rate is higher and why?

Example with numbersExample with numbers

Suppose the current yield (or rate) on the 3 month US T-bill is 5.00% and the current yield on 90 day commercial paper is 5.50%

The difference 5.50 – 5.00 = 0.5% is referred to as the paper – bill spread

Historically, 0.5% is a ‘low’ paper-bill spread What does a low spread indicate? Suppose both rates are the same – what’s the

implication?

The Spread and the crisisThe Spread and the crisis

The Risk aversion (the psychology of going from one side of the boat to the other) resulted in investors shunning away from commercial paper – a credit crunch

Importance – “For most large, highly rated corporations, the commercial paper market is now the primary source of short-term credit”

The Spread and the crisis – The Spread and the crisis – cont’dcont’d

The shunning away from paper resulted in lower prices which is the same as saying higher yields on paper

At the same time – investors flocked to the safe haven of US Tbills – WHY?

Result – prices of Tbills skyrocketed or equivalently – yields plummeted

Implications on spread?

With numbersWith numbers

Before crisis – paper – bill spread = 0.5 % with paper yielding 5.5% and the bill at 5.00%

At ‘worst of crisis’ – paper – bill spread = 1.9% Yield on paper 5.5%, yield on bill = 3.6%

Why didn’t yield on paper rise indicating investors unwillingness to buy?

Think of volume rather than price Some Pictures

Commercial Paper – Tbill SpreadCommercial Paper – Tbill Spread

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Key TermsKey Terms

Margin and collateral callsLack of liquidity - markets seized upincrease in the paper-bill spreadback up line of creditdiversity of credit markets - its like having a

spare tire - Japan and E. Asia don’t - Europe?? - Sweden

Greenspan ExcerptsGreenspan Excerpts

Following the Russian default of August 1998, public capital markets in the United States virtually seized up. For a time not even investment-grade bond issuers could find reasonable takers.

Greenspan ExcerptsGreenspan Excerpts Arguably, at least as relevant was the existence of

backup financial institutions, especially commercial banks, that replaced the intermediation function of the public capital markets.

When American banks seized up in 1990, as a consequence of a collapse in the value of real estate collateral, the capital markets, largely unaffected by the decline in values, were able to substitute for the loss of bank financial intermediation.


The speed with which the Swedish financial system overcame the crisis offers a stark contrast with the long-lasting problems of Japan, whose financial system is the archetype of virtually bank-only financial intermediation. The keiretsu conglomerate system, as you know, centers on a “main bank,” leaving corporations especially dependent on banks for credit.


Thus, one consequence of Japan’s banking crisis has been a protracted credit crunch.

The failure to have backup forms of intermediation was of little consequence. The lack of a spare tire is of no concern if you do not get a flat.


Despite its close trade and financial ties to Asia, the Australian economy exhibited few signs of contagion from contiguous economies, arguably because Australia already had well-developed capital markets as well as a sturdy banking system. But going further, it is plausible that the dividends of financial diversity extend to more normal times as well.


The addition of distinct capital markets outside of banking systems is possible only if scarce real resources are devoted to building a financial infrastructure. It is a laborious process whose payoff is often experienced only decades later.


It is thus not a simple matter to append financial infrastructure to an economy developed without it. Accordingly, full convergence across countries of domestic financial infrastructure or even of the international components of financial infrastructure is a very difficult task.

Russian Crisis TermsRussian Crisis Terms

1. Margin calls2. Public capital markets3. Lack of liquidity4. Diverse credit markets5. Commercial paper

Russian Crisis Terms (cont’d)Russian Crisis Terms (cont’d)

6. The paper-bill spread7. The corporate bond market8. Collateral9. Risk aversion


10. Emerging market bonds11. Risk premium12. Psychology of going from one side of

the boat to the other13. The amount was irrelevant


14. Spooking the markets15. Credit rating16. Back-up line of credit17. Bond market rally18. Safe haven of US securities19. Hedge funds20. Credit markets locking up

introduce the russian crisis historical context – weathered the asian crisis much better than...

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