Archive for June 17th, 2008

BoE writes to Chancellor for breaching its inflation target

June 17, 2008

Under the UK monetary policy framework, Bank of England Governor is supposed to write to the Chancellor if BoE deviates from its inflation target of 2% by more than 1 %. The letter explains why it happened and what BoE would do?

In their 11 year framework, the Governor has written this letter twice, both within a year. First time in April 2007 when inflation for March 2007 touched 3.1% and second now in June 2008 when May inflation touched 3.3%.

The recent Governor letter is here and Chancellor’s reply is here. Chancellor agrees to Governor’s letter and calls it a global worry. Not much he can do anyways. The Gov. letter is more interesting:

Why has inflation increased? The Gov says because of unanticipated rise in prices of fuel, food, gas and electricity? But why was it unanticipated? It has been expected for a while.

Then is the BoE policy action to control inflation. It says it has cut rates three times since December (yes to manage inflation it has cut rates) as it is balancing 2 risks: slipping growth and rising inflation. It perceives falling growth to take care of rising inflation.

Further, the letter says inflation is expected to be around 3.5% for a while now (so we should expect more of such letters, which Chancellor also acknowledges).

Buffet on derivatives

June 17, 2008

Warren Buffet’s views on derivatives are well-known- time bombs, weapons of mass destruction etc. I read Berkshire Hathaway shareholder report -2002 (page 13- 15) where these Buffet euphemisms for derivatives are mentioned.

Apart from these select words, Buffet has highlighted risks from these instruments. At hindsight, these are the very risks which have led to the recent collapse. Sample this:

Unless derivatives contracts are collateralized or guaranteed, their ultimate value also depends on the creditworthiness of the counterparties to them. In the meantime, though, before a contract is settled, the counterparties record profits and losses – often huge in amount – in their current earnings statements without so much as a penny changing hands.

He says if you want a derivative speculating on number of twins to be born in Nebraska in 2020 you can have it 🙂

The range of derivatives contracts is limited only by the imagination of man (or sometimes, so it seems, madmen). At Enron, for example, newsprint and broadband derivatives, due to be settled many years in the future, were put on the books. Or say you want to write a contract speculating on the number of twins to be born in Nebraska in 2020. No problem – at a price, you will easily find an obliging counterparty.

On mark to market:

Those who trade derivatives are usually paid (in whole or part) on “earnings” calculated by mark-to-market accounting. But often there is no real market (think about our contract involving twins) and “mark-to-model” is utilized. This substitution can bring on large-scale mischief. As a general rule, contracts involving multiple reference items and distant settlement dates increase the opportunities for counterparties to use fanciful assumptions. In the twins scenario, for example, the two parties to the contract might well use differing models allowing  both to show substantial profits for many years. In extreme cases, mark-to-model degenerates into what I would call mark-to-myth.

He then discusses how derivatives lead create a daisy chain (i call it a house of cards) leading to a collapse from A entity to Z entity. He also says they continue to expand and central banks haven’t developed ways to monitor the risks. His take on risktaking is enough of a alarm (even now):

When Charlie and I finish reading the long footnotes detailing the derivatives activities of major banks, the only thing we understand is that we don’t understand how much risk the institution is

If he doesn’t understand, I am not sure who would??

Finally the famous words:

In our view, however, derivatives are financial weapons of mass destruction, carrying dangers that, while now latent, are potentially lethal.

Assorted Links

June 17, 2008

1. WSJ Blog points Fedspeak- Richard Lacker 

2. ISB points Mumbai dominates government Viability gap funding

3. Blattman points check your political compass

4. NB points out to practices in restaurants that lead to higher tips

5. Fin Prof points forget country bias, people seem to have state bias.

6. Bogle Blog points to new John Bogle speech. Must read to understand developments in finance.

7. PSD Blog points to reforms in Honduras

8. Deux Blog points to ECB worries 


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