lessons from a plane flight

- There is no free lunch. Sitting next to an exit door will give you more leg space. But on the other hand you will be the last person receiving meal since the distribution starts (simultaneously) from the two ends of the plane. And since you get to choose the last, you will be left with the crappier meal option.

- Sometimes your leader will lie to you for your own good. Just about ten minutes before the arrival time, the pilot announced that our landing time was being delayed due to heavy traffic at the airport. Then we circulated around the airport for about half an hour. My friend was agitated. He cursed at the pilot and complained about the infrastructural inefficiencies and deficiencies of Istanbul. The truth was that there was no traffic. We could not land because the city was being combed with the heaviest surface winds in its near history. (I knew this in advance due to a phone call just before the departure.) The pilot chose to tell another story in order to avoid an unnecessary panic.

- Leading people in a territory with many unpredictable elements requires guts. I knew what was expecting us when the pilot finally announced that we had obtained the permission to land. It was an absolute roller-coster experience. (I remember myself uttering several "Bismillah"s in a reflexive fashion. I am agnostic!) If I was in charge of the plane, I would have probably directed it to another airport. Perhaps I am extremely risk averse when it comes to making decisions about other peoples' lives. Anyways the decision required real guts. That is indisputable.

- Spread the risks. Never put all eggs in one basket. The whole executive team of our company was flying together. We should have splitted the group and flied separately. If the plane had crashed, the company would have gone along with it.

fluctuations without guarantees

Constancy of economic conditions numbs the imagination and eventually leads to a complete ignorance of history. Asset managers start acting as if the correlations across different assets will always stay the same. Firms start behaving as if the economic stability will linger on forever. Low interest rates available in the foreign credit markets become too tempting to ignore and the exchange rate risks seems too low to factor into calculations. Then a crisis hits out of nowhere. Dollar appreciates and the companies without a dollar denominated income start defaulting on their interest payments...

So what is the lesson here? Should Chief Financial Officers make sure that there is no significant mismatch between the currencies of their liabilities and income? Yes and No. In times of crises even a dollar denominated income may not to save you from defaulting on your dollar denominated liability.

Consider the case of a typical commodity exporter that sells a locally mined good into a dollar denominated international market. The dollar income leads to an ungrounded feeling of security which encourages the company to take on substantial amounts of dollar denominated debt. A worldwide financial crisis unexpectedly unfolds and causes a big stir. Companies who used to depend on the availability of cheap trade finance withdraw from the market. The financially weak ones default on their payments and the increase in counterparty risk results in a scare. Everyone in the sector starts working on a strictly cash basis and the trade volumes collapse. End-users of the commodity start complaining about the price as dollar appreciates against the currencies of their clients. The revenues of our commodity exporter diminish along with the fall in sales volume and prices. Soon or later the result is a default.

Lesson: Currency mismatch is only part of the story. No matter what you do, there is no guarantee that the value of your assets will fluctuate in tandem with the value of your liabilities.

cash-hoarding believers

Today central banks employ monetary policies aimed at encouraging consumption. When interest rates go down, people are supposed to be more tempted to spend money on tangible goods and investments. Unfortunately this is not happenning so far. The interest rates hit almost zero and people still continue to hoard money and cut on consumption.

Interest rates cannot go below zero. If they ever did, you would simply pull your savings out of the deposit account and put them in a safe. So the essential question is how central banks can punish people for hoarding cash in a zero-interest rate environment.

Marvin Goodfriend suggested imposing a carry tax on money. Such a tax would effectively act as a negative interest rate. However the employment of such a policy is problematic for several reasons:

1) It is impossible to tell how much cash a person is really hiding under his pillow without constant (very costly) monitoring.
2) There may be a massive switch into another currency. (This problem could be dealt with if "prominent" nations are willing to coordinate and impose the same percentage of carry tax on their currencies.)
3) People may lose confidence in the fiat currency regime and resort to gold as a medium of exchange. (In order to avoid such a situation the government can resort to banning individuals from holding precious metals. Such a move may sound like a violation of basic, constitutionally granted liberties. But that should not be surprising. All fiat currency regimes contain a hidden element of coercion. Otherwise why would anyone be willing to hold pieces of paper that are backed by government bonds which are essentially just promissory notes that pay the same pieces of paper in future? Almost everyone suspects that the regime is constructed upon a web of faith. However, for some reason, some are unwilling to make the connection between faith and coercion. It is certainly not a coincidence that the history is littered with examples of religious faith and coercion feeding off from each other.)

strategy, chaos and morality

Do not attempt to strategize in an environment where there are just way too many unknowns. A strategy can succeed only when you can "anticipate" and "adjust". If you can not anticipate, all you will end up doing is constant revision. When there is chaos and panic, just follow the trend and panic.

Do not whine about how irrational the markets have been behaving lately. The set of rational strategies changes along with the market conditions. However if you are too arrogant and slow to "adjust", these shifts will go unnoticed.

Do not stick to moral principles. Principles lead to predictability and predictability is a weakness. If other actors can anticipate your behavior within reasonable bounds, they will push you to a corner from which you can exit only by violating your principles. Soon you will find yourself outside the game.

macroeconomic misconceptions

- Forget about textbook relationships between macroeconomic variables. Even the most innocent looking relationship breaks down in practice. For example lower interest rates may lead to deflation as opposed to inflation. Say a substantial number of consumers decides to lock up their income in cheap car loans to buy imported cars. Then these consumers will have less money to spend elsewhere. Assuming that most of the money spent on cars gets sucked out of the country and does not indirectly return to it, this change in consumer behaviour will create a deflationary pressure on the prices of goods for which demand has now diminished. If such goods carry more weight in the official inflation formula than cars do, then the reported inflation rate may become negative.

-There is nothing inherently wrong about excessive consumption. What is dangerous from a macroeconomic point of view is unsustainable consumption. If the rich desires to buy fancy stuff, that is fine. As long as this behaviour can be prolonged, the system will experience no shocks. On the other hand, if the government suddenly withdraws a subsidy which was supposed to be in place for at least several decades, then the system will experience a demand shock. The people who used to receive the withdrawn subsidy will change their consumption behavior, and the businesses which expanded their production capacities to deal with the increased consumption that used to be financed by the subsidy will suffer from an unanticipated decline in revenues. Even if the government decides to spend the freed-up money on other things (i.e. there is no absolute change in the aggregate demand), the system will still suffer a shock due to the change in the composition of the aggregate demand.

surcharge mechanism

Here are some possible explanations of why ArcelorMittal recently decided to offer fixed-price contracts to its customers which previously did not have any choice but to stick to the surcharge mechanism.

The story line: 1,2,3,4

- ArcelorMittal may be trying to resolve a mismatch between its assets and liabilities. Banks prefer financing floating-rate credit with floating-rate debt, and fixed-rate credit with fixed-rate debt. This is a basic risk management philosophy. Perhaps, in a similar fashion, ArcelorMittal desires to finance its fixed-price purchasing contracts with fixed-price supply contracts. This allows ArcelorMittal to lock-in on the difference. (In November ArcelorMittal has unilaterally cancelled most of its purchasing agreements. The contracts I am referring to here are the ones that, I suppose, were recently signed behind closed doors at prices far lower than ones on previous contracts.)

- “When prices are going up everybody is happy but one day they had to go down,” Arcelor's Payet-Gaspard tells MB. “Now people are making tremendous losses, the value of the industry is being destroyed and they want someone to blame.” It seems as if it is in the interest of steel makers to switch to the old fashioned fixed-price system, because under the surcharge mechanism the steel prices collapse immediately along with the ferro-alloys prices. But is this really a valid argument?

It depends. Swapping floating agreements with fixed ones does not necessarily increase Arcelor’s profits. As in every swap transaction, the key point is the swap rate. For example, assume that you have a liability that floats along with LIBOR and you believe that LIBOR will increase in the future. If the market’s beliefs are aligned with yours, then the market will not swap your floating liabilities with a fixed rate that will make you happy. Why? Because, just like you, the market believes that LIBOR will go up and therefore it will demand a fixed-rate that is higher than the floating rate which you are currently paying. The chances are that you will gain from the swap agreement only if LIBOR moves up more than the amount anticipated by the market.

Similarly, ArcelorMittal will gain from the removal of the surcharge mechanism only if the ferro-alloys prices depreciate more than the amount anticipated by the steel buyers. In the supply chain it is closer to the ferro-alloys markets than the steel buyers are. Moreover, due to its sheer size, ArcelorMittal can physically influence the ferro-alloys prices. Hence it probably has a deeper understanding of the ferro-allloys markets and its expectations have higher chances of being in line with the ferro-alloys price developments. However this still does not mean that ArcelorMittal will be able to gain from the removal of the surcharge mechanism. Why? Because the customers of ArcelorMittal already know that ArcelorMittal is more informed about the ferro-alloys markets. Therefore they will be risk-averse and ask for significant price cuts during negotiations.

- In a similar fashion to the above argument, one could claim that customers of ArcelorMittal believe that the ferro-alloys prices will appreciate more than the amount that is anticipated by the steel producers. Therefore it makes sense for them to demand a switch from a floating contractual agreement to a fixed one. Today the steel market is a buyers’ market, and ArcelorMittal desperately needs cash in order to retain a healthy debt-coverage ratio. Buyers have the bargaining power to dictate both the terms and the forms of contractual agreements.

- Buyers will benefit from the increased competition among steel makers: “The surcharge gives stable returns and stable margins and keeps the industry and customer aware of what is going on with the raw material prices,” Arcelor Stainless International CEO Pascal Payet-Gaspard tells MetalBulletin. “The alloy surcharge gives flexibility to the market which we don’t have. The Danish market is very competitive and for this reason stockists will not talk to each other. We are quite stupid because if we communicated, like in Germany, then we could have a margin,” one trader says. In other words, steel producers may be using the surcharge mechanism as a vehicle to collaborate and preserve margins that would otherwise be impossible to maintain in a competitive environment.

- Buyers will benefit from increased pricing transparency from the removal of surcharge mechanism:"The pricing system of stainless is so complicated," one trader tells MetalBulletin. "ThyssenKrupp started it and everybody had to follow. I try to calculate it myself each month but it is a misty area." The rebate system that has emerged in ferro-alloys pricing is nice example of how steel buyers become victim of the lack of transparency. Instead of asking for a direct discount on ferro-alloys prices, the purchasing departments of steel producers ask for a rebate. This keeps the published ferro-alloys prices higher than the actual market levels and pushes up the surcharges.

- Buyers may believe that ArcelorMittal is in a better position to manage the risks involved in the fluctuation of raw materials prices that can not be hedged via financial markets.

adjusted unemployment

The seasonally adjusted rate of unemployment for January may not be an accurate gauge of changes in the near-future aggregate personal consumption in US because it

1- (as opposed to alternative measures of labor underutilization) does not count as unemployed the people who work part-time because of unavailability of full-time jobs, and completely ignores the people who (out of frustration) give up looking for work. Nevertheless economists still prefer to use the U-3 figures because of sample size considerations. (The reliability of an econometric analysis varies positively with sample size. Among the different measures of unemployment rate, U-3 has the longest running time series.)

Note that the departure of unemployed people from work force actually decreases the U3 unemployment rate. For example, assume that the size of the work force is 100 million people and the unemployment rate is 5%. If 20% of the unemployed leaves work force, then the unemployment rate becomes 4% = [100,000,000*5%*(100%-20%)]/[100,000,000*(1-(5%*20%))].

2- understates the real January unemployment rate due to seasonal correction.

3- omits the role of expectations. While spending money today, people worry about not only the current unemployment rate but also the future employment prospects.

4- does not reflect wage cuts and decreases in working hours.

5- does not contain any information related to non-wage income or marginal propensity to save.

Hence it is not surprising that there is a not-so-clear (but discernible) relationship between the year-on-year monthly percentage changes in seasonally adjusted rate of unemployment and year-on-year monthly percentage changes in personal consumption expenditure. (It is hard to tell where the causation starts but there is certainly a positive feedback mechanism between the two variables.)

fluidity concerns

In order to prop up the balance sheets of banks and inject liquidity into the system, FED is now buying mortgage backed securities and commercial paper from the market. During these operations it is literally printing money and crediting the excess reserves of the recipient banks. Hence the explosion of excess reserves to previously unimaginable levels:

What are the banks doing with all the cash? They are just sitting on it. Excess reserves are not withdrawn from FED. Otherwise we would have seen a significant jump in "currency in circulation":

The balance sheets of banks have improved but the system remains fragile. True, the interbank lending rates (such as LIBOR) have gone down. However, due to the explicit guarantees extended by the governments, these rates no longer reflect the true health of the financial system. The interbank lending market is now on medication.

The banks are still hesitant about extending loans to non-financial companies amid the continuously deteriorating economic conditions. FED can expand the monetary base as much as it desires to. But if banks refuse to create money by making loans, then the money supply will not increase:

Even if banks turn on the tap, the money will not flow as fluidly as it used to. Say a bank gives out a commercial loan and the receiving company makes a purchase. The new holders of the cash will either sit on it or use it to pay down debt. Either way the money will immediately flow back into the hands of risk-averse banks. The pipe is clogged. It does not matter whether you turn on the tap or not.

The extremely uncertain economic environment makes every CEO tremble with fear. The time horizon of supply chains has collapsed. Purchasing managers buy material only on spot and only when needed. None of them are willing to commit to long-term contracts. Most of the previous long-term contracts has been unilaterally cancelled and the number of litigations has sky rocketed.

Postscript 1:

Banks lend their excess reserves in the overnight market to those institutions whose reserves are below the legally required level. The prevailing interest rate in this market is called the FED funds rate. FED conducts its monetary policy by setting a target FED funds rate and by trying to push the market towards this target via open market operations. Up until September FED was able to achieve this. Then it lost control:

The exploding excess reserves put downward pressure on the FED funds rate. The interest rates hit zero and consequently the overnight money markets froze. FED wanted to maintain a low interest rate but did not want to kill the money markets which play a principal role in supplying short-term credit to the banking system. Moreover FED funds rate had become dangerously jittery. In this context FED had three main goals: To contain the volatility of FED funds rate in order to provide some certainty to the unstable markets / To keep FED funds rate low and hope that this will stimulate the real economy despite the broken banking system /To create a non-zero floor under FED funds rate to ensure the survival of money markets.

In order to attain these goals, FED cut its target rate to a range of 0% to 0.25% and declared that it will pay 0.25% interest rate on all reserves and excess reserves. (Note that, during normal times, excess reserves earn the FED funds rate and reserves kept at FED earn no interest at all.) This is another reason why banks are sitting on excess reserves and not withdrawing them from FED. On a risk-adjusted basis, FED's 0.25% is perceived as the best over-night interest rate in the market. For comparison, note that even the 3-month treasury bills (backed by the full faith and credit of US government) currently yield less than 0.25%. What about commercial paper, corporate bonds and etc.? Banks simply do not have the risk appetite to touch those.

Postscript 2:

One of the reasons why asset prices are so depressed at the moment is due to the massive deleveraging that is taking place. When banks call back loans, companies can do three things: Pay cash / Refinance / Sell non-cash assets. Refinancing is impossible for anyone but those who do not need it. Cash is extremely hard to find since consumers have cut back on spending and companies have shelved their investment projects. So there is only one option left. The companies will have to liquidate their inventories and sell parts of their businesses. However if every single company in the economy does the same thing, the value of these inventories and businesses will simply collapse. Why? Because there will be no buyer side! All balance sheets can not shrink at the same time. If one balance sheet shrinks, somewhere another balance sheet needs to expand. Fortunately there is one candidate that can technically absorb everything: FED's balance sheet.

Think of the FED & Treasury couple as the only trustworthy bank left in town. Investors are willing to buy 1-Month Treasury bills at 0% interest rate and banks are happy with the 0.25% interest rate paid on their excess reserve accounts. Hence, in case nobody wants to buy commercial papers or mortgage backed securities, FED can easily step in by borrowing from US Treasury through the Supplementary Financing Program, or by spending the excess reserves provided by the banks.

If banks at some point decide to withdraw their excess reserves, FED can either relabel the withdrawn amount as "currency in circulation" or sell some of its assets. If there is a worry about inflation, then FED will choose the latter option which effectively sterilizes the cash supplied to banks by draining money from the them through asset sales.

capital intensive projects

During the boom times the risk appetite of financiers increase, money and credit becomes plentiful, and a lot of capital-intensive, green-field projects get approved. Invariably a substantial portion of these investments fail before starting to generate positive cash flows.

Engage in simple, non-capital-intensive projects. Maintain a low debt level. Accumulate cash and wait for a financial crisis to take place. (The chances are that you will not have to wait for too long, especially in countries like Turkey.) Buy into a economically viable, capital intensive business that has run into serious financial difficulties due to the indiscriminate credit rationing. Wait until the economy improves and investors become optimistic about the future growth potential. Sell the recently bought stake and put the profits into safe, liquid assets. Go back to your old, simple business.

Let others finance and construct capital intensive projects, whose development period often last longer than the half life of an average boom/bust cycle. When money and credit flow around in vast quantities, there are always some people who are overly confident of their ability to value complicated projects. After the end of the boom period, investors will start to shun such extremely illiquid businesses which you can then buy into at bargain prices.

Do not forget that many businessmen made a lot of money in simple businesses and lost everything in complicated ones.

cross-border acquisitions

I was quite dumbstruck when a McKinsey partner said that he advised his clients to engage in cross-border M&A due to the relatively higher historical returns associated with such transactions.

True, acquisitions abroad may have higher yields. However these extra returns often come with additional risks. For example, the acquirer needs to cope with cultural differences in business practices, difficulties involved in monitoring a physically far-away entity, exchange rate risks created by a cost structure denominated in a different currency, and socio-political risks associated with investing in another country. In other words, on a risk-adjusted basis, returns on domestic acquisitions may still be more favorable.