A Song of Gold and Iron

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I wrote this short story a couple of years ago and I parked it in a dusty corner of the hard drive. The first spark of this story lit up while I was reading the fourth book of the saga “A Song of Ice and Fire”, also known as Game of Thrones by TV-series addicted.
I had almost forgotten it when I read a long Twitter thread published by Prof. Fabio Ghironi of Washington University. Prof. Ghironi made use of ducks (Ludwig von Drake and Uncle Scrooge) to explain a few basic concepts of international finance. He reminded me of my tiny hoax grounded in the imaginary worlds of Westeros which was amassing grime in my laptop.
If you are not a big fan of fantasy novels, do not be too scared and keep reading. Stat rosa pristina nomine, nomina nuda temenos, or in other words, once you read beyond the names, you will discover the universal and immortal meaning of things.
The world created by George R. R. Martin shows two continents, Westeros and Essos, separated by the Narrow Sea. King’s Landing is the capital of the Seven Kingdoms, a group of territories which live and frequently die through wars (many) and truces (few) in the Westeros continent.

One key feature of King’s Landing, that immediately caught the financial corner of my eye, is that the city is highly indebted. The three largest creditors are the Iron Bank of Braavos, the House Lannister (the richest and most powerful family of Westeros) and a Church called Faith of the Seven God.
When I read about the distressed finances of the capital city, I began transposing kingdoms, territories and families to the real world. Westeros can be seen as a union of western developed countries, King’s Landing resembles the United States and the Faith of the Seven God is the Catholic Church. What about Braavos?
Initially I fancied that the Iron Bank was a sort of Federal Reserve but I soon realized that my first intuition was inaccurate. Not by chance, the author settled Braavos in the Essos continent, on the other side of the Narrow Sea. Geographically, Braavos looks like an ancient Asian city, similar to a Phoenician harbor, where sailors and merchants govern business and politics.
In modern era, the Iron Bank mimics the People’s Central Bank of China, a mighty institution that stores the fortunes of exporters and buys the debt issued by the United States.
With all these good premises, I began fantasizing about the economy of this imaginary world.
King’s Landing has its own currency, the Dragon, divided in moons, stags, stars, groats and pennies. The value of the Seven Kingdom’s coins, minted out of gold, silver and copper is given by their intrinsic value. The Iron Bank of Braavos issues iron coins that, we assume, have a very low or close to zero intrinsic value. Therefore, Braavos, the richest and financially most powerful city, makes use of a fiat currency, a monetary system that relies on the reputation of its Central Bank, with a very loose connection to precious metals. I could not find the name of the currency in the book, but allow me to be a bit ironic and let me call it Irony.
Fiat money, gold-backed currencies, public debt, distressed assets. The game seems to be more and more intriguing and quite familiar.

Imagine a Braavosi (a Braavos’ inhabitant that we may call Stavros) who sells silk to King’s Landing and buys armors and weapons. P(S) and P(W) are the prices of silk and weapons in Braavos while K(S) and K(W) are the prices of silk and weapons in King’s Landing.

By using draconian rules and assumptions (no tolls, no frictions, no legal constraints), the price in Ironies of silk must be equal to the price in Dragons times the exchange rate.Similarly:
Putting everything together:

The allocation between silk and weapons between the two countries depends on the previous formula, that takes the name of Law of One Price and it is the basis of Purchasing Power Parity, an economic theory that compares the currencies of two or more countries through a basket of good. If for any reason the production of silk in Braavos increases, the price will go down. If the price is not allowed to go down, the exchange rate will be adjusted to reflect the impact of the excess of supply. But what happens when the market players are allowed to add complexities, like different prices for goods that are sold domestically and externally, transaction costs and trade barriers? Well, the simple Law of One Price stops working.
Let’s go one step further and imagine that Stavros wants to invest his savings either in bonds issued by his own city, denominated in Ironies, or in the debt of King’s Landing, denominated in Dragons.
His own city, financially solid and highly rated, will offer a small interest rate, that we can identify with “i”.

Braavosis are financially literate and they know the concepts of real value and inflation. They know that, in the future, what is important is not the nominal values of capital (C) and interests (i), but their real value, once adjusted by inflation (I).
Our Braavosi evaluates the purchase power (PP) of his future domestic capital according to the following formula:

Stavros has an idea of the future real value of his investment, but this is still only an idea and cannot be determined with certainty. It is therefore recommendable to write the previous formula in terms of expectations (E).The Iron Bank of Braavos offers another investment to his client: instead of buying local debt, Stavros can purchase bonds from King’s Landing, at a higher interest rate (z), accepting the currency risk of investing in Dragons. Please note that z>i, due to the credit spread that exists between the two economies: Westeros’ capital must pay a higher interest rate when its governors want to borrow. The capital must then be converted at the current exchange rate (*), it will be invested in highly risky treasuries and finally discounted by a different inflation rate (K). And do not forget to convert back the Dragons into Ironies (5).Allow me a short digression.
King’s Landing is conquered by the Lannister’s family and for a short period of time by the Faith of the Seven Son. What is the impact of those events on the variables z, X and K?
The three variables are economically linked: the inflation risk is embedded in the forward exchange rate and into the expected interest rate.
Do not forget that both the Lannisters and the Church are co-creditors together with the Iron Bank of Braavos: they can all be seen as senior bondholders of King’s Landing. From a financial point of view, when the Lannisters take control of the Iron Throne, they swap their credit into an equity participation. The credit risk of the Iron Bank is expected to decrease, z will be lower for the new debt and the price of the current debt stored in the vaults of the Iron Bank goes up. Does it not resemble a Greek-type restructuring?

While reading of King’s Landing conquerors, I was wondering why the Bravoosis did not say a word when the debtor’s treasure changed hands from Robert Baratheon to the Lannisters first and to the Faith of the Seven Son at a second stage. The change of credit seniority perfectly explains their behavior: with the Lannisters or the Church taking the equity risk of the Throne, the bankers will be better off.

But let’s go back to our main story.
The investment in a foreign country’s debt implies the creation of new variables that the investor can only estimate today based on his expectations, like we did before:The Iron Bank may offer an option to its clients who want to invest in King’s Landing: they may hedge the currency risk by entering in a forward FX transaction. Mathematically:And more precisely:The investor transforms the uncertainty of the future currency exchange rate into a deterministic and known rate differential between the short-term risk-free rates of the two cities. Keep in mind that z, K, B and KL are, once again, strictly connected.

I am pretty sure you did not get lost. The next point is to answer a simple but essential question: should the Braavosi invest in the highly indebted King’s Landing or should he keep its money in the more peaceful and safe debt of Braavos?
Also in this case the answer is pretty straightforward. He will invest in foreign debt if:or:We have already shown how we can hedge the currency risk by using a forward contract to balance out the exposure. We made use of the covered interest rate parity. Risk-neutral investors will be indifferent among the available interest rates in two cities because the exchange rate between those cities is expected to adjust such that the domestic return on domestic debt is equal to the Irony return on King’s Landing debt once the credit risk is netted out. In a nutshell:In the actual world, other variables and barriers play against these formulas, among them: taxation regimes, transaction costs and irrational expectations.
It is important to highlight how credit spreads, currency rate, inflation and interest rates are bound together to express the real risks of an investment in different cities and currencies.

By Andrea Luzzi
CEO of Ayaltis, a Swiss asset management company specialized in funds of hedge funds.
Andrea has a Masters degree in Economics, a Master in Quantitative Finance from the Bocconi University in Milan and he is a PRM and a CAIA charter holder.

From Time to Time, Banks Produce Worthy Pieces of Research.

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Last month was the case of Credit Suisse that perfectly predicted the current shortage of liquidity that forced three massive interventions of the FED in the last three days.

The Treasury will issue over $800 billion in net new debt and increase its cash balances at the Fed by $200 billion by the end of the year. The augmented supply pushes funding under stress.

Supply came at a very bad time, while companies are cashing in for their tax payments.

Dealer inventories are at a record. Given the curve inversion, supply is having a big impact on the front-end of the curve.

The Fed appears to sense these mounting pressures and that’s why is no longer tapering.

But cutting taper short by about $60 billion is a drop compared to $800 billion – a nice gesture, but not a solution. Solutions like asset purchases (“mini-QEs”) or a standing repo facility are unlikely to be ready any time soon as they take time to design, test and communicate – and fiscal dominance starts “tomorrow”. That’s why O/N repos are under stress.

Absent a technical bazooka, stresses will leave one option left: more rate cuts. Cuts that are aggressive enough to re-steepen the Treasury curve such that dealer inventories can clear and inventories don’t drive funding market stresses.

We never had this much Treasury supply during a curve inversion on top of record inventories with leverage constraints. The Fed has her hands tied up.

More aggressive cuts are an easier “sell” politically and optically than outright asset purchases in an environment of record Treasury issuance. Nevertheless, the FED is divided: the last cut came with only 7 members in favour out of 10.

Dealer inventories are the actual problem. Banks funding dealer inventories is the private solution, but that private solution has a huge limit: intraday liquidity.

The public solution for that is the Fed’s balance sheet. Let’s expand it again adding a permanent repo facility. But it is not so easy to set it up, and here we are.

Rate cuts must be aggressive enough to re-steepen the curve so that dealer inventories can clear .

Cuts must be deep enough that would incentivize real-money investors to lend long, not short and that would enable carry traders to borrow short and lend long again.

How many cuts are needed to keep funding stresses at bay?

Certainly more than the last shy move that left all these problems still on the table.

The plumbing are no longer able to let the enormous volume of water pass. But it seems that nobody cares about the plumbing: not the Treasury that has inundated the market with paper neither the FED.

The flattening of the last two days is a message from the plumber: I need more!

The curious case of WeWork

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WeWork represents the tip of the iceberg of a severe dichotomy between private and public markets. In a sort of reedition of “Barbarians at the Gates”, big houses, like Softbank, pushed by large sovereign and pension funds, are running an opaque business that melts down when it reaches the new ultra-transparent reality of the public markets.
The IPOs of Uber, Lyft, Snapchat and the coming quotations of AirBnB and WeWork are no longer exceptions, but they are becoming a worrying rule in the market.
Never before we have seen companies that rushed toward an IPO with bigger pre-IPO losses than WeWork and Uber.
The old age of private equity was full of fulgid examples of organic growth, pre and post IPOs. Companies went public presenting realistic scenarios of growth and, many times, innovative processes able to set high entry barriers, essential to justify valuations and guidance.
Unicorns are changing the paradigm. Uber and Lyft shares have plunged 29% and 48% from their respective peaks since their IPOs and the new approach of earlier investors and CEOs is today to actually rip off shareholders with obscene pre-IPO deals on preferential liquidity.

But the WeWork case goes beyond anything we saw before, like RBR Nabisco did in the ‘80s.
As private company, WeWork was “valued” at $47 billion. No financial statements are available but this sort of magic comes out from closed-door negotiations whose purpose can only be to beef up expectations.
Recently, the IPO valuation had fallen to as low as $10 billion.
In its SEC-filing, WeWork shows a company that made 1.8 bio in revenues in 2018 and had 1.9 bio of net losses. Revenues doubled between 2017 and 2018 but so did expenses as well.
Both WeWork and Uber have a lot in common, in terms of losses and cash-burn business models. In addition, gargantuan stock-based compensation costs and low entry-barriers.

Where does WeWork spend so much money?

Fixing up office properties. Office properties: the most cyclical commodity in the world.

In its filing WeWork writes:
“We have a history of losses and, especially if we continue to grow at an accelerated rate, we may be unable to achieve profitability at a company level (as determined in accordance with GAAP) for the foreseeable future.”


To create excitement, they actually wrote in the report that they expect revenue opportunities of $3 trillion. Literally. In other words, France’s GDP. How they came up with that number tells you a lot about their sickness. They have WeWork facilities in 111 cities and they plan to open offices in other 169 cities. They estimate a potential member population of approximately 255 million people. They multiply that number by the average revenue per WeWork membership and you’ve got $1.6 trillion.
With a bit of hocus-pocus, referred to the average occupancy cost of an employee they reach $3.0 trillion in revenues. What is produced in France in one year.
Apparently, they also plan to inundate members with adverts to increase revenues.
Yet, we have very little information, or none, about its financials. Good for us that in April 2018 they issued a note due in May 2025 that now trades at 91.25 cents on the dollar. To get a meager B+ from S&P they had to publish their stunning figures on net losses.
These losses of nearly $2 billion in 2018 are operating losses, and not investments in new office projects. After the company leases office space and decks it out, it takes up to 18 months to fill the space, and during that time, the space produces lots of expenses but revenues start out at zero and grow only gradually until the space is filled. That’s what they call: the price of expansion.

But then there is a lot of churn, as “members” might not need that desk for all that long, and WeWork has to work furiously to find new “members” to rent those desks, and that involves a lot of expenses as well.

Ok. They burn tons of money. What about the investors?

Its biggest investor is Japanese conglomerate Softbank. In January, Softbank agreed to a $2 billion deal of which only $1 billion was new funding. But that was down from an initially hyped $16 billion deal with $6 billion in new funding. Previously, WeWork had signed $4 billion in deals with Softbank, a $1 billion convertible note and a $3 billion warrant.

But WeWork is just one example.

Lyft lost shy of 1 billion in 2018, Uber loses about $800 million a quarter.
Slack share price is in freefall, while the company lost $360 million in a single quarter, from $32 million last year. Snapchat also is in the billion club in terms of yearly losses.
Only Pinterest, for the time being, seems to be an exception to the new burning-money rule. Operating losses are contained (once IPO expenses are netted out).

And from the land of Private Equity, that’s it folks… for now.

Why the Tearing System Introduced by the ECB Is so Important

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Graph 1: Annual Cost on Banks’ Excess Reserves Held at the ECB

Graph 1: Annual Cost on Banks’ Excess Reserves Held at the ECB

On September 12,  the ECB decided a 10 basis point rate cut to -0.5%. But even more importantly, they introduced a tiering system, where the exempt tier will be remunerated at 0% and applies to the minimum reserve times six. Both the multiplier and the interest rate can be changed over time. This is a massive relief for the banking sector.

Currently, the European banking system keeps 178 bio in reserves with the central bank. Although the central bank moved down the interest rate on deposits from -0.4% to 0.5%, the reality is that it allows banks to keep money at 0% up to six times the minimum reserve. It means that the European banking system may move between 300 and 500 bio into 0% yielding deposits, moving the money away from negative-yielding securities. Think of it: the new QE is only 20 bio per month (expected 30 bio) and the banks will be incentivized to sell core-European assets: Germany, France and Dutch Treasuries (See Graph 1).

It comes with no surprise that the Governor of the Bank of France joined Weidmann and Knot in opposing this decision. The Governing Council of the ECB seems to be more divided than ever.  However, Draghi said during the Conference Call that there was consensus and no vote. A common procedure for the ECB, when most of the Governors are united. But half of the economy of the Eurozone was apparently against it (See Graph 2).

A divided Council combined with the expected selling pressure on Govies had significant impacts on financial assets: Government yields went up, EUR was stronger, equity mixed and Financials positive in Spain, Portugal and Italy.

Graph 2: Governors from the Heartland of the Euro Opposed the Resumption of QE

Graph 2: Governors from the Heartland of the Euro Opposed the Resumption of QE

Regarding the Tearing System:

The Bank of Japan applies a tiering system since January 2016.

The Japanese version of pain relief involves breaking up banks’ deposits into three tiers — one with a positive rate, one at zero and one that is negative.

In Switzerland, the Swiss National Bank is using negative rates to prevent an appreciation of the Swiss Franc. It operates a two-level system, with amounts equal to 20 times a bank’s minimum reserves exempt from any charge. Above that level, an annualized rate of 0.75% is levied on the deposits held at the central bank.
The new European QE is just a placebo, it has very little substance. In reality, the banking system will do much less to support Government bonds. All in all, a zero-sum game.