Tag Archives: CDS

A Trillion Here, A Trillion There, Pretty Soon You’re Talking About Real Money

What a way to start out the week:

The European Central Bank, the Bank of England and the International Monetary Fund have all recently warned of a looming crunch, especially in Europe, where banks have enough trouble raising money as it is.

Their concern is that banks hungry for refinancing will compete with governments — which also must roll over huge sums — for the bond market’s favor. As a result, credit for business and consumers could become more costly and scarce, with unpleasant consequences for economic growth.

via Crisis Awaits World’s Banks as Trillions Come Due – NYTimes.com.

Wow.  I didn’t know I could get a S**t Sandwich special first thing on a Monday…

And in case that wasn’t enough, they threw in a menacing chart for emphasis:

And just in case you still didn’t get the message, there’s this quote from the article:

“There is a cliff we are racing toward — it’s huge,” said Richard Barwell, an economist at Royal Bank of Scotland and formerly a senior economist at the Bank of England, Britain’s central bank. “No one seems to be talking about it that much.” But, he added, “it’s of first-order importance for lending and output.”

And so this is where I roll out one of those Minsky charts that illustrates this.  Oh, wait:

But why all the fuss over banks being able to roll the debt over?  Forget the amount for a second.  The key is to look at the average maturity:

A study in November by Moody’s Investors Service found that new bond issues by banks during the past five years matured in an average of 4.7 years — the shortest average in 30 years.

Now why does that matter?  It matters because there’s this issue called a maturity mismatch, where the assets and liabilities have different maturities.  Usually the assets are longer dated than the liabilities because when a yield curve is upward-sloping like this (from the FT)…

The incentive is to borrow short-dated funds and lend on long-dated assets.  I’ve covered this in similar ways before talking about duration hedging in the past where you measure sensitivities to interest rate moves, and this follows in a related vein.  When the yield curve inverts, or you have rate shocks at the front-end of the curve, you can find yourself in a precarious position if you have a lot of paper to roll.  Which is exactly where a lot of banks are finding themselves now.

But take a look at this section from the article (emphasis mine):

The financing crunch has its origins in a worldwide trend for banks to borrow money for shorter periods.

The practice of short-term borrowing and long-term lending contributed to the near-collapse of the world financial system in late 2008 when short-term financing dried up. Banks suddenly found themselves starved for cash, and some would have collapsed without central bank support.

Government bank guarantees extended in response to the crisis also inadvertently encouraged short-term lending. The guarantees were typically only for several years, and banks issued bonds to match.

So the maturity mismatch issue played a huge role in getting us into this mess, and the government’s response may very well end up in exacerbating the problem.

Brilliant… I might as well go build a house and then torch it myself…

And Tim Backshall has a very interesting chart that shows the spreads between senior bank debt and sovereign are highly correlated and compressing.  That means the lines between sovereign and bank debt in Europe are getting blurrier:

One other facet about this problem: the link between external bank funding and Euro Libor:

Bond issuance by financial institutions in Europe plunged to $10.7 billion in May, compared with $106 billion in January and $95 billion in May 2009, according to Dealogic, a data provider. New issues have recovered somewhat since, to $42 billion in June and $19 billion so far in July.

My take: proof positive that the funding crisis for European banks is ongoing and getting worse.  How so?  Simple.  Longer dated bond issuance has fallen, which has led to a change in the maturity profiles of European bank liabilities.

Because the banks are rolling into shorter-dated Libor based funding…

Which has lead to the run-up in the Euro…

One way to mitigate this risk is matched maturity funds transfer pricing – where the asset side of the balance sheet has the same maturity profile your liabilities has.  I’m going to leave you with this paper which I also posted on Scribd:

And a link to this post by Don van Deventer at Kamakura, that has some really good ideas on how to implement funds transfer pricing effectively.


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And Now, The Fun Really Begins…

Things seem to be moving rather quickly in China.  First, there was the move to increase flexibility.  Now, there’s this:

China plans to introduce credit derivatives soon to control risks in the nation’s growing domestic bond market, according to the National Association of Financial Market Institutional Investors.

“We will make this a true risk-hedging instrument for the growth of the financial market,” unlike how the derivatives were used during the financial crisis, Shi Wenchao, secretary- general of the government-backed body, said at a briefing in Beijing today.

via China Plans Credit Derivatives Soon to Limit Bond Risk, Investor Body Says – Bloomberg.

It seems all at once that China has been moving from a regime that is rather tight-fisted to one that isn’t.  From zero-to-gun-slinging capitalist in no time flat.

But is that what really is going on?  Let’s consider another piece from Bloomberg:

China’s central bank set its daily reference rate for yuan trading 0.18 percent weaker, the biggest drop since 2008, a sign the currency is being guided to reflect the global risk environment following the end of a two-year peg.

via China Central Bank Sets Yuan Reference Rate 0.18% Weaker as Euro Declines – Bloomberg.

So they’re not quite ready to step away from the mechanisms they’ve used, stating they will prevent “excessive” exchange-rate moves.  And then there’s this from the same piece:

“There’s a new normal now for the yuan as it increasingly reflects what’s happening in the broader market,” said Brian Jackson, a Hong Kong-based strategist at Royal Bank of Canada. “Yesterday, there was talk that state banks were buying dollars on behalf of the PBOC. This indicates that they want to introduce more two-way moves to reflect what’s going on in the rest of the world. It won’t just be a one-way bet.”

I wonder if their reserve requirement management regime will give us any indicator as to how active they will be in the currency market.  See, where most central banks try to use overnight lending rates to sway credit appetites one way or the other, the Chinese use minimum reserve requirements.  Raise requirements, credit tightens.  Lower reserve requirements, credit loosens and flows more freely.  They have had a tradition of being rather interventionist and hands-on in that regard, so I wonder just how much intervening they plan on doing in currency markets.  I assume they will be pretty active.

It also makes me wonder about secretary-general Wenchao’s statement on the use of credit derivatives.  How are they going to do this?  Will they outlaw outright credit protection purchases and only allow purchases for hedging purposes?  Are there any other wrinkles they plan on introducing to the market?  It’s not all that clear.  The one thing that strikes me is that the National Association of Financial Market Institutional Investors is government-backed.  Not very typical.

But let’s take a look at the would-be reference entities that CDS will be bought and sold on.  From the first Bloomberg piece:

Treasury bonds, central bank bills and policy bank bonds made up 78 percent of bond issuance in China last year, according to the website of Chinabond, the nation’s largest debt clearing house.

In the first quarter, 346 billion yuan of corporate bonds, medium-term notes, and financing bills were issued, compared with 317 billion yuan in the same quarter last year, according to China Lianhe Credit Rating Co.

So obviously there’s a bunch of government debt involved here.  A big majority of it, in fact.

But here’s the bottom line: the Chinese appear to be moving to a more market-based framework, which should be applauded.  Just how market-based it is, is a whole other matter completely.  Because make no mistake: they hope the market will do some things for them so they have political cover with the G-20.  As I said yesterday:

If the enhanced flexibility means the Yuan goes lower, the Chinese would’ve pulled off a brilliant coup: a depreciating currency with little to no interference from the government.

via How Do You Say “Negative Basis” In Mandarin? We Might Need To Learn It « Deep Thoughts by Professor Pinch.

“Little to no” may have been pushing it on my part.  Significantly less seems more reasonable on second thought.

The most curious thing to me about this whole situation?  Just how liquid the market for China CDS will become.  There are well-documented issues with CDS liquidity in its current state, but that being said, I’ll be curious to see how much volume gets done in both the sovereign and the corporate names.

This could get interesting…


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Hedging and 2-Way Liquidity Explained, Ice Block Edition

We’ve all seen pictures like this:

Or this:

Even tweets sent out that discuss the possibility of such an event:

The Ice.  Devastating.  Even embarrassing.  But the only thing that is worse?  The Ice Block:

Ah, the Ice Block.  In the bizarrely hilarious and demeaning game that is Icing, there are only two rules:

  • Whenever and wherever you’re presented with an Ice, get down on one knee and chug.  If you refuse you’re banned.
  • You can Ice Block by presenting an Ice of your own in the event you’re presented with an Ice.  Whomever presented the Ice to you now has to get down and chug.

The Ice Block, in simple terms, is a hedge.  A hedge against an undesired outcome.  I mean, even I spent some time in Manhattan this past week lugging around a 24oz bottle as insurance while I was out & about.  Will I do it again?  You bet.  I’m risk averse when it comes to Icings.  I may keep several with me.  Like a building super with a giant belt full of Smirnoffs (I hear the Wild Grape or the Mango are particularly great).

Thinking about hedging makes this piece from Zero Hedge important in my mind, because there are some very serious questions about risk management that are brought up as a result.  I wrote earlier in the week about my views on CRE and CMBS from a fundamental credit and asset valuation perspective, but this piece hits on some added dimensions worth considering with FinReg and the talk about the health of banks in the background.  Let’s start with some stats:

  • US CMBS delinquenices are now at 7.5%, an increase of 48bps according to Moody’s.
  • Number of delinquent loans more than doubled from last year.  There were 1,800 delinquent loans last year, now there are 4,400.  Balances on delinquent loans more than tripled from $15.5bn to $48.8bn.
  • Hotel and multifamily are the worst with delinquency rates above 13% while industrial and office are the best with delinquency rates between 5 and 6%.

Now why is that important?  Because of the news that JPM launched a new CMBS offering this week.  While they sold the AAA tranche rather easily, other pieces won’t be sold so the bank will retain them.  Given the current state of the CRE market, I’d think they’d want to hedge that exposure (Call me crazy.  You’re dying to anyway after I put that ridiculous image in your head of seeing someone walk around with a Smirnoff Ice utility belt).  But here are some key pieces from Cheeky Bastard I want to highlight:

Therefore I ask this question in name of all potential future investors who might want to know who, where and based on which pricing method will sell the protection in form of a CDS on a CMBS structure which bears little resemblance to CMBS structures of the past.

I know of no derivatives desks who are willing to act as a counterparty in such a transaction; so JPMs Structured Products desk might have succumbed to hedging its exposure to non-investment grade tranche by buying in-house CDS from their derivatives trading brethren.

That’s a terrible state for the market to be in.  Others have talked about the issues in the CDS market as is, which need to be addressed, but in the meantime let’s focus on what the bank is going to be able to do here.  The short answer is not much.  This is an individual transaction which will have very little correlation to previous transactions that made up CMBX indices in the past.  Unhedged risk can be painful.  Just like walking around without the ability to Ice Block.

I see some folks at JPM getting ready to take a knee and chug in the future…

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Buckle Up For Safety: Liquidity (Or Lack Thereof) In CDS

The issue of liquidity in CDS has been many people’s minds of late, myself included.  This piece from FT Alphaville, written by Gavan Nolan at Markit, is exceptional.  First, we have the ways market liquidity in CDS can be measured:

These are all important indicators in determining liquidity.  I, along with other folks, have talked about liquidity issues in the CDS arena before:

But isn’t the 83.7% of trading by dealers “real”? If there are only 6 firms in the United States controlling the credit derivatives market and slightly more than that internationally, how can that be “real”? Since CDS positions are a zero sum game, all dealers combined can only be net long what non-dealers are net short, and vice versa. Just as in the used car analogy, we care only about the trading by retail car buyers, not the movement of volume between dealers, who still need to sell whatever cars they buy en masse. Moreover, we want as many price points from retail car buyers as we can get, so we want the www.kbb.com Kelly Blue Book prices, not the prices from one dealer’s lot.

via Kamakura Blog – Kamakura Blog: Sovereign Credit Default Swaps and Lessons from Used Car Dealers.

My hope is that the data from Markit will begin to get at the heart of some of these issues.  It looks like it will because a bunch of that data will show market breadth and depth.  Which many folks believe to be shallower than a kiddie pool.

But there’s also some disturbing – but expected – trends we see taking shape:

However, if we look at the bid/ask spreads this week, we can see that they have widened dramatically. This is to be expected – the CDS spreads of all five countries have widened sharply. But the expansion of the bid/ask spreads outpaces the widening in CDS spreads.

via FT Alphaville » CDS liquidity update: Focus on European sovereigns.

Why?  Call this a consequence of the BaFin ban.  And I don’t think it was unintended.  Indeed, as the Alphaville piece continues:

It is also evident that there was a big jump in the bid/ask spreads on May 19. This was after the German regulator Bafin announced a ban on naked CDS referencing eurozone sovereigns. The move created some uncertainty in the market and appears to have led to a disruption in liquidity. Overall, the disproportionate widening in bid/ask spreads in recent weeks suggests that liquidity has fallen.

This is just more of the same government heavy handedness directed at symptoms instead of diseases.  Don’t like reading about CDS quotes screaming higher on a day-to-day basis?  Ban their use; that will sort it all out.


Because as I pointed out before, viewing CDS strictly as “insurance” is wrong:

Liquid credit indices are just like liquid stocks.  You can buy/sell them in size, and pay very little for the privilege.  Illiquid credit protection, however, is a whole other ballgame.  You can’t get in/out of positions easily even in good times and you’re going to pay through the nose to do it.  And if you try to do a trade in size?  Puhleeeze…

This also illustrates why it’s laughable to think CDS have anything to do with making the sovereign credit situation worse. These are synthetic shorts when you buy them. If they didn’t exist, there would only be one option: sell the cash bonds and watch the yields & spreads blow out even higher than where they are.

via On Goldman, Synthetic Longs & Shorts, and S_ _ _ Sandwiches « Deep Thoughts by Professor Pinch.

So what are we going to be in for?  Most likely, reduced liquidity in the market.

And with reduced market liquidity, we get things like this


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A Rant About Xenophobia Run Amuck

This is getting quite ridiculous, really.  No more than a week ago, I had a post about the idiotic comments coming from Europe on “wolfpacks” and “wolfpack behaviors” that were “rampant in the marketplace.”  Those comments about wolfpacks elicited a reaction from me:

It’s amazing what folks in his position do in reaction to market events. To me, it’s very clear that the market isn’t looking to take the Euro down, or as he put it “tear the weaker countries apart.” What the market wants is for Brussels to show they have some guts and draw a line in the sand with respect to their mantras of fiscal responsibility. Not just pay it lip service.

via Comments on “Wolfpack” Behavior Epitomize Idiotic Behavior « Deep Thoughts by Professor Pinch.

Now we have comments in the Financial Times from Wolfgang Schauble, Germany’s finance minister, who thinks markets are “really out of control.”  He also thinks “the ratio of financial transactions to the real exchange of goods and services” needs to be regulated.


I guess my first question is define “out of control.”  Are prices only supposed to go one way, depending on the prevailing political winds (up for stocks, down for commodities)?  Puhleeze.  That will get you just as far as a kid gets complaining about a dog eating their homework.  Markets are a product of the people/institutions that participate in them, the products/services that are bought/sold/traded there and the rules that they can operate under.  Rules that are made by people.  So is he really saying people screwed up in setting up markets?  Or that people screwed up in the enforcement of those rules?  If that’s what he means, I’d buy it.  Sadly, I don’t think that’s what he meant.

Which leads me to this asinine idea of regulating “the ratio of financial transactions to the real exchange of goods and services.”  Who sets that ratio?  And who says they know better than me?  Or that they know better than you for that matter?

To me, this is clearly an outgrowth of some things I highlighted in another post.  Let’s take what I said about CDS for example.  There’s a huge disparity between inter-dealer trading volumes and client-based flow trading:

First, I have to say the volume differences between inter-dealer trading and non-dealer trading is staggering. But it leads me to some questions. Questions that need answers…

  • What are the dealers doing? Is this how they are trying to make the market appear “liquid?”
  • Is there another explanation? I’ve been toying around with this idea that there may be another reason completely unrelated to trading and market-making. The volumes are such to support the headcount in those departments – so this could be bureaucracy and bloat. It may be totally wrong, and a sign my medication needs to be upped dramatically, but I’m just saying there may be an alternative explanation.

via Quick Hits on Credit & Liquidity « Deep Thoughts by Professor Pinch

I’m just trying to come up with ideas as to explain what’s going on, I don’t assume for a minute I’ve hit on anything.  But sticking with CDS for a second, I picked this instrument strictly because it is, to borrow the words of Baudrillard (courtesy of  Kevin Depew), a manifestation of the simulacra.  CDS are a synthetic of an organic/cash instrument.  But yet, we talk more about CDS than cash bonds.  It’s like we talk more about Super Bowl bets than the actual game.

But there’s a point there.  Sports betting is a derivative of the event: an event occurs, people are betting on its outcome.  The same can be said of the markets.  The issue is not in the market action, it’s that the market has become so concentrated – so cartel-like and oligopolistic – that when we need true liquidity to facilitate things like “Flash Crashes” or massive carry unwinds, it’s not there to be had.  People have failed in their regulation of markets and in how regulations should be enforced.

So if Herr Schauble wants to talk about how to fix markets through better policy, fine.  If it’s to punish market participants for participating in the market, like what he said here, the only words that come to mind come courtesy of Gordon Ramsay:

“You!  Over there.  Shut it!  Now!”

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On Goldman, Synthetic Longs & Shorts, and S_ _ _ Sandwiches

The news about Goldman has definitely been making its way around.  Just look here, here, here, here and here.  There’s something particularly nostalgic and ‘newspaperish’ in the Huffington Post’s presentation: you’d think it was V-E Day all over again.

For those who want to see the pitchbook, it’s included here:

This slideshow does a good job of explaining the transaction…

But I want to take a different angle on this story.  I want to look at it from the decision-making process that Goldman the firm was faced with.  Not Goldman the marketing machine, not the Goldman you see in its company history pages on its website, but the Goldman that has to manage risk.  What were its options?  Why did it choose the option it chose?  I’m not going to talk about the legality/illegality of the deal, because I’m not a lawyer.  But the characteristics of the market at that time were such that were plenty of bad decisions made.  Some on the part of the structurers, but also a bunch by the investors, who supposedly had a level of “sophistication.”

The Trade

We all know John Paulson was looking to make a bet against the housing market.  So via ACA, he created a CDO of the MBS he wanted to short.  Goldman, as Paulson’s broker, facilitated his request by selling him the credit protection against the securities that were put in the CDO.  Essentially, Goldman created a bespoke credit default swap index in handling Paulson’s end of the trade.

I emphasized bespoke because it should tell you something about the liquidity risk inherent in such a trade.  There’s tons of it. There are liquid credit indices, which you can find at Markit’s site.  Liquid credit indices are just like liquid stocks.  You can buy/sell them in size, and pay very little for the privilege.  Illiquid credit protection, however, is a whole other ballgame.  You can’t get in/out of positions easily even in good times and you’re going to pay through the nose to do it.  And if you try to do a trade in size?  Puhleeeze…

This also illustrates why it’s laughable to think CDS have anything to do with making the sovereign credit situation worse.  These are synthetic shorts when you buy them.  If they didn’t exist, there would only be one option: sell the cash bonds and watch the yields & spreads blow out even higher than where they are.

Goldman’s Decisions

But in the process of selling Paulson the protection he wanted, Goldman took on a position itself as well: selling credit protection is a synthetic long on the credit risk of the position.  It’s not like Goldman lent ACA or the SPEs that created those subprime MBS the money to originate the loans, but in selling the protection, you’re expressing a view on the credit risk that’s there – a view that says it’s overpriced to you.  This is actually a cheap way to gain credit exposure to an MBS, a company, you name it.  I say it’s cheap because you’re gaining credit exposure by betting that the entity won’t default on its obligations and you’re not putting actual balance sheet at risk via traditional lending.

So the first decision you’re confronted with: do you want to keep this long credit exposure?  If you answer ‘Yes’ then you do nothing else.  But if you don’t want to keep it, you have to figure out a way to off-load it somehow.  There are several ways you can short/get rid of this risk:

  • Buy credit protection yourself and create a synthetic short position in the process.
  • You can sell the assets off your balance sheet.
  • Or you can create a synthetic loan sale in the form of a CDO if you don’t have the assets on your books, but still have credit risk in the form of credit protection you sold.

Buying protection on an illiquid index will be expensive.  You may not want to take the risk that buying the protection from Credit Suisse, JP Morgan, or some other firm will cost more than what you charged Paulson for it.  You may have hedged the risk, but you have a P&L issue as a result.  These assets were not on Goldman’s balance sheet, so no bulk loan/securities sale would work.  You’re really left with exiting the position by creating a CDO.  Bringing the CDO to market also has the benefit of generating a positive contribution to the P&L, even if it’s only a modest contribution.  The real goal is to off-load the synthetic long position you created by selling the CDS to Paulson in the first place.

Final Points

I’m not a Goldman apologist.  I’m pretty sure they made some bad decisions in this situation, namely getting too chummy with a client to get additional deals/trades to work for them.  The disclosure issue?  Is it a case of withholding information or if they did disclose it, would that have been a case of releasing MNPI?  I don’t know, but it seems to me the case is far from a slam dunk for either side.

As for AIG?  I still remember this quote from Andrew Ross Sorkin’s “Too Big To Fail” from Sam Cassano at AIG’s Financial Products unit:

My brother works at Goldman, and he’s an idiot!

Ah, Sam… Really?  If that’s true, that pretty much makes you full-retard.  $6bn in wrap guarantees?  What were you guys thinking?

So folks, next time someone hands you a sandwich, you might want to check what’s between those pieces of bread…


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Playing Devil’s Advocate with Dr. Don (For a Minute)…

This week, one of my friends on Twitter, Dr. Donald van Deventer posted this link in a tweet:

It’s an article by Luke Baker, Reuters’ foreign correspondent in Brussels. I told him I was going to take the other side of some the things stated in the article, and this post is my way of making good on the commitment.

I don’t disagree with everything Baker says in it, actually. He makes some valid points. For example:

The yield on 10-year Greek government bonds over dependable German Bunds (the spread) rose to more than 400 basis points — a euro-era record — at one point last week, meaning Greece had to offer a 4-percentage-point premium over Germany to entice people to buy its debt, offering a yield of more than 7 percent. That obviously increases its debt financing costs and leaves it even more in a fiscal hole than it needs to be at a time when it’s trying to raise more than 50 billion euros to finance the budget — and when finances are already under pressure following the economic crisis.

Yes, we’ve seen a blow-out in spreads of Greek debt to the German bund. And yes, we might think 400 bps is too high, since Greece’s economy is a developed one as opposed to a developing/emerging one. But to complain about its debt servicing burden while it’s being beaten down? Well, that’s just the way it is. The strong are rewarded with cheap funding costs while the weak have to prove they can handle the high funding costs they’ve been dealt. So Papandreou has to prove he can play with the short stack while Merkel has a commanding chip lead. Sorry. Play your way and earn chips or go bust. It’s that simple.

But the lion’s share of my disagreement is here:

But when it comes to absolute risk — the real possibility of Greece defaulting on its debt — it’s questionable that Greece is really as much of a liability as that. Not only is it a developed, European sovereign debt issuer, but it shares a currency with 15 other countries in the euro zone. Their stability depends greatly on Greece’s stability and so in effect it has 15 backers — call them lenders of last resort if you like – standing by ready to help out if things really get to breaking point.

See, I think he has it wrong. The EMU is nowhere near as symbiotic a framework as Baker thinks or suggests. Now I’m going to use one of my posts to show you how I believe the system really works:

So the Greeks can’t conduct monetary policy on their own, and fiscal policy has been largely handed over to others as well because they have to adopt inflation policies and government spending policies across the Euro-zone for the privilege of using the Euro and piggy-backing off of France & Germany’s credit ratings.

So, you can see what dynamic I think is at work: the rest of the continent is piggybacking off of Germany and to a lesser extent, France. While Spain’s economy is relatively large to others on the continent, Germany is the country that “moves the pile.” As such, I don’t think Greece has 15 backers. If Germany decides they want to bring back the Mark, most of the continent is screwed because the benefits of Germany’s fiscal and monetary discipline that the continent enjoyed will be gone. Those benefits will be once again reflected in the Mark – not the Euro.

Papandreou’s talk about speculators and CDS? I have two reactions: 1) Tell that to Jimmy Cayne, John Meriwether, Dick Fuld, and Jeff Skilling. If the market senses you can be taken down, they’ll try to do it. That won’t change. The solution? Don’t put yourself in that position in the first place. 2) As Tim Backshall points out, it’s not CDS that’s driving this crazy train, but the cash bonds. The CDS spread is actually tighter (i.e. less risk) than the cash bond spread to the Bund.

And since it’s Friday night and I’m thinking of crazy trains, I’m going to close this post with this: Ozzy frickin’ Osbourne’s “Crazy Train.” Seems to be pretty apropos for the credit and currency markets these days…

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