As we've rolled into 2010, the annual plethora of analyst predictions for the year ahead have been furnishing the financial pages and beyond. At different times this Nostradamus-like process is probably pretty straightforward, I would think, though often in those "dull" times not particularly exciting - unemployment to rise or fall by 0.2%, and interest rates to remain within a 0.5% boundary and other such mundane predictions. Typically, 12 months forward those predictions are long forgotten by those who were wrong (about 90%) and hailed (by themselves) as god-like foresight by those who were right-ish (the other 10%). The low level of effectiveness is surprising in the dull times - as the saying goes, even a stopped clock is right twice a day.
This year, what's been noticeable is that there is a disturbing level of optimism amongst many of the world's financial prophets - a lot of which, to be fair, is entirely understandable. It requires little genius for example, to see that the exceptional fiscal and monetary measures adopted worldwide in response to the recent crisis do guarantee a return to global growth in 2010. Financial markets are perhaps less clear - for much of the past year most asset classes rose in sync before wobbling when confronted with sovereign debt issues in Dubai and Greece in particular. Yet before taking cover in the face of escalating risk, investors have to recognise one inescapable reality: as long as exceptional monetary measures remain, the penalty for holding cash as opposed to financial assets, will be quite penal in relative terms.
This is a truism that I was at pains to acknowledge through 2009, and remain at pains to acknowledge for the coming year. There is more than a tinge of bitterness about the fact that I missed out on the bumper returns of 2009, because I couldn't get my head around how long the "artificial" government supports would remain in place. Sour grapes I know!
As I've written before, in effect we have been solving one short term issue with more of the stuff that caused cracks in the first place - too much debt. Saying that is not rocket science. Asset prices have increased across the board because of "quantitative easing" and near zero interest rates. Consequently we have created a wall of money that is chasing all assets around the financial system. With a bit of simple economics, we arrive at higher asset prices across the spectrum. Simples.
Where my burning issue lies is that all of this must have some long term economic consequences, which the equity analysts (in particular) seem keen to ignore, by and large. The excess liquidity isn't going to heal the economic system for the long term. While the short term benefits are significant (which makes the analysts right over that time period) there is a real risk that the financial system will become addicted to leverage in an even more profound and destructive way than we were when Lehman Brothers went bankrupt in 2008. I remain, to my own short-term detriment, of the Warren Buffett view that "when you combine ignorance and leverage, you get some pretty interesting results."
When the financial crisis struck - we were warned of excessive leverage in the system, and the willingness of those who couldn't afford it to take on more and more debt. A free-functioning economic system is meant to reward good decision making, and punish the bad - a form of economic Darwinism. So far not enough "natural selection" has been allowed to occur. I remain rooted to the spot and intent on waiting against the current tide for the opportunities that must come when the stabiliser wheels are removed from the financial bike. In the short term it is maddening to think that public policy is actually re-emphasising the importance of debt to finance consumer spending in our economies. It's not unlike a doctor prescribing crack to beat a crack habit - makes the patient feel good in the short term, but not really viable for the future.
The judgements of the world's analysts should be harder than ever this year, but you would be unlikely to hear such talk. Neither credit nor equity markets offer bargains. Commodities look even more dangerous - given that they have soared in price when the global economy has been going the other way - it's clear to me that speculation about future growth has created a bubble. The big question for commodities, as for all risky assets, is what happens when economists try to forecast growth in the world post fiscal and monetary easing. Will the private sector pick up the baton to the extent required?
Many equity analysts seem pretty chilled about this point, but I'm not sure why. The valuations they have been applying to corporate earnings rely heavily on a robust recovery. Banks - the creditors to these companies - remain undercapitalised and incapable of providing sufficient credit to sustain a "normal" recovery. In the world's deficit countries, households and corporations are rebuilding their balance sheets, and consequently investment remains low because of excess capacity. When we arrive at the end of the fiscal and monetary shennanigans, the global economy's former big borrowers and consumers (UK, US etc.) will have to rely on increasing exports for economic growth, but it's questionable as to where the buyers will come from. Japan, China and Germany have the highest concentrations of surplus "savers", but the likelihood of a cultural/ structural shift towards a greater reliance on consumption to drive demand is unlikely. Either way, I hope I'm prepared.
So, I've proven to myself through 2009 that I have an appalling sense of market timing. In hindsight the incredible stimuli that have surrounded the financial system were bound to lift all risky assets. I don't regret sitting on the sidelines to the extent I have done, because as hard as I tried I could never rationalise the market situation - all apart from the fact that my wife wouldn't have allowed me to! I suspect that we will have opportunities going forward as the governments of the world contemplate their exit strategies from their ongoing participation in not-so-free markets. I'm firmly of the view that when these stabiliser wheels are removed then we will have some real problems - and if they are not removed in the short term, then we will have a whole other set of problems.
Sunday 10 January 2010
Sunday 13 December 2009
We woz robbed...
A few weeks ago Irish football fans were subjected to an agonising exit from the World Cup qualifying campaign, when the second leg of the deciding match against France ended 1-1 (it was 2-1 on aggregate - France beat Ireland 1-0 in the first leg). As anyone vaguely interested in sport will know, the circumstances of the exit were particularly painful. A late equaliser from France via a blatant handball from Thierry Henry (he handled twice, which is even illegal in volleyball) gifted victory and a trip to South Africa for the world cup finals next year.
This may seem trivial to some, but the implications of the loss of this mere football game are substantial. As a country Ireland's economic plight is well known - and at the very least a World Cup campaign would have provided a much needed boost to economic morale. To give a little bit more context - there are those who go as far as to suggest that when Ireland beat England in the European Championships in Stuttgart in 1988, it played a significant part in the economic recovery that spawned the Celtic Tiger. Amazingly it can be that important for a nation's sense of self worth.
While I love sport, I am not a big football fan. Watching this match helped clarify my rationale for this point of view - it's based in what I would see as the spirit of the game. I don't particularly like the segregation in the stadiums, or the aggression of some supporters, but most of all I don't like what I see on the pitch. For me, what happens on the pitch is the root cause of the problems off of it. It is a game where the rule-makers have managed to foster an environment where cheating (and getting away with it) are a significant part of the skill set of the professional game. The responsibility for correct behaviour has been almost entirely abdicated from the individual player and onto the match referee and his linesmen. It's OK to cheat, you just need to make sure you get away with it - which is down to how well you can dupe the referee at the appropriate moment.
The protections afforded to these poor souls charged with refereeing responsibilities seem fairly limited - their job is highly pressurised and very difficult - for which they suffer regular abuse which largely goes unpunished. The facilities to correct this situation are entirely available - there are countless video angles that record the action at the big games; yet none of this is used to aid the referee during the course of the match, and it is very rarely used to identify cynical or cheating behaviour in the aftermath of a big game.
In the case of Thierry Henry's handball, not only did the player himself know of his foul, but the majority of the people in the stadium, the other players and the millions watching on TV knew that a foul had been committed. That information was captured both in real time and in replay. It would appear that the only person who didn't know there was a foul was the Swedish referee Martin Hansson. It was a bad mistake, but the speed at which things can happen on a football field makes such mistakes almost inevitable. What is tragic is that it occurred at such a pivotal moment in the context of Irish and French sport. In all honesty, if roles were reversed and the situation had involved an Irish player, he would likely have acted the same way as Monsieur Henry - it's the nature of the game. (Though the referee probably would have spotted it!).
In the aftermath, the recriminations have been widespread - some more serious than others. An Irish radio phone-in the day after the match clarified the extent of ill-feeling; one caller went as far as saying he would give up both french fries and french kissing as a protest. In seriousness, the focus of protests has been varied from anger at Thierry Henry, to anger at the referee, to anger at the lack of video replay in these key decisions. For me what's tragic is that those who run the game - FIFA - seem to be of the view that what happened is part and parcel of their sport; just one of the trials and tribulations that the "bounce of the ball" subjects participants to. This is the most maddening aspect of the situation. Their response merely reinforces the importance of cheating well in the game.
I know you're probably thinking that I'm using this week's blog to vent my frustration about the fact that Ireland won't be at next year's World Cup finals! That's only part of the aim.
There is an interesting parallel to be drawn here between the way in which rule makers in the footballing world choose to administer their game, and the way in which regulators have tried to manage the world's financial system. The similarities between Sepp Blatter's approach to running FIFA and the various bodies from the FSA to the SEC who regulate financial markets is dangerously similar, and has in many ways produced the same results. Many of the methods used to "game the system" - the financial system, that is - which have blown up in the past couple of years came because "gaming it" became culturally accepted by individuals (players), their peers (team-mates), their bosses ("gaffers"), and their shareholders (club owners). Football terminology in brackets.
The responsibility for "calling a foul" was abdicated almost entirely onto external bodies - poorly equipped or empowered regulators (who didn't have access to video replay) or rating agencies (who turned a blind eye to video replay). Regulators, while sadly displaying a lot of incompetence in the past few years, did not have the powers to make a meaningful cultural shift happen within financial services. The largest penalties for foul play seen in the past few years in the UK have been fines of a few thousand pounds combined with removal from the industry. These penalties have been nowhere near widespread or strong enough to act as a catalyst to alter the behaviour "on the playing field".
In the same way, until football players are subjected to post match critique that examines cynical or foul play, then they will continue to cultivate this particular art-form. All of the Galacticos, whether they be in financial services or football, are supposed to be superstars. They need to be held to standards that match that status.
This may seem trivial to some, but the implications of the loss of this mere football game are substantial. As a country Ireland's economic plight is well known - and at the very least a World Cup campaign would have provided a much needed boost to economic morale. To give a little bit more context - there are those who go as far as to suggest that when Ireland beat England in the European Championships in Stuttgart in 1988, it played a significant part in the economic recovery that spawned the Celtic Tiger. Amazingly it can be that important for a nation's sense of self worth.
While I love sport, I am not a big football fan. Watching this match helped clarify my rationale for this point of view - it's based in what I would see as the spirit of the game. I don't particularly like the segregation in the stadiums, or the aggression of some supporters, but most of all I don't like what I see on the pitch. For me, what happens on the pitch is the root cause of the problems off of it. It is a game where the rule-makers have managed to foster an environment where cheating (and getting away with it) are a significant part of the skill set of the professional game. The responsibility for correct behaviour has been almost entirely abdicated from the individual player and onto the match referee and his linesmen. It's OK to cheat, you just need to make sure you get away with it - which is down to how well you can dupe the referee at the appropriate moment.
The protections afforded to these poor souls charged with refereeing responsibilities seem fairly limited - their job is highly pressurised and very difficult - for which they suffer regular abuse which largely goes unpunished. The facilities to correct this situation are entirely available - there are countless video angles that record the action at the big games; yet none of this is used to aid the referee during the course of the match, and it is very rarely used to identify cynical or cheating behaviour in the aftermath of a big game.
In the case of Thierry Henry's handball, not only did the player himself know of his foul, but the majority of the people in the stadium, the other players and the millions watching on TV knew that a foul had been committed. That information was captured both in real time and in replay. It would appear that the only person who didn't know there was a foul was the Swedish referee Martin Hansson. It was a bad mistake, but the speed at which things can happen on a football field makes such mistakes almost inevitable. What is tragic is that it occurred at such a pivotal moment in the context of Irish and French sport. In all honesty, if roles were reversed and the situation had involved an Irish player, he would likely have acted the same way as Monsieur Henry - it's the nature of the game. (Though the referee probably would have spotted it!).
In the aftermath, the recriminations have been widespread - some more serious than others. An Irish radio phone-in the day after the match clarified the extent of ill-feeling; one caller went as far as saying he would give up both french fries and french kissing as a protest. In seriousness, the focus of protests has been varied from anger at Thierry Henry, to anger at the referee, to anger at the lack of video replay in these key decisions. For me what's tragic is that those who run the game - FIFA - seem to be of the view that what happened is part and parcel of their sport; just one of the trials and tribulations that the "bounce of the ball" subjects participants to. This is the most maddening aspect of the situation. Their response merely reinforces the importance of cheating well in the game.
I know you're probably thinking that I'm using this week's blog to vent my frustration about the fact that Ireland won't be at next year's World Cup finals! That's only part of the aim.
There is an interesting parallel to be drawn here between the way in which rule makers in the footballing world choose to administer their game, and the way in which regulators have tried to manage the world's financial system. The similarities between Sepp Blatter's approach to running FIFA and the various bodies from the FSA to the SEC who regulate financial markets is dangerously similar, and has in many ways produced the same results. Many of the methods used to "game the system" - the financial system, that is - which have blown up in the past couple of years came because "gaming it" became culturally accepted by individuals (players), their peers (team-mates), their bosses ("gaffers"), and their shareholders (club owners). Football terminology in brackets.
The responsibility for "calling a foul" was abdicated almost entirely onto external bodies - poorly equipped or empowered regulators (who didn't have access to video replay) or rating agencies (who turned a blind eye to video replay). Regulators, while sadly displaying a lot of incompetence in the past few years, did not have the powers to make a meaningful cultural shift happen within financial services. The largest penalties for foul play seen in the past few years in the UK have been fines of a few thousand pounds combined with removal from the industry. These penalties have been nowhere near widespread or strong enough to act as a catalyst to alter the behaviour "on the playing field".
In the same way, until football players are subjected to post match critique that examines cynical or foul play, then they will continue to cultivate this particular art-form. All of the Galacticos, whether they be in financial services or football, are supposed to be superstars. They need to be held to standards that match that status.
Sunday 6 December 2009
Bonus please Darling...
The Christmas lights have gone up in Bond Street and London's investment bankers know that we're entering bonus season. Luxury retailers and banker's mothers wait alongside expectantly to see whether it's Asprey or Asda this Christmas. By all accounts its been a bumper year across the city, with all parts of investment banking operations posting record profits. In any "normal" year the expectation of big individual payouts would be bordering on uncontrollable. This year though it is likely to be considerably less predictable than has been the case in the past. The poor souls, god love them in this uncertain time.
All of the big banks in London will be under pressure to conform to the G20 principles on bonus payouts, but the banks with continued government involvement will be most at risk of having to pay their staff "unsatisfactory" (i.e. low) amounts. In this realm, RBS has been the subject of most discussion. The UK government owns 70% of the ordinary shares and £13bn worth of B-shares, comprising an economic interest that will rise to about 84% upon conversion of option rights. That effectively gives the Treasury the right to interfere in whatever it wants. Given the political ramifications of allowing "excess" at RBS, the Treasury has predictably warned the board off awarding bumper bonuses this year.
There is a strong political imperative behind this veto. The general public - who are facing large scale public sector cuts, tax increases, and an election next year - cannot see why traders at the UK's busted banks should be granted lavish bonuses so soon after their multi-billion pound collapse. It's hard to argue against that point of view - without the taxpayer lifeline in the UK and around the world, the domino effect that Lehman Brother's collapse started would have taken out all but the very strongest of financial institutions. In that context bonuses would have become a fabled relic of an indulgent past. "The fact is that we have gifted vast profits to the banks as a result of our actions," said one MP. "If they were using those profits simply to strengthen themselves that would be okay. But what we can't accept, and what society can't accept, is that they are using those profits to pay enormous bonuses."
The hard line being taken by the Treasury has prompted RBS directors to consider their options amidst concern that it will be tricky to retain key staff if they aren't paid their "market rate". As the Sunday Times reported yesterday, more than 1,000 investment bankers have quit RBS to join rivals in the recent past on the basis of better financial prospects; and a London based headhunter told me a couple of weeks ago that she has been inundated with CVs of RBS staff who are looking to jump ship. The 1,000 who have already left were said to have contributed between £600-£700mm to the bank's coffers last year - funds that the taxpayer would presumably like to be earned in future years as it seeks a nice return on its investment.
As a lawyer friend of mine has pointed out - it seems that corporate governance has come full circle. If RBS lose their top producing staff because the government prevents them from paying them what they need to pay them, then are the board in breach of their fiduciary duty to protect the interests of shareholders? There are reports that lawyers representing board members at RBS have advised the board to resign en masse if the government intervenes to block or cap bonus payments. The argument goes that if the board did accept any restrictions which could be perceived to make RBS uncompetitive then they would be breach of their statutory responsibility, which could have legal implications for each member of the board.
Given that the government owns more than the 75% shareholding required to force a "special resolution" in theory they can force through whatever bonus related concerns they have. In practice, however, if the board still think that this is not in the best interests of these same shareholders they, as i understand it, are not obliged to follow the special resolution. In which case the only option for the government would be to remove the board. Do-able, but it would certainly be a little on the messy side of things.
Presumably the complexity of reducing the bonus payments at RBS is one of the factors behind Alistair Darling contemplating the "nuclear option" of a windfall tax on investment bonuses across the City of London, which would not just apply to the state owned banks, but all international banks operating out of London. This is rumoured to be a central tenet of his pre-budget report due this Wednesday, which will need to outline a host of ways in which the government can increase tax revenues and reduce expenditures. It's thought that a windfall tax could generate £1bn per year - a useful contribution, but unfortunately more of a political ploy than a significant revenue generator. In reality, the transient nature of the the London investment banking community would mean that other jurisdictions will quickly pull workers away from the City. As a consequence the current corporation and personal tax raising capacity from the financial services sector may ironically diminish as a result of the windfall tax.
What is clear to me is that solving for the false incentives that cash bonuses create cannot be isolated to one bank, let alone a city. If RBS can't pay, or there is a windfall tax on investment bankers bonuses in London, the bigger picture issue will not be solved. The financial system needs to be set-up to reward for performance that is real, and not short-termist. It's been acknowledged by the G20 leaders in the past that solutions to the financial crisis, in terms of better regulation and greater transparency, need to be global in nature. If the UK government is acting in an aggressive way, but nobody else is following, it might be good political capital for a baying public, but the real systemic issue of skewed risks and rewards in the financial system will remain, just at a different bank or in a different city.
All of the big banks in London will be under pressure to conform to the G20 principles on bonus payouts, but the banks with continued government involvement will be most at risk of having to pay their staff "unsatisfactory" (i.e. low) amounts. In this realm, RBS has been the subject of most discussion. The UK government owns 70% of the ordinary shares and £13bn worth of B-shares, comprising an economic interest that will rise to about 84% upon conversion of option rights. That effectively gives the Treasury the right to interfere in whatever it wants. Given the political ramifications of allowing "excess" at RBS, the Treasury has predictably warned the board off awarding bumper bonuses this year.
There is a strong political imperative behind this veto. The general public - who are facing large scale public sector cuts, tax increases, and an election next year - cannot see why traders at the UK's busted banks should be granted lavish bonuses so soon after their multi-billion pound collapse. It's hard to argue against that point of view - without the taxpayer lifeline in the UK and around the world, the domino effect that Lehman Brother's collapse started would have taken out all but the very strongest of financial institutions. In that context bonuses would have become a fabled relic of an indulgent past. "The fact is that we have gifted vast profits to the banks as a result of our actions," said one MP. "If they were using those profits simply to strengthen themselves that would be okay. But what we can't accept, and what society can't accept, is that they are using those profits to pay enormous bonuses."
The hard line being taken by the Treasury has prompted RBS directors to consider their options amidst concern that it will be tricky to retain key staff if they aren't paid their "market rate". As the Sunday Times reported yesterday, more than 1,000 investment bankers have quit RBS to join rivals in the recent past on the basis of better financial prospects; and a London based headhunter told me a couple of weeks ago that she has been inundated with CVs of RBS staff who are looking to jump ship. The 1,000 who have already left were said to have contributed between £600-£700mm to the bank's coffers last year - funds that the taxpayer would presumably like to be earned in future years as it seeks a nice return on its investment.
As a lawyer friend of mine has pointed out - it seems that corporate governance has come full circle. If RBS lose their top producing staff because the government prevents them from paying them what they need to pay them, then are the board in breach of their fiduciary duty to protect the interests of shareholders? There are reports that lawyers representing board members at RBS have advised the board to resign en masse if the government intervenes to block or cap bonus payments. The argument goes that if the board did accept any restrictions which could be perceived to make RBS uncompetitive then they would be breach of their statutory responsibility, which could have legal implications for each member of the board.
Given that the government owns more than the 75% shareholding required to force a "special resolution" in theory they can force through whatever bonus related concerns they have. In practice, however, if the board still think that this is not in the best interests of these same shareholders they, as i understand it, are not obliged to follow the special resolution. In which case the only option for the government would be to remove the board. Do-able, but it would certainly be a little on the messy side of things.
Presumably the complexity of reducing the bonus payments at RBS is one of the factors behind Alistair Darling contemplating the "nuclear option" of a windfall tax on investment bonuses across the City of London, which would not just apply to the state owned banks, but all international banks operating out of London. This is rumoured to be a central tenet of his pre-budget report due this Wednesday, which will need to outline a host of ways in which the government can increase tax revenues and reduce expenditures. It's thought that a windfall tax could generate £1bn per year - a useful contribution, but unfortunately more of a political ploy than a significant revenue generator. In reality, the transient nature of the the London investment banking community would mean that other jurisdictions will quickly pull workers away from the City. As a consequence the current corporation and personal tax raising capacity from the financial services sector may ironically diminish as a result of the windfall tax.
What is clear to me is that solving for the false incentives that cash bonuses create cannot be isolated to one bank, let alone a city. If RBS can't pay, or there is a windfall tax on investment bankers bonuses in London, the bigger picture issue will not be solved. The financial system needs to be set-up to reward for performance that is real, and not short-termist. It's been acknowledged by the G20 leaders in the past that solutions to the financial crisis, in terms of better regulation and greater transparency, need to be global in nature. If the UK government is acting in an aggressive way, but nobody else is following, it might be good political capital for a baying public, but the real systemic issue of skewed risks and rewards in the financial system will remain, just at a different bank or in a different city.
Sunday 29 November 2009
Blingtastic
This week Dubai, the glitzy debt-fuelled emirate that makes Paris Hilton look short on bling, announced that it is seeking a standstill on repayment of part of the debt of Dubai World, a state holding company. Short on detail, as you might expect, nobody is yet clear what this means or what the details of this postponement will look like. A Machiavellian pot pourri of Madoff-Enron-AIG-subprime conspirators all rolled up into one secretive national entity - that's Dubai's way. Intriguingly the announcement came on the eve of Eid-al-Adha, a national holiday, which marks the end of the Hajj (the annual pilgrimmage to Mecca), so public faces to answer the substantial queries as to when you'll get your money back were thin on the ground. Regardless of whether this was deliberate or not, the news managed to scare the hell out of global markets at the back end of the week.
The scale of the market's response surprised many. Dubai was a big borrower during the boom times, running up debts of at least $80bn - which is a lot of money for a country who's biggest natural resource is sand - but in the global context, however, this is not huge. The nervous reaction of the world's markets shows the continuing fragility of the financial system, and heightened the awareness that sovereign debts can go unpaid just like any other form of debt, especially if the assets backing those debts are as valueless as the ones knocked together in Dubai over the past 15 years.
As I've blogged about before, the financial system remains massively over-leveraged and undercapitalised. Token green shoots are pointed to by the optimists, but the clear picture is that the unprecedented increase in sovereign and sub-sovereign debt over the past 18 months is the new "elephant in the room".
On Thursday the world's financial institutions with exposure to Dubai World were forced, for the first time, to put some real thought into what their level of competence would be in trying to make a creditor claim in the UAE.
Not a lot, was the instant response followed by nervy panic, and a quick acknowledgement that for all their other loans in other jurisdictions the world over, if those over-leveraged bodies decide that they don't want to pay, what would I be able to do about it. Suing a government entity, wherever it happens to be, is always going to be more tricky than suing a private sector institution. Time intensive, costly, and typically futile.
In Dubai's case, thinking through the logistics of making a creditor claim exposes a clear minefield. This emirate doesn't function in any way that is comparable to the economic and legal frameworks in the countries that have lent most of the $80bn. Sheikh Mohammed bin Rashid al-Maktoum, Dubai's autocratic leader has been on a mission to usher in nothing short of an Arab renaissance - albeit one that Liberace rather than Michaelangelo would be proud of. His decisions on any specific matter will easily outrank the decision of whatever legal body a creditor might make a claim through. Ironically, 40% of the inmates at Dubai's main jail are there because it is a prisonable offence to fail to pay back a debt. I suspect that such harsh terms don't apply evenly across the hierarchy that rules Dubai and the rest of the UAE.
Those who have lent to Dubai World, or any of its subsidiaries, seem to have made the assumption - unwritten but widely accepted - that Abu Dhabi would be on hand to pick up the tab if things went amiss. While the UAE is a one country, "united" just like the USA, it appears to be two sets of people in a form of cohabitation. Locally, I'm sure there has been significant resentment from the "big brother" that Dubai has grabbed all international headlines while bringing the worst of western excesses to the region. Dubai is the badly behaved younger brother, and Abu Dhabi like the good older brother wants to get some commitments to change before he steps in to help solve the youngster's troubles.
The question many have raised is what price would Abu Dhabi put on its support? Would it require equity stakes in the better-run Dubai entities? Would it use its financial clout to rein in Dubai to ensure the excesses were not repeated? All of these should be causes for concern for the international bondholders in Dubai World, who have quickly realised that their negotiating position in this particular part of the world is likely to be quite weak.
The reaction of the markets to the situation was probably a symptom of a wider sense that there is a limit to where federal support begins and ends around the world. If California defaults on its debts, will the US government step in to support it, particularly when the federal deficit is so large. In Eastern Europe, where $1.7trillion has been borrowed abroad ($400bn due this year, much of it to eurozone banks), will stronger European nations step-in to help in the event of default? The situation in Dubai has served to highlight that there are no guarantees.
The scale of the market's response surprised many. Dubai was a big borrower during the boom times, running up debts of at least $80bn - which is a lot of money for a country who's biggest natural resource is sand - but in the global context, however, this is not huge. The nervous reaction of the world's markets shows the continuing fragility of the financial system, and heightened the awareness that sovereign debts can go unpaid just like any other form of debt, especially if the assets backing those debts are as valueless as the ones knocked together in Dubai over the past 15 years.
As I've blogged about before, the financial system remains massively over-leveraged and undercapitalised. Token green shoots are pointed to by the optimists, but the clear picture is that the unprecedented increase in sovereign and sub-sovereign debt over the past 18 months is the new "elephant in the room".
On Thursday the world's financial institutions with exposure to Dubai World were forced, for the first time, to put some real thought into what their level of competence would be in trying to make a creditor claim in the UAE.
Not a lot, was the instant response followed by nervy panic, and a quick acknowledgement that for all their other loans in other jurisdictions the world over, if those over-leveraged bodies decide that they don't want to pay, what would I be able to do about it. Suing a government entity, wherever it happens to be, is always going to be more tricky than suing a private sector institution. Time intensive, costly, and typically futile.
In Dubai's case, thinking through the logistics of making a creditor claim exposes a clear minefield. This emirate doesn't function in any way that is comparable to the economic and legal frameworks in the countries that have lent most of the $80bn. Sheikh Mohammed bin Rashid al-Maktoum, Dubai's autocratic leader has been on a mission to usher in nothing short of an Arab renaissance - albeit one that Liberace rather than Michaelangelo would be proud of. His decisions on any specific matter will easily outrank the decision of whatever legal body a creditor might make a claim through. Ironically, 40% of the inmates at Dubai's main jail are there because it is a prisonable offence to fail to pay back a debt. I suspect that such harsh terms don't apply evenly across the hierarchy that rules Dubai and the rest of the UAE.
Those who have lent to Dubai World, or any of its subsidiaries, seem to have made the assumption - unwritten but widely accepted - that Abu Dhabi would be on hand to pick up the tab if things went amiss. While the UAE is a one country, "united" just like the USA, it appears to be two sets of people in a form of cohabitation. Locally, I'm sure there has been significant resentment from the "big brother" that Dubai has grabbed all international headlines while bringing the worst of western excesses to the region. Dubai is the badly behaved younger brother, and Abu Dhabi like the good older brother wants to get some commitments to change before he steps in to help solve the youngster's troubles.
The question many have raised is what price would Abu Dhabi put on its support? Would it require equity stakes in the better-run Dubai entities? Would it use its financial clout to rein in Dubai to ensure the excesses were not repeated? All of these should be causes for concern for the international bondholders in Dubai World, who have quickly realised that their negotiating position in this particular part of the world is likely to be quite weak.
The reaction of the markets to the situation was probably a symptom of a wider sense that there is a limit to where federal support begins and ends around the world. If California defaults on its debts, will the US government step in to support it, particularly when the federal deficit is so large. In Eastern Europe, where $1.7trillion has been borrowed abroad ($400bn due this year, much of it to eurozone banks), will stronger European nations step-in to help in the event of default? The situation in Dubai has served to highlight that there are no guarantees.
Friday 20 November 2009
Accentuate the positive...up to a point
On the third Friday of every month the US Bureau of Labor Statistics releases its preliminary data on non-farm payrolls, which are seen widely as a barometer of the broader economic picture in the US. Markets move significantly on the basis of these figures, so there is always a keen sense of anticipation on trading floors about what "the number" will be. The children of the bull-market (like me) working on trading floors of investment banks through the mid-2000s typically only ever saw a positive read out for the payrolls number - month on month the US economy was adding jobs, as the economy grew. This was taken to the point where the perception appeared to be that the number could only ever be positive - we had blocked out the notion of a negative figure.
As was typical of the trading floors I worked on there was always at least one trader "making a market" on what the payroll number would be, looking to make a few quid out of would be punters. The youngsters of the trading floor with this "only can be positive" perspective were often the target of such markets. The trader/ bookmaker of the payrolls number at Lehman Brothers, for example, aimed to capture the market in such a way as that he had no downside in the event that the number was positive, but had huge upside if shock-horror the number came out negative. In the bull-market his strategy never worked, but he was convinced rightly that this was a good strategy.
Bill Gross, the head of PIMCO, writing in his monthly "Investment Outlook" reminded me of these monthly payroll gambles. In a world where interest rates are near zero, and where deposit rates are truly awful (again almost zero), there is a desperation mindset in the investment community that Gross calls "Anything but 0.01%". To clarify - while the world seems to know that there are good reasons not to invest in riskier assets than deposits, it will always take that gamble because it cannot stomach such a paltry return as the 0.01%.
As Gross points out it would take close to 7000 years to double your money at that 0.01% rate - not exactly compelling even if you are saving for your great great grand children's school fees. The problem, as with the mentality of the young punters on the non-farm payrolls, is that in the "new normal" world that we are supposed to be living in 0.01% could be seen as a reasonable rate of return. The last twelve months of great returns in risk assets, however, are serving to delude us into thinking otherwise. Very quickly we have resumed the notion that "the number" is bound to be positive.
One of the great concerns about the rally in asset prices over the past year is that virtually every asset you can think of has gone up in value - from gold (the ultimate inflation hedge), to equities, through to government bonds. Old inverse relationships seem to have broken-down, which suggests that the "reflation" in asset prices is not caused by underlying economic improvement, but by an excess of liquidity in the system - in effect there is more money than sense.
Recently, as Gross points out, approximately $20bn a week has been flowing out of deposit accounts in search of higher yields. The rewards for having made this transition have been stellar in the past year - Gold at $1130 an ounce, global equity markets up 60-70% from their lows this year, oil at $80, mortgage rates at 4% thanks to a $1 trillion credit card from the Federal Reserve, commodities up across the board. The legitimate question of the day, as posed by Bill Gross: "Is a 0% interest rate creating the next financial bubble, and if so, will the Fed and other central banks raise rates proactively - even in the face of double-digit unemployment." The answer is that they won't, and the implications of that policy will start to tell.
Nationwide, the UK building society, on Friday accused government-backed companies of seriously distorting the UK retail savings market with "uneconomic pricing" of products. The building society, which had weathered the economic storm relatively well, saw retail savings outflows of £5.6bn in the half year ending September, which it ascribed to both lower market rates and tougher competition.
"We have elected not to chase market share in a retail savings market, which is subject to serious competitive distortion and uneconomic pricing, often by institutions which benefit from government guarantees", it said. Naming Northern Rock, Lloyds and the NS&I, Nationwide rightly commented that these institutions were paying way over the odds to attract market share in a way in which Nationwide could not compete. NS&I had been offering a 3.95% return on a fixed one year bond, while the market was offering 95 basis points. That's 300 basis points over Libor" said Chris Rhodes, the Nationwide marketing director. In layman's terms, a private sector company (Nationwide) can't compete against a UK government backed institution paying the standard interbank lending rate with an additional 3% kicker on top. And that 3% kicker is almost entirely subsidised by the taxpayer.
You then have to ask the question, if NS&I or any other government backed entity is borrowing at such high rates surely they must be taking way too much risk on the loans they are then offering out.
We have reached a point where the efforts to save the system, while initially critical, are now actually creating distortions such that markets are no longer allocating capital in an efficient or sensible way. The reality should be that the 0.01% paid on deposit accounts might actually represent a "reasonable rate of return" given the underlying real economic context. Those who have chased returns in risky assets, have been successful in the past year, but it doesn't necessarily make them smart or sensible. The fact that governments and central banks continue to flood the system with liquidity certainly doesn't make them smart or sensible either.
As was typical of the trading floors I worked on there was always at least one trader "making a market" on what the payroll number would be, looking to make a few quid out of would be punters. The youngsters of the trading floor with this "only can be positive" perspective were often the target of such markets. The trader/ bookmaker of the payrolls number at Lehman Brothers, for example, aimed to capture the market in such a way as that he had no downside in the event that the number was positive, but had huge upside if shock-horror the number came out negative. In the bull-market his strategy never worked, but he was convinced rightly that this was a good strategy.
Bill Gross, the head of PIMCO, writing in his monthly "Investment Outlook" reminded me of these monthly payroll gambles. In a world where interest rates are near zero, and where deposit rates are truly awful (again almost zero), there is a desperation mindset in the investment community that Gross calls "Anything but 0.01%". To clarify - while the world seems to know that there are good reasons not to invest in riskier assets than deposits, it will always take that gamble because it cannot stomach such a paltry return as the 0.01%.
As Gross points out it would take close to 7000 years to double your money at that 0.01% rate - not exactly compelling even if you are saving for your great great grand children's school fees. The problem, as with the mentality of the young punters on the non-farm payrolls, is that in the "new normal" world that we are supposed to be living in 0.01% could be seen as a reasonable rate of return. The last twelve months of great returns in risk assets, however, are serving to delude us into thinking otherwise. Very quickly we have resumed the notion that "the number" is bound to be positive.
One of the great concerns about the rally in asset prices over the past year is that virtually every asset you can think of has gone up in value - from gold (the ultimate inflation hedge), to equities, through to government bonds. Old inverse relationships seem to have broken-down, which suggests that the "reflation" in asset prices is not caused by underlying economic improvement, but by an excess of liquidity in the system - in effect there is more money than sense.
Recently, as Gross points out, approximately $20bn a week has been flowing out of deposit accounts in search of higher yields. The rewards for having made this transition have been stellar in the past year - Gold at $1130 an ounce, global equity markets up 60-70% from their lows this year, oil at $80, mortgage rates at 4% thanks to a $1 trillion credit card from the Federal Reserve, commodities up across the board. The legitimate question of the day, as posed by Bill Gross: "Is a 0% interest rate creating the next financial bubble, and if so, will the Fed and other central banks raise rates proactively - even in the face of double-digit unemployment." The answer is that they won't, and the implications of that policy will start to tell.
Nationwide, the UK building society, on Friday accused government-backed companies of seriously distorting the UK retail savings market with "uneconomic pricing" of products. The building society, which had weathered the economic storm relatively well, saw retail savings outflows of £5.6bn in the half year ending September, which it ascribed to both lower market rates and tougher competition.
"We have elected not to chase market share in a retail savings market, which is subject to serious competitive distortion and uneconomic pricing, often by institutions which benefit from government guarantees", it said. Naming Northern Rock, Lloyds and the NS&I, Nationwide rightly commented that these institutions were paying way over the odds to attract market share in a way in which Nationwide could not compete. NS&I had been offering a 3.95% return on a fixed one year bond, while the market was offering 95 basis points. That's 300 basis points over Libor" said Chris Rhodes, the Nationwide marketing director. In layman's terms, a private sector company (Nationwide) can't compete against a UK government backed institution paying the standard interbank lending rate with an additional 3% kicker on top. And that 3% kicker is almost entirely subsidised by the taxpayer.
You then have to ask the question, if NS&I or any other government backed entity is borrowing at such high rates surely they must be taking way too much risk on the loans they are then offering out.
We have reached a point where the efforts to save the system, while initially critical, are now actually creating distortions such that markets are no longer allocating capital in an efficient or sensible way. The reality should be that the 0.01% paid on deposit accounts might actually represent a "reasonable rate of return" given the underlying real economic context. Those who have chased returns in risky assets, have been successful in the past year, but it doesn't necessarily make them smart or sensible. The fact that governments and central banks continue to flood the system with liquidity certainly doesn't make them smart or sensible either.
Sunday 15 November 2009
Forgotten but not gone
This week the pound fell from a three-month high against the dollar after Fitch Ratings said the U.K.'s sovereign credit rating is most at risk among top-rated nations. David Riley, Fitch's head of "global sovereign ratings" said Britain needs the "largest budget adjustment" among countries it rates AAA. Not exactly revelationary stuff. We all know that the UK is in quite the financial pickle, so why does anybody care what a discredited rating agency has to say about it? And why did literally billions of pounds worth of sterling assets see their demand fall on the back of this seemingly innocuous, and not new, information? The reality seems to be that these guys are actually more relevant than ever - and the ratings that they provide are more critical for companies and governments than they ever have been.
Back when I worked at Lehman Brothers we used to have a term to describe dubiously structured investments in the credit world: "Fitch only". To explain - Fitch is one of the 3 main credit rating agencies; they get paid fees for assessing the credit worthiness of governments, companies or any other flora and fauna of the financial markets - you name it and they will stick a rating on it for a fee. In the rating agency world there was a clear hierarchy - Standard & Poor's at the top, Moody's a close second, and the black sheep of the family was Fitch. Given their position in the hierarchy, our sense was that Fitch tended to be a bit more liberal with the credit ratings applied to particular structured investments - it appeared to be their way of "competing" with their more exalted brethren. Consequently if ever you spotted a bond that was solely rated by Fitch, the inside track was that this was probably something to be avoided at all costs. Thus "Fitch only" became the blanket term.
Having said all that, the service that each of the rating agencies provided had clear benefits to their clients (and to us bankers, who paid their fees). A high rating from one of these guys significantly altered the regulatory capital requirements for a particular asset, and consequently made that investment more appealing. I won't go too much into the detail, but essentially the lower the capital requirement for an asset the higher potential return on equity for an investor. In effect the rating agencies were a great leverage-enabler. At the start of 2008, there were about 20 nations and only 12 corporations that had a AAA rating. At the same time more than 64,000 structured financial products, such as mortgage backed securities were given a AAA status.
As has been widely reported, many of these assets are now worthless. When the financial crisis kicked off in earnest with the collapse of many of these "AAA rated" assets, governments of the world roundly criticised the outrageously conspiring behaviour of these rating agencies. Ironically, as governments and companies now have an increased requirement for funding their budget deficits, the power of the rating agencies stamp of approval seems to have actually increased since the crisis started. Last Tuesday the UK government found this out to their significant cost, when our old friends at Fitch ratings suggested that Britain might lose its AAA status at some point in the future.
The Independent said of Fitch this week: "Were it to come out with something of a little more significance like, oh, let's say, lopping a notch off that prized AAA rating, the consequences would be truly awful. The cost of all that debt would increase dramatically, for starters. Sterling would execute a nosedive and we would probably find ourselves at parity with the euro, and maybe the dollar as well." It's a bit mad then that with so much at stake, so much is in the hands of a band of fairly second rate and potentially morally dubious folks. Why is this so?
The truth is that this is a financial regulatory issue. The world's financial regulators have placed the rating agencies at the center of the process of measuring whether banks and other financial institutions are "sufficiently capitalised". In theory if you have a good asset, then there is minimal chance of a catastrophic loss. Consequently less "insurance" against a catastrophic loss for a good asset is required. For banks "regulatory capital" is essentially a form of insurance against a catastrophic loss. Where the rating agencies come into the equation is that the world's financial regulators have made their ratings the determining factor in deciding how much capital a bank has to hold against each of its assets. A 'AAA' rated government bond requires very minimal (or none at all) capital, whereas a 'CCC' rated asset requires a lot of capital.
In a way, the responsibility for knowing whether an asset is good or not has been outsourced from people who are professionally trained to do so (the investors themselves), to the rating agencies - who basically aren't very good at it. In the case of Britain's debt, if a downgrade were to take place, it wouldn't matter if the world's financial institutions disagreed with Fitch, the regulatory situation would mean that whatever UK debt these institutions owned would suddenly be less attractive to own. In order to then compensate investors, all future debt would have to pay a significantly higher interest rate.
This year the total amount of sovereign debt (of national and state governments) that needs refinancing globally is estimated to be $3 trillion, and that figure is likely to be similar in coming years. The global "bun fight" to compete for that money is therefore likely to be intense - so a AAA rating will only become more relevant. The world's financial regulators are the ones responsible for the relevance of these ratings and they should be looking to re-establish regulatory capital rules in a complete overhaul, so that regulatory capital is not so inextricably linked to ratings. This is unlikely, so it appears that the band of discredited rating agencies will remain center stage for the foreseeable future.
Back when I worked at Lehman Brothers we used to have a term to describe dubiously structured investments in the credit world: "Fitch only". To explain - Fitch is one of the 3 main credit rating agencies; they get paid fees for assessing the credit worthiness of governments, companies or any other flora and fauna of the financial markets - you name it and they will stick a rating on it for a fee. In the rating agency world there was a clear hierarchy - Standard & Poor's at the top, Moody's a close second, and the black sheep of the family was Fitch. Given their position in the hierarchy, our sense was that Fitch tended to be a bit more liberal with the credit ratings applied to particular structured investments - it appeared to be their way of "competing" with their more exalted brethren. Consequently if ever you spotted a bond that was solely rated by Fitch, the inside track was that this was probably something to be avoided at all costs. Thus "Fitch only" became the blanket term.
Having said all that, the service that each of the rating agencies provided had clear benefits to their clients (and to us bankers, who paid their fees). A high rating from one of these guys significantly altered the regulatory capital requirements for a particular asset, and consequently made that investment more appealing. I won't go too much into the detail, but essentially the lower the capital requirement for an asset the higher potential return on equity for an investor. In effect the rating agencies were a great leverage-enabler. At the start of 2008, there were about 20 nations and only 12 corporations that had a AAA rating. At the same time more than 64,000 structured financial products, such as mortgage backed securities were given a AAA status.
As has been widely reported, many of these assets are now worthless. When the financial crisis kicked off in earnest with the collapse of many of these "AAA rated" assets, governments of the world roundly criticised the outrageously conspiring behaviour of these rating agencies. Ironically, as governments and companies now have an increased requirement for funding their budget deficits, the power of the rating agencies stamp of approval seems to have actually increased since the crisis started. Last Tuesday the UK government found this out to their significant cost, when our old friends at Fitch ratings suggested that Britain might lose its AAA status at some point in the future.
The Independent said of Fitch this week: "Were it to come out with something of a little more significance like, oh, let's say, lopping a notch off that prized AAA rating, the consequences would be truly awful. The cost of all that debt would increase dramatically, for starters. Sterling would execute a nosedive and we would probably find ourselves at parity with the euro, and maybe the dollar as well." It's a bit mad then that with so much at stake, so much is in the hands of a band of fairly second rate and potentially morally dubious folks. Why is this so?
The truth is that this is a financial regulatory issue. The world's financial regulators have placed the rating agencies at the center of the process of measuring whether banks and other financial institutions are "sufficiently capitalised". In theory if you have a good asset, then there is minimal chance of a catastrophic loss. Consequently less "insurance" against a catastrophic loss for a good asset is required. For banks "regulatory capital" is essentially a form of insurance against a catastrophic loss. Where the rating agencies come into the equation is that the world's financial regulators have made their ratings the determining factor in deciding how much capital a bank has to hold against each of its assets. A 'AAA' rated government bond requires very minimal (or none at all) capital, whereas a 'CCC' rated asset requires a lot of capital.
In a way, the responsibility for knowing whether an asset is good or not has been outsourced from people who are professionally trained to do so (the investors themselves), to the rating agencies - who basically aren't very good at it. In the case of Britain's debt, if a downgrade were to take place, it wouldn't matter if the world's financial institutions disagreed with Fitch, the regulatory situation would mean that whatever UK debt these institutions owned would suddenly be less attractive to own. In order to then compensate investors, all future debt would have to pay a significantly higher interest rate.
This year the total amount of sovereign debt (of national and state governments) that needs refinancing globally is estimated to be $3 trillion, and that figure is likely to be similar in coming years. The global "bun fight" to compete for that money is therefore likely to be intense - so a AAA rating will only become more relevant. The world's financial regulators are the ones responsible for the relevance of these ratings and they should be looking to re-establish regulatory capital rules in a complete overhaul, so that regulatory capital is not so inextricably linked to ratings. This is unlikely, so it appears that the band of discredited rating agencies will remain center stage for the foreseeable future.
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