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.
Sunday 13 December 2009
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.
Sunday 8 November 2009
For the love of Goldman...
This week´s edition of the Sunday Times has a supplement dedicated to understanding the particularly polarising topic that is Goldman Sachs. The Times Online website has one of the articles from the supplement at the top of its "most read" list - an article in which the Goldman Sachs CEO Lloyd Blankfein apparently uttered the immortal line "We do God´s work." Boris Johnson recently suggested that Goldman suffered from a form of collective Asperger´s syndrome - which at the time seemed a bit harsh, but on reading this there does seem to be some truth to the comment, and by the looks of things it starts at the top of the organisation. There´s nothing surprising about this article being the "most read" - this particular phrase is likely to take the venomous anger at Goldman to new levels.
Most of this venom is poorly directed. While I´ve written before about the grievances I have with some of what Goldman does, by-and-large I have a sincere respect for this institution. My past criticisms are related to specific representations about events – Goldman would not have been in existence had they not received government money as part of the AIG bailout for example, but the way Goldman represents this is as though it was an insignificant event, and that they did not need this money. That being said, they basically outperform their competition in what is a poorly regulated and often less than entirely moral industry, and I think that it´s sad if success is a reason to object to a person or institution. In the UK people should be considerably more angry about the plight of RBS, which is now 84% owned by the taxpayer, than Goldman Sachs.
If Goldman does eventually pay out in 2009 bonuses to its London-based employees what it indicated last week then HM Revenue & Customs stands to pick up £2 billion of it in income and corporation taxes. That is £2 billion that will not be needed from the rest of us; and given this country’s disastrous shortfall between tax revenues and public expenditure all help should be duly appreciated. This is not to mention the significant trickle-down effect of these bonus funds - many London based jobs, from chefs in restaurants to salespeople in retail stores will see the benefit in increased consumer spending as a result of this new discretionary income. It´s a sad fact that this country pays out more in social security benefits than it receives in income taxes, and yet lambasting the contributors seems to be higher on the agenda than addressing the receivers.
My chief grievance with Goldman is that as the bastion of the industry, with the best and brightest, it is they who should be leading the moral uprising that is required to get the world financial system back on track, as that should be in their own long term self interest. In reality what I believe happens is that they try to kid the outside world that they are something that they are not.
Specifically in relation to the article in the Sunday Times my issue is with the notion that Lloyd Blankfein has of his own organisation. While I´m sure his comments were media orientated, there was a clear insensitivity to the comments. When Blankfein claims to be "doing God´s work" he clarifies; "We´re very important. We help companies to grow by helping them to raise capital. Companies that grow create wealth. This is turn, allows people to have jobs that create more growth and more wealth. It´s a virtuous cycle. We have a social purpose."
There once was a time when there was a high correlation between earnings of banks, and the earnings of companies in "the real economy". When real businesses making cars or widgets or iPhones did well then the banks that facilitated their endeavour did well too. Similarly when those businesses struggled, so did their bankers. In theory there never should have been a time when the banks were doing well, while the real businesses of their clients were struggling. Blankfein´s notion of doing social good in that context I believe to be absolutely correct. My personal admiration is for a form of sustainable capitalism, engendered by the “social purpose” that Blankfein describes.
The real problem with his comments are the fact that they simply don´t represent reality. Goldman will have coined it this year, against a backdrop that isn´t particularly good in the real economy. While Goldman participates in the economy in the way that Blankfein speaks of, they also use their access to these companies and governments that are their clients, and the information that they gather from them in a way that often is less than socially optimal. Goldman is making money despite their clients situation – helping undercapitalized companies, and governments raise funds and then trading “the other side” of those markets. They are the great controllers of information flow.
Goldman has benefited from the upside of all the recent booms – dot.com, commodities, housing and while they are excellent at managing risk they play their part in inflating the bubbles in the first place – handling share and debt offerings for big clients, trading these securities and then pulling back.
The global economic context isn´t particularly good – unemployment in the US running at all time highs, budget deficits in countries like the UK, US, Spain and Ireland are at staggering levels, and a long term perspective that all this will add up to tax rises or inflation or both. The world´s middle classes will likely pay for this economic crisis as a consequence. These are the sort of people who rely on their monthly wages to pay their mortgages, their gas bills and their children´s education – the sort of “real economy” workers that Blankfein claims to be helping. They will be the ones who are hit by tax increases, and won´t be protected from inflation by a “diversified portfolio”, in the way that Blankfein´s well financially educated “social workers” will be.
Over the long term there are serious issues to address as to how the “real economy” will get itself on track. Instead of manipulating the current environment to its own short term advantage, Goldman if it truly is the great organization that it believes itself to be, should be helping to address the fundamental issues that befall the world economy.
Blankfein is conscious of this fact and what is disappointing is that he is trying to represent Goldman as something other than what it is. Good for him and his disciples if they can succeed in the money machine that is Goldman Sachs, but don´t patronize the rest of the real world by suggesting that the role that they are playing is one built around a social conscience.
Most of this venom is poorly directed. While I´ve written before about the grievances I have with some of what Goldman does, by-and-large I have a sincere respect for this institution. My past criticisms are related to specific representations about events – Goldman would not have been in existence had they not received government money as part of the AIG bailout for example, but the way Goldman represents this is as though it was an insignificant event, and that they did not need this money. That being said, they basically outperform their competition in what is a poorly regulated and often less than entirely moral industry, and I think that it´s sad if success is a reason to object to a person or institution. In the UK people should be considerably more angry about the plight of RBS, which is now 84% owned by the taxpayer, than Goldman Sachs.
If Goldman does eventually pay out in 2009 bonuses to its London-based employees what it indicated last week then HM Revenue & Customs stands to pick up £2 billion of it in income and corporation taxes. That is £2 billion that will not be needed from the rest of us; and given this country’s disastrous shortfall between tax revenues and public expenditure all help should be duly appreciated. This is not to mention the significant trickle-down effect of these bonus funds - many London based jobs, from chefs in restaurants to salespeople in retail stores will see the benefit in increased consumer spending as a result of this new discretionary income. It´s a sad fact that this country pays out more in social security benefits than it receives in income taxes, and yet lambasting the contributors seems to be higher on the agenda than addressing the receivers.
My chief grievance with Goldman is that as the bastion of the industry, with the best and brightest, it is they who should be leading the moral uprising that is required to get the world financial system back on track, as that should be in their own long term self interest. In reality what I believe happens is that they try to kid the outside world that they are something that they are not.
Specifically in relation to the article in the Sunday Times my issue is with the notion that Lloyd Blankfein has of his own organisation. While I´m sure his comments were media orientated, there was a clear insensitivity to the comments. When Blankfein claims to be "doing God´s work" he clarifies; "We´re very important. We help companies to grow by helping them to raise capital. Companies that grow create wealth. This is turn, allows people to have jobs that create more growth and more wealth. It´s a virtuous cycle. We have a social purpose."
There once was a time when there was a high correlation between earnings of banks, and the earnings of companies in "the real economy". When real businesses making cars or widgets or iPhones did well then the banks that facilitated their endeavour did well too. Similarly when those businesses struggled, so did their bankers. In theory there never should have been a time when the banks were doing well, while the real businesses of their clients were struggling. Blankfein´s notion of doing social good in that context I believe to be absolutely correct. My personal admiration is for a form of sustainable capitalism, engendered by the “social purpose” that Blankfein describes.
The real problem with his comments are the fact that they simply don´t represent reality. Goldman will have coined it this year, against a backdrop that isn´t particularly good in the real economy. While Goldman participates in the economy in the way that Blankfein speaks of, they also use their access to these companies and governments that are their clients, and the information that they gather from them in a way that often is less than socially optimal. Goldman is making money despite their clients situation – helping undercapitalized companies, and governments raise funds and then trading “the other side” of those markets. They are the great controllers of information flow.
Goldman has benefited from the upside of all the recent booms – dot.com, commodities, housing and while they are excellent at managing risk they play their part in inflating the bubbles in the first place – handling share and debt offerings for big clients, trading these securities and then pulling back.
The global economic context isn´t particularly good – unemployment in the US running at all time highs, budget deficits in countries like the UK, US, Spain and Ireland are at staggering levels, and a long term perspective that all this will add up to tax rises or inflation or both. The world´s middle classes will likely pay for this economic crisis as a consequence. These are the sort of people who rely on their monthly wages to pay their mortgages, their gas bills and their children´s education – the sort of “real economy” workers that Blankfein claims to be helping. They will be the ones who are hit by tax increases, and won´t be protected from inflation by a “diversified portfolio”, in the way that Blankfein´s well financially educated “social workers” will be.
Over the long term there are serious issues to address as to how the “real economy” will get itself on track. Instead of manipulating the current environment to its own short term advantage, Goldman if it truly is the great organization that it believes itself to be, should be helping to address the fundamental issues that befall the world economy.
Blankfein is conscious of this fact and what is disappointing is that he is trying to represent Goldman as something other than what it is. Good for him and his disciples if they can succeed in the money machine that is Goldman Sachs, but don´t patronize the rest of the real world by suggesting that the role that they are playing is one built around a social conscience.
Sunday 1 November 2009
The Pot calling the Kettle black...
This week the Federal Deposit Insurance Corp (FDIC) - the body responsible for insuring US bank deposits - took over its 100th failed bank. That's a lot of banks. The plethora of failures since the start of the financial crisis means the organisation now has control of billions of failed bank assets. As an organisation, FDIC is not alone - plenty of state and semi state bodies around the world are dealing with similarly huge volumes of bad "legacy" assets.
Back when Northern Rock was one of the world's first bank failures, one of the big faults ascribed to their banking model was the excessive use of wholesale funding, and in particular, securitisation. Securitisation allowed Northern Rock to originate loans massively disproportionate to the size of their capital base, because these loans were repackaged and sold to other institutions around the world as bonds from these securitisations. Northern Rock would only hold the risk of the loans they were making for a short period of time, before refinancing in this way. Their problems arose when the securitisation market shut abruptly and the bank was stuck with huge quantities of loans that it couldn't finance. The scenes of customers queuing to take their deposits back followed shortly thereafter.
For a time, securitisation had allowed Northern Rock to be very successful - it allowed them to improve their regulatory capital position, improve their ratings, increase the size of their loan portfolio, and reduce their overall cost of funding. Basically without altering the fundamental nature of their business, they were able to massively increase their return on equity. In the aftermath of the fallout of all of these bank failures there has been plenty of commentary on the fact that securitisation was part of the toolkit that allowed the financial institutions to pile leverage into the world's financial system. Consequently it is recognised as a significant contributor to the financial crisis as a whole. We can all recall how governments around the world attacked "the rating agencies" for their complicit role in helping banks to create ABSs, CDOs, SIVs and all the acronyms that went with this form of financial alchemy.
Now we are at the point where bank failings around the world have left governments and their taxpayers carrying the can. Budget deficits, as I've written about before, are sky high in countries like the UK, the US, Ireland and Spain. Essentially the private sector problems of the banking system have become public sector problems, and governments are exploring all sorts of options to finance these bad debts in the most efficient ways. They have the same problem that the banks did - how to maintain ratings, meet budget targets, tidy-up balance sheets etc. State institutions like FDIC have a huge quantum of assets to find financing for.
With no great awareness of the irony, it was intriguing to read this week that one of the options that FDIC are considering is the "mother of all securitisations". Michael Krimminger, special advisor for policy at FDIC, speaking at the ABS East conference in Miami said that "it is likely that they may seek to do a securitization". Brilliant. And they are not alone. In Ireland, the National Asset Management Agency (NAMA), which is taking on a €77 billion notional of bad loans from Irish banks, is apparently creating a "special purpose vehicle to acquire the loans. NAMA will own 49% of the SPV, with the remaining 51% belonging to as yet unidentified private investors". In other words, they want to do a securitisation to shift most of the debt off the country's balance sheet.
Ireland's budget deficit is a focus for Eurostat, who monitor European Union members' economic position particularly when one of its members is likely to breach one of the pillars of the Stability and Growth Pact. This agency, which in theory is aimed at protecting European Union "growth" and "stability" is actually advising the Irish government on how it can keep NAMA "off balance sheet", so that it meets European Union fiscal rules. Surely there is something wrong with this?
While I still believe that there is some merit in the process of securitisation, one of the big issues I have with it relates to transparency. When a securitisation involves shifting risks off-balance sheet, but where there is some residual risk that these liabilities may come back onto balance sheet, then not accounting for that contingency in any way would appear odd. It is a form of organised delusion, and goes against the worldwide state calls for greater transparency in the financial system.
The Irish Finance Minister, Brian Lenihan confirmed: "The preliminary decision of Eurostat means that the acquisition of the assets from the financial institutions by NAMA may be treated as off-balance sheet in the budgetary arithmetic under European national accounting rules. In other words, it will not increase the general government debt ratio, and neither will our budget balance be directly affected by the NAMA initiative."
This great from an accounting perspective, but NAMA will sell the 51% to private sector investors, with a state guarantee - i.e. in the event that the underlying loans don't perform well enough to pay bondholders what they are owed, the Irish government will pick up the tab for the difference. NAMA is therefore an ongoing contingent liability for the Irish government, even if their accounts don't show it. This is exactly where the private sector problems with the banks that are being bailed out started. Off balance sheet liabilities that weren't accounted for made the numbers look good when the times were good, but when the assets started performing poorly, the liabilities moved from being "contingent" to actual and immediate, and the system started to break down.
In my old jobs at Lehman Brothers and BNP Paribas, we helped banks perform securitisations for various reasons from funding, to improving their "regulatory capital position", and we made a lot of money from doing it. Some of it was sensible, but the vast majority of the business was a form of organised delusion - trying to make something look better than it actually was. I can only imagine that the semi-redundant masters of this art form currently still in these investment banks are rubbing their hands together at the prospect of "helping" the governments of the world in the same way.
Back when Northern Rock was one of the world's first bank failures, one of the big faults ascribed to their banking model was the excessive use of wholesale funding, and in particular, securitisation. Securitisation allowed Northern Rock to originate loans massively disproportionate to the size of their capital base, because these loans were repackaged and sold to other institutions around the world as bonds from these securitisations. Northern Rock would only hold the risk of the loans they were making for a short period of time, before refinancing in this way. Their problems arose when the securitisation market shut abruptly and the bank was stuck with huge quantities of loans that it couldn't finance. The scenes of customers queuing to take their deposits back followed shortly thereafter.
For a time, securitisation had allowed Northern Rock to be very successful - it allowed them to improve their regulatory capital position, improve their ratings, increase the size of their loan portfolio, and reduce their overall cost of funding. Basically without altering the fundamental nature of their business, they were able to massively increase their return on equity. In the aftermath of the fallout of all of these bank failures there has been plenty of commentary on the fact that securitisation was part of the toolkit that allowed the financial institutions to pile leverage into the world's financial system. Consequently it is recognised as a significant contributor to the financial crisis as a whole. We can all recall how governments around the world attacked "the rating agencies" for their complicit role in helping banks to create ABSs, CDOs, SIVs and all the acronyms that went with this form of financial alchemy.
Now we are at the point where bank failings around the world have left governments and their taxpayers carrying the can. Budget deficits, as I've written about before, are sky high in countries like the UK, the US, Ireland and Spain. Essentially the private sector problems of the banking system have become public sector problems, and governments are exploring all sorts of options to finance these bad debts in the most efficient ways. They have the same problem that the banks did - how to maintain ratings, meet budget targets, tidy-up balance sheets etc. State institutions like FDIC have a huge quantum of assets to find financing for.
With no great awareness of the irony, it was intriguing to read this week that one of the options that FDIC are considering is the "mother of all securitisations". Michael Krimminger, special advisor for policy at FDIC, speaking at the ABS East conference in Miami said that "it is likely that they may seek to do a securitization". Brilliant. And they are not alone. In Ireland, the National Asset Management Agency (NAMA), which is taking on a €77 billion notional of bad loans from Irish banks, is apparently creating a "special purpose vehicle to acquire the loans. NAMA will own 49% of the SPV, with the remaining 51% belonging to as yet unidentified private investors". In other words, they want to do a securitisation to shift most of the debt off the country's balance sheet.
Ireland's budget deficit is a focus for Eurostat, who monitor European Union members' economic position particularly when one of its members is likely to breach one of the pillars of the Stability and Growth Pact. This agency, which in theory is aimed at protecting European Union "growth" and "stability" is actually advising the Irish government on how it can keep NAMA "off balance sheet", so that it meets European Union fiscal rules. Surely there is something wrong with this?
While I still believe that there is some merit in the process of securitisation, one of the big issues I have with it relates to transparency. When a securitisation involves shifting risks off-balance sheet, but where there is some residual risk that these liabilities may come back onto balance sheet, then not accounting for that contingency in any way would appear odd. It is a form of organised delusion, and goes against the worldwide state calls for greater transparency in the financial system.
The Irish Finance Minister, Brian Lenihan confirmed: "The preliminary decision of Eurostat means that the acquisition of the assets from the financial institutions by NAMA may be treated as off-balance sheet in the budgetary arithmetic under European national accounting rules. In other words, it will not increase the general government debt ratio, and neither will our budget balance be directly affected by the NAMA initiative."
This great from an accounting perspective, but NAMA will sell the 51% to private sector investors, with a state guarantee - i.e. in the event that the underlying loans don't perform well enough to pay bondholders what they are owed, the Irish government will pick up the tab for the difference. NAMA is therefore an ongoing contingent liability for the Irish government, even if their accounts don't show it. This is exactly where the private sector problems with the banks that are being bailed out started. Off balance sheet liabilities that weren't accounted for made the numbers look good when the times were good, but when the assets started performing poorly, the liabilities moved from being "contingent" to actual and immediate, and the system started to break down.
In my old jobs at Lehman Brothers and BNP Paribas, we helped banks perform securitisations for various reasons from funding, to improving their "regulatory capital position", and we made a lot of money from doing it. Some of it was sensible, but the vast majority of the business was a form of organised delusion - trying to make something look better than it actually was. I can only imagine that the semi-redundant masters of this art form currently still in these investment banks are rubbing their hands together at the prospect of "helping" the governments of the world in the same way.
Sunday 25 October 2009
The more I practice the luckier I get...
I saw this week that a chap by the name of John Meriwether, a bell-weather name of the hedge fund world, is about to embark upon his 3rd attempt at running a hedge fund. Incredible really. This guy's "ability" required the Federal Reserve to establish the entire precedent of "too big to fail" in 1998, when they were forced to rescue his first hedge fund, Long Term Capital Management (and the banks that lent to it). He then had another cut at punting other people's money, which ended 3 months ago - investors in JWM Partners were handed back 56% of their initial investment. And now, like a Phoenix from the flames, he's back again with the collection bowl out raising money for a 3rd fund. The most wonderful point is that the fund is expected to use the same strategy as both LTCM and JWM Partners to make money: so-called relative value arbitrage. If this guy succeeds in raising any meaningful size of funds, he really should turn his hand to selling something easier - like ice to eskimos.
Meriwether, will undoubtedly justify his past failures as having been so-called "Black Swan" events - i.e. that the circumstances that led to these funds' demise were epoch making events, which could not possibly have been foreseen. In the first case "irrational" market movements following the Russian crisis in 1998, and in the most recent case a credit market that lost its "rationality". The common theme being a basic lack of human rationality when it mattered - wow, never would have seen that. This guy must be the unluckiest guy on the planet if he has been hit by 2 once-in-a-millenium events in the past 12 years. Surely third time round he can't possibly be as unlucky?
I can only hope that those managing money in pension funds and insurance companies around the world will see this guy for what he is - not "unlucky", but just someone who isn't actually very good at understanding financial markets. To quote George Bush: "Fool me once, shame on you - shame on you. Fool me - you can't get fooled again." You get the picture.
In all likelihood Meriwether will manage to raise a goodly chunk of money for his 3rd fund, from another round of deluded asset managers and high net worths with more money than sense (I can't believe any original investors will go back for a 2nd or 3rd roll of the dice - but who knows). Here's how the conversation will go: "No way he can be wrong a third time!! We have a rare opportunity to add this really smart guy to our stable of fund managers. Let's give him $250 million."
If you compared Meriwether to an airline pilot, or a doctor, or any other profession that I can think of, he would be struck-off whatever register of professional standards existed for that industry, as would the asset managers who chose to bet their funds on such a track record.
The fact that he can raise a second or, now third fund, helps demonstrate to me that the world is fundamentally pretty poor at analysing luck, good or bad. A fact which I think applies in all aspects of life - from financial management, to health, to relationships. In Meriwether's case, investors who are willing to invest money with him have obviously accepted that he had a decent strategy, but was just tremendously unlucky (twice).
In other worldly situations, we might think someone was lucky when their achievements have been the result of real personal impact and talent, and conversely, there are situations where someone has been affected by luck, but observers put it down to their own personal impact and ability. In other words, we get a bit confused when it comes to judging where luck does or doesn't exist. Usually success is a combination of impact and luck. (I've stolen that from here: http://docs.google.com/View?id=dgrdmfgk_33d42brbs5 - thanks bro!)
When Rudy Giuliani became mayor of New York, for example, the crime rate in the city dropped precipitously in the following couple of years. Observers put this down to the "zero tolerance" attitude that he had adopted to crime, which was widely lauded. It's been suggested recently, however, that he may just have been lucky - 18 years prior to Giuliani's election, the ground-breaking Rowe vs. Wade abortion case meant that abortion became legalised in some US states, New York included. The unobserved "luck" for Giuliani was that many of the would-be criminals had not been born 17-18 years previously - many of the aborted children would have been born into broken homes, or family environments where care would have been difficult; which statistically would have increased the probable propensity towards crime in later life.
All this led me to think of two books - one that I'm currently reading, and one that I read recently. Both address the analysis of our notions of success. In Outliers (currently reading), by Malcolm Gladwell the idea is that success is a lot more haphazard than people would tend to think. Similarly in Fooled by Randomness, a former options trader - Nassim Taleb - presents an account of the role of chance not only in personal life, but also in theoretically quantifiable spheres, such as making investment decisions - and further how much it costs society to underestimate the probability of the sort of "Black Swan" events that John Meriwether was hit by. Taleb hammers home the point that the rich (as one measure of success) are frequently just lucky rather than smart.
If you have enough participants flipping a coin, 1 of them will flip heads 10 out of 10 times. There are plenty of successful hedge fund managers who've flipped heads 4-5 times and been hailed as geniuses, and like Meriwether (before his 'bad luck' set in) have raised vast sums of money on the back of it. The truth is that many of them have been lucky, and they have a 50-50 chance of flipping a tail the next year.
Meriwether, will undoubtedly justify his past failures as having been so-called "Black Swan" events - i.e. that the circumstances that led to these funds' demise were epoch making events, which could not possibly have been foreseen. In the first case "irrational" market movements following the Russian crisis in 1998, and in the most recent case a credit market that lost its "rationality". The common theme being a basic lack of human rationality when it mattered - wow, never would have seen that. This guy must be the unluckiest guy on the planet if he has been hit by 2 once-in-a-millenium events in the past 12 years. Surely third time round he can't possibly be as unlucky?
I can only hope that those managing money in pension funds and insurance companies around the world will see this guy for what he is - not "unlucky", but just someone who isn't actually very good at understanding financial markets. To quote George Bush: "Fool me once, shame on you - shame on you. Fool me - you can't get fooled again." You get the picture.
In all likelihood Meriwether will manage to raise a goodly chunk of money for his 3rd fund, from another round of deluded asset managers and high net worths with more money than sense (I can't believe any original investors will go back for a 2nd or 3rd roll of the dice - but who knows). Here's how the conversation will go: "No way he can be wrong a third time!! We have a rare opportunity to add this really smart guy to our stable of fund managers. Let's give him $250 million."
If you compared Meriwether to an airline pilot, or a doctor, or any other profession that I can think of, he would be struck-off whatever register of professional standards existed for that industry, as would the asset managers who chose to bet their funds on such a track record.
The fact that he can raise a second or, now third fund, helps demonstrate to me that the world is fundamentally pretty poor at analysing luck, good or bad. A fact which I think applies in all aspects of life - from financial management, to health, to relationships. In Meriwether's case, investors who are willing to invest money with him have obviously accepted that he had a decent strategy, but was just tremendously unlucky (twice).
In other worldly situations, we might think someone was lucky when their achievements have been the result of real personal impact and talent, and conversely, there are situations where someone has been affected by luck, but observers put it down to their own personal impact and ability. In other words, we get a bit confused when it comes to judging where luck does or doesn't exist. Usually success is a combination of impact and luck. (I've stolen that from here: http://docs.google.com/View?id=dgrdmfgk_33d42brbs5 - thanks bro!)
When Rudy Giuliani became mayor of New York, for example, the crime rate in the city dropped precipitously in the following couple of years. Observers put this down to the "zero tolerance" attitude that he had adopted to crime, which was widely lauded. It's been suggested recently, however, that he may just have been lucky - 18 years prior to Giuliani's election, the ground-breaking Rowe vs. Wade abortion case meant that abortion became legalised in some US states, New York included. The unobserved "luck" for Giuliani was that many of the would-be criminals had not been born 17-18 years previously - many of the aborted children would have been born into broken homes, or family environments where care would have been difficult; which statistically would have increased the probable propensity towards crime in later life.
All this led me to think of two books - one that I'm currently reading, and one that I read recently. Both address the analysis of our notions of success. In Outliers (currently reading), by Malcolm Gladwell the idea is that success is a lot more haphazard than people would tend to think. Similarly in Fooled by Randomness, a former options trader - Nassim Taleb - presents an account of the role of chance not only in personal life, but also in theoretically quantifiable spheres, such as making investment decisions - and further how much it costs society to underestimate the probability of the sort of "Black Swan" events that John Meriwether was hit by. Taleb hammers home the point that the rich (as one measure of success) are frequently just lucky rather than smart.
If you have enough participants flipping a coin, 1 of them will flip heads 10 out of 10 times. There are plenty of successful hedge fund managers who've flipped heads 4-5 times and been hailed as geniuses, and like Meriwether (before his 'bad luck' set in) have raised vast sums of money on the back of it. The truth is that many of them have been lucky, and they have a 50-50 chance of flipping a tail the next year.
Sunday 18 October 2009
The 20 year plan...
There is an amusing TV advert for Walls sausages doing the rounds at the moment, that as a recent entrant into the world of parenthood and the ensuing sleepless nights, has struck a chord. The advert shows 2 scenes; the birth of a child and, secondly, the departure of said child from home 20-odd years later. The tagline for the sausage company is: "Wall's sausages: we only select the best bits". A bit harsh maybe, but with a 3-month old son, who's lovely, but at the same time a 20 odd year financial liability, I can get the gist. I've been doing some thinking of late about what sort of assets will have value over that sort of timeframe. In trying to select the best bits, there's not a lot that's obvious to me.
As I've blogged before, I'm not much of a buyer into the current rally in stock and bond prices, so they are a bit of a no go area. Endless streams of central bank liquidity, and the transfer of private sector losses onto government balance sheets has so far postponed a reckoning for the flawed global economic approach. Governments are pursuing what should and will ultimately be highly inflationary monetary policies. The US monetary base (coins, paper money and central bank reserves) at the end of August 2008 was about $800 billion. In response to the economic crisis, the US government has printed so much money that the monetary base has swelled to $1.7 trillion. This is the largest expansion in history and a staggering devaluation of the dollar, even if that devaluation is yet to be properly recognised within financial markets.
It means that for every dollar in America one year ago, the US government has created 2.1 more of them. At some point in time, and perhaps not for some time, there must be a serious bout of inflation or increased taxes, or both; these are the only 2 conceivable ways in which governments will extract themselves from their debt burdens. For the time being, in the "postponement period", it's possible to remain comfortably deluded; in countries where substantial stimulus packages have been promised, much of these monies are yet to be put to work - so the delusion period may run for some time.
In the context of the 20 year time horizon I'm thinking of when I plan for our son's future, I'm pretty sure the proverbial will have hit the fan sometime between now and then. With that in mind, I am looking for long-term fundamentals that will almost certainly play-out over an extended time period.
The obvious suggestion, given my views, is to put money into gold - as a hedge against inflation and the effects of a weak dollar. As I've written before, I can't fully get my head around that - since the US broke any direct linkage between the dollar and gold 38 years ago, gold's relevance should theoretically have waned. Granted, the supply of gold is limited and it has been an excellent store of value for centuries, but I can't get a proper grasp of the fundamentals. The only reason it seems to be so popular is for reasons that are no longer relevant - it's a 1000 year fad, that may continue for another 1000 years, but I can only partially rationalize why this fad continues. There is a chance that gold hits a tipping point - unlikely - but possible.
So here is where I am at so far on this quest. Inspiration was provided in the form of a recent David Attenborough nature program in which he said that since he had started making nature documentaries, that the worlds population has doubled. A fairly striking fact.
The world's population has risen from 2.5 billion in 1950 to 6.8 billion. It is growing by 75 million a year and is almost certain to exceed 9 billion by 2050. Thirty years ago half the world's population were not even participating in the world economy, and now they are trying to live like we do; consuming in the same expansive ways. That emerging megaforce will put a substantial squeeze on commodity prices - in particular on basic food stuffs, like wheat. The average daily per capita consumption of oil in the US at 0.677 barrels (an amazing 26 gallons per day)., vs. India's infinitely smaller consumption (0.021bbl.s) and China's (0.049 bbl.). Even if the Chinese and Indians just start consuming as much electricity as Koreans now do, the price of oil will take off. As a fairly fundamental farming input, the knock-on effect for agricultural commodities is likely to be substantial.
It's clear that the world is in the early stages of an unprecedented explosion of the middle class, and the pace will likely pick-up significantly. India and China, where half the world's population live, are a the center of this movement. A recent Goldman Sachs report suggested that India's percentage of people in the "middle class" increased from 1% in 2000 to 5% today, but if growth conditions along the lines of their projections become reality, the vast majority of Indians could be in this group by 2040. One characteristic of "middle class" Indians or Chinese, for that matter, is that they are much more likely to have meat as a regular part of their diet. It takes 9 times as much wheat to put meat on the table (feeding pigs/cows etc.), than to put bread. What seems inevitable is that as the global population continues to grow exponentially, and as the world's middle class grows, the pressure on basic food supplies is only going to increase.
Now this I can rationalize, even if it does scare the hell out of me. Maybe farmland is the answer to financing our son's future, and an early enrollment in agricultural college. Back to his Irish roots!
As I've blogged before, I'm not much of a buyer into the current rally in stock and bond prices, so they are a bit of a no go area. Endless streams of central bank liquidity, and the transfer of private sector losses onto government balance sheets has so far postponed a reckoning for the flawed global economic approach. Governments are pursuing what should and will ultimately be highly inflationary monetary policies. The US monetary base (coins, paper money and central bank reserves) at the end of August 2008 was about $800 billion. In response to the economic crisis, the US government has printed so much money that the monetary base has swelled to $1.7 trillion. This is the largest expansion in history and a staggering devaluation of the dollar, even if that devaluation is yet to be properly recognised within financial markets.
It means that for every dollar in America one year ago, the US government has created 2.1 more of them. At some point in time, and perhaps not for some time, there must be a serious bout of inflation or increased taxes, or both; these are the only 2 conceivable ways in which governments will extract themselves from their debt burdens. For the time being, in the "postponement period", it's possible to remain comfortably deluded; in countries where substantial stimulus packages have been promised, much of these monies are yet to be put to work - so the delusion period may run for some time.
In the context of the 20 year time horizon I'm thinking of when I plan for our son's future, I'm pretty sure the proverbial will have hit the fan sometime between now and then. With that in mind, I am looking for long-term fundamentals that will almost certainly play-out over an extended time period.
The obvious suggestion, given my views, is to put money into gold - as a hedge against inflation and the effects of a weak dollar. As I've written before, I can't fully get my head around that - since the US broke any direct linkage between the dollar and gold 38 years ago, gold's relevance should theoretically have waned. Granted, the supply of gold is limited and it has been an excellent store of value for centuries, but I can't get a proper grasp of the fundamentals. The only reason it seems to be so popular is for reasons that are no longer relevant - it's a 1000 year fad, that may continue for another 1000 years, but I can only partially rationalize why this fad continues. There is a chance that gold hits a tipping point - unlikely - but possible.
So here is where I am at so far on this quest. Inspiration was provided in the form of a recent David Attenborough nature program in which he said that since he had started making nature documentaries, that the worlds population has doubled. A fairly striking fact.
The world's population has risen from 2.5 billion in 1950 to 6.8 billion. It is growing by 75 million a year and is almost certain to exceed 9 billion by 2050. Thirty years ago half the world's population were not even participating in the world economy, and now they are trying to live like we do; consuming in the same expansive ways. That emerging megaforce will put a substantial squeeze on commodity prices - in particular on basic food stuffs, like wheat. The average daily per capita consumption of oil in the US at 0.677 barrels (an amazing 26 gallons per day)., vs. India's infinitely smaller consumption (0.021bbl.s) and China's (0.049 bbl.). Even if the Chinese and Indians just start consuming as much electricity as Koreans now do, the price of oil will take off. As a fairly fundamental farming input, the knock-on effect for agricultural commodities is likely to be substantial.
It's clear that the world is in the early stages of an unprecedented explosion of the middle class, and the pace will likely pick-up significantly. India and China, where half the world's population live, are a the center of this movement. A recent Goldman Sachs report suggested that India's percentage of people in the "middle class" increased from 1% in 2000 to 5% today, but if growth conditions along the lines of their projections become reality, the vast majority of Indians could be in this group by 2040. One characteristic of "middle class" Indians or Chinese, for that matter, is that they are much more likely to have meat as a regular part of their diet. It takes 9 times as much wheat to put meat on the table (feeding pigs/cows etc.), than to put bread. What seems inevitable is that as the global population continues to grow exponentially, and as the world's middle class grows, the pressure on basic food supplies is only going to increase.
Now this I can rationalize, even if it does scare the hell out of me. Maybe farmland is the answer to financing our son's future, and an early enrollment in agricultural college. Back to his Irish roots!
Sunday 4 October 2009
Party Pooping...
The IMF this week said that they think that the world's banks are still yet to acknowledge over half of the losses that they projected in April this year. Their projected figure was $2,800bn back then, and in their latest financial stability report that figure remains their expectation. So far during the financial crisis the world's banks have acknowledged $1,300bn of writedowns, leaving another $1,500bn of losses to be accounted for - if the IMF are to be believed. At the same time, one of the main topics of regulatory discussion is how insufficient bank capital was under the old regime, and how it needs to be greater in future.
Basically regulators want banks to be better capitalised. If for example banks were forced to return to the average tangible common equity to assets ratios they had in the 1990s, then US and European banks would need to raise upwards of $1,000bn. So, adding that number to the IMF number of unaccounted-for losses, is a simple calculation adding to a fairly mind-blowing figure of $2,500bn.
That's $2,500bn worth of equity capital. Even if the real number is much less than that, what is patently clear is that the world is going to have to de-lever significantly. If we held things constant and assumed that banks lend something along the lines of 12 times equity (a conservative estimate given that Lehman Brothers were around 50 times leveraged in September 2008), then that is $30 trillion worth of credit that very theoretically would have to be removed from the system before the world's banking system is back to being "well capitalised".
When you consider that number (again this is highly conceptual) in some context then the current revival of global asset prices seems a bit crass. The biggest five banks in the world have total assets of around $15 trillion, the top ten around $26 trillion and the top 50 banks in the world have a total of $62 trillion of assets. So, essentially to regain the IMF and regulators' concept of sufficiently "capitalised" we are looking at the top 50 banks in the world halving the size of their balance sheets, or more likely all of the world's banks reducing the size of their balance sheets by somewhere between 25-40%.
To reiterate - this is all very much a rough pointer to the numbers; the IMF may be way off the mark (unlikely) and regulators may not enforce capital rules to such a strong extent (more likely). Nonetheless, there is no doubt at all that banks are going to have to raise very large sums of new equity capital, whether it be to counteract write-downs or to deal with a stiffer regulatory requirement.
At the moment there are several things helping to postpone this inevitability. Firstly the real level of interest rates around the world is next to nil, so there is an abundance of liquidity available to virtually all banks to rollover their balance sheets for the short term in debt capital markets. This is helping to sustain, or increase asset prices and is as a consequence preventing the need to acknowledge further mark-to-market write downs in the short term - even the most extravagant assets of the credit boom (things like CDO equity and subprime ABS) have seen their prices rise significantly over the past couple of quarters.
Secondly, the fact that interest rates are so low has enticed retail deposit investors to ditch their savings accounts paying 0.5% and to look for higher returns in other asset markets, from stock markets to property to convertible bonds - all of these are rising as buying interest grows. Thirdly, and this is related to the first two points, banks have seen stellar earnings from their capital markets operations in the past few quarters as debt and equity underwriting, trading and mortgage refinancing activity has created big earning opportunities. This paradise has meant that banks can claim to be "recapitalising" themselves through earnings.
All of these points, I believe, are blinding the markets from the bigger picture reality that nobody is incentivised to acknowledge. Banks may see margins erode as they incur higher debt interest costs to extend their funding, and competition for savings bids up the cost of attracting deposits. Furthermore, higher deposit insurance premiums, costs from tighter regulation and the need to hold more and higher quality capital will reduce returns on equity.
The current trend is for banks and governments to suggest that they can pay off their liabilities, or increase their equity bases through earnings or growth. In both cases the scale of the growth requirement just to get back to a relatively even keel is beyond what both government bond prices and bank equity prices justify. Friday saw stock markets respond badly to the US non-farm payroll figure, and the knock-on effect on the US jobless rate which has hit 9.8%. Another statistic that should cause concern (ironically) is that the US savings rate is increasing all the time and is now at a significant high of over 8%. The growth that is required around the world to sustain our economic system needs to have a US consumer in the hot seat - they need to be spending like there is no tomorrow and buying up cheap imports from China and their cheap exporting brethren. If the US consumer is not at the party, then it's a bit like a pub with no beer.
I don't want to be a party pooper, but there seems to be an startled ostrich approach from the world's financial markets to the inevitable issues that the world's banks and governments will have to deal with. Stick your head in the sand, interest rates are low, and liabilities are on the back burner. At a fundamental level the system, by any measure, remains way over-leveraged, and ironically is actually getting more leveraged in many areas. While that makes people feel good in the short-run, I can't see how it's sustainable for the long-term.
I think it's fair to say that I'm not a buyer of the current rally!
Basically regulators want banks to be better capitalised. If for example banks were forced to return to the average tangible common equity to assets ratios they had in the 1990s, then US and European banks would need to raise upwards of $1,000bn. So, adding that number to the IMF number of unaccounted-for losses, is a simple calculation adding to a fairly mind-blowing figure of $2,500bn.
That's $2,500bn worth of equity capital. Even if the real number is much less than that, what is patently clear is that the world is going to have to de-lever significantly. If we held things constant and assumed that banks lend something along the lines of 12 times equity (a conservative estimate given that Lehman Brothers were around 50 times leveraged in September 2008), then that is $30 trillion worth of credit that very theoretically would have to be removed from the system before the world's banking system is back to being "well capitalised".
When you consider that number (again this is highly conceptual) in some context then the current revival of global asset prices seems a bit crass. The biggest five banks in the world have total assets of around $15 trillion, the top ten around $26 trillion and the top 50 banks in the world have a total of $62 trillion of assets. So, essentially to regain the IMF and regulators' concept of sufficiently "capitalised" we are looking at the top 50 banks in the world halving the size of their balance sheets, or more likely all of the world's banks reducing the size of their balance sheets by somewhere between 25-40%.
To reiterate - this is all very much a rough pointer to the numbers; the IMF may be way off the mark (unlikely) and regulators may not enforce capital rules to such a strong extent (more likely). Nonetheless, there is no doubt at all that banks are going to have to raise very large sums of new equity capital, whether it be to counteract write-downs or to deal with a stiffer regulatory requirement.
At the moment there are several things helping to postpone this inevitability. Firstly the real level of interest rates around the world is next to nil, so there is an abundance of liquidity available to virtually all banks to rollover their balance sheets for the short term in debt capital markets. This is helping to sustain, or increase asset prices and is as a consequence preventing the need to acknowledge further mark-to-market write downs in the short term - even the most extravagant assets of the credit boom (things like CDO equity and subprime ABS) have seen their prices rise significantly over the past couple of quarters.
Secondly, the fact that interest rates are so low has enticed retail deposit investors to ditch their savings accounts paying 0.5% and to look for higher returns in other asset markets, from stock markets to property to convertible bonds - all of these are rising as buying interest grows. Thirdly, and this is related to the first two points, banks have seen stellar earnings from their capital markets operations in the past few quarters as debt and equity underwriting, trading and mortgage refinancing activity has created big earning opportunities. This paradise has meant that banks can claim to be "recapitalising" themselves through earnings.
All of these points, I believe, are blinding the markets from the bigger picture reality that nobody is incentivised to acknowledge. Banks may see margins erode as they incur higher debt interest costs to extend their funding, and competition for savings bids up the cost of attracting deposits. Furthermore, higher deposit insurance premiums, costs from tighter regulation and the need to hold more and higher quality capital will reduce returns on equity.
The current trend is for banks and governments to suggest that they can pay off their liabilities, or increase their equity bases through earnings or growth. In both cases the scale of the growth requirement just to get back to a relatively even keel is beyond what both government bond prices and bank equity prices justify. Friday saw stock markets respond badly to the US non-farm payroll figure, and the knock-on effect on the US jobless rate which has hit 9.8%. Another statistic that should cause concern (ironically) is that the US savings rate is increasing all the time and is now at a significant high of over 8%. The growth that is required around the world to sustain our economic system needs to have a US consumer in the hot seat - they need to be spending like there is no tomorrow and buying up cheap imports from China and their cheap exporting brethren. If the US consumer is not at the party, then it's a bit like a pub with no beer.
I don't want to be a party pooper, but there seems to be an startled ostrich approach from the world's financial markets to the inevitable issues that the world's banks and governments will have to deal with. Stick your head in the sand, interest rates are low, and liabilities are on the back burner. At a fundamental level the system, by any measure, remains way over-leveraged, and ironically is actually getting more leveraged in many areas. While that makes people feel good in the short-run, I can't see how it's sustainable for the long-term.
I think it's fair to say that I'm not a buyer of the current rally!
Sunday 27 September 2009
Congrats to the Koni Kats...
I read an article this week about a group of four teenagers from Co. Wicklow in Ireland, who were crowned world champions in a global science competition. The "Koni Kats" team from St. David's Secondary School in Greystones took the top honours at the fifth Formula One Schools Technology Challenge World Championships in London. At an awards ceremony attended by Lewis Hamilton and a large VIP entourage from Formula One, the students were presented with the Bernie Ecclestone World Championship Trophy and Automotive and Motorsport Engineering scholarships to the University of London. Thirty one teams from 20 countries were vying for the title, with students using generic software to design, build and test a model compressed air-powered balsa wood F1 car of the future.
Two things struck me about this, beyond being mildly pleased that Irish intellects were to the fore - firstly: these young kids are representative of the quality and focus of the Irish education system, but they will take their scholarships at university in London and will likely end up employed in great jobs somewhere other than Ireland, which is a concern. The second thing that struck me was that having gone through a large part of secondary school education in the UK, it's hard to believe that I would have been reading about a group of four British students accepting such a prize. The lack of focus on engineering or scientific education in the UK just isn't going to produce the contenders.
I mention this article because it's symptomatic of some bigger picture problems in both Ireland and the UK. For Ireland there has always been a pressure from the so-called "brain-drain" - well educated talent leaving the country for bigger opportunities. Over the past 15-20 years, opportunities within Ireland have seen many would be leavers stay, and many past leavers return. Employers like Intel, Pfizer and Dell have allowed the best and brightest scientists and engineers opportunities at home through their large investments within Ireland - and these companies have chosen to base themselves in Ireland not least because of the access to a high quality pool of talent provided by a generally well focused third level education system. It's a healthy working relationship.
A cause for concern, naturally, during tough economic times is diminished foreign investment by these companies and others as they retreat to their bases in the US. Regardless of the economic times, though, it is critical for Ireland to have a good looking "shop window" to attract whatever FDI is going, and to continue to focus on fostering the talent pool that will form that shop window. The Lisbon Treaty vote that's imminent will have important consequences for the look of the Irish shop window.
In the case of the UK, I firmly believe that there are far greater structural problems. The recent nose-dive of sterling in the currency markets, while driven to some extent by the short term effects of "quantitive easing", is grounded in some significant long term problems that the currency markets are becoming more and more aware of. Britain has, since 1990, run a deficit on its balance of payments' current account averaging 2% of gross domestic product - which for the layman means that the UK is consistently buying more stuff from abroad than it's selling. This was fine as long as capital flowed into Britain from other countries - which it did. Britain's banks borrowed from the international markets and lent into the UK economy. That process, however, looks like it has ended - and therefore the sustainable long-run exchange rate against the rest of the world's currencies is perceived to be lower.
A weak pound, isn't necessarily problematic - it's good for exporters, and bad for holiday-makers - swings and roundabouts and all that. What is significant, however is that it may be indicative of the view that the UK isn't capable of producing companies and products that will be competitive in the world. If that's the case it's questionable where the tax revenues are going to come from to fund the huge budget deficit that the government is running. The Adventure Capitalist Jim Rogers said in January of this year, that "the UK has nothing to sell... There's two big holes developing in the UK's balance of payments - North Sea oil drying up and the financial industry. I don't see anything replacing those two big holes". While his view is somewhat prejudiced by his whopping personal short position on the currency, the gist of what he's saying has some truth.
Some countries can justify a higher budget deficit than others - on the basis of their ability to produce successful companies that can provide the tax revenues to pay for these debts. It's really no different to the choice of what size house to buy and what size mortgage to finance it with. If your income growth prospects are good and secure, a higher amount of borrowing might be justified. If on the other hand, you're not too sure, then a 2 bedroom semi in East Ham might be more appropriate than the penthouse in Knightsbridge.
The prospects for the income growth to fund the penthouse just don't seem to be there in the UK - second and third level education is poorly directed, and underfunded. The prospects for a Silicon Valley to appear out of such a poorly directed system are quite bleak, but will be crucial to the ability of the government to justify such a significant mortgage on the country. It's not going to be easy - global competition is getting tougher in this regard with both India and China graduating more than 500,000 engineers per year. In Ireland's case, I hope that the Koni Kats return to Ireland in the future and create a world beating automotive company for the 21st century, which employs thousands of people and creates local wealth, and local tax revenues. Such endeavour will be critical for the country as a whole in the years ahead. In the case of the UK, something needs to change quickly, not least to justify the international capital markets continuing to finance the ever growing supply of UK gilts.
Two things struck me about this, beyond being mildly pleased that Irish intellects were to the fore - firstly: these young kids are representative of the quality and focus of the Irish education system, but they will take their scholarships at university in London and will likely end up employed in great jobs somewhere other than Ireland, which is a concern. The second thing that struck me was that having gone through a large part of secondary school education in the UK, it's hard to believe that I would have been reading about a group of four British students accepting such a prize. The lack of focus on engineering or scientific education in the UK just isn't going to produce the contenders.
I mention this article because it's symptomatic of some bigger picture problems in both Ireland and the UK. For Ireland there has always been a pressure from the so-called "brain-drain" - well educated talent leaving the country for bigger opportunities. Over the past 15-20 years, opportunities within Ireland have seen many would be leavers stay, and many past leavers return. Employers like Intel, Pfizer and Dell have allowed the best and brightest scientists and engineers opportunities at home through their large investments within Ireland - and these companies have chosen to base themselves in Ireland not least because of the access to a high quality pool of talent provided by a generally well focused third level education system. It's a healthy working relationship.
A cause for concern, naturally, during tough economic times is diminished foreign investment by these companies and others as they retreat to their bases in the US. Regardless of the economic times, though, it is critical for Ireland to have a good looking "shop window" to attract whatever FDI is going, and to continue to focus on fostering the talent pool that will form that shop window. The Lisbon Treaty vote that's imminent will have important consequences for the look of the Irish shop window.
In the case of the UK, I firmly believe that there are far greater structural problems. The recent nose-dive of sterling in the currency markets, while driven to some extent by the short term effects of "quantitive easing", is grounded in some significant long term problems that the currency markets are becoming more and more aware of. Britain has, since 1990, run a deficit on its balance of payments' current account averaging 2% of gross domestic product - which for the layman means that the UK is consistently buying more stuff from abroad than it's selling. This was fine as long as capital flowed into Britain from other countries - which it did. Britain's banks borrowed from the international markets and lent into the UK economy. That process, however, looks like it has ended - and therefore the sustainable long-run exchange rate against the rest of the world's currencies is perceived to be lower.
A weak pound, isn't necessarily problematic - it's good for exporters, and bad for holiday-makers - swings and roundabouts and all that. What is significant, however is that it may be indicative of the view that the UK isn't capable of producing companies and products that will be competitive in the world. If that's the case it's questionable where the tax revenues are going to come from to fund the huge budget deficit that the government is running. The Adventure Capitalist Jim Rogers said in January of this year, that "the UK has nothing to sell... There's two big holes developing in the UK's balance of payments - North Sea oil drying up and the financial industry. I don't see anything replacing those two big holes". While his view is somewhat prejudiced by his whopping personal short position on the currency, the gist of what he's saying has some truth.
Some countries can justify a higher budget deficit than others - on the basis of their ability to produce successful companies that can provide the tax revenues to pay for these debts. It's really no different to the choice of what size house to buy and what size mortgage to finance it with. If your income growth prospects are good and secure, a higher amount of borrowing might be justified. If on the other hand, you're not too sure, then a 2 bedroom semi in East Ham might be more appropriate than the penthouse in Knightsbridge.
The prospects for the income growth to fund the penthouse just don't seem to be there in the UK - second and third level education is poorly directed, and underfunded. The prospects for a Silicon Valley to appear out of such a poorly directed system are quite bleak, but will be crucial to the ability of the government to justify such a significant mortgage on the country. It's not going to be easy - global competition is getting tougher in this regard with both India and China graduating more than 500,000 engineers per year. In Ireland's case, I hope that the Koni Kats return to Ireland in the future and create a world beating automotive company for the 21st century, which employs thousands of people and creates local wealth, and local tax revenues. Such endeavour will be critical for the country as a whole in the years ahead. In the case of the UK, something needs to change quickly, not least to justify the international capital markets continuing to finance the ever growing supply of UK gilts.
Monday 21 September 2009
All things tend to entropy...
Entropy - A thermodynamic quantity representing the unavailability of a system's thermal energy for conversion into mechanical work, often interpreted as the degree of disorder or randomness in the system.
A year has passed since Lehman Brothers, my former employer, passed into the annals of the has-beens. This week has seen plenty of media commentary looking into the lasting impact of that moment on 15th September 2008 when all the avenues of potential rescue had been exhausted, including a final desperate phone call from a relative of George W. Bush who worked for the bank, and Lehman declared itself bankrupt.
I'm currently reading a book called "A Colossal Failure of Common Sense", written by a former Lehman trader which looks at the whys and wherefores of the the bank's collapse. The basic gist seems to be that a long serving CEO, with a gigantic ego, lost the plot and either stopped listening to his subordinates or removed those that disagreed with him. There is an amazing sense of inevitability about the implosion - the hugely successful mortgage group at Lehman printed money for the bank in the boom times in the early 2000s, and more success gave them more and more power and more and more capacity for risk. In the end, the strongest part of the Lehman artillery became the weakest link, as they took some massive risks sanctioned by a management team that has lost all grounding in common sense.
Lehman's demise it seems was representative of the 2nd Law of Thermodynamics - that even the most orderly process will tend to disorder over time - that all things tend to "entropy".
I vaguely knew the guy who wrote the book - Larry McDonald. He was a trader in the distressed debt group in New York - a group that traded the bank's capital in companies with a "complicated" past or future. He and his cohorts would look deep into the balance sheets of distressed companies, or even bankrupted companies and buy and sell their debts on the basis of whether the market price of the debt undervalued or overvalued them. For example, when Delta airlines went bust, his group became the market in the bankrupted debt. The Atlanta based carrier was assailed by $18bn worth of debts. In addition they had significant pension obligations and every time jet fuel went up by a cent it cost Delta $25mm annually. Basically the airline didn't work. Nevertheless it did have lots of valuable assets - lots of grounded planes, which if they were all sold would give a "recovery rate" on Delta's bonds of over 50%. So when the less well-researched members of the investment community saw that Delta had gone bankrupt, they rushed to sell - on the first day the Lehman group acquired around $200mm worth of Delta bonds at prices between 15-20% of par, and over time pocketed significant profits as the wider market started to understand what the real price should be for this debt.
I tell this story to demonstrate that these guys were pretty astute - they worked very hard to understand the intrinsic value of these complicated situations, which gave them the edge on the rest of the market, which tended to be either lazier or less competent. As the property market reached fever pitch in 2007 these guys started to turn their attention to some of the US home builders as more and more reports suggested that things had become "toppy" or overdone. Tales of "NINJA" mortgage loans (no income, no job and no assets) struck all but the daftest as odd and worthy of further investigation. As this group started to investigate some of the companies involved in the process of subprime mortgage lending - they were struck by the fact that a lot of the dangerous lending led back to Wall Street, and a significant part of the market to their own front door. Brokers with mortgage companies like New Century, Ameriquest, BNC and Aurora Loan would "originate" mortgages in faraway states, and wholesale flog them to Wall Street banks who would sit on them for a short period of time before selling them off in bits to investors around the world - so called securitisations. The distressed debt group that Larry McDonald was part of had started to take an interest in this market as they thought there might be a way to profit from the potential doom that they saw might be coming, but in the end found themselves more concerned about their own institution's bigger picture situation.
The mortgage group within Lehman had been hugely successful in the few years previously, basically minting it in a market of endless liquidity and asset price inflation. Their gameplan as it turned out, wasn't all that complicated - acquire as much capacity as possible in the US and European mortgage markets, and then repackage and ship the risk to institutional clients from Dublin to Tokyo.
Where I sat in all this was a seller of the these securitisations - trying to offload these risks. I recall in a meeting in early 2006, a group of senior guys from the mortgages group in New York had despatched themselves to London with the intent of educating the European salesforce on the the US mortgage platform, with the ultimate aim of selling more of their product through our channels. The standard investment banking type pitch-books were handed around, outlining the strengths of the US housing market, the quality of the Lehman platform and the madness that we should accuse our clients of if they did not choose to buy into the subprime dream.
One of the pages in the pitch book had a summary of the expected performance of different types of securitised bonds on the basis of US HPA (House Price Appreciation). I noticed that the axis on which HPA had been plotted began at zero - as in there was no conceivable scenario in which house prices would fall. I put my hand up cautiously (as always in these meetings) and inquired as to what would happen if there was a situation where house prices fell - as surely my clients to whom I would be pitching these deals would be inclined to want to know. I don't remember the guy's name who was running the presentation, but he very publicly balled me out and suggested that such a notion would be ridiculous, and quoted what seemed to be the mantra - that the worst single year fall in house prices since the Great Depression had been 5%, but even in that scenario the following year had been positive. I didn't pursue this any further, more concerned about being publicly embarassed and not thinking that there was any upside for me. I did leave Lehman in the few months afterwards, and would like to think in hindsight that this meeting played a part in that decision.
Interestingly on reading Larry McDonald's account, it turns out the same mantra was being peddled in the US - and while the profits were rolling in senior management was more than happy to listen to it. Nevertheless his group were starting to form a cabal of non-believers - who were beginning to push the idea quietly that the US property market was "pumped up like an athlete on steroids, rippling with a set of muscles that did not naturally belong there." Mike Gelband, who was the global head of fixed income, held a semi-secretive meeting as early as June 2005, outlining his contrarian point of view on the US property market. In this meeting he had cited the "shadow banks", the vast complex network of mortgage brokers that were not really banks at all but had somehow managed to insert themselves into the lending process, making an enormous number of mortgages available while having to borrow money themselves to do so. He cited the interest only loans, the no down-payments, the no-docs, the negative amortization loans (the one where the mortgage gets bigger as you pay), and the option ARMs (Adjustable Rate Mortgages) which gave you a cheap initial interest rate on your mortgage for the first couple of years and then hammered you with a massive rate rise. At that point in mid-2005 most of the option ARMs had yet to reset to their higher rates, which meant that defaults on mortgage payments would surely spike in the coming year or so.
He raised the issue of the securitisation market, that was being used by Wall Street to repackage and distribute these mortgages - Lehman for one was buying up $300k mortgages, in pools of 10,000 a time, parceling them into collateralized bonds, getting them highly rated by the rating agencies, and selling them into the market. A standard 1% commission on a $3bn bundle of collateralized debt added $30mm to the Lehman coffers, and multiples of that were being done on a monthly basis. The problem being that the $3bn worth of assets were sitting on Lehman's books until they were sold - he foretold of the situation where the market for this securitised debt caves in and Lehman gets caught with many billions of these unsellable assets - and that happens at a time where every other Wall Street bank is rushing to the door to sell.
Through the end of 2005 Mike Gelband started to push harder on this point of view - taking it directly to the CEO Dick Fuld, and also to the heads of the mortgage group. While his views were latched onto amongst his own people on the Fixed Income trading floor, he was perceived to have developed something of an attitude problem elsewhere. On taking his presentation to the mortgage group he was viewed as way too conservative, and clearly unappreciative of the fact that the they were carrying Lehman's balance sheet quarter by quarter.
Basically, it seems he had formed a view, that with hindsight was an entirely accurate perception of how the world would play out, but his view was falling largely on deaf ears. The past successes of the mortgage business had stopped senior management from separating the wood from the trees. It didn't help that the rest of Wall Street was up to the same activity, but just not quite the same extent of risk. In the end Mike Gelband quit Lehman in early May 2007, unable to continue to accept the direction the bank was being taken. While it's easy to point to the person who was right in hindsight, what was evident was that senior management had lost the ability to reasonably debate a contrarian point of view - something for which there always has to be a place. The inevitable process towards entropy was hastened by a basic loss of common sense.
A year has passed since Lehman Brothers, my former employer, passed into the annals of the has-beens. This week has seen plenty of media commentary looking into the lasting impact of that moment on 15th September 2008 when all the avenues of potential rescue had been exhausted, including a final desperate phone call from a relative of George W. Bush who worked for the bank, and Lehman declared itself bankrupt.
I'm currently reading a book called "A Colossal Failure of Common Sense", written by a former Lehman trader which looks at the whys and wherefores of the the bank's collapse. The basic gist seems to be that a long serving CEO, with a gigantic ego, lost the plot and either stopped listening to his subordinates or removed those that disagreed with him. There is an amazing sense of inevitability about the implosion - the hugely successful mortgage group at Lehman printed money for the bank in the boom times in the early 2000s, and more success gave them more and more power and more and more capacity for risk. In the end, the strongest part of the Lehman artillery became the weakest link, as they took some massive risks sanctioned by a management team that has lost all grounding in common sense.
Lehman's demise it seems was representative of the 2nd Law of Thermodynamics - that even the most orderly process will tend to disorder over time - that all things tend to "entropy".
I vaguely knew the guy who wrote the book - Larry McDonald. He was a trader in the distressed debt group in New York - a group that traded the bank's capital in companies with a "complicated" past or future. He and his cohorts would look deep into the balance sheets of distressed companies, or even bankrupted companies and buy and sell their debts on the basis of whether the market price of the debt undervalued or overvalued them. For example, when Delta airlines went bust, his group became the market in the bankrupted debt. The Atlanta based carrier was assailed by $18bn worth of debts. In addition they had significant pension obligations and every time jet fuel went up by a cent it cost Delta $25mm annually. Basically the airline didn't work. Nevertheless it did have lots of valuable assets - lots of grounded planes, which if they were all sold would give a "recovery rate" on Delta's bonds of over 50%. So when the less well-researched members of the investment community saw that Delta had gone bankrupt, they rushed to sell - on the first day the Lehman group acquired around $200mm worth of Delta bonds at prices between 15-20% of par, and over time pocketed significant profits as the wider market started to understand what the real price should be for this debt.
I tell this story to demonstrate that these guys were pretty astute - they worked very hard to understand the intrinsic value of these complicated situations, which gave them the edge on the rest of the market, which tended to be either lazier or less competent. As the property market reached fever pitch in 2007 these guys started to turn their attention to some of the US home builders as more and more reports suggested that things had become "toppy" or overdone. Tales of "NINJA" mortgage loans (no income, no job and no assets) struck all but the daftest as odd and worthy of further investigation. As this group started to investigate some of the companies involved in the process of subprime mortgage lending - they were struck by the fact that a lot of the dangerous lending led back to Wall Street, and a significant part of the market to their own front door. Brokers with mortgage companies like New Century, Ameriquest, BNC and Aurora Loan would "originate" mortgages in faraway states, and wholesale flog them to Wall Street banks who would sit on them for a short period of time before selling them off in bits to investors around the world - so called securitisations. The distressed debt group that Larry McDonald was part of had started to take an interest in this market as they thought there might be a way to profit from the potential doom that they saw might be coming, but in the end found themselves more concerned about their own institution's bigger picture situation.
The mortgage group within Lehman had been hugely successful in the few years previously, basically minting it in a market of endless liquidity and asset price inflation. Their gameplan as it turned out, wasn't all that complicated - acquire as much capacity as possible in the US and European mortgage markets, and then repackage and ship the risk to institutional clients from Dublin to Tokyo.
Where I sat in all this was a seller of the these securitisations - trying to offload these risks. I recall in a meeting in early 2006, a group of senior guys from the mortgages group in New York had despatched themselves to London with the intent of educating the European salesforce on the the US mortgage platform, with the ultimate aim of selling more of their product through our channels. The standard investment banking type pitch-books were handed around, outlining the strengths of the US housing market, the quality of the Lehman platform and the madness that we should accuse our clients of if they did not choose to buy into the subprime dream.
One of the pages in the pitch book had a summary of the expected performance of different types of securitised bonds on the basis of US HPA (House Price Appreciation). I noticed that the axis on which HPA had been plotted began at zero - as in there was no conceivable scenario in which house prices would fall. I put my hand up cautiously (as always in these meetings) and inquired as to what would happen if there was a situation where house prices fell - as surely my clients to whom I would be pitching these deals would be inclined to want to know. I don't remember the guy's name who was running the presentation, but he very publicly balled me out and suggested that such a notion would be ridiculous, and quoted what seemed to be the mantra - that the worst single year fall in house prices since the Great Depression had been 5%, but even in that scenario the following year had been positive. I didn't pursue this any further, more concerned about being publicly embarassed and not thinking that there was any upside for me. I did leave Lehman in the few months afterwards, and would like to think in hindsight that this meeting played a part in that decision.
Interestingly on reading Larry McDonald's account, it turns out the same mantra was being peddled in the US - and while the profits were rolling in senior management was more than happy to listen to it. Nevertheless his group were starting to form a cabal of non-believers - who were beginning to push the idea quietly that the US property market was "pumped up like an athlete on steroids, rippling with a set of muscles that did not naturally belong there." Mike Gelband, who was the global head of fixed income, held a semi-secretive meeting as early as June 2005, outlining his contrarian point of view on the US property market. In this meeting he had cited the "shadow banks", the vast complex network of mortgage brokers that were not really banks at all but had somehow managed to insert themselves into the lending process, making an enormous number of mortgages available while having to borrow money themselves to do so. He cited the interest only loans, the no down-payments, the no-docs, the negative amortization loans (the one where the mortgage gets bigger as you pay), and the option ARMs (Adjustable Rate Mortgages) which gave you a cheap initial interest rate on your mortgage for the first couple of years and then hammered you with a massive rate rise. At that point in mid-2005 most of the option ARMs had yet to reset to their higher rates, which meant that defaults on mortgage payments would surely spike in the coming year or so.
He raised the issue of the securitisation market, that was being used by Wall Street to repackage and distribute these mortgages - Lehman for one was buying up $300k mortgages, in pools of 10,000 a time, parceling them into collateralized bonds, getting them highly rated by the rating agencies, and selling them into the market. A standard 1% commission on a $3bn bundle of collateralized debt added $30mm to the Lehman coffers, and multiples of that were being done on a monthly basis. The problem being that the $3bn worth of assets were sitting on Lehman's books until they were sold - he foretold of the situation where the market for this securitised debt caves in and Lehman gets caught with many billions of these unsellable assets - and that happens at a time where every other Wall Street bank is rushing to the door to sell.
Through the end of 2005 Mike Gelband started to push harder on this point of view - taking it directly to the CEO Dick Fuld, and also to the heads of the mortgage group. While his views were latched onto amongst his own people on the Fixed Income trading floor, he was perceived to have developed something of an attitude problem elsewhere. On taking his presentation to the mortgage group he was viewed as way too conservative, and clearly unappreciative of the fact that the they were carrying Lehman's balance sheet quarter by quarter.
Basically, it seems he had formed a view, that with hindsight was an entirely accurate perception of how the world would play out, but his view was falling largely on deaf ears. The past successes of the mortgage business had stopped senior management from separating the wood from the trees. It didn't help that the rest of Wall Street was up to the same activity, but just not quite the same extent of risk. In the end Mike Gelband quit Lehman in early May 2007, unable to continue to accept the direction the bank was being taken. While it's easy to point to the person who was right in hindsight, what was evident was that senior management had lost the ability to reasonably debate a contrarian point of view - something for which there always has to be a place. The inevitable process towards entropy was hastened by a basic loss of common sense.
Sunday 13 September 2009
Taking the rough with the smooth...
Barack Obama reportedly brought five books on his recent holiday in Martha's Vineyard - a careful mix of fiction and nonfiction, a dose of urban crime and rural tranquility, with a dash of global economic thought and some American history. An ambitious list I would think, as I tend to battle my way through just the one Dan Brown book at a push on my holidays. The global economic insight on Obama's reading list was provided by the NY Time journalist/ author Thomas Friedman in "The World is Flat". Friedman has been a regular commentator on the trials and tribulations that the process of economic globalisation produces for those who choose to participate in it freely.
One of Friedman's theses is that individual countries must sacrifice some degree of economic sovereignty to global institutions (such as capital markets and international corporations), a situation he has termed the "golden straitjacket". The main implication of giving up some sovereignty is that bridging the gap between the attitudes of the voting population of a country and these global institutions can be increasingly difficult - particularly when economic times are tough. Inevitably, though, when it comes to the crunch, local governments will tend to pander more towards their electorates than these global institutions for the obvious reason that political survival depends on votes. Obama himself has a current trade off between trying to protect the domestic job market in the US, and maintaining a strong relationship with the biggest funder of the US budget deficit - China. If he needs to print money to save jobs, but in doing so erodes the value of the dollar to the detriment of the Chinese, he will invariably opt to do that regardless. With the tough global economic backdrop, these sorts of domestic versus international trade-offs are appearing around the world more and more.
This coming Wednesday the Irish Finance Minister, Brian Lenihan, is set to announce the specifics of Ireland's version of the bank bailout plan - NAMA. The specifics he's going to clarify are the average discounts that will be applied to the banks' loan portfolios upon their transfer into this new government agency. The level of discount will be critical in determining how much fresh capital each bank will need - and what level of state ownership they can expect in the future. The larger the discount, the larger the upfront loss that will be triggered in each bank on the transfer of their loans - and the greater the damage to their already stretched capital bases.
Whatever numbers he comes up with he's likely to upset almost everyone - basically it's a lose-lose situation. If he pays too much for the loans then there is a perceived moral hazard that the banks' shareholders and creditors will not have taken a sufficient hit for the risks that they chose to take, and if he pays too little then this will only clarify for the international financial community that currently funds these banks that they are basically insolvent, and will make it very difficult to raise private capital going forward.
It's a very big few months coming up for Ireland. Aside from the NAMA debate, there is a critical second go at the Lisbon treaty referendum (the first answer wasn't the right one). While the terms of the Lisbon treaty in and of themselves are not that significant, the referendum is seen as a symbolic indication of the direction Irish people want to be going with regard to Europe - is it a continued concession of power to Brussels, or is it now the time to say this is far enough, thanks. In practice if both NAMA and the Lisbon Treaty issues go the wrong way, the implications for Ireland could be substantial - to the extent that some commentators think the IMF (at the request of the European Central Bank) may have to be called in by Christmas.
The stakeholders in Ireland Inc. are manifold - but the two biggest are the electorate, who are in control over who is in power, and the multitude of international investors who provide financing into Ireland. The "golden straitjacket" of globalisation have left these two parties running on entirely different tracks it would seem. On the one hand the government is reliant on the electorate for its capacity to govern, but on the other hand the government is reliant on the international capital markets to allow it to manage its finances, and for investment into the Irish companies that will create growth, jobs and tax revenues. Intel, for example, which employs thousands of people in Ireland have a strong interest in Ireland being fully committed to further European integration - they are putting 1mm Euros into the "Yes" campaign for the Lisbon treaty referendum, and the consequences of a "No" vote may result in serious repercussions for Intel's long-term desire to invest in Ireland. There is a very serious trade-off here.
Ireland plotted it's economic path over the past 20 years as a "small, open country" - small in the sense of geographic size and population, and open in the sense that it had realised the benefits of international trade, particularly the benefits of a full participation in the ever extending European Union. During the good times this costume suited quite nicely. Ireland focused on high margin pharmaceutical and information technology businesses, attracting inward investment on the back of a well-educated, English speaking workforce. Lower margin work, was "traded away" in the comparative advantage stakes, and instead of mass producing cheap clothing and the like these were imported from Taiwan and China at mind-blowingly cheap prices. For quite a time this worked well, and Ireland was the poster-child for the high margin export led growth model. Domestically, tax revenues were substantial, credit flowed, asset prices soared and the living was easy.
In the space of alarmingly few years, however, Ireland has fallen from the top of the world economy beauty parade. The evidence shows that Ireland's most respected institutions including the Central Bank, the major Irish banks, the Department of Finance, and others failed to grasp the massive danger to the economy posed by the property bubble.
Whatever happens in Ireland over the next few months, what is increasingly clear is that there is a growing divide between what the electorate want their government to do and what it actually can do. Ireland is running a substantial budget deficit, like most of the rest of the Western world, and unemployment is pushing 13%. Domestically, the bankers are apparently to blame for the situation, and the prospect of further concessions to a European Union that Ireland is now a net contributor towards are a difficult proposition to swallow. The "golden straitjacket" is not going to provide the government with much room to manoeuvre, but there is a serious risk that favouring the views of the electorate too heavily versus international stakeholders will leave Ireland in a worse position over the long run. A no vote to the Lisbon Treaty and a overly harsh approach to NAMA will put Ireland in a very tricky position with Europe and the international capital markets. Having plotted it's economic course and benefitted heavily from economic integration it's now Irelands responsibility to take the rough with the smooth.
One of Friedman's theses is that individual countries must sacrifice some degree of economic sovereignty to global institutions (such as capital markets and international corporations), a situation he has termed the "golden straitjacket". The main implication of giving up some sovereignty is that bridging the gap between the attitudes of the voting population of a country and these global institutions can be increasingly difficult - particularly when economic times are tough. Inevitably, though, when it comes to the crunch, local governments will tend to pander more towards their electorates than these global institutions for the obvious reason that political survival depends on votes. Obama himself has a current trade off between trying to protect the domestic job market in the US, and maintaining a strong relationship with the biggest funder of the US budget deficit - China. If he needs to print money to save jobs, but in doing so erodes the value of the dollar to the detriment of the Chinese, he will invariably opt to do that regardless. With the tough global economic backdrop, these sorts of domestic versus international trade-offs are appearing around the world more and more.
This coming Wednesday the Irish Finance Minister, Brian Lenihan, is set to announce the specifics of Ireland's version of the bank bailout plan - NAMA. The specifics he's going to clarify are the average discounts that will be applied to the banks' loan portfolios upon their transfer into this new government agency. The level of discount will be critical in determining how much fresh capital each bank will need - and what level of state ownership they can expect in the future. The larger the discount, the larger the upfront loss that will be triggered in each bank on the transfer of their loans - and the greater the damage to their already stretched capital bases.
Whatever numbers he comes up with he's likely to upset almost everyone - basically it's a lose-lose situation. If he pays too much for the loans then there is a perceived moral hazard that the banks' shareholders and creditors will not have taken a sufficient hit for the risks that they chose to take, and if he pays too little then this will only clarify for the international financial community that currently funds these banks that they are basically insolvent, and will make it very difficult to raise private capital going forward.
It's a very big few months coming up for Ireland. Aside from the NAMA debate, there is a critical second go at the Lisbon treaty referendum (the first answer wasn't the right one). While the terms of the Lisbon treaty in and of themselves are not that significant, the referendum is seen as a symbolic indication of the direction Irish people want to be going with regard to Europe - is it a continued concession of power to Brussels, or is it now the time to say this is far enough, thanks. In practice if both NAMA and the Lisbon Treaty issues go the wrong way, the implications for Ireland could be substantial - to the extent that some commentators think the IMF (at the request of the European Central Bank) may have to be called in by Christmas.
The stakeholders in Ireland Inc. are manifold - but the two biggest are the electorate, who are in control over who is in power, and the multitude of international investors who provide financing into Ireland. The "golden straitjacket" of globalisation have left these two parties running on entirely different tracks it would seem. On the one hand the government is reliant on the electorate for its capacity to govern, but on the other hand the government is reliant on the international capital markets to allow it to manage its finances, and for investment into the Irish companies that will create growth, jobs and tax revenues. Intel, for example, which employs thousands of people in Ireland have a strong interest in Ireland being fully committed to further European integration - they are putting 1mm Euros into the "Yes" campaign for the Lisbon treaty referendum, and the consequences of a "No" vote may result in serious repercussions for Intel's long-term desire to invest in Ireland. There is a very serious trade-off here.
Ireland plotted it's economic path over the past 20 years as a "small, open country" - small in the sense of geographic size and population, and open in the sense that it had realised the benefits of international trade, particularly the benefits of a full participation in the ever extending European Union. During the good times this costume suited quite nicely. Ireland focused on high margin pharmaceutical and information technology businesses, attracting inward investment on the back of a well-educated, English speaking workforce. Lower margin work, was "traded away" in the comparative advantage stakes, and instead of mass producing cheap clothing and the like these were imported from Taiwan and China at mind-blowingly cheap prices. For quite a time this worked well, and Ireland was the poster-child for the high margin export led growth model. Domestically, tax revenues were substantial, credit flowed, asset prices soared and the living was easy.
In the space of alarmingly few years, however, Ireland has fallen from the top of the world economy beauty parade. The evidence shows that Ireland's most respected institutions including the Central Bank, the major Irish banks, the Department of Finance, and others failed to grasp the massive danger to the economy posed by the property bubble.
Whatever happens in Ireland over the next few months, what is increasingly clear is that there is a growing divide between what the electorate want their government to do and what it actually can do. Ireland is running a substantial budget deficit, like most of the rest of the Western world, and unemployment is pushing 13%. Domestically, the bankers are apparently to blame for the situation, and the prospect of further concessions to a European Union that Ireland is now a net contributor towards are a difficult proposition to swallow. The "golden straitjacket" is not going to provide the government with much room to manoeuvre, but there is a serious risk that favouring the views of the electorate too heavily versus international stakeholders will leave Ireland in a worse position over the long run. A no vote to the Lisbon Treaty and a overly harsh approach to NAMA will put Ireland in a very tricky position with Europe and the international capital markets. Having plotted it's economic course and benefitted heavily from economic integration it's now Irelands responsibility to take the rough with the smooth.
Sunday 30 August 2009
Survival of the fattest...
And so the financial world ticks on. Stock-markets continue to move up the world over and there are shoots of confidence re-appearing. The FT this weekend headlined that London has seen sales of £1mm properties back to the record pre-recession days, and investment banker's wallets are looking as good as ever. As regular readers will have noted, I'm pretty cynical about all this and think there is plenty more to play out. What I believe has happened is that the financial world has been prescribed some antibiotics that are starting to have an effect on the areas that were "credit infected", but in the background the weaknesses that existed within the framework of the world's financial system have only been masked by the medicine.
At a very basic level, there has been a systematic transfer of the losses within the global economy from private to public sector, and a systematic postponement of the ramifications of a faulty system from this generation to the next. Current public debt levels aren't sustainable in places like the UK or Ireland, without taxes increasing significantly or growth rates increasingly dramatically in the coming years. Fundamentally, modern society is not very good at confronting things head on. Most of the time this is because we don't have to - it's very often possible to take the antibiotics to address a short term problem, even if the longer term consequences are likely to be even worse.
This problem doesn't just apply to the economic world. It applies to the whole nature of the way in which modern societies operate now and into the future. We are creating "super-bubbles" as George Soros would call them, by putting bandages over wounds that need major surgery. This idea has been prevalent in the medical world for some time, where the discussion about whether Darwinism is relevant anymore is widespread. The progress of modern medicine has thrown Darwin's concept of "natural selection" into disarray - the selection process in the world of people is less about Nature taking its effect on who will thrive or survive, and more about which humans have access to the best medical treatments.
In a way the Darwinian process has mutated itself - Warren Buffett has said a few times that his ability to thrive in the current society is because the skills he has are highly valued, yet if he was born 3,000 years ago he would have been at the back of the herd when it came to outrunning the chasing lion. His limited physical prowess would have seen him naturally de-selected in those times, but in current society his mental faculties have allowed him to afford the best healthcare and consequently to thrive. In the same way, Stephen Hawking's capacity to interpret the inner workings of the universe, whilst immensely physically disabled, have allowed him to thrive. And no offense to Mr. Hawking, but I suspect he's better at understanding black holes than he is at throwing spears at wild animals.
As much as the mentally gifted like Buffett and Hawking have a firm foothold in our society, at the other end of the spectrum the "deselection" process may have stopped in certain societies altogether. While the wealthy have more comfortable beds and more attentive nurses in their private hospitals, the universal nature of healthcare in the western world has almost meant that there is no selection process, Natural or otherwise. We have effectively stopped the process of the "survival of the fittest" which as a consequence may ultimately contribute to a form of super bubble in the future. Nature will find a way to restart the natural regeneration process, but because we are postponing that process currently, when the "forest fire" comes it may well be of super-sized proportions. We will have taken so many antibiotics to ward off short-term issues that there is a significant risk of being blindsided by some form of natural disaster. Swine flu, for example, is apparently less likely to affect older members of society notably because when they were young they tended to have far less access to antibiotics than the current baby boomer generation and consequently have more antibodies to fend off mutated viruses like H1N1.
In my view, the way governments and regulators have addressed the current financial crisis is merely symptomatic of a wider bandaging that is prevailing in the Western world. We are becoming less resilient to future problems, whether they be economic, social or health related.
The recent bushfires in Australia, are a fitting metaphor. Small bushfires are part of Nature's process - they happen naturally and they play an important role in the regeneration of the land. It's perfectly understandable that humans would interfere in order to prevent those small bushfires. In the bushfire sense, however, by preventing the small fires that naturally occur over many years, a very large area of land has not been "regenerated" and consequently the scope for a one-off massive fire is increased. The pictures from around Melbourne earlier this year were the manifestation of years of human interference, which in the short-term, had previously looked extremely positive.
In a similar vein, there are those who bravely suggest that the significant aid flows into Ethiopia in the late 1980s to address the impact of famine and widespread starvation, may have only solved part of the problem - and in doing so created an even bigger risk for the future. Aid flows may have soothed the hunger of many for a time, but without a systematic change in the way in which the at risk people in Ethiopia address farming and how famine conditions arise, then the survivors of the last famine and their offspring may be victims of an even bigger catastrophe. As un-PC as it is, those voices quietly suggest that more people may end up dying in Ethiopia as a consequence of the massive influx of aid - on the basis that the real issues that caused famines there have never really been addressed.
On a more positive note there are examples of natural regeneration being harnessed effectively, in a way that has long-term sustainability. "Farmer Managed Natural Regeneration" is a reforestation technique developed in West Africa in the 1980s and 1990s, now practiced on 30,000 square-kms of land in the Niger Republic as well as Chad, Burkina Faso, parts of Ethiopia and Mali. Natural Regeneration refers to the natural process by which plants replace or re-establish themselves. FMNR relies on the presence of remaining live tree roots - reproduction comes from self-sown seeds or by vegetative recovery (sprouting from stumps, lignotubes, rhizomes or roots) after the tops of the plants have been killed (by fire, cutting, browsing, etc.).
In an economic sense this process is not dissimilar to what the 1940s Austrian economist Joseph Schumpeter called "creative destruction". Many businesses around the world have proverbially had their heads chopped off, particularly if the assumptions upon which their business plans were based included: cheap debt, regular and predictable demand growth, asset prices continually rising, and the adding of capacity being low risk.
In the Schumpeter world, these businesses would be forced to adapt or die, and therefore would leave only the "fit" survivors, who would be better prepared for the trials of the next generation. There would be a regeneration process where old ideas are adapted or cast aside and new ideas and processes are creatively implemented. Unfortunately, as with many aspects of modern society the response to this financial crisis has not been to accept change head on, but to bandage up the old system and postpone the real Reckoning. There aren't too many obvious lessons to be taken from the farmlands of Chad, but accepting some destruction and the ensuing natural regeneration may well be one. For the long term it's the only approach that will be sustainable.
At a very basic level, there has been a systematic transfer of the losses within the global economy from private to public sector, and a systematic postponement of the ramifications of a faulty system from this generation to the next. Current public debt levels aren't sustainable in places like the UK or Ireland, without taxes increasing significantly or growth rates increasingly dramatically in the coming years. Fundamentally, modern society is not very good at confronting things head on. Most of the time this is because we don't have to - it's very often possible to take the antibiotics to address a short term problem, even if the longer term consequences are likely to be even worse.
This problem doesn't just apply to the economic world. It applies to the whole nature of the way in which modern societies operate now and into the future. We are creating "super-bubbles" as George Soros would call them, by putting bandages over wounds that need major surgery. This idea has been prevalent in the medical world for some time, where the discussion about whether Darwinism is relevant anymore is widespread. The progress of modern medicine has thrown Darwin's concept of "natural selection" into disarray - the selection process in the world of people is less about Nature taking its effect on who will thrive or survive, and more about which humans have access to the best medical treatments.
In a way the Darwinian process has mutated itself - Warren Buffett has said a few times that his ability to thrive in the current society is because the skills he has are highly valued, yet if he was born 3,000 years ago he would have been at the back of the herd when it came to outrunning the chasing lion. His limited physical prowess would have seen him naturally de-selected in those times, but in current society his mental faculties have allowed him to afford the best healthcare and consequently to thrive. In the same way, Stephen Hawking's capacity to interpret the inner workings of the universe, whilst immensely physically disabled, have allowed him to thrive. And no offense to Mr. Hawking, but I suspect he's better at understanding black holes than he is at throwing spears at wild animals.
As much as the mentally gifted like Buffett and Hawking have a firm foothold in our society, at the other end of the spectrum the "deselection" process may have stopped in certain societies altogether. While the wealthy have more comfortable beds and more attentive nurses in their private hospitals, the universal nature of healthcare in the western world has almost meant that there is no selection process, Natural or otherwise. We have effectively stopped the process of the "survival of the fittest" which as a consequence may ultimately contribute to a form of super bubble in the future. Nature will find a way to restart the natural regeneration process, but because we are postponing that process currently, when the "forest fire" comes it may well be of super-sized proportions. We will have taken so many antibiotics to ward off short-term issues that there is a significant risk of being blindsided by some form of natural disaster. Swine flu, for example, is apparently less likely to affect older members of society notably because when they were young they tended to have far less access to antibiotics than the current baby boomer generation and consequently have more antibodies to fend off mutated viruses like H1N1.
In my view, the way governments and regulators have addressed the current financial crisis is merely symptomatic of a wider bandaging that is prevailing in the Western world. We are becoming less resilient to future problems, whether they be economic, social or health related.
The recent bushfires in Australia, are a fitting metaphor. Small bushfires are part of Nature's process - they happen naturally and they play an important role in the regeneration of the land. It's perfectly understandable that humans would interfere in order to prevent those small bushfires. In the bushfire sense, however, by preventing the small fires that naturally occur over many years, a very large area of land has not been "regenerated" and consequently the scope for a one-off massive fire is increased. The pictures from around Melbourne earlier this year were the manifestation of years of human interference, which in the short-term, had previously looked extremely positive.
In a similar vein, there are those who bravely suggest that the significant aid flows into Ethiopia in the late 1980s to address the impact of famine and widespread starvation, may have only solved part of the problem - and in doing so created an even bigger risk for the future. Aid flows may have soothed the hunger of many for a time, but without a systematic change in the way in which the at risk people in Ethiopia address farming and how famine conditions arise, then the survivors of the last famine and their offspring may be victims of an even bigger catastrophe. As un-PC as it is, those voices quietly suggest that more people may end up dying in Ethiopia as a consequence of the massive influx of aid - on the basis that the real issues that caused famines there have never really been addressed.
On a more positive note there are examples of natural regeneration being harnessed effectively, in a way that has long-term sustainability. "Farmer Managed Natural Regeneration" is a reforestation technique developed in West Africa in the 1980s and 1990s, now practiced on 30,000 square-kms of land in the Niger Republic as well as Chad, Burkina Faso, parts of Ethiopia and Mali. Natural Regeneration refers to the natural process by which plants replace or re-establish themselves. FMNR relies on the presence of remaining live tree roots - reproduction comes from self-sown seeds or by vegetative recovery (sprouting from stumps, lignotubes, rhizomes or roots) after the tops of the plants have been killed (by fire, cutting, browsing, etc.).
In an economic sense this process is not dissimilar to what the 1940s Austrian economist Joseph Schumpeter called "creative destruction". Many businesses around the world have proverbially had their heads chopped off, particularly if the assumptions upon which their business plans were based included: cheap debt, regular and predictable demand growth, asset prices continually rising, and the adding of capacity being low risk.
In the Schumpeter world, these businesses would be forced to adapt or die, and therefore would leave only the "fit" survivors, who would be better prepared for the trials of the next generation. There would be a regeneration process where old ideas are adapted or cast aside and new ideas and processes are creatively implemented. Unfortunately, as with many aspects of modern society the response to this financial crisis has not been to accept change head on, but to bandage up the old system and postpone the real Reckoning. There aren't too many obvious lessons to be taken from the farmlands of Chad, but accepting some destruction and the ensuing natural regeneration may well be one. For the long term it's the only approach that will be sustainable.
Sunday 23 August 2009
Give an inch...
We took our 8 week old son to our local GP this week after a real struggle to book an appointment. The media coverage of swine flu has clearly played its part in filling doctor's surgeries across the country and around the world, so access to the diaries of medical professionals is tough. Having said that, on arriving at the surgery there was a large white board in front of the receptionist's desk with two numbers on it - 216 and 178. These were the numbers of hours of missed appointments in that surgery over the previous two months. Based on the number of GPs working there, and based on a 5 day working week this equates to around 3 hours per day, per doctor of missed appointments. What an unbelievable waste, and what a representation of how selfish some people can be.
As I sat there waiting to introduce our little fellow to Dr. Greaves I was pondering why such a situation should exist, and what should be done to correct it (I like to think there is always a solution, economic or otherwise). Fundamentally, as I have grown to believe, if you give something to somebody for nothing, they will not treat it with anywhere near as much respect as something that they have to contribute towards. While all taxpayers do indirectly contribute to the provision of the health service in the UK, their contribution at the point of consumption is nil - and to me that is where the problem lies.
The NHS in the UK has its faults, but at its core it is full of good people trying to do good things for people. It is an unwieldy and difficult organisation to run, and sadly for the employees of the NHS their position in society is undervalued. I believe that this is at least partly because what they give to people has been turned into a right for all, and this sense of entitlement and the fact that it is undervalued go hand in hand.
On a visit to Hong Kong last year, I visited a GP and paid the equivalent of £15 for the privilege - and received prescription medicine worth comfortably more than that figure. In France, there is a flat charge of around 3 euros per GP visit - a small sum, but one that I am sure guarantees that more appointments are fulfilled. The absolute level of contribution does not need to be a large figure, in fact it could be that a charge is only applied for missed appointments, but the principal that I believe needs to be applied is that in order to have a relationship that is fully valued there needs to be give and take. This rule doesn't just apply to running a health service, but is probably a pretty sound approach to running any organisation.
As Barack Obama pushes for healthcare reform in the US, he has been met by scathing criticism from the Republican right and progressing the reform bill through Congress is likely to be very tricky. At its core the aim is to provide health insurance for the 47 million Americans who do not have any, and drive down the spiralling costs of healthcare. The issue of whether a particular standard of healthcare is a right or a privilege goes to the core of what it is to be American, and is separating opinion accordingly.
In the UK the "Welfare State" concept as coined by William Beveridge in 1942 aimed to address the five "Giant Evils" in society: "squalor, ignorance, want, idleness and disease". Clement Attlee's 1945 Labour government pledged to eradicate these Evils, and the government undertook measures in policy to provide for the people of the United Kingdom "from the cradle to the grave." On the surface, a very noble and moral ambition.
The policy itself resulted in massive expenditure and a great widening of what was considered to be the state's responsibility. It would appear that the reform bill that Barack Obama is trying to push is polarizing US opinion for this reason - firstly it will be very expensive to provide, and secondly, in the context of all of the financial bailouts of the past year, it may represent a structural shift in the level of state involvement in peoples lives for the foreseeable future.
In a country that prides itself on the people in its society that demonstrate the ability to help themselves, this looks like an unacceptable form of charity. The American dream upon which the last 50 years of economic growth is based has at its core the principal that regardless of who you are, hard work will allow you to progress. There aren't many situations in the US where you get something for nothing. From my point of view, past governments haven't done enough to truly help the real underclass that is growing in their society, but I can completely understand the segments of US society who don't want to create some of the helpless aspects of British society engendered by the freeloaders using the NHS. As always there is probably a middle ground to be found, one that retains the charitable aspects of the NHS, but that also means that healthcare is properly appreciated by those who have access to it.
Something for nothing is an unsustainable situation not only for the cost associated, but further because of the way it affects the motivations of those who have access to it. As Mae West once said, "Give a man a free hand, and he'll run it all over you."
As I sat there waiting to introduce our little fellow to Dr. Greaves I was pondering why such a situation should exist, and what should be done to correct it (I like to think there is always a solution, economic or otherwise). Fundamentally, as I have grown to believe, if you give something to somebody for nothing, they will not treat it with anywhere near as much respect as something that they have to contribute towards. While all taxpayers do indirectly contribute to the provision of the health service in the UK, their contribution at the point of consumption is nil - and to me that is where the problem lies.
The NHS in the UK has its faults, but at its core it is full of good people trying to do good things for people. It is an unwieldy and difficult organisation to run, and sadly for the employees of the NHS their position in society is undervalued. I believe that this is at least partly because what they give to people has been turned into a right for all, and this sense of entitlement and the fact that it is undervalued go hand in hand.
On a visit to Hong Kong last year, I visited a GP and paid the equivalent of £15 for the privilege - and received prescription medicine worth comfortably more than that figure. In France, there is a flat charge of around 3 euros per GP visit - a small sum, but one that I am sure guarantees that more appointments are fulfilled. The absolute level of contribution does not need to be a large figure, in fact it could be that a charge is only applied for missed appointments, but the principal that I believe needs to be applied is that in order to have a relationship that is fully valued there needs to be give and take. This rule doesn't just apply to running a health service, but is probably a pretty sound approach to running any organisation.
As Barack Obama pushes for healthcare reform in the US, he has been met by scathing criticism from the Republican right and progressing the reform bill through Congress is likely to be very tricky. At its core the aim is to provide health insurance for the 47 million Americans who do not have any, and drive down the spiralling costs of healthcare. The issue of whether a particular standard of healthcare is a right or a privilege goes to the core of what it is to be American, and is separating opinion accordingly.
In the UK the "Welfare State" concept as coined by William Beveridge in 1942 aimed to address the five "Giant Evils" in society: "squalor, ignorance, want, idleness and disease". Clement Attlee's 1945 Labour government pledged to eradicate these Evils, and the government undertook measures in policy to provide for the people of the United Kingdom "from the cradle to the grave." On the surface, a very noble and moral ambition.
The policy itself resulted in massive expenditure and a great widening of what was considered to be the state's responsibility. It would appear that the reform bill that Barack Obama is trying to push is polarizing US opinion for this reason - firstly it will be very expensive to provide, and secondly, in the context of all of the financial bailouts of the past year, it may represent a structural shift in the level of state involvement in peoples lives for the foreseeable future.
In a country that prides itself on the people in its society that demonstrate the ability to help themselves, this looks like an unacceptable form of charity. The American dream upon which the last 50 years of economic growth is based has at its core the principal that regardless of who you are, hard work will allow you to progress. There aren't many situations in the US where you get something for nothing. From my point of view, past governments haven't done enough to truly help the real underclass that is growing in their society, but I can completely understand the segments of US society who don't want to create some of the helpless aspects of British society engendered by the freeloaders using the NHS. As always there is probably a middle ground to be found, one that retains the charitable aspects of the NHS, but that also means that healthcare is properly appreciated by those who have access to it.
Something for nothing is an unsustainable situation not only for the cost associated, but further because of the way it affects the motivations of those who have access to it. As Mae West once said, "Give a man a free hand, and he'll run it all over you."
Monday 17 August 2009
Heads I win, tails you lose...
There is a lot of ongoing discussion in the world's media about the so-called "scandal" that is the investment banking bonus system. While there is plenty to be displeased about, much of the available commentary is mis-guided guff that misses the point. The real issue is this: If individual "rain-makers" make a lot of money for their respective banks, then they should get paid. If, however, in making that money those individuals take big risks that under certain stressed circumstances could threaten their bank and potentially the entire financial system then those returns need to be risk adjusted. Currently that doesn't happen and that is where the major issue lies.
At the moment there is a huge "externality" in the financial system. An externality is an impact or cost on a party that is not directly involved in a particular transaction. In the financial system the externality is that bankers own the upside of the risks they take, but in extreme circumstances (like the ones we have seen) the taxpayer bears the external costs of too much risk. One of the central goals of effective economic policy-making is to "internalize externalities", which basically means that the risks and rewards are borne solely by the participants in a transaction. The biggest current conundrum of this nature for global policy-makers is climate change, with the financial crisis not far behind. From the environmental point of view - a Chinese coal-fired power station benefits from the price it can sell its power at, but the negative "externality" of its contribution to global warming is borne disproportionately by all.
The real aggravation with the bonus "scandal" is that the externalities within the financial system remain unmitigated even after all that has happened. Policy-makers have yet to "internalize the externality". Traders can take huge risks, where if their bets pay off they benefit significantly, and if they don't then shareholders, creditors and in extreme cases taxpayers all suffer. We have been in a similar position before.
In 1933 after the Great Depression the US government established the Federal Deposit Insurance Corporation as part of the Glass-Steagall act. FDIC provides deposit insurance which guarantees the safety of deposits in member banks, currently up to $250,000 per depositor per bank. Today FDIC insures deposits at over 8,000 institutions with $13.5 trillion in assets. Insured deposits are backed by the full faith and credit of the United States, and since the start of FDIC on January 1st 1934, no depositor has lost a cent. FDIC is not unique and has been replicated in various forms around the world.
At the time, FDIC was an excellent concept - the banking system was much more localised than it is now, and most of the financing that banks had came in the form of deposits from it's corporate and retail clients. Consequently, the insurance premium that banks paid to FDIC covered most of the risks that could lead to a proverbial run, in the event that the bank took the wrong risks.
Close to 75 years on, in 2009, in terms of market protections the banking systems of the world haven't moved on much from the basic deposit insurance concept, yet in the interim period the changes in global capital markets have made the deposit insurance concept woefully insufficient. When Lehman Brothers was declared bankrupt last September its demise heralded a sequence of events that almost broke the entire financial system. As an investment bank, Lehman did not finance itself through deposits, but through international bond and equity markets, so FDIC was irrelevant to Lehman.
What needs to happen is a proper acknowledgement by all parties that the banking system is implicitly underwritten by an insurance policy written by the taxpayer. Currently there is no premium paid by the banks for that insurance policy. The only direct benefit to the taxpayer of that insurance is in the event that the banking system fosters an economic environment that generates high tax revenues and lots of jobs. In the recent past that benefit has been significant - global GDP growth was stellar, and lots of jobs were created - but as has become clear that economic boom happened on the back of a serious increase in the amount of risk in the system.
In order to internalize the externality that exists in the financial system, there needs to be some form of premium paid to central banks by financial institutions based on the amount of risk that they are taking. If each individual bank choses to take on more risk, then that is their prerogative, if less then likewise - just like a car or house insurance policy. If a person chooses to drive a fast, expensive car then they should pay more insurance, and they should pay yet more if they have a history of driving recklessly. There are of course practical issues with the implementation - where are the premiums paid for a global bank, how to measure risk and how to minimize what I will call the "Goldman effect" (political interference in pricing the insurance policy) - but the principal of the insurance policy concept is the best way to approach the heads I win, tails you lose nature of the banking system. If policy-makers get that right then the bonus issue will correct itself.
At the moment there is a huge "externality" in the financial system. An externality is an impact or cost on a party that is not directly involved in a particular transaction. In the financial system the externality is that bankers own the upside of the risks they take, but in extreme circumstances (like the ones we have seen) the taxpayer bears the external costs of too much risk. One of the central goals of effective economic policy-making is to "internalize externalities", which basically means that the risks and rewards are borne solely by the participants in a transaction. The biggest current conundrum of this nature for global policy-makers is climate change, with the financial crisis not far behind. From the environmental point of view - a Chinese coal-fired power station benefits from the price it can sell its power at, but the negative "externality" of its contribution to global warming is borne disproportionately by all.
The real aggravation with the bonus "scandal" is that the externalities within the financial system remain unmitigated even after all that has happened. Policy-makers have yet to "internalize the externality". Traders can take huge risks, where if their bets pay off they benefit significantly, and if they don't then shareholders, creditors and in extreme cases taxpayers all suffer. We have been in a similar position before.
In 1933 after the Great Depression the US government established the Federal Deposit Insurance Corporation as part of the Glass-Steagall act. FDIC provides deposit insurance which guarantees the safety of deposits in member banks, currently up to $250,000 per depositor per bank. Today FDIC insures deposits at over 8,000 institutions with $13.5 trillion in assets. Insured deposits are backed by the full faith and credit of the United States, and since the start of FDIC on January 1st 1934, no depositor has lost a cent. FDIC is not unique and has been replicated in various forms around the world.
At the time, FDIC was an excellent concept - the banking system was much more localised than it is now, and most of the financing that banks had came in the form of deposits from it's corporate and retail clients. Consequently, the insurance premium that banks paid to FDIC covered most of the risks that could lead to a proverbial run, in the event that the bank took the wrong risks.
Close to 75 years on, in 2009, in terms of market protections the banking systems of the world haven't moved on much from the basic deposit insurance concept, yet in the interim period the changes in global capital markets have made the deposit insurance concept woefully insufficient. When Lehman Brothers was declared bankrupt last September its demise heralded a sequence of events that almost broke the entire financial system. As an investment bank, Lehman did not finance itself through deposits, but through international bond and equity markets, so FDIC was irrelevant to Lehman.
What needs to happen is a proper acknowledgement by all parties that the banking system is implicitly underwritten by an insurance policy written by the taxpayer. Currently there is no premium paid by the banks for that insurance policy. The only direct benefit to the taxpayer of that insurance is in the event that the banking system fosters an economic environment that generates high tax revenues and lots of jobs. In the recent past that benefit has been significant - global GDP growth was stellar, and lots of jobs were created - but as has become clear that economic boom happened on the back of a serious increase in the amount of risk in the system.
In order to internalize the externality that exists in the financial system, there needs to be some form of premium paid to central banks by financial institutions based on the amount of risk that they are taking. If each individual bank choses to take on more risk, then that is their prerogative, if less then likewise - just like a car or house insurance policy. If a person chooses to drive a fast, expensive car then they should pay more insurance, and they should pay yet more if they have a history of driving recklessly. There are of course practical issues with the implementation - where are the premiums paid for a global bank, how to measure risk and how to minimize what I will call the "Goldman effect" (political interference in pricing the insurance policy) - but the principal of the insurance policy concept is the best way to approach the heads I win, tails you lose nature of the banking system. If policy-makers get that right then the bonus issue will correct itself.
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