There has been a lot of reason of late to feel a true breakdown of trust has occurred between the "common man" and their various elected and unelected institutional representatives. From the banking crisis, to the ongoing political situation in the UK over expense claims, our senses are weakened daily to the notion as to whether anybody can be trusted. The nostalgic media commentators tend to talk about the good old days, where trust was a consistent aspect of community living - where you knew your locals and they knew you and things worked better that way. There is some truth to the claim - my maternal grandfather’s job as a bank manager in the west of Ireland involved seeing the "whites of the eyes" of his very local borrowers, and their relationships were based on trust more than any legal framework or regulatory mandate, and that situation worked just fine.
The conspiracy theorists, who I think occupy most media positions, would like to suggest that society has become inherently more evil, and people truly can't be trusted for that reason. To me, that overstates things - people haven't inherently changed all that much. People are on average probably no less trustworthy or untrustworthy than they used to be. The real change has been the disparate nature of the daily interactions that people have now, which ends up altering the attitude that people bring to bear on their relationships with people. You are much less likely to act in an inappropriate way towards someone you will potentially see in your local pub, than a person who lives in Shanghai, but who you have “connected” with on the Internet.
It took 38 years for the radio to gain a global audience of 50 million. It took TV 13 years to achieve the same. It took the Internet 4 years, the iPod 3yrs and Facebook 2 years. We truly live in exponential times. A consequence of that is that the nature of interaction between people has changed exponentially too. With all these increases in communication channels, we ironically have not actually improved in the quality of our communication. Perhaps, we may have even seen a worsening in communication as we take it for granted that we are "connected".
This week I was directed towards a piece of research that was trying to understand the implications that different forms of corporate ownership have on the success and longevity of those businesses. Specifically the researchers at the London Business School were trying to establish some of the effects of having dispersed ownership structures - where the owners are both numerous and geographically disparate. Disparate ownership has developed rapidly with truly global capital markets where information technology has allowed owners to theoretically stay "informed" whether they are geographically local, or literally on the other side of the world.
The problem, however, for an investor who is geographically distant is that he can’t really stay “informed” in the truest sense. He’s not part of the community of the company directors, and he can’t look into the “whites of their eyes” on a regular basis. There is both a geographical and cultural divide. A consequence of this has therefore been an increase in cross-jurisdictional legal protections, which fill the cultural and geographical divide, or the “trust gap”. Instead of fostering relationships of trust, what we have done, is to establish a system that expects the worst and tries to protect for it through legal and regulatory structures.
The system is not as the London Business School research would say a "trust generating mechanism" - it is actually the opposite. As the research looks back over the 100 years of data, it was clear that relations of trust created the conditions in which interactions between firms and investors were repeated and where directors had incentives to sustain their reputations among local communities. The likelihood of acting improperly to an investor in Beijing and another one who lives on your street is quite different. The borrowers who were granted loans by my grandfather in the west of Ireland, were they to fall behind on payments, were very likely to bump into him in the local pub, or out shopping – and the public sense of shame was a sound motivator in the relationship.
From the data in the LBS research it was clear that in the less disparate ownership world of 50-100 years ago shareholders had little recourse in courts but much influence in the communities and local markets of which they and their firms were a part. Even as ownership dispersed in terms of numbers of shareholders, it remained geographically concentrated and directors were concerned to maintain their reputations among local investors. Eventually as local relations of trust became harder to sustain then formal investor protection emerged to substitute for them.
How is all of this relevant to today's turbulent and truly global trading environment? Well, the motto of the London Stock exchange remains "My word is my bond", as it has been for centuries since brokers traded with each other literally across the floor of the exchange. The globalization of the capital markets has changed all that. Trust is usually no longer so intimate an experience. But, we still need to create or generate new mechanisms of trust. Without some sense of trust in the figureheads who run our institutions we will become endlessly and bureaucratically tied up in oversight, regulation and legal process. Which is expensive, and not much fun.
The distant relationship between the mortgage broker in southern California and the German insurance company that would ultimately own the mortgage through a securitisation managed by a bank in New York or London, makes the creation of a relationship based on trust difficult to achieve. A legal process can help, but ultimately if the inclination of that broker isn't towards doing "the right thing", then with all the legal protection in the world you should probably be concerned about doing business with him. In the "old days" where the brokers clients lived in his community the potential shame of acting immorally, which would outcast him and his family in that society, was a good trust generating mechanism.
The irony of this situation is that we regularly told that we live in the Communication Age – the exponential growth of networking sights like Facebook, MySpace and Twitter show how people can connect without geographical boundaries. The 6 billion people in the world are merely six degrees of separation from eachother, which with the network effect is diminishing all the time. The irony though is that these networks aren’t necessarily making society any less secular. All of these networking tools allow the users to project an image of themselves out to their network that is self-created. For many that may mean that they aren’t connecting in a real sense with their network – they are conveying an artificial image out to a group of people who will probably rarely actually see the real image in person. Paul Saffo, who is a futurologist, is pessimistic about how society will be affected by the media revolution. "Each of us can create our own personal-media walled garden that surrounds us with comforting, confirming information and utterly shuts out anything that conflicts with our world view," he says. "This is social dynamite" and could lead to "the erosion of the intellectual commons holding society together. We risk huddling into tribes defined by shared prejudices".
Hopefully it won't come to that, but this sense has parallels to the world of international capital markets or politics where often your representative seems like a faceless figurehead who says all the right sound bites but never really makes you feel connected or fully engaged. The benefits of having global information networks, and global capital markets are clear and manifold. They provide the seeds upon which countries and individuals can participate in the worlds markets and have genuinely helped to increase wealth and reduce poverty. Nonetheless, the exponential increase in the global network has not actually increased the sense of trust across the system – it may have fostered the opposite.
Trust is an enormously valuable commodity. If trusting was a viable option in our daily interactions with people then we'd save ourselves a whole lot of grief and expense. If, for example, we could trust politicians to make reasonable expense claims, then we wouldn't have to establish any oversight committee, to oversee the oversee-ers and could consequently reduce the costs of the political system. To have a system that is entirely based on trust is obviously an unrealistic utopian concept. Nevertheless it's hugely important that we do have some "trust generating mechanisms" in place which if well established are typically cost free, but enormously cost saving in terms of diminished bureaucracy and oversight. If we don't have these mechanisms in place we will be in a vicious circle - lack of trust will distance decision makers even further from their stakeholders.
In trust we trust.
Monday 25 May 2009
Monday 18 May 2009
You've got to know when to hold 'em, know when to fold 'em...
The cardinal sin in poker, worse than playing dud cards, worse even than failing to figure your odds correctly, is (apparently) becoming emotionally involved in the game. Emotions such as charity, greed, hope and fear all get in the way of deciding correctly whether to hold or fold. All too often in the current financial crisis the hands that governments around the world have been dealt, have looked pretty awful on the face of it - broken banks, rising unemployment, increasing budget deficits and the like. In many cases, however bad these hands have been, governments have tended to underplay their cards for emotional reasons - fear often, but understandably, being the main emotional roadblock to an efficient playing strategy.
Often this emotive instinct has played into the hands of the notoriously hard-nosed - Goldman Sachs and others in the AIG shambles for example (see previous blog - http://aidan.neills.net/2009/03/real-aig-scandal.html). To take the poker analogy further - it should be far easier to be aggressive with a hand when you have most of the chips, no matter how bad the hand is. In most cases, as the lender of last resort, governments have been holding virtually all of the remaining chips in the casino that is financial markets, but have rarely used their position to the full benefit of their taxpayers who are funding their entertainment.
The poker game that has been played out over the Chrysler bankruptcy in the US, seen from a taxpayers eyes, should be quite heart-warming, as it appears to be one of the first occasions where the taxpayer’s hand has been reasonably played by their elected players. The Federal government holds virtually all of the available chips, or available capital in this case, and has exploited the situation to it's benefit, in a quite fantastic way. Most of the time it's the investment banks or hedge funds putting the government or other interested parties over the barrel. Not this time.
The struggle between the US government and its stakeholders began last year when Chrysler and GM faced a potential meltdown, unable to sell enough cars to justify creditors refinancing past loans via the capital markets. Chrysler went to the lenders that held 70% of its debt - JPMorgan, Citigroup, Goldman Sachs and Morgan Stanley. It wanted to know whether they would lend more and if they would provide financing in case Chrysler filed for bankruptcy.
When each of these banks, in turn, said a resounding "no", Chrysler was forced to look to Washington for some Federal assistance. Last December, the Bush administration in its final desperate days, agreed to lend Chrysler $4bn as well as $13.4bn to GM. The Treasury gave Chrysler three months to reduce its debt and forge a cost-cutting agreement with the United Auto Workers Union (UAW).
In its first attempt to reduce its outstanding liabilities Chrysler went back to its lenders, and instead of asking for more money, asked them to agree to not get paid in full for their old loans. It wanted to cut the $6.9bn debt to $5bn, on the grounds that if it’s liabilities weren’t cut it would likely spiral towards a bankruptcy where the lenders would get much less than $5bn back.
This polite request was roundly given the two-fingered salute by the banks in question. With the government now involved in supporting Chrysler, the banks held out for more constructive talks with federal officials. The sense from the banks was that they could “game the government” in the process, as they sensed that the government wanted a liquidation of Chrysler even less than they did. This was similar to the situation with AIG, where the banks who had big exposures to AIG claimed that they would collapse if the government did not step in assume AIG’s liabilities. In the AIG case this brinkmanship cultivated government emotions (fear), which ultimately served those banks, but not the taxpayer, very well.
On the Obama side, the auto task force held minimal hope that all of Chrysler's 46 different lenders would agree to a compromise. Many of these interested parties were small hedge funds and distressed debt funds, most of whom had bought their holdings at a discount (i.e. less than 100% or "par value") in the secondary debt markets. With no consumer operations, these institutions had less reputation on the line that the big banks did so did not have to worry about being seen as the ‘bad guys’ who forced Chrysler into liquidation.
The view that the big banks could game the government (again) started to change when Obama very publicly talked about the possibility of Chrysler going into bankruptcy or even liquidation. The credibility of his words was increased by the more aggressive approach it was talking towards GM who’s chief executive, Rick Wagoner had just been pushed aside by the government. Acting like a bank that is a troubled firm's last hope, which the government effectively was, Obama sketched out what Chrysler would have to do to get more federal money.
On April 2nd, the head of the auto task-force, Steven Rattner, hosted a meeting of senior bank officers, where they heard presentations from Chrysler's CEO Robert Nardelli and Fiat’s CEO Sergio Marchionne. Fiat had been brought into the discussions as a potential operating partner for a restructured Chrysler. The 25 listeners were told that deals with Fiat and the UAW had almost been agreed – the ownership of Chrysler after the negotiations would be between Fiat, a trust fund run by the UAW and the American and Canadian governments. The deal, which could give Fiat up to 51% of Chrysler, was designed to increase Chrysler’s overseas sales and get Fiat to develop fuel-efficient vehicles in the US by 2013, an area where they had developed considerable expertise.
That fact that such progress had already be made in itself may have scared the room’s participants, but when the issue of the repayment of the $6.9bn in debt came up, the nausea would have truly set in. Steven Rattner looked at the lending group and said, "We have in mind for you a much lower number than the $6.9bn that is outstanding….$1 billion."
The $1bn figure wasn't the real maximum that the auto task-force was willing to pay - the figure they had in mind as their cut-off point was the amount the lenders would get in a liquidation of Chrysler assets - which was estimated by Chrysler earlier in the year at $2bn. Which given that the book value of Chryslers assets in their audited accounts had been given as $39.3bn shows both how illiquid the market for these assets is and also how daft some accounting measures are.
The bankers gathered in the room asked the government for projections of what a combined Chrysler-Fiat alliance would look like. In the following days, the lenders began to realize the strength of their negotiating position was weak and getting weaker. Only the government had the ability or willingness to finance a bankruptcy reorganisation of Chrysler, while also supporting its warranties and suppliers. None of the lenders had any desire to take over and liquidate the company, or to recapitalize it.
The lenders spent a week haggling over how to respond to the auto task-force position. The big banks at first proposed that the group offer to cut the debt in half and get no equity stake. That outraged some hedge funds and distressed-debt firms that didn't face the banks' broader concerns about reputation and that were accustomed to "street fighting" for their interests. The reply, sent April 20, reflected the hardening position of the hedge funds: The lenders would cut just $2.4 billion in debt, in exchange for 40% of Chrysler's equity.
The offer was duly and rightly rejected as the lenders were seeking much more than market value for their debt, which would have amounted to an unnecessary taxpayer subsidy. It was just 10 days until the government's deadline to reach agreements with the UAW, Fiat and lenders if Chrysler was to get more government money.
After receiving one more bank counteroffer, the Treasury on April 28 offered what it had planned all along, to buy out the lenders for $2 billion.
The big banks quickly agreed to the deal -- equal to 29 cents on the dollar. News that the big banks were accepting the offer leaked before they had told the smaller lenders. JP Morgan as lead negotiator for the creditors was intent on winning the required 100% approval from debtholders, to ensure that the deal went ahead and therefore the government had the option of avoiding a Chrysler bankruptcy filing. After a flurry of phone calls from JP Morgan, about 20 firms, mostly small hedge funds, voted no.
The following day, Barack Obama said Chrysler would file for bankruptcy. He blamed "speculators" who had turned down the $2 billion offer for their $6.9 billion of debt. “They were hoping that everybody else would make sacrifices, and they would have to make none. I don’t stand with them”, he said.
A few days later, the battle-weary holdout firms abandoned the fight as too costly, financially and politically, and agreed to the $2bn deal.
The government had won, after rounds of brinkmanship that could have induced poor decisions through the fear of ugly consequences. They had effectively played the banks and the hedge funds at their own game – a game that in the past has falsely resulted in taxpayer’s bailout money being used to compensate risk takers for the past mistakes that they have made. The banks and hedge funds made loans to a car company that was not well run, and did not perform - if the reverse had been true then they would have benefited. It’s fitting that they should bare risk and reward in equal measure.
This was a bad hand well-played.
Often this emotive instinct has played into the hands of the notoriously hard-nosed - Goldman Sachs and others in the AIG shambles for example (see previous blog - http://aidan.neills.net/2009/03/real-aig-scandal.html). To take the poker analogy further - it should be far easier to be aggressive with a hand when you have most of the chips, no matter how bad the hand is. In most cases, as the lender of last resort, governments have been holding virtually all of the remaining chips in the casino that is financial markets, but have rarely used their position to the full benefit of their taxpayers who are funding their entertainment.
The poker game that has been played out over the Chrysler bankruptcy in the US, seen from a taxpayers eyes, should be quite heart-warming, as it appears to be one of the first occasions where the taxpayer’s hand has been reasonably played by their elected players. The Federal government holds virtually all of the available chips, or available capital in this case, and has exploited the situation to it's benefit, in a quite fantastic way. Most of the time it's the investment banks or hedge funds putting the government or other interested parties over the barrel. Not this time.
The struggle between the US government and its stakeholders began last year when Chrysler and GM faced a potential meltdown, unable to sell enough cars to justify creditors refinancing past loans via the capital markets. Chrysler went to the lenders that held 70% of its debt - JPMorgan, Citigroup, Goldman Sachs and Morgan Stanley. It wanted to know whether they would lend more and if they would provide financing in case Chrysler filed for bankruptcy.
When each of these banks, in turn, said a resounding "no", Chrysler was forced to look to Washington for some Federal assistance. Last December, the Bush administration in its final desperate days, agreed to lend Chrysler $4bn as well as $13.4bn to GM. The Treasury gave Chrysler three months to reduce its debt and forge a cost-cutting agreement with the United Auto Workers Union (UAW).
In its first attempt to reduce its outstanding liabilities Chrysler went back to its lenders, and instead of asking for more money, asked them to agree to not get paid in full for their old loans. It wanted to cut the $6.9bn debt to $5bn, on the grounds that if it’s liabilities weren’t cut it would likely spiral towards a bankruptcy where the lenders would get much less than $5bn back.
This polite request was roundly given the two-fingered salute by the banks in question. With the government now involved in supporting Chrysler, the banks held out for more constructive talks with federal officials. The sense from the banks was that they could “game the government” in the process, as they sensed that the government wanted a liquidation of Chrysler even less than they did. This was similar to the situation with AIG, where the banks who had big exposures to AIG claimed that they would collapse if the government did not step in assume AIG’s liabilities. In the AIG case this brinkmanship cultivated government emotions (fear), which ultimately served those banks, but not the taxpayer, very well.
On the Obama side, the auto task force held minimal hope that all of Chrysler's 46 different lenders would agree to a compromise. Many of these interested parties were small hedge funds and distressed debt funds, most of whom had bought their holdings at a discount (i.e. less than 100% or "par value") in the secondary debt markets. With no consumer operations, these institutions had less reputation on the line that the big banks did so did not have to worry about being seen as the ‘bad guys’ who forced Chrysler into liquidation.
The view that the big banks could game the government (again) started to change when Obama very publicly talked about the possibility of Chrysler going into bankruptcy or even liquidation. The credibility of his words was increased by the more aggressive approach it was talking towards GM who’s chief executive, Rick Wagoner had just been pushed aside by the government. Acting like a bank that is a troubled firm's last hope, which the government effectively was, Obama sketched out what Chrysler would have to do to get more federal money.
On April 2nd, the head of the auto task-force, Steven Rattner, hosted a meeting of senior bank officers, where they heard presentations from Chrysler's CEO Robert Nardelli and Fiat’s CEO Sergio Marchionne. Fiat had been brought into the discussions as a potential operating partner for a restructured Chrysler. The 25 listeners were told that deals with Fiat and the UAW had almost been agreed – the ownership of Chrysler after the negotiations would be between Fiat, a trust fund run by the UAW and the American and Canadian governments. The deal, which could give Fiat up to 51% of Chrysler, was designed to increase Chrysler’s overseas sales and get Fiat to develop fuel-efficient vehicles in the US by 2013, an area where they had developed considerable expertise.
That fact that such progress had already be made in itself may have scared the room’s participants, but when the issue of the repayment of the $6.9bn in debt came up, the nausea would have truly set in. Steven Rattner looked at the lending group and said, "We have in mind for you a much lower number than the $6.9bn that is outstanding….$1 billion."
The $1bn figure wasn't the real maximum that the auto task-force was willing to pay - the figure they had in mind as their cut-off point was the amount the lenders would get in a liquidation of Chrysler assets - which was estimated by Chrysler earlier in the year at $2bn. Which given that the book value of Chryslers assets in their audited accounts had been given as $39.3bn shows both how illiquid the market for these assets is and also how daft some accounting measures are.
The bankers gathered in the room asked the government for projections of what a combined Chrysler-Fiat alliance would look like. In the following days, the lenders began to realize the strength of their negotiating position was weak and getting weaker. Only the government had the ability or willingness to finance a bankruptcy reorganisation of Chrysler, while also supporting its warranties and suppliers. None of the lenders had any desire to take over and liquidate the company, or to recapitalize it.
The lenders spent a week haggling over how to respond to the auto task-force position. The big banks at first proposed that the group offer to cut the debt in half and get no equity stake. That outraged some hedge funds and distressed-debt firms that didn't face the banks' broader concerns about reputation and that were accustomed to "street fighting" for their interests. The reply, sent April 20, reflected the hardening position of the hedge funds: The lenders would cut just $2.4 billion in debt, in exchange for 40% of Chrysler's equity.
The offer was duly and rightly rejected as the lenders were seeking much more than market value for their debt, which would have amounted to an unnecessary taxpayer subsidy. It was just 10 days until the government's deadline to reach agreements with the UAW, Fiat and lenders if Chrysler was to get more government money.
After receiving one more bank counteroffer, the Treasury on April 28 offered what it had planned all along, to buy out the lenders for $2 billion.
The big banks quickly agreed to the deal -- equal to 29 cents on the dollar. News that the big banks were accepting the offer leaked before they had told the smaller lenders. JP Morgan as lead negotiator for the creditors was intent on winning the required 100% approval from debtholders, to ensure that the deal went ahead and therefore the government had the option of avoiding a Chrysler bankruptcy filing. After a flurry of phone calls from JP Morgan, about 20 firms, mostly small hedge funds, voted no.
The following day, Barack Obama said Chrysler would file for bankruptcy. He blamed "speculators" who had turned down the $2 billion offer for their $6.9 billion of debt. “They were hoping that everybody else would make sacrifices, and they would have to make none. I don’t stand with them”, he said.
A few days later, the battle-weary holdout firms abandoned the fight as too costly, financially and politically, and agreed to the $2bn deal.
The government had won, after rounds of brinkmanship that could have induced poor decisions through the fear of ugly consequences. They had effectively played the banks and the hedge funds at their own game – a game that in the past has falsely resulted in taxpayer’s bailout money being used to compensate risk takers for the past mistakes that they have made. The banks and hedge funds made loans to a car company that was not well run, and did not perform - if the reverse had been true then they would have benefited. It’s fitting that they should bare risk and reward in equal measure.
This was a bad hand well-played.
Sunday 10 May 2009
It was the best of times, it was the worst of times...
"It was the best of times, it was the worst of times, it was the age of wisdom, it was the age of foolishness, it was the epoch of belief, it was the epoch of incredulity, it was the season of Light, it was the season of Darkness, it was the spring of hope, it was the winter of despair, we had everything before us, we had nothing before us..."
Dickens' opening line to "A Tale of Two Cities" is a wonderful piece of literary craftsmanship, and as he described the European backdrop leading up to the French Revolution in the late 18th Century, he could easily have been describing world sentiment at this current point in time. The to-ing and fro-ing of perspective between complete despair and unmitigated hope has taken a recent turn towards the latter within the financial world over the past fortnight. This last week has seen world stock markets continue to rise, risk aversion drop significantly, and a clear emphasis amongst analysts that "green shoots" are definitely taking root.
The "stress tests" carried out on the major US banks categorically told us that these banks are in serious trouble, but not completely insolvent - they need close to $75bn worth of capital of which Morgan Stanley and Wells Fargo raised $11.5bn between them in a single day on Friday. The continuing capacity to plug capital shortfalls from willing global investors is hugely impressive, given the various rounds of pain these same investors have felt in the not-too-distant past.
Good news it appears, but with a context of ever extending unemployment in the US (which hit a 25-year high on Friday) and more significant long-term structural issues with the finances of the major world economies, the current exuberance albeit pleasant, is overdone. We are still somewhere between the "winter of despair" and the "spring of hope".
Barack Obama recently passed his first 100 days in the White House, and answering reporters questions for nearly an hour in the East Room, he showed what has become his trademark cool and calm no matter whether the question was about torture, the auto industry, Pakistan, Iraq, abortion, black unemployment, the financial crisis or swine flu. At one point, he properly encapsulated his personal philosophy, echoing the sentiments of Dickens' fictional world, without the literary waffle: "Things are never as good as they seem and never as bad as they seem." Which is both a good working definition of keeping cool, and also a good recipe for successful living.
I come from a family where this paradigm was both practiced and quietly preached - the dinner table was a good place for bringing individual achievements back down to earth, and also acknowledging failure as just part of the learning process.
In the current case of the extended financial market rebound, I would like to recreate the Neill dinner table, and temper the animal spirits by suggesting that things are not as good as they seem. Financial institutions around the world, almost without exception, have been making money from new lending and trading in the 1st quarter of 2009. This isn't all that surprising given the fact that interest rates are effectively 0% in the US and almost the same in the UK - so you would imagine that a banker's job in terms of the new stuff is pretty easy. It's the old stuff that continues to be the problem - and the rescue efforts of the past 24 months are still to be paid for.
Interestingly, the "stress testing" of US banks that has caused the financial world to suddenly feel more optimistic seems, to me at least, to be made of the same smoke and mirrors stuff that investment bankers have become famed for. In the tense back-room negotiations that preceded Thursday's release of the results, bank executives were able to persuade regulators to alter many of the assumptions on the sector's future health that they had independently made. They flooded the briefcases of Treasury and Fed officials with the same brightly coloured charts, spreadsheets, long presentations and the same brilliantly put-together sales pitches that sold sub-prime CDOs and the like - and consequently these regulators were jockeyed into thinking that the "worst case" scenarios for capital adequacy of these banks is not as bad as their previous assumptions suggested.
The FT makes the case that on one particular point, the Fed and the Treasury officials held firm. This was the idea that banks could recapitalise themselves out of expectations of future earnings. According to the FT the authorities "took a relatively dim view of the financial sector's earnings power". Apparently Citigroup (for example) claimed that it's expected earnings over the next 2 years would be $80bn - which the authorities "hammered down" to the figure of "only" $49bn. All of these people are clearly taking some form of amphetamine that has yet to hit the broader market. While each of the banks should be making a few bucks on current business, the write-downs on legacy business will be a bigger drag for some time yet.
I'm pleased that optimism is back, but the context is that this banking system will still be woefully under-capitalised if even a not-very-good scenario plays out, let alone any sort of worst case. Aside from discussions over whether banks have enough capital there are other more systemic issues that are at play.
Forgive me for paraphrasing John Authers commentary in the FT this weekend:
Firstly, the scale of the stimulus package that has got us to this renewed confidence in the financial markets has come at a very significant cost, which is currently like an unpaid credit card bill. Someone will have to pay for what has been the biggest fiscal stimulus the world has ever seen, which means a combination of inflation, higher interest rates and higher taxes. None of these things will be good for stocks, as they are counterproductive for the private sector.
Secondly, companies still have a lot of capital raising to do, which will dilute their stock market valuations.
Thirdly, history has shown that once bond yields go above a certain level, it becomes difficult to justify buying stocks. They could reach this level when the Treasury bond market finally chokes on the huge new issuance governments are trying to push down its throat to fund the various deficits. The extra risk of investments in companies versus investment in government backed bonds may create a form of "crowding out" of private sector investment.
Finally, there are demographic issues. The developed world is ageing, which will put a greater drag on public expenditures, and lead to sales of stocks as the baby-boom generation retires and cashes in what is left of its savings.
Given that the world is pretty tired of bad news after very tough times over the past 18 months, and several false dawns in between, the current enthusiasm for an extended bull market run is understandable. Without wanting to spoil the party, the grounds that the new found risk taking is based on, namely the outcome of the US banks "stress tests", is disturbing in itself. It seems to me that the 19 participating banks have done a marketing job to the Fed and the US Treasury that works out relatively well for them, and not-so-hot for the people who are financing many of these banks currently. The taxpayer stitch-up continues. Quite apart from the outcome of these tests, the backdrop is a global economy where there are still very significant structural issues to be addressed, which aren't going to be solved by a few months of rising stock markets. It's not quite the worst of times, but it's certainly not the best of times either.
Dickens' opening line to "A Tale of Two Cities" is a wonderful piece of literary craftsmanship, and as he described the European backdrop leading up to the French Revolution in the late 18th Century, he could easily have been describing world sentiment at this current point in time. The to-ing and fro-ing of perspective between complete despair and unmitigated hope has taken a recent turn towards the latter within the financial world over the past fortnight. This last week has seen world stock markets continue to rise, risk aversion drop significantly, and a clear emphasis amongst analysts that "green shoots" are definitely taking root.
The "stress tests" carried out on the major US banks categorically told us that these banks are in serious trouble, but not completely insolvent - they need close to $75bn worth of capital of which Morgan Stanley and Wells Fargo raised $11.5bn between them in a single day on Friday. The continuing capacity to plug capital shortfalls from willing global investors is hugely impressive, given the various rounds of pain these same investors have felt in the not-too-distant past.
Good news it appears, but with a context of ever extending unemployment in the US (which hit a 25-year high on Friday) and more significant long-term structural issues with the finances of the major world economies, the current exuberance albeit pleasant, is overdone. We are still somewhere between the "winter of despair" and the "spring of hope".
Barack Obama recently passed his first 100 days in the White House, and answering reporters questions for nearly an hour in the East Room, he showed what has become his trademark cool and calm no matter whether the question was about torture, the auto industry, Pakistan, Iraq, abortion, black unemployment, the financial crisis or swine flu. At one point, he properly encapsulated his personal philosophy, echoing the sentiments of Dickens' fictional world, without the literary waffle: "Things are never as good as they seem and never as bad as they seem." Which is both a good working definition of keeping cool, and also a good recipe for successful living.
I come from a family where this paradigm was both practiced and quietly preached - the dinner table was a good place for bringing individual achievements back down to earth, and also acknowledging failure as just part of the learning process.
In the current case of the extended financial market rebound, I would like to recreate the Neill dinner table, and temper the animal spirits by suggesting that things are not as good as they seem. Financial institutions around the world, almost without exception, have been making money from new lending and trading in the 1st quarter of 2009. This isn't all that surprising given the fact that interest rates are effectively 0% in the US and almost the same in the UK - so you would imagine that a banker's job in terms of the new stuff is pretty easy. It's the old stuff that continues to be the problem - and the rescue efforts of the past 24 months are still to be paid for.
Interestingly, the "stress testing" of US banks that has caused the financial world to suddenly feel more optimistic seems, to me at least, to be made of the same smoke and mirrors stuff that investment bankers have become famed for. In the tense back-room negotiations that preceded Thursday's release of the results, bank executives were able to persuade regulators to alter many of the assumptions on the sector's future health that they had independently made. They flooded the briefcases of Treasury and Fed officials with the same brightly coloured charts, spreadsheets, long presentations and the same brilliantly put-together sales pitches that sold sub-prime CDOs and the like - and consequently these regulators were jockeyed into thinking that the "worst case" scenarios for capital adequacy of these banks is not as bad as their previous assumptions suggested.
The FT makes the case that on one particular point, the Fed and the Treasury officials held firm. This was the idea that banks could recapitalise themselves out of expectations of future earnings. According to the FT the authorities "took a relatively dim view of the financial sector's earnings power". Apparently Citigroup (for example) claimed that it's expected earnings over the next 2 years would be $80bn - which the authorities "hammered down" to the figure of "only" $49bn. All of these people are clearly taking some form of amphetamine that has yet to hit the broader market. While each of the banks should be making a few bucks on current business, the write-downs on legacy business will be a bigger drag for some time yet.
I'm pleased that optimism is back, but the context is that this banking system will still be woefully under-capitalised if even a not-very-good scenario plays out, let alone any sort of worst case. Aside from discussions over whether banks have enough capital there are other more systemic issues that are at play.
Forgive me for paraphrasing John Authers commentary in the FT this weekend:
Firstly, the scale of the stimulus package that has got us to this renewed confidence in the financial markets has come at a very significant cost, which is currently like an unpaid credit card bill. Someone will have to pay for what has been the biggest fiscal stimulus the world has ever seen, which means a combination of inflation, higher interest rates and higher taxes. None of these things will be good for stocks, as they are counterproductive for the private sector.
Secondly, companies still have a lot of capital raising to do, which will dilute their stock market valuations.
Thirdly, history has shown that once bond yields go above a certain level, it becomes difficult to justify buying stocks. They could reach this level when the Treasury bond market finally chokes on the huge new issuance governments are trying to push down its throat to fund the various deficits. The extra risk of investments in companies versus investment in government backed bonds may create a form of "crowding out" of private sector investment.
Finally, there are demographic issues. The developed world is ageing, which will put a greater drag on public expenditures, and lead to sales of stocks as the baby-boom generation retires and cashes in what is left of its savings.
Given that the world is pretty tired of bad news after very tough times over the past 18 months, and several false dawns in between, the current enthusiasm for an extended bull market run is understandable. Without wanting to spoil the party, the grounds that the new found risk taking is based on, namely the outcome of the US banks "stress tests", is disturbing in itself. It seems to me that the 19 participating banks have done a marketing job to the Fed and the US Treasury that works out relatively well for them, and not-so-hot for the people who are financing many of these banks currently. The taxpayer stitch-up continues. Quite apart from the outcome of these tests, the backdrop is a global economy where there are still very significant structural issues to be addressed, which aren't going to be solved by a few months of rising stock markets. It's not quite the worst of times, but it's certainly not the best of times either.
Monday 4 May 2009
Socialist banking...
Throughout the current financial crisis the threat of the requirement for widespread bank nationalization has loomed large in many countries around the world. With it, much has been made of the "necessity" for banks to remain firmly within the private sector, as it's only from that position that they can act as the engine room of private enterprise - the suggestion being that government owned banks will be inefficient in the process of allocating capital across the economy. It has always been somewhat of an oxymoron, at least to me, to think of banks as strictly private sector enterprises at any point in time anyway.
Sure, they have private shareholders and, yes, those shareholders get all the upside of the net interest margin intrinsic to the "alchemy" of banking (lend at a higher rate than you borrow). But, the truth is that the whole banking enterprise itself depends on various governmental safety nets, provided in different forms by the nation states of the world. All of the world’s banks are effectively nationalized in some form or other, and many of them always have been - it has just been implicit as opposed to explicit support.
I would argue that this divide doesn't matter as much as many commentators would suggest - the real discussion should be about whether incentives are correctly skewed. They haven't been in the past, as governments and their taxpayers have effectively owned all of the "downside" of banks (i.e. picking up the pieces after bad lending), but shareholders and employees have owned all of the "upside". The real debate really should be focused on how these incentives can be more fairly skewed in the future, without completely removing the willingness of banks to take risks.
Private sector banking has not truly existed in the United States since the Federal Reserve bank in 1913 allowed regional banks access to the discount window, where assets can be posted for loans to pay back flighty depositors. A second "sleep-well" governmental safety net was introduced in 1933 in the form of deposit insurance, in which the federal government insures that deposits - up to a point - will always trade at 100% of their nominal sum, regardless of how foolish bankers may be on the other side of their balance sheets.
The fact is that there is no use getting all ideological at the current time about keeping banks private, because they never really have been. What is understandable is that countries don't want to record their national banks liabilities "on balance sheet" - but these banks are, and since the early part of last century have been, contingent liabilities of governments and their taxpayers.
Ideas of nationalization, or the creation of "bad banks" by state bodies and various derivations of these, are methods that are being discussed to address the current shortage of capital in the worlds banking system. In and of their name, none of these solutions are necessarily trump cards - the devil is really going to be in the detail of any solution's structure. The solution we want is one where investment decisions are driven by economic value rather than political dictat, but at the same time capital formation has positive spillovers so there is good justification for it to be publicly subsidized.
How best to meet those objectives is a structural rather than an ideological question - yet many commentators seem to get caught up in standing firm on one solution over another for purely ideological reasons. I think many of them are missing the point.
Over the course of the past couple of months this debate has taken center stage in various countries. Currently it’s at the forefront of economic and political debate in Ireland, where banking woes have left the six main domestic lenders effectively insolvent in all but name. Badly timed or simply ill-judged loans to property developers are hung on balance sheets like bad smells, with limited deodorant available to minimize the odour. As the marketability of these loans has fallen so has the capital adequacy of each of the banks. It’s estimated that there are EUR 90bn worth of problem loans, which are virtually unmarketable at any realistic pricing levels. If these loans were written down by 50%, which is a potentially optimistic market clearing level, then the EUR 45bn hit would be equivalent to twice the core equity base of the main six banks. On these terms the banks are comfortably insolvent – so in a legal sense should not be trading at all. Understandably, private sector investment in the banks is fairly hard to come by currently without some form of very explicit government support or intervention.
The current ‘golden’ solution in Ireland is a form of “bad bank”, to be managed by a new government organization called NAMA (National Asset Management Agency). Their job will be to take these unmarketable loans off the balance sheets of the banks in a sort of mother-of-all exorcisms. The idea being that once these assets are transferred into this new institution, that the "clean" books of the main banks will engender confidence from global creditors and international credit will start to flow back into the Irish banks. In turn this credit will be passed on to domestic based enterprises, which will refuel the core of the Irish economic system. So far, so easy.
As with similar attempted "bad bank" solutions being proposed in the US, and elsewhere, the big question that is at the crux of matters, is what price the assets should be sold from the banks to NAMA. The price needs to ensure that banks capital isn't eroded so much that the government has to take them over fully anyway, or that the price isn't too high such that the taxpayer is being completely stiffed. The price also needs to reflect an acceptable compromise between protecting stakeholders from oblivion and ensuring that they are sufficiently whacked for their past involvement in the excessive risky undertakings of the banks they have been stakeholders in. Shareholders in the banks, for example, deserve to lose everything on the basis of expected write-downs on their loans, and if they don’t then how will the appropriate lesson be learned? On the flipside, if the approach is so penal that private sector investors are turned away from investing in Irish banks for good then that may be a consequence that has no long-term benefit to anyone. Similarly if Irish pensioners with AIB or Bank of Ireland shares are completely written off, then what does that say about the encouragement government has given them to save for retirement in this way in the past? What is clear though is that no solution will be known to be perfect in advance, nor is there a perfect solution for all. Furthermore, the commentators who argue so confidently about the merits of one solution over are deluded in their confidence as these truly are unchartered waters.
The local stockbrokers, Davy’s, said that it expected the banks to take a 15%, or EUR 13.5bn, haircut on the loans being transferred. This conservative estimate would still result in a hit to the main lenders capital that would be comfortably more than their entire stock market valuations at this point in time – so come what may, they will probably need more capital, which will most likely come from the Irish government.
What complicates the whole process is the lack of clarity that any solution will produce a good long-term outcome. Nobody has any experience in dealing with a situation like this, and there are few historical contexts to be learned from. Amidst the confusion there are some stakeholders keen to use this muddlement to their own advantage by confidently asserting the merits or demerits of one solution over another. The well-known Irish financier, Dermot Desmond, for example, has said that he opposes the State taking control of the banks' risky property loans through NAMA under the current plan. He has recently acquired substantial stakes in both Allied Irish Bank and Bank of Ireland - the two biggest domestic banks - and has commented that he could not support an entity "where it's impossible to value the assets". This begs the question as to why he bought the stakes in BOI and AIB in the first place - as if the assets are impossible to value, how did he know what he was buying when he made his investments?
His suggestion is that instead of transferring the assets, they should remain on the books of the banks: "Let's just park it and freeze everything, without gain or loss to anybody, until we know there is a market and then determine what the write-offs are". What he really wants, reading between the lines, is that the "bad" and extremely illiquid assets sit on the banks books and to be rollover financed by the government. The logic being that the current illiquidity of the market has meant that most of these assets are marked down to very low prices, potentially well below a future realizable value. To give an example - a loan to a property developer that is backed by a half built housing estate in Cavan has no current value, because with the developer bankrupt and no new equity available there is no scope for the project to be completed. Consequently the current mark-to-market of the loan if not at zero, will not be much above zero. In theory though, if new equity becomes available and the project is completed the "realizable value" of the bank loan will be higher than zero - to what extent depending on the terms of the restructuring of the loan.
At current mark-to-markets, the transfer prices of the assets in question would literally wipe out the entire capital bases of all the major 6 banks, and in doing so would clear out Desmond's equity investment with it. The game Desmond is playing, is based on the idea that over time as some order is restored to the global credit markets, that the capacity for banks to hold onto their impaired assets and to "work them out" will increase - in the case above, to find a property developer who is willing to take on the completion of the Cavan housing estate. That is currently a luxury of time that the banks don't have. The chances are that in the work-out process the upside versus where these assets are currently marked to market will be positive for the banks equity holders - of which Desmond would be a principle beneficiary. In effect Desmond is advocating the old situation where the government and their taxpayers perform the role of backstop financier, but with all the downside of the banks bad loans, and none of the upside - which would be retained by Desmond and the other shareholders. Hardly a move away from the skewed incentives of the old style banking model that was the foundation of the current mess.
On the flipside, if assets are transferred to NAMA at reasonable prices, and if NAMA is well run then there could be a very decent return on the government's and the taxpayers investment. These are very big 'ifs'. For example - in order to restructure and to "work out" these loans NAMA would require very bright and very commercially minded employees - who will likely cost quite a lot to hire. Hiring at big expense, however, is likely to be completely politically unpalatable amidst the current banker bashing in the Irish media.
The ideal outcome for any solution is one where the economic incentives for both taxpayers who have implicitly supported of the banking system in the past (and who are currently very explicitly supporting it) and those private sector stakeholders, who own the "upside" of banking endeavour, are fairly skewed. To me, this is an almost impossible task as there are so many potential conflicts of interest. Nonetheless, there are merits to many of the solutions that are being proposed around the world, but the effectiveness of any of these solutions over the long-term will be down to the minute detail of their agreement. What's abundantly clear, though, is that the confidence with which many commentators argue the ideological merits of the different solutions is misguided. It's not possible to be so confident about the long-term implications of something so complicated - which when the electorate want immediate answers to why we are where we are, makes things ever harder. May the force be with the decision makers.
Sure, they have private shareholders and, yes, those shareholders get all the upside of the net interest margin intrinsic to the "alchemy" of banking (lend at a higher rate than you borrow). But, the truth is that the whole banking enterprise itself depends on various governmental safety nets, provided in different forms by the nation states of the world. All of the world’s banks are effectively nationalized in some form or other, and many of them always have been - it has just been implicit as opposed to explicit support.
I would argue that this divide doesn't matter as much as many commentators would suggest - the real discussion should be about whether incentives are correctly skewed. They haven't been in the past, as governments and their taxpayers have effectively owned all of the "downside" of banks (i.e. picking up the pieces after bad lending), but shareholders and employees have owned all of the "upside". The real debate really should be focused on how these incentives can be more fairly skewed in the future, without completely removing the willingness of banks to take risks.
Private sector banking has not truly existed in the United States since the Federal Reserve bank in 1913 allowed regional banks access to the discount window, where assets can be posted for loans to pay back flighty depositors. A second "sleep-well" governmental safety net was introduced in 1933 in the form of deposit insurance, in which the federal government insures that deposits - up to a point - will always trade at 100% of their nominal sum, regardless of how foolish bankers may be on the other side of their balance sheets.
The fact is that there is no use getting all ideological at the current time about keeping banks private, because they never really have been. What is understandable is that countries don't want to record their national banks liabilities "on balance sheet" - but these banks are, and since the early part of last century have been, contingent liabilities of governments and their taxpayers.
Ideas of nationalization, or the creation of "bad banks" by state bodies and various derivations of these, are methods that are being discussed to address the current shortage of capital in the worlds banking system. In and of their name, none of these solutions are necessarily trump cards - the devil is really going to be in the detail of any solution's structure. The solution we want is one where investment decisions are driven by economic value rather than political dictat, but at the same time capital formation has positive spillovers so there is good justification for it to be publicly subsidized.
How best to meet those objectives is a structural rather than an ideological question - yet many commentators seem to get caught up in standing firm on one solution over another for purely ideological reasons. I think many of them are missing the point.
Over the course of the past couple of months this debate has taken center stage in various countries. Currently it’s at the forefront of economic and political debate in Ireland, where banking woes have left the six main domestic lenders effectively insolvent in all but name. Badly timed or simply ill-judged loans to property developers are hung on balance sheets like bad smells, with limited deodorant available to minimize the odour. As the marketability of these loans has fallen so has the capital adequacy of each of the banks. It’s estimated that there are EUR 90bn worth of problem loans, which are virtually unmarketable at any realistic pricing levels. If these loans were written down by 50%, which is a potentially optimistic market clearing level, then the EUR 45bn hit would be equivalent to twice the core equity base of the main six banks. On these terms the banks are comfortably insolvent – so in a legal sense should not be trading at all. Understandably, private sector investment in the banks is fairly hard to come by currently without some form of very explicit government support or intervention.
The current ‘golden’ solution in Ireland is a form of “bad bank”, to be managed by a new government organization called NAMA (National Asset Management Agency). Their job will be to take these unmarketable loans off the balance sheets of the banks in a sort of mother-of-all exorcisms. The idea being that once these assets are transferred into this new institution, that the "clean" books of the main banks will engender confidence from global creditors and international credit will start to flow back into the Irish banks. In turn this credit will be passed on to domestic based enterprises, which will refuel the core of the Irish economic system. So far, so easy.
As with similar attempted "bad bank" solutions being proposed in the US, and elsewhere, the big question that is at the crux of matters, is what price the assets should be sold from the banks to NAMA. The price needs to ensure that banks capital isn't eroded so much that the government has to take them over fully anyway, or that the price isn't too high such that the taxpayer is being completely stiffed. The price also needs to reflect an acceptable compromise between protecting stakeholders from oblivion and ensuring that they are sufficiently whacked for their past involvement in the excessive risky undertakings of the banks they have been stakeholders in. Shareholders in the banks, for example, deserve to lose everything on the basis of expected write-downs on their loans, and if they don’t then how will the appropriate lesson be learned? On the flipside, if the approach is so penal that private sector investors are turned away from investing in Irish banks for good then that may be a consequence that has no long-term benefit to anyone. Similarly if Irish pensioners with AIB or Bank of Ireland shares are completely written off, then what does that say about the encouragement government has given them to save for retirement in this way in the past? What is clear though is that no solution will be known to be perfect in advance, nor is there a perfect solution for all. Furthermore, the commentators who argue so confidently about the merits of one solution over are deluded in their confidence as these truly are unchartered waters.
The local stockbrokers, Davy’s, said that it expected the banks to take a 15%, or EUR 13.5bn, haircut on the loans being transferred. This conservative estimate would still result in a hit to the main lenders capital that would be comfortably more than their entire stock market valuations at this point in time – so come what may, they will probably need more capital, which will most likely come from the Irish government.
What complicates the whole process is the lack of clarity that any solution will produce a good long-term outcome. Nobody has any experience in dealing with a situation like this, and there are few historical contexts to be learned from. Amidst the confusion there are some stakeholders keen to use this muddlement to their own advantage by confidently asserting the merits or demerits of one solution over another. The well-known Irish financier, Dermot Desmond, for example, has said that he opposes the State taking control of the banks' risky property loans through NAMA under the current plan. He has recently acquired substantial stakes in both Allied Irish Bank and Bank of Ireland - the two biggest domestic banks - and has commented that he could not support an entity "where it's impossible to value the assets". This begs the question as to why he bought the stakes in BOI and AIB in the first place - as if the assets are impossible to value, how did he know what he was buying when he made his investments?
His suggestion is that instead of transferring the assets, they should remain on the books of the banks: "Let's just park it and freeze everything, without gain or loss to anybody, until we know there is a market and then determine what the write-offs are". What he really wants, reading between the lines, is that the "bad" and extremely illiquid assets sit on the banks books and to be rollover financed by the government. The logic being that the current illiquidity of the market has meant that most of these assets are marked down to very low prices, potentially well below a future realizable value. To give an example - a loan to a property developer that is backed by a half built housing estate in Cavan has no current value, because with the developer bankrupt and no new equity available there is no scope for the project to be completed. Consequently the current mark-to-market of the loan if not at zero, will not be much above zero. In theory though, if new equity becomes available and the project is completed the "realizable value" of the bank loan will be higher than zero - to what extent depending on the terms of the restructuring of the loan.
At current mark-to-markets, the transfer prices of the assets in question would literally wipe out the entire capital bases of all the major 6 banks, and in doing so would clear out Desmond's equity investment with it. The game Desmond is playing, is based on the idea that over time as some order is restored to the global credit markets, that the capacity for banks to hold onto their impaired assets and to "work them out" will increase - in the case above, to find a property developer who is willing to take on the completion of the Cavan housing estate. That is currently a luxury of time that the banks don't have. The chances are that in the work-out process the upside versus where these assets are currently marked to market will be positive for the banks equity holders - of which Desmond would be a principle beneficiary. In effect Desmond is advocating the old situation where the government and their taxpayers perform the role of backstop financier, but with all the downside of the banks bad loans, and none of the upside - which would be retained by Desmond and the other shareholders. Hardly a move away from the skewed incentives of the old style banking model that was the foundation of the current mess.
On the flipside, if assets are transferred to NAMA at reasonable prices, and if NAMA is well run then there could be a very decent return on the government's and the taxpayers investment. These are very big 'ifs'. For example - in order to restructure and to "work out" these loans NAMA would require very bright and very commercially minded employees - who will likely cost quite a lot to hire. Hiring at big expense, however, is likely to be completely politically unpalatable amidst the current banker bashing in the Irish media.
The ideal outcome for any solution is one where the economic incentives for both taxpayers who have implicitly supported of the banking system in the past (and who are currently very explicitly supporting it) and those private sector stakeholders, who own the "upside" of banking endeavour, are fairly skewed. To me, this is an almost impossible task as there are so many potential conflicts of interest. Nonetheless, there are merits to many of the solutions that are being proposed around the world, but the effectiveness of any of these solutions over the long-term will be down to the minute detail of their agreement. What's abundantly clear, though, is that the confidence with which many commentators argue the ideological merits of the different solutions is misguided. It's not possible to be so confident about the long-term implications of something so complicated - which when the electorate want immediate answers to why we are where we are, makes things ever harder. May the force be with the decision makers.
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