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.

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.

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.

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.

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.