Tuesday, March 31, 2009

Submission to the FDIC on the Legacy Loan Program

The FDIC has called requested submissions as to how the Legacy Loan Program should be run.

You can find the request here.

Given that we are publicly minded people with some expertise you can find our submission here.  

It should later be posted to the FDIC website.  At least it will if the FDIC keeps its promises.

The concerns I detail are the same as outlined on this blog - particularly conflict of interest, the appropriate degree of leverage and the continuance of Sheila Bair in her current position.

Read only if you are into boring government documnents.

I do however have lots of opinionated readers.  Give them good submissions.  It can't hurt.


John

Monday, March 30, 2009

Covering the Ricks short

Several months ago I put a short on Rick’s Cabaret – a listed strip club owner with a private jet.  The code of ethics covered use of the private jet.

I wondered what executives of a listed jiggly joint could do with a private jet that breaches their (rather narrowly written) code of ethics.  (The original post is here.)  

Anyway Ricks still looks like it will fail due to unrefinanceable debt – but the stock has been hammered and I covered recently.  

Not worth mentioning because the position was so small as to be for comedy value only.  [Also might make a visit tax deductible!  Stock research of course…  Just kidding – I never went.]

The old saying about Wall Street is that when the tide goes out you see who is swimming naked.  Nobody much swims in New York any more.  But boy do they dance.

Now the News Corp "Paper of Record" (The New York Post) reports former Wall Street analysts are jiggling at Ricks.  (See Axed Gals take Pole Positions.)  

Slogan for the 21st Century: When the tide goes out you get to see who is dancing naked.  

Come to think of it - not a great slogan.  Can you imagine what Sandy Weill or Dick Fuld look like?  



John

Also - before Wall Street gets high-and-mighty about this - the former Wall Street Analyst notes that the strip joint is run better than her former Wall Street firm (Morgan Stanley) and that the level of sexual harrassment is lower.  

Wall Street has much to be ashamed of - and not all of it is financial.  


Two days later this was added:

PPS.  It appears the New York Post story was false.  I was inclined to believe it because I am naturally short RICKS and the story was positive for Ricks.  

General rule as a stock picker: take seriously stories that are against your position - and not seriously stories that are in favour of your position.

General rule as a blogger or journo.  Believe nothing.

My bad.

PPPS:  I still think that Ricks can't refinance its debt.  But at this market cap I am not interested in staying short.  Ricks will go to zero though.

Saturday, March 28, 2009

Sheila Bair is either a criminal or a grotesquely incompetent stark raving idiot

It is no secret that I do not like Sheila Bair.  My original reason for dislike was posted here.

But now she is open to deliberately allowing massive fraud against US Taxpayers.

There is a serious conflict of interest problem with the Geithner Plan.  These problems were first outlined by Steve Waldman in his “dark thoughts” post.  I noted that the application terms for the Geithner funds seem guaranteed to maximise conflict of interest.

In short – if you have a small interest in a fund (kindly levered to be large by the US taxpayer) and a big interest in a bank you have a massive incentive to overpay for the assets purchased from the bank sticking the losses to taxpayers and thus increasing the value of your bank holdings.

The defence of course is to have strict separation between the banks selling the assets and the Geithner Funds buying the assets.  Arms length separation is thus a basic and minimal requirement of the Geithner Plan.

However Sheila Bair is now open to letting banks selling assets participate in the Geithner funds.  This was reported in the WSJhat tip to Clusterstock.

I guess Sheila Bair can’t see a conflict of interest – only a “convergence of interest”.

However designing the plan to maximise theft is designing the plan to fail.  This is American politics – and rampant deliberate tampering with government procurement (ie criminality) is a possibility – but in Sheila Bair’s case I see only incompetence.

I am naturally attracted the Geithner plan.  I have stated that many times – but now I am plain sickened.  Sheila Bair should be removed from office if the Obama administration is to have any chance of succeeding.  This statement potentially maximising conflict of interest – and the possibility that criminal fraud is the driver – should be enough to impeach her.  Her defence – and in her case it is a solid defence – is incompetence.  And that determines the right outcome.  She should resign.  

Monetary union and banks - some thoughts

The biggest – and most consistent criticism that my last post received is that the national champions in Europe (particularly the Netherlands) are in deep trouble.

I was very careful describing how HSBC Hong Kong should be capitalised (separately and with very large – even 100% - capital charges for cross border funding).  If this had been done in the Netherlands there would be no trouble.  Even the Icelandic banks would have survived in Iceland - though their UK subsidiaries would be worm food.

The problem is that cross border funding by leveraged institutions is dangerous.  It almost caused Citibank to fail in the early 1990s.  It was a key part of the bank collapse in Korea.  In this cycle it was key in the Dutch banks, in Sweden as I wrote about here.  It was also key in Norway and Sweden during their famous bank collapse (here).

Monetary union and currency zones are famously dangerous for banks.  

But more to the point - banks intermediate current account deficits - and that can make country problems contagious.  

This leads to a question on which I express only a weak view.  In some sense the issue in America this time is also monetary union.  Because of the peg there is a sort of monetary union between China and the United States.  It was the supply of Chinese savings that – as much as anything – powered this boom. 

My question?  Is there a safe way of recycling all of those offshore dollars held in China and oil exporting countries?  If there is not then the value of having the reserve currency is massively overstated.


John

Friday, March 27, 2009

The case for letting bankers rip us off

In the last post I proposed the radical – but disagreeable – proposition that the right way to regulate banks is to allow them to rip us all off.

I didn't expect any support – but surprisingly I got some.  At least one commentator noted – as I would – that the only thing worse than bankers making outrageous profits is bankers not making outrageous profits.    

Several Canadians saw their banking system (bureaucratic, dull, profitable and stable) more or less as I saw the Australian system.  

In general – and one commentator actually raised this – I was suggesting we go back to a 3-6-3 banking world – where a banker took deposits at 3 percent, made loans at 6 percent and hit the golf course by 3 pm.   That was a fair summary except that maybe I lean towards a 3-7-3 system.  

Hong Kong was also raised.  Hong Kong had a formalized 3-7-3 system – where the bankers knocked off early every day except Friday.  On Fridays they went to the office of the governor of the currency board and set interest rates for next week.  A truly cozy oligopoly.

The wealth from the great Hong Kong oligopoly is what allowed HSBC to become “the world's local bank” (and America's stand-over merchant).

Of course semi-socialist banking completely killed all Hong Kong entrepreneurship and turned Hong Kong into the poor colonial trash of Asia.  

Ahem – actually it wasn't all that destructive.  

But the Hong Kong example gives the next clue in how a post-crisis banking system should be regulated.  If the Hong Kong subsidiary of HSBC – the extraordinary money machine – is separately capitalized then it will be bailed out.  But if the Hong Kong monies are all lent to the much larger US Subprime market then – hey – it could still fail.

So what you need to do if you are Hong Kong is insist that the Hong Kong subsidiary is a separately capitalized subsidiary and cannot inject money into any other HSBC subsidiary without a 100% capital charge.  The result would be that it would not matter whether the rest of the HSBC went to pot – the Hong Kong subsidiary – and hence Hong Kong – would be fine.  Even if it were insolvent it would be worth someone's while to recapitalize it.  HSBC Hong Kong was of course a goose laying golden eggs.

Some thought that Australia (and presumably Canada) were OK because of the commodity booms.  Sorry – no dice.  If you haven't noticed the commodity boom is over you are not watching the distress coming out of Western Australia.  

One objection to having really large banks (often expressed by Simon Johnson) is that really large banks are good at regulatory capture and that is a bad thing.  But I advocate much higher profitability for banks.  Regulatory capture is to be encouraged so long as it allows the banks – in the manner of a utility – to apply too much capital for reasonable incremental returns.  Regulatory capture in my view is a good thing.

Actually the only real objection I got was the one I expected which was the notion that Fannie and Freddie were my too-profitable-to-fail government mandated oligopoly and provided a counter-example.  Even that notion is garbage.  The peak profit net income of Fannie Mae was about 7 billion dollars – and it was typically in the 4-6 billion range.  The peak net income of Freddie Mac was about 10 billion but it was typically in the 3-4 billion range.  In almost every year the combined profit was under 10 billion.  And for that they took credit risk on over 5 trillion of mortgages.  They earned – at best – 20bps post tax on all risks they took.  The pre-tax fee for taking credit losses was typically about 20bps.  

The thing about Fannie and Freddie was that they were staggeringly unprofitable.  If Fannie and Freddie had earned even half a percent total credit exposure then they would have been so profitable that they would not have failed now.  

The problem with Fannie and Freddie is that they didn't convince regulators to increase their profit enough.  Very sad – but for all their legendary prowess lobbying they just failed miserably to score.  By the end they had regulators who were ideological warriors against their existence – a measure of their total lobbying failure.  What we needed was regulators who were far more captured by Fannie and Freddie.

The shadow banking system as the real competitor

The real problem with Fannie Mae – and with American and English banking – was that the shadow banking system became huge and a devastatingly effective competitor.  The shadow banking system shook margins to very low levels – so low that even Fannie and Freddie – with the seemingly overwhelming advantage of their quasi-government status – could barely eek out a profit.  

And no amount of lobbying – no matter how competent – could undo the huge competitive threat that Fannie and Freddie were under.  Fannie and Freddie's lobbying effort just wasn't up to it because the task was too hard.  The financial engineers who dreamed up the shadow banking system were just too clever.

The Pandora's box of financial innovation

And herein is the ultimate problem – that some of my commentators picked up on.  That is that the real driver of low margins in banking was the shadow banking system.  The highly paid people were the brokers and traders and hedge fund managers who made all that work.

And at the moment the shadow banking system is in ruins – and as a result pre-tax, pre-provision pre-trading loss  profitability of banks (or for that matter Fannie and Freddie) is rising sharply.  And we are getting to the sort of world I envisage, that of fat lazy banks with “lazy balance sheets” who have completely captured their regulators.

But unfortunately markets don't look like that.  Pandora can't put financial innovation back in its box – and when this crisis is over the shadow banking system will re-emerge to crush margins again.  

Of course we can stop it.  All those high-power, high-paid traders and brokers who are central to the shadow banking system should eventually be fired.  They are not necessary in my hoped for 3-7-3 world.  And they caused all the problems anyway.  Firing them now should be done so long as it does not exacerbate the current crisis.

And when the competition is gone even Fannie and Freddie can double or triple their margins – and even they will wind up costing taxpayers very little.  

Alas consumers will pay for the mistakes of the past – interest spreads (and hence rates paid by consumers) will be higher and that “tax” is what  recapitalizes our system and keep us out of future messes.  In first instance it is not good for consumers.

But it is not clear that consumers really benefited in the end from hyper low mortgage rates.  They just seemed to get capitalized into the value of houses – and that was part of the creation of our current predicament.  

Let me end with some stylised facts

This little rant of mine is contrary to the received wisdom both of my training (economics) and of the world we live in.  

But I digress.  

Economics is meant to be a science based on observation – but more often than not degenerates into an ideological slanging match.  Here are a few observations:

  • Highly regulated – indeed price fixed – banking did not visibly hinder economic growth in Hong Kong.
  • Highly indebted countries with highly oligopolistic banking systems and quite a lot of financial regulation are doing relatively well at the moment – see Australia, Canada, possibly Israel.  
  • Fannie and Freddie may have made huge and seemingly formidable lobbying efforts – but those lobbying efforts failed miserably – with Fannie and Freddie combined profits never going about $10 billion for carrying about half of all mortgages in the United States.  This number seems large but is trivial relative to the size of the exposure or the stated profits of competitors.  
  • The collapse of mortgage margins in the UK simply resulted in banks maintaining returns on equity by increasing leverage.  Bank profits did not fall – but bank risk – and system risk 

Some of these facts are uncomfortable because the facts do not fit my off-the-cuff economist's reaction.  They don't fit my usual presumption that markets and deregulation are mostly good.  And they argue that we are better off with nasty bureaucratic Australian banks than most the alternatives.  

But – to paraphrase Keynes – when the facts are inconsistent with my theory I change my mind.  What do you do sir?




John

Thursday, March 26, 2009

Watch those baskets: Why Citigroup should be allowed to merge with Wells Fargo

There is a lot of woolly thinking about the right way to regulate banks post this crisis.  The consensus is that banks should never again be allowed to grow to be “too big to fail”.  The right banking system is one in which there are hundreds of banks – all sufficiently small that their failure does not cause systemic problems.  The argument is that Citigroup or Bank of America or whatever is bailed out as soon as it clearly returns to solvency it should be broken up.  

Indeed one of the cases cited for nationalisation is that it is much easier to break the banks up under government ownership than it is when there are private shareholders.

I think this consensus is absolutely cock-eyed wrong – and that the list of the blogging intellegentsia who are wrong on this covers pretty well every big-name economic pundit out there.

The division of American banking into thousands of banks did not help during the 1930s.

More bluntly I think the US should end this crisis with substantially fewer banks – which because they have a high degree of market power should be highly profitable.  The high level of profitability will

(a).  Reduce the incentive for banks to take excessive risks (if you have a goose that lays golden eggs it does not make sense to risk killing that goose), and

(b).  Increases the chance that the banks can work through any problems that they do have (because the underlying franchise will generate enough profit to fill any holes).

The strategy I advocate is to put your financial system eggs in relatively few baskets and to watch those baskets.

The experience of bank collapses

I have spent a bit of time looking at how banks collapse in countries other than the US.  The model I have in head is Taiwan.  Taiwan until relatively recently had about 50 banks.  This is in an economy about the size of a mid-ranking US State.  

The banks were highly competitive and margins were sickly thin.  Bank management respond to the high margins by increasing risk.  Its kind of odd but banks in highly non-competitive markets (eg Australia) have returns on equity of about 18 percent.  Banks in highly competitive markets seem to have equity returns of about 16 percent.  The difference is that in highly competitive markets the banks take more risk to get 16% and they tend to blow up with monotonous regularity.  A blow-up in Taiwan causing something looking like a local recession happens more than once a decade.

Every blow up results in the reduction of the number of banks.  As this happens the level of competition goes down and the profitability goes up.  At the end you wind up with a banking system like Australia – which has four super-profitable banks.  These four banks can survive almost anything because the pre-tax, pre-provision operating profit is so huge.  In Australia and New Zealand the numbers are almost 5 percent of GDP.

I know what I am doing is turning standard economic dogma (particularly amongst conservatives) on its head here.  The standard dogma (questioned by some with financial services) is that competition is almost everywhere a good thing.  But I would have the other view.  My view is that competition in financial services causes massive financial crises.
Much more instructive – and much more familiar to my English speaking readership is the UK recent experience.  The UK banking system was changed by massive competition in mortgages.  UK mortgage margins went to 40bps.  This was extraordinarily low and it was devastating to the UK banking system.  Various banks responded differently to it – Northern Rock levered its mortgage book about 60 times – and then very small changes in spread and credit blew it up (see my old notes here).  HBOS did similarly.  Royal Bank of Scotland bought everything that moved and also levered itself up.  Barclays decided to become one of the world's biggest investment banks.  The problems of the UK banking market were caused by too much competition compressing margins.  

Ditto – the problems in American finance were caused by massive competition from the new (and huge) shadow banking system.  You had mortgage companies spring from nowhere – and start originating huge quantities of mortgages.  Companies like Countrywide – which had very little capital indeed – could originate literally over a trillion dollars in mortgages.  

The financial innovation spread from personal to corporate finance – with all sorts of bizarre credit securitisations.  All of these things reduced margins.  The banks responded to reduced margins not by accepting reduced profit (something that in retrospect would have been the right course of action) but by increasing their risk profile (and hence profitability).  

It was the competition that caused things to blow up.

The counterfactual is Australia.  Australia is very similar to America – except that the consumer was even more in debt.  Our credit card industry was bigger (relative to GDP) as were our mortgages.  Our car loans were substantially lower.  But the consumer here was also fairly close to hocked out.  

However our banks are solvent.  There is only a remote chance that they will become insolvent despite a property boom that makes America's look modest.  They are solvent despite not being well run.  Indeed they are famously bureaucratic and inept.  I once worked for one after having worked for the government.  I can assure you the government department I worked for was far more competently run.  

The banks survive because they are just so profitable.  They are profitable despite being in an economy that should be sour (from indebtedness).  

What I am advocating is – that as a matter of policy – you should deliberately give up competition in financial services – and that you should do this by hide-bound regulation and by deliberately inducing financial service firms to merge to create stronger, larger and (most importantly) more anti-competitive entities.

The last thing you want to do is break up Citigroup.  It would be far better if it merged with Wells Fargo.

What does a post-competition banking system look like?

First the banks are going to be huge.  

They will lay enormous golden eggs for their shareholders.  I hope to be one!

These golden eggs will give the shareholders very strong incentive to act to preserve the banks.  Bob Dylan howled out that “when you got nothing you got nothing to lose”.  Like much of Bob Dylan it is the truth.  And the solution is to make sure the shareholders have something really good – so they have something to lose.

Because the goose lays golden eggs its management should be conservative.  Of course there will be agency problems – with management with incentives to lever up the golden egg laying goose as they will (via cashing their options) have a big part of the golden egg laying goose when it works – and if it doesn't work then the shareholders own the carcase.  So there will need to be corporate reform in such a way that shareholders can better protect their investment from managers.  (Carl Icahn's blog has plenty of worthwhile suggestions.)  

And – as a backstop there should be regulation – and the regulation should be stiffling.  It should limit competition and increase bank profitability.  Captured by the interests of shareholders (but maybe not management) is not a bad place for the regulator to be.

In the end I want this to look like a regulated utility.  Highly profitable and dull as dishwater.  The salaries should also look like a regulated utility (above average – but nothing special).  

The losses from my anti-competitive stance

The first and obvious loss is a generally higher cost of financial services as competition is constrained.  Essentially the anti-competitive strategy will reverse the benefit of cheap and widely available financial services created by the last two decades of financial innovation.  Such is life – that is what the credit crisis is doing – and the benefits of that have been overstated anyway.

The second loss is far more important – you lose the driver of financial innovation.  Competition isn't great because it lowers prices (although it does).  Competition is great because it rewards innovation – and allows companies or individuals who do innovative (usually better) things to thrive and grow.  Companies that don't innovate eventually wither.  This is the “creative destruction” of competition – and it is the greatest driver of capitalism.

Well the last decade and half has rewarded financial innovation above other forms of innovation.  The best and the brightest (and many of them really are very smart) have headed towards the financial sector because that is where the money is.  The best and the brightest do not (with the exception of my business partner*) leave university to join an electricity utility. 

If we remove competition in financial services we remove that chimera called financial innovation.  I argue that is a small loss.  Financial innovation is a chimera because it rewards individuals but creates massive societal risks (as this crisis demonstrates).  Real economy innovation is what drove income and wealth up throughout the 20th Century – and at the moment the failure of financial innovation is stifling real economy innovation through stifling the economy.  My strategy – four to six deliberately anti-competitive banks – is the death knell to financial engineering – and will sharply reduce the salaries of people in that business.  It is bad for New York but it will free the best-and-brightest to do something ultimately more important. 

A call for debate

This is a debate which it is important we have – because almost everybody (outside Australia) thinks differently to me.  That doesn't mean that I am wrong.  I come from a country that has been well served by its four banks – even though they are grotesquely incompetent and bureaucratic.  




John


*The business partner did wind up as CEO of the utility.

Wednesday, March 25, 2009

Why the Countrywide guys should be allowed to get mega-rich

Pimco is a bond management firm which has come through this crisis almost unscathed.  The monthly letters from Pimco are amongst the few must-reads of Wall Street.  I have no reason to believe that Pimco has ever acted with anything but integrity.

A few days ago I posted about cumulative loss data at Fannie Mae and Freddie Mac.  I pointed out that Fannie's credit on qualifying mortgages was consistently worse than Freddie's and asked for comments.  One comment suggested – and I have since confirmed – that the main difference was that Countrywide largely originated for Fannie – and was Fannie's largest source of loans.

Given that they used the same sort of computer data as everyone else it is likely that they were at best aggressive in how they confirmed mortgagee income and employment.  Its a culture thing. 

And given that the losses at Fannie and Freddie now appear to belong to the US Government these guys were not nice to taxpayers.

The guys from Countrywide have started a new firm – Penny Mac – which will deal in scratch-and-dint mortgages.  They clearly have some experience in the area.  The New York times wrote a story which was – at least editorially – a little sickened by how guys that manage to cause the crisis are now profiting from it.  The tone rings politically true.

The terms for the Geithner funds were written so that Pimco could (almost certainly) run one of the funds.  Indeed the terms appear to be written in a way as to maximise conflicts of interest.  This is a problem – because say $10 billion that Pimco puts up will give Pimco power to buy maybe $200 billion in bonds.

Pimco owns a lot of debt of large banks.  If they were to use that $200 billion for say $80 billion of overpayment as suggested by Steve Waldman then they could make good their huge holdings of bank debt.  They are conflicted.  The conflict is large.

By contrast if the Countrywide guys are to put in the bulk of their personal fortunes they are not conflicted.  (It would be almost everything they had – and they have no other remaining interests.)

The treasury should refuse Pimco's application and accept Penny Mac's if Penny Mac makes a decent submission.

Its an outcome that politically stinks.  It will deliver a fortune to the Countrywide guys.  It will sure play badly in the New York times.

But agency problems are at the core of how we got into this crisis – whether it be mortgage brokers with an incentive to say one thing and do another or whether it is traders who got paid huge bonuses when they lied about their mark-to-market profits or rating agencies who were paid by issuers of dodgy debt..

The Treasury should be writing the criteria to minimise agency problems – and instead they have written them to maximise agency problems.

This is not good.


John

Tuesday, March 24, 2009

The biggest problem with the Geithner plan

Is that the banks choose which assets to sell to the fund.

It allows selective price discovery on assets where the company taking the test selects the questions.

That doesn't prove anything except that banks taking self assessed exams for which the penalty is death tend to pass.

At least some assets should be put to auction either randomly selected or selected by the FDIC.  The bank doesn't need to take the price bid - but a price should be recorded.

Steve Waldman's dark musings

Steve Waldman (interfluidity) is my all time favourite blogger.  

We disagree on a lot - but his is the only blog I have ever back read every article on.  I really like smart people I disagree with.

Today he has some (very) dark musings about the Geithner plan.   His musing is that conflicts of interest could render the Geithner funds liable to massive fraud.

I agree.  

I remember chatting to a journalist about the Geithner plan and I suggested that one of the big problems is that almost everyone is conflicted – and conflict-of-interest with that much government participation poses a very serious fraud risk.  

The solution of course is to find non-conflicted funds.  

May I suggest – and I am only half joking here – Bronte Capital. 

The only problem is that the criteria for eligibility specifically include only those with a conflict of interest.  Here they are:

Fund Managers will be pre-qualified based upon criteria that are anticipated to include:

• Demonstrated capacity to raise at least $500 million of private capital.

• Demonstrated experience investing in Eligible Assets, including through performance track records.

• A minimum of $10 billion (market value) of Eligible Assets currently under management.

• Demonstrated operational capacity to manage the Funds in a manner consistent with Treasury’s stated Investment Objective while also protecting taxpayers.

• Headquarters in the United States.

Given that we are start-up we fail the first, second, third, fourth criteria.  We are Australian and we fail the fifth criteria.

Now did I once say something positive about the Geithner plan?

Actually I have too much integrity to withdraw that – but the dark musings are to be taken seriously - and indeed the criteria described above are precisely the criteria you would pick if you want conflicted people to rip off the taxpayer.



John

Felix Salmon misrepresents me...

Felix Salmon mischaracterises my views… 

In particular he says

The status quo, absent any Treasury proposal, is basically the Hempton plan: let profitable-but-insolvent banks work their way slowly back to solvency by making large operating profits and not paying dividends. But the problem with the Hempton plan is that it only works on a kind of don't-ask-don't-tell basis: the banks can't be publicly insolvent, since then they need to be taken over by the government.

No.  My view is that we should have nationalisation after DUE PROCESS.  My view is that very few things will be nationalised – but I could be wrong.

What I like about the Geithner plan is that it provides PRICE DISCOVERY.

The price discovery gives regulators a process for marking the banks' books.  The bank “stress test” is no longer a “self assessed exam in which the punishment for failure is death” but an externally assessed exam, assessed by (admittedly subsidized) private money.

Once you have the true bank capital position determined you can allow the banks with adequate capital to muddle through (possibly with government liquidity support) and force the insolvent banks to raise capital.  If they can’t raise the capital you nationalise them.

As the exam is now objective – not self assessed – a lower capital standard (say a third normal) should be allowed.  High capital standards are really required in part because banks lie.  If they can’t lie a lower standard should be acceptable.  Moreover you suspend dividends whilst they muddle through.

Now the Geithner plan – done on a larger scale – can also support another policy objective.  If a bank comes to the Treasury and says “we are illiquid – help” the Treasury can now say “sell some assets”.  The bank cannot any longer claim there is no market for those assets – they can sell them to the Geithner plan fund(s).  

When they are forced to sell them the difference between illiquidity and insolvency will become clear.  If the assets sell near their book value then the bank really is just illiquid.  If large haircuts are required the bank is insolvent.  The government response can be dictated by a market price.

I never advocated that muddle through is the right policy.  I just happen to think that muddle through will work for most banks because most banks are not that insolvent.

But – after this process – I could be found to be wrong.  Very wrong.

And we will have nationalisations.  And they will not appear as theft because markets determined who was solvent and who was not.



John

The Treasury held a blogger's conference call...

Apparently the Treasury held a blogger conference call yesterday.  


My readership is large enough - and my blog is on-topic.

I am even modestly supportive.

Can I have an invite next time?  

Please.

Monday, March 23, 2009

Keener body surfers than me

This guy - Gordon Hempton - is a second or third cousin.  


He is also a Grammy award winner for his nature sound recordings - but otherwise makes a living recording sounds for computer games.  You have almost certainly heard his recordings in some Microsoft game or other...

I went to visit him outside Seattle and he looks like me too.

Anyway - I am a keen body surfer.  But not as keen as this.  When you have to clear the snow in front of your van to take you to the beach you know that you will not be rescuing a hapless Japanese tourist.


J


Brad deLong joins me!

He posts that he thinks Paul Krugman is wrong.

And his nervousness about that statement matches mine...

He notes that if the past decade has taught [him] anything, it has taught [him] that mistakes are avoided if you follow two rules:
  1. Remember that Paul Krugman is right.
  2. If your analysis leads you to conclude that Paul Krugman is wrong, refer to rule #1.
I have a similar view of the quality of Paul Krugman - and I am equally nervous saying he is wrong.

Nonetheless I formed the view that he was mistaken about five or six weeks ago...  and posted it here and here and here and here and here and here and in a few other places.  

I asked Paul Krugman for an email - because I am sure we could identify where we differ very accurately with an email exchange.  No such luck.  

Please Paul...


John

Geithner's part plan

Henry Blodget has noted that I do not think that the Geithner plan is a bad idea.

That is I do not think it is a bad idea to lend money to hedge funds at low rates to buy dodgy bank assets.

I do not love the idea.  I just think it is better than any of the alternatives.  I do require a good level of private capital before I am happy with it.

Henry Blodget publishes an objection to my plan which I quote:

Hempton's point is well taken.  As he comments to one of his readers, "If I set up a new bank and borrow with brokered deposits I can lever 12 times non-recourse. If I win I keep the profit. If I lose the FDIC pays the losses. ... Geithner lends the money to the special purpose fund. Not against the pool of purchased assets - but with private capital pitched in. Sounds like banking to me."  So Hempton objects to what he sees as Krugman's inconsistency.

But Hempton's analogy isn't quite right.  Krugman wants big banks nationalized, giving taxpayers the equity upside.  The Geithner plan is at best an inefficient way of bolstering bank capital because some of the taxpayer funds go not to bank capital, but to bank shareholders and hedge funds.

However, Henry Blodget’s objector – and most other people are forgetting the second part of my plan – detailed in the long post and elsewhwere on this blog.

I want the regulators to come into the banks and say – now you have a ready – if somewhat subsidized market for your assets then it is no longer tenable for you to say that the market price for them is unrealistic.

This asset that you have marked at 95% of par.  We want you to sell some of it (or a part interest in it or similar.)  If you get 75% of par – then we want you to mark your book to 75.  

If – given a real market for bank assets – you are shown to be capital inadequate then you should have time (say 6 weeks) to raise private capital.  Failing that your bank becomes government property.

The objection detailed in the Blodget post is still right – which is that this plan is better for shareholders than outright nationalisation of banks without a process to determine who is capital adequate. 

Nationalisation without process – which appears to be the alternative – is a dagger to the heart of capitalism.  

Tell me a process that will have banks and regulators with adequate external parties indisputably saying to bank management “this asset should be marked at 75 and you have it marked 95” then I will listen.  Until then the objectors to the Geithner Plan are left saying “nationalise now”, but without an answer to the nasty question of which banks to nationalise.  And do not say the stress tests are adequate - because they are a joke.

It is of course open for the Federal Government to follow a process that will scare liquidity away from the banking sector and result in everything being nationalised.  So far that is the only real alternative I see to a more complete version of the Geithner plan.  It is of course also open for the Government to guarantee everything and get no upside – but that is a really bad non-plan.


John

Saturday, March 21, 2009

Weekend edition: racial profiling at the beach

Regular readers will know that I double as a surf lifesaver at Bronte Beach.  I was on patrol today.

It was relatively calm, warm without being hot and 21 centigrade (70 Fahrenheit in the water).

Bliss.

The patrol captain (Johnson) wandered by – said you should keep an eye on (he points) those three guys… then shouts “I am going in”.

I went in after him.

Two of the three made it back to the sandbar but the third guy – a Japanese tourist was pretty close to drowning.  Johnson was holding him up – but it was tough.  The extra person made it easier.  We waived to the shore for more assistance (a board) and with some effort we got our victim onto the board.  Five minutes later (and after I had swum in against the rip) he told me we saved his life.  I confirmed we knew that.

Like most people rescued he disappeared pretty quickly – I suspect a mixture of shock and embarrassment.  

How did Johnson know?  Well the victim was Japanese and pretty clearly a tourist.  Maybe it was racial profiling – but there are a fair few Asian Australians.  Maybe it was just fashion profiling (the tourists dress differently).  But Johnson was watching from before the victim got in the water.

Racial profiling is a large part of how surf lifesavers operate.  It is hard to see the struggling swimmer when there are 300 people in the water.  Much better to identify "customers" in advance.

Many of our “customers” fit clichés – pasty English of both sexes*, drunken Irish men (but seldom their women), militant Germans, strapping men 6 foot tall who say to female lifesaver dressed in baggy figure-hiding clothing** that they are champion swimmers only to reveal they have never swum in the surf by picking the most dangerous part of the beach to swim, Slavic men who see big surf as a test of their machismo, hoards of Asian (especially Japanese) tourists, and Muslims whose modesty means that they often swim in so much clothing that they risk drowning when knocked over by a wave in waist-deep water.  Racial profile here is mostly a short-hand for detecting inexperience in the surf.  Race is fairly well correlated with competence.

Racial profiling doesn’t work at all on a really hot day because then the Australians who go to the beach only once a year (and are as inexperienced as the pasty Poms) get in the water.  They need rescuing too – and we find it hard to tell who they are in advance.  Fortunately on those days the beach is so crowded that other swimmers do most the initial rescue.  Anyway on really hot days the correlation between race and competence breaks down.

I don’t think our Japanese tourist today – safe back in his backpackers’ hostel rather than being shipped back to Japan in a body bag – is unhappy about our racial profiling.  I would prefer a better method for doing this – but frankly we don’t have one.




John

*The pasty English needing rescues include a fair number of younger female backpackers whose idea of an adventure on their holiday is to seduce a Bondi surf lifesaver.  I have seen more than one deliberately get themselves in a position that they needed to be rescued.

**The female lifesaver hiding behind the baggy (sun protective) clothing is an Olympic triathlete and is generally amused at what the German guys think passes for good swimming.   By contrast I know what good swimming looks like - and it is not and never will be something I can do...

PS.  Investmentgardener's comment below - is I think an accurate appraisal of this...

Stereotyping is a method that allows our brain to make split-second decisions based on a 'shortcut' reasoning. It doesn't matter that you're wrong sometimes, as long as you are right when a split-second reaction is needed. Nevertheless the 'shortcut' is not a rational way of reasoning. There is no rational reason why someone who looks like a pasty pom (and very well may be one) would be more likely to drown than his olympic swimmer girlfriend. At least not on an individual level. Stereotyping and generalisations are good, as long as you don't confuse them with reality.

It pays to use stereotypes - especially in split-second decision making like life-saving - and it pays to be absolutely conscious of how wrong they can be when making complex decisions...

Now the goal is to get good at both the split-second and the long-term decision making...

Friday, March 20, 2009

AIG bonuses

Despite all that has happened there are still some good businesses at AIG.  21st Century – an auto insurance company largely based in California is one.

AIG was not fraudulent from top to bottom – and not everyone working there stuffed up the real economy though AIG FP was probably ground zero for bad lending.

I have no idea what the guy who runs 21st century is paid – and I haven’t looked.  But if 21st Century were private – and I controlled it – I would have no problem paying a good guy there 15-20 times average earnings – that is something in the 1-1.5 million range.  Those sums would make the said executive extraordinarily wealthy by the standards of the average American.  If he is good – and I was a shareholder – I would just wear it.  

I might make a fair bit of the salary bonus – and make it contingent on some performance metric – but I would have no problem justifying it.

I would have an awful time justifying paying the guy 50-100 times average.  There is just nothing that the guy could do that would justify that incremental level of salary.  

We have executives paid 30 million a year and executives paid 1.5 million a year and they generate the same level of outrage on Main Street where (compared to say $65000 in household income) both numbers are incomprehensible.  That said – 30 million per annum is enough money that you can’t spend it unless you run multiple houses with servants and fly private jets fractional share.  1.5 million per annum buys you an upper middle class life in Manhattan – or an opulent existence in Los Angeles – but multiple houses with servants are still out of the question.  Private jets are unthinkable.

The bonuses paid at Merrill Lynch were 3.6 billion - 22 times the AIG bonuses.  

They were paid by a firm that would not have survived without a bailout by the US Government through Bank of America.  Moreover they were sometimes large – the 30 million variety – not the 1.5 million variety.

We should be at least 20 times as outraged over the Merrill Lynch bonuses than the AIG bonuses.  But as a society we are not.

And don’t tell me it is because AIG is ultimately public and Merrill Lynch private.  I used to be a retail fund manager – and my end investors included a broad cross-section of society.  The low paid council worker was a part owner of companies where senior staff were paid $20 million per annum.  

I have come to the conclusion a long time ago that most people are ill equipped to handle large numbers.  They can’t see the difference between a billion and a trillion.  This leads to irrationality in bull markets and bear markets.  The irrationality is common amongst rich and poor and across genders and political views.  

There has to be investment opportunities in that.  But also in the eyes-glaze-over aspect of big numbers there are plenty of opportunity for management to loot shareholders entirely.

Tuesday, March 17, 2009

Gold is very expensive

When priced against real assets.  

I know the gold bugs – and there are many of them – compare the amount of gold in existence (160 thousand tonnes being the total ever mined) with the amount of nominal money (including bank deposits etc) in existence.  Gold adds up to $4.7 trillion at $950 per oz – nominal money maybe 60 trillion.

They thus assume that gold must go up.  

I am not going to approach that argument – because much of the cash really is trash (or should be trash after we have got through throwing it out of helicopters).  

What I want to note is the widespread headlines that maybe 50 trillion dollars of nominal wealth has been “wiped out” in this crisis and that something between 150 and 200 trillion remains.  The official figure for the total US household wealth about 51 trillion.  I don't have a number for the whole world – but just under 200 trillion is a reasonable guess in total – the US being just under a quarter of global activity – and having slightly more expensive equity markets than most the rest of the world.

Now does anyone really believe that the store of gold in vaults is worth over 2% of all tangible assets everywhere?  Seriously?    

Gold may be cheap against nominal assets in which case you would be better off holding gold than US Treasuries.  But I can't believe you would be better off holding gold than diversified timberlands or other real assets.  Unless of course the world degenerates into total war and all your timberlands burn down.

I know the gold bugs will hate this idea – because it harks back to the argument against gold – which is that it has no intrinsic value.  We spend a lot of money (and kill a lot of birds with cyanide) to dig gold out of the ground only so we can bury it again with expensive guards on the vault.  

And I am not bullish on nominal assets.  Long Treasuries at very low yields look like a very bad bet to me.  But maybe now is the time for lowly levered real assets.  

Even better is highly levered real assets – but where the debt is very long dated and cannot be called and has no covenants attached.  You get to be long the real assets (good) and short the nominal assets (also good) without the financial crisis risk of being called on the debt (very bad). Candidates for that (rare) category highly desired.




John

Post script - looking at the comments in the email most people are giving me assets where the asset value has not been marked down appropriately (lots of real estate for instance) or where there are problems rolling the debt (most assets).

I am being pretty picky.  I want an asset appropriately priced for NOW as if it were non-leveraged - but with huge leverage and with NO DEBT ROLLS at all.  If it requires a debt roll I am not interested.

Leverage is death if you need to roll it.  But long dated debt that you do not need to roll for 20 years - that is wonderful.  That is effectively short treasuries.  

Monday, March 16, 2009

Fannie versus Freddie credit performance


For a long time I was convinced that Fannie's credit criteria were slightly more stringent than Freddie's.  

It appears I was wrong.

Fannie and Freddie give cumulative default curves in their latest results.  The 2006 pool (which is very bad at both) has 115 points of cumulative default at Freddie and 148 points at Fannie.  The cumulative default curves are pointing to the sky at both companies.

This occurs across almost all vintages.

Is there anyone knowledgeable who can explain to me why the cumulative defaults are so different between companies.



Thanks




John 

Friday, March 13, 2009

Financial chauvinism


There is a lovely comment on the last post accusing me of financial chauvinism – suggesting it is wrong to guarantee all bank liabilities.

This gets to the nub of the issue.

The current US policy is – pretty close to officially – that there should be “no more Lehmans”.  Bernanke said it this week.  Geithner has said similar.  

It is unequivocal that a policy of “no more Lehmans” requires an effective guarantee of all the large US financial institutions.  When one of them threatens to become the next Lehman it needs to be bailed out.  The US government tips $30-300 billion in and gives us a Sunday evening press release – just for me to read in my Asian time zone before our local market opens!

Face it – the current policy is to issue the broad guarantee.  That is what we have done.  That is what “no more Lehmans” means.  It means losses are covered when they are incurred by the taxpayer.

Once we have done that there is no real argument against a non-recourse funded troubled-asset program.  That is just another form of non-recourse funded financial institution.  The argument really is “how much capital should we demand the private sector put in, and on what leverage and confiscation terms?”  It is the same argument for regulation of a bank.

But it is not universally accepted that the right policy is “no more Lehmans”.  Chris Whalen (who I respect) thinks the right model for the dismantling of large financial institutions is Lehman.  As he says the model is easy to determine – just go down to the Southern District of New York and talk to the trustee.

I think the consequences of allowing several uncontrolled large bank failures would be catastrophic – and the cost to the taxpayer of the effective guarantee will be huge (but probably less than a trillion dollars by the end of the cycle) – but lower than the cost of the great-depression event that would follow from a cycle of mega-bank collapses.

In Sweden the right policy was the guarantee – and selective nationalisation – precisely because the cost of the guarantee was not large.  The institutions were not very insolvent.  In Iceland the institutions were so large that the guarantee just was not feasible.

It is however very hard to tell what is insolvent in advance.  Svenska Handelsbank was brimming with solvency and the market wrote it off for dead.  It was a rapid 20 bagger when the crisis ended.  If it were easy to tell how insolvent then there would be no big banks that were rapid 20 bagger stocks when financial crises end.

And it would be easy to tell the right policy.

The most important policy question is whether you issue the blanket Swedish guarantee.  I think the answer is an unequivocal yes in the US – and a probable no in the UK.  Krugman is edging towards a yes as he says in this post.

If it is a yes (open for debate) then the non-recourse finance model for the troubled asset funds does not pose any further problem.

The facts on the ground are that the policy is a de-facto guarantee – as officials regularly say that there will be “no more Lehmans”.

Krugman’s current position (probable yes on the Swedish position, blanket opposition to new capital on a non-recourse basis) is untenable.




John


PS.  I have stated before - and it is reiterated in the comments

The problem with the ad-hoc guarantee is that nobody really thinks that it is a guarantee – and the generalised wholesale run on financial institutions will continue until they are sure. In other words we are effectively guaranteeing the liabilities without getting the policy benefit of that guarantee (which is the restoration of faith in the financial system).

Thursday, March 12, 2009

Krugman’s illogic extended

I am flattered that Paul Krugman thought to reference this blog on his.  I have been a fan since undergraduate days at the Australian National University where I read (as a second year) some of his then recently published trade papers and thought that he was a seriously smart guy.  He later won the Nobel Prize for that work.  

I have kept a copy of Currency and Crises on my shelf for years too – and – like Paul am surprised that currency has played such a small role in this crisis.  The post on Swedbank (still the most visited post on this blog) was a direct application of Krugman’s book to the business of stock picking.  (Paul please read the post.  You will be amused.  Given what has happened in Latvia since I wrote that post it looks pretty good.)

I purchased seven copies of Pop Internationalism – Krugman’s mid 1990s popular work – and gave them to people who spouted all sorts of (Lester Thurow) crap about trade.  I even reviewed Krugman's book on Amazon – you can find that and my other reviews here.  

To put it bluntly – I am a Krugman fan almost to the point of idolatry. 

So I am getting puzzled at some illogic.  Paul has not (yet) agreed that the Swedish bullet (effective guarantee of all banking liabilities before selective nationalization) is going to be the way the US goes – but he acknowledges that a large amount of banking is effectively non-recourse finance with the losses going to the taxpayer.

He agrees with the obvious – that when banks are guaranteed they need to be regulated so they have more than zero capital.  Presumably they want to have quite a bit of capital (amount open to debate) or the incentives on the management to bet the money on red at the casino – or even loot the bank – is pretty high.  They also need to be regulated.

But he appears vehemently opposed to the (still not well detailed) Geithner plan to price toxic assets by giving a bunch of hedge funds non-recourse finance to purchase them.  He even refers to this a zombie financial idea - one that will not die.

This an illogical position.  Banks are non recourse.  Krugman acknowledges that and says that banks require adequate capital or they should be confiscated.  (No disagreement there – but I am sure we would disagree about the quantum of capital and how to measure it and what the confiscation process should be.)  

Anyway if there is new capital put in banking it will also be levered up non-recourse.  

I hope (and maybe I read Paul wrong here) that he wants new capital in banking and he would prefer it be private.  

Well isn’t that the Geithner plan?  Lets finance the tough stuff (scratch and dint mortgages, some commercial property) with new capital – as per any other bank – leveraged non-recourse to the taxpayer.  

The objection Paul makes is to it being “non recourse” – an objection which is illogical.  He has made this objection repeatedly.

 The debate should be – as this blog has made clear before – about the numbers (and possibly the confiscation rules).  It is not whether the Geithner idea is good or bad – it is whether Geithner demands enough private capital to be a reasonable outcome for taxpayers.

If the government requires enough capital then hey it is real capital and it reduces risk to the taxpayer.  If they require too much capital then the returns won’t be attractive enough.  There is not much economic difference between just establishing new banks and the Geithner idea – spelt out in some detail in the "long post" – for providing non recourse finance to several toxic asset funds.  

Just because it is non-recourse doesn’t mean it is evil.  If there is adequate capital then – hey – its new capital to the banking system – something that many (but not all) of us strongly desire now.  The issue is how much new capital for how much taxpayer risk.





John  

PS.  Paul - I know you are a busy guy - but I would love an email.  I once sent you an email (on Iceland) via Joe Nocera of the NYT.  I have no idea whether you got it - but it also looks pretty good...

Wednesday, March 11, 2009

Accrued interest on Voodoo maths

Accrued interest argues that banks should be given time (by government fiat) to work out of their problems - so that their underlying cash flow keeps them solvent.  My voodoo maths point entirely.  And he does it in the context of GE - where I think Voodoo Maths will do its job.

Any more people on this bandwagon and we would have a movement.




John


Note - an assessment is still required.  Nationalisation after due process.

Paul Krugman’s false logical step


To my way of thinking Paul Krugman has finally nailed the question as to bank nationalisation that matters.  This the money quote:

That said, some decision must be reached on bank liabilities. Sweden guaranteed all of them. If forced to say, I would go the Swedish route; but of course we can’t do that unless we’re prepared to put all troubled banks in receivership. And I’m ready to be persuaded that some debts should not be honored — this is a deeply technical question.

He is absolutely right that this is the critical step in the decision making process is what parts of the banking structure you are going to either guarantee or effectively guarantee.  The critical question is not nationalisation.

Sweden could guarantee all banking liabilities because – frankly – their banks were not that deeply insolvent.

We know they were not that deeply insolvent for a few reasons – the best of which is that ex-post the Swedish bailout cost very little (and the Norwegian bailouts were actually profitable for the government).

However it is fairly easy ex-post to tell how insolvent the banking system was.  It is not very easy ex-ante to tell.  If it were easy then banks that were not at all insolvent (such as Svenska Handelsbank) would not become 20 bagger stocks quite quickly after the crisis.  The stock market would not have marked them down so much.  

The US Government’s stated position – Bernanke yesterday as well – is that there will be "No More Lehmans".  What that means is that there will be no more uncontrolled liquidations of large financial firms.  

The only way that the government can say that there will be no more Lehmans is to effectively guarantee large parts of the financial system.  That is what the statement “no more Lehmans” means.  If you want to make that statement operational you either (a) need to guarantee the banking system or (b) pour money in continuously whenever a bank (Citigroup. AIG or otherwise) threatens to become the next Lehman Brothers.

The state of US policy at the moment is nothing more sophisticated than (b) above – which is whenever an institution threatens to become Lehman the US Government tips in another 30-300 billion.  We are still in the world of the ad-hoc guarantee - of the Sunday press release.

The problem with the ad-hoc guarantee is that nobody really thinks that it is a guarantee – and the generalised wholesale run on financial institutions will continue until they are sure.  In other words we are effectively guaranteeing the liabilities without getting the policy benefit of that guarantee (which is the restoration of faith in the financial system).

Krugman has nailed the right question.  The right question is whether the correct policy is “No More Lehmans”.  I am pretty sure it is.  I think the revisionist history about how bad the Lehman failure was is simply revisionist crap.  I am convinced that at least in some instances the “no more Lehmans” policy will be operationally expensive in some instances and will leave the taxpayer with an enormous hangover*.  The alternative is simply to allow big institutions to be pulled apart by the FDIC.  Chris Whalen by contrast is convinced the other way – he says the model is easy to determine – just go down to the Southern District of New York and talk to the Lehman Trustee.  

There is a reason why the right policy might not be "No More Lehmans".  Its about cost.  If the cost of making that promise operational was $12 trillion then you probably should just let the financial system burn.  Why – because it is so much money the taxpayer could not plausibly absorb it without decades of higher taxes.  If the cost is $1 trillion then hey – just suck it up - a fast rebound to the US economy as per Sweden after its crisis is worth more than a trillion dollars.  The cost depends on the size of the banking system and the size of the losses relative to GDP.  Iceland had to let its system burn because it could not plausibly bail out its banks.  The UK banks started with very little capital and with very big balance sheets relative to GDP.  They are also problematic.  The US banks by contrast started with lots more capital and smaller balance sheets relative to US GDP.  The upper-end estimate of losses (Roubini) is $3.4 trillion.  If that is the case the upper limits to cost of the "No More Lehmans" policy is less than $3.4 trillion.

My long post has some indication of how you might estimate the costs of making a “No More Lehmans” promise operational.  I have a forthcoming post which explains quite carefully what the least cost way of making that promise operational is.   (The costs are however potentially very large - and whilst I think substantially less than the Roubini number I can't dismiss the possibility the costs could be large indeed.)  

Anyway – if you have made the decision to have “No More Lehmans” then you have made the important decision – you are going the Swedish Route and guranteeing stuff - whether by Friday evening crisis or whether by design.  I think America will go the Swedish Route – I am just waiting.  The Swedish route is guarantee and selective nationalistion.  I have never been afraid of the Nationalisation word – and anyone who buys money center banks now can expect a few of them to be nationalised.  I have small positions - which would be larger positions if I knew the rules.

But the second part of Krugman’s paragraph contains a deeply troubling false logical step.  He says: “but of course we can’t do that unless we’re prepared to put all troubled banks in receivership”.

To see why this is a false logical step you need a little history.  A long time ago most the liabilities of almost all banks were deposits.  The government guaranteed the deposits by creating the FDIC – it hence stopped crisis driven bank runs.  It increased stability in a crisis.  However it also allowed financial firms to take huge risks or even be looted (as per Charles Keating).  The solution which was adopted (and let lapse of late) was that banks got the guarantee – but were heavily regulated to protect taxpayer interests.  There was no need to nationalise the banks simply because you guaranteed the bulk of their liabilities.  There was however a requirement to (a) regulate them, (b) assess their capital and (c) take “prompt” corrective action when that capital was inadequate.  Prompt corrective action included confiscation.  You did not take over banks because they had runs (the purpose of the FDIC guarantee was to stop runs), you took over banks when they inadequate capital.**

Nowadays a lot of banks have the bulk of their assets funded by things that are not deposits.  Indeed at many banks deposits constitute less than half the balance sheet.  

The old FDIC guarantee can’t stop runs because the run that happens is wholesale – it happens outside FDIC guarantee limit.  If you want to stop bank runs the way that the original FDIC stopped bank runs you need to bite the “Swedish Bullet” – that is you need to effectively guarantee everything.

However just as the creation of the FDIC did not require you to be “prepared to put all troubled banks in receivership” a Swedish guarantee also does not require you to put all troubled banks into receivership.

What the FDIC guarantee required – and what a Swedish Guarantee will require – is you be prepared to (a) regulate banks heavily on an ongoing basis, (b) test the capital of banks, (c) force them to be adequately capitalised (rasing money if they can), and (d) nationalise the banks that cannot raise adequate capital.  

When the good times return you probably need walk away from this general guarantee.  In other words you have to regulate banks in such a way that they can’t become large enough to destroy the whole economy - so that you reduce the systemic risk at the cost of stifling "financial innovation".  That means that the recidivist Citigroup – a bank that seems to blow up every cycle – will never be allowed to become as big and nasty again.  It would be a terrible policy outcome if we did not learn from this crisis and did not regulate in such a way that it was less likely to happen again.  Willem Buiter's call for "over regulation of banks" looks right to me.

Krugman’s illogic however does not help the debate.  There is a need to guarantee all banking assets – and it should be done provided it is affordable.  There is no consequent need to nationalise the whole system – though there will be a need to have a process which will result in nationalisation of some institutions – what I call “nationalisation after due process”.   

Oh, and the number of losses in the system is not fixed.  If the ability to borrow to fund risk assets is not restored then commercial property for instance will fall until its yield becomes attractive to an unlevered buyer.  My guess is that is about 15%.  As the economy will be in a slump at the same time and rents will also fall that might mean a top to bottom move in commercial property of 80%.  If the move is that big then all the banks (good, bad, otherwise) are insolvent.  However if the banks had guaranteed funding then (a) they could lend so the slump in the economy would not be so bad and (b) people could borrow to buy commercial property so its price does not need to fall until the yield is 15%.  The top to bottom fall might be 35%.  The system losses would be smaller.

If we do not guarantee all bank funding then I am afraid that Christopher Whalen will be right - the macroeconomic wave going through the economy will just smash up everything fast.  

The longer we wait before biting the Swedish bullet the larger the system losses will be - and hence the higher the cost of biting that bullet.  Either do it now or give up saying that there will be "No More Lehmans".  If you wait too long everything becomes Lehman.  

It took Krugman a long time to realise that the "Swedish Guarantee" is the important question.  And it is.  Nationalisation (which should happen for some institutions) is only the secondary question.








John Hempton




Some post scripts

*The instances in which I think the “no more Lehmans” policy will be operationally expensive are (obviously) AIG (almost certainly) Fannie and Freddie and speculatively a few others that are properly insolvent.  My biggest problem child is Barclays – which is technically a UK institution – but it is too big for the UK to bail out – and which has a lot of its operations in the US.  I suspect that the US can – as a technical thing – let Barclays be the next Lehman – saying – hey – its not one of ours!  But that is a post for another time.  

**This is one of the things that most annoys me about Sheila Bair’s confiscation of Washington Mutual.  WaMu had a run.  The old role of the FDIC was not to make banks fail when they had runs – it was to stop runs.  I would have no objection to confiscation of WaMu if it was demonstrably insolvent.  However it was not demonstrably insolvent – and Sheila Bair’s own press release said it was capital adequate when confiscated.  It was a very strange interpretation of her role indeed that she should close a bank because it had a run.  

Tuesday, March 10, 2009

Fools seldom differ

Warren Buffett was on CNBC last night.  Maybe he is getting old and vain and likes to be on TV.  Maybe he is falling for the (considerable) charms of Becky Quick – but he allowed himself to be interviewed for three hours starting at 5am Omaha time.

That made it good evening TV for me in Sydney Australia.

I was amused to hear my own views – parroted back to me in a more articulate and folksy manner than this blog.  

There is a saying – usually ironic – that “great minds think alike”.  I immediately think of the come-back that “fools seldom differ”. 

Whether Buffett and I are fools – well I will leave that for others to decide.  However Joe Kernan (and not the dulcet Becky) got out of Buffett what I believe to be the money quote of the whole interview:

BUFFETT: Yeah, the interesting thing is that the toxic assets [of American banks is] if they're priced at market, are probably the best assets the banks has, because those toxic assets presently are being priced based on unleveraged buyers buying a fairly speculative asset. So the returns from this market value are probably better than almost anything else, assuming they've got a market-to-market value, you know, they have the best prospects for return going forward of anything the banks own.  The problems of the banks are overwhelmingly not toxic assets, you know. They may have been one or two at the top banks, but they are not going to do in--if you take those 20 banks that are subject to the stresses, they're not going to do those banks in. Those banks have the earning power which has never been better on new business going out of this to build capital positions if they pay low dividends which they're starting to do now.

JOE: Hm.

BUFFETT: Toxic assets really are not the problem they were. Now, when I said it was contingent--I didn't remember being exactly contingent on TARP, but it was contingent on the government jumping in. 

JOE: Right.

BUFFETT: The government needed to act big time in September, I will tell you that.

JOE: So...

BUFFETT: And they did act big time.

JOE: So you are OK with the shift to providing the banks with capital as opposed to the original intention of the TARP for actually getting the toxic assets off the books?

BUFFETT: Yeah, and interestingly enough, they don't need to supply the banks, in my view, with lots of capital. They need to let almost all of--I mean, the right prescription with most of the banks is just let them pay very little in the way of dividends and build up capital for awhile, and they will build up a lot of capital. The government has needed to say--what the government needs to say is nobody's going to lose a dime by having their deposits in these banks. They're going to make lots of money with the deposits.

JOE: Hm.

BUFFETT: The spreads have never been wider. This is a great time to be in banking, you know, if you just get past the past and they are getting past the past. I mean, right now every time a loan is made to somebody to buy a house--and we're making, you know, making millions of loans--four and a half million houses will change hands this year out of a total stock of less than 80 million. So those people are making good mortgages. You want those assets on your books and you get a great spread in putting them on now. So it's a great time to be in banking, but you do have to get past this past. But the toxic assets, in my view, you know, if they've been written down to market, I'd rather buy those assets from the bank than any other assets they've got.

JOE: Hm. OK...

Lets pick this apart:  Warren Buffett has been saying that the toxic assets are the best assets of the bank (provided they are marked to market).  This is precisely what I have been saying.  Moreover he says it for precisely the same reasons that I do – which is that they are being priced based on “unleveraged buyers” buying a fairly speculative asset.  Compare this to my explanation in the “long post” – which was that they had large yields because you could not borrow to buy them.

Then Buffet says that the returns from the toxic assets are better than almost anything else.  Several people (including some high profile academic economists) disagreed with me about the spread on those assets.  That is fine – they are also disagreeing with Warren.  He is wrong fairly regularly too.

Then he says the problem of American banks are not overwhelmingly toxic assets.  This is a radical view – but it is in my view correct.  The problem with the banks is that nobody will trust them and they have not been able to raise funds.  The view that this is a liquidity crisis – and not a solvency crisis – has long been a staple of the Bronte Capital blog.  It is radical though.  Krugman, Naked Capitalism and Felix Salmon think alike – asserting – seemingly without proof – that the problem is solvency.  Buffett doesn’t even think the US banks (on average) require capital – a view that most people would find startling (though again I think is correct provided appropriate regulatory forbearance is given).  

Moreover Buffett thinks it is not solvency for the same reason as me.  To quote: “those banks [including presumably most of the big 20 banks in the US] have earning power which has never been better on new business going out of this to build capital positions even if they pay low dividends which they're starting to do now.”  I have been criticised endlessly for pointing out that on pre-tax, pre-provision earnings American banks can quickly regain solvency provided they can maintain funding.  This was the point of my Voodoo Maths post – and also the point of much of the long post.  

Moreover he goes on to repeat that the opportunities in banking are simply wonderful now – so long as you can get past the past.  This was the point in my series of posts on Bank of America’s quarterly numbers.  To anyone that looks at the American numbers it is self-evident that the margins in banking are going up sharply and that the opportunities are large right now.  However this simple observation set my inbox on fire – to the point that I felt I needed four posts (links 123, and 4) to defend the obvious.  

(Incidentally the margin expansion is not evident in the UK – where the banks are properly insolvent – and it is not evident in France where the banks are almost certainly highly solvent.  I can’t work out why it is not in evidence in France but if someone wants to explain it send me an email. I would be pleased.) 

There were other parts of the interview where Buffett simply agreed with me.  For instance he thinks that bank liabilities should simply be guaranteed at this point (at least for the large banks) and that guarantee should carry the personal weight of the President.  The alternative is either endless government injections costing as much as the guarantees or uncontrolled liquidation –a dozen Lehmans - as the banks run out of funding.  They did issue guarantees in Sweden – and I was hoping and praying that the US would become Swedish.  

Krugman is finally coming to the view that the important technical question is whether to issue that guarantee.  He is right.  Provided the guarantees can be issued at reasonable cost they should be issued.  Both Warren and I think the cost would be reasonable in the USA.  By contrast I am not sure the UK has the blanket guarantee option because the UK banks are very large relative to the UK economy and they started highly capital inadequate.  US banks by contrast started with a lot of capital.

Buffett did not approach the issue of how you treat banks after you have issued that guarantee.  I think you should have a process for assessing their capital and require that they have sufficient.  Those that do not have sufficient and can't raise it you should nationalise (by diluting the shareholders and preference shares out of existence).  That was the point of my “nationalisation after due process” post.  Though the nationalisation question is entirely secondary to the question of whether you treat this like a liquidity crunch (by guaranteeing liquidity) or whether you treat it like a solvency crunch (by forcing insolvent banks to liquidation).  I know which side I am on – and it is the same side as Warren.

Now it is all very nice to be demonstrably thinking the same way as Warren Buffett.  I should have an operating funds management business after I get through complexities of Australian licensing and similar hurdles.  If people widely believed that I thought like Warren I would be inundated with money – and that would be a good thing – at least for me.  

But I have to note that Warren was not entirely straight forward in the interview.  Warren did not think he could get the preference share deals he got from GE or Goldman Sachs now.  That might be true with Goldies – but it was unequivocally false with GE.  With GE you could construct a better deal on market.

This blog (painfully) admits its mistakes and tries to analyse them.  A money manager should be brutally honest with himself.  Warren however is an old man and his credibility is harder to question that mine.  But Warren was wrong with his GE preferred (if only because he could get a better deal later).  He should have admitted that (at a minimum) his timing on that one was awry.  

It would be inordinate vanity to hope that I will be better than Warren.  But I hope at least to think clearly and rationally like him.  Oh, and to hold myself to a decent standard of self-analysis and criticism when I stuff up.  



John 

General disclaimer

The content contained in this blog represents the opinions of Mr. Hempton. Mr. Hempton may hold either long or short positions in securities of various companies discussed in the blog based upon Mr. Hempton's recommendations. The commentary in this blog in no way constitutes a solicitation of business or investment advice. In fact, it should not be relied upon in making investment decisions, ever. It is intended solely for the entertainment of the reader, and the author.  In particular this blog is not directed for investment purposes at US Persons.