Babe – I can’t find a vein

Paul Kelly – an Australian poet troubadour howls about addiction: babe – I can’t find a vein.

I know how he feels.

One reader is working with me on some very small regional banks for shorting. I will not write about them – because they are just too small.

However we have found one where we think the subordinated debt is a fabulous short.

So here is my howl:

Babe - I can’t find a borrow.

The security in question is not on the SEC’s new list of things you can’t naked short – but still the discount broker is not giving me a borrow. They are usually pretty good – but sometimes they can’t maintain the borrow and they call me in.

Does anybody know a broker who will give me a naked short?

I thought not.

I will continue in the way of Paul Kelly

Little cloud little cloud way up in the air
Little cloud little cloud way up in the air
Well I ain't receiving, little cloud's moved on somewhere

Things I got right and wrong

In a previous post I referred to a history of US finance I wrote in the first half of 2007.

Most (but by no means all) of that document reads pretty well.

Time makes most predictions in the stock market look awful.

There are few here that bear repeating.

One paragraph is as follows:

For American banks in general there are few credit risks we can identify. [Oops - I really wrote that...] There are exceptions - regional banks with undiversified Florida apartment construction loans...

There is some redemption in that paragraph. The regional bank I was referring to was Bank United. See this stock price chart...

In the same document I noted Washington Mutual had a massive subprime mortgage exposure but I thought that it was not existentially threatened. Well its deeply subordinated debt is trading at 30c in the dollar - which sounds pretty existential to me.

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All this is to prove that there is a reason that stock-pickers shouldn't make too many public pronouncements. Humble pie will be the bloggers diet.

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I have a short idea I am working on. The company just put out a record profit. Humble pie coming up!!!

John

Thing that stuns me - Natixis: French turds and raisins

Alejandro Valverde a pre-race favourite who rides for the Caisse d’Epargne cycling team in le Tour de France blew up on the mountain top finish into Hautacam. He is down more than 4 minutes – and his chance of emerging a winner of the tour is now low.

Group Caisse d’Epargne – the sponsor - is a collection of mutual savings banks in France. The mutuals however own majority control of an investment bank with a big asset management business. That investment bank is Natixis. It used to be called Natexis but it merged with Ixis (which used to be outright owned by mutuals) and changed its name. Ixis is an asset management business. Ixis has since changed its name to Natixis Global Asset Management. They also own a none-too-bad wealth management group in there – La Compagnie 1818.

The blow-up of Caisse D'Epargne's subsidiary cyclist cost 4 minutes. The blow up of their susbsidiary investment bank is somewhat more expensive.

The Natexis investment bank is very bad. It had most of its business in securitisation where they were the suckers at the end of many deals. They are one of the more spectacular blow ups of Europe.

Howeer Ixis has some very good businesses in it. Ixis got that way by using the profits of the mutuals (which could not be distributed) to buy lots of good asset managers (often at high prices). The fund managers it owns include Harris Associates (Oakmark Funds) and Loomis Sayles. Ixis is the largest funds management group that you have never heard of. It manages about 600 billion euro - almost a trillion dollars. Natixis is a large proprotion of the size of UBS.

The asset management businesses must spit off cash. They would generate capital even in this environment. But Natexis has blown it and all. Natixis is doing yet another big capital raise - this one for USD6 billion.

This all leads to what I call the French banking question: why do very well run regional banks with perfectly solid wealth management businesses insist on being bad investment banks? It all reminds me of the Munger view of turds mixed with raisins. They are still turds.

I guess this is also the UBS question. UBS took the best wealth management business on the planet and mixed it with an enormous pile of turds. Natixis is just more problematic and much cheaper...

Now does anyone have any idea how you separate turds and raisins?

Mistakes

We all make mistakes.

I have made two substantial mistakes I know about in doing this blog. (There are probably more I do not know about.)

For one mistake I just annotated the post. The other mistake was so central to the argument I just deleted the post as a demonstrably false argument is not worth any reader's time. [That post was on Fannie Mae and Freddie Mac. If you remember it - just forget it.]

In this business mistakes cost money.

If any of my readers spot something that they know to be wrong - or even think to be wrong I would really appreciate an email. We might agree to disagree - but I will try to approach any position with an open mind.

I am not writing this blog to push positions. I would rather tell you of the warts in positions (such as GE Real Estate at GE). The world is complex and most good positions have a bit of hair on them. Intellectual honesty is - in my view - a key to good investing. I am trying hard to cultivate that trait.

So please readers - keep the emails coming.

Thanks

John Hempton

The peculiarity of Fannie and Freddie’s market cap

This post is deleted. It is wrong.

I much appreciate people indicating mistakes. I am kind of embarrased about that one...

J

The Norwegian bank collapse – a fixed currency model with a current account deficit

In my post about the Japanese bank collapse I showed how insolvent banks could remain liquid and hence operating for decades provided that they had (a) sufficient deposit funding and (b) low enough interest rates. [Please read the Japan post before you read this one.]

Given that the Japan situation required sufficient deposit funding I argued the Japanese deflation model was not a good model for how the US situation would wind up. I promised to talk about the Scandinavian bank collapse in a follow up post.

As I wrote this post I realised that I did not know enough about the Scandinavian collapse generally to write a useful post. But I know plenty about the Norwegian collapse.

This is helped by the Norwegian Central Bank (Norges Bank) who have published a long English language description of the Norwegian banking debacle and its aftermath. You will find it online here – and it is free. This is the single most useful document I have ever read on decoding that sort of banking disaster – and anyone that claims to speak knowledgeably about this sort of banking collapse who has not read it should probably be ignored for spouting theory rather than data. (Ideology abounds amongst the pundits – ignore it.)

The Norwegian case is held up by many pundits (including Krugman and myself) as the best model for how government and central banks should behave in a financial debacle. For reasons that will become clear in this post I am not sure that is always the case.

Anyway Norway had a few preconditions not all of which are necessary but which are often associated with bank failure:

• It had a recently deregulated financial system where new forms of lending and new processes of credit approval were rapidly introduced
• It had a current account deficit
• It had a fixed exchange rate and
• It had a fairly recent adverse terms-of-trade change (namely a big fall in the oil price).

Of these – in my view – and probably in Norges Bank’s view – the most important factors were the fixed exchange rate and current account deficit.

Financial institutions and current account deficits

Financial institutions intermediate current account deficits. Joe Sixpack is hardly borrowed a couple of hundred thousand for his mortgage by going to the global financial market. Instead he goes to a local bank and the local bank raises the money in global markets either by issuing debt in its own name or by securitisation, covered bonds or some other route. This is true everywhere that there are current account deficits. When there are sustained current account deficits banks on average lend more than they take in deposits.

If there is a run on a fixed currency – meaning people want to take money out of that currency – that in effect becomes a run on the wholesale funded banks.

Norway had a current account deficit and naïve wholesale financed banks. They were naïve because recent deregulation meant that they really knew relatively little about wholesale funding risks or the new types of lending they were doing. Worse it had a fixed exchange rate. This was a nasty set of preconditions.

Further, in the early 1990s there were several countries that had fixed exchange rates in anticipation of European monetary union. In some of those countries (especially the current account deficit countries) the exchange rates were too high – and were vulnerable to speculative attack. By far the most famous speculative attack was against the UK pound. George Soros famously made a billion pounds “breaking” the bank of England. To this date the UK has never never even looked like again fixing its currency to the Eurozone.

The Scandinavian countries were likewise subject to speculative attack. The Norwegian attack was the most severe because the current account was getting massively worse. [Norway – an oil rich economy – had a massive spending boom financed by bank lending as the oil price crashed towards $10.] The speculative attack quite literally ran the banks out of money. There was thus an economy wide crash.

It is worth making an aside here. When the banks actually run out of money they can’t lend. Asset prices depend critically on the ability to borrow against them (and that includes the price of current mortgages in the secondary market). When the banks can’t lend asset prices can fall to very low – indeed insanely low levels. At the height of the crisis some 2 bedroom apartments walking distance from the centre of Oslo (one of the richest cities in the world) and with full 180 degree fjord views traded hands for USD15000. You would have easily made 30 times your money buying those properties. Property prices can fall to very low levels without any bank lending. Indeed the ability to borrow to buy assets is often crucial in maintaining their prices…

Now at this point it is worth noting that the banks are illiquid and point-in-time insolvent. When property prices had fallen to such (absurdly) low levels the entire market was upside-down and if you were to liquidate the banks they would be grotesquely insolvent.

All this ended very rapidly. The government guaranteed bank liquidity – and wound up with ownership. The mechanism by which they nationalised the banks is beyond the scope of this post. Most importantly they floated the Kroner – and the currency driven run on the banks ended almost overnight. Certainly the crisis had seriously abated within three months.

When the run ended the banks were again liquid – so they could again lend. Property prices rapidly rose returning to something that looked more normal (if not expensive by global standards) and the banks were solvent. This was a strange crisis because if the underlying assets were priced rationally the banks were solvent always – they were just illiquid.

There is a proof of this assertion. Paul Krugman suggests in the NYT that the Scandinavian bank bail-out cost a lot of money. But the Norwegian government actually made a profit on the bank bail out. The loans wound up not-very bad and the Norwegian government wound up owning most of the banking sector which they again privatised. Norway is as close to the case of illiquid but solvent banks as I am aware of.

What does this mean in the US context?

It is regularly asserted that the Norwegian model is the superior model for dealing with banking crises. The economy bounced back very fast (and isn’t that the goal?). The government didn’t wind up insolvent. Indeed all was indeed well.

But this misses the point. Norway was the case example of illiquid but solvent banks. Bailing out illiquid but solvent banks is the right thing to do (if you can trust the government to identify illiquidity without insolvency). Bailing out insolvent banks tends to reward behaviour that makes you and insolvent. And it is costly. If you think that the Norway experience can be duplicated in any bank bail out – then unfortunately you are sadly mistaken. I doubt the average government can identify the difference between illiquidity and insolvency. Certainly the bulk of the investor population couldn’t (or the banks would not have been illiquid). The Norwegian government got really lucky because the banks it chose to bail turned out just fine.

What does this mean generally?

For investors there is a simple lesson: be careful of fixed exchange rates and current account deficits. I have already pointed to Spain. I have a post coming which points to what I believe is a huge forthcoming financial crisis with nasty geopolitical implications. Oh, and a great investment idea.

But dear readers, you will have to wait for that one…

John

Santander buying Alliance & Leicester

Whoa big news just after I write about Spanish banks.

Santander is buying Alliance and Leicester. That fits with Santander’s other UK operation – Abbey National. So I shouldn’t be surprised.

Santander is a bank with funding problems – as is A&L. The funding issues however are reflected in A&Ls share price. A&L has been for sale for a long time – and Credit Agricole didn’t confirm the rumours by buying them at 12 pounds. 3 pounds (the Santander price) is a long way down.

All this reminds me of a conversation I had a long time ago at a banking conference in London. It was the conference dinner and I was sat next to an indescribably boring US fund manager who simply didn’t have a clue that there were risks in banking and a somewhat more interesting (but equally clueless) senior executive at Alliance & Leicester. I was drowning my sorrows in cheap cheerful French wine.

I remember taking the guy (who worked in the finance department at A&L) through his own balance sheet. Amusingly I seemed to know it better than him. They had relatively few risks in the mortgage business – but they had taken considerable funding risks. The inter-bank funding was growing 25% per annum – and that funding is hot. They were also running out of capital. My clueless executive understood they were running out of capital and suggested that that was OK because when they ran low they would just sell the bank. The clueless fund manager thought that was fine because he could buy A&L waiting for the takeover. And maybe he made money so maybe he wasn’t so clueless – provided he sold on the rumour of the Credit Agricole acquisition…

But neither of them realised that the liability side of their balance sheet contained risks. My notes clearly say that the senior finance executive simply had never thought about the risks on the funding side.

I guess Santander is thinking about them though. They are paying stock.

Newsflash: Spain looks dicey

If it were not for Fannie Mae and Freddie Mac going insolvent this would be the biggest financial story in the world today.

Spain can’t sell its sovereign debt reported here and here. The spreads of Spanish bonds of German Bunds is still small - so this is a warning shot. But it is a shot that rings very loudly at Bronte Capital.

Background

Spain is a current account deficit country with large wholesale financed banks. If you can’t sell Spanish sovereign debt the you shouldn’t be able to sell Spanish (mortgage) covered bonds. Moreover it is a current account deficit country with a permanently fixed currency (it gave up the Peseta and joined the Eurozone).

A while back the most liquid bank stock in the world wasn’t Citigroup or JP Morgan – it was Santander. The second most liquid bank stock in the world was BBVA. These are giants.

They are highly dependent on wholesale funding. If they can't raise wholesale funds they will come close to failing - and Spain will wind up in a horrid recession.

And it is very hard for the Spanish government to bail the mega Spanish Banks out because the Spanish government can’t print Euros. (Being unable to print a fixed currency is part of a model for bank collapse I will deal with in some future posts.)

If the Spanish can’t bail out their own banks I guess the Bundesbank (I mean European Central Bank) can – but that would be a call on German taxpayers to bail out the Spanish.

Of course the Eurozone could collapse. Spain can then go back to its old ways printing pesetas.

Alternatively this could all wash over by next week. But the implications of the Spanish pulling sovereign debt auctions are pretty horrible. Even if the spreads remain under 50bps.

Watch this space...

Deflation and bank bailouts in Japan

Given what is happening with Fannie Mae at the moment I should share a little of the history of non-US bank bail outs. I will start with Japan and later do Scandinavia.

Japan was an unusual bank collapse. It happened despite excess savings in the system. This is really strange. Most bank collapses happen when there is a lending binge that drives excess or investment or consumption and with a current account deficit. (See for instance Korea – where there was excess investment or Argentina where there was excess consumption.)

Japanese banks always had (at least collectively) sufficient deposits. [See my post on 77 Bank to see just how much excess deposits they now have.]

But the Japanese banks lent very badly indeed. Part of this lending was to the "Zombie companies" but most was on property. The formalised golf-club membership exchange in Japan at one stage was worth a good multiple of the entire Australian stock exchange (including giants such as BHP and Conzinc Rio Australia). Golf club memberships were of course a pure-play method of speculating on land.

But you need to notice that the Japanese bank collapse looked very different from what is going on in America now. The Japanese bank collapse was not a collapse of funding – it was a collapse of asset values and solvency. [Exceptions noted.]

American financial institutions are now having wholesale funding runs (or finding wholesale funding is unavailable which amounts to the same thing). Japanese financial institutions did not need wholesale funding (most had deposits) and hence by-and-large did not have runs. [There were some institutions such as the long-term-credit banks and similar institutions which had wholesale funding – they were effectively nationalised.]

Many Japanese regional banks (Nishi Nippon for example) were breathtakingly insolvent at the height of the crisis but they remained liquid because they had plenty of deposits. Because they remained liquid they never actually failed.

The zero interest rate policy

Insolvent but liquid banks are the key to understanding Japanese interest rate policy. There are several prominent macroeconomists in America (led notably by Krugman but joined by Bernanke) who argue that the zero interest rate policy was insufficiently expansionary – and that monetary policy should have been eased until it induced inflation. In theory this could be done by flying a helicopter over Tokyo throwing out freshly printed 5 thousand yen notes. Indeed it was in a speech about Japan that Bernanke uttered the famous helicopter line.

The BOJ always thought this policy was “risky”. Krugman’s response was that it was less risky that the endless government deficits Japan ran. Krugman missed the point – the question was who was inflation risky for? My answer: the banks.

A hypothetical insolvent bank

Imagine a hypothetical insolvent bank. Suppose the bank has 90 in funding, 10 in “stated equity” and “stated” 100 in assets. [I have left the currency blank because this could be 100s of billions of yen or billions of dollars.]

And suppose that the assets are not really 100 but 70 good and 30 bad - and everyone knows about the bad assets.

Then the bank “really” has 70 in assets, 90 in funding and minus 20 in equity. This is a realistic picture of insolvent Japan in 1994.

If the bank was in a current account deficit country like America, Australia, New Zealand or the UK there would be an immediate problem. In a wholesale funded market the 90 in funding would be say 60 of deposits and 30 of wholesale funds – and the wholesale funding would leave. The bank would go insolvent quite rapidly (see Northern Rock which was very reliant on wholesale funding).

But in Japan the 90 in funding was all deposits and was sticky. The funding never left and the bank continued quite nicely. Capital market discipline was not imposed – and the hypothetical bank could pretend there was no problem for many years. Banks fold when they go illiquid - not when they go insolvent. No liquidity problem means no crisis.

But the problem is still real. Over time insolvency may turn into illiquidity.

Now suppose that (and this is a gross simplification) that the spread between deposit rates was 2%. But rates could either be 10 and 12 percent or 0 and 2 percent.

If the rates were 10% and 12% the 90 of funding would cost 9 per year. The 70 of “real” assets would yield 8.4 per year. The bank would be cash flow negative. Anything that is cash flow negative for long enough goes illiquid eventually. The insolvency problem would turn into a liquidity problem.

Now suppose the rates were 0% and 2%. The 90 in funding is free. The 70 in assets yields 1.4%. The same banks is cash flow positive in a low interest rate environment. If they are cash flow positive for 15 years the bank will fully recapitalise.

• Summary: zero interest rates were critical to bank recapitalisation in Japan.

The reason why the BOJ rejected the Krugman/Bernanke line was that it was risky to the banks and the BOJ (and the MOF) are totally captured by their bank constituency. It was risky not to the economy but to banks. [Note the practice of amakudari translated as “descent from heaven” where former government officials get to be CEO of banks late in their career.]

Why this form of bailout won’t happen in America

In America it is the wholesale funded institutions that are in the most trouble. Think Bear Stearns, Lehman, Fannie, Freddie.

They are in diabolical trouble.

The funding is leaving them. It does not matter whether rates are 0 or 10 – the funding is still going.

America will look far more like Scandinavia than Japan. Scandinavia was a funding crisis. The posts by Naked Capitalism and others suggesting that Japan’s wasted decade will be the new normal are just plan wrong.

Implications

I still have not worked out what side of the inflation/deflation divide I am. But the people that point to Japan as a likely outcome miss a point. Japan chose deflation because the alternative was nationalising the banks.

America does not have that choice. The American institutions are wholesale funded and hence will nationalised or fail if the wholesale funding disappears.

Nationalisation can be inflationary if it involves printing. The date the Federal Reserve is not printing – but Helicopter Ben has made clear that in Japan the BOJ should have printed. And the institutional imperative to stop him printing will not be present in America.

The Trading Post – a story of slow technological adoption

I walked into the local corner shop in Bronte. In pride of place there was a copy of the Trading Post for sale. Timber that had gone through crushing, bleaching, milling and other machines just to carry classified adverts.

The Trading Post is a specialist classifieds paper in Australia that has been around for a very long time. It is now owned by the dominant phone company (Telstra). It charges for adverts and charges for the newspaper which comes out weekly. It has classifieds in a few hundred categories. There is no content other than classifieds.

It is precisely what you would think the internet destroys. But here it is – still wanting to take your advert.

I should note that it is cheaper to place an advert in the trading post than it once was. The adverts are placed until the item is sold. The car adverts are cheaper than listing a car on Ebay (suggesting Ebay’s ever increasing prices are creating an umbrella under which dying businesses can shelter).

But all of that argues for an electronic trading post. But in my local shop precious retail space is devoted to a newsprint trading post.

Why? And what does this say about Ebay?