Geopolitics and financial crisis

Dopeyness warning.  Whilst I was familiar with the Icelandic bank balance sheets relative to GDP (Iceland is the second most bank revenue to GDP in the world after Switzerland which tells you something) I was simply sure - and wrong - about Iceland being an EU member state.  

They are not - as many comments have pointed out.  My mistake.

I was also familar with Kauthing Edge and Ice Savings - and indeed had mentioned them in the comments - and was concerned about the effect of the Icelandic banks on the Norwegian deposit market.  (If you look back at past posts I found some Norwegian readers to confirm to me what DNB Nor management was saying).  

I am a dope.  I thought that there was no way the UK would allow the Icelandic banks to raise 5 billion pounds plus in deposits at high rates in the UK unless they were forced to under EU rules.  

Something else went wrong with UK policy here.  Either way its very problematic.

J

I am short Swedbank.  It’s a call on the collapse of the Baltic States – something I regard as almost inevitable.

The risk with that short is a bail-out because the Baltic States are geopolitically significant.

But then I am wondering how dumb American foreign policy is becoming.  Russia is now lending Iceland 4 billion euro.  A lot of money to be sure – but the Spectator is speculating (probably with reason) that the quid-pro-quo is allowing Russia to use the former US military bases in Iceland.

The Spectator also reports that the US were asked for the loan first and declined.

Some questions: what is political union in Europe if Europe will let a member state have an Argentina type default event?  Where is the Committee to Save the World?

Who is in charge here? 

Is it an enormous geopolitical decision to allow Russia to have a refuelling base in the middle of the Atlantic?  Hey – a failed adventure in Iraq is a 1000 billion plus experiment.  This one is cheap.

I have a question for the conservatives: would Ronald Reagan have allowed it?

Sir Fred not quitting

I have a British passport.

I am considering sending it back.  Sir Fred Goodwin is not quitting.

http://www.thisislondon.co.uk/standard/article-23566426-details/City+cautiously+welcomes+‘positive,+sensible+move’/article.do

Hey - this is a guy who ran cap-in-hand to the UK government asking for money for the bank he destroyed.

In the US the Government had the decency to sack the CEO of the companies they nationalised.

Come on Her Majesty - your government is better than that!

Sir Fred Goodwin deathwatch - hopefully final edition

The press is reporting the sacking of Sir Fred Goodwin before the bank has announced it.

http://www.thisislondon.co.uk/standard-business/article-23566287-details/Banking+bailout+claims+scalps+of+top+pair+at+RBS/article.do

Three cheers for common decency.

Now deny him the termination payment.  

Dumb things I did not do for real

I wrote out a model portfolio for a hedge fund in January this year.  I also wrote a draft note explaining every position - part of a due diligence package if you will.  

The longs did awful (eg GE), the shorts did really awful (Bear and Lehman) - but the portfolio would still be down as there were more longs than shorts.

The "model portfolio" had a very small position (minus 1 percent) short Fortis.  I wrote a small note on the stock:

Fortis

This is a place-holder position.  But they paid way too much for ABN Amro and got the worst end of the deal (RBS got the better stuff!). 

They also have an undisclosed amount of subprime in the insurance company on which they have refused to take charges because they are “going to hold the assets to maturity”.  [This is an exact quote.]

They are capital constrained from the ABN Amro deal and refuse to take losses because (at best) they require a large capital raising.  

There are rumours about them needing to lean on the European Central Bank.

They are not particularly cheap and my experience of individual operations is that they are poorly run.

This however is not a sufficient case for a large position. 

Further work

Plenty.  Main thing is to work out the size of the raising and whether it is doable.  With work it might wind up as a core position.

Anyway - this little note - which I dug up again yesterday - looks fantastic now. 

Pity though - I did not do the further work and I never put the position on for myself.  

Execution is everything John and don't forget it.

Royal Bank of Scotland – some comments

One of the first posts I made on this blog was about Royal Bank of Scotland.  In it I described Sir Fred Goodwin as "the worst CEO of any big bank anywhere".

I promised a Sir Fred Goodwin Death Watch part II and III and had articles written – but the stock got ahead of me – and I didn’t much feel like picking the wings off butterflies.

Besides I thought I was just being vindictive.  My worst ever day at work was provided by Sir Fred.  I was short a very large amount of Charter One (a Midwest Bank) and Sir Fred purchased the company for a substantial premium.  I cost my clients many tens of millions of dollars.

In my history of US Finance note I drolly noted that the (then) universal acceptance that the acquisition of Charter One was dramatically overpriced provided “thin consolation, but no refund”.  My motives for going after Sir Fred were not entirely pure – so I decided to steer clear.  (Sir Fred - the refund would be nice...)

Besides – in the scheme of things Sir Fred raised a lot of capital.  Enough to cover a multitude of sins.  I thought RBS would survive.  I thought (incorrectly) that long RBS short Barclays was probably a good pair.  Thankfully I never put it on. 

Now RBS is at the edge.  It looks like it is failing.  It might survive – so I don’t want to fan the fire too much.  However the stock price is plenty fanning the fire.

At year end RBS had the biggest balance sheet of any bank anywhere in the world.  This balance sheet was inflated as it consolidated Fortis’s position in ABN Amro for instance.  Even net of this however RBS really matters.

I thought the expression “too big to fail” meant something – however this cycle has proved me wrong. 

RBS could provide the alternative test – too big and too global to bail out.  RBS is heavily integrated in the United States where it is one of the top ten banks.   The UK end is large relative to the UK economy and sterling is falling on the panic – the UK Government cannot do RBS alone – and the US end will need a US backstop.  RBS has large operations in many countries (including for instance a deposit base in Switzerland and a lending business in my home country of Australia).  I have no idea how the various governments will be involved – but I would seriously doubt that Australia would contribute. 

But for the time being I will take you back to one of the best – but most un-noticed business articles in the world this year.  It was by Bethany McLean in Fortune in Mid February. 

In it Bethany starts with the prophetic line:

 Could Royal Bank of Scotland be the new AIG?

For the rest of this article I just pass you to Fortune.   

Bethany told me once that this article generated almost no feedback – to which I say to the magazine readers – shame on you.

The Sheila Bair disgrace sequence

1).  Sheila Bair rings Jamie Dimon and suggests to him that she might confiscate the assets of Washington Mutual.  She says that Jamie should prepare a bid. 

2).  One week later the Office of Thrift Supervision signs a memorandum of understanding with WaMu saying that WaMu does not need to raise capital or increase liquidity.

3).  Sheila Bair forces WaMu to get investment bankers in who will do due diligence.

4).  The investment bankers talk down WaMu for weeks in press and cause a minor run. 

5).  The OTS seizes WaMu without any real indication to the management that this was going to happen and sells it to her hand-picked banker (Jamie Dimon).  The deal is irrevocable.  In the process she puts the fear-of-government in all the intermediate holders of US Bank finance.  This exacerbates the crisis.

6).  The WaMu deal causes a panic at Wachovia.  There was no panic at Wachovia prior to this – though Wachovia stock is justifiably weak.

7).  On Sheila’s timetable a deal has to be done for Wachovia in three days.

8).  Sheila decides that no deal can be done without government support and she offers that support.  Wells Fargo has simply told her they need more time.  Having done due diligence on a small bank I can assure you three days is not enough for a large bank unless the Government is going to give you large warranties.  Sheila created a timetable that forced the government into a deal that was potentially bad for taxpayers.

9).  A few more days and the deal turns up that doesn’t cost taxpayers anything.  Sheila however has staked her reputation on the prior deal and defends her prior behaviour.

I have argued that Sheila should be sacked.  I think that is pretty obvious now.

But someone on Wall Street has a better idea.  It is in this photo:

 

 

 

John Hempton

Its amazing how bad Sheila Bair looks now

Sheila Bair - without giving anyone time to do due diligence - forced Wachovia into a merger with Citigroup in which she warranted that the taxpayers would pick up the losses (beyond a certain point well below the book value of the deal she did).

Now she is defending that deal - and her tattered reputation - 

http://blogs.wsj.com/economics/2008/10/03/fdics-bair-statement-on-wachovia-deal/

Then she says not to assume the FDIC is opposed to Wells/Wachovia...  

This is the way a bad public servant makes a sausage.

Sheila - do us a favour and resign.

John Hempton

Did Sheila Bair force the confiscation of a solvent bank?

Well - yes.  If Sheila had not acted Wachovia would not have been in play.  She basically forced a deal whereby Wachovia banking operations were purchased by Citigroup.

Wachovia had 70 billion in net worth.

Now Wells is prepared to buy the lot.  No government assistance required.

I stand by my assertion that WaMu was solvent too - and if left alone would have survived.  But Sheila never gave it a chance.  

Sack Sheila Bair now!

Irish government guarantees the bank debt (not the bank equity)

This is blunt.

Government Decision to Safeguard Irish Banking System

Government Decision to Safeguard Irish Banking System

The Government has decided to put in place with immediate effect a guarantee arrangement to safeguard all deposits (retail, commercial, institutional and interbank), covered bonds, senior debt and dated subordinated debt (lower tier II), with the following banks: Allied Irish Bank, Bank of Ireland, Anglo Irish Bank, Irish Life and Permanent, Irish Nationwide Building Society and the Educational Building Society and such specific subsidiaries as may be approved by Government following consultation with the Central Bank and the Financial Regulator.  It has done so following advice from the Governor of the Central Bank and the Financial Regulator about the impact of the recent international market turmoil on the Irish Banking system. The guarantee is being provided at a charge to the institutions concerned and will be subject to specific terms and conditions so that the taxpayers’ interest can be protected.  The guarantee will cover all existing aforementioned facilities with these institutions and any new such facilities issued from midnight on 29 September 2008, and will expire at midnight on 28 September 2010

It will also end any funding problems the banks have and end any Irish financial crisis. My main objection to this is the taxpayer should expect a return to the risk they take but as I am not an Irish taxpayer what do I care?

Insert jokes about Dumb Irish Taxpayer in the comments.

John Hempton

How to make the bailout work

Almost everyone (including Krugman who should know better) thinks this banking crisis is about inadequate capital caused by losses.

They are wrong.  Its about inadequate finance caused by lack of trust.

Let me explain

Nobody I know calculates the total system losses plausibly above 2 trillion dollars.  I have had several goes at calculating the losses on this blog.  Here is an early attempt at scoping non GSE mortgage losses.  If I add the private equity disasters, GSE losses and things like car loans to this I still can't get end credit losses above 1.5 trillion.

That is a vast amount of money – enough for instance to solve most of Africa’s education and water problems.  But in the context of the huge industry that is America’s finance system it is just not that big. 

So far financial institutions have raised (well) above 400 billion in fresh capital – its probably nearing 500 billion.  The Federal Government has absorbed losses through the takeover of Fannie, Freddie, contingent liabilities on Wachovia, AIG and others of maybe 50-200 billion (lets use the low number). 

The pre-tax, pre-provision operating profit of S&P financials used to be above 400 billion and is probably still above 350 billion.  Two years of that and there is another 700 billion. 

The banks had some capital to start with – in some cases excess capital against regulatory standards. 

All up – we have almost certainly raised or passed to the government – or within two years will have earned – something approaching 1.5 trillion.

There is no capital shortage.  Get used to it.  The Krugman endorsement of the idea that you can’t save the financial system if you can’t read a balance sheet is dumb. 

The problem is the problem that begets all sharp-shock financial crises – which is just the sheer erosion of trust.  [I consider Japan to be a slow burn financial crisis whereas Korea was more like America.]

The erosion of trust was caused by lies

Wall Street and big banks sold lies for years.  I wrote once that the lies that destroyed Bear Stearns were told by Bear Stearns (note unfortunate investment theme in the link!).  The lies that are now destroying the whole of American Finance were told by American Financial Institutions.  The creditors simply do not believe any more.

What is needed to make this crisis go away is the re-emergence of trust.  When that happens people will lend to American financial institutions and they will stop failing.

American financial institutions require lots of wholesale funding – far more wholesale funding than they require in equity.  The crisis is not about the equity holders - its about the debt financiers of the US financial system.

Wholesale funding is just not available.  The banks are all subject to modern bank runs – the mass failure to roll or withdrawal of wholesale funding. 

There are several ways that the wholesale funding can be either replaced or rolled.  One way is (dare I say it) the original (and deeply suspect) Paulson plan but on a much larger scale.  The idea is that rather than securitise the mortgages and other assets on the bank balance sheet and sell the wholesale to people who no longer trust American Financial Institutions you sell them wholesale to the US Government.  The US Government funds it wholesale by selling US Treasuries – which – despite weapons of mass destruction and other deceptions – are still widely trusted assets.

The only problem is that the loan – to deposit ratios of the US Financial Institutions are just too high – and pretty well the entire wholesale funding needs to be replaced.  Buying 750 billion in assets simply does not do it.  Idea works – scale is not big enough.

Moreover the original Paulson plan involved the taxpayer taking considerable risks – and in my view the taxpayer deserves a return for those risks.  The usual solution is to give equity (ie the Democrats plan) but when the risks are large enough you wind up giving enough equity to simply nationalise the institutions.  That works. 

We know it works – we have Sweden/Norway as external examples – and even the takeover of Fannie and Freddie clearly worked – it gave confidence to the people who provide wholesale funding and lowered the price of mortgages.  

But nationalisation works not because it injects equity – it works because it injects confidence.  It makes the debt of those institutions similar to Treasuries and hence inspires confidence.

I blogged once about how this is a very different situation from Japan.  Japanese banks had no equity but plenty of funding.  They survived for more than a decade in a much weakened state.  By contrast Wachovia and WaMu went down when they still had plenty of stated equity but limited confidence.  The reason – America needs wholesale funding.

So please – I am begging here – can the pundits get their thinking straight.  Its not about equity – its about funding.

Got it.  And the problem I have with Sheila Bair is that she thinks it is about loan books – and she scares the funding off.  Moreover her takeover of WaMu was almost designed to scare off the funding – and that was dumb and should be a sacking offence.

Please get this right though - its about FUNDING not about CAPITAL.  Government action - Sheila included - should be designed as far as possible to give confidence back to the people who fund America.

 

 

 

John Hempton