The 1934 Securities Exchange Act and all that

When you sign up to a margin account in almost all cases you pledge your securities to the broker with the ability for them to repledge. 

The reason to broker-dealer must be able to repledge is that it needs to finance the loans to you – and to reduce the cost of that financing it needs to offer collateral. 

So, when I take my million dollars worth of securities to the broker and borrow 100K on my margin account it looks like I have pledged a million dollars to a broker who might be questionable in order to get 100 thousand worth of financing.

There is one word for this.  Dumb.  They can – on face of it – take your assets and pledge them to finance their risky business.

If you do not believe it is dumb have a look at my post on Opes Prime, a small broker-dealer that went down in Australia taking something near a billion in client assets with it.  It involved organised crime, guys that killed hitmen and all sorts of other colourful characters.  There ain’t no way I would want to lend my securities to these guys and wind up an unsecured creditor.

The US had huge problems with broker-dealers in the 1930s.  They folded and lots of people lost their entire fortune by not understanding their credit arrangements. 

Enter the US Securities Exchange Act of 1934.  This is one piece of depression era legislation that survives and thank the Good Lord for that.

What the broker dealer act does is (a) ring fence the US broker dealer and (b) limit the amount that the broker dealer can borrow against your securities and the amount of collateral it may take. 

I am hardly a lawyer – so take the bush lawyer caveat – but the way it works is that the broker dealer may not borrow against your securities to finance their own business, only client business.  So Lehman Brothers US broker dealer could take collateral of securities and if they had 100 million out on client margin loans the most that they could raise using client securities is 100 million and not a brass razoo more.   This is really important because it meant that client assets were not used to finance Lehman’s disastrous commercial real estate and other businesses. 

Moreover when you deposit a million dollars at the broker dealer and give them the right to repledge those securities they can only rehypothecate 140 percent of your outstanding balances.

If you have 1 million deposited and you have 100 thousand borrowed then only 140 thousand can be rehypothecated and the rest must sit in a segregated client account.  [If your broker wants to steal from the segregated client account there are precious few defences – but…]  You can not contract out of this requirement. 

So (provided the broker is not acting criminally) you should get the bulk of your money back if the broker dealer fails.  And provided the capital requirements are adequate (and they mostly are) the broker dealer won’t fail.  Even the Drexel Burnham Broker Dealer did not fail.

Goldman Sachs claims that they can determine the capital requirements of their broker dealer intra-day.  I have no proof of this claim – but in this age of computers that is plausible.

The result.  Whilst Lehman brothers went bust Lehman US broker dealer did not.  This pretty well saved the US hedge fund industry. 

Europe however was a different story.  Lehman Europe failed – and the clients of the European broker dealer (read a good proportion of the London hedge fund community) are now queuing as unsecured creditors of Lehman.  Many funds have folded.  Far more have been nicked.  Whilst the US hedge fund business is currently looking dazed, confused and a little problematic the UK business is on life support. 

In some sense this is the end of the City of London.

I am on record as saying the UK took Maggie Thatcher to heart and deregulated financial activity to such an extent that the whole UK market worked without capital.  That was of course inordinately attractive in a boom where having capital was just a cost.  That attractiveness was one of the reasons why the London market grew and grew – and why UK banks wound up being amongst the biggest in the world.

But now with the biggest bank in the world by balance sheet (Royal Bank of Scotland) effectively nationalised and the and a large part of the UK hedge fund community lying with open veins it looks a little stupid.

This puts in a different light the 8 billion dollars that Lehman London transferred to the US when it was failing.  I stand open to correction – but I would guess that the money was obtained from client accounts from the European/London broker dealer.  It is certainly being investigated by Lehman clients.   This is a scandal of the first order allowed by an insane lassis faire approach to financial regulation. 

So here is a plea for US Depression style financial regulation.  Some of it (such as the Broker Dealer regulation) was well thought out and should be duplicated.   (Some of it was less sensible…)  

If I have a plea to my home country (Australia) after the Opes Prime debacle – a copy of the US 1934 Act would be a good start. 

As for London – I am sorry, but it is a wreck.  Maggie Thatcher you stand condemned.

 

John Hempton

Fred Goodwin hangs tough

Come on Sir Fred

You worked for an inconsequential arm of National Australia Bank.

You walked to an historic but small bank in Scotland.

You went on a binge of overpriced and insane acquisitions and turned your tiny bank into the world's largest by balance sheet.

The bank failed at huge risk to the global economy and required government to bail it out.

And you did not resign and instead hung tough for a golden parachute.

I have said that you are the worst CEO of any major bank anywhere. Vindication I claim.

Resign and waive the right to any package. It is simply indecent to charge a parachute to the taxpayers.


John

Bakkavor Group, an Icelandic follow up...

I got no comments on the Bakkavör Group accounts, see here...

For those that want to know, the balance sheet is written in pounds. It is serious money. Almost 2 billion dollars in debt for a token Icelandic food processing company.

It is the corporates, not the banks that are going to send this around the world. I noted the list of principal bankers contain more usual suspects – they are Barclays, RBOS, Rabobank, Mizuho, Fortis, ABN Amro, Bank of America Securities and HSBC.

The Icelandic confessional has included Erste Bank in Austria (a crash large enough to close the Austrian exchange) and various UK banks and will include others.

But more, still more, will come to the confessional...

J

Iceland denies the airbase link

It did not take long. Iceland has denied the airbase link.

http://www.timesonline.co.uk/tol/comment/columnists/bronwen_maddox/article4916541.ece

But it is clear the Russians have an agenda. What it is is unclear.

Iceland however needs the foreign currency desperately and should take it.

Welcome to the 21st century...

British deposits in Icelandic banks

I simply said in a previous post that Iceland intended to default on its deposit insurance obligations.

They now say they intend to honour them.

http://www.bloomberg.com/apps/news?pid=20601102&sid=aXXW.vOmh8Ao&refer=uk

Intention is fine. They do not have the cash.

J

Funny reaction as to the prostitution comment

Two people I trust suggested that this post is a little hot headed and that I should revise or tone down.

The email however is suddenly running very supportive.

The purpose of the post is and was to make sure everyone knows just how important and nasty financial crises are.

If I have offended people doing that I am sorry, but the crisis is the central fact in what will be modern Icelandic history...

The central policy question raised by the Asian crisis was 'why did the market deal such harsh punishment for so minor economic crimes?'

This will be the question asked by Icelandic people too. And it is a question that should be asked of all those who subscribe to the dumb doctrine that is Austrian economics...

In Asia they ran large current account deficits caused mostly by good excess investment... it still crashed (and recovered).

The stakes here are very high. Iceland is a nasty case but there is no 'Icelandic exceptionalism' and there will be no 'Australian exceptionalism' if we stuff up either. Australia is warmer than Iceland and that is a darn good thing. But it is a small thing.

So, please take my hot headedness as it is intended, which is to outline the stakes...

********************


There is a long history of financial crises, there is a long history of the aftermath. I made a semi-flippant comment about part of the aftermath. It has sent my email and the comments wild. I have gone from 1 regular Icelandic visitor who knew my views in detail because he asked to hundreds of Icelandic visitors. The comment was about financial crisis and prostitution.

I know of no crisis where pretty women have not prostituted themselves out of desperation or for advantage. There are people who have emailed me who can confirm this first hand for Argentina, both as clients and as good Catholic girls turned to distasteful work. Do not think for a moment that I am pleased by these stories...

The journalist whose story of the Russian crisis was one of pretty women aspiring to be dollar whores said it as a matter of fact...

This is not new.

I have now had so many emails and comments that tell me that Icelandic women would rather shoot me and eat me than prostitute themselves that I am sick of it. It may be true but it is not an option open to most Icelandic people.

Financial crises are pernicious affairs. And if there is something about Icelandic exceptionalism I do not see it in the market place. Take your Icelandic exceptionalism and stick it with what is left of your Krona.

I do not mean to be tough. I think that the US should bail out Iceland. Its a democracy full of fundamentally decent people and they deserve much better than what is about to befall them. If the goal of US policy is to make the world safe for democracy fixing Iceland is a cheap shot.

But the US is not going to bail out Iceland. And life is going to be very tough indeed. Tough enough to undo all Iceland's excessively high opinion of itself.

For that I am sorry.

Australia also has a high opinion of itself, and an unsustainable current account deficit. Not as unsustainable as Iceland but bad. I would not like it at all if what is about to befall Iceland befell my home town.

John

PS. My view is not fundamentally different from this view in the British press...

http://www.independent.co.uk/news/business/news/fear-on-streets-of-reykjavik-as-country-can-only-go-to-imf-for-financial-bailout-957876.html

Iceland the absurd

I mentioned Iceland a few times only on this blog – because it was sort of well known in the hedge fund community – a crowded trade even.  Paul Krugman did an (incorrect) anti-hedge fund piece where he happily swallowed the dogma about hedge funds of conspiring against Iceland.  You didn’t need to conspire against Iceland – it was obvious once you read the balance sheet of any of the banks or any of the major corporates.

The first time I mentioned Iceland on this blog was in my list of current account deficit countries with potential banking problems.

Later I mentioned – but only in the comments – the raid on the UK savings market done by IceSavings and Kaupthing.  These were high interest rate deposits that seemed to be insured by a combination of the Icelandic and UK government if you read the documentation.

I wrote a post about high rate deposits (Wachovia will walk over you) and I confess that I had an ulterior motive – I was looking for someone to tell me how much the Icelandic banks were raiding the deposit market of Norway.  I got a few nice helpers amongst my readers (thank you). 

But this post is an ex-post analysis of just how absurd Iceland became – and some speculations from there.

Firstly the Russian loan (5.4 billion) is really big.  The population of Iceland is about 320 thousand people.   This translates to almost 17 thousand per person.  That is a real bailout – none of this small stuff that America is doing. 

It is pretty hard to see how an economy that has functionally destroyed itself is going to pay that back.  Whatever it looks like a darn big loan to a very dodgy credit – and I presume that there is a non-financial motive for granting it.

In my quick post on Iceland (done at JFK airport with a beer whilst waiting for a plane and not adequately fact checked) I linked to Andrew Neil who thought that the ulterior motive was Russian access to Iceland as a military base – or at least as a military refuelling depot – an unsinkable aircraft carrier if you will.

That is plausible because there is no obvious financial motive for this loan.  But there is an alternative theory doing the rounds – which is that one of the Icelandic banks was closely tied to the Russian Mafia – and the loan by the Russian Government is just make-good.  [The implication being that the Russian Government is just another arm of the Russian Mafia.]  Again I have no proof for that hypothesis – however as you need a non-commercial explanation of the loan its as good as most.  [Access to military bases however looks more likely…]

But you got to realise just how big the Icelandic problem is relative to the Icelandic economy.  Kaupthing Edge and IceSavings raided the UK deposit market as noted above and raised 3 billion pounds in deposits.  That is another 20 thousand dollars per person in Iceland.  Iceland as I need not remind readers cannot print pounds or dollars.  It is small wonder the Icelandic government is not going to meet its deposit insurance liabilities.  We have the Sovereign Default of a democracy at hand.  That is rare… I always thought it was populist dictators that defaulted.   Now I guess it is just populist democracies.

So Iceland is going to default at the national level and the level of every bank.  Lets have a look at its corporates.  I did this – there are about 20 companies listed on the Icelandic stock exchange.  I went and read the annual reports of about 5 and they were mostly similar – over-levered global acquisition conglomerates with Kaupthing as the major investment bank. 

Bakkavör Group sticks in mind – just because it was so levered in such an ordinary business – processed fresh food.  The five year summary is as follows:

(Click for detail...)

Yes – it does have quick ratios of less than one, current ratios of less than one and ebit of only about a ninth of outstanding debt. 

It might be possible to survive that – but it will be tough.

And whilst the investment bank is Kaupthing with whom it shares multiple board members – the list of “principal bankers” contains more usual suspects – they are Barclays, RBOS, Rabobank, Mizuho,  Fortis, ABN Amro, Bank of America Securities and HSBC.

Oh Iceland the international.  What happens in Iceland does not entirely stay in Iceland.

==========

It is also worth considering what happens to Iceland in the absence of new funding...  It has no banking system left.  There is nobody much willing to take Icelandic Kroner.  The country has no reserves of hard cash that matter.  Its winter coming.

They can sell fish and energy intensive manufactures (their main exports) for hard currency.  But this is not like Australia - when the going got really tough in Australia in the depression you gave up and went and hunted (feral) rabbits for food.  

Iceland is a little colder.

My guess - and it said only half in cynicism - the women are beautiful in Iceland - the place just pushes out Miss World winners.  Its almost as close to NYC as Vegas.  Sex Tourism for hard cash will be their next export industry.

If they adopt the Vegas slogan will it work for financial crisis as well?  What happens in Iceland/Vegas ...

J

The Bronte Capital thesis breaks down

This blog has an over-arching thesis – which is that current account deficit countries are going to have bad banking systems – but current account surplus countries are going to be sort-of-OK.

This post was outlined in the second substantive post on this blog in which I said:

America is a land with little in deposits and considerable lending. There are similar lands – such as Spain, the UK, Australia, New Zealand and Iceland.

But I was pretty happy with the banks in current account surplus countries – although their profitability was limited.

Well – the facts on the ground look much uglier than that.

Sure the failure in Germany (Hypo Real Estate) was largely caused by its dumb Irish subsidiary (Depfa).  And the banks in Iceland and the UK have essentially imploded – as have several in the US.

But my problem is that the banks in current account surplus countries are behaving very badly.  The relatively well run Chiba bank in Japan has halved.  Ditto DNB Nor – in oil rich current account surplus Norway.  

This is significant and signifies either irrational panic or the thesis being wrong.

Thoughts please.

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!