Tax benefits, Wells and Wachovia

The most repeated argument against my line that Sheila Bair erred badly when gifting Wachovia to Citigroup is that Wells could only make the alternative work because of tax benefits.

Lets dismiss that for once and for all.

The tax benefits would also have been available to Citigroup.  

John

A more sensible idea: A Citigroup pre-pack bankruptcy

It looks more and more like Citigroup is going to the Federal Government for help (something that neither Washington Mutual nor Wachovia did).  

In the WaMu and Wachovia cases Sheila Bair either confiscated or forced a transaction against the wishes of management and without a management approach to government requesting help.

When Citigroup does go to the Feds then the case for confiscation is MUCH stronger than it was with Washington Mutual.  Washington Mutual management still thought they could survive and they were still liquid. 

That said – I don’t think WaMu should have been confiscated and I do not think Citigroup should be confiscated in the same way either.  The problem with the WaMu confiscation is not that it wiped out my preferred (tough John), it was that it wiped out debt that had a reasonable right to think that it would get something in a liquidation. 

I think the confiscation of WaMu eventually doomed Citigroup (for which Sheila Bair should resign).  

But she has a chance to make good.  

I suggested in my quickly infamous confiscation post that Sheila Bair might just confiscate Citigroup and leave the holding company with nothing but its debt, debenture, preferred and equity liabilities.

The case for doing this is strong – much stronger than when she recklessly confiscated Washington Mutual.  

But I can suggest better.  You can confiscate Citigroup and treat the debtholders fairly.

You wouldn’t want to merge Citigroup with anything and have the debt assumed.  Banks that big we have discovered are globally dangerous.  If anything you would want to split it.  But for the moment mere survival would be adequate.

So here goes for a suggestion:

If (and only if) Citigroup comes looking for assistance then Sheila Bair should confiscate it.  

However…

When she does the holding company will file bankruptcy – and she should offer them a prepackage bankruptcy option option.  If they agree to convert all the debt to equity in the New Citigroup with the preferreds and junior debentures getting way out of the money options then she will gift the company that she has restructured  back to the old (and now restructured) Citigroup holding company.  The bond holders would it appears have no choice to accept.

They would get what they deserve  – and what the confiscation of WaMu denied them – first claim on the residual value of Citigroup.

This would not solve Citigroup’s liquidity problems (though converting 184 billion of debt to equity would solve the capital problems).  

To solve the liquidity problems Sheila should guarantee say 400 billion of unpledged Citigroup assets beyond the first 50 billion in losses.  She should extract a fee for this (say 10% ownership of the new Citigroup).  And Citi should be expected to repo finance the said pool of assets to get cheap funding.

After that she should do the same for any other major bank that comes through the door.  It will be most of them…

John Hempton

Why Sheila Bair must resign

Sheila Bair is doing a fine job at one thing – modifying mortgage terms in the mortgages she has taken over – particularly those at Indy Mac.  As a liberal I would be expected to applaud – but I am profoundly glad that Obama did not do as Robert Kuttner suggested and nominate Sheila Bair for the Treasury Secretary post.

Sheila Bair is simply wrong when she implys that the problem started with mortgages and therefore it will end with mortgages.  The problem with mortgages is no more than a trillion dollars (say 20 percent of the mortgages in the US defaulting with a 50% loss).  Indeed it is much less than a trillion.  If the financial crisis were about mortgages it would be over now – what with 500 billion of capital raising, a few hundred billion chipped in elsewhere (either by the Government into AIG or Maiden Lane or by Lehman and Washington Mutual bond holders and all the Fannie and Freddie losses that will be picked up by the Feds).  The financial crisis is not about mortgages – it is about trust.  

The people who provide finance to financial institutions (inter-bank and otherwise) no longer believe they will get their money back – and so are no longer willing to provide finance.  The unwillingness to lend to financial institutions dooms them regardless of their solvency.  The crisis is about trust.  

It is alarming enough that the head of the FDIC in so self serving a manner misdiagnoses the nature of the financial crisis – self serving because her institution is building up enviable expertise in modifying mortgage terms.  Indeed at best Sheila Bair is the woman saying “we must do something, modifying mortgage terms is something – therefore we must do it”.

But if misdiagnosis of the crisis were the end of it then there would be no pressing need for Sheila Bair to resign.  It is not the end of it.  Sheila Bair is an obstacle – indeed one of the principal obstacles in the way of reinstalling trust to American financial institutions.  

It comes about as follows:  if you accept that the problem is that people will no longer lend to financial institutions then the core thing that is required is the perception that the US Government will not arbitrarily confiscate your rights if you lend to financial institutions.

On Friday I suggested that Sheila Bair might confiscate Citigroup wiping out in excess of 100 billion dollars in parent company debt.  I am just a humble blogger in Australia – and my suggestion would be outrageous except that Sheila Bair through her actions on Washington Mutual and Wachovia made my suggestion plausible.  She has form.  She has done it before.  She has unilaterally determined that Wachovia required a government assisted takeover when Wells Fargo proved only days later that she was wrong.  Her judgement is unsound (proven) and her willingness to use powers to wipe out or compromise people who lend to financial institutions make her unsound judgement dangerous.

She just might confiscate Citigroup – because that sort of rash action is up her ally.  She shoots from the hip – and Wachovia proves her aim is not true.

Anyway – this crisis will be over when people are willing to lend to American financial institutions unsecured again.  And they will not lend to financial institutions when Sheila Bair is around.  Her presence makes it dangerous.

A policy statement saying she will not do it again would be nice – but is implausible.  Debt holders make a small amount of money when they are right – and lose a large amount when they are wrong.  Sheila Bair – even if she promised not to be so rash again would not be believed. 

 There remains a small chance that she will again exercise her unsound judgement to compromise debt holders – and that alone is enough reason not to lend to American financial institutions.

I do not know what a complete solution to the financial crisis (other than full nationalisation as per the Citigroup post) would look like – but if full nationalisation is not on the agenda (and as far as I can tell it is not) then any solution to the financial crisis involves removing Sheila Bair.  She is an obstacle to trust.

It is simple Sheila.  Resign now.  You owe it to your country.

John Hempton

Postscripts:

1.  There has been some comment my view is because I lost money (a very small amount) in Washington Mutual preferreds.  It is not.  Had the preferreds but not the debt been wiped out I would think that fair enough.  I purchased the prefs with three times the yield of the debt.  Sheila Bair made them roughly equivalent.  I have no qualms whatsoever about wiping out equity investors and I was one.

2.  I have purchased Sheila Bair's name on Google Adwords.  The adverts link to this post.  I am doing my bit to help solve the financial crisis.

Sheila Bair and seizing Citigroup

I suggested that Sheila Bair might seize Citigroup precisely because it is the sort of irrational, arrogant and dumb thing she does.  She did after all force the issue at Wachovia – signing a government guarantee (to Citigroup) even though a fully private sector solution was available.

But people took my suggestion seriously.  Some thought I had “jumped the shark”.  Others thought that I was straight predicting it.

So now – just to lay out the issues – I am going to discuss – in all seriousness – what a government seizure of Citigroup would look like – and how it might affect the rest of the economy and other bank stocks.

It is open to Sheila Bair (and her fellow regulators) to seize Citigroup (deeming it unsound) and to leave at the holding company – and worth near zero – all the equity, preferred shares and holding company debt obligations.  Indeed this is precisely what she did at Washington Mutual.  What she did once she might do again. 

This will in fact result in a full successful resolution of the Citigroup problem at no cost to the government from Citigroup.  There is a darn strong case for doing it. 

Here is the liability side of the Bank Holding Company balance sheet from the last filing period:

 

 

I am sorry it is in thousands but it is a regulatory statement – and that is how they come. 

Click and look at it.  There are 17.5 billion in short term parent company debt and 117.5 billion in parent company debt with more than a year’s maturity.  There are a further 27.4 billion in perpetual preferred securities and 28.5 billion in subordinated debentures. 

If Sheila Bair confiscates Citigroup and leaves all those liabilities at the holding company then it is economically the equivalent of a 184 billion dollar equity injection into the remaining group.  A cancelled liability of course is the equivalent of new (non cash) capital.

The new Citigroup should be adequately capitalised – albeit government owned.  The FDIC could IPO the new Citigroup once this market mess had died down (and remit most the proceeds to former bond holders).  A shrinking Citigroup with an additional 184 billion in capital shouldn’t cost the government anything.

But Sheila Bair does not need to stop there.  She has the power to guarantee some assets of the new entity – and her guarantees carry the full faith and credit of the US Government.  She did this with Wachovia.  The new Citigroup could then put the guaranteed assets into a special purpose entity and repo finance the entity.  This would look similar to repo-financing treasuries – and the new Citigroup could thus obtain very cheap funding.  That cheap funding would guarantee its liquidity and its profitability – and hence ensure that the government does not lose anything further (other than borrowing capacity) from the Citigroup nationalisation.

Remember both steps of this Sheila Bair has performed before.  She confiscated Washington Mutual and left behind the parent company liabilities.  She guaranteed assets at Wachovia.  This is Sheila Bair’s proven style.  And she would look a hero because Citigroup would be resolved at no cost to taxpayers.

But…

And you knew there would be a but…

If Sheila Bair was to confiscate a really big bank and cancel all the parent company liabilities then no other bank in America would be able to raise parent company debt.  Indeed I think that has been the case ever since Sheila Bair did the reckless and irresponsible takeover of Washington Mutual… but it would certainly be the case if the parent company liabilities of Citigroup were cancelled.

And that would be a huge decision indeed because then every bank with parent company liabilities (meaning almost every bank in North America) would fail. 

Many – but not all – could be taken over in the same fashion at little cost to the government.  But almost all of them would wind up property of the US Government.

Full nationalisation, Swedish or Norwegian style, is an effective end to a financial crisis – and Sheila Bair has the power and has proved that she is willing to use it.  But it is a decision way above her pay grade.  (Where is President Obama’s new Treasury Secretary?)

My view is that Sheila Bair should not only not use the powers she has previously shown a willingness to use – but that she should resign immediately and admit that her previous decisions were in error.  She should resign now – or Citigroup is likely to be hers anyway.  

 

 

John Hempton

Postscript:  The Holding Company has several regulated subsidiaries - presumably in several jurisdictions.  All the regulated subsidiaries would have to be seized together - and if some came up short some form of solution would need to be found.

Postscript 2:  Actually I think the die was cast for Citigroup when Sheila Bair confiscated WaMu.  The lesson was learnt that bank debt could be treated very unfairly by regulators and hence banks were never going to be able to get finance again.  The worst decision of this cycle was to let Lehman fail so badly - creditors got very scared.  The second worst was the reckless way in which creditors of WaMu were treated - it made them even more scared.

Remember Sheila Bair wanted to sell Wachovia to Citigroup

I loved the sequence.  Sheila Bair forces the issue at Washington Mutual - a bank that she did not need to force the issue at but which might have been insolvent.

Then she absolutely forced the issue at Wachovia.  She insisted that Wachovia sell to Citigroup even though Wells Fargo wanted more time and a market solution was available for Wachovia with no hint of a government guarantee.  

If Sheila had sucessfully sold Wachovia to Citigroup she might have two banks to deal with or Citigroup might just sell the loans she had guaranteed.  

But now is Sheila Bair's moment.  If her past behaviour is anything she will confiscate Citigroup because it looks sick.  She has the ego, she has the momentum, she has the form.

Sheila can of course run this, sort it out, become Treasury Secretary and otherwise rule the world.

Sheila Bair - just admit the precedent you set is inappropriate and resign!

John Hempton

The Mark Cuban charges – and the economic purpose of insider trading laws

Warning: this post contains observations on American law written by a non-lawyer Australian. Technicalities might be wrong but (I think) the general theme is right.

Mark Cuban is loud and opinionated. I like his opinions sometimes. He also gave me one nice big-cap stock idea once – but he didn’t even mean to give it to me. Indeed he probably didn’t even trade it himself. It is just that something he said about high definition TV changed my views on DirecTV and I purchased it about $13 as a result. It was a very quick profit. Thank you Mark.

That said Mark Cuban has famously been charged with insider trading regarding his trades in mamma.com – a stock I would never have touched. On the information given his actions look unethical – but whether they are illegal is another thing.

The purpose of insider trading rules

The purpose of this post is really to explore the economics of insider trading in light of the Cuban charges.

There is a daft argument that pops up every now and again about why insider trading should be legal. Here is one reference to it. It takes some doing to explain why this is daft. Here goes:

The total returns to stockholders from a business over a very long period should equal the return from the business less transactional costs. The stock market doesn’t actually “make profits”. Businesses make profits – and hopefully those profits get distributed to shareholders via buybacks and dividends. Of course some clever people buy low and sell high – but to the extent that some smarty (hopefully me) makes a return above the business return some sucker out there (hopefully someone who does not read this blog) makes a return below the business return.

If the market were perfect we would all know what the returns to each sort of business were and we would allocate capital accordingly. There would be no misallocation.

But the market is not perfect – and the returns to a business can only be estimated. Most shareholders solve the problem by owning a bundle of stocks (its called diversification) and the returns to the bundle of stocks should in some sense be reflective of the returns to business per-se. Of course this is only true if you hold the stocks over a very long period of time – but it should prima-facie be true on average if the market approximates efficiency.

Of course all this breaks down if management steal from shareholders. Indeed if management always stole all the returns to shareholders there would be no shareholders – and there would be massively sub-optimal investment in business. If management steals a little the returns to investors would be slightly lower than the returns to business and the investment level would thus be sub-optimal.

Now back to insider trading. Insider trading cannot change the end returns over very long periods to shareholders. The returns to shareholders are ultimately determined by the returns of the business. The stock market does not make economic returns – the businesses do that. But insider trading increases the returns of insiders and hence must reduce the returns of non-inside shareholders. It is economically the equivalent of theft as it allocates returns from capital providers to insiders.

It is facile to say that insider trading is good because it brings stocks closer to fair value. That would only be desirable if it brought shareholder returns closer to business returns… and it does not do that.

Now having stated this, it is clear what insider trading rules are meant to do. They are meant to stop theft by people who are in a position of trust with respect to a company and thus deny insiders and advantage over external shareholders.

Fine – but that is not what the Australian laws do (though it is closer to what the American laws do).

The Australian law is an ass. There was a case of a guy who found gold on a mining lease he personally owned. The only problem was that the ore body was open-ended and clearly extended far onto the neighbours lease. He did what a sensible sort of fellow would try to do – he tried to buy the neighbours lease without telling him about the ore body. Of course he was trying to get maximum return from his prospecting effort (and I still have not worked out what is wrong with that from a microeconomist’s point of view…)

But the problem was that the neighbour’s lease was owned by a small public company controlled by Joe Gutnick. [Regular readers will know that Diamond Joe has made a few appearances on this blog…]

So he started buying stock in Joe’s company.

This was deemed by the Australian authorities (and later the courts) to be insider trading. He was trading on non-public information (that there was gold in them there hills). The only problem is that he found that non-public information by informed and legal sleuthing on his own and not by being an insider. This would seem to make stock research (at least if involves digging in the dirt) look like insider trading. I hope the authorities don’t want to stop me doing research. But the key here is our hapless gold prospector was not an insider, did not have a position of trust and hence did not abuse that position of trust. I cannot see the justification for the insider trading rules – but being an Australian I have to live with them.

Anyway the American rules are much more clearly about position of trust. When the CEO of Imclone sold shares (or sold his daughter’s shares) when he knew the FDA was going to reject his drug that was insider trading. If he hinted or told another person (Martha Stewart) to sell her shares that was also a breach of the position of trust. But Martha Stewart selling her shares – that was legal. Martha Stewart is not an insider. What Martha Stewart did would have been illegal in Australia – but it was not in the US. For those that do not know she went to the big house for lying to investigators and not for insider trading.

I think the American rule is right from the economic perspective – but it is awful hard to prove.

Enter the Mark Cuban case.

Mark Cuban owned a large stake in mamma.com. He received a call from the CEO asking if he wanted to participate in a secondary offering (a pipe). He sold his shares.

There is no criminality in that because Mark Cuban is not an insider. If it were Australia the case would be easy to prove because he does not need to be an insider – he only needs to be in possession of non-public knowledge – and that is clearly the case.

To make him an insider he needs to have agreed to be an insider. He needs to have agreed with the CEO that he will take information confidentially. In other words the case hinges almost entirely on the contents of a phone call between the CEO of a failing dot.com and Mark Cuban – and the call is meant to have taken place in 2004. Nobody is going to credibly remember it. If it came to a criminal charge (which required absence of reasonable doubt) then you would have to acquit Cuban because at best this case will be two people saying “he said” and the other saying “no I did not” about a conversation years ago. As far as I know there is nothing in writing in which Mark Cuban agrees to be an insider (though something in writing is what is required). It is telling that there was no criminal charge filed with the civil charge. The criminal charge wouldn’t fly.

Now the fact that I don’t think (at least beyond reasonable doubt) that Mark Cuban is guilty of insider trading doesn’t mean I condone what he did. It was unethical – in that with information given to Mark at least because of his position (as a rich guy) he acted in a way that increased his returns vis other shareholders. It is not nice behaviour and it would be illegal in Australia.

And that makes the only case I can think of for the Australian laws. As the Aussie laws do not require evidence that Mark Cuban agreed to treat information as confidential he would be guilty here. It would be a slam dunk to use the American phrase. The case for the Aussie law is that the case is easier to prove.

For the record I am fairly sure no criminal charge will be filed (in the absence of the bit of paper or email in which Cuban agrees to treat information as confidential the case would not fly). On the civil charges on the evidence given I would acquit however there may be considerably more evidence than is given. I am not sure that is economically the right outcome – but I think it is where the law is as I understand it.

In full disclosure I have to say that I still feel favourably to Mark Cuban (I made money on DirecTV). I wish him luck even though the most charitable interpretation of his behaviour is that it stinks.

As for lessons: it doesn’t pay to hit the ball close to the line. Even if Cuban’s behaviour was legal (as I suspect) it invites criticism and it looks bad. Mark is paying dearly for it now – and that payment might be deserved.

John Hempton

William Buiter has written up the London as Reykjavic idea for the FT

I referred to Willem Buiter's Iceland paper here.

He has done a thorough job of writing up the UK implications for the FT here.  Recommended.

Citigroup, Whachovia, Sheila Bair and a post I didn't make...

In the middle of the Citigroup/Wachovia thing I wrote a post which I circulated amongst friends but do not remember posting.  It was a little hot.

As speculation that Citigroup is insolvent is now widespread (see Felix for a recent example), I thought I might just post it.  Sorry dear readers to not give it you when it was more relevant:

Is Citigroup going under? Is Sheila Bair's erratic behaviour really her trying to save Citi? 

Readers will know that I think pretty lowly of the head of the FDIC. Maybe I am wrong. 

I have been puzzling this weekend – trying to work out what is going on using the assumption that all is part of a grand and competently executed strategy.

And the result was unsettling. The best hypothesis I came to is that Citigroup is going down and that Sheila Bair is trying to save it.

Sheila Bair – as readers will remember – forced Wachovia to sell itself in three days whilst other parties had not had anything like enough time to complete due diligence. She – unilaterally and incorrectly – told the world that this deal could not be done without government assistance. She unilaterally decided to issue a guarantee that on a pool of $312 billion of Wachovia assets Citigroup could not lose more than $42 billion. She made that decision even though Wells Fargo was telling her that all they required was more time to do due diligence.

Given that Wells Fargo was willing to acquire Wachovia at no-cost to taxpayers that looks like a very bad decision indeed. But this is the post assuming that Sheila Bair is smarter than all of us.

And so we need to understand the significance of that guarantee. The significance is as follows: Once Citi owns $312 billion in assets on which they can only lose $42 billion the remaining pool must be worth $270 billion. That $270 billion is guaranteed by the US Government – as the FDIC is a full faith and credit organisation. Citigroup can put that $270 billion (plus the $42 billion in non-guaranteed assets) in a pool and repo it – and as Treasuries yield very little they will wind up paying well under a percent of interest. The Sheila Bair decision was equivalent to a cash injection into Citigroup of 270 billion because the repo-market will turn government guaranteed loans into cash.

That cash injection is almost 40 percent of the size of the whole bailout package and it was given to Citigroup by Sheila Bair without congressional oversight. We got all stroppy at giving Paulson that sort of unilateral powers – but – hey – we are prepared to forget that Sheila Bair already has them.

Anyway – Citigroup buying Wachovia reliquefies Citigroup. Big time. Citigroup almost certainly knows this. Sheila Bair – if she is smart – knows this. That is why it is so important for Citigroup to complete the deal.

Now Wells Fargo have come to destroy the party. They are prepared to buy Wachovia without any government guarantee. The FDIC should be cheering as this removes all cost to the taxpayer – but Sheila Bair stands behind the decision to sell Wachovia to Citigroup.

Citigroup isn't looking to sue Wachovia for a break-up fee. They are looking to enforce specific performance on Wachovia. They are not interested in a $20 billion break-up fee – that does not save them. That is just too small. They are interested – critically interested – in the net $270 billion in guaranteed assets because that is the equivalent of $270 billion in cash – enough to save Citigroup from destruction.

Specific performance is very hard to enforce as numerous blogs have pointed out – here and here for example. But in this case it is necessary.

Sheila Bair is smarter than I thought and she knows it too. So I withdraw my demand that Sheila Bair resign – on the basis that it is probable that Sheila Bair knows more than me and she deemed it necessary to inject $270 billion in cash into Citigroup to stop their imminent failure.

Of course if this thesis is wrong Sheila should just save me the trouble of issuing a correction and resign forthwith.

 

 

John Hempton

 

 

 

 

Iceland, Switzerland, Denmark, Sweden, Jordan and countries with banks that are too big to bail out

There is a wonderful (simply wonderful) paper by Willem Buiter and Anne Siebert on the Icelandic banking crisis.

It’s the sort of paper that puts the lie to the line “nobody expects the Spanish Inquisition” because the core part of the paper was written – under contract – to the Icelandic Central Bank.  All agreed that the contents were “too hot” and the academic authors agreed to secrecy. 

Now that the worst has happened there is less need for secrecy so the paper has been published along with policy prescriptions for Iceland.

Ok – well and good. 

Their explanation was that it doesn’t matter whether the Icelandic banks were solvent or insolvent – there was a simple problem that the banks were large compared to the Icelandic economy and the governments could not conceivably bail them out.  As a result a run on one of them would collapse them all. 

I will express an opinion on one – and one only.  I think Kaupthing – which was by far the most aggressive purchaser of foreign assets – was probably insolvent. 

Anyway the lesson was that a country could not afford to have banks whose liquidity they could not guarantee in a run.  If the banks were so big you could not guarantee the liquidity then the banks were set up to fail.

Of course Iceland is not the only country with big banks.  [It was – when I did a study a while ago – the country with the second highest bank revenue to GDP ratio in the world…]

The country that beat it of course was Switzerland.  And sure the Swiss banks are better than Kaupthing – but UBS is not that good – and relative the Swiss Economy it is about as big… that is too big to bail out. 

I have been saving this post ever since I read the Buiter/Siebert paper (on the weekend) but Felix Salmon has sort of beat me to the punch – and the competitive instinct has made me run with it.

The other countries that stand out as having big multi-currency, multi-national banks are Denmark (Danske), Sweden (Nordea, SEB and Swedbank) and Jordan (Arab Bank).  Of these Danske is usually quite well run but they purchased a bank in Ireland before Ireland’s economy went to crap.  [They run it well but…]  And they purchased a bank in Finland (Sampo) on which they have not only overpaid but stuffed up the system integration.  Still I like Danske management personally and the good bits are very good.  Also they sold their crappy investment bank to Kaupthing a few years ago for an insane amount of money – and that sort of win covers a multitude of other sins.

Nordea is (in my opinion) very well run (but I no longer own shares).  Swedbank is deluded and awful and SEB has good bits and bad bits.

Arab Bank is a fine institution if you don't mind litigation risk associated with funding terrorism.

Of course there is one remaining country with banks that are large-relative-to-the-economy – and that is the UK.  RBOS and Barclays are both enormous and - at best opaque. 

Now do American taxpayers want to pick up UBS or Barclays?  I don’t think in the end they will have any choice.  The banks will fail or they won’t.  And if they fail – well I hate to say it – but the new administration will be stuck with it.  I guess UBS will lose its tax avoidance business in the process…  and a few American rich folk can help pay for it all with their back taxes...  unfortunately the risks to the system are bigger than that...

 

 

 

 

John Hempton

A sort of postscript... I guess ING is very large compared to the home market.  It is not without issues... but generally I think it is very well run.

I was also probably too kind to Danske - as noted in the comments...

Getting your duration and diversification offshore – how bond market crises and currency crises intertwine

It helps if you read the post about international diversification first.  If you do not understand the problem of owning foreign equities and hedging back into your own currency by the end read my further explanation in the comments.

That said – once you have eaten your spinach – I will show you a really nasty problem that some small country bond funds have.

An equity portfolio doesn’t have to be very diversified to get most the benefits of diversification – twenty well chosen stocks will give you most of the benefit.  A bond portfolio requires considerably more diversification primarily because of the asymmetrical nature of bond performance – in a twenty stock portfolio one stock that does much worse than the index is likely to be offset by one that does better.  With a bond portfolio a bad bond doesn’t have an offset except the spread on good ones. 

Anyway in small countries if you want to run a diversified bond portfolio you generally have to go offshore – the local country seldom carries enough diversified names. 

Issuers know this – and issue regularly in lots of little currencies.  Lots of American companies for instance had Australian bond programs (Kangaroo bonds) because the local managers wanted diversification.  The American company would then would change the money back into USD and protect their currency risk with currency swaps.

Alternatively local bond managers regularly purchased bonds offshore and used derivatives to protect themselves from currency risk.

This process is common.  Even American bond managers buy foreign currency bonds and protect themselves from currency movements with currency derivatives.  This extract from a 2004 Pimco Investment Outlook is a case in point.  Bill Gross is suggesting that to the extent that Pimco wants duration it should look offshore (Bunds, Gilts even) and (presumably) swap the currency back into USD. 

[The solution to the inflation risk in the US] is to be rather choosy about the country where you hold your duration, to reduce it in reflating countries (U.S., Japan) and increase it in relatively vigilant ones (Euroland, U.K.). In so doing, the potential pain from holding bonds in a reflating global environment can be reduced if not anesthetized entirely. 

Now put yourself in the position of the Australian bond fund manager who has massively diversified their bonds globally – and has covered their currency risk by entering contracts to buy AUD at a fixed exchange rate (say parity to the USD) at some stage in the future.  The AUD – as anyone who lives here knows – has had a rough trot lately – falling over 30 percent quite rapidly. 

The currency hedges are either margined or one or three month rolls.  Either way you are going to have to come up with about 30 percent of the offshore portfolio in cash as that is what you have lost on the currency hedges. 

Presumably of course you have made an offsetting amount by owning bonds in a foreign currency that has appreciated. 

This of course presumes that you can sell the bonds.

Which is a problem. 

As everyone should have noticed by now bond markets are not exactly liquid.  A lot of bonds are 90 offered, 20 bid but with a real value that might be 95.  Most are better than that - but if you have to sell billions in bonds you have a problem.

The real value is irrelevant – my Australian fund manager (which could be a life insurance company and hence implicitly levered) has a problem – they need the liquidity.

They can get the liquidity by selling Australian bonds – which infects the Australian market with the contagious selling/no buyers that foreign markets have.  But somewhere they need to sell.  Big time.

Well I can see a few life insurance companies (which are levered entities) in small countries having big problems.  It wouldn’t do to mention names …

As for Australian bond managers – they have a rather nasty habit of imploding – see Basis Capital or Absolute Capital Management for an example.  These were levered sellers of volatility – the name of Basis Capital told most the story. 

That said – even the surviving Aussie bond managers are having a rough time.  Very rough.

There is a lot in the relationship between currency and crises.  Much I do not understand and much I don’t grok. 

As for Bill Gross: Pimco hardly looks like the disastrous Australian bond funds.  It is not levered for a start (and that makes a world of difference).  It is mostly in US agency and GSE mortgage backed securities anyway.  And besides the US – unlike Australia – is not a small country.  But the strategy that Pimco employed (own foreign assets swap out of the currency) is widespread.  And in a US currency crisis (if such a thing ever happens) the runs on funds that use that strategy could be large.  It’s a potential issue.

But I am an Australian – and unfortunately I know the truth – this is far more likely to hurt us than the United States.

 

 

John Hempton