Luigi Zingales has it right

Luigi Zingales knows a few things about how the new administration should behave.

He may be a little too jaundiced about nationalisation - but here is the money quote:

Get a strategy

To begin, you (Mr Geithner) need an overall strategy. Even a mediocre strategy is better than an ad hoc approach that confuses markets and fuels the perception of playing favorites. Legendary portfolio manager David Swensen (who in 23 years transformed the $1 billion of Yale endowment into $23 billion) in reference to the government intervention in this crisis commented “the government has done it with an extreme degree of inconsistency. You almost have to be trying to do things in an incoherent and inconsistent way to end up with the huge range of ways they have come up with to address these problems.”

The cost of ad hocery

The cost of this inconsistency is that it has forced the private capital to stay on the sideline. Short of a complete nationalization of the financial sector (which we hope is not in the plan), the problem cannot be resolved without the help of private capital. But a necessary condition to attract private capital back is a consistent and predictable strategy by the government. Without it any other effort is in vain.

I should note I disagree with a lot the rest of Zingales paper - and will explain why in a later post.

I do not oppose nationalisation - but I would prefer that private money came to the fore. Private money will not pony up if they do not know the rules.

The way to do nationalisation is nationalisation AFTER due process. Due process (anywhere) does not seem to have been a hallmark of the Bush administration.

Confiscation without process (WaMu springs to mind) guarantees that there will be a private capital strike.

With a private capital strike everything eventually needs the government to bail it out. Everything - JPM and Goldies included.






John

Lest you think I disagree with Krugman too much

Krugman makes the obvious point that being fixed to the Euro hardly imunizes you from financial crises.

http://krugman.blogs.nytimes.com/2009/01/19/the-pain-in-spain/

I still do not get Willem Buiter's pamphleting for the UK joining the Eurozone.  This post was more softly stated than normal.  

John Hempton

A slogan for the new administration: nationalisation after due process

A lot of my readers mis-understood my last post.  It was only to point out that with a government guarantee even fairly heftily insolvent banks will live.  

In some sense the conclusion is not surprising.  The purpose of capital in a bank is to ensure that the funding sources get repaid.  A government guarantee does that – and so is capital.  The guarantee ensures profitability because it ensures that there is adequate capital.  

Now there is a cost to these guarantees.  They are expensive – especially in an ex-ante sense.  The taxpayers are taking a risk – and they should be compensated for that risk.  That is a basic capitalist principal – but it also is just plain fair.  Real capitalists nationalise.

But there is a cost to nationalisation too.  The cost is that potential capital providers – sometimes with some justification – see it as theft.  I personally see the snitching of WaMu as theft – and nobody has yet come up with a credible argument against that.  

Who cares whether it was theft or not though – it appears to be theft – and that is sufficient to do damage.  The effect of the seemingly arbitrary action of Sheila Bair in confiscating WaMu was to discourage any and all new private capital to banks.  

Once capital providers have decided that the government will arbitrarily nationalise there will be no capital providers.  Nationalisation can be a nasty self-fulfilling policy.  We have – and I have blogged about it before – the opposite of moral hazard.  We (people who as a matter of course might provide capital for banks) are living in fear of arbitrary actions by government.   Believe me - I buy and sell bank stocks and I live in fear!

And if anyone here thinks the process for bailing out financial institutions hasn’t been arbitrary then you haven’t been looking.  Every single major failure has been handled differently.  I would say rules are being made up on the fly – but in fact there are no rules.

So here is a proposal.  Call it “nationalisation after due process”.

An organisation is in deep do-do – and needs a bailout.  Following Paul Krugman we will call it Gotham Bank.  

Gotham has stated $2 trillion in assets and $1.9 trillion in liabilities – a stated $100 billion in capital.  Suppose the required capital is $100 billion according to regulatory rules.  

But Gotham’s accounts are nonsense.  It has an unknown number of bad assets – say something between $100 billion and $500 billion.  If it has $100 billion in bad assets then there really is shareholder value there.  It has earnings potential and is solvent.  If there is $500 billion in bad assets the bank can be so insolvent that even time is not a solution.  

It goes to the government.  Under the Bush administration the government would make a set of rules up for Gotham over a disorganised weekend.  The fait-acompli would be presented before Asian markets opened.  

But it does not have to be that way.  The government could inject some capital into the bank as a temporary subordinated loan.  A third party could then be appointed (new management – or answerable to another arm of government) to produce fair accounts for Gotham.  Ten weeks should do it.  At the end of ten weeks Gotham will be found to have – as a middle estimate – say $150 billion in losses – it is thus negative capital by $50 billion or a full $150 billion short of its required regulatory capital.  

The management of Gotham can go to the markets.  If the management can raise $100 billion (something to get it back to half capitalisation) then the shareholders keep Gotham.  Sure existing shareholders might get diluted - but at least they get to have a decent go at keeping their capital stake.  

If they can't or won't fund the bank in full knowledge of its position then it is nationalised.  It is in that case unambiguosly not theft - shareholders had the chance to keep the bank under fairly administered rules.  

What I want is extreme government action (nationalisation) but with a process to ensure that existing property rights are honoured.  I want the benefits of nationalisation (that it works) without the costs (that it is seen to be arbitrary to capital providers).  

Due process if you will.

Due process is one thing that the Obama administration should get right over the Bush administration.  It is a mark of good government.

Here is hoping.

John Hempton

PS.  Why half capitalistion?  Because bank capital is there to buffer against losses.  Once the losses have occured the bank should be allowed to run to build the capital back up.  Full capitalisation at the bottom of a banking cycle would make banking regulation too procyclic for the general good.

PPS.  When I was a junior public servant (Australian Treasury) I saw the policy prescription - the events of the weekend or crisis - as the important thing.  The longer I looked at it the more I realised that the processes were as important as the outcome.  Indeed they are more important.  Markets work because we have a legal process.  They do not work in Cambodia because there is no process other than he-who-pays-the-biggest-bribe wins.  

A funding market for banks will not reappear until process reappears.  Getting the process right is KEY to solving the financial crisis.

Voodoo maths and dead banks

I am not afraid bank nationalisation.  Real capitalists nationalise – meaning if the taxpayer takes the risk the taxpayer gets (any) upside.  However I want to take issue with Professor Krugman’s NYT editorial today.  Krugman accuses members of the incoming administration of believing in voodoo rituals to keep banks alive.  He takes a worthy shot at the person I most dislike amongst the continuing economic team (Sheila Bair).  But I still think Paul has his maths wrong.

Here is the key part of the article – with Gotham being a thinly disguised moniker for Citigroup.

On paper, Gotham has $2 trillion in assets and $1.9 trillion in liabilities, so that it has a net worth of $100 billion. But a substantial fraction of its assets — say, $400 billion worth — are mortgage-backed securities and other toxic waste. If the bank tried to sell these assets, it would get no more than $200 billion. 

So Gotham is a zombie bank: it’s still operating, but the reality is that it has already gone bust. Its stock isn’t totally worthless — it still has a market capitalization of $20 billion — but that value is entirely based on the hope that shareholders will be rescued by a government bailout. 

PK is wrong.  With sufficient trust Gotham is far from bust on PK’s numbers.  Suppose – and this is an understated assumption – that the normalised pre-tax spread on Gotham’s assets was two percent – say – and for the same of simplicity – the bank would earn 3% on assets and pay 1% on liabilities.

Then the bank (if it did not have the bad loan problems) would earn $60 billion on its (normal) $2 billion in assets and pay out $19 billion on its $1.9 trillion in liabilities.  The pre-tax profit of Gotham would be $41 billion dollars.

But – as Krugman suggests – the real assets of Gotham are not $2 trillion, but in fact $1.8 trillion.  The liabilities are (unfortunately) solid.  They remain worth $1.9 trillion.

Then – if the bank can continue to operate – it will earn $54 billion on its assets still pay out $19 billion on its liabilities.  Pre-tax profits will still be $35 billion.

If the bank runs for three years it will again be solvent.  If it runs for less than six years it will be fully and adequately capitalised.  This is in fact how the Japanese mega-banks recapitalised.  I blogged about it here.  At the spreads in America – which are several percent – the recapitalisation will happen much quicker than this and much quicker than in Japan.  Indeed it is likely that with quasi government guarantees for bank funding and market rates for bank loans the spreads would be over five percent in America right now.

Paul thinks the bank has value only because there is a perception that it will be bailed out.  I think it has value because it still has positive operating cash flow (provided it does not have a run).  The value - which I believe is large - might mean that widespread nationalisation is (ex-post) profitable for government - though it may not be profitable on an (ex ante) risk adjusted basis.  

Paul Krugman might consider it voodoo economics to give implicit guarantees to banks – but the Japanese experience shows – and this post explains – that things that stop a run will eventually recapitalise a bank.  It worked in Japan.  It was not a particularly pretty way to run things from a macroeconomic perspective – though people like Nihon Cassandra think that Japanese capitalism works pretty well.  

Paul is accusing Sheila Bair et al of voodoo economics.  I am inclined to agree with almost anything nasty about Sheila Bair.  But in this case PK is publishing voodoo maths.  

John Hempton

Sweden, Norway and a request for some decent macroeconomic models

Warning – non-stock post – mostly macroeconomics problems.

There is a debate online about what the Swedes did or did not do to bail out their banking system.  See Kevin Drum here and Steve Waldman here.  Having long followed the Scandinavian banks (and once having spoken for 2% ownership of Nordea – the former State Bank) I can confirm that Steve Waldman is closer to the truth.

However the best example is not Sweden – it is Norway – and a full history in English of their banking crisis can be found here – compiled by Norges Bank after their crisis.  

It is the single most useful volume anywhere on the Scandinavian crisis – even though it limits itself to Norway.  I gave a summary here.  

Can people read the Norwegian document before they start professing expertise on this stuff.  Please.  

I only point it out to raise the quality of debate, but more importantly I have an intellectual puzzle.

A lesson from the Scandinavian banking crisis was that you did not want to have a fixed currency.  To this day only Finland has pegged to the Euro – and Finland does not own any of its banks.  Norway, Sweden, Denmark and Iceland had their own currencies – and it has always been my belief – following the Norwegian experience – that if you want to have a banking system and avoid financial crises you better have your own currency.  The Scandinavian central banks would agree with that statement.  Indeed a good part of the problem of the Scandy banks this time is that they lend in the Baltic States – and those are small states with fixed currencies.

This time countries with their own floating currencies are having problems – notably Iceland.  Willem Buiter is pamphleting about the UK joining the pound as a way of avoiding becoming Reykjavik on Thames.  However we have Reykjavik on Liffey (Dublin) and they did everything in Euro.  

My guess is that Buiter is plain wrong – and Norway provides his counter-example.  Moreover the Iceland example that Buiter points to is misleading because the Icelandic banks did a lot of their borrowing in GBP and Euro.  

I find it odd that I am having academic debates with Willem Buiter about macroeconomics.  He might be the most famous macroeconomist in Europe and I did my last macroeconomics course twenty years ago.  Can someone help me out here with a simple model? 

John

HSBC are thugs (sorry “partners”)

HSBC has gotten a little aggro lately – an analyst dispute widely reported in the FT and other places.   By the standards of the story I am about to tell you the behaviour is quite genteel.  

I know relatively little about HSBC.  I thought they paid an absurd amount for a Taiwanese bank I understood really well.  I later met the guy who was responsible for the purchase and decided that I knew far more about the target than him.  Fortunately I was not short the target.

I never much liked Household (indeed I lost money betting that HSBC might come to its senses and not consummate the Household deal.)

I also had a fairly aggressive argument once with a colleague who wanted to buy HSBC.  But realistically I only knew about a few cockroaches and I wasn’t sure whether the place was infested.

This post is about a really nasty cockroach.  I will leave determination as to whether this is an infestation up to my readers.

The Bally Total Fitness scam

Bally Total Fitness was a favourite of shortsellers.  I sold it short myself and made good coin.  It was a simple scam.

The company ran gyms which had seemingly attractively priced memberships.  Running fitness centres is a notoriously tough business.  Anyway these seemed to work – at least in an accounting sense.  

In fact the company scammed the customer.  Customers thought they were signing a month-to-month gym membership – but – and I am not joking here – they were signing a loan document – and there were huge penalties for not paying.  The documents were often non-cancellable.  The customers were misled.  

There was a website called ballysucks.com (now defunct) which told the story.  They were sued by Bally and lost.  The story can still be found here and here amongst dozens of consumer rip-off reports on the web.

Bally managed to report not only overdue fees (for which the customer had falsely been induced to agree) as receivables – but they included penalties as per credit cards.  

Obviously collection was a problem.  Bally filed bankruptcy.

So what has this got to do with HSBC?

Well the Bally scam required a collection process.  It required thugs to go chase the delinquent “loans”.

HSBC provided the thugs – and surprisingly – given the thuggish nature of the activity they have never been pulled apart in the financial press for it.  They didn’t doing it using the glamorous HSBC name.  No it was Orchard Bank.  They used to ring up the customers and say they were a partner of Bally.  Sometimes HSBC purchased this debt (according to Bally at par) which suggests that their due-diligence was lacking.

They were the debt collectors for Bally’s fraudulently obtained loans.  Standover men if you will.

But I will use the word of the HSBC/Orchard debt collectors.  They were “partners”.  Indeed the partnership extended more widely and there were over 100 thousand credit cards issued by Orchard to Bally customers.  

Do you judge someone by their partner?  In this case it was Bally’s customers who were "consummated" in the relationship.

John Hempton

Riots in Riga

There are times that I would prefer not be right

In the single most famous post on this blog (Hookers that cost too much) I predicted middle class riots in Latvia.  

It is happening as you can see here and here.

Book review – Gerald Stone’s Who killed channel 9?

For the non-Australians out there - Channel 9 is the once dominant TV network in Australia with a "galaxy of stars".  It had the largest revenue base and the largest profit.  It has lost both positions.  It was once owned by Kerry Packer.  It is now owned by private equity firm CVC. 

This is a highly parochial book for me to review – but hey – I do media stocks as well as financials – and Channel 9 is a very salutary lesson.  Further Channel 9 is likely to come back to market as the LBO which owns it likely has trouble.  When you read this book keep in mind the main commercial difference between print and TV.  In print if you do not like what you see you turn the page.  In TV you change the channel.  In print the media company keeps the customer.  On TV they just lost them.  It is the fundamental difference in driving programming and management style.  

And this book is fundamentally about managing a mass-market TV station – a job which – as a first requirement – ensures that people don’t change channel.

As it about management let me start with a management story.  This I think is the key to determining the ultimate success of a big media conglomerate – and it is one of the hardest things for a bean-counting stock analyst (me) to do well.  

Steven Spielberg’s flop and some lessons

Once Steven Spielberg made a commercial flop.  The film was 1941.  The next film he had a constrained budget.  It was Raiders of the Lost Ark.  When making that film they ran low on money – and they had a scene which was going to cost the then princely sum of $2 million to shoot.  Senior cast and crew sat around trying to work out how they could do it for cheaper.  The problem was that there was a baddy out there who Indianna Jones just had to get past – and there was going to be (another) over-the-top battle scene.

Harrison Ford suggests “why don’t I just come out and shoot him?”  Everyone rubbished the idea – it was going to make the hero (Indianna Jones) look like a callous thug, not a swashbuckling Errol Flynn.  But Harrison Ford pulled it off with the appropriate level of disdain – and it is the single funniest moment in the film.  

Now this lets you know what Hollywood has known for a while – which is that Harrison Ford really is a genius.  

But it tells you a few other things:

1. Budget and artistic (and even commercial) relevance are only weakly correlated, and
   
   
2. Actors, mid ranking staff and all sorts of other people when working collaboratively in an atmosphere of trust can make fabulous decisions which add to the bottom line.

No Taylorist management school or top-down bean counter is going to achieve this.  What is required is a fairly hefty level of trust and mutual respect.

Bean counters and the Nine network

The theme of the book is what happens when a Machiavellian bean-counter is put in charge of a creative enterprise.  That bean counter is Gerald Stone's anti-hero – one John Alexander.  JA runs a minimalist aesthetic lifestye – he is married to a famous photographer and reads high-brow books.  He was a successful print executive and never really got the difference between print and screen.  

It is not that someone like JA wasn’t needed at Nine.  Entertainment figures at a highly profitable enclave (and Nine was such a place) can become ludicrously indulgent.  They are amongst the few who can match hedge fund mangers for seeming petty indulgence.  And even that is alright whilst everything is going well.  But Nine faced the pressure that free-to-air media companies have everywhere – new media and a fracturing audience and advertising market.  

The problem is how do you keep camaraderie and appropriate teamwork whilst ripping out costs?  In other words how do you get Harrison Ford to just come out and shoot him?  

When I put it this way I know why I don’t manage (and never want to manage) a large media company.  It is REALLY hard.  You need to be a hard bastard who people respect (to keep the costs under control) but you also need to inspire the sort of team loyalty that keeps the creative types (who are peculiarly hard to manage) happy and productive.  The people in the industry are paid very well (five to ten times average wages does not appear uncommon) but – except for a few – they are not paid like hedge fund managers.  

It is about as far from managing Walmart as it gets.  Walmart burns through literally millions of staff members (associates) and has a system which keeps their training and hiring costs low.  They would like to build team camaraderie – but not at the expense of paying substantially above minimum wages.  (If you are interested compare to Costco.)  

A lot of America has a first-in, first-out attitude to hiring and firing so expensive (senior, older) people get fired first.  In many industries this is shareholder friendly – but it doesn’t build a sense of lifetime belonging as per Japan.  [Sacking older-female on-camera staff however appears as prevalent at Nine as anywhere in the media.]

Australia has produced a fair number of the likeable and inspiring hard bastards required for the job of managing media companies.  They are throughout News Corp – and are part of the Rupert Murdoch success story.  Rupert himself is one of them – and from what I know the key son (James) has the right stuff.  (Lachlan seems more intellectual - and a little less hard - but that is the perception of someone who has met him only twice even though he lives 200 yards away.)  

Kerry Packer – who controlled Nine until his bad health caught up with him – was of the same type.  Intelligence is not the defining requirement (though it helps).  It is about personality.  Some of the best media executives (Sam Chisolm springs to mind) keep an office which looks like an extended bar.  They drink with the staff – but decisions are made, handshakes are honoured and the staff feel they belong and are valued.  

The book contains a number of Kerry Packer anecdotes.  Anyone who dealt with the (truly frightening) man has them.  Here is an oft told story about Kerry Packer which is the sort of stuff that produces both the requisite fear, loyalty and creative inspiration needed to run a media company.  I quote:

Channel Nine's brilliant head of entertainment, Peter Faiman, remembered that the hardest thing he ever did in his career was to try to tell Kerry he intended to resign to work for Rupert Murdoch. Packer kept demanding to know what Murdoch at Channel Ten could do for him that Channel Nine couldn't. 

At every excuse - more money, wanting to do something new, establishing his own business - Packer kept hammering away with just one powerful line: "I can fix it."

Faiman felt more and more desperate until Packer, the master negotiator, finally brought the tense confrontation to a head.

"So son, what do you want to do now?"

"Oh, Kerry, please, I feel like shooting myself."

Faiman will never forget the next moment. Packer reached into a drawer, pulled out a huge western-style six-shooter and slammed it down on the desk in front of him. 

"Well, I can fix that, too," he smiled.

Well JA might have been the bean-counter that Nine needed – but in Stone’s view he was the Machiavalian anti-hero – the guy who dismantled the culture that made Nine great.

Its hard to see who Packer (probably the younger James who ran it whenever Kerry’s health packed up) should have appointed to do the bean-counter job – the guy that could keep the creative baby whilst throwing out the expensive bathwater.  One executive I can think of is David Hill – then a Nine sports executive – now running Fox Sport for News Corp after a stint as head of programming for DirecTV.  That job requires a lot of negotiating with over-priced sports content providers.  Still whatever – JA had only half the skills required for the job in Stone’s view.  Peter Faiman (The guy who did not shoot himself) should also have been a candidate.  Faiman runs FX for Rupert these days.

Handshakes and stock analysis

Gerard Stone makes the point that once upon a time a handshake was the bond of Nine.  A deal was negotiated with talent (a small production company for a TV special for instance – of with key staff) and cemented with a handshake.  Contract details were drawn up later – but always reflected the handshake deal.  As the internal politics of Nine became worse the handshake became less and less honoured to the point of full dishonour.  In individual deals (screw-overs really) this deal saved Nine money – and added to the bottom line.  But over time it increased the cost of negotiating and (more importantly) created an us-versus-them culture between creative staff and management.  The loss of the handshake as deal was symbolic of the control of the legalistic rather than creative bean-counters and the symbol of the demise of the Nine dream machine.  

Staff turnover is common enough at media companies.  Creative types get fired.  Programs get axed.  Its not a good sign – it pleases me that Jim Gianopoulos – the key executive at Fox Studios – has been there so long – especially as his touch looks so golden.  But firing and change is not necessarily bad.  It leads to renewal.  

If the media types who read this blog – and I know there are a few – could tell me which execs do not honour handshakes – it would be much appreciated.  It would help with the stock anlaysis.

Bean counters and private equity

Now having read a book which was really a few hundred pages of well argued diatribe against John Alexander I have to leap to JA’s defence.

Packer junior sold Nine to private equity.  He did it with indecent haste after daddy died.

He got a fantastic price – and CVC who run the place have probably done their dough.  

JA still works for James Packer – and remains highly respected – albeit disliked by many.  

If the goal was to keep as much of the super-profitability of Nine throughout the next twenty years of fracturing media audiences then JA almost certainly was the wrong man to do the job.  But if the job was to strip costs, keep the contract negotiations in check – that is to promote the bottom line above audience and by implication the bottom line over production values – then there is little evidence that JA failed.

And the billions that young James received for the network is proof of that.

So maybe private equity more generally could be Gerald Stone’s anti-hero.  The desire to flick Nine for lots of money to dumb buyers might be the ultimate answer to Gerald Stone’s whodunit.  

Some hope for the future

Nine – at least the CVC buyout version – has some financial difficulties.  They may or may not be terminal.  But now David Gyngell – a true media creative exec – is back as CEO.  Gyngell may have been best man at James Packer’s wedding – but I think he was probably as close to Kerry as James.  He certainly shared Kerry’s love of TV.  Whether he is the fully fledged inspirational hard-assed bastard required for this job – well I will leave that to people closer to the situation.

The appointment of Gyngell reflects well on CVC.  So I probably am over-stretching to paint private equity as the villain.  In the intersection of finance and media remains more complex than that.  And that is why media stocks are such fun.

J

Post script: boning Jessica Rowe

I can’t review this book without mentioning the single most famous incident in the demise of Nine.  Mark Llewellyn was demoted as head of news and current affairs and told to eat a “shit sandwich” by management.  He left for a competitor and was sued for breach of contract.

His sworn affidavit included all sorts of juicy bits including editorial interference in news by JA.  In Australia that could cost the TV station its license.

But the most famous bit of the affidavit was the instruction to sack Jessica Rowe – the attractive – but no longer in her 20s host of a fading morning show.  The phrasing: “what are we going to do about Jessica?  When should we bone her?  I reckon it should be next week.”

The expression to bone someone has become so widespread since in Australia that it rates a mention in the Macquarie Dictionary of Australian English.

If you really want to amuse yourself – and you are seriously interesting in media – the Llewellyn affidavit is here.

Jessica Rowe and Eddie McGuire later made up for the cameras.  

How diabolically desperate are the oil exporting states?

The oil market is currently in super-contango.  That is the forward prices are much higher than current prices.

Usually speculators fix this.  Buy oil now, store it, sell it forward and make a profit.

But the easy storage is full.  The WSJ reports that people are buying tankers to moor off the coast of Scotland to exploit the arbitrage.  It looks to be a surprisingly good trade.

So given the storage is full it is possible that the super-contango exists.  However a super-contango has implications – both for investment and geopolitics.  This post explores those implications.

What is happening in the oil exporting states?

Not all storage is full.  Most oil is stored in the ground.  It has been for hundreds of millions of years – and the ground storage is mostly stable.  

Surely the oil exporting states (Russia, Saudi Arabia, Venezuela etc) can store the oil and release it later – and hence take advantage of the super-contango.  

But for some reason they are not doing so.  I have a couple of theories:

Theory 1: the oil exporters are diabolically desperate for cash

The most obvious theory (not necessarily correct) is that that oil exporters are diabolically desperate for cash.  They can’t defer today’s cash receipts for much bigger ones tomorrow.

Usually if you have a really good investment idea (oil storage appears to be one) then there is finance available.  But seemingly there is no finance and Gazprom amongst others has liquidity issues.

We know about Gazprom – but most of the oil exporters – certainly the ones alleged to have excess capacity to bring the oil to the surface in the future – are in the Middle East.  If they are all that diabolically desperate for cash it has geopolitical implications.  Collapsed economies are not pretty.

Theory 2: there is insufficient extraction capacity to bring the oil to the surface in the forward period and hence take advantage of the contango

My second explanation is that there really is no ability to store oil in the ground this month to extract extra oil in (say) 18 months because the exporters are short extraction capacity.  This seems unlikely.  Opec claims it is cutting back production – which implies they are leaving some capacity idle.  They could however by lying.  There might not be all that spare capacity around.

In which case you want to get really long the drillers and anyone else who provides oil extraction capacity.  

I have no third explanation.  But in summary either the oil exporters are diabolically desperate for cash (and their economies are about to totally fail) or OPEC is lying about oil capacity and they are really constrained – or a combination of the above.

If anyone has a third explanation I am really keen to hear it.

John

Lessons from shorting JGBs – the credible promise to be reckless

I once lost money shorting Japanese Government Bonds (JGBs). It was a funny sort of trade – because I am normally allergic to leverage – but this was one of those exceptions – and even though I was levered and wrong I did not lose much money. I just lost it with the sort of grinding relentless certainty that feels really bad.

A background to the trade

The logic was as follows. Seven year JGBs were yielding about 130bps. The government looked like it would try quantitative easing – and that there was a chance – albeit small – that inflation could take off.

If you shorted seven year JGBs you were obliged to pay out 130bps (plus or minus small borrow fees or derivative margins) for seven years. Given short rates were zero at the time, being short JGBs and long cash had a negative carry of 130bps. It was painful – but not very expensive. If you shorted 100% of your wealth the negative carry would be 1.3% of your wealth per year.

The maximum loss would obtain if the seven year JGB suddenly traded – like cash – at a zero yield. Then you would lose the entire seven years of spread at once – or about 10% of your wealth all of a sudden. This would be painful – but is tolerable as a maximum theoretical loss. (Its not uncommon to have 10% of your wealth in a stock portfolio at any time.) Moreover the largest practical loss was a few percent of your wealth – somewhere near my actual loss.

A bad trade – and normally I would suck it up – learn a lesson and go on.

But times like this remind me again of the fortune you could make if inflation returned. Suppose – and it was unlikely in Japan – that inflation really took off – and bond yields went back to 7.3%. Roughly (and there is plenty of bond maths I am over-simplifying here) you would make 6% times seven years discounted a bit in profit – a very big profit on a trade with a seemingly small maximum loss. Indeed the gain might be 20 times the practical maximum annual negative carry.

And it struck me that the chance of inflation was real – and under-priced. Over time I found different ways to lose money betting on the possibility of reflation in Japan – most notably on Japanese regional banks (see this post on 77 Bank).

Moreover – I was just betting on policy being something other than entirely stupid. But for that you need my (admittedly trivial) understanding of where asset price deflation got to in Japan. Lets start closer to home – Australia.

Asset price inflation in Australia and deflation in Japan – or why Ben Bernanke wants to throw money out of helicopters

In Australia it became absolutely standard practice to buy real estate with negative carry. The idea was that you could buy a house for 100 thousand using 7% money and have a 3% rental yield. You made a 4% loss each year. The 4% loss could offset other tax. But everyone accepted it because house prices rose more than 4% a year and the capital gains tax was (slightly) concessional. The negative yield was sustainable so long as people continued to expect property prices to rise.

Well there was a point where Japan was the reverse of this. Banks would fall over themselves to lend you money at 1% to buy property with a 4% yield. You got 3% positive carry in a land where almost everything yielded something close to nothing. And yet people wouldn't do it. Why not? Because everyone knew that property prices fell more than 3% per yield. Positive carry was not enough to offset property price deflation.

When things deflate at 3-5% per year then money in the bank at zero interest (of which the Japs have plenty) is a very fine investment – it yields 3-5% per year post tax real – and it is very low risk. Obviously that was a better investment than almost everyone made in 2008. In realty it is an investment better than is available to most people anywhere.

And if everyone thinks this way (cash is good, borrowing bad, don't buy assets because they fall in price) then the situation is self-sustaining. Welcome to Japan.

Japan deflated because – well everyone thought it would continue to deflate. And that led to a lack of domestic investment and (eventually) the Japanese – like the Chinese – managing to fund a whole lot of really dumb lending in America. It was just bad.

Lots of people could see this – Krugman and Ben Bernanke to name just two. And a simple shock to the system which convinces people that holding the money in the bank is stupid and that they better go out and buy real assets would fix it.

What you needed was to credibly convince the population that deflation was over – and that there would be inflation. What the BOJ needed to do was credibly promise to be irresponsible.

You have to convince that cash-is-trash.

How do you do this? Well the first answer is just print money.

And that is what the BOJ did – and what central banks around the world are still doing. And it doesn't work. The reason that it doesn't work is that people are more than happy to hold the money idle in enormous quantity. It yields 3-5% post tax real after all.

Just printing money is not enough. You need a real shock.

The Ben Bernanke suggestion – and he really did suggest this: load up a helicopter and throw it out the window over downtown Tokyo. If that doesn't work continue doing it until you get inflation.

This would be a dramatic uncontrolled experiment – and it could induce LOTS of inflation. In Japan bank deposits are a large multiple of GDP – and very large per capita relative to America. If the Japanese were shocked into believing that cash is trash they might try to spend these on assets very fast – and that might produce dangerous outcomes. The BOJ dismissed Kruman's suggestions as “dangerous”. And they probably were dangerous – but they might have been better than years of continued deflation.

Anyway they chose continued deflation and my short JGB position lost money.

Now Ben Bernanke is in charge

Ben suggested helicopters for Japan. He wants to credibly promise inflation in the US too. Ben is – I suspect – good for his word – even though the bond market sees it otherwise.

And if it comes to the crunch my guess is that he will charter the helicopter. He will pick a middle income state (Iowa – because it is politically sensitive?) and drop cash.

Maybe – less reckless in appearance than throwing money out of helicopters would be the Fed turning up at schools with big piles of crisp $20 notes. Whatever. He wants to credibly promise to be reckless.

Giving money in one-off tax breaks (as per Australia or Bush's various plans) is not the same thing. That money isn't freshly printed cash. You need to credibly convince the populace that you are prepared to risk the Zimbabwe outcome. You have to credibly promise to be reckless.

Bernanke knows this. He is on the record for suggesting it.

So when do you short treasuries?






John