Bed and Breakfast capital at Bramdean Alternatives

I keep an eye on Bramdean Alternatives – the listed fund of hedge funds and private equity funds run by Nicola Horlick’s Bramdean Asset Management.

What really interests me is the capital calls on private equity – these being numbers large enough to potentially bankrupt Bramdean Alternatives.

So far the capital calls have been manageable – but detailed disclosure about how large they are and when they are due is not available.  Without that disclosure I am inclined to think the worst.

Anyway the February "factsheet" contains the following gem (emphasis added):

Four capital calls were received from underlying Funds in February, though one of these was purely for regulatory capital purposes and was refunded the same day. Revaluations were received from two managers of the Company's Private Equity and Specialty Funds and these have been incorporated into the February NAV calculations. Both revaluations were downwards revaluations, reflecting falls in the values of market comparables and adverse currency movements. As stated in previous communications, downward valuations are to be expected given the exceptional market environment and it is likely that the Company will receive further fair market valuation write-downs, including valuations as at 31 December 2008, from some of its managers. As at February, six of the 18 private equity and specialty managers have reported their December 2008 year-end valuations; these have been reflected in the NAV of BAL. One other manager's portfolio is revalued every month.

The first sentence just leaves me gobsmacked.  Bramdean sent a whole lot of money – a capital call – to a private equity fund (or other fund) – and they sent it back the same day – after presumably including it in their accounts.

This was done for "regulatory purposes" – but – for the life of me – I cannot think what the regulatory purpose might be – and why this might be legitimate.  

If it was to fool a regulator or a creditor into believing that the fund had adequate capital on balance date it looks and smells like it was designed to mislead or at least to circumvent some kind of regulatory test.

But it could be another reason – it is just that I can’t think of any real reason why a fund of funds would send its money to some underlying fund for just a few hours without a design on fooling someone.  I sent an email to Bramdean hoping that they might give me a legitimate reason but alas there was no reply.

And I am not picking on Nicola Horlick here.  If Bramdean sends the capital and it comes back on the same day the fund presumably sent this request to several funds-of-funds – and they all complied.  And they all didn’t think it unusual that their money might be needed for a few hours.

So to repeat the question.   Can anyone think of a legitimate purposes for this?

Please.

John

ps.  If you want to spot me a few million dollars for a few hours - then - I am interested.   I just can't think of any legitimate reason why you would want to do that either.

pps.  Someone with no intention to repay may be more interested still.  

That Legacy Word

Toxic assets are no more.  The Geithner Plan is officially a “legacy asset plan”.

Legacy assets sounds so much better than toxic assets.

By contrast Chevron (latest security analysts conference call) has as its first stated goal (in upstream business) to "grow profitably in core areas and build new legacy positions".

Bankers and oilmen leave a different legacy.

The seemingly criminal Sheila Bair*

I am not opposed to the Geithner Plan – but the execution is bordering on criminal.  This article in the FT runs as follows:

Bailed-out banks eye toxic asset buys

By Francesco Guerrera in New York and Krishna Guha in Washington 

Published: April 2 2009 23:20 | Last updated: April 2 2009 23:57

US banks that have received government aid, including Citigroup, Goldman Sachs, Morgan Stanley and JPMorgan Chase, are considering buying toxic assets to be sold by rivals under the Treasury’s $1,000bn (£680bn) plan to revive the financial system.

The plans proved controversial, with critics charging that the government’s public-private partnership - which provide generous loans to investors - are intended to help banks sell, rather than acquire, troubled securities and loans. 

Spencer Bachus, the top Republican on the House financial services committee, vowed after being told of the plans by the FT to introduce legislation to stop financial institutions ”gaming the system to reap taxpayer-subsidised windfalls”.

It is so blatantly obvious that the people that should not participate as buyers in the Geithner funds are the conflicted.  This was first pointed out by Steve Waldman – but I thought his dark thoughts were too dark.  However Clusterstock argues that Sheila Bair is seemingly oblivious to the corruption possibilities.

She isn't seemingly oblivious.  She is totally captured by JPM and Citi.

After all WaMu was gifted to JP Morgan in a reckless and irresponsible manner and she attempted to gift Wachovia to Citigroup.  It should not surprise me that Sheila Bair continues to act as if she is on the take.  That represents no change in behaviour.

Recommendation:  Indict Sheila Bair if she won't resign.  Indict her now.

*Note - I have always believed that Sheila Bair is either incompetent or corrupt.  She seems to be corrupt - but incomeptence in her case is probably a sound defence.  She should resign before she is (perhaps mistakenly) indicted for corruption.  

A little bit of careful thinking – and why Krugman’s despair is misplaced

I am not an economics academic. I gave that game away for the lure of lucre and funds management. But this job throws up more than a few ideas for publishable economics papers – whereas when I was a student I was desperately short good ideas.

Here is one – a pure throwaway – for anyone that wants it. (It’s a nice paper for a masters thesis.)*

It has also explained neatly the problem of not getting banks to bring assets to the Geithner Funds – and in a way which I suggest is surprising.

It started as I tried to pick apart Rortybomb’s analysis of the Geithner Plan. Rortybomb does – in more formal form what Krugman does – analyse the non-recourse financing of the plan as a subsidy. He suggests that the non-recourse nature of the funding is a put option to the Treasury/FDIC of the assets – and that the correct way to model it is using (standard) option pricing models. Rortybomb’s posts are here and here. Krugman is a little more simplistic – but the idea is the same. Krugman produces a two-outcome model (rather than the range implicit in the option pricing model) and demonstrates there is a subsidy. Krugman’s post is here.

Anyway if you use a standard option pricing model and assume some volatility of outcome it is not hard to quantify the subsidy implicit in the plan. I have borrowed Mike’s (ie Rortybomb’s) diagrams. I hope he doesn’t mind.

The subsidy is dependent – as Rortybomb would acknowlege – on the leverage of the fund, the diversification of the fund and the variability of outcomes (particularly stress outcomes). All of this is standard option theory.

Now this is all fairly convincing until you work out that the party selling the assets (presumably a large and stressed bank) is also subsidized. The policy of the US Government (stated many times) is that there should be “No More Lehmans”. You may argue with this policy (reasonable people myself not included) think that this is the wrong policy. But you can’t argue that it isn’t the policy. The demonstration is that any bank that gets into any kind of liquidity trouble gets a “Sunday Night Liquidity Fix”. The availability of that Sunday Night Fix is a subsidy for the bank – just as surely as the non-recourse funding is a subsidy for the Geithner Fund.

So the issue is whether the Geithner Funds reduce the tail risk for the government – not whether the funds are themselves subsidized. After all the assets being sold are from non-recourse finance banks (losses beyond capital borne by the taxpayer) to non-recourse financed funds (losses beyond capital borne by the government). It depends on the relative solvency of the banks and the Geithner funds.

Thinking carefully there should be four broad outcomes:

• Both the bank and the Geithner fund is solvent

• Both the bank and the Geithner fund is insolvent

• The Geithner fund is insolvent but the bank is solvent

• The Geithner fund is solvent and the bank is insolvent

When both the bank and the Geithner Fund is solvent ex-poste there was no cost to the government. Sure there was an ex-ante subsidy but it didn’t cost anything. This case should not worry us.

The second case – when both the banks and the Geithner funds are insolvent the government will lose money – but it will lose less money than it would without the Geithner Plan. After all there was some private money in the fund – and that reduced the end loss borne by the government. In other words subsidy be damned - the plan reduced government losses.

The third case is problematic. If the Geithner Fund is insolvent and the bank is solvent then the Geithner plan cost the taxpayer real money.

The fourth case where the fund is solvent and the bank is insolvent is also problematic – but in a different way. The fourth case is where the banks sold good assets to the fund (presumably for liquidity) and kept the bad book for itself (because it could not sell it). Now in this case the subsidy to the Geithner Funds is not a problem – rather it is the desperation of the banks to sell assets, any assets and only being able to sell good assets. The more subsidy you give the Geithner Funds and the more competition between Geithner Funds you have (bidding up the price of the asset) the lesser the end problem for the banks. Either way however we shouldn’t be that stressed about the subsidy to the Geithner Fund.

Indeed the only place that we should be really stressed about subsidy to the Geithner Funds is the third case – where the fund is insolvent but the banks are solvent.

Oops. The people that are really stressed about the subsidy to the Geithner Fund (Krugman, Felix Salmon, Yves Smith of Naked Capitalism, Mike of Rortybomb) are also worried about or even convinced that the banks are insolvent. Indeed several of these people just advocate nationalisation now.

This is illogical. It is the second time I have accused Krugman of gross illogic – but it is simply illogical to believe that

(a). The banks are largely insolvent,

(b). The right or actual government policy is guarantee big banks (ie no more Lehmans) and

(c). The subsidy to the Geithner Funds is a real problem.

If both (a) and (b) applied the Geithner Fund MUST save the government money - so the subsidy is irrelevant.  

This illogic extends to several of the bloggers I admire most. That is why I think there is a good academic paper in there. Krugman actually expresses “despair” over the subsidy. His despair is misplaced.

I guess the extension is to model it with many Geithner Funds, some of which are solvent, and some of which are insolvent. The situation might wind up more nuanced. Indeed my rough modelling (Monte Carlo rather than rigorous maths) suggests that it is more nuanced – but only slightly. The nuance disappears if the diversity of the Geithner Funds matches the diversity of the banks.

Success of the Geithner Plan

One concern with the Geithner plan is that the banks won’t actually come to the party and sell assets. It’s a concern taken up by Charlie Rose when he interviewed Timothy Geithner and dismissed in the Bronte Capital submission on administration of the plan.

Now – thinking about it I am not quite so sure. There are simple explanations as to why banks won’t bring assets to the plan – see for instance this post from Accrued Interest. But the most obvious reason is that the relatively good assets logically belong with the party with the biggest subsidy. And that might be the banks. The fact that banks won’t bring assets to the Geithner funds is in fact a measure that the relative subsidy of the Geithner funds is too low.

John Hempton

*At one stage I tried to contact Brad DeLong possibly about being involved in a PhD program at Berkley (ideally with him). We managed never to connect. And I have since given up that goal.

Rortybomb argues my point (though he didn't mean to)

Rortybomb is a blog where I find myself entirely agreeing with the mathematics and totally disagreeing with the conclusion.  I have added it to the blog roll – and intend on taking a few shots at it.  I consider Rortybomb as providing an illustration of all the things you can do to abuse mathematics in economics.  

Mike (the blogger) posts empirical research suggesting the obvious – that big banks selling loans that can’t be securitised tend to have fatter margins.  When they sell loans that can be securitised they tend to have thinner margins.

He then concludes that we should have smaller banks and more access to securitisation.  Felix Salmon agrees with him and wants smaller banks and more securitisation.

No objection to the empirical fact that oligopolistic banks without securitisation competition are profitable.  I see it in many places.  And I see it today.  Securitisation is being removed and bank margins are going up.  Pre-provision, pre-trading loss profit of banks is rising.

My objection to Rortybomb is to the conclusion.  Fat margins for banks are a good thing.  They lead to the absence of financial crises.  Thin margins lead banks to take more risk – and when they fail they have huge collateral damage.  

Having a few fat rich banks is a small price to pay if you don’t trigger great depressions.  

In the olden days banks used to give out toasters to anyone who would open an account.  Why?  Because new customers were frightfully profitable.  Why didn't the banks compete with lower prices?  Because they were not allowed to.  Bank regulators actually regulated the value of the gifts (then known as "premiums") that banks could give their customers.  They wanted to ensure that the toasters did not cost too much.  Essentially they wanted to guarantee bank profitability.  Krugman wants to go back to the toaster days.  I just want to go back to days when banks were consistently very profitable over a cycle.

Big banks with no securitisation will be sufficiently profitable.

Rortybomb makes precisely my argument for big banks.  That they rip us off.  And that is a good thing.

Submission to the FDIC on the Legacy Loan Program

The FDIC has called requested submissions as to how the Legacy Loan Program should be run.

You can find the request here.

Given that we are publicly minded people with some expertise you can find our submission here.  

It should later be posted to the FDIC website.  At least it will if the FDIC keeps its promises.

The concerns I detail are the same as outlined on this blog - particularly conflict of interest, the appropriate degree of leverage and the continuance of Sheila Bair in her current position.

Read only if you are into boring government documnents.

I do however have lots of opinionated readers.  Give them good submissions.  It can't hurt.

John

Covering the Ricks short

Several months ago I put a short on Rick’s Cabaret – a listed strip club owner with a private jet.  The code of ethics covered use of the private jet.

I wondered what executives of a listed jiggly joint could do with a private jet that breaches their (rather narrowly written) code of ethics.  (The original post is here.)  

Anyway Ricks still looks like it will fail due to unrefinanceable debt – but the stock has been hammered and I covered recently.  

Not worth mentioning because the position was so small as to be for comedy value only.  [Also might make a visit tax deductible!  Stock research of course…  Just kidding – I never went.]

The old saying about Wall Street is that when the tide goes out you see who is swimming naked.  Nobody much swims in New York any more.  But boy do they dance.

Now the News Corp "Paper of Record" (The New York Post) reports former Wall Street analysts are jiggling at Ricks.  (See Axed Gals take Pole Positions.)  

Slogan for the 21st Century: When the tide goes out you get to see who is dancing naked.  

Come to think of it - not a great slogan.  Can you imagine what Sandy Weill or Dick Fuld look like?  

John

Also - before Wall Street gets high-and-mighty about this - the former Wall Street Analyst notes that the strip joint is run better than her former Wall Street firm (Morgan Stanley) and that the level of sexual harrassment is lower.  

Wall Street has much to be ashamed of - and not all of it is financial.  

Two days later this was added:

PPS.  It appears the New York Post story was false.  I was inclined to believe it because I am naturally short RICKS and the story was positive for Ricks.  

General rule as a stock picker: take seriously stories that are against your position - and not seriously stories that are in favour of your position.

General rule as a blogger or journo.  Believe nothing.

My bad.

PPPS:  I still think that Ricks can't refinance its debt.  But at this market cap I am not interested in staying short.  Ricks will go to zero though.

Sheila Bair is either a criminal or a grotesquely incompetent stark raving idiot

It is no secret that I do not like Sheila Bair.  My original reason for dislike was posted here.

But now she is open to deliberately allowing massive fraud against US Taxpayers.

There is a serious conflict of interest problem with the Geithner Plan.  These problems were first outlined by Steve Waldman in his “dark thoughts” post.  I noted that the application terms for the Geithner funds seem guaranteed to maximise conflict of interest.

In short – if you have a small interest in a fund (kindly levered to be large by the US taxpayer) and a big interest in a bank you have a massive incentive to overpay for the assets purchased from the bank sticking the losses to taxpayers and thus increasing the value of your bank holdings.

The defence of course is to have strict separation between the banks selling the assets and the Geithner Funds buying the assets.  Arms length separation is thus a basic and minimal requirement of the Geithner Plan.

However Sheila Bair is now open to letting banks selling assets participate in the Geithner funds.  This was reported in the WSJ – hat tip to Clusterstock.

I guess Sheila Bair can’t see a conflict of interest – only a “convergence of interest”.

However designing the plan to maximise theft is designing the plan to fail.  This is American politics – and rampant deliberate tampering with government procurement (ie criminality) is a possibility – but in Sheila Bair’s case I see only incompetence.

I am naturally attracted the Geithner plan.  I have stated that many times – but now I am plain sickened.  Sheila Bair should be removed from office if the Obama administration is to have any chance of succeeding.  This statement potentially maximising conflict of interest – and the possibility that criminal fraud is the driver – should be enough to impeach her.  Her defence – and in her case it is a solid defence – is incompetence.  And that determines the right outcome.  She should resign.  

Monetary union and banks - some thoughts

The biggest – and most consistent criticism that my last post received is that the national champions in Europe (particularly the Netherlands) are in deep trouble.

I was very careful describing how HSBC Hong Kong should be capitalised (separately and with very large – even 100% - capital charges for cross border funding).  If this had been done in the Netherlands there would be no trouble.  Even the Icelandic banks would have survived in Iceland - though their UK subsidiaries would be worm food.

The problem is that cross border funding by leveraged institutions is dangerous.  It almost caused Citibank to fail in the early 1990s.  It was a key part of the bank collapse in Korea.  In this cycle it was key in the Dutch banks, in Sweden as I wrote about here.  It was also key in Norway and Sweden during their famous bank collapse (here).

Monetary union and currency zones are famously dangerous for banks.  

But more to the point - banks intermediate current account deficits - and that can make country problems contagious.  

This leads to a question on which I express only a weak view.  In some sense the issue in America this time is also monetary union.  Because of the peg there is a sort of monetary union between China and the United States.  It was the supply of Chinese savings that – as much as anything – powered this boom. 

My question?  Is there a safe way of recycling all of those offshore dollars held in China and oil exporting countries?  If there is not then the value of having the reserve currency is massively overstated.

John

The case for letting bankers rip us off

In the last post I proposed the radical – but disagreeable – proposition that the right way to regulate banks is to allow them to rip us all off.

I didn't expect any support – but surprisingly I got some.  At least one commentator noted – as I would – that the only thing worse than bankers making outrageous profits is bankers not making outrageous profits.    

Several Canadians saw their banking system (bureaucratic, dull, profitable and stable) more or less as I saw the Australian system.  

In general – and one commentator actually raised this – I was suggesting we go back to a 3-6-3 banking world – where a banker took deposits at 3 percent, made loans at 6 percent and hit the golf course by 3 pm.   That was a fair summary except that maybe I lean towards a 3-7-3 system.  

Hong Kong was also raised.  Hong Kong had a formalized 3-7-3 system – where the bankers knocked off early every day except Friday.  On Fridays they went to the office of the governor of the currency board and set interest rates for next week.  A truly cozy oligopoly.

The wealth from the great Hong Kong oligopoly is what allowed HSBC to become “the world's local bank” (and America's stand-over merchant).

Of course semi-socialist banking completely killed all Hong Kong entrepreneurship and turned Hong Kong into the poor colonial trash of Asia.  

Ahem – actually it wasn't all that destructive.  

But the Hong Kong example gives the next clue in how a post-crisis banking system should be regulated.  If the Hong Kong subsidiary of HSBC – the extraordinary money machine – is separately capitalized then it will be bailed out.  But if the Hong Kong monies are all lent to the much larger US Subprime market then – hey – it could still fail.

So what you need to do if you are Hong Kong is insist that the Hong Kong subsidiary is a separately capitalized subsidiary and cannot inject money into any other HSBC subsidiary without a 100% capital charge.  The result would be that it would not matter whether the rest of the HSBC went to pot – the Hong Kong subsidiary – and hence Hong Kong – would be fine.  Even if it were insolvent it would be worth someone's while to recapitalize it.  HSBC Hong Kong was of course a goose laying golden eggs.

Some thought that Australia (and presumably Canada) were OK because of the commodity booms.  Sorry – no dice.  If you haven't noticed the commodity boom is over you are not watching the distress coming out of Western Australia.  

One objection to having really large banks (often expressed by Simon Johnson) is that really large banks are good at regulatory capture and that is a bad thing.  But I advocate much higher profitability for banks.  Regulatory capture is to be encouraged so long as it allows the banks – in the manner of a utility – to apply too much capital for reasonable incremental returns.  Regulatory capture in my view is a good thing.

Actually the only real objection I got was the one I expected which was the notion that Fannie and Freddie were my too-profitable-to-fail government mandated oligopoly and provided a counter-example.  Even that notion is garbage.  The peak profit net income of Fannie Mae was about 7 billion dollars – and it was typically in the 4-6 billion range.  The peak net income of Freddie Mac was about 10 billion but it was typically in the 3-4 billion range.  In almost every year the combined profit was under 10 billion.  And for that they took credit risk on over 5 trillion of mortgages.  They earned – at best – 20bps post tax on all risks they took.  The pre-tax fee for taking credit losses was typically about 20bps.  

The thing about Fannie and Freddie was that they were staggeringly unprofitable.  If Fannie and Freddie had earned even half a percent total credit exposure then they would have been so profitable that they would not have failed now.  

The problem with Fannie and Freddie is that they didn't convince regulators to increase their profit enough.  Very sad – but for all their legendary prowess lobbying they just failed miserably to score.  By the end they had regulators who were ideological warriors against their existence – a measure of their total lobbying failure.  What we needed was regulators who were far more captured by Fannie and Freddie.

The shadow banking system as the real competitor

The real problem with Fannie Mae – and with American and English banking – was that the shadow banking system became huge and a devastatingly effective competitor.  The shadow banking system shook margins to very low levels – so low that even Fannie and Freddie – with the seemingly overwhelming advantage of their quasi-government status – could barely eek out a profit.  

And no amount of lobbying – no matter how competent – could undo the huge competitive threat that Fannie and Freddie were under.  Fannie and Freddie's lobbying effort just wasn't up to it because the task was too hard.  The financial engineers who dreamed up the shadow banking system were just too clever.

The Pandora's box of financial innovation

And herein is the ultimate problem – that some of my commentators picked up on.  That is that the real driver of low margins in banking was the shadow banking system.  The highly paid people were the brokers and traders and hedge fund managers who made all that work.

And at the moment the shadow banking system is in ruins – and as a result pre-tax, pre-provision pre-trading loss  profitability of banks (or for that matter Fannie and Freddie) is rising sharply.  And we are getting to the sort of world I envisage, that of fat lazy banks with “lazy balance sheets” who have completely captured their regulators.

But unfortunately markets don't look like that.  Pandora can't put financial innovation back in its box – and when this crisis is over the shadow banking system will re-emerge to crush margins again.  

Of course we can stop it.  All those high-power, high-paid traders and brokers who are central to the shadow banking system should eventually be fired.  They are not necessary in my hoped for 3-7-3 world.  And they caused all the problems anyway.  Firing them now should be done so long as it does not exacerbate the current crisis.

And when the competition is gone even Fannie and Freddie can double or triple their margins – and even they will wind up costing taxpayers very little.  

Alas consumers will pay for the mistakes of the past – interest spreads (and hence rates paid by consumers) will be higher and that “tax” is what  recapitalizes our system and keep us out of future messes.  In first instance it is not good for consumers.

But it is not clear that consumers really benefited in the end from hyper low mortgage rates.  They just seemed to get capitalized into the value of houses – and that was part of the creation of our current predicament.  

Let me end with some stylised facts

This little rant of mine is contrary to the received wisdom both of my training (economics) and of the world we live in.  

But I digress.  

Economics is meant to be a science based on observation – but more often than not degenerates into an ideological slanging match.  Here are a few observations:

• Highly regulated – indeed price fixed – banking did not visibly hinder economic growth in Hong Kong.

• Highly indebted countries with highly oligopolistic banking systems and quite a lot of financial regulation are doing relatively well at the moment – see Australia, Canada, possibly Israel.  

• Fannie and Freddie may have made huge and seemingly formidable lobbying efforts – but those lobbying efforts failed miserably – with Fannie and Freddie combined profits never going about $10 billion for carrying about half of all mortgages in the United States.  This number seems large but is trivial relative to the size of the exposure or the stated profits of competitors.  

• The collapse of mortgage margins in the UK simply resulted in banks maintaining returns on equity by increasing leverage.  Bank profits did not fall – but bank risk – and system risk 
  

Some of these facts are uncomfortable because the facts do not fit my off-the-cuff economist's reaction.  They don't fit my usual presumption that markets and deregulation are mostly good.  And they argue that we are better off with nasty bureaucratic Australian banks than most the alternatives.  

But – to paraphrase Keynes – when the facts are inconsistent with my theory I change my mind.  What do you do sir?

John