How brilliantly run is Freddie Mac?

Nobody writes anything positive about either Fannie Mae or Freddie Mac (the GSEs) lately. However believing that credit should go where credit is due I would remedy that.

Freddie Mac – more than almost anyone in the market got the recent interest rate shift right. That matters because (if you have not noticed) by far the biggest thing that has happened in financial markets in the last few weeks is a very rapid rise in long bond interest rates. And Freddie Mac is very exposed if they get their hedging wrong.

Given that the risks of Freddie’s exposure lie mainly with taxpayers this is something that should be celebrated.

So I am celebrating it.

Background

The GSEs own lots of 30 year fixed rate mortgages. Nearly a trillion dollars worth each (Freddie is smaller).

Those assets become less valuable as interest rates rise. If rates for instance went up to 8% then there would be very substantial losses from holding a trillion dollars 30 year 5.5 percent fixed rate mortgages.

The GSEs can reduce this risk by either selling some of their owned mortgages or by changing their funding mix so they have fewer short term borrowings and more long term fixed rate borrowings.

Unfortunately as the GSEs remove their risk of rising rates they reduce their profits. After all it is very profitable for a GSE to borrow short (at rates close to zero) and lend at above 5% in new well collateralised fixed rate mortgages. Or it would be profitable until rates rose.

Until the end of the first quarter the GSEs were lending very large amounts funded largely short term. Freddie in particular noted (complained?) in their first quarter SEC filings that they were being pressured by regulators to grow their balance sheet to make funding available to the housing market.

And so they grew their balance sheet funded largely short term. The incremental business was highly profitable but carried a large risk of interest rate rises. (Fully hedged Freddie noted that the business was at best marginally profitable.)

When I read the Freddie quarterly SEC filings I looked at this interest rate risk – and thought – oops – here the taxpayer goes again.

But it was not to be. During April (reported in monthly data) Freddie turned on a dime and started selling mortgages, reducing their floating rate funding and increasing their fixed rate funding. They did this just before interest rates spiked.

Freddie Mac got it right.

You can see this in this monthly series. Note that the mortgage portfolio shrunk at an annualised rate of 50.9 percent – the fastest I can remember and probably the fastest ever. Moreover almost all this shrink was in long-dated fixed rate mortgages.

Freddie’s fixed rate debt increased from 582 to 603 billion – with an even larger reduction in floating rate debt.

There are plenty of people in privately run financials who wished they traded that well. All those people carted out by the sudden shift in interest rates for instance.

I know there is revulsion at paying high salaries to executives at financial institutions that have received government bail outs. But someone at Freddie Mac deserves a big bonus – a really big one.

Memo to Senator Dodd: don’t complain too much about it when the bonus gets paid.

John

PS. Fannie Mae’s portfolio moves were in the right direction but nowhere near the scale of Freddie Mac. I hope and expect that the bonuses will be smaller at Fannie Mae.

A question about appropriate ethical standards for lawyers

Warning - This post comes with my usual - I am not a lawyer - caveat.  I am not asking about the legal duties of lawyers in the US - rather about the ethical standards that should apply to them.  

I once put on my blog – without comment – a letter to clients written by Francesco Rusciano of the Ponta Negra fund.

I did not think it made sense because the stated returns were not possible with the strategy described.  I asked my readers for their views.  Bluntly, on just reading two of their letters I thought fraud was a fair guess and so did a fair number of my readers.

That was only marginally interesting to me – this financial market is riddled with fraud and Ponta Negra was only small.  What was interesting to me was that Ponta Negra was housed in the same office, shared a phone number and marketing agent with Paradigm Global – a fund of hedge funds owned by Hunter and James Biden.  Hunter and James are the Vice President’s son and brother respectively.  

Since then Ponta Negra has been closed by a Federal Judge, and is facing civil charges.  Francesco Rusciano is facing wire fraud charges.  The SEC and Federal Prosecutors are alleging a fraud that I could only guess at.  The Biden’s lawyer has stated that Ponta Negra were subtenants.  I have summarised the issues surrounding Paradigm Global in this post.

That however is not my purpose today.  When I wrote the original post I received threatening letters from Ponta Negra’s lawyers.  Douglas R Hirsch, a partner at Sadis Goldberg asked me to destroy all documents I had from Ponta Negra and “certify in an affidavit” that I had done so.  This was only a few weeks before charges were laid against Ponta Negra – and almost certainly whilst investigations were ongoing.  

Now if Ponta Negra’s lawyers did not have any reason to suspect that investigations were going on into Ponta Negra then I guess the request I got was not obstruction of justice.  But this would mean that Douglas Hirsch is hopelessly naïve – because the letters looked prima-facie suspect.  Besides Douglas Hirsch read the letters on my blog and thought that I was alleging fraud – which means he thought that I thought the letters were suspect.

So (at a minimum) a lawyer asked me to destroy a document that he thought might be evidence in something he thought that I thought was a crime.

Even if he thought that there was no investigation and that no crime existed doesn’t that constitute an ethical lapse?  

John

Do you or did you ever have friends in the FDIC?

"Here in my hand is a list of 205 communists in the blogosphere and the mainstream media."

Well – no actually – but I have a long list of people who – on the record – supported the confiscation of Washington Mutual.

Washington Mutual – by far the biggest bank confiscation in US history – happened during the AIG/Lehman week.  It was confiscated despite being liquid and adequately capitalised at the time.  Sheila Bair – the head of the Federal Deposit Insurance Corp (FDIC) did the deed – and in my opinion it was not her finest hour. 

Washington Mutual was given to JP Morgan who did not need to honour all of WaMu’s debts.  Debt holders – who would normally have expected to recover most or all of their investment were wiped out. 

After this – and until very recently – no major US bank could raise any debt without a government guarantee.  After all – if the government could wipe you out why would you ever invest in low risk margin debt?

The confiscation of Washington Mutual thus forced the entire system onto the government guarantee tit.  The cost to taxpayers is thus potentially enormous.

Now at the time the confiscation looked justified to many because they assumed that Washington Mutual was insolvent no matter what their accounts said.  JP Morgan – the acquirer – obliged this view by writing down the value of WaMu’s assets by about 20 billion.  This write-down also justified the action by Sheila Bair.  I said at the time that Sheila Bair was acting improperly despite this – and I said later that JPM was lying. 

However if JPM was telling the truth – and Sheila Bair had a decent basis for believing them – then this was not arbitrary confiscation – though it was confiscation without appeal.  It would be costly for the system – and it might have been justified. 

Alas the facts have a neat way of outing the incompetence of Sheila Bair.   JPMorgan is now confessing that almost all of the charges taken when Washington Mutual was confiscated will be reversed through their P&L.  Washington Mutual was never insolvent and should never have been confiscated.  [Hat tip – Felix Salmon.]

Sheila Bair – a Republican appointee no less – confiscated without compensation and without right of appeal valuable private property.  I have argued repeatedly that she should resign – but now my basic thesis is proven her position is totally untenable.

A huge number of people supported her at the time.  These are people who supported the confiscation of private property without appeal.  Usually such people are called communists.  The alternative explanation is that these people are just dopes.

Actually I know a lot of these people and they are not dopes.  [Using McCarthyist logic therefore they must be communists.]

But they are not Communists either.  Instead they were dopes on this occasion.  Panics – be them financial or political do that.  They turn thinking – even iconoclastic people like high profile bloggers – into dopes.

Now Washington Mutual was in fact very easy to add up.  It was obviously solvent if you ran the numbers properly – but people find it quite difficult to run the numbers on banks.  This applies to senior government officials too.  And that explains why financial crises happen.  People thought there was no risk in financial assets that were obviously risky during 2005 and 2006 and even into 2007.  Thereafter they thought that financial assets that were most likely safe were (near) worthless.  Government officials seemingly arbitrarily confiscating assets into the height of the crisis just added to that fear.  A preferred stock is worthless if the government steals the underlying collateral (as I found out to my cost in the WaMu case). 

After the confiscation of WaMu we needed not only to judge the solvency of banks (something which I think I am capable of doing) but also to judge the behaviour of individual officials in crisis (which I am not capable of doing).

The irrational fear in markets was not unlike the irrational fear that other manias (eg Joe McCarthy) engendered.  That doesn’t make the fear less real or less destructive.

I thought at the time that Sheila Bair’s resignation would heal that wound– and would be the single best thing that the government could do to ease the financial crisis.  Her resignation would break the nexus between fear in the market and the fear of seemingly arbitrary confiscation by government officials.

That nexus is broken now through repeated and consistent subsidy at huge potential cost to the taxpayers.  The government – through repeated capital injections and guarantees – has managed to convince most people that American banks are safe.

It would have been cheaper for Sheila Bair just to resign.

However – the immediate and pressing need for Sheila Bair to resign as a matter of policy has past.  The market is no longer outright afraid of arbitrary government confiscation of financial assets though they might have some fear about government intervening in Detroit’s bankruptcy. 

But whilst the time for Sheila Bair’s resignation as a matter of national priority is past, the time for her resignation for proven incompetence has just begun.

 

 

 

John

 

Goodbye to the Sole True Hero (Sol Trujillo goes back to San Diego)

I am an outsider (an Australian) who keenly observes the ways of American CEOs.  As a group they have not covered themselves with glory – fat cats – overpaid and led their companies to ruin.  But they have their strengths and their weaknesses.  Mostly I like to focus on their strengths.

The strength of American CEOs is to a large extent an artefact of the strength of the US economy.  The US has a bigger and more homogeneous market than anywhere else on the planet (China included).  It has a decent swathe of entrepreneurs – and in almost every industry there is – as a result – fierce competition.  Competition is usually good for consumers – but rarely as nice for shareholders or managers.  It destroys bad businesses and it punishes bad management.  Competition breeds stronger businesses and stronger management.  It kills the weak and toughens the survivors.

The best American CEOs are – as a rule – the survivors from this competitive grind.  They are toughened – and in my opinion they are on balance the best senior executives in the world.  I am as a rule a fan of American management.

But not entirely.  Corporate governance in America sucks.  Only in America is it standard to combine the job of CEO and Chairman of the board – making the CEO answerable to nobody.  Only in America are boards so stacked with scratch-my-back-on-compensation buddies to make CEOs breathtakingly rich.  [Unfortunately America is exporting that cultural trait to the rest of the world.]  Moreover the pay of CEOs (often 100 times average) and the perks (private jets and exclusive golf clubs) have bred a CEO culture that is overweening and arrogant – and simply tone-deaf when it comes to many issues.  Only in America could a bunch of CEOs take private jets to Washington to beg for taxpayer dollars.

So I have a piece of advice to offer boards when searching for a new CEO.  

If you are a business which is struggling with fierce competition from numerous and new directions – and where your response to that threat will determine your future –then your default position should be to hire an American.  That is what they are generally good at.

If your business problems are not fierce competition but dealing with complex competing interests and government regulators in a way that creates win-win outcomes then do not hire an American.  You run the risk of alienating your target groups with arrogance and private jets.

There are exceptions – a few CEOs – especially in drug industries but also in IT – have created truly inclusive work places in which talent is catered for as individuals, and thrives.  Google springs to mind. 

Also there are the obvious non-American ruthlessly competitive CEOs who seem to meet any competitive threat with overwhelming force and tactical brilliance (Rupert Murdoch stands out).  

But despite the obvious exceptions the stereotype rings true because it has a basis in reality.  That really is how the modal American CEO is.  

Sol Trujillo – the bad American CEO

Telstra is the dominant Australian phone company – the now privatised former government owned monopoly.  It still owns the twisted copper pair of wires that goes into every home and now carries an increasing variety (and speed) of traditional telephony, voice over IP, internet and entertainment.  How it extracts value from that monopoly position will be the ultimate determinant of Telstra’s long term position.

That however requires continuous and careful negotiation with government as the monopoly is (justifiably) regulated to ensure appropriate contractual arrangements with a host of other parties that want access to the copper loop.  If you want the CEO to do that you don’t hire the stereotypical American Imperial Overlord.

Alas that is what Telstra did.  His name was Sol Trujillo – and almost immediately the wags noticed the self-centeredness of the man and dubbed him the Sole True Hero.  He proceeded over several years to alienate governments of both political persuasions with bombast and dodgy lawsuits.  He hired cronies who were equally tone deaf.

And he singularly failed to improve the competitive position of the company in the competitive business.

In other words Sol Trujillo was everything bad about American CEOs with few of the redeeming features.  He was a failure.

He departed Australia early – and there was no love lost.  When told of his departure the Prime Minister (Kevin Rudd) responded with a single word – “adios”.

Sol Trujillo says that word proves his assertion that his difficulties in Australia was because of racism.  Well say what you will about our Prime Minister but he is not a racist.  He speaks a few Asian languages – including Mandarin fluently.  His daughter has married a Chinese man.  He is empathetic to other cultures and has indeed immersed himself in them.  

Sol is grasping at straws to justify his failure – a failure rewarded, in American imperial CEO style, with cumulative pay above AUD30 million.

So – lest I be accused of racism I will give him a more appropriate farewell.  

Adieu.  

John

PS.  Yes - I agree that Kevin Rudd's comment was a lapse.  But racism is not the explanation for the total failure of Sol Trujillo.

Japan, Korea, Detroit and banker bonuses

It surprises me how few people followed up the logic from my Japan and Korean banking collapse post. 

Japan and Korea had very similar industrial structures.  You can get into a lather describing differences between Keiretsu and Chaebol – but if you look at the heavy industry and government support and how the finance worked it was all very similar.

When the system broke down in Japan there was never any great recession – but there was never a recovery.  Growth just slowed to anaemic levels and stayed slow for two decades – the lost period.  However the average Japanese person doesn’t have a lot to be unhappy about.  Real wages stayed high, employment, whilst more difficult than in the boom years, remained fairly easy to obtain.  You would describe the situation as malaise – not failure.  The people who think it was a failure are largely people who played the Japanese stock market – which forever looked really cheap, only to get significantly cheaper.  It is my class (stock-investing capitalists) who think of Japan as a failure.

Korea by contrast had a true banking collapse.  The banks were not only insolvent but illiquid.  They could not lend – and several Chaebol crashed and burnt.  Even quite large modern companies (Hynix for example) failed.  Indeed it is only the strongest of the Chaebol that got through (notably Samsung).  

But the Korean experience was considerably worse for Mr and Mrs Soon (and their average Korean family) than it was for Mr and Mrs Watanabe (and their average Japanese family).  In Korea there was a five fold increase in unemployment (admittedly from very low levels) and a very large increase in small business insolvency.  

Korea’s advantage was that it recovered.  

I argued that the problem in Japan was their ability to keep zombie corporations (not zombie banks) alive for decades.  Japan has a “Rip-Van-Winkle” industrial legacy to go along with its absolutely brilliant modern technology industries.  This old industry sucks resources which would better be used by the modern industry.  It makes sense to keep the old industries alive during a deep recession because the resources would otherwise be unemployed.  It makes no sense to keep them alive long term as you wake up 30 years later (as per Rip-Van-Winkle) and lo – you still have the old industrial structure.  

Translate this to America – and the standout yesterday industries are Detroit and mortgage broking.  The US at peak had about 500 thousand mortgage brokers or one per sixty mortgages outstanding.  This was insane – and it has changed.  Detroit also (politely) looks as if it will employ about two thirds as many people (or less) after the bad bits of Chrysler and GM are closed as part of the bankruptcy process.  

I also argued that the problem with Korea was that the banks became totally illiquid and hence were unable to lend at all.  This mattered because not only inefficient Chaebol died – but plenty of good stuff suffered the same fate.  A banking system that cannot lend is indiscriminate about who it kills.  It will result in the death of dodgy businesses – but will also kill perfectly fine businesses that need cash for short term requirements.  

If you want to avoid the really deep malaise that was Korea then keep the banks liquid.  Then at least they will lend to the more worthy borrowers – and whilst industry will die banks can be selective about who they kill.

Killing Detroit whilst bailing out fat-cat bankers is politically unpopular.  If you want to see a justifiably upset victim have a look at this letter from a Dodge dealer.  I don’t think the political sentiment in the letter is accurate – but it is perfectly understandable.  

Likewise there is no end of complaint about bailing out banks so they can continue to pay million dollar bonuses – and the political sentiment in those complaints is accurate and entirely understandable.

So let me say I agree with the unpopular.  I think the Obama administration is right to let Detroit file bankruptcy and to bail out banks.  I know this is unpopular – I just think the outcomes will be better that way.  I am very impressed by an Administration that does things that are so politically offensive but probably ultimately the right thing to do.  That doesn't make the political pill any easier to swallow.

John

A tale of two banking crises: Japan and Korea

Economics may be a “science” but it lacks controlled experiments.  Especially in macroeconomics you can’t repeat an experiment with one variable changed and see how the single variable changes the outcome.  Economists have lots of statistical tools to deal with this – but those make the discipline either incomprehensible or diabolically boring.  [Apologies to all those who taught me econometrics.]

But every now and again people throw up a controlled experiment – two situations that are very similar and differ markedly only in one major element.  Yet strangely these situations seem under-studied. 

What I want to do here is give a stylised version of Japanese and Korean economic history and how it pertains to the banking crisis both countries had.  My knowledge of this however comes the way much of my stuff comes – from the history of the banks backwards.  So I am sure to offend people with deep understandings of the political/economic history and I welcome someone telling me I am just wrong.

First however I need a stylised history of Japan starting with the arrival of Commodore Perry’s black ships in 1853.

Before Perry Japan was almost autarkic.  There was a relatively weak central government and about 300 “han” – being relatively strong feudally controlled districts.  The emperor did not effectively speak for Japan when Perry came in, guns blazing.

The Meiji Restoration changed this.  Japan was reformed as a centrally controlled empire – with a ruling oligarchy ruling through the Emperor who claimed dominion over all of Japan.  The “han” were combined to form (75?) prefectures with a governor appointed centrally.

The view of the new oligarchs was that Japan would get rich through (a) industrialisation and (b) unequal trade treaties to match the unequal treaties imposed on Japan by Perry et al.  To this end they invaded Korea and started the military industrialisation that ended eventually with World War 2.  There were major wars in Korea and against an expansionist Tsarist Russia (especially 1904-1905). 

Ok – that is your 143 word history of Japan from Perry to World War 2.  Like any 143 word history it will leave out important stuff.  I just want to focus on how this foreign policy adventurism was financed.

Financing Japanese expansionism - and that financial system until today 

Firstly it is simply not possible to expand heavy industrialisation of the type required by an early 20^th Century military-industrial state without massive internal savings.  Those steel mills had to be funded.  And so they set up the infrastructure to do it. 

Central to this was a pattern of “educating” (the cynical might say brainwashing) young girls into believing that their life would be happy if they had considerable savings in the form of cash balances at the bank (or post office).  Japanese wives often save very hard – and are often insistent on it.  The people I know who have married Japanese women confirm this expectation survives to this day. 

Having saved at a bank (and for that matter also purchased life insurance from an insurance company loosely associated with the bank) the financial institutions had plenty of lendable funds.

The financial institutions by-and-large did not lend these funds to the household sector.  Indeed lending to the household sector was mostly discouraged and was the business of very seedy loan sharks.  To this day Japan has a relatively undeveloped credit card infrastructure with very high fees.  These high fees are a throwback to the unwillingness of the institutions to lend to households. 

Japanese banks instead lent to tied industry – particularly heavy industry.  It was steel mills, the companies that built power plants, the big machine tool makers.  Many of the companies exist today and include Fuji Heavy Industries, Kawasaki Heavy Industries and other giants such as Toshiba.  Most of these super-heavy industrials were tied to the banks (and vertically integrated) called Zaibatsu. 

Now steel is a commodity which has wild swings in its price.  Maybe not as ordinarily wild as the last five years – but still very large swings.  And these steel mills were highly indebted to their tied banks.  Which meant that they could go bust.

And as expected the Japanese authorities had a solution – which is they deliberately cartelized the steel industry and used the cartel (and import restrictions) to raise prices to a level sufficient to ensure the heavy industry in question could service its debt. 

The formula was thus (a) encourage huge levels of saving hence (b) allow for large debt funded heavy industrial growth.  To ensure it works financially (c) allow enough government intervention to ensure everyone’s solvency.

When the Americans occupied Japan their first agenda was to dismantle the Zaibatsu.  They were (in the words of Douglas McArthur) “the moneybags of militarism”.  

Like many post WW2 agendas that agenda was dumped in the Cold War.  The owners of the Zaibatsu were separated from their assets and some cross shareholdings were unwound – but the institution survived – and the Zaibatsu (now renamed Keiretsu) remained the central organising structure of Japan.  Dismantling Japan’s industrial structure did not make sense in the face of the Korean War.  The pre-war Zaibatsu had more concentrated ownership than post-war Keiretsu.

The point is that it was the similar structure before and after the war – and it allowed massive industrialisation twice – admittedly the second time for peaceful purposes. 

Now the system began to break down.  Firstly by 1985 steel was not the important industry that it had been in 1950 or 1920.  Indeed almost everywhere you looked heavy industry became less important relative to other industrialisation.  By the 1980s pretty well everywhere in the world tended to look on such heavy industries as “dinosaurs”.  This was a problem for Japanese banks because they had lent huge sums to these industries guaranteed by the willingness of the State to allow cartelisation.  You can’t successfully cartelise a collapsed industry.

Still the state was resourceful.  Originally (believe it or not) they opposed the formation of Sony – because they did not know how to cartelize a transistor industry.  Fifteen years later the UK Prime Minister French Prime Minister  President would refer to his Japanese counterpart as “that transistor salesman” and he was not using hyperbole.  Still the companies coming out of new Japan – technology driven mostly – did not require the capital that Japan had in plentiful supply.  If you look at the companies coming out of Kyoto (Japan’s Silicon Valley) they include such wonders as Nintendo – companies which supply huge deposits to banks – not demand huge funds from them.  [Incidentally in typical Japanese fashion the biggest shareholder in Nintendo is Bank of Kyoto.  Old habits re-cross shareholdings die hard.]

The banks however still had plenty of Yen, and they lent it where they were next most willing – to landholders.  The lending was legion and legendary – with golf clubs being the most famous example of excess.  [At one stage the listed exchange for golf club memberships had twice the market capitalisation of the entire Australian stock exchange.]

Another place of excessive lending was to people consolidating (or leveraging up) the property portfolios of department stores.  Think what Bill Ackman plans to do to Target being done to the entire country – and at very high starting valuations. 

Meanwhile the industrial companies became zombies.  I have attached 20 year balance sheets for a few of them here and here.  These companies had huge debts backed by dinosaur industry structures.  They looked like they would never repay their debts – but because they were so intertwined with the banks the banks never shut them down.  As long as interest rates stayed near zero the banks did not need to collect their money back from them.  As long as they made token payments they could be deemed to be current.  There was not even a cash drain at the banks at low rates.  The rapid improvement in the zombie-industrial balance sheets in the past five years was the massive boom in heavy industrial commodities (eg steel, parts for power stations etc).  Even the zombies could come alive again…  only to return to living dead status again quite rapidly with this recession.

Anyway – an aside here.  Real Japan watchers don’t refer to the banks as zombies.  They refer to the industrial companies as zombies.  (Although most of the Western blogosphere does.)  

Most of the banks had plenty of lendable funds and a willingness to lend them.  They did not have the customers – and the biggest, oldest and most venerable of Japanese companies were zombies.  So were the golf courses, department stores and other levered land holders.  I get really rather annoyed when people talk of zombie banks in Japan – it shows a lack of basic background in Nihon. 

Note how this crisis ended.

1).  The bank made lots of bad loans – firstly to heavy industrial companies and secondly to real estate related companies (golf courses, department stores etc). 

2).  The loans could not be repaid.

3).  The system was never short of funding because the Japanese housewives (the legendary Mrs Watanabe) saved and saved and saved – and the banks were thus awash with deposit funding.

4).  The savings of Mrs Watanabe went on – indeed continued to grow – with zero rates.

5).  Zero rates and vast excess funding at the banks made it unnecessary for the banks to call the property holders and (especially) the industrial giants to account for their borrowings.  Everything was just rolled.

6).  Employment in the industrial giants of Japan thus never shrank (Toshiba alone employs a quarter of a million people).  The economy continued to sink its productive labour force into dinosaur industries and dinosaur department store chains.

7).  The economy stagnated – but without collapse of any of the major banks and without huge subsidies to the banking system.  [The number of banks – mostly regional banks – that failed during the crisis was not large given the depth of the crisis.]

Now lets look at Korea. 

Korea was occupied by Japan until the end of WW2.  They chose to industrialise in the pattern they understood – a Japanese pattern.  For Keiretsu substitute Chaebol and you have the idea.  The Chaebol were private heavy industrial conglomerates tied to financial institutions and with intense government support. 

And the Chaebol suffered the same fate (slow irrelevance of heavy industry) as the Japanese heavy companies except they were called to account and many of them failed.

The reason is the different banking structure.  Korea started its Chaebol industrialisation later than Japan – and the one multi-generational part of the formula (educating young women that they should save and save and save) was just not done as well.  This is a multi-generational process.  

The result is that the Korean banks – unlike their Japanese counterparts – were short funds.  Endless funding at zero interest rates was simply not possible.  Given that the banks eventually collapsed – with many becoming government property and with the government winding up as the largest shareholder in almost all banks.  This was a spectacular crash – as opposed to a slow-burn malaise.  Chaebol failed.  In some instances their founders were imprisoned.  The strongest Chaebol is the one most associated with new industries (Samsung).  It survived and prospered – but others did not.

Korea had a much worse recession than Japan.  Vastly worse.  Japan was just low growth for a very long time.  By contrast the Korean economy crashed and burned.  But it also recovered very fast and at one point (1999-2000) the Korean Stock market was 1932 Great Depression cheap.  It bounced. 

It is my contention that the main difference between the Korean and Japanese crashes (and Korea’s case recoveries) was the funding of the banks.  In this view Korea’s was so sharp because the banks simply ran out of money – and that caused massive liquidations across the economy – systemic failures. 

The recovery was also sharp because the systemic failure meant that businesses that shouldn’t have failed (because they were profitable worthwhile businesses) got into deep distress.  Real companies died not because they deserved to die but because the system in crisis killed them.  There was a case for bailing out those companies – and the rapid recovery told you this was something systematic – not business specific.  The massive upward movement in the stock market at the end of the crisis was the secondary proof that good businesses were killed.  It was also probably the best investment opportunity globally in the last twenty years.

The economic decline in Japan was so gradual and so sustained precisely because there was no systemic failure and no reason to reallocate resources from bad businesses to good businesses.  Zombie companies could exist for decades – and there was no renewal.  A little bit of failure would have been a good thing – creative destruction.  And the survival of bad businesses in Japan is part of the reason the stock market never bounced there.  No investment opportunities.

Policy question:  how do you ensure the creative destruction without putting the good bits of the real economy to the sword? 

Investment question: what bits of the USA (and the rest of the world) will wind up looking like Korea and providing the best investment opportunity in two decades?  And what bits will look depressed for two decades before going into a bit of a decline? 

For discussion.  And thanks for bearing with a long post.

John

When the stockmarket does the analysis

Today the news is all about green shoots becoming brown shoots.  A couple of (entirely predictable) bad bits of data and the stock market goes down telling everyone that all is ill.  But green shoots were always a metaphor.  Almost all data suggests and continues to suggest is that things are getting worse – but less fast.  We are past the “point of inflexion”.

Unemployment is still getting worse – just less fast.

Mortgage delinquencies are still getting worse – just less fast.

Indeed there are very few things that are not getting worse.  Rupert Murdoch said that US television advertising is not getting worse but that was one of the few unequivocal “point of recovery” statements I have heard from a credible source.  (Rupert was early calling how bad it was too.)

That said – when things inflected the stock market started going up hard.  And people reinterpreted “point of inflexion” to mean “point of recovery”.  

Now being past the point of inflexion is important.  It doesn’t signal the end of difficulties – but at least it enables you to do some modelling.  When things are getting worse at an increasing rate (say mortgage delinquencies) and they are outside historical bounds, then anyone who tells you they can model them is frankly “just making it up”.  Even the most sophisticated analyst out there (including Warren Buffett) is just a talking head.

When things have inflected the confidence in your model will increase.  If things are getting worse at a less rapid rate then it makes some sense to model a slowdown on historical norms.  Whilst your number remains an “estimate” (and liable to be wrong) it is more likely to be a good estimate.  You have at least some basis for your statements.  

Before the inflexion almost everyone who estimated end losses on a rigorous basis (including me) underestimated them.  The only people who were right were people who diagnosed that this was not like other recessions and managed to pull a reasonable number out of the air.  I did a bit of that too and my guesses were better than my models.  But they were non-rigorous guesses.

The recession could suddenly turn for the worse again and what looks to be a reasonable estimate will (again) be wrong.  I would never bet my life or entire fortune on such an estimate – but moderate guesses are sensible – indeed as sensible as they ever get in stock market land.

The point of inflexion is important because “it is moderately safe” to be a stock analyst again.  

Not that you would know from today’s market action.  Green shoots it seems have dried up.  But that is reading from the stock market to the economy.  Reading the other way there were never any really substantial green shoots and never to actually dry up.

But that doesn’t mean all is ill.  We are past the point of inflexion – and that is good news independent of where the market is.  It is not great news for the people who will lose their jobs next month (and there will be plenty of such people - just less than last month.

But then we live in the age of omniscient markets.  The markets do the analysis.  Why bother reading this blog?

The hookers no longer cost too much: geopolitics and the price of prostitutes in the Baltic States

There is a article about me and about the Bronte Capital blog in the Sydney Morning Herald today. It mentions that I diagnosed the economic problems in Eastern Europe by analysing the price of hookers. That is true as far as it goes – though the original post was more nuanced than that.

The blog however owes a thank you to the (now suffering) people of Latvia. Before I mentioned their forthcoming problems I had about 50 readers. A post about the price of prostitutes got me my first 1000 reader day and my first mention in the main stream media (the Estonian business press).

For those that are new the argument was as follows:

• Latvia and to a lesser extent Estonia and Lithuania had a massive and unsustainable current account deficit. That means they bought more from the rest of the world than they sold (just like America buys far more from China et al than they sell). The current account deficits (relative to GDP) was however much bigger in Latvia.

• In a floating exchange rate regime this would usually be remedied by the currency falling dramatically, increasing the competitiveness of exports (and increasing the price of imports). The market provides a solution. With America this can't happen because the Chinese fix their currency against the US dollar. In the Baltic States the currency is fixed against the Euro.

• Normally to fix the exchange rate a central banker needs to buy the currency that is tending weaker. They buy it and remove it from circulation. In so doing the reduce the money supply in the weaker currency causing interest rates to rise and a mild monetary deflation (increasing the competitiveness of local industry versus foreign competition) and hence over time remedying the current account deficit.

• Unfortunately this monetary deflation causes a recession in the country with the naturally weaker currency. Ultimately that makes fixed rates unpopular in countries with chronic relative economic under-performance – because the populace doesn't like more or less continuous mild recessions. Some countries dealt with this through periodic competitive devaluations (Spain, Italy). Other just gave up on fixed exchange rates (UK). Generally the world has tended towards permanently fixed exchanges (Europe inside the Eurozone) or floating exchange rates (eg Australia).

• Now there is one exception to the idea that the country with a fixed exchange rate and a lack of competitiveness has a sort-of-perpetual monetary squeeze and low-level recession. And that is if somebody cheaply finances your current account deficit ad-infinitum. Then you can have the nice strong currency and spend it and not have any domestic price pressure. Unfortunately you also wind up owing your foreign benefactors just way too much money.
  

• The party has to end. And it can end quite sharply when the foreign benefactor becomes less willing to lend to you.

When that happens you are going to get a really big recession. If this sounds like the once seemingly endless willingness for foreigners to fund American spendthrift consumers you are right.

But in Latvia the situation was (at least) three times as unsustainable as the US. And ultmately Latvia has less credibility in repaying those loans than say the US.

When it ended in America we got a big recession.

In Latvia it ended when the Swedish banks providing the funding (Swedbank and SEB) themselves got into trouble. Latvia is experiencing something more akin to a depression. Latvian GDP has now dropped almost 20% - about the same proportionate drop as America in the Great Depression. And it is going to get worse still. This is really truly ugly – and the street riots I predicted in the original post have unfortunately happened in all the Baltic States. The governments (and the people can feed themselves) because of foreign aid – mostly through IMF packages funded by the Scandinavian governments.

Well what has all this got to do with the price of hookers?

At least partly for effect I noted that one of the most important (perhaps the most important) export industries in Latvia has been tourism. And it is not any type of tourism – it has traditionally been sex tourism. Latvians are beautiful Scandinavian people (if you like that Northern European look). They also have a more Scandinavian sexual morality and they were relatively poor. This meant that Ryanair put on discount flights and filled them with salivating Irish and English lads. Swill beer on the Friday flight over. Party all weekend, soil the plane on the way home. You could not walk around Riga as a single English guy and not be thought of as a Ryanair sex tourist.

The only problem is that the ridiculous exchange rate made the hookers very expensive.

Ryanair canceled the Shannon/Riga flight (and the Irish lads now go to Prague). The London Riga flights are less full. There are plenty of complaints on the web about over-priced bars and rip-offs in Riga. The oldest and one of the most dependable of professions was – due the ridiculous exchange rate situation – just priced out of existence.

Still markets are correcting in the end. Now that there is a Great Depression in Latvia there is price deflation. Lots of it.

The faster the deflation happens the faster Latvia will again become competitive. [Hint to the IMF – just float the currency and deal with the consequences of the new exchange rate rather than try to defend the old rate.]

Anyway the problem is that most industries have contractual arrangements which fix prices. Wages are very hard to flex downwards. Rents are fixed over sustained periods and the like. All of this means that people go bust rather than reduce prices – simply because prices are sticky.

Well – most prices. The contractual terms of prostitution are short (an hour, a night) and entry to the industry is unconstrained. That means that the prices are very flexible. Extraordinarily flexible.

The price – looking at websites I will not link for decency's sake – has fallen by at least two thirds in the past year – and the advertised price (for a non-English speaking young woman) is LVL30 – or less than 60 US dollars. I am sure the rip-offs are still there – but anecdotal evidence suggests the hookers no longer cost too much.

The first question is how far do other prices have to fall – and how bad will it get in Latvia before it improves.

I did say this was ultimately about geopolitics. The Baltic States all have sizable Russian Minorities. Russia under Putin is very concerned about the state in which those minorities live – and has been prepared to take military action to protect what it perceives as the interest of the Russian people. [Read Georgia/South Ossetia.]

Now I am not going to opine on the validity of the Russian claims. Tensions run very high on all sides.

I will note the Russian-Estonian relation riots in Estonia in particular have been lethal in the past (see the story of the Bronze Soldier).

And I will leave you with a somber note. In Latvia the hookers did cost too much. They don't any more – but most things still do – and there is no easy fix. However what is a classic text-book macroeconomic problem fast risks becoming a geopolitical one. And whilst there are big difficulties bailing out the Baltic economies one of them is not the size of the check you will need to write. These places are small and the checks disappear in a US or even European Budget.

And there are big difficulties allowing the Baltics to drown in their economic problems. Geopolitically a bailout looks like the cheap option.




John

For the benefit of Gaius Marius

 Gaius Marius of the (usually lower case) “decline and fall” blog left the following comment on my 77 Bank note.  

But American banks are not awash in funding – and given the profligacy (especially historic) of the American consumer – not to mention tax cut funded Iraq wars and the like – the US financial system is almost always going to be an importer of spondulicks. That might change in twenty five years – but it is not changing now.i think this is really the big question, isn't it? were not japanese banks in more or less exactly this position in 1991-2, but with corporate rather than consumer credits sucking up all available lending capacity? 

western banks are collecting fat spreads right now, but the true long-term test for the system won't be in loan supply -- it's in loan demand. if banks can't make sufficient new loans to replace the fat ones rolling off their books, earning power will diminish over time even as asset prices continue to deteriorate.

as i understand it, japan ended up with massive excess funds in banks because (beginning in 1996) the private sector started to repay loans (ie, aggregate loan demand went negative), to the tune during the early 2000s of 5% GDP. but in 1989, the japanese nonfinancial corporate sector was increasing its bank debt at a rate of in excess 12% of GDP (and issuing debt on the order of 5% GDP in capital markets to boot). that massive 17%-of-GDP swing in private credit took ten years to effect. aggregate private sector loan repayment seemed to have ended in 2005, but has probably resumed in this crisis.

to prevent a crash in monetary aggregates, the government borrowed out these excess deposits, which at 77 bank shows up as a massive investment portfolio in JGBs. 

for what it's worth, i think a more appropriate comparison would be to the 77 bank of 1991. i have a sneaking suspicion that 77 bank was then also a mirror image of the current 77 bank, but i'd love to be disabused of that notion.

 

The comment is reflected in several emails I have received.  It seems several people had the same idea - though maybe less well articulated than Gaius.

Well Gaius – you can be disproved of the notion.  I have uploaded a 20 year balance sheet for 77 Bank here.  It is here.  The loan to deposit ratio started at 74 percent and wound up at 64 percent – with the mix of the loans moving towards lower margin government loans over time. 

Japan was long funding when it went into its crisis.  The crisis was long, slow and with thin bank margins but very little “crisis” but a lot of sustained malaise.  The banks got longer funding as the malaise/liquidity trap went on.

Korea and Thailand were short funding when they went into the crisis – and the crisis was severe and relatively quick.  Banks failed rapidly (and were bailed out in both countries either through subsidy or nationalisation).

Note that relatively quick in this context is a depression level recession lasting a few years - rather than a sustained malaise lasting decades.

Still this difference has profound investing implications - and also some policy implications - and that makes it worth thinking about. 

JP Morgan lied to regulators

I purchased preferred shares in Washington Mutual when it was in distress and lost money when it was confiscated by Sheila Bair.  I have argued that it was the most extraordinary action made by government during this crisis and that an essentially solvent bank was confiscated.  

In anger I posted my response to the WaMu takeover the day after it happened.  I also purchased adwords on Google so that when you google Sheila Bair’s name you will get an advert linking to my blog and explaining why she should resign.  It is no secret I dislike Sheila Bair.

Moreover there are law suits (whose basic premise I agree with) that JP Morgan whilst doing due diligence on Washington Mutual was also badmouthing them in the press and encouraging the regulator to take them over.  [It is easier to sue JPM than the Federal Government.]

That said – we have a fairly comprehensive proof that JP Morgan did lie to regulators.  The only issue is did they lie to regulators when encouraging them to confiscate Washington Mutual or did they lie when they were conducting the stress test?  If they lied to Sheila Bair to get them to confiscate WaMu and she believed them then she must resign.  But the alternatives I see are worse.

Detailing the JP Morgan lies

First you need to look at the document that JPM released when it took over WaMu.

Here is – with what they think the losses will be in the various stress scenarios.

 

JP Morgan is predicting $36 billion in losses in WaMu's book in their base case and $54 billion in the "severe recession" case.

These losses are measured since December 31 2007.  The losses as estimated in the stress test are from the end of 2008 – and to get the numbers consistent you need to take about 8 billion dollars off these numbers as about 8 billion in losses were realised during 2007.

It already looks like we are in the severe recession.  Unemployment is well over 8 percent.  On these numbers – numbers that were presented by JP Morgan to the market and to regulators – JPM has to take a further $46 billion in losses on the Washington Mutual book alone.  (46=54-8).  

Almost all of these losses come from mortgages.  Indeed in the presentation JP Morgan made when it merged with Washington Mutual all the losses except about a billion dollars came from the mortgage book.  

The only problem is that the losses estimated on mortgages by the regulators (including Sheila Bair) in the stress test include only $39 billion in losses – being 12 percent of the entire mortgage book.  Here are the results of the stress test on JPMorgan.

The implication is that there are negative losses in the rest of JP Morgans very large book.  This is unlikely.  

So we are left with two possibilities both of which involve JP Morgan telling porkys:

1. The losses as estimated by the JP Morgan and told to regulators when they were manipulating Sheila Bair into confiscating Washington Mutual were lies – indeed were so grotesquely over-estimated as to be absurd criminal lies or 
   
2. The losses as estimated by JP Morgan and the regulators in the stress test are grotesque under-estimates – which – in order to be that grotesquely wrong had to involve major misrepresentations of their book by JP Morgan.
   

It is possible that both sets of losses were grotesquely mis-estimated - though the differences here are so stark that a simple and honest "bit of both" is not possible.

I prefer the first choice.  The losses at WaMu as suggested by JPM never made any sense – and I prefer the idea that – encouraged by JPM’s lying – Sheila Bair confiscated a solvent bank.

The second choice suggests the stress tests were totally phoney and allowed JP Morgan to lie at will.  If that is correct the regulators have a duty to confiscate JPMorgan as its embedded losses (using similar ratios as they used in arguing for the Washington Mutual takeover) leave it desperately and diabolically insolvent.

The idea that Sheila Bair confiscated a solvent bank encouraged by lying bankers should not surprise anyone familiar with big-bank lobbying prowess.  Most the bears in the blogosphere would prefer believe the stress test was phoney without any real assessemnt of likely losses.

John

Technical accounting note the losses in the stress test page were before 20 billion in purchasing adjustments.  Those purchasing adjustments were JPMorgan over-estimating the losses at WaMu so - as the loans come in a little better than expected JPM shows better-than-real earnings.

POST SCRIPTS:  The first response I got to this suggests a third possibility - that JP Morgan (and presumably all the other banks) were ASKED to give the regulators the information that they wanted to hear for the stress test - that they were asked to lie.  That I suspect stretches reality.  It is hard to keep things like that quiet - and also some banks (notably Wells Fargo) are very unhappy.