Sonray Capital – another Australian broker failure

Sonray Capital failed a couple of days ago and the clients are likely to incur nasty losses.  Strangely I first found out about this from US news sources.  Only three weeks ago I wrote a letter to a blog reader who knew someone who worked at Sonray expressing my doubts about the organization.

For my global audience I should specify that Sonray commanded four-fifths of five-eights of not very much of the market.  In no way is the failure of this broker a reflection of the economy.  It is a failure – as if another one was needed – of Australian broker-dealer rules – or more precisely the lack of broker dealer rules.

The United States has strict rules which segregate client assets from broker assets.  The broker can’t use client assets to fund their own business and there are limits on the extent to which client assets can be rehypothecated.  In the UK those limits are thinner – and in Australia non-existent.  That means that if you pledge your securities to a broker (for a margin loan or even as collateral against a bill as low as $100) you can lose the lot in the event of a broker failure because the broker can repledge them to cover their own borrowings.

When Lehman failed the US broker-dealer sailed through unharmed.  The UK broker dealer failed causing huge client losses and a huge panic.  I blogged about that here and here. 

Opes Prime was smaller than Lehman London but the characters were just as unsavory.  I blogged about that here. 

I have no problem with a broker-dealer using their own capital to run their business or to trade.  I have a big problem with a broker dealer using their client capital to run their business.  I suggested a fix to the Australian Government in a submission to the Cooper review – but alas this has disappeared into the do-nothing basket. 

How long is it that Australia needs to hold itself up as a place where you can come, open a broker dealer, fund it with client money – and – in at least one case disappear with client money before the Australian Government will do something?

 

 

John

 

PS.  There is a reflexive no-government-regulation thing amongst some of my readers.  But the question here is not whether we should allow brokers such as Goldman to speculate.  The question is whether we should allow them to speculate for their own profit with the clients’ money.  Lehman US speculated itself into oblivion but it did not do it with client money and the clients of the broker dealer were made whole.  Lehman UK speculated with client money speculating their clients into oblivion.  In the Sonray case the clients were mostly retail.

Normal adjustment mechanisms – part five in the Edward Hugh tribute series…

Australia is a commodity sensitive economy.  Greece is tourism sensitive.  Tourism is almost as big in Greece as mining is in Australia. 

But unlike Greece Australia has a really effective adjustment mechanism to a decline in demand for its product.  When metals prices/demand falls the Australian dollar falls.

One way to think about it is that when metal prices halve (a surprisingly common occurrence) then Australian export labor just is not as productive (in the sense that it earns less USD or hard currency per hour of work– not in terms of metal output).  We could solve this problem by paying everyone less (which involves the changing of many internal prices with complex and hard-won contract terms) or by simply changing a single variable – the price of the Australian dollar.  It is much easier for the market to adjust a single variable (the currency) than to adjust many (everyone’s wages) and so – more-or-less – that is what happens – the market takes the easiest available adjustment route.  The wages on the mine tend to fall – but slowly – relative to other wages.  The AUD reacts quite quickly – and as it falls everyone is paid less in USD terms. 

The adjustment really is simple – don’t change everyone’s wage, change the exchange rate.  Suddenly Australian labor can (again) produce commodities profitably… 

America is a large country with many sub-economies on different cycles but with a common currency.  If terms of trade move against Texas (as happened in the mid 1980s when the oil price collapsed) you can’t have the Texas Dollar fall because there is no Texas dollar.  Houston – we have a problem…

There is a solution too – but it is not as neat as the Australian solution.  The Australian solution to a recession in the mining belt is to allow the currency to devalue – the American solution to (say) a recession in Houston is for people to move out of Houston. 

America has an amazingly mobile population – with almost all of the world’s busiest airports inside the US.  Almost nobody seems to live in the town in which they are born.  It is OK for Las Vegas to have a tourism based economy, Los Angeles to be based on entertainment and aerospace and Florida to be retirement because people in the US move when one part of the economy is struggling.   In Australia – a country very similar to the US – internal migration is much less noticeable. 

Alas Europe has neither much internal migration nor any ability for say the Greek or Spanish Euro to devalue against the German Euro.   I exaggerate a little – a cursory look at the racial mix of Spain over the past 15 years will tell you that immigrants to the Euro Zone settled in Spain in large numbers – and presumably they won’t be doing that any more.  But I do not see too many Spanish living in Munich. 

And so Club Med is left with its nuclear-solution to adjustment which is internal deflation to give adjustment.  What Greece needs right now is a flurry of German tourists spending big on retsina and hotels – and it needs to be able to tax that spending.  Alas Greece is expensive now – and whilst a devaluing Euro will make my “ruins tour” cheaper it won’t make it any cheaper for Germans to visit.  What will make it cheaper is lower Greek wages achieved through lots and lots of unpleasant austerity…

Alas I think it is worse than that

As observed the Australian solution to a local slump is to allow the dollar to devalue.  This makes Australian industry more competitive and hence provides the solution to the problem. 

There is one more consideration – Australia – like “Club Med” countries has a lot of external debt.  Indeed Australia has a massive amount of external debt – we are far more (privately) indebted than any of the so-called “PIGS”.   But fortunately (for Australia) that debt is denominated in Australian dollars.  If the Australian dollar devalues that debt devalues with it and it is no more difficult to repay.  If the debt were denominated in (say) US dollars then as the Australian dollar devalued the amount that would need to be repaid would go up and up and up at least when measured against Australian physical output.  If you devalue the debt simply becomes too big. 

It is the core of the Australian miracle that Australia is a small open economy with a floating currency allowed to borrow in that currency.

There is a reason why we are allowed to borrow in that currency – which is that the Chinese (with some justification) see Australian dollars as a claim on all of those minerals (and a history of 100 years of not-too-bad government).

Now Greece and Spain et-al do not borrow in their local currency – they borrow in Euro.  And if they had converted their local economy back to Drachma or Peseta those currencies would devalue against the Euro making their debt unreasonably large measured against Greek or Spanish output.  Private debt denominated in a foreign currency where it is just manageable prior to currency devaluation becomes entirely unmanageable once the currency loses a third of its value.

But the currency is pegged and whilst it remains pegged the nominal value of the debt – measured in Peseta or Drachma cannot increase….  But we know what the adjustment mechanism is – it is internal deflation.  Prices will fall in Spain and the rest of the PIGS – they are already falling in Spain.  And whilst this is a necessary part of the adjustment it has a side effect of increasing the effective amount that needs to be repaid vis say Spanish wages – just as surely as it would if Australia had borrowed in US dollars and the Aussie dollar devalued. 

Essentially club-med is in the position of a country with a floating currency too indebted in foreign currency when their currency collapses.  Except that it is worse – because the crisis will get drawn out -

Internal devaluation – the only adjustment mechanism Club Med has – will drive up the value of that debt measured against Club Med output just as surely as external devaluation drove up the value of Thai US Dollar denominated debt from the perspective of the Thai.

Even with internal devaluation there is alas no real equilibrium.  This is just a pug-ugly situation.

 

 

 

John

Post script: one reader reminds me that there is one remaining Finnish bank – but it has almost no cross-border business – and the general point – that Scandinavia got rid of currency union on a banking crisis and today only Finland with a small domestically owned banking sector is uses the Euro.

Weekend edition: he is not sick he is fully sick sick

No stock implications – just a fabulous YouTube rap.  Christiaan Van Vuuren is locked up in quarantine in Sydney with a really nasty strain of multi-drug-resistant tuberculosis.  He connects with the world with his rap videos…

 

And now that he is lonely he needs a quarantine girl…

 

I could leave singing about TB there – but much less cheery though utterly astounding is Van Morrison’s TB Sheets…  not much video – just get the headphones…

Stress tests and sovereign solvency – part IV in the Edward Hugh tribute series

The Scandinavian banking crisis was solved in the following manner

(a).  The banks were guaranteed

(b).  Someone independent of the banks was invited in to reassess bank capital.

(c).  The banks were then told how much capital they had to raise.  They had a fixed period of time to raise it.

(d).  If they could raise it – well and good – and they kept operating.  If they could not the Government injected capital cancelling existing equity as it went and where it could ultimately wind up with 100 percent ownership.  They were not afraid of the “n-word” (ie nationalisation).

The American solution worked almost identically except for step (d).  In America

(a).  The government told us that there would be “no more Lehmans” and they kept telling us and giving banks access to additional funds until we all knew the banks were effectively guaranteed,

(b).  They had a “stress test” to assess how much capital to raise.

(c).  The banks were told how much capital to raise and given a time.  They raised it in common equity.

(d).  If the banks could not raise the capital the government injected capital as common shares until they had enough.  Note that the US process could not wind up with 100 percent ownership of a bank – and the “n-word” was not used.  If the US had run on the Scandianvian formula Citigroup would be entirely government property. 

That said – the end solution in America and Scandinavia were remarkably similar – it was just that the language around them was different.  The “n-word” – which Americans are scared of and Scandinavians are not was the key difference.

This solution works provided you have sovereign solvency.  A sovereign can do this if it can print money (I will go into mechanics later) but cannot do it on a gold-standard or Euro standard.  The Scandinavians needed to de-peg their currency from Europe to achieve their solution and to this day there is a Swedish, Norwegian and Danish Kroner.  Finland alone took up the Euro – but Finland has no large domestically owned banks. 

The solution will work in Europe too provided the currency of the PIGS is separated from the Euro.  It will not work otherwise because step (a) above – the Government guarantee of the banks – is not possible.

Mr Geithner is encouraging Europe to run stress tests – because they worked so well in America.  That is fine – but it is only fine if you also run sovereign stress tests.  A guarantee is a necessary part of this solution – and that guarantee means that the real stress is on the sovereign not on the bank.

Scandinavia found that out.  The classic Norges Bank book on the crisis makes it absolutely clear that delinking the currency was the key to the solution.  And so it will be again.  The stress tests done in a vacuum mean nothing.

 

 

 

John

Digital rights management and international travel – a reason not to buy a Kindle – but maybe a reason to buy Amazon stock…

I purchased a Kindle in the US.  I wasn’t an early adopter – but it was an early Kindle DX.  I loved it.  I get almost any book I want and the font size is whatever I want.  A Kindle is the obvious gift for a reader getting on in years or slack in eyesight…

My Kindle screen has failed – or “distorted” to use the language in the Amazon emails.  This appears to be a frequent problem and Amazon has a policy of replacing screen-defunct devices on a no-questions asked basis.  Or so I thought…

This is critical.  I have purchased about 40 books on my Kindle – and in a few years I suspect it would be 400 books.  And they can only be read on a Kindle because the Kindle is not an open-standard.  I can’t go read them on a competitors reader.  And if my reader fails to read my books I have to get ANOTHER KINDLE.  I am stuck in the land-of-Amazon for all eternity – unable to move my library to any competitor format.

That is the glue that binds Amazon’s business strategy – its as anti-competitive as Microsoft’s glue with operating systems.  It is a reason I might consider buying Amazon stock despite its lofty price – customer lock of that sort is hard to obtain. 

This “glue” however relies on everyone having goodwill towards Amazon because you would not buy a Kindle if you expected Amazon to rip you off in the future.  Amazon can’t make their business strategy work if people think that Kindles are fragile and that you will be forced to fork out $400 every couple of years to replace the reader.  They really can’t make this strategy work if the screens fail and the customer service sucks.  Goodwill is critical.

Alas my goodwill towards Amazon is evaporating.  My Kindle is a US model – and was purchased in the US.  I need it replaced and Amazon will not send the replacement to me in Australia (though they say they will send it to the US).  I offered to pay additional postage even – but no dice.  My entire library is useless.

If I could take the library to another reader.  I would – but it is digital rights locked.  If I could have my time again and buy another reader – any other reader – I would.  But alas I am stuck because my library is stuck.

So – in desperation – and because I cannot live without my books I just purchased another Kindle which I hope they will send to me and which I hope will not prove as fragile as the last.

And I have almost no recourse.  I can’t find jurisdiction to sue them in Australia – and so hey – I might have to learn my way around the Washington State petty claims court.  Maybe I will just write the whole thing off as a bad experience.  (But if any reader has ever filed anything in small-claims in Washington State send me an email…)

But I have a recommendation.  If you travel a lot – and if you worry about digital rights and electronic readers DO NOT BUY A KINDLE.  If you buy one you will be forced to buy another and another and another.  This is like heroin for readers – fun when you get the first hit – but after a while it is a drag and eventually it will leave you a washed-out Amazon victim. 

 

John

PS.  This is an investment blog and my complaint does not preclude owning Amazon shares – dealing heroin with legal protection can be highly profitable.  And that is I suspect where Amazon is going…

Emporiki – a Greek-French sideline – the third post in my Edward Hugh tribute series

I once met the CEO of a French regional bank affiliated with Credit Agricole.  His bank was rich and a quasi-mutual – and hence he was only marginally concerned about profits – though he himself was extremely competent and his bank executed brilliantly.  His accounts were in French only.  He did not need to raise money and hence he did not speak English.  He also served the best simple French food I have ever eaten in his corporate dining room – fish carpaccio with a drizzle of good oil, capers, dill, a citrus-fennel-salad and good bread, and I can taste it to this day.  I assure you this is way-better-than-Goldman-Sachs dining.  Life is fun as the CEO of a deposit-rich bank in Southern France.  I have met many billionaires – but nobody who had it this good.

However a good proportion of his balance sheet was on loan to Credit Agricole SA (the large listed bank) and Credit Agricole SA was building an empire across Europe.  I wondered why they were doing it.  He said – and this is a direct quote: “we are industrialists”.  He meant he wanted to grow a huge concern across Europe.

So here is the balance sheet of Emporiki – the expensively purchased Greek subsidiary and part of the end game of Credit Agricole’s Napoleonic ambition…

 

 

Now this bank is slightly over-lent.  It has loans of about 21 billion, deposits of 13.6 billion.  These are UK or Spanish ratios rather than Greek ratios.  Nonetheless the numbers are small compared to the Greek economy. 

The doozy here is note 19 – “due to other banks”.  I figure you can guess it is all due to the French…  last I confirmed it was due almost entirely to the listed Credit Agricole SA.

Moreover this bank is having a bit of a run.  Deposits dropped almost 10 percent in the quarter.  Due to other banks rose by 800 million euro.  Obviously that was more exposure of Credit Agricole Group to Emporiki.  Any run will of course hurt the parent…

Unlike National Bank of Greece there is no critical exposure to the Greek government (only about 300 million Euro). 

If Greece decouples from the Euro and forms a new Drachma it is likely that the interbank liabilities will get reformed as Drachma (see my last post).  A relatively small equity value could cause quite large losses – many billions of Euro.  (Assume 30 percent devaluation and they lose 30 percent of the equity – which is trivial and 30 percent of the “due-to-banks” which is not.)

Next time a French bank gets Napoleonic remind them of this.  My French banker-friend should have stuck to eating the fine food.  Leave industrialism to the real industrialists.

 

 

 

 

John

Post script – I got one comment too long for the official comments – not mine but worth reporting.  I do not agree – but that will come out later in the series…

John, a few answers/thoughts... I tried posting some of them yesterday (only on NBG) but the text was too long – so here it comes via email (with an additional point on Emporiki).

On NBG, from note 31, ECB funding has increased by around 2 billion; repos with banks have increased by 3 billion; and Interbank (unsecured) seems to be more or less the same.

Moreover, during the first quarter of the year there were definitely cases of foreign banks not wanting to do repos with Greek banks where the collateral was Greek bonds - since the default correlation was so high that the repo in effect became non-collateralised lending. At the most serious points in the crisis, foreign banks didn't want to do ANY repos with Greek banks, whatever the collateral.

As such, I am pretty sure that the further increase of 6bio in "due to banks" shown in the balance sheet of 31.3.10 is all ECB funding; or to be more exact, the increase in ECB compared to the 11bio at 31.12.09 will be more than 6bio, as a large part of the repos with banks will have matured and not been renewed - and hence the bonds will have gone to ECB.

Thus, it's ECB who's very much on the hook in this case; from personal experience I'm pretty sure that German banks (and French and Swiss etc etc – well, except from Credit Agricole or Soc Gen) have VERY low exposure to NBG (or other Greek banks)

At this point, please note that ECB gives cash for an amount up to the Market Value of the bonds pledged (taking the market price into account, and a haircut). So NBG would not be buying at a discount and pledging at par. The only chance of this happening is if the prices of the bonds actually rise; but with spreads at 600bp (up from 100bp in September) what has happened is really the opposite: they've paid 100 (or 95 or 105) for a bond and now they're getting 80 (or 70 or 60) from ECB when they pledge it.

On customer deposits, there were wild rumours flying around the country ("we couldn't sleep due to the noise of the presses where the drachmas are being printed") which led people to do many things - some rational, some irrational. The interesting thing about NBG is that they claimed in the press conference for their Q1 results that in May they had an INFLOW of 1bio of deposits; I know that a (slightly) smaller bank seems to have around 20mio of inflows DAILY since mid-May only from cash deposits (i.e. people who had stuffed Euros under the mattress or in the flowerpots). To me, 500mio a month from cash previously stuffed in mattresses looks as if local sentiment has changed and people are now less receptive to rumours about the “default-and-exit” scenario.

As for Emporiki and the decrease in customer deposits you mention: obviously, some of it was withdrawn (as per above, to be stuffed in cuddly bears and pillowcases). But I hazard a guess that a significant part of it was also transferred to other banks in the Credit Agricole group, temporarily. Many Greek banks had customers transferring cash to subsidiaries in Cyprus or Luxembourg (as you mention at some point); you could walk into a branch of one bank in Athens and open an account in a Cypriot branch of the same bank. And yes, I know that getting your customer to transfer his cash to the mother bank isn’t exactly the same as him transferring to a subsidiary – but still, it’s liquidity that stays within the Group.

Having mentioned the D-word… Two different paths have been mentioned. There’s the first (very obvious) one: all the measures in the world won’t be enough to turn the situation around, or the Greeks will not implement the measures and the Europeans/IMF will grow tired of the whole situation, hence leading to a default/restructuring. The second might sound more surprising: that the measures ARE effective, in a couple of years’ time they generate a primary surplus for the Government - at which point the State restructures its debt (with or without agreement of creditors) to lighten the load for the future. If it’s done unilaterally I’m sure that it will get the ECB (and others) very angry (imagine the amount of GGBs the ECB will own in a couple of years, plus the amounts pledged as collateral) so most probably there will be a big effort to do this through agreement.

Will Greece simply default one day soon? I’m pretty certain not. Will Greece restructure its debt at some point in the next 2-3 years? Perhaps. Will Greece exit the Eurozone? I sincerely doubt it for the next few years: there’s been considerable energy spent on the whole project of European integration in the past 50 years, I doubt the powers-that-be will simply allow the Euro to start splintering. However I can’t say I’m 1000% sure in 20 years there are going to be the same countries in the Euro (or that the Euro will exist).

And of course, there’s always the sunny scenario: the measures DO start working, there is enough of a surplus generated to start paying down debt and things work out well… Some numbers that have started coming out seem more than decent: for example, March Retail Sales up 15% compared to last year (with all the retailers complaining of a drop in turnover). Of course this is not a sign of increased activity but of increased REPORTING: first measure which was taken before the IMF/EU cavalry were called was to make people get receipts from all businesses (by linking the receipts with the tax-free part of their income – long story). Also, one bank’s customers have been making VAT payments for the first quarter which are up around 12-15% compared to the same quarter last year. Has this bank been so successful in attracting the businesses that are blooming in a recessionary economy???? I would love to say it’s so but I doubt it: simply, the businesses are paying more VAT due to reporting of greater activity. And this was before the big increases in the VAT rate.

We’ll see how it goes. These are going to be tough times… but it might just work.

National Bank of Greece: part 2 in the Edward Hugh series

Edward Hugh is obsessed mainly with Spain – and Spain is the big picture – but the markets are obsessed with Greece.  Greece is ground-zero in the Euro-zone implosion.  At ground zero is a bank – a surprisingly nice bank – the National Bank of Greece. 

Most people are not like me.  They don’t read bank balance sheets for fun.  So let me hold your hand and I will take you through it so I can ponder a few imponderables about Greek default…

 

Group in this case includes the subsidiaries in former Yugoslavia and other places.  Bank represents the bank in Greece.  The core thing to notice is that the loan deposit ratio is roughly 100 – maybe just a little over 100 but not extended.  Also Bank (ie Greek) loans are under 60 billion euro – small relative to the economy of Greece (maybe 300 billion euro counting a black economy).  This bank is simply not over lent. 

Growth rates are just under 10 percent per annum – but for most of the cycle growth rates were lower.  This is important because a fast growing loan book can hide a lot of problem (by extending more credit to people who cannot pay).  There is little evidence that the National bank of Greece has been doing this though I would be more comfortable with a lower growth rate in good times – but it is as it is.

Secondly the bank is surprisingly profitable.  It has interest spreads and costs commensurate with the great oligopoly banking systems of the world (Australia, Canada, Scandinavia, regional France).  The Group remained profitable in the first quarter – though the Greek parent had become slightly loss making.

 

 

There really is only one big problem with National Bank of Greece – and that is Greece.  Lurking in the balance sheet you will see about 20 billion euro of “due-to-banks”.  This is interbank funding due to other European banks (presumably German).  Offsetting this is about 16 billion in investment securities.  Note 22 covers those – and they are mostly Greek Government Bonds – and if they not “Hellenics” then they are credit conditional the Greek Government anyway…  For masochists the table is here:

 

 

Take the investment securities away – and throw in the deep recession that is likely if the Government defaults – and it is pretty hard to see how NBG gets out of this. 

The last quarterly conference call was one of the saddest things I have ever listened to – because the management seemed – certainly by the standard of regional bankers – to be a very fine group of individuals.  They ran a darn tight ship – a bank that should be OK and indeed I quite like.  Certainly NBG is one of the better run banks out there.  Most of the conference call was about running day-to-day banking and how you operate in what is a very tough environment. That of course was the one credit that they could not “manage” – the local Sovereign.  And the management stated that they were “the best credit in town”.  This line is a paragon of wishful thinking.

Alas if Greece defaults it looks likely that NBG goes with it – as would any other Greek bank (except probably Emporiki where the losses will be borne by Credit Agricole). 

In delay there lies no plenty

Shakespeare asserted that in delay there lies no plenty – and that is most certainly true if you need to fund the National Bank of Greece. 

If you were a Greek rich guy with substantial deposits what would you be doing?  Short answer: run at par.  You can get out at par something that is ultimately credit risk Greek Government without any penalty. 

Deposits are falling in Greece.  Not a lot – but the fall in the first quarter results was just under 2 billion euro.  This is not seasonal…  Rich Greek guys of course know about capital flight (they have done that before) but they are only doing it a little – indeed it surprises me that there are not violent runs happening... [contra possibility: the rich guys were never in Greek banks at all…]

The strange shift in the due-to-banks and other balance sheet items. 

Obviously the run –small though it is – needs to be funded.  Cash was down (no surprise there).  The rest is strange…

The due to banks is up about 5 billion in the quarter.  I would have thought by the first quarter people knew not to extend further credit to NBG. 

Does anyone know who is funding this?  Is it all ECB or are the Germans just walking further out on the plank?  Is it possible that NBG is buying Hellenics at a big discount to par and funding themselves by pledging the same bonds to the ECB at close to par?  The investment securities rose during the quarter - which is similarly strange – and portends the bank buying securities at a discount and pledging them to the ECB at par.   

If you want the quarter balance sheet it is below…

 

Is sovereign default without bank default even possible?

NBG is a good bank.  But if the Sovereign defaults it is in deep trouble.  Sovereign default will mean that NBG cannot pay back its interbank obligations.  None of this should be a surprise to anyone watching the stock price.  NBG has not been a good stock.  The German banks will lose not only on their holdings of Greek sovereign securities but on their NBG inter-bank funding as well – again demonstrating the adage that if I lend you $100 and you can’t pay you have a problem but if I lend you $1 billion and you can’t pay I have a problem. 

This however answers you the question of what a sovereign default has to look like.  A straight Sovereign default will bankrupt all the key Greek institutions (even when well managed).  And the only way to save them is to allow them to default at the same time without triggering a liquidation. 

When you have a pegged currency that is easy – which is that you float the currency but legislate (as per Argentina) that all banks are obliged to pay off their foreign debt in Pesos (sorry Drachma) at the old exchange rate.  That way the banks are not killed by the sovereign.  But it meant that people who left their US dollars in Argentine banks got back crappy pesos and presumably those with Euro in NBG will get back Drachma.  To successfully run from the dodgy-peso you had to put the money in a bank outside Argentina.  Merely converting to USD was not enough.  Even placing those funds with the local subsidiary of a foreign bank is probably not enough.  I suspect this will need to happen in Greece too.

I have no idea of how the mechanics of doing this will work when the currency is the same currency rather than just a peg.  Bank systems are non-trivial.  If anyone has thought through the mechanics let me know.  Most people look at this problem and just conclude that “default is unthinkable”.  But that reflexive response – effectively deciding because it is difficult we will not think about it - hardly helps.  Whatever – the mechanics will be unbelievably complex.

Thoughts please…

 

 

John

FTAlphaville makes a very similar point.

In honor of Edward Hugh – Part 1

Edward Hugh writes A Fistful-of-Euros – one of my favorite blogs. I always thought of Edward as some second-tier economics academic who was right about several key issues and had an obsession which left his faculty members nonplussed. Academic rigor was not the key – and almost everything on Hugh's blog could have been fined-up by someone who had a decent understanding of Paul Krugman's book on currency and crises. (Of course fine technical detail did not detract from Mr Hugh being right – and on the key issues he was and remains emphatically right.)

I have in the past referred to him as Professor Hugh – and whilst someone corrected me in the comments it never occurred to me he was some disheveled amateur economist living a low-key life in Catalonia. He was way better than that – indeed way better than most economics professors.  Besides he had some help from Claus Visteen – an uber-nerd macroeconomics grad student who writes the very competent alpha-sources blog. [I would have incorrectly guessed that Ed was Claus's PhD supervisor or something like that..  Still I only once seriously thought about doing a PhD in economics and Brad Delong did not answer my emails... I guess I am not knowledgeable about the ways of the academy.]

Edward Hugh is having his day in the sun and the New York Times has honored him with an article. An in celebration I thought of further (and trivially) honoring him with a blog post – about how a post-crisis Europe might look and the path to getting there.

Alas I found that I could not write a single post to cover the ground – and so I will write a couple which will wind up longer and more complicated than I envisaged.

The first post – tomorrow I hope – will cover a bank right at the center of the storm – the surprisingly well-run National Bank of Greece.  NBG is however a small part of the big problems of Europe.  I think the best way of explaining macroeconomics to non-economists is to work from specific and concrete examples and NBG is an excellent example.  (Krugman’s book tends to stand real-world examples – but is hardly light reading…)

And so, at least for tonight, I will raise another glass of Spanish wine to Edward Hugh and settle down to drafting some serious bank analysis.

 

 

John

PS.  For completeness I should disclose several positions here. 

1.  National Bank of Greece has preference shares listed on the New York Stock Exchange where there is no restriction on shorting them.  They were priced at about 80c in the dollar until quite late into the crisis – indeed they traded at a premium to the sovereign and they were a good short.  We remain short them – but the bet is not as delicious as it was when we first put it on and we have covered almost all of the position.

2.  We remain substantially short the Spanish banks.  Again it is illegal to short them in Spain (except via derivatives).  It remains legal to short their ADRs.  At one stage in the fund the Spanish bank shorts were (collectively) our largest losing position.  We increased them – and increased them again on the way down and they are now (collectively) our second largest winning position.  We are also slowly covering the position.  I have blogged about BBVA and I thought (and still think) they are fudging the accounts of their US subsidiary – though that is not the reason we are short these stocks. 

3.  We have minor positions – long and short – in various European banks.  Generally smaller banks in solvent countries (especially France) are OK – and bigger banks tend to have cross-border exposures.  In 2003 or 2004 I went to a banking conference in London where the theme was cross-border banking consolidation in Europe.  That was not a good idea but plenty of investment bankers made a career on it.  [In investment banking you can make extra-good money promoting bad mergers.]

4.  I have not run this series through Edward Hugh.  I hope he appreciates the attention and does not resent my intrusion onto turf he covers so well.  I am closer to Claus than Edward Hugh (emails number over a dozen from Claus and very few from Mr Hugh – though none are close).  However I have met none of these people and chatted to Claus only a couple of times.

The Fannie Mae and Freddie Mac reform proposal from Goldman Sachs

Donald Marron and Phil Swagel have written a paper which proposes a reform structure for Fannie Mae and Freddie Mac.  It should not be taken seriously – and indeed it should disqualify this pair from serious debate – a larger gift to Wall Street that does not solve the problems of the GSEs is hard to envisage.  But – as the Washington Post takes it seriously and this pair are not lightweights I thought I should have a go at explaining what is wrong with it.

Fannie and Freddie (collectively the GSEs) did a few things some of which wound up hurting them and some of which did not. 

a.  They guaranteed mortgages – taking credit risk.  Some of these mortgages were well secured first mortgages with significant downpayments.  Some were more funky including 95 percent loan to valuation mortgages with odd payment features but supplementary credit insurance.  They insured substantial portfolios of what is now widely known as Alt-A.

b.  They purchased mortgages for their own book – usually, but not exclusively, the mortgages that they insured anyway.

c.  They purchased securitization strips including the (originally rate AAA strips) of private label mortgage securitisations including some truly atrocious mortgages.

In doing this they took credit risk (the risk the mortgages would default), interest rate risk (the risk that interest rates would change sharply causing loss of value of the mortgages or loss of spread on funding mortgages) and refinance risk (being the risk one day they would find they could not borrow money even if they were solvent).

You can take credit risk by guaranteeing mortgages or owning them.  But it is only by owning mortgages that you take interest rate risk and refinance risk.  If all you have done is guarantee the mortgage you don’t have to finance it or refinance it – so there is no refinance risk.  And you don’t care what the coupon on the mortgage is because you are not collecting the coupon.

I should not need to say at this point that the problems of Fannie and Freddie were entirely credit related.  They lost money guaranteeing mortgages and owning AAA strips of securitizations but they did not lose money on interest rate risk.  Interest rates have not been sufficiently volatile to do them great harm.

Alas every solution around for the GSEs that is in the public domain – ranging from the original (Hank) Paulson GSE conservatorship agreement down, force the companies to reduce their interest rate risk (by shrinking their portfolios) and do nothing at all about the credit risk (by allowing them to grow their guarantee business). 

The Swagel/Marron proposal is this taken to its logical extreme – it wants to allow multiple private entities with an explicit government backstop to compete in issuing guarantees – presumably driving the market price of the guarantee down.  They do not state this – but this will allow Wall Street to lay credit risk off to the government at minimum cost to them.  These entities however will not be allowed to own or finance mortgages or take interest rate risk – in other words they will be prevented only from doing the thing that is (a) profitable and (b) did not actually hurt Fannie and Freddie.  The profitable business that did not hurt the GSEs will of course be taken up by the banks – especially the investment banks.

Swagel and Marron are not completely stupid – they want to restrict the type of mortgages the competitive entities can guarantee to limit the risk to the government – with maybe a more strict definition of “qualifying mortgages”.  However one lesson of the crisis is that private sector entities competing with thin capital are more-than-keen to sell the trashiest mortgages and pretend they are golden.  If private sector institutions can do that to other private sector institutions (proven by observation) then it is absolutely assured that competitive private sector GSEs will do that to their regulator. 

The Swagel/Marron proposal is all the credit risk (proven nasty) to the Government and all the rest (so far looking pretty benign) to Wall Street.  It is the proposal from Goldman Sachs and – I presume that Wall Street could not be happier.

Serious and non-serious contributions to the economic debate

I like to think you know people who are not serious when they always have the same solution – no matter what the problem.  For instance there is a faction in the Republican party who think that whatever the problem the solution is to cut taxes.  If you are running too big a surplus the solution is to cut taxes. If you are running a deficit the solution is to cut taxes.  If you are fighting a war the solution is to cut taxes.  If you face global warming the solution is to cut taxes.  These people can be effective political operators but are useless at furthering the intellectual debate.  There are similar groups who think the solution is always more government regulation.  Puerile arguments exist on all sides of politics.

If you go back to the anti-Fannie-Mae debate as it was about the year 2001 the argument was always that Fannie and Freddie were taking too much interest rate risk – and that the interest rate risk would eventually blow them up.  You can see that in Greenspan’s 2005 views on how to reform the GSEs.  Greenspan stated that the GSEs posed  a threat to the system.  However the risk he focuses on exclusively comes from the owned portfolio – from interest rate risk.  I believed Greenspan’s views when he stated them in 2005 – and I was short many stocks based on interest rate risk.  [I got that wrong as I have detailed before on this blog.]

Greenspan proposed solutions to the interest rate risk problems posed by the GSEs.  Incidentally they are the right solutions if you think interest rate risk is the problem – they are the wrong solutions if you think credit risk is the problem.  Greenspan (and other GSE critics) would have handed the whole financing issue – including interest rate risk management to the banks (including the investment banks).  I thought that was right because they could manage that better.  Sure it would have been good for Goldman Sachs but the standard analysis of the risks said you wanted to put that risk in Goldies hands anyway.  I would have supported the gift to Goldies because I thought it was the right thing to do.

The GSEs blew up – but they blew-up entirely on credit risk.  The risk Greenspan and all the bulk of anti-GSE thought (including me) identified was the dog-that-did-not-bark.  The GSE critics (including myself) got the analysis wrong.  The solution we proposed was not the right solution to the problem that actually occurred (but it remains the right solution if you are Goldman Sachs).  Moreover post crisis there is little evidence that the banks could handle the derivatives exposure embedded in hedging Fannies and Freddie’s book any better than the GSEs (the other pre-crisis assumption I made). 

Alas the bulk of the GSE critics want to enact the solution for the problem that did not occur.  Like Swagel and Marron they want the solution that maximises government exposure to credit risk and minimizes government exposure to (and revenue from) all the other risks in the mortgage business.  They want the solution from Goldman Sachs despite it being the solution to the wrong problem.

I was wrong on the facts.  I changed my mind.  Most of the other critics were wrong too.  They did not change their mind.  That might make them effective political operators but it makes them useless at furthering the public debate.

Marron and Swagel however are (usually) far better than that.  They are amongst the best that the Republican Party has to offer on economic policy – thoughtful and knowledgeable.  I ran my criticism of their proposal past them and they stated that they just assumed that the “American Public” wanted the government to absorb mortgage market credit risk.  That may be their view (and they should state it up front) – but for “American Public” here I think you should substitute “Goldman Sachs” and you will have a more accurate picture of the politics.

That said – I hope serious commentators less in love with Wall Street come up with some decent solutions – because if they don’t what we will get is the solution from Goldman Sachs because no other proposal is on the table.  Mike Konczal – I am laying out a challenge for you.

Nigerian spam email of the week

From: Dudley Caruthers Esq (Barrister at Law)

Subject: BP Related Agreement Entitlement

E-mail:

Dear Friend

I am the private solicitor for Mr Tony Hayward, the esteemed Chairman and Chief executive of British Petroleum.  My client has various personal and family related holdings of BP stock and options. Due to his faithful long standing service to BP the total value of his holdings amounts to in excess of 100m pounds sterling.  Mr Heywood is a British citizen but it has been my sorrowful duty to advise him that his personal and family wealth is at great risk of being wrongfully confiscated by US authorities acting extra-territorially under special powers authorised by the US government and with the secret consent of a supine UK political and legal establishment. 

Mr Heywood is also at great risk of losing his personal liberty and becoming another victim of the long reach of the politicised USA legal system in the same way that was meted out to other British subjects including, most egregiously, the 3 bankers from Natwest (see  http://en.wikipedia.org/wiki/NatWest_Three).  Unfortunately I am not able to advise or assist him in this regard as my expertise lies in the structuring of executive compensation schemes and the management of private endowments; but I am horrified at the witch hunt being perpetrated on my client by the Obama administration and its agencies and I will do all that I can to safeguard my client's financial position.

I am reaching out to you as it has become clear that Mr Hayward's holdings must be liquidated and held in trust for the benefit of himself and his family beyond USA or UK legal jurisdiction. Exercise of his options and liquidation of his stock is now complete but it has proven necessary to assign title to the ensuing 100m pounds of cash to a person such as yourself who resides in a non recognised tax haven country and where there is a sound basis for UK and USA authorities to recognise the legal validity of local agreements.  The taxation and legal recognition agreements between your jurisdiction of Australia and those of UK and USA present a unique opportunity to protect these assets whilst providing you with a benefit in accordance with your key role.  I am a keen reader of your blog and greatly admire your economic and political acumen.  I immediately recognised that, at this hour of great urgency and risk to my client, you are the man who is capable of securing protection of the Hayward estate.

It is with this in mind that I wish you to consider the possibility that you and I (as Mr. Hayward's agent) have previously entered into verbal agreements providing for you to become the beneficiary of all Mr Hayward's BP stock and stock option benefits upon their occurring a significant "force majeure" event affecting my client and British Petroleum.  It is my legal interpretation that such an event occurred with the sinking of Deepwater Horizon and that title to Mr Hayward's rights and holdings transferred at that time.

If you do recollect our agreement then it is now necessary to transfer the 80m pounds of  cash proceeds to yourself which are after payment of  a 20m pound advisory and arrangement fee for the services rendered by my firm. Transfer of the cash will only occur to you upon you executing the correct documents which are (i) the force majeure beneficiary transfer agreement  (ii) a statutory declaration that the force majeure beneficiary transfer agreement was properly entered into as a verbal agreement in January 2002  and (iii) details of your Australian bank account including account name, password and account number and most critically an agreement between yourself and myself as trustee for Hayward related entities granting the trustee the right to claw back  50% (40m pounds) of the transfer at any time and requiring you to escrow the 40m pounds in a separate account.

I sincerely trust that you will search your memory and recollect that we met in Sydney in 2002 and recollect the nature of our agreement.

Please contact me at my firm's Nigerian subsidiary's offices at the address below such that we can act with the speed required of us.