In defence of naked short selling – or why the crackdown on a phoney problem is costing taxpayers at least a billion dollars

Brief synopsis: a misguided government policy driven by fraudsters in the stock market is making the market less efficient at a cost to taxpayers of at least a billion dollars.

This post has two start points – a start point for people unfamiliar with the basic operation of short selling and risk arbitrage – and a start point for most my readership (who seem to be hedge fund managers).

Start point for readers without a financial market background

There are readers that do not know what short selling is – and what naked short selling (allegedly) is. So to help readers out – imagine I think for some reason a particular stock will go down – and I want to bet that it goes down. Then there is a mechanism by which I can make that bet. I can “borrow” the shares (say some shares in Citigroup). Then I sell those shares in the market (selling what I do not own – and have only borrowed). If the shares go down I can buy identical shares back in the market and return the identical shares. Rather than aim to “buy low and sell high” I just reverse the order – I aim to “sell high and buy low”. As an ordinary shareholder I can stuff up by “buying low and selling lower”. As a short seller I can stuff up by “selling high and buying (back) higher”.

When I buy back the shares (either at a profit or loss) I close out the transaction by returning them to the person I have borrowed them from. At all times my account is collateralised so the risk to my broker is minimal. [The risk to me unfortunately is not.]

Naked short selling is a much promoted – but in my view almost entirely fictional problem – whereby people do the short selling but without actually borrowing a share first. When they do so they will inevitably fail to deliver the shares to the exchange on the due date. The existence of fails is – at least according to the proponents of the “naked short selling hypothesis” proof that there is a major problem. But fails have happened since time immemorial (including in highly liquid markets such as Treasuries). There is usually a requirement to post cash collateral if you fail to deliver the actual security – and historically a small fine from the exchange (increasing over time).

Still some people have argued that a collateralised fail-to-deliver in a financial market has the ability through price manipulation of a stock to bring a business to its knees. Sorry – but generally the business does not care who owns the stock or what is going on the stock market unless the business is weak and needs capital. [This is the corollary of the old Wall Street truism: “the stock doesn’t know you own it”.]

Most short selling is mere speculation – but sometimes it involves arbitrage. Arbitrage is kind of useful and goes on all the time in financial markets. For instance if Company A agrees to buy Company B for stock the price should converge – over time – on the agreed stock swap deal. But if for some reason it does not arbitragers could buy company B’s stock and shortsell company A. When the Company B stock converts into company A shares they could just deliver the new Company A shares in satisfaction of their short-sale agreement. This allows the holders of company B to sell their shares at full price whilst the details of the takeover are sorted out. Arbitrage is the process which makes financial markets more efficient – it makes it so there is one price which means markets treat people more fairly. Arbitrage is by-and-large a good thing. Perfect arbitrages rarely (if ever) have substantial profit for the arbitrageurs. Indeed at best you are picking up pennies. Efficient markets reduce the profits of market participants at least on a per-transaction basis. That is usually a good thing if the public doesn’t want to subsidize sophisticated money market types.

Start Point for people with decent financial market knowledge

“Naked short selling issue” was a phoney issue – promoted by flim flams, stock promoters and other market slime-bags invented a problem which did not exist but helped them to promote their stock or justify the failure of their own businesses. The idea was that “miscreant” short sellers sold stock that they did not own in order to drive down the stock price and drive the company out of business. Bloomberg (and others) have taken the idea seriously. Gary Weiss has done a great job on his blog of exposing the slime-bag proponents of the imaginary naked short selling problem for what they are (which is usually crooks).

The story was that selling stock you did not own was producing “counterfeit shares”. I have yet to see mischievous naked short selling of any real business – though I have seen some fails-to-deliver (that is not actually being able to borrow the stock on the delivery date) remedied a few days later and with all obligations to the exchange cash collateralised over the interim period. There were plenty of “fails” but no real naked short selling “problem”. Hard to borrow stocks did fail regularly – but I assure you – and I have been doing this for years – when there were fails to deliver my broker called my short back and hey – presto – a few days later I had settled. If there was a “counterfeit share” it was cash collateralised and it was cancelled a few days later (in exchange for the cash collateral). The person who purchased the share from me got all the economic benefit of owning that share – and a full voting share was delivered to them within a modest time.

Fails to deliver now are – with electronic settlement – a far lesser and far quicker remedied problem than they were in the days of paper certificates. And with the speed at which they are settled – and the ability to demand cash collateral when a party fails to deliver they cause no economic problem at all.

Nonetheless the SEC took the slime-bag stock promoters seriously – at one stage issuing subpoenas to journalists who called the slime-bags for what they were. Journalists who got subpoenas – and who have considerably more demonstrated competence than the SEC include Herb Greenberg (unfortunately no longer a journalist) and Joe Nocera (New York Times).

Nonetheless in response to the well-promoted bogus threat of “naked short selling” the SEC radically tightened the delivery rules for stock. Now you have to locate a borrow before you actually short the stock (rather than having to locate a borrow before you deliver the stock) and if you can’t maintain a borrow you must cover the stock immediately – rather than fail (and pay fail-fees) for a couple of days.

Well and good you might say – but you would be wrong.

At the moment there is a well publicised arbitrage in Citigroup stock. There are four classes of Citigroup Preferred Shares which – on tendering to Citigroup – convert to common equity. And – surprise – you can buy Citigroup cheaper if you buy those preferred shares rather than buy the common. As of last night it was 18% cheaper to buy the Citigroup preferred than the common. So – with seemingly free money on the table we at Bronte Capital decided to short sell Citigroup common and buy the preferreds. An 18% return over about a month looks pretty darn good for a pure arbitrage. (So good it should not exist… its billion dollar bills on the sidewalk.)

But alas there is a problem. This deal is large - $20 billion – and as a result Citigroup common has become modestly difficult to borrow. You can’t short-sell the Citigroup common with certainty because you might not be able to borrow the shares and hence you might be forced to buy it in. And if you buy it in before you get the new (and identical) shares from tendering your preferred you could get “squeezed”. You will be forced to buy back your Citigroup stock at the same time as the other arbitragers (who have also been called on their borrowed stock) and you will pay a high price.

After paying a high price to borrow the stock you will receive your (now unhedged) new Citigroup shares at the same time as the other arbitragers (most of whom will be sellers) and – inevitably you will sell the shares then too as your plan was not to “own” Citibank. You will sell at the same time as the other arbitragers (presumably at a low price).

In the old days it would be easy. You would simply fail to deliver your Citigroup common for a few days whilst the new shares were delivered to you – and then you would deliver the new shares.

What was a perfect arbitrage has become an imperfect one.

So what you say – why should arbitragers like us at Bronte Capital be given a free ride? Well – hey we were not being given any ride – but now we are. Currently we are earning 18% on face value in a month for taking this risk – in the old days the price would have equilibrated almost instantly and people like me would not be making that money.

And that money comes from somewhere. Largely the difficulty in equilibrating the price through arbitrage makes it harder for Citigroup to raise the capital it wants. It has thus made that capital more expensive (by the bulk of our expected profits on the arbitrage).

Alas – even if you do not own any Citigroup you should be worried by this. The government is and remains the biggest holder of Citigroup stock – and when Citigroup has to pay more to raise private sector equity capital that “more” is effectively “less” for the existing shareholders. That is less for you the taxpayer.

So – in pursuing the bogus issue of naked short selling not only has the SEC diverted resources from its real job (which is chasing the real crims in the financial market such as Madoff) but it has imposed significant and real costs on the taxpayer and made it harder and more expensive for banks to raise capital in a financial crisis.

But – I should not complain. It has put a reasonable risk arbitrage our way – and I hope to report back that – thanks to the SEC crackdown on a bogus issue our clients are just that little bit richer.

Nonetheless I will know a commentator who really gets it when they defend modest levels of cash collateralised fails to deliver as a normal part of a normally functioning financial market. Naked short selling is good for markets, good for taxpayers and good for capitalism.

Quantifying the loss to taxpayers

Consider who bears this loss? There is 18% discount for buying the common over the preferred. To anyone who swaps preferred for common there is an 18% profit. As this is a 20 billion deal this profit is 18% of 20 billion or $3.6 billion.

The market is a zero sum game – that $3.6 billion is paid by someone. Well that someone is two groups. The first group is the existing preferred shareholders who should have got more for their shares. The other someone is Citigroup who get a less good price for the shares they are issuing. The incidence is hard to determine but given the recent history of squeezing shorts on preferred conversions is obvious enough that Citigroup bears at least half of the incidence.

As half of the loss is born by Citigroup who gets to issue the shares at a price that is too low. That is the loss is borne by Citigroup shareholders.

The cost to the taxpayer – well 18% of 20 billion raised is 3.6 billion. Just over half of Citigroup is owned by the taxpayer – and more than a half of that arbitrage profit comes from the issuing company (Citigroup). The cost to the taxpayer – a neat gift to hedge fund operators – is at least a billion dollar.

These days I guess that is small change. Either way – as a recipient of this gift I wish to thank the slime-bag proponents of the naked short selling hogwash.

John

Correction. I have been emailed to say that Joe Nocera did not get a subpoena.

Correction 2 - in the comments - if you account for the borrow cost on Citi the profits to the arb are originally about half (now well under half) of the profits indicated in this post. [We put it on with a wider spread than this. And the spread has narrowed for a few days. Also the borrow cost has been rising.] That just reallocates the profits to prime brokers - who really deserve it anyway.

The current borrow rate on Citigroup is just over 100%. We may take the trade off when the numbers make no sense any more.

PPS. The spread narrowed and the borrow rate on the Citi remained high. We covered this for a small profit. Trivial really. The biggest profit is being made by the prime brokers who get to lend out the shares.

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