Friday, October 31, 2008

It is surprising how few people got the joke...

The hedge fund trade was long Porsche, short Volkswagen.  

Porsche after all owns many times its market cap in VW shares so the trade was obvious...

This has been a disastrous trade.  Plenty of hedge funds got hurt bad.  Most of them are still long Porsche.

When I suggested the only responsible trade was short Porshe I was teasing.  A serious tease because Porshe is playing with fire and there are ways that Porsche could go bust.  But it is not a position I would put on.  

Calling it "the only responsible trade" was a tease.  Pure and simple...

Sorry if it did not translate to print.

John Hempton

Wednesday, October 29, 2008

The only responsible trade...

Warning – I strongly recommend against trading in any security mentioned in this post. The volatility is enormous and the situation fluid. The stocks are not being driven by fundamentals… The recommendations in this post are made in a somewhat humorous manner. They might even be reckless...

I am horrified - despite this warning at least one person has thought that the trade should be placed. Please take this warning seriously. I have no position.

The Stutz Motor Car Company

There was once a fine American sports car company called Stutz. It made beautiful – even legendary cars. The cars had a reputation for dependability, reliability and punishing speed. I know they look antique – but these were really quick for their day – and they won big races like Indianapolis and the Le Mans 24 hour race. Le Mans (at least) is an event that Porsche likes to win. Here is their 1913 Stutz Bearcat – a car that was modified, overpowered etc and won races into the mid 1920s.

Anyway Stutz was controlled by Alan Aloysius Ryan through family holdings. For reasons mostly to do with improved mass production by competitors the company found itself under pressure. Short sellers could smell blood. And they shorted the stock. And shorted some more.

Through this Alan Aloysius Ryan stood firm, buying stock when he could (possibly through options and hidden holding companies so the shorts could not see what he had done). He did this until he declared one day in 1920 that he owned 105 percent of the company and the shorts could settle with him on his terms.

His terms were a price so high that it would bankrupt broker dealers who had stood as intermediaries between the stock exchange and shorts.

Well to put it bluntly the financial market and regulators defended their own. The story is told here and here and here and here in the New York Times – and the amounts of money involved were monstrous for the time. Eventually the New York Stock Exchange –with the threat of criminal proceedings – arbitrarily determined a price to settle the short positions. The shorts even got an officially sanctioned “protective committee”.

That price was way below the top price that Ryan paid – but far more than intrinsic value. The shorts – well – except those that shorted right at the end – lost money. Ryan wound up paying too much for a motor car company which was slowly declining anyway. As he now owned 100 percent of Stutz his debts got intertwined with the car company and both he and the car company went bust. Some family members got a little out but only by suing other family members. The only winners were ordinary longs of Stutz who sold along the way – or even at the final settlement price.

As you might have guessed this looks horribly familiar. Porsche is now firmly in control of Volkswagen – and they did it with non-standard cash settled options and other things they argue that they did not need to disclose. It looks and smells like market manipulation – and Volkswagen – General Motors for Europe – may be - depending on the time of day - the biggest company in the world by market cap. [Yes – its market cap is higher than Microsoft, Exxon or PetroChina.] This is the short-squeeze from hell – the first short-squeeze to infinity since the Stutz corner…

Now I think Porsche is one of the great businesses of the world. They have convinced middle aged richer Americans that they are more attractive – or at least more fun – if they drive that particular fast car. (Viagra is for poorer guys…)

And unlike Ferrari (which spends all of its profits on Formula One) Porsche – like Stutz before it – managed to make its mark with near-production cars in events like Le Mans. In the automobile world there are only two car companies with margins near 10 percent – Porsche and Toyota. And they got there different ways.

Porsche (the business) is having a rough time at the moment because if you haven’t noticed the willingness of middle aged American men to drop 100K on a car is somewhat reduced of late. But that might be temporary.

Porsche is a company I want to love – a very fine consumer brands company masquerading as an automobile company. And it is not expensive at the moment – especially if you back out their holding of Volkswagen. Indeed its holding of Volkswagen is worth many times Porsche’s market cap – making Porsche one of the cheapest stocks in the world.

But if history is a guide the Porsche and its controlling family are going to go the way of the Ryans. Their behaviour doesn’t look any more criminal than Alan Aloysius Ryan – and that wound up with him – and his company bankrupt. The system has a knack of defending itself – and the family that controls Porsche and indeed the Porsche company itself is every bit as expendable as Alan A Ryan.

I started this post with a warning – which was that nobody should play any security involved in this story – and I want to stick with this warning. But if you want to play – and it pains me to say this – the only responsible trade is to short Porsche. Porsche – the company – and possibly the car – like Stutz before it – will likely get confined to the dustbin of history.

This is a sad thing – because Porsche – as I have noted – is a nicely run and profitable company. But the appearance of criminal market manipulation will have consequences – and Porsche will pay the piper. My guess – some hapless European investment bank (say Fortis or UBS) is at risk in this – the greatest squeeze since Stutz – and the European court when forced to decide between a mid-ranking German car company and a bank that is integrated with a European government they will chose the bank at Porsche’s expense.

Porsche lovers can however console themselves if they are going to live another 40 years. Someone made some pug-ugly cars under the name of the “New Stutz Company” in the 1960s. Elvis Presley loved his. A small consolation – but the name lives on well after any family legacy is gone.

John Hempton

PS. Having spent some time the other day slamming the New York Times I would thank them for making available – for free no less – the original newspaper articles about the Stutz Corner.

Monday, October 27, 2008

Is the New York Times giving us a bad read on the newspaper business?

News Corp’s newspaper advert numbers are bad – but they are not catastrophic.  They have got markedly weaker very recently – but until then they were down single digit percentages – and low single digits in most papers.  Some were up - but they were local property papers and the like.  The death of newspapers looked exaggerated if your benchmark was News Corp.

The WSJ is doing OK- not stellar – but OK.  Murdoch clearly has plans to turn it (a) into a national paper, and (b) into the dominant paper in NYC.  In that he is helped by the seeming failures of the New York Times.   

The New York Times is a paper I want to like,  but in fact like less and less.  It is falling into catastrophic disrepair and the stock price shows it.

The New York Times has become the poster boy for the demise of newspapers everywhere.  Revenue and profitability is weak – and the paper looks doomed.

Well is it possible – just possible – that the NYT editorial policies are giving us all a false read about the demise of papers?  

  • Why is it that the paper employs Ben Stein despite the regular and ludicrous columns so well criticised by Felix Salmon?

  • Does anybody still read Maureen Dowd?  As far as I can tell the same incoherent column has been repeated for about a decade.  (Maybe I am just insensitive to "gender issues"?)  Is this worth a regular editorial column in what purports to be the world’s greatest paper?

  • Bob Herbert suits my liberal predisposition – but I don’t bother reading him because I learn little new or useful.  He is too predictable.  And he has been that predictable for fifteen years...

  • Friedman seems to know less about foreign affairs (outside Israel and Beirut) than I do.  And I know very little.  He has been spectacularly wrong quite often.  Unlike Friedman though I know I know little about foreign affairs - he has a platform to show off his ignorance twice a week...

  • David Brooks is a poor replacement for the conservative William Safire.  Safire wrote better – and more to the point I had little idea what he was going to say and sometimes I was forced by sheer power of argument to agree with him.  David Brooks has never done that for me.  Safire was a disingenous guy who twisted facts to suit his political views - but he was darn clever about how he did it...

  • In the editorial area all they have is the very clever Krugman.  I agree with Krugman a good proprotion of the time - but I am forced to think.  He drives conservatives to apoplexy for the same reasons that Safire drove liberals to apoplexy.  He is too darn good.  Unlike Safire he doesn't twist the facts - at least in my view.  If only the paper could find five writers the standard of Krugman covering most political persuasons.  But then it would need to sack the others!

And that is when I get to the editorial policy.  Need I repeat that this was the paper that employed Jayson Blair (who just made it up with little consequence for the world) and Judith Miller (whose seemingly made up stories helped propel America to the Iraq war). 

The New York Times is failing – and the newspaper is failing. 

In the past the New York Times would be forgiven their failures – because there were few alternative sources of information.  But now there are plenty… competition is rife.

Competition is seldom good for shareholders.  It hurts well run businesses but competition has a knack of totally disposing of badly run businesses.  Indeed that is the real charm of competition. 

I want to ask a question: how much of the awful results of the New York Times are because of the demise of newspapers generally – and how much are newspaper specific?  How would we know?  



John Hempton

PS.  Rupert Murdoch would tell you that ultimately content is all that matters.  It suits his business mix to say that.  But maybe there is far more to this than the internet causing destruction...

Buffett by comparison is fairly bearish about the newspaper Berkshire owns.

Thursday, October 23, 2008

A new disclosure "Magically" appears

In August – which in this market seems like years ago – I did two posts on MGIC  – the largest mortgage insurer and a company colloquially known as Magic. 

These posts are here and here

I concluded that I did not believe in Magic – but I outlined the bull case (which was that the companies had something close to positive cash flow) and had a readers who tried to convince me that the bull case was right.  (I was and remain short.) 

In the second post I made an observation about statutory capital and possible shortages thereof. 

My further objection is that statutory capital deficiency happens way earlier than this - and stat capital deficiency will close the business as per TGIC.

It is an innocuous line – but two readers (both of whom I respect) followed me up on it – and one was sure that statutory capital was going to be adequate (he was long).  The other modelled it with brackets for his own uncertainty – and we thought that statutory capital might run short.

Anyway MGIC’s results contained a new disclosure on this issue:

Some states that regulate us have provisions that limit the risk-to-capital ratio of a mortgage guaranty insurance company to 25:1. If an insurance company’s risk-to-capital ratio exceeds the limit applicable in a state, it may be prohibited from writing new business in that state until its risk-to-capital ratio falls below the limit.

We believe that our 2006 and 2007 books of business will continue to generate material incurred and paid losses for a number of years. The ultimate amount of these losses will depend in part on the direction of home prices in California, Florida and other distressed markets, which in turn will be influenced by general economic conditions and other factors. Because we cannot predict future home prices or general economic conditions with confidence, we cannot predict with confidence what our ultimate losses will be on our 2006 and 2007 books. Depending on the extent of future losses, MGIC’s policy holders position could decline and its risk-to-capital could increase beyond the levels necessary to meet these regulatory requirements and this could occur before the end of 2009. As a result, we are considering options to obtain additional capital, which could occur through the sale of equity or debt securities and/or reinsurance.

That is slightly worse than the worst end of the models my readers created for me in August.

In other words it is bad out there.  And if you look its bad not in Magic’s subprime book (where the number of delinquent loans are up only a little in year – because the bad loans have been mostly foreclosed).  It is bad in the prime book (which is really a near-prime book).  Delinquent so called “prime loans” are the problem as they were when I wrote the original posts.  In that category the delinquency (by which they mean edge-of-default delinquency) has nearlydoubled and the loss per claim has also nearly doubled in the last 5 quarters…  [For those interested in actual loans – a year ago they had 11,700 subprime near default loans.  Now they have 12,700.  For “prime loans” the near default pool has risen from 36,700 to 71,100 loans.]

Anyway the disclosure about needing more capital is super-bad.  If the company is forced to stop writing business it will end nastily because the holding company is levered.  And I doubt very much it can raise capital now. 

The stock is down less than 50% in the past two months – so I can’t crow about the short.  (Plenty that is that levered is down more.)  But if the long investors can explain to me why they shouldn’t run for the exits right now I would appreciate it. 

There is also some disclosure that appeared far more prominently.  I looked for it before and it was in footnotes.  I know I should read the footnotes but…

Anyway it says more about Fannie and Freddie than it does about Magic.  It is a definition of “full documentation” that could only exist in the twenty first century mortgage industry:

In accordance with industry practice, loans approved by Government Sponsored Enterprise and other automated underwriting systems under “doc waiver” programs that do not require verification of borrower income are classified by us as “full documentation.”


Wednesday, October 22, 2008

It's about the real economy now

Wal Mart was always a down market retailer.  I feel at home in Target - wide, brightly lit isles, a good collection of kids clothes.  I don't at Wal Mart.
The average household income of people who shop at WalMart and not Target is above what I lived on as a student, but below the income of my (mostly part-time-employed) student household.  
Three years ago Jeff Matthews commented on the difference by saying WalMart had "Target Envy".   This reflected income demographics in the US - where the squeeze was already on lower income households (oil etc) and the middle income demographics were doing middling to OK.  
Target envy might be a thing of the past - but it is clearly getting worse in Wal Mart's demographic.  Paul Kederosky talks about things that WalMart is now seeing.  
Wal Mart has always had a pay-check related shopping spike - with a substantial number of customers living (as I did when a student) from pay stubb to pay stubb.  
But for the first time they are having pay-check driven spikes in the sales of baby formula suggesting the economic pressure is more widespread.  
It is about the real economy now.  
John Hempton

Friday, October 17, 2008

Why Lehman mattered

Read my post on the 1934 Act first… this will not mean much to you unless you have done so… and after that get ready for some seriously wonky stuff…

I was chit-chatting with a very prominent NYC financial journalist the other day and gave him the accepted view – which is that the decision to let Lehman fail was a big mistake. 

He asked quickly and fairly why it was a big mistake. 

I had to confess that I did not know.  Just the facts on the ground since that decision have confirmed that it was a mistake.  That hardly seemed satisfactory to me or to him.

At the time of the decision I thought that whilst the decision was risky Paulson had made the correct call.  Lehman was – he thought and I thought – just not important enough.  I blogged about constructive uncertainty and unfortunately I was wrong.

Krugman (who I admire almost to the point of idol worship even though I think he wrong often) had an editorial in the New York Times which said that Paulson was playing with a loaded gun – but Krugman was not then prepared to call it a mistake (though he has since).   (Score Krugman 1, me 0).

But I now I think I know why letting Lehman fail was a mistake.  It was the absence of suitable broker-dealer regulation in the UK. 

The 1934 Securities Act was written with recent memory of what it means for a major broker-dealer to fail.  Indeed legislators were so scared of this they enacted two pieces of legislation – the first ring fenced the broker deal from all the other business of the broker (the 1934 Act) and the second (Glass Steagall) prohibited combining any of it with a conventional bank. 

It turns out I think that the Great Depression double-separation was overkill – and you could do without the Glass Steagall legislation.  But you could not do without the 1934 Act. 

Anyway Lehman had lots of assets pledged to its European broker dealer which they could in turn repledge to finance client business (as would be possible in the US) and to finance their own business (which would not be possible in the US).  As Lehman’s own business became stretched the UK broker dealer repledged more and more client assets to keep Lehman alive.  This eventually made the UK hedge funds (and the European operations of many US hedge funds) unsecured creditors of Lehman.

Now it turns out that many of the most levered books were resident in the UK.  Why?  Because the UK had eschewed many capital controls of the type favoured in Great Depression legislation.  Lehman’s own UK book was similarly levered.

Lehman UK behaved appallingly pledging pretty well the entire UK client asset base and sending big cheques back to NYC. 

Several hedge funds (notably led by Harbinger) are trying to investigate these transactions and have made requests to the US bankruptcy judge to force Lehman to hand over the details.  I guess the issue is fraudulent conveyance.  Lehman has asked the bankruptcy judge to deny the request for administrative reasons.  The bankruptcy judge should force Lehman to hand over the documents, but being Southern District of NY (the most creditor friendly bankruptcy jurisdiction in the world) Lehman will probably get its way.  A prosecutor looking for indictments should probably look here too…

But let’s see it as it now is.  The assets and liabilities of these highly levered hedge funds became assets and liabilities of Lehman in bankruptcy.  [The entire books effectively were hocked to Lehman creditors…]  The leverage had to come off – and fast.

And so what the Lehman bankruptcy did was trigger waves of delivering – and it did it through the mechanism of UK broker-dealer.

The European trade de-jour – run at high leverage through the UK Broker Dealer was long Porsche, short Volkswagen.  Porsche (a very fine company indeed) owns a very large amount of Volkswagen (read General Motors for Europe).  Indeed Porsche owns several times its market cap in VW stock.   It was a trade everyone had on.  And the more leveraged a player the more they had on – and they had it on in London because it was (a) European, and (b) favoured by people with leverage.

And so – after the Lehman bankruptcy – this trade exploded.  VW went up every day – Porsche went down and the ratios became totally absurd.  Go look – either Porsche is absurdly cheap or VW is absurdly expensive or both.  Anyone that believes in the rational market hypothesis (and there are plenty of them out there) would have a real problem with this data as there is no way the movement is explained by rational valuation… 

Anyway Porsche Volkswagen example of massive deleveraging – but it was perhaps the most spectacular.  It happened across the board – and anyone who was levered to anything that looked like an obvious position had their backsides thrashed following Lehman.  It did not matter if they were housed at Goldman Sachs because enough people would have had the position on at Lehman London to get market prices to administer the thrashing. 

There was a day when high short interest stocks started rising in a falling market for no reason.  Almost all high short interest stocks.  Why?  My guess is because someone at Lehman London was short them and Lehman started covering the positions in bankruptcy.  The move was big enough to destroy some levered players.  But it also happened to stocks into which people were levered long. 

Soon delivering took on its own dynamic because people who were housed way-away from Lehman but were still over-levered got themselves in the vortex. 

Finally the redemptions are coming – and if you were not over-levered before the redemptions you can be over-levered after them.  Redemptions have their own dynamic.

The leverage of course was not only in equity markets – leverage is much more pronounced in debt markets because debt markets typically only have a couple of points of spread and you need to lever that seven to twenty times to get a reasonable ROE.  Moreover Lehman was always primarily a debt house, not an equity house – and the debt-arb funds were far-more-likely to be housed at Lehman than the equity guys…

The deleveraging of debt markets following the Lehman failure left everyone (maybe except Uncle Warren) hoarding cash.  [It also ran the Federal Reserve out of balance sheet in a single day – something that I will come back to in a later post…]

Lehman’s failure cracked this market – and it did so because the UK lacked the basic depression era legislation (the 1934 Act) and had encouraged reckless leverage by reducing capital requirements to low levels. 

It was the failures of London that made Paulson’s decision wrong.  I didn’t see it at the time – and nor did he.  However I have never been CEO of a broker-dealer – and Paulson has.  So one bad mark for me and three for him.  I keep score…




PS.  I should tell you what the German take is on Volkswagen and Porsche… a surprising number think it is reasonable that Porsche trades so cheap because the arb is between a voting stock and a non-voting stock – and being Germans they have seen non-voters ripped off shamelessly in the past – so it is reasonable to discount Porsche massively.  They do think that Volkswagen is over-priced but as there are already so many people on the trade it is an expensive stock to borrow and hence hard to short.  The problem with this argument is that it was just as true when the spreads were a third as attractive as now.  The market remains irrational – but it might be irrational for rational reasons.  

PPS.  This is a good summary of the legal issues as they are now...

Tuesday, October 14, 2008

The 1934 Securities Exchange Act and all that

When you sign up to a margin account in almost all cases you pledge your securities to the broker with the ability for them to repledge. 

The reason to broker-dealer must be able to repledge is that it needs to finance the loans to you – and to reduce the cost of that financing it needs to offer collateral. 

So, when I take my million dollars worth of securities to the broker and borrow 100K on my margin account it looks like I have pledged a million dollars to a broker who might be questionable in order to get 100 thousand worth of financing.

There is one word for this.  Dumb.  They can – on face of it – take your assets and pledge them to finance their risky business.

If you do not believe it is dumb have a look at my post on Opes Prime, a small broker-dealer that went down in Australia taking something near a billion in client assets with it.  It involved organised crime, guys that killed hitmen and all sorts of other colourful characters.  There ain’t no way I would want to lend my securities to these guys and wind up an unsecured creditor.

The US had huge problems with broker-dealers in the 1930s.  They folded and lots of people lost their entire fortune by not understanding their credit arrangements. 

Enter the US Securities Exchange Act of 1934.  This is one piece of depression era legislation that survives and thank the Good Lord for that.

What the broker dealer act does is (a) ring fence the US broker dealer and (b) limit the amount that the broker dealer can borrow against your securities and the amount of collateral it may take. 

I am hardly a lawyer – so take the bush lawyer caveat – but the way it works is that the broker dealer may not borrow against your securities to finance their own business, only client business.  So Lehman Brothers US broker dealer could take collateral of securities and if they had 100 million out on client margin loans the most that they could raise using client securities is 100 million and not a brass razoo more.   This is really important because it meant that client assets were not used to finance Lehman’s disastrous commercial real estate and other businesses. 

Moreover when you deposit a million dollars at the broker dealer and give them the right to repledge those securities they can only rehypothecate 140 percent of your outstanding balances.

If you have 1 million deposited and you have 100 thousand borrowed then only 140 thousand can be rehypothecated and the rest must sit in a segregated client account.  [If your broker wants to steal from the segregated client account there are precious few defences – but…]  You can not contract out of this requirement. 

So (provided the broker is not acting criminally) you should get the bulk of your money back if the broker dealer fails.  And provided the capital requirements are adequate (and they mostly are) the broker dealer won’t fail.  Even the Drexel Burnham Broker Dealer did not fail.

Goldman Sachs claims that they can determine the capital requirements of their broker dealer intra-day.  I have no proof of this claim – but in this age of computers that is plausible.

The result.  Whilst Lehman brothers went bust Lehman US broker dealer did not.  This pretty well saved the US hedge fund industry. 

Europe however was a different story.  Lehman Europe failed – and the clients of the European broker dealer (read a good proportion of the London hedge fund community) are now queuing as unsecured creditors of Lehman.  Many funds have folded.  Far more have been nicked.  Whilst the US hedge fund business is currently looking dazed, confused and a little problematic the UK business is on life support. 

In some sense this is the end of the City of London.

I am on record as saying the UK took Maggie Thatcher to heart and deregulated financial activity to such an extent that the whole UK market worked without capital.  That was of course inordinately attractive in a boom where having capital was just a cost.  That attractiveness was one of the reasons why the London market grew and grew – and why UK banks wound up being amongst the biggest in the world.

But now with the biggest bank in the world by balance sheet (Royal Bank of Scotland) effectively nationalised and the and a large part of the UK hedge fund community lying with open veins it looks a little stupid.

This puts in a different light the 8 billion dollars that Lehman London transferred to the US when it was failing.  I stand open to correction – but I would guess that the money was obtained from client accounts from the European/London broker dealer.  It is certainly being investigated by Lehman clients.   This is a scandal of the first order allowed by an insane lassis faire approach to financial regulation. 

So here is a plea for US Depression style financial regulation.  Some of it (such as the Broker Dealer regulation) was well thought out and should be duplicated.   (Some of it was less sensible…)  

If I have a plea to my home country (Australia) after the Opes Prime debacle – a copy of the US 1934 Act would be a good start. 

As for London – I am sorry, but it is a wreck.  Maggie Thatcher you stand condemned.


John Hempton

Monday, October 13, 2008

Fred Goodwin hangs tough

Come on Sir Fred

You worked for an inconsequential arm of National Australia Bank.

You walked to an historic but small bank in Scotland.

You went on a binge of overpriced and insane acquisitions and turned your tiny bank into the world's largest by balance sheet.

The bank failed at huge risk to the global economy and required government to bail it out.

And you did not resign and instead hung tough for a golden parachute.

I have said that you are the worst CEO of any major bank anywhere. Vindication I claim.

Resign and waive the right to any package. It is simply indecent to charge a parachute to the taxpayers.


Sunday, October 12, 2008

Bakkavor Group, an Icelandic follow up...

I got no comments on the Bakkavör Group accounts, see here...

For those that want to know, the balance sheet is written in pounds. It is serious money. Almost 2 billion dollars in debt for a token Icelandic food processing company.

It is the corporates, not the banks that are going to send this around the world. I noted the list of principal bankers contain more usual suspects – they are Barclays, RBOS, Rabobank, Mizuho, Fortis, ABN Amro, Bank of America Securities and HSBC.

The Icelandic confessional has included Erste Bank in Austria (a crash large enough to close the Austrian exchange) and various UK banks and will include others.

But more, still more, will come to the confessional...


Iceland denies the airbase link

It did not take long. Iceland has denied the airbase link.

But it is clear the Russians have an agenda. What it is is unclear.

Iceland however needs the foreign currency desperately and should take it.

Welcome to the 21st century...

British deposits in Icelandic banks

I simply said in a previous post that Iceland intended to default on its deposit insurance obligations.

They now say they intend to honour them.

Intention is fine. They do not have the cash.


Funny reaction as to the prostitution comment

Two people I trust suggested that this post is a little hot headed and that I should revise or tone down.

The email however is suddenly running very supportive.

The purpose of the post is and was to make sure everyone knows just how important and nasty financial crises are.

If I have offended people doing that I am sorry, but the crisis is the central fact in what will be modern Icelandic history...

The central policy question raised by the Asian crisis was 'why did the market deal such harsh punishment for so minor economic crimes?'

This will be the question asked by Icelandic people too. And it is a question that should be asked of all those who subscribe to the dumb doctrine that is Austrian economics...

In Asia they ran large current account deficits caused mostly by good excess investment... it still crashed (and recovered).

The stakes here are very high. Iceland is a nasty case but there is no 'Icelandic exceptionalism' and there will be no 'Australian exceptionalism' if we stuff up either. Australia is warmer than Iceland and that is a darn good thing. But it is a small thing.

So, please take my hot headedness as it is intended, which is to outline the stakes...


There is a long history of financial crises, there is a long history of the aftermath. I made a semi-flippant comment about part of the aftermath. It has sent my email and the comments wild. I have gone from 1 regular Icelandic visitor who knew my views in detail because he asked to hundreds of Icelandic visitors. The comment was about financial crisis and prostitution.

I know of no crisis where pretty women have not prostituted themselves out of desperation or for advantage. There are people who have emailed me who can confirm this first hand for Argentina, both as clients and as good Catholic girls turned to distasteful work. Do not think for a moment that I am pleased by these stories...

The journalist whose story of the Russian crisis was one of pretty women aspiring to be dollar whores said it as a matter of fact...

This is not new.

I have now had so many emails and comments that tell me that Icelandic women would rather shoot me and eat me than prostitute themselves that I am sick of it. It may be true but it is not an option open to most Icelandic people.

Financial crises are pernicious affairs. And if there is something about Icelandic exceptionalism I do not see it in the market place. Take your Icelandic exceptionalism and stick it with what is left of your Krona.

I do not mean to be tough. I think that the US should bail out Iceland. Its a democracy full of fundamentally decent people and they deserve much better than what is about to befall them. If the goal of US policy is to make the world safe for democracy fixing Iceland is a cheap shot.

But the US is not going to bail out Iceland. And life is going to be very tough indeed. Tough enough to undo all Iceland's excessively high opinion of itself.

For that I am sorry.

Australia also has a high opinion of itself, and an unsustainable current account deficit. Not as unsustainable as Iceland but bad. I would not like it at all if what is about to befall Iceland befell my home town.


PS. My view is not fundamentally different from this view in the British press...

Friday, October 10, 2008

Iceland the absurd

I mentioned Iceland a few times only on this blog – because it was sort of well known in the hedge fund community – a crowded trade even.  Paul Krugman did an (incorrect) anti-hedge fund piece where he happily swallowed the dogma about hedge funds of conspiring against Iceland.  You didn’t need to conspire against Iceland – it was obvious once you read the balance sheet of any of the banks or any of the major corporates.

The first time I mentioned Iceland on this blog was in my list of current account deficit countries with potential banking problems.

Later I mentioned – but only in the comments – the raid on the UK savings market done by IceSavings and Kaupthing.  These were high interest rate deposits that seemed to be insured by a combination of the Icelandic and UK government if you read the documentation.

I wrote a post about high rate deposits (Wachovia will walk over you) and I confess that I had an ulterior motive – I was looking for someone to tell me how much the Icelandic banks were raiding the deposit market of Norway.  I got a few nice helpers amongst my readers (thank you). 

But this post is an ex-post analysis of just how absurd Iceland became – and some speculations from there.

Firstly the Russian loan (5.4 billion) is really big.  The population of Iceland is about 320 thousand people.   This translates to almost 17 thousand per person.  That is a real bailout – none of this small stuff that America is doing. 

It is pretty hard to see how an economy that has functionally destroyed itself is going to pay that back.  Whatever it looks like a darn big loan to a very dodgy credit – and I presume that there is a non-financial motive for granting it.

In my quick post on Iceland (done at JFK airport with a beer whilst waiting for a plane and not adequately fact checked) I linked to Andrew Neil who thought that the ulterior motive was Russian access to Iceland as a military base – or at least as a military refuelling depot – an unsinkable aircraft carrier if you will.

That is plausible because there is no obvious financial motive for this loan.  But there is an alternative theory doing the rounds – which is that one of the Icelandic banks was closely tied to the Russian Mafia – and the loan by the Russian Government is just make-good.  [The implication being that the Russian Government is just another arm of the Russian Mafia.]  Again I have no proof for that hypothesis – however as you need a non-commercial explanation of the loan its as good as most.  [Access to military bases however looks more likely…]

But you got to realise just how big the Icelandic problem is relative to the Icelandic economy.  Kaupthing Edge and IceSavings raided the UK deposit market as noted above and raised 3 billion pounds in deposits.  That is another 20 thousand dollars per person in Iceland.  Iceland as I need not remind readers cannot print pounds or dollars.  It is small wonder the Icelandic government is not going to meet its deposit insurance liabilities.  We have the Sovereign Default of a democracy at hand.  That is rare… I always thought it was populist dictators that defaulted.   Now I guess it is just populist democracies.

So Iceland is going to default at the national level and the level of every bank.  Lets have a look at its corporates.  I did this – there are about 20 companies listed on the Icelandic stock exchange.  I went and read the annual reports of about 5 and they were mostly similar – over-levered global acquisition conglomerates with Kaupthing as the major investment bank. 

Bakkavör Group sticks in mind – just because it was so levered in such an ordinary business – processed fresh food.  The five year summary is as follows:

(Click for detail...)

Yes – it does have quick ratios of less than one, current ratios of less than one and ebit of only about a ninth of outstanding debt. 

It might be possible to survive that – but it will be tough.

And whilst the investment bank is Kaupthing with whom it shares multiple board members – the list of “principal bankers” contains more usual suspects – they are Barclays, RBOS, Rabobank, Mizuho,  Fortis, ABN Amro, Bank of America Securities and HSBC.

Oh Iceland the international.  What happens in Iceland does not entirely stay in Iceland.


It is also worth considering what happens to Iceland in the absence of new funding...  It has no banking system left.  There is nobody much willing to take Icelandic Kroner.  The country has no reserves of hard cash that matter.  Its winter coming.

They can sell fish and energy intensive manufactures (their main exports) for hard currency.  But this is not like Australia - when the going got really tough in Australia in the depression you gave up and went and hunted (feral) rabbits for food.  

Iceland is a little colder.

My guess - and it said only half in cynicism - the women are beautiful in Iceland - the place just pushes out Miss World winners.  Its almost as close to NYC as Vegas.  Sex Tourism for hard cash will be their next export industry.

If they adopt the Vegas slogan will it work for financial crisis as well?  What happens in Iceland/Vegas ...


Thursday, October 9, 2008

The Bronte Capital thesis breaks down

This blog has an over-arching thesis – which is that current account deficit countries are going to have bad banking systems – but current account surplus countries are going to be sort-of-OK.

This post was outlined in the second substantive post on this blog in which I said:

America is a land with little in deposits and considerable lending. There are similar lands – such as Spain, the UK, Australia, New Zealand and Iceland.

But I was pretty happy with the banks in current account surplus countries – although their profitability was limited.

Well – the facts on the ground look much uglier than that.

Sure the failure in Germany (Hypo Real Estate) was largely caused by its dumb Irish subsidiary (Depfa).  And the banks in Iceland and the UK have essentially imploded – as have several in the US.

But my problem is that the banks in current account surplus countries are behaving very badly.  The relatively well run Chiba bank in Japan has halved.  Ditto DNB Nor – in oil rich current account surplus Norway.  

This is significant and signifies either irrational panic or the thesis being wrong.

Thoughts please.

Geopolitics and financial crisis

Dopeyness warning.  Whilst I was familiar with the Icelandic bank balance sheets relative to GDP (Iceland is the second most bank revenue to GDP in the world after Switzerland which tells you something) I was simply sure - and wrong - about Iceland being an EU member state.  

They are not - as many comments have pointed out.  My mistake.

I was also familar with Kauthing Edge and Ice Savings - and indeed had mentioned them in the comments - and was concerned about the effect of the Icelandic banks on the Norwegian deposit market.  (If you look back at past posts I found some Norwegian readers to confirm to me what DNB Nor management was saying).  

I am a dope.  I thought that there was no way the UK would allow the Icelandic banks to raise 5 billion pounds plus in deposits at high rates in the UK unless they were forced to under EU rules.  

Something else went wrong with UK policy here.  Either way its very problematic.


I am short Swedbank.  It’s a call on the collapse of the Baltic States – something I regard as almost inevitable.

The risk with that short is a bail-out because the Baltic States are geopolitically significant.

But then I am wondering how dumb American foreign policy is becoming.  Russia is now lending Iceland 4 billion euro.  A lot of money to be sure – but the Spectator is speculating (probably with reason) that the quid-pro-quo is allowing Russia to use the former US military bases in Iceland.

The Spectator also reports that the US were asked for the loan first and declined.

Some questions: what is political union in Europe if Europe will let a member state have an Argentina type default event?  Where is the Committee to Save the World?

Who is in charge here? 

Is it an enormous geopolitical decision to allow Russia to have a refuelling base in the middle of the Atlantic?  Hey – a failed adventure in Iraq is a 1000 billion plus experiment.  This one is cheap.

I have a question for the conservatives: would Ronald Reagan have allowed it?

Wednesday, October 8, 2008

Sir Fred not quitting

I have a British passport.

I am considering sending it back.  Sir Fred Goodwin is not quitting.

Hey - this is a guy who ran cap-in-hand to the UK government asking for money for the bank he destroyed.

In the US the Government had the decency to sack the CEO of the companies they nationalised.

Come on Her Majesty - your government is better than that!

Sir Fred Goodwin deathwatch - hopefully final edition

The press is reporting the sacking of Sir Fred Goodwin before the bank has announced it.

Three cheers for common decency.

Now deny him the termination payment.  

Tuesday, October 7, 2008

Dumb things I did not do for real

I wrote out a model portfolio for a hedge fund in January this year.  I also wrote a draft note explaining every position - part of a due diligence package if you will.  

The longs did awful (eg GE), the shorts did really awful (Bear and Lehman) - but the portfolio would still be down as there were more longs than shorts.

The "model portfolio" had a very small position (minus 1 percent) short Fortis.  I wrote a small note on the stock:


This is a place-holder position.  But they paid way too much for ABN Amro and got the worst end of the deal (RBS got the better stuff!). 

They also have an undisclosed amount of subprime in the insurance company on which they have refused to take charges because they are “going to hold the assets to maturity”.  [This is an exact quote.]

They are capital constrained from the ABN Amro deal and refuse to take losses because (at best) they require a large capital raising.  

There are rumours about them needing to lean on the European Central Bank.

They are not particularly cheap and my experience of individual operations is that they are poorly run.

This however is not a sufficient case for a large position. 

Further work

Plenty.  Main thing is to work out the size of the raising and whether it is doable.  With work it might wind up as a core position.

Anyway - this little note - which I dug up again yesterday - looks fantastic now. 

Pity though - I did not do the further work and I never put the position on for myself.  

Execution is everything John and don't forget it.

Royal Bank of Scotland – some comments

One of the first posts I made on this blog was about Royal Bank of Scotland.  In it I described Sir Fred Goodwin as "the worst CEO of any big bank anywhere".

I promised a Sir Fred Goodwin Death Watch part II and III and had articles written – but the stock got ahead of me – and I didn’t much feel like picking the wings off butterflies.

Besides I thought I was just being vindictive.  My worst ever day at work was provided by Sir Fred.  I was short a very large amount of Charter One (a Midwest Bank) and Sir Fred purchased the company for a substantial premium.  I cost my clients many tens of millions of dollars.

In my history of US Finance note I drolly noted that the (then) universal acceptance that the acquisition of Charter One was dramatically overpriced provided “thin consolation, but no refund”.  My motives for going after Sir Fred were not entirely pure – so I decided to steer clear.  (Sir Fred - the refund would be nice...)

Besides – in the scheme of things Sir Fred raised a lot of capital.  Enough to cover a multitude of sins.  I thought RBS would survive.  I thought (incorrectly) that long RBS short Barclays was probably a good pair.  Thankfully I never put it on. 

Now RBS is at the edge.  It looks like it is failing.  It might survive – so I don’t want to fan the fire too much.  However the stock price is plenty fanning the fire.

At year end RBS had the biggest balance sheet of any bank anywhere in the world.  This balance sheet was inflated as it consolidated Fortis’s position in ABN Amro for instance.  Even net of this however RBS really matters.

I thought the expression “too big to fail” meant something – however this cycle has proved me wrong. 

RBS could provide the alternative test – too big and too global to bail out.  RBS is heavily integrated in the United States where it is one of the top ten banks.   The UK end is large relative to the UK economy and sterling is falling on the panic – the UK Government cannot do RBS alone – and the US end will need a US backstop.  RBS has large operations in many countries (including for instance a deposit base in Switzerland and a lending business in my home country of Australia).  I have no idea how the various governments will be involved – but I would seriously doubt that Australia would contribute. 

But for the time being I will take you back to one of the best – but most un-noticed business articles in the world this year.  It was by Bethany McLean in Fortune in Mid February. 

In it Bethany starts with the prophetic line:

 Could Royal Bank of Scotland be the new AIG?

For the rest of this article I just pass you to Fortune.   

Bethany told me once that this article generated almost no feedback – to which I say to the magazine readers – shame on you.

Saturday, October 4, 2008

The Sheila Bair disgrace sequence

1).  Sheila Bair rings Jamie Dimon and suggests to him that she might confiscate the assets of Washington Mutual.  She says that Jamie should prepare a bid. 

2).  One week later the Office of Thrift Supervision signs a memorandum of understanding with WaMu saying that WaMu does not need to raise capital or increase liquidity.

3).  Sheila Bair forces WaMu to get investment bankers in who will do due diligence.

4).  The investment bankers talk down WaMu for weeks in press and cause a minor run. 

5).  The OTS seizes WaMu without any real indication to the management that this was going to happen and sells it to her hand-picked banker (Jamie Dimon).  The deal is irrevocable.  In the process she puts the fear-of-government in all the intermediate holders of US Bank finance.  This exacerbates the crisis.

6).  The WaMu deal causes a panic at Wachovia.  There was no panic at Wachovia prior to this – though Wachovia stock is justifiably weak.

7).  On Sheila’s timetable a deal has to be done for Wachovia in three days.

8).  Sheila decides that no deal can be done without government support and she offers that support.  Wells Fargo has simply told her they need more time.  Having done due diligence on a small bank I can assure you three days is not enough for a large bank unless the Government is going to give you large warranties.  Sheila created a timetable that forced the government into a deal that was potentially bad for taxpayers.

9).  A few more days and the deal turns up that doesn’t cost taxpayers anything.  Sheila however has staked her reputation on the prior deal and defends her prior behaviour.

I have argued that Sheila should be sacked.  I think that is pretty obvious now.

But someone on Wall Street has a better idea.  It is in this photo:




John Hempton

Its amazing how bad Sheila Bair looks now

Sheila Bair - without giving anyone time to do due diligence - forced Wachovia into a merger with Citigroup in which she warranted that the taxpayers would pick up the losses (beyond a certain point well below the book value of the deal she did).

Now she is defending that deal - and her tattered reputation - 

Then she says not to assume the FDIC is opposed to Wells/Wachovia...  

This is the way a bad public servant makes a sausage.

Sheila - do us a favour and resign.

John Hempton

Friday, October 3, 2008

Did Sheila Bair force the confiscation of a solvent bank?

Well - yes.  If Sheila had not acted Wachovia would not have been in play.  She basically forced a deal whereby Wachovia banking operations were purchased by Citigroup.

Wachovia had 70 billion in net worth.

Now Wells is prepared to buy the lot.  No government assistance required.

I stand by my assertion that WaMu was solvent too - and if left alone would have survived.  But Sheila never gave it a chance.  

Sack Sheila Bair now!

Wednesday, October 1, 2008

Irish government guarantees the bank debt (not the bank equity)

This is blunt.

Government Decision to Safeguard Irish Banking System

Government Decision to Safeguard Irish Banking System

The Government has decided to put in place with immediate effect a guarantee arrangement to safeguard all deposits (retail, commercial, institutional and interbank), covered bonds, senior debt and dated subordinated debt (lower tier II), with the following banks: Allied Irish Bank, Bank of Ireland, Anglo Irish Bank, Irish Life and Permanent, Irish Nationwide Building Society and the Educational Building Society and such specific subsidiaries as may be approved by Government following consultation with the Central Bank and the Financial Regulator.  It has done so following advice from the Governor of the Central Bank and the Financial Regulator about the impact of the recent international market turmoil on the Irish Banking system. The guarantee is being provided at a charge to the institutions concerned and will be subject to specific terms and conditions so that the taxpayers’ interest can be protected.  The guarantee will cover all existing aforementioned facilities with these institutions and any new such facilities issued from midnight on 29 September 2008, and will expire at midnight on 28 September 2010

It will also end any funding problems the banks have and end any Irish financial crisis. My main objection to this is the taxpayer should expect a return to the risk they take but as I am not an Irish taxpayer what do I care?

Insert jokes about Dumb Irish Taxpayer in the comments.

John Hempton

How to make the bailout work

Almost everyone (including Krugman who should know better) thinks this banking crisis is about inadequate capital caused by losses.

They are wrong.  Its about inadequate finance caused by lack of trust.

Let me explain

Nobody I know calculates the total system losses plausibly above 2 trillion dollars.  I have had several goes at calculating the losses on this blog.  Here is an early attempt at scoping non GSE mortgage losses.  If I add the private equity disasters, GSE losses and things like car loans to this I still can't get end credit losses above 1.5 trillion.

That is a vast amount of money – enough for instance to solve most of Africa’s education and water problems.  But in the context of the huge industry that is America’s finance system it is just not that big. 

So far financial institutions have raised (well) above 400 billion in fresh capital – its probably nearing 500 billion.  The Federal Government has absorbed losses through the takeover of Fannie, Freddie, contingent liabilities on Wachovia, AIG and others of maybe 50-200 billion (lets use the low number). 

The pre-tax, pre-provision operating profit of S&P financials used to be above 400 billion and is probably still above 350 billion.  Two years of that and there is another 700 billion. 

The banks had some capital to start with – in some cases excess capital against regulatory standards. 

All up – we have almost certainly raised or passed to the government – or within two years will have earned – something approaching 1.5 trillion.

There is no capital shortage.  Get used to it.  The Krugman endorsement of the idea that you can’t save the financial system if you can’t read a balance sheet is dumb. 

The problem is the problem that begets all sharp-shock financial crises – which is just the sheer erosion of trust.  [I consider Japan to be a slow burn financial crisis whereas Korea was more like America.]

The erosion of trust was caused by lies

Wall Street and big banks sold lies for years.  I wrote once that the lies that destroyed Bear Stearns were told by Bear Stearns (note unfortunate investment theme in the link!).  The lies that are now destroying the whole of American Finance were told by American Financial Institutions.  The creditors simply do not believe any more.

What is needed to make this crisis go away is the re-emergence of trust.  When that happens people will lend to American financial institutions and they will stop failing.

American financial institutions require lots of wholesale funding – far more wholesale funding than they require in equity.  The crisis is not about the equity holders - its about the debt financiers of the US financial system.

Wholesale funding is just not available.  The banks are all subject to modern bank runs – the mass failure to roll or withdrawal of wholesale funding. 

There are several ways that the wholesale funding can be either replaced or rolled.  One way is (dare I say it) the original (and deeply suspect) Paulson plan but on a much larger scale.  The idea is that rather than securitise the mortgages and other assets on the bank balance sheet and sell the wholesale to people who no longer trust American Financial Institutions you sell them wholesale to the US Government.  The US Government funds it wholesale by selling US Treasuries – which – despite weapons of mass destruction and other deceptions – are still widely trusted assets.

The only problem is that the loan – to deposit ratios of the US Financial Institutions are just too high – and pretty well the entire wholesale funding needs to be replaced.  Buying 750 billion in assets simply does not do it.  Idea works – scale is not big enough.

Moreover the original Paulson plan involved the taxpayer taking considerable risks – and in my view the taxpayer deserves a return for those risks.  The usual solution is to give equity (ie the Democrats plan) but when the risks are large enough you wind up giving enough equity to simply nationalise the institutions.  That works. 

We know it works – we have Sweden/Norway as external examples – and even the takeover of Fannie and Freddie clearly worked – it gave confidence to the people who provide wholesale funding and lowered the price of mortgages.  

But nationalisation works not because it injects equity – it works because it injects confidence.  It makes the debt of those institutions similar to Treasuries and hence inspires confidence.

I blogged once about how this is a very different situation from Japan.  Japanese banks had no equity but plenty of funding.  They survived for more than a decade in a much weakened state.  By contrast Wachovia and WaMu went down when they still had plenty of stated equity but limited confidence.  The reason – America needs wholesale funding.

So please – I am begging here – can the pundits get their thinking straight.  Its not about equity – its about funding.

Got it.  And the problem I have with Sheila Bair is that she thinks it is about loan books – and she scares the funding off.  Moreover her takeover of WaMu was almost designed to scare off the funding – and that was dumb and should be a sacking offence.

Please get this right though - its about FUNDING not about CAPITAL.  Government action - Sheila included - should be designed as far as possible to give confidence back to the people who fund America.




John Hempton

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The content contained in this blog represents the opinions of Mr. Hempton. You should assume Mr. Hempton and his affiliates have positions in the securities discussed in this blog, and such beneficial ownership can create a conflict of interest regarding the objectivity of this blog. Statements in the blog are not guarantees of future performance and are subject to certain risks, uncertainties and other factors. Certain information in this blog concerning economic trends and performance is based on or derived from information provided by third-party sources. Mr. Hempton does not guarantee the accuracy of such information and has not independently verified the accuracy or completeness of such information or the assumptions on which such information is based. Such information may change after it is posted and Mr. Hempton is not obligated to, and may not, update it. The commentary in this blog in no way constitutes a solicitation of business, an offer of a security or a solicitation to purchase a security, or investment advice. In fact, it should not be relied upon in making investment decisions, ever. It is intended solely for the entertainment of the reader, and the author. In particular this blog is not directed for investment purposes at US Persons.