Sunday, November 30, 2008

Weekend edition: surf lifesaving as a spectator sport

I am a volunteer surf lifesaver at Bronte Beach.  I used to be at North Bondi (one of the softest but most crowded Sydney beaches) but moved my allegiance when I moved to Bronte.  It scares me though because Bronte Beach, whilst having a reputation as a family beach – and a multi-cultural hang-out – is actually quite dangerous.  A large amount of water comes in (usually on the north end of the beach) and cycles out in a fierce rip.  [For the uninitiated a rip is a current going straight out to sea.]  The rip is a “Kieren Perkins rip” because on days like today you would need to be Kieren Perkins to swim in against it.

Anyway I had a patrol on Saturday afternoon.  It was quiet – very quiet because it rained in the morning and rain was predicted in the afternoon.  I spent my time chatting to a lifesaver who I had never previously met – but who was a lot fitter than me.  (He rowed for Australia at the Beijing Olympics.)  

Sunday afternoon was different.  The beach was crowded, the surf was up and the rip was strong.  

I said Bronte had a reputation as a family beach – and so it does – but for two main reasons:

  1. there is a large grassed area where large family groups (extended newer-Australian families, drunk groups of younger Anglo-Saxons) have barbeques, play cricket or kick soccer balls, and

  2. propped against the southern edge of the beach is a big rock hole which is very child-friendly at low tide.  Bulldozers have dragged the rocks out of the centre – and left a beautiful and calm sandy swimming hole – known ubiquitously as the “bogey hole”.  You can see a picture of it in calm conditions here.  

I was down the beach with my son (aged 8), a friend of similar age and the neighbourhood six year old.  The surf was up so we were playing in the bogey hole.  The kids were playing with some other 8 year olds who had come with an extended group of Muslim Australians.  I wound up chatting with one of the dads.  The Muslim group was racially mixed but highly identifiable because the women were wearing head-clothes.  Even then there was a range of hijab – black African muslims in form fitting jeans but loose (and hence obscuring) upper-body clothing and fairly full hijab, and a European Muslim (probably Bosnian) wearing a scarf loosely over her shoulders but not obscuring any of her hair.  The men told me they had come from Belmore – a suburb of Sydney with a large mosque and a double-digit percentage of Arabic speakers.

The boys would have fitted neatly in anywhere.  They were wearing board shorts, playing a little loudly and splashing water on each other - and they spoke in English and Arabic.  Some of the women were throwing sand at them as they played in the bogey hole.  

Two of the fathers climbed through the rocks that sheltered the bogey hole from the wild surf (the waves had 8-10 foot faces).  The tide was rising and the dads enjoyed the water splashing around them.  At least they enjoyed it until they didn’t – as the waves were getting just a little rough.

I wasn’t the only person that noticed.  Two lifesavers (clubbies) were also watching from the shore.  They tried climbing around the rocks to talk to the men – but they thought better of it and snuck back to the beach.  

I should explain "clubbies".  The beaches of Sydney mostly have amateur surf-lifesaving clubs.  However the amateurs only patrol the beaches on weekends and public holidays.  They also have professional life-guards.  The clubbies wear red-and-yellow.  The life-guards (almost all former clubbies) wear blue.  The lifeguards are all amazingly fit and competent.  The lifesavers (clubbies) vary – from overweight middle-aged finance executives (me) to super-fit amateurs (the Olympic rower I was chatting with on Saturday).  

Anyway the two clubbies were on it – as the obvious happened.

The two blokes – now getting quite uncomfortable as bigger surf washed them against the rocks – decided to swim for it.  They swam out to sea.

The only problem was that they wound up immediately in a very strong rip – and it was obvious within seconds that they were going to need rescuing.  There were two lifesavers.  They immediately radioed back to the tent what was happening and one clubby got into the surf on a yellow rescue board.  The other stayed on the shore watching.  By this stage I was watching – along with twenty others – quite enjoying the spectacle.  I tapped the wife of one the victims on the shoulder – a woman of indeterminate Middle Eastern origin in a fairly formal hijab.  I pointed out her husband needed rescuing.  She didn’t believe I was talking about her husband – and ignored me.  She apologised later – when she was getting over her utter panic.  

Anyway a lifeguard (blue shirt – blue rescue board) ran in (he heard the radio) and got out in maybe 20 seconds.  Some surfers had also managed to get to our hapless victims.  The clubby cheered me up by proving my inadequate surf-rescue board skills were not alone.  Clubby number 1 lost the board as he was trying to get victim number 2 onto the board.  The lifeguard came in with victim number 1.  [It turns out later than number 2 was a competent swimmer who did not understand rips and would have drowned eventually, number 1 could barely swim and would have drowned rapidly without rescue.  Victim 2 held onto the clubby 1 whilst they both awaited something that looked like rescue.]

The rescue board washed up on the beach – and I was sprinting down the beach ready to grab it and do some heroics of my own.  Another clubby beat me to it – and as he was on patrol and in uniform it really was his turn.  He went out.  I grabbed a rescue tube (just some floatation) and decided if clubby number 2 was going to have troubles that I would jump into the rip and ride the same current out as they had.  I was not needed (for which I was grateful).  

Only about this time did the Muslim women realise that their men-folk were in mortal danger.  There must have been 50 people watching this as the best entertainment all day before the women realised there was a problem.  But once the Muslim women realised there was a problem there was plenty of commotion.

The two blokes were ferried into shore.  The lifeguard (who had gone out again in case he was needed) surfed in gracefully on his knees on a very large wave.  He made me feel inadequate as to my rescue board skills all over again.  

I chatted freely to the woman in the formal hijab.  She was shocked – and told me how common drowning was in her home country.  I explained to her that the clubby that rescued her husband was a volunteer – she had no idea.  She was amazed that volunteers would “risk their lives” like that.  For a competent lifesaver there isn’t that much risk – but the action is still of volunteers savings lives.

The last I saw the whole group of Muslim families – maybe 20 people in all – walked up to the lifesavers’ tent to say thank you.  

A few years ago there were race riots at Cronulla beach with drunken Anglo louts beating up on Maronite and Muslim Lebanese Australians.  The proximate cause was a Lebanese lout assaulting a lifesaver after the lifesaver had told the man not to play soccer on the beach (which was crowded with passive sunbathers).  The lifesaving clubs however didn’t cover themselves in glory either – with one racist younger lifesaver having written on his body the line “we crew here – they flew here”.  

But today made me proud.  It made me proud of my surf club and made me proud of Australia.  It also made it patently clear that there are ways that we can coexist – that Muslim/Western relations do not have to be all bad.  And that us Westerners would risk our lives for a couple of wayward Muslim blokes just as we would for each other.


Thursday, November 27, 2008

Even Krugman doesn't get how plainly irrationally bad it is out there

I used to think that if the government only made the GSE obligations full faith and credit (FFC) obligations the remaining problems in the conventional mortgage market would go away.  Paul Krugman still thinks it:

The Fed is confusing me

OK, so the Fed is planning to buy obligations of the GSEs — as well as securities guaranteed by the GSEs. This is in an effort to lower spreads. The Fed will in effect pay for these purchases by having the Treasury issue U.S. government debt.

But the GSEs have been nationalized. Their obligations are already U.S. government debt. What’s going on here?

It’s true, as the Fed’s statement says, that

Spreads of rates on GSE debt and on GSE-guaranteed mortgages have widened appreciably of late.

But that’s presumably because the Bush administration, weirdly, has refused to declare that GSE debt is backed by the full faith and credit of the US government. Why not just make that declaration, turning GSE debt into Treasury obligations, rather than stuff the obligations onto the balance sheet of the Federal Reserve?

Is this some kind of strange political game? Is there something else going on here? Inquiring minds want to know.

He is of course wrong.  The Goldman Sachs obligation is full faith and credit of the US Treasury - and trades at an irrationally wide spread.  Nobody has given a plausible explanation (except lack of trust in the government) as to why the spread on FDIC paper issued by Goldies but backed by the full faith and credit of the US Treasury is 200 bps.

For once the world is even stranger than Paul Krugman thought and stranger than his models.

Now there is an implication here - which is if the market will not believe that something is full faith and credit of the US Government then the government should buy it, issue treasuries and make an arbitrage profit.  There is a free lunch here.  Of course this mucks government accounting around (the debts wind up on balance sheet of the government rather than just contingent).  However it does not change the economics from the government perspective.

And in the process we go from the government buying the troubled assets of financial institutions to the government buying the guaranteed liabilities of financial institutions.

John Hempton

Wednesday, November 26, 2008

Proof we are not in Kansas any more

Brad Delong thinks that the failure of Citigroup is about “risk premium”.  I think it is about trust – and I guess in some sense these are the same thing.  However it is about trust then no plausible amount of capital solves the problem – whereas in the Brad DeLong model there is a reasonably estimable and plausible quantum of capital that is sufficient.

Anyway today was a deal that proved to me just how strange these markets are. 
Goldman Sachs got to issue some FDIC bonds.  These bonds are guaranteed by the FDIC and are hence full faith and credit of the US government.  They were issued at over 200bps of spread.  The spread traded to about 200bps.

That spread makes no sense whatsoever unless you really believe that there is a chance that the US government is going to selectively default.

Once upon a time Long Term Capital Management traded “on-the-run” versus “off-the-run” Treasury bonds, noting that a 29 year bond (which was off the run) had a different yield to the current 30 year bond (which was the reference bond and hence more liquid).  If you went long the illiquid bond and short the liquid bond you might make 16-20bps.  Lever that 100 times and you get quite a nice return on equity.  However if the spread between them (call it a liquidity premium) blows out you can get into some trouble.  

Now we have an FDIC bond with a spread of 200bps or more.  No need to lever 100 times – ten times will make you a super-profitable hedge fund.  And you are leveraging 10 times to term matched US Government obligations which should be less risky than the slightly term mismatched positions taken by LTCM.  

Of course it is a little harder these days to borrow the government securities needed to pull the LTCM stunt.  (There has been a problem with fails in the Treasury market.)  But the margin leaves me gob-smacked.  

If anyone has an explanation other than trust (a belief the US government might default on full faith and credit obligations) or liquidity let me know.  If Brad Delong is right – and it is about capital then this should be able to be levered 5 times as there should be little capital risk.  

But I don’t think it is about capital – it is about something else – something altogether darker and harder to solve.

In the Wizard of Oz all you needed to do was click your red shoes together.  

I have been trying all day!

John Hempton

Arguably the best proxy disclosure of the year

I had never heard of Schulman until today – but then Footnoted led me to  a proxy disclosure.  I won’t adorn this:

During fiscal 2008, the Compensation Committee determined that maintaining a lease on a private airplane was no longer a cost-effective method for providing business-related transportation to our Named Executive Officers and Directors. The airplane was used only for business-related travel, and personal use was not permitted. With the termination of the lease on the airplane, it also became increasingly difficult and cost prohibitive to access our Canadian fish camp. Consequently, the fish camp, which was only used for business entertainment purposes, was offered for sale during 2008. The only offer to purchase the fish camp came from Terry L. Haines, our former Chief Executive Officer and President. Ultimately we negotiated with Mr. Haines to sell the fish camp for a purchase price of $55,000 and the transaction closed during fiscal year 2009.

Tuesday, November 25, 2008

Reaction to the bailout

The consensus is that the Citigroup bailout was bad - see Mark Thoma.

I am going to differ here.  The bailout was well designed...


1).  The Government should have taken a much larger fee - at least 20 percent ownership of Citigroup - and arguably more.  Shareholders should be punished.

2).  The attachment point of the excess of loss policy is too low.   If the attachment point had been 80 billion Citigroup would survive.  There was no need for a 40 billion dollar attachment point.  

The problem with the bailout was not the design - it was the amount extracted from Citigroup shareholders.  The government took too much risk for too little reward.

I am surprised that the shareholders were not effectively wiped out as per Fannie, Freddie, AIG.

Not displeased - but somewhere I wish the government would get a happy medium somewhere - rather than one rule Citigroup and one rule for Fannie.

John Hempton

The Brad DeLong question - and how to design a bailout that works

Brad DeLong asks a question which seems obvious enough to me – but seems to elude him.  

Why oh why can't we have a better press corps? Eric Dash and Julie Creswell write that:

Citigroup had poor risk controls.
As a result, the bank owned $43 billion of mortgage-related assets that it incorrectly thought were safe.
They weren't.
And so as a result the market value of Citi has collapsed by a factor of ten: from $200 billion to $20 billion.

To which the only appropriate response is: "Huh?" How can losses out of $43 billion of optimistically overvalued asserts eliminate $224 billion of value? Eric Dash and Julie Creswell don't answer that question. They don't even seem to recognize that it is a question that they should be interested in. That they were given this story to write, and that no editors said "wait a minute! this doesn't add up!" is yet another signal that the New York Times is in its death spiral: not the place to go to learn anything about an issue.
I think he is a little rough to criticise the NYT for that – or for that matter any other paper – because at the moment the Treasury and the FDIC are also acting (at least until now) as if they do not know the answer.

The answer is that the crisis is not about the amount of losses yet realised or yet to be realised, and it is not about capital adequacy of the banks and it is not about their level of leverage.  It is simply about the question “do we trust them to repay their debts”.  You might think is about capital or losses or leverage – but even if the bank has adequate capital and losses come are relatively small if we believe collectively that they can’t repay then they can’t repay.  Sure more capital would produce more trust – but the level of distrust at the moment is so high that nobody can tell you how much capital is needed.  All estimates are a shot in the dark.  In reality all that is needed is more trust.

The short answer to the Brad deLong question is that due to the losses and the lack of risk control people stopped believing in Citigroup – and hence Citigroup dies without a bailout.  It was however pretty easy to stop believing in Citigroup because nobody (at least nobody normal) can understand their accounts.  I can not understand them and I am a pretty sophisticated bank analyst.  I know people I think are better than me – and they can’t understand Citigroup either.  So Citigroup was always a “trust us” thing and now we do not trust.  

The long answer has to be a replay of the various themes of this blog.  So lets do it in pieces.

1).  The losses in the banking system in America are not unmanageably large.  Anyone that tells you otherwise just hasn’t done the maths (and that is most people).  I have written this idea uphere…  and nobody yet has an adequate response though Mark Thoma has tried and even Kevin Drum on the Mother Jones blog has commented on it.

One offender not doing the maths is (very surprisingly) Paul Krugman - although his last post in which he blamed lack of capital for the crisis was March  - so maybe he has done some maths since.  Krugman usually does the maths and is spot-on in his analysis of Fannie and Freddie.   I am usually an unabashed fan of the Shrill Professor – so his various diagonoses  leave me perplexed.

2).  The problem with the banking system is that it is structurally short of stable funding.  America has a loan to deposit ratio that is collectively well above 100.  So does the UK, Iceland, the Baltics and most of Eastern Europe, Australia and New Zealand.  This means that collectively the banks need an awful lot of wholesale funding.

Japanese banks fizzle, they make no profit – but they do not collapse.  Why?  Because they are structurally long finance.  Agricultural Bank of China (the notorious ABC) is deeply desperately insolvent – but it is still here.  Why?  Because it is long funding.  Generally it is banks in current account deficit countries that are vulnerable.  The main German bank that collapsed (Hypo Realestate) had two large businesses with no deposit base.  It was the bank in a current account surplus country that collapsed – the exception that proved the rule.  [There is an issue with banks with life insurance subsidiaries in current account surplus countries.  They are vulnerable but for completely different reasons – the subject of another blog post – a long time into the future...]

3).  The crisis will end when people are convinced to roll the wholesale funding.  Government policy that brings us closer to that point is probably effective.  Government policy that does not bring us closer to that point is almost certainly ineffective.  Policy that takes us further from that point is counter-productive.  My case examples of counter-productive policies are the confiscation of the rights of the debt holders of Washington Mutual, and the pointed refusal to issue government guarantees even when it is utterly obvious that the government is on the line (as in Fannie Mae and Feddie Mac).  The confiscation of Washington Mutual convinced bond holders that their positions would be compromised by government fiat and with little notice.  As I have posted many times I thought that was reckless and that Sheila Bair should resign.  The refusal to guarantee Fannie Mae and Freddie Mac at this point looks like sheer stubbornness but I think is driven as much as anything by government accounting concerns – a full guarantee means the assets and (more importantly) liabilities get bought onto the government balance sheet.  

The cause of the crisis

This is a wholesale funding crisis and the cause of the crisis is plain.  It is lies told by financial institutions.  Financial institutions sold AAA rated paper which they almost certainly – deep in their bowels – knew was crap.  They sold it to people who provide wholesale funding.  

Now they need to roll their own debt.  The people who would normally wholesale fund them are the same people who have had a large dose of defaulting AAAs.  They no longer believe.  It is “fool me once, shame on me, fool me twice, shame on you”.  As I have put it the lies that destroyed Bear Stearns were not told by short sellers.  They were told by Bear Stearns.

Now the problem is that no matter how many times Pandit says that Citigroup is well capitalised nobody will believe him.  In answer to the Brad DeLong question – the company told lies about its mortgage book – which compounded the lies about the dodgy CDO product they sold.  The lies about the mortgage book totalled $20 billion on say $43 billion of optimistically valued assets – and those lies reduced the value of Citigroup by $200 billion because they removed the trust in Citigroup.

It is one of those ironic things that when financial institutions lied in 2006 the market seemed to believe them.  When they tell the truth now, nobody will listen.  

Robert Rubin racks his brain about how he would have done things differently.  Well one thing he would have done differently is get Citigroup to remove the culture of obfuscation – the culture that allowed it to be perceived as if it were lying even when it was telling the truth.  The problem is that even Robert Rubin doesn’t have enough uncashed integrity to save Citigroup.  Even Robert Rubin.  In a world where Berkshire credit default swaps are going skyward because people do not believe that Warren Buffett has no collateral requirement Robert Rubin’s reputation ain’t going to count for much.  

Anyway given that the crisis is a wholesale funding crisis we need to do something to make the people who provide wholesale funds happy.  

What of course would make the people who provide the funding happy is a plausible government guarantee.  Iceland couldn’t provide one because its banking sector was ten times GDP.  But the US probably could. 

The most extreme (and probably effective) solution would be a full guarantee of all sorts of bank debt.  The problem of course is that is hugely risky for the taxpayer.  My view – and I think the only way in which such a guarantee is viable – would be that if the taxpayer takes the risk they should also get the upside.  That is full nationalisation.  The advantage of full nationalisation is that since the system is actually solvent (but illiquid) the government will make a profit out of it.  That is fine.  Take the risk – make a profit – it’s the capitalist way.  Incidentally the Sheila Bair approach of confiscation from the equity holders and subordinate debt holders works fine in this scenario.  Indeed the sub-debt holders should wear it – but they will still be willing to lend again because they will be lending again to the government.  In a full nationalisation I see no reason for Sheila Bair to resign.  (Her tenure in that position would not threaten the financial system.)  

I suspect that wholesale nationalisation is the cheapest (and most sure) way to end the financial crisis.  But it would be difficult to find a Deputy Secretary of the Treasury for Citigroup (and Bank of America, JPM etc).  Still as I think the system is eventually solvent if the government nationalised pretty well the whole system as it failed then the government would make a shocking profit.  It would not be the first time – Norway made such a profit.

But I am not sure that the American politic is ready for a wholesale nationalisation of the financial system.  Indeed they are determined it seems not to control financial institutions.  If you are not convinced of that see the Deal Professor’s wonderful piece on who controls AIG.

A cost effective TARP

What however is required is something that convinces the funders that the banks are solvent at the least possible cost to the Treasury.  Now my view is that if the treasury guarantees (and hence takes the risk) it should own.  That is a view in favour of nationalisation, but as that is not on the table let’s do the next best thing.  Suppose the Treasury takes the “fat tail only”.  Then the banks are solvent.  Imagine for instance if the treasury agreed to capture the losses at Citigroup above say $90billion.  Why did I chose 90 billion – well – it is the stated capital of Citigroup.  

As Citigroup has at least its net worth guaranteed then Citgroup is solvent.  Funding should come back.  

Note that excess of loss insurance policies are almost certainly the cheapest way in which to guarantee banks.  The reason of course is that you take on only the losses you need to take on.  However you leave the upside with the banks.  

The Federal Government should logically charge for the excess of loss policy.  There will be some banks with very big losses that will claim on it – and so there will be losses recognised even if the system is solvent.  My rule – which is a little arbitrary – the government should take 20% of the equity of all institutions that want to buy an excess of loss policy.  I figure in five years time selling the equity should pay most government losses.

To be precise the excess of loss policies should not be for 100% of losses beyond an attachment.  In reality the government should guarantee only 90% of the losses beyond the attachment.  The reason for that is when the attachment point is hit you want the bank in question to have an incentive (be it 10% of recoveries) to actively mitigate the losses.  A better incentive is also to have the losses covered by the government – but with the government receiving equity in the institution dollar for dollar for the losses covered.  This will still mean that institutions are nationalised – precisely those with the biggest losses.  [The equity grant to the government for covering the losses will punish institutions that have to claim and will help mitigate government losses from the scheme…]

Mr Paulson seems however to be wanting to give government money inefficiently to financial way too cheap.  The bailout of Citigroup is a case in point.  They gave a capital injection (subordinated debt) for which they charged the princely sum of 8 percent.  Hey – that was what bank preferred stock yielded in 2006 – and way below the fair value of such money now.  Then they just guarantee 300 billion of assets – admittedly subject to an excess of loss rule (above 40 billion).  This excess of loss threshhold is way too low.  It could be 80 billion and Citigroup would remain solvent.  Then the government also did not take anything like a large enough equity stake in Citigroup even though Citigroup would have willingly handed one over.  Why not?  Because they play fast-and-loose with taxpayer resources.  

That said – the excess of loss policy is the right idea and for that (and for once) I applaud Mr Paulson.  This is the first bailout I have seen with a decent design.

Now as for Sheila Bair.  Her takeover of Washington Mutual and the subsequent collapse in Wachovia is perhaps the most glaring example of abusing the bank intermediate creditors this cycle.  She should resign for it – and the intermediate creditors will not be comfortable until she takes the fall.  But, and you will sense me relenting a little here, if the deal is that the government writes excess of loss policies on a grand scale her continued tenure in the job doesn’t actually threaten the financial system.  But until then she is the symbol of the risks faced by the providers of intermediate finance.  Absent a comprehensive solution as outlined here she should resign.  With a comprehensive solution her position is neutered – and she can stay in it without risk.  If she is driver for a comprehensive solution then I will forgive her staying around - but at the moment she seems far more concerned with modifying mortgage terms - that is about first loss.  An efficient comprehensive solution is about excess of loss - and she isn't playing that ballgame.  

John Hempton

Monday, November 24, 2008

I risk being detained by the Latvian secret police

It appears that a Latvian academic was detained by the secret police for spreading rumours about the possible devaluation of the Latvian currency.  (Hat tip to the Latvian economy blog.)  

I think I did that first.  

Do you think they can be bothered coming to Australia?


Tax benefits, Wells and Wachovia

The most repeated argument against my line that Sheila Bair erred badly when gifting Wachovia to Citigroup is that Wells could only make the alternative work because of tax benefits.

Lets dismiss that for once and for all.

The tax benefits would also have been available to Citigroup.  


A more sensible idea: A Citigroup pre-pack bankruptcy

It looks more and more like Citigroup is going to the Federal Government for help (something that neither Washington Mutual nor Wachovia did).  

In the WaMu and Wachovia cases Sheila Bair either confiscated or forced a transaction against the wishes of management and without a management approach to government requesting help.

When Citigroup does go to the Feds then the case for confiscation is MUCH stronger than it was with Washington Mutual.  Washington Mutual management still thought they could survive and they were still liquid. 

That said – I don’t think WaMu should have been confiscated and I do not think Citigroup should be confiscated in the same way either.  The problem with the WaMu confiscation is not that it wiped out my preferred (tough John), it was that it wiped out debt that had a reasonable right to think that it would get something in a liquidation. 

I think the confiscation of WaMu eventually doomed Citigroup (for which Sheila Bair should resign).  

But she has a chance to make good.  

I suggested in my quickly infamous confiscation post that Sheila Bair might just confiscate Citigroup and leave the holding company with nothing but its debt, debenture, preferred and equity liabilities.

The case for doing this is strong – much stronger than when she recklessly confiscated Washington Mutual.  

But I can suggest better.  You can confiscate Citigroup and treat the debtholders fairly.

You wouldn’t want to merge Citigroup with anything and have the debt assumed.  Banks that big we have discovered are globally dangerous.  If anything you would want to split it.  But for the moment mere survival would be adequate.

So here goes for a suggestion:

If (and only if) Citigroup comes looking for assistance then Sheila Bair should confiscate it.  


When she does the holding company will file bankruptcy – and she should offer them a prepackage bankruptcy option option.  If they agree to convert all the debt to equity in the New Citigroup with the preferreds and junior debentures getting way out of the money options then she will gift the company that she has restructured  back to the old (and now restructured) Citigroup holding company.  The bond holders would it appears have no choice to accept.

They would get what they deserve  – and what the confiscation of WaMu denied them – first claim on the residual value of Citigroup.

This would not solve Citigroup’s liquidity problems (though converting 184 billion of debt to equity would solve the capital problems).  

To solve the liquidity problems Sheila should guarantee say 400 billion of unpledged Citigroup assets beyond the first 50 billion in losses.  She should extract a fee for this (say 10% ownership of the new Citigroup).  And Citi should be expected to repo finance the said pool of assets to get cheap funding.

After that she should do the same for any other major bank that comes through the door.  It will be most of them…

John Hempton

Sunday, November 23, 2008

Why Sheila Bair must resign

Sheila Bair is doing a fine job at one thing – modifying mortgage terms in the mortgages she has taken over – particularly those at Indy Mac.  As a liberal I would be expected to applaud – but I am profoundly glad that Obama did not do as Robert Kuttner suggested and nominate Sheila Bair for the Treasury Secretary post.

Sheila Bair is simply wrong when she implys that the problem started with mortgages and therefore it will end with mortgages.  The problem with mortgages is no more than a trillion dollars (say 20 percent of the mortgages in the US defaulting with a 50% loss).  Indeed it is much less than a trillion.  If the financial crisis were about mortgages it would be over now – what with 500 billion of capital raising, a few hundred billion chipped in elsewhere (either by the Government into AIG or Maiden Lane or by Lehman and Washington Mutual bond holders and all the Fannie and Freddie losses that will be picked up by the Feds).  The financial crisis is not about mortgages – it is about trust.  

The people who provide finance to financial institutions (inter-bank and otherwise) no longer believe they will get their money back – and so are no longer willing to provide finance.  The unwillingness to lend to financial institutions dooms them regardless of their solvency.  The crisis is about trust.  

It is alarming enough that the head of the FDIC in so self serving a manner misdiagnoses the nature of the financial crisis – self serving because her institution is building up enviable expertise in modifying mortgage terms.  Indeed at best Sheila Bair is the woman saying “we must do something, modifying mortgage terms is something – therefore we must do it”.
But if misdiagnosis of the crisis were the end of it then there would be no pressing need for Sheila Bair to resign.  It is not the end of it.  Sheila Bair is an obstacle – indeed one of the principal obstacles in the way of reinstalling trust to American financial institutions.  

It comes about as follows:  if you accept that the problem is that people will no longer lend to financial institutions then the core thing that is required is the perception that the US Government will not arbitrarily confiscate your rights if you lend to financial institutions.
On Friday I suggested that Sheila Bair might confiscate Citigroup wiping out in excess of 100 billion dollars in parent company debt.  I am just a humble blogger in Australia – and my suggestion would be outrageous except that Sheila Bair through her actions on Washington Mutual and Wachovia made my suggestion plausible.  She has form.  She has done it before.  She has unilaterally determined that Wachovia required a government assisted takeover when Wells Fargo proved only days later that she was wrong.  Her judgement is unsound (proven) and her willingness to use powers to wipe out or compromise people who lend to financial institutions make her unsound judgement dangerous.

She just might confiscate Citigroup – because that sort of rash action is up her ally.  She shoots from the hip – and Wachovia proves her aim is not true.

Anyway – this crisis will be over when people are willing to lend to American financial institutions unsecured again.  And they will not lend to financial institutions when Sheila Bair is around.  Her presence makes it dangerous.

A policy statement saying she will not do it again would be nice – but is implausible.  Debt holders make a small amount of money when they are right – and lose a large amount when they are wrong.  Sheila Bair – even if she promised not to be so rash again would not be believed. 

 There remains a small chance that she will again exercise her unsound judgement to compromise debt holders – and that alone is enough reason not to lend to American financial institutions.

I do not know what a complete solution to the financial crisis (other than full nationalisation as per the Citigroup post) would look like – but if full nationalisation is not on the agenda (and as far as I can tell it is not) then any solution to the financial crisis involves removing Sheila Bair.  She is an obstacle to trust.

It is simple Sheila.  Resign now.  You owe it to your country.

John Hempton


1.  There has been some comment my view is because I lost money (a very small amount) in Washington Mutual preferreds.  It is not.  Had the preferreds but not the debt been wiped out I would think that fair enough.  I purchased the prefs with three times the yield of the debt.  Sheila Bair made them roughly equivalent.  I have no qualms whatsoever about wiping out equity investors and I was one.

2.  I have purchased Sheila Bair's name on Google Adwords.  The adverts link to this post.  I am doing my bit to help solve the financial crisis.

Friday, November 21, 2008

Sheila Bair and seizing Citigroup

I suggested that Sheila Bair might seize Citigroup precisely because it is the sort of irrational, arrogant and dumb thing she does.  She did after all force the issue at Wachovia – signing a government guarantee (to Citigroup) even though a fully private sector solution was available.

But people took my suggestion seriously.  Some thought I had “jumped the shark”.  Others thought that I was straight predicting it.

So now – just to lay out the issues – I am going to discuss – in all seriousness – what a government seizure of Citigroup would look like – and how it might affect the rest of the economy and other bank stocks.

It is open to Sheila Bair (and her fellow regulators) to seize Citigroup (deeming it unsound) and to leave at the holding company – and worth near zero – all the equity, preferred shares and holding company debt obligations.  Indeed this is precisely what she did at Washington Mutual.  What she did once she might do again. 

This will in fact result in a full successful resolution of the Citigroup problem at no cost to the government from Citigroup.  There is a darn strong case for doing it. 

Here is the liability side of the Bank Holding Company balance sheet from the last filing period:



I am sorry it is in thousands but it is a regulatory statement – and that is how they come. 

Click and look at it.  There are 17.5 billion in short term parent company debt and 117.5 billion in parent company debt with more than a year’s maturity.  There are a further 27.4 billion in perpetual preferred securities and 28.5 billion in subordinated debentures. 

If Sheila Bair confiscates Citigroup and leaves all those liabilities at the holding company then it is economically the equivalent of a 184 billion dollar equity injection into the remaining group.  A cancelled liability of course is the equivalent of new (non cash) capital.

The new Citigroup should be adequately capitalised – albeit government owned.  The FDIC could IPO the new Citigroup once this market mess had died down (and remit most the proceeds to former bond holders).  A shrinking Citigroup with an additional 184 billion in capital shouldn’t cost the government anything.

But Sheila Bair does not need to stop there.  She has the power to guarantee some assets of the new entity – and her guarantees carry the full faith and credit of the US Government.  She did this with Wachovia.  The new Citigroup could then put the guaranteed assets into a special purpose entity and repo finance the entity.  This would look similar to repo-financing treasuries – and the new Citigroup could thus obtain very cheap funding.  That cheap funding would guarantee its liquidity and its profitability – and hence ensure that the government does not lose anything further (other than borrowing capacity) from the Citigroup nationalisation.

Remember both steps of this Sheila Bair has performed before.  She confiscated Washington Mutual and left behind the parent company liabilities.  She guaranteed assets at Wachovia.  This is Sheila Bair’s proven style.  And she would look a hero because Citigroup would be resolved at no cost to taxpayers.


And you knew there would be a but…

If Sheila Bair was to confiscate a really big bank and cancel all the parent company liabilities then no other bank in America would be able to raise parent company debt.  Indeed I think that has been the case ever since Sheila Bair did the reckless and irresponsible takeover of Washington Mutual… but it would certainly be the case if the parent company liabilities of Citigroup were cancelled.

And that would be a huge decision indeed because then every bank with parent company liabilities (meaning almost every bank in North America) would fail. 

Many – but not all – could be taken over in the same fashion at little cost to the government.  But almost all of them would wind up property of the US Government.

Full nationalisation, Swedish or Norwegian style, is an effective end to a financial crisis – and Sheila Bair has the power and has proved that she is willing to use it.  But it is a decision way above her pay grade.  (Where is President Obama’s new Treasury Secretary?)

My view is that Sheila Bair should not only not use the powers she has previously shown a willingness to use – but that she should resign immediately and admit that her previous decisions were in error.  She should resign now – or Citigroup is likely to be hers anyway.  



John Hempton

Postscript:  The Holding Company has several regulated subsidiaries - presumably in several jurisdictions.  All the regulated subsidiaries would have to be seized together - and if some came up short some form of solution would need to be found.

Postscript 2:  Actually I think the die was cast for Citigroup when Sheila Bair confiscated WaMu.  The lesson was learnt that bank debt could be treated very unfairly by regulators and hence banks were never going to be able to get finance again.  The worst decision of this cycle was to let Lehman fail so badly - creditors got very scared.  The second worst was the reckless way in which creditors of WaMu were treated - it made them even more scared.

Remember Sheila Bair wanted to sell Wachovia to Citigroup

I loved the sequence.  Sheila Bair forces the issue at Washington Mutual - a bank that she did not need to force the issue at but which might have been insolvent.

Then she absolutely forced the issue at Wachovia.  She insisted that Wachovia sell to Citigroup even though Wells Fargo wanted more time and a market solution was available for Wachovia with no hint of a government guarantee.  

If Sheila had sucessfully sold Wachovia to Citigroup she might have two banks to deal with or Citigroup might just sell the loans she had guaranteed.  

But now is Sheila Bair's moment.  If her past behaviour is anything she will confiscate Citigroup because it looks sick.  She has the ego, she has the momentum, she has the form.

Sheila can of course run this, sort it out, become Treasury Secretary and otherwise rule the world.

Sheila Bair - just admit the precedent you set is inappropriate and resign!

John Hempton

Thursday, November 20, 2008

The Mark Cuban charges – and the economic purpose of insider trading laws

Warning: this post contains observations on American law written by a non-lawyer Australian. Technicalities might be wrong but (I think) the general theme is right.

Mark Cuban is loud and opinionated. I like his opinions sometimes. He also gave me one nice big-cap stock idea once – but he didn’t even mean to give it to me. Indeed he probably didn’t even trade it himself. It is just that something he said about high definition TV changed my views on DirecTV and I purchased it about $13 as a result. It was a very quick profit. Thank you Mark.

That said Mark Cuban has famously been charged with insider trading regarding his trades in – a stock I would never have touched. On the information given his actions look unethical – but whether they are illegal is another thing.

The purpose of insider trading rules

The purpose of this post is really to explore the economics of insider trading in light of the Cuban charges.

There is a daft argument that pops up every now and again about why insider trading should be legal. Here is one reference to it. It takes some doing to explain why this is daft. Here goes:

The total returns to stockholders from a business over a very long period should equal the return from the business less transactional costs. The stock market doesn’t actually “make profits”. Businesses make profits – and hopefully those profits get distributed to shareholders via buybacks and dividends. Of course some clever people buy low and sell high – but to the extent that some smarty (hopefully me) makes a return above the business return some sucker out there (hopefully someone who does not read this blog) makes a return below the business return.

If the market were perfect we would all know what the returns to each sort of business were and we would allocate capital accordingly. There would be no misallocation.

But the market is not perfect – and the returns to a business can only be estimated. Most shareholders solve the problem by owning a bundle of stocks (its called diversification) and the returns to the bundle of stocks should in some sense be reflective of the returns to business per-se. Of course this is only true if you hold the stocks over a very long period of time – but it should prima-facie be true on average if the market approximates efficiency.

Of course all this breaks down if management steal from shareholders. Indeed if management always stole all the returns to shareholders there would be no shareholders – and there would be massively sub-optimal investment in business. If management steals a little the returns to investors would be slightly lower than the returns to business and the investment level would thus be sub-optimal.

Now back to insider trading. Insider trading cannot change the end returns over very long periods to shareholders. The returns to shareholders are ultimately determined by the returns of the business. The stock market does not make economic returns – the businesses do that. But insider trading increases the returns of insiders and hence must reduce the returns of non-inside shareholders. It is economically the equivalent of theft as it allocates returns from capital providers to insiders.

It is facile to say that insider trading is good because it brings stocks closer to fair value. That would only be desirable if it brought shareholder returns closer to business returns… and it does not do that.

Now having stated this, it is clear what insider trading rules are meant to do. They are meant to stop theft by people who are in a position of trust with respect to a company and thus deny insiders and advantage over external shareholders.

Fine – but that is not what the Australian laws do (though it is closer to what the American laws do).

The Australian law is an ass. There was a case of a guy who found gold on a mining lease he personally owned. The only problem was that the ore body was open-ended and clearly extended far onto the neighbours lease. He did what a sensible sort of fellow would try to do – he tried to buy the neighbours lease without telling him about the ore body. Of course he was trying to get maximum return from his prospecting effort (and I still have not worked out what is wrong with that from a microeconomist’s point of view…)

But the problem was that the neighbour’s lease was owned by a small public company controlled by Joe Gutnick. [Regular readers will know that Diamond Joe has made a few appearances on this blog…]

So he started buying stock in Joe’s company.

This was deemed by the Australian authorities (and later the courts) to be insider trading. He was trading on non-public information (that there was gold in them there hills). The only problem is that he found that non-public information by informed and legal sleuthing on his own and not by being an insider. This would seem to make stock research (at least if involves digging in the dirt) look like insider trading. I hope the authorities don’t want to stop me doing research. But the key here is our hapless gold prospector was not an insider, did not have a position of trust and hence did not abuse that position of trust. I cannot see the justification for the insider trading rules – but being an Australian I have to live with them.

Anyway the American rules are much more clearly about position of trust. When the CEO of Imclone sold shares (or sold his daughter’s shares) when he knew the FDA was going to reject his drug that was insider trading. If he hinted or told another person (Martha Stewart) to sell her shares that was also a breach of the position of trust. But Martha Stewart selling her shares – that was legal. Martha Stewart is not an insider. What Martha Stewart did would have been illegal in Australia – but it was not in the US. For those that do not know she went to the big house for lying to investigators and not for insider trading.

I think the American rule is right from the economic perspective – but it is awful hard to prove.

Enter the Mark Cuban case.

Mark Cuban owned a large stake in He received a call from the CEO asking if he wanted to participate in a secondary offering (a pipe). He sold his shares.

There is no criminality in that because Mark Cuban is not an insider. If it were Australia the case would be easy to prove because he does not need to be an insider – he only needs to be in possession of non-public knowledge – and that is clearly the case.

To make him an insider he needs to have agreed to be an insider. He needs to have agreed with the CEO that he will take information confidentially. In other words the case hinges almost entirely on the contents of a phone call between the CEO of a failing and Mark Cuban – and the call is meant to have taken place in 2004. Nobody is going to credibly remember it. If it came to a criminal charge (which required absence of reasonable doubt) then you would have to acquit Cuban because at best this case will be two people saying “he said” and the other saying “no I did not” about a conversation years ago. As far as I know there is nothing in writing in which Mark Cuban agrees to be an insider (though something in writing is what is required). It is telling that there was no criminal charge filed with the civil charge. The criminal charge wouldn’t fly.

Now the fact that I don’t think (at least beyond reasonable doubt) that Mark Cuban is guilty of insider trading doesn’t mean I condone what he did. It was unethical – in that with information given to Mark at least because of his position (as a rich guy) he acted in a way that increased his returns vis other shareholders. It is not nice behaviour and it would be illegal in Australia.

And that makes the only case I can think of for the Australian laws. As the Aussie laws do not require evidence that Mark Cuban agreed to treat information as confidential he would be guilty here. It would be a slam dunk to use the American phrase. The case for the Aussie law is that the case is easier to prove.

For the record I am fairly sure no criminal charge will be filed (in the absence of the bit of paper or email in which Cuban agrees to treat information as confidential the case would not fly). On the civil charges on the evidence given I would acquit however there may be considerably more evidence than is given. I am not sure that is economically the right outcome – but I think it is where the law is as I understand it.

In full disclosure I have to say that I still feel favourably to Mark Cuban (I made money on DirecTV). I wish him luck even though the most charitable interpretation of his behaviour is that it stinks.

As for lessons: it doesn’t pay to hit the ball close to the line. Even if Cuban’s behaviour was legal (as I suspect) it invites criticism and it looks bad. Mark is paying dearly for it now – and that payment might be deserved.

John Hempton

Friday, November 14, 2008

William Buiter has written up the London as Reykjavic idea for the FT

I referred to Willem Buiter's Iceland paper here.

He has done a thorough job of writing up the UK implications for the FT here.  Recommended.

Citigroup, Whachovia, Sheila Bair and a post I didn't make...

In the middle of the Citigroup/Wachovia thing I wrote a post which I circulated amongst friends but do not remember posting.  It was a little hot.

As speculation that Citigroup is insolvent is now widespread (see Felix for a recent example), I thought I might just post it.  Sorry dear readers to not give it you when it was more relevant:

Is Citigroup going under? Is Sheila Bair's erratic behaviour really her trying to save Citi? 

Readers will know that I think pretty lowly of the head of the FDIC. Maybe I am wrong. 

I have been puzzling this weekend – trying to work out what is going on using the assumption that all is part of a grand and competently executed strategy.

And the result was unsettling. The best hypothesis I came to is that Citigroup is going down and that Sheila Bair is trying to save it.

Sheila Bair – as readers will remember – forced Wachovia to sell itself in three days whilst other parties had not had anything like enough time to complete due diligence. She – unilaterally and incorrectly – told the world that this deal could not be done without government assistance. She unilaterally decided to issue a guarantee that on a pool of $312 billion of Wachovia assets Citigroup could not lose more than $42 billion. She made that decision even though Wells Fargo was telling her that all they required was more time to do due diligence.

Given that Wells Fargo was willing to acquire Wachovia at no-cost to taxpayers that looks like a very bad decision indeed. But this is the post assuming that Sheila Bair is smarter than all of us.

And so we need to understand the significance of that guarantee. The significance is as follows: Once Citi owns $312 billion in assets on which they can only lose $42 billion the remaining pool must be worth $270 billion. That $270 billion is guaranteed by the US Government – as the FDIC is a full faith and credit organisation. Citigroup can put that $270 billion (plus the $42 billion in non-guaranteed assets) in a pool and repo it – and as Treasuries yield very little they will wind up paying well under a percent of interest. The Sheila Bair decision was equivalent to a cash injection into Citigroup of 270 billion because the repo-market will turn government guaranteed loans into cash.

That cash injection is almost 40 percent of the size of the whole bailout package and it was given to Citigroup by Sheila Bair without congressional oversight. We got all stroppy at giving Paulson that sort of unilateral powers – but – hey – we are prepared to forget that Sheila Bair already has them.

Anyway – Citigroup buying Wachovia reliquefies Citigroup. Big time. Citigroup almost certainly knows this. Sheila Bair – if she is smart – knows this. That is why it is so important for Citigroup to complete the deal.

Now Wells Fargo have come to destroy the party. They are prepared to buy Wachovia without any government guarantee. The FDIC should be cheering as this removes all cost to the taxpayer – but Sheila Bair stands behind the decision to sell Wachovia to Citigroup.

Citigroup isn't looking to sue Wachovia for a break-up fee. They are looking to enforce specific performance on Wachovia. They are not interested in a $20 billion break-up fee – that does not save them. That is just too small. They are interested – critically interested – in the net $270 billion in guaranteed assets because that is the equivalent of $270 billion in cash – enough to save Citigroup from destruction.

Specific performance is very hard to enforce as numerous blogs have pointed out – here and here for example. But in this case it is necessary.

Sheila Bair is smarter than I thought and she knows it too. So I withdraw my demand that Sheila Bair resign – on the basis that it is probable that Sheila Bair knows more than me and she deemed it necessary to inject $270 billion in cash into Citigroup to stop their imminent failure.

Of course if this thesis is wrong Sheila should just save me the trouble of issuing a correction and resign forthwith.



John Hempton





Wednesday, November 12, 2008

Iceland, Switzerland, Denmark, Sweden, Jordan and countries with banks that are too big to bail out

There is a wonderful (simply wonderful) paper by Willem Buiter and Anne Siebert on the Icelandic banking crisis.

It’s the sort of paper that puts the lie to the line “nobody expects the Spanish Inquisition” because the core part of the paper was written – under contract – to the Icelandic Central Bank.  All agreed that the contents were “too hot” and the academic authors agreed to secrecy. 

Now that the worst has happened there is less need for secrecy so the paper has been published along with policy prescriptions for Iceland.

Ok – well and good. 

Their explanation was that it doesn’t matter whether the Icelandic banks were solvent or insolvent – there was a simple problem that the banks were large compared to the Icelandic economy and the governments could not conceivably bail them out.  As a result a run on one of them would collapse them all. 

I will express an opinion on one – and one only.  I think Kaupthing – which was by far the most aggressive purchaser of foreign assets – was probably insolvent. 

Anyway the lesson was that a country could not afford to have banks whose liquidity they could not guarantee in a run.  If the banks were so big you could not guarantee the liquidity then the banks were set up to fail.

Of course Iceland is not the only country with big banks.  [It was – when I did a study a while ago – the country with the second highest bank revenue to GDP ratio in the world…]

The country that beat it of course was Switzerland.  And sure the Swiss banks are better than Kaupthing – but UBS is not that good – and relative the Swiss Economy it is about as big… that is too big to bail out. 

I have been saving this post ever since I read the Buiter/Siebert paper (on the weekend) but Felix Salmon has sort of beat me to the punch – and the competitive instinct has made me run with it.

The other countries that stand out as having big multi-currency, multi-national banks are Denmark (Danske), Sweden (Nordea, SEB and Swedbank) and Jordan (Arab Bank).  Of these Danske is usually quite well run but they purchased a bank in Ireland before Ireland’s economy went to crap.  [They run it well but…]  And they purchased a bank in Finland (Sampo) on which they have not only overpaid but stuffed up the system integration.  Still I like Danske management personally and the good bits are very good.  Also they sold their crappy investment bank to Kaupthing a few years ago for an insane amount of money – and that sort of win covers a multitude of other sins.

Nordea is (in my opinion) very well run (but I no longer own shares).  Swedbank is deluded and awful and SEB has good bits and bad bits.

Arab Bank is a fine institution if you don't mind litigation risk associated with funding terrorism.

Of course there is one remaining country with banks that are large-relative-to-the-economy – and that is the UK.  RBOS and Barclays are both enormous and - at best opaque. 

Now do American taxpayers want to pick up UBS or Barclays?  I don’t think in the end they will have any choice.  The banks will fail or they won’t.  And if they fail – well I hate to say it – but the new administration will be stuck with it.  I guess UBS will lose its tax avoidance business in the process…  and a few American rich folk can help pay for it all with their back taxes...  unfortunately the risks to the system are bigger than that...





John Hempton

A sort of postscript... I guess ING is very large compared to the home market.  It is not without issues... but generally I think it is very well run.

I was also probably too kind to Danske - as noted in the comments...

Tuesday, November 11, 2008

Getting your duration and diversification offshore – how bond market crises and currency crises intertwine

It helps if you read the post about international diversification first.  If you do not understand the problem of owning foreign equities and hedging back into your own currency by the end read my further explanation in the comments.

That said – once you have eaten your spinach – I will show you a really nasty problem that some small country bond funds have.

An equity portfolio doesn’t have to be very diversified to get most the benefits of diversification – twenty well chosen stocks will give you most of the benefit.  A bond portfolio requires considerably more diversification primarily because of the asymmetrical nature of bond performance – in a twenty stock portfolio one stock that does much worse than the index is likely to be offset by one that does better.  With a bond portfolio a bad bond doesn’t have an offset except the spread on good ones. 

Anyway in small countries if you want to run a diversified bond portfolio you generally have to go offshore – the local country seldom carries enough diversified names. 

Issuers know this – and issue regularly in lots of little currencies.  Lots of American companies for instance had Australian bond programs (Kangaroo bonds) because the local managers wanted diversification.  The American company would then would change the money back into USD and protect their currency risk with currency swaps.

Alternatively local bond managers regularly purchased bonds offshore and used derivatives to protect themselves from currency risk.

This process is common.  Even American bond managers buy foreign currency bonds and protect themselves from currency movements with currency derivatives.  This extract from a 2004 Pimco Investment Outlook is a case in point.  Bill Gross is suggesting that to the extent that Pimco wants duration it should look offshore (Bunds, Gilts even) and (presumably) swap the currency back into USD. 

[The solution to the inflation risk in the US] is to be rather choosy about the country where you hold your duration, to reduce it in reflating countries (U.S., Japan) and increase it in relatively vigilant ones (Euroland, U.K.). In so doing, the potential pain from holding bonds in a reflating global environment can be reduced if not anesthetized entirely. 

Now put yourself in the position of the Australian bond fund manager who has massively diversified their bonds globally – and has covered their currency risk by entering contracts to buy AUD at a fixed exchange rate (say parity to the USD) at some stage in the future.  The AUD – as anyone who lives here knows – has had a rough trot lately – falling over 30 percent quite rapidly. 

The currency hedges are either margined or one or three month rolls.  Either way you are going to have to come up with about 30 percent of the offshore portfolio in cash as that is what you have lost on the currency hedges. 

Presumably of course you have made an offsetting amount by owning bonds in a foreign currency that has appreciated. 

This of course presumes that you can sell the bonds.

Which is a problem. 

As everyone should have noticed by now bond markets are not exactly liquid.  A lot of bonds are 90 offered, 20 bid but with a real value that might be 95.  Most are better than that - but if you have to sell billions in bonds you have a problem.

The real value is irrelevant – my Australian fund manager (which could be a life insurance company and hence implicitly levered) has a problem – they need the liquidity.

They can get the liquidity by selling Australian bonds – which infects the Australian market with the contagious selling/no buyers that foreign markets have.  But somewhere they need to sell.  Big time.

Well I can see a few life insurance companies (which are levered entities) in small countries having big problems.  It wouldn’t do to mention names …

As for Australian bond managers – they have a rather nasty habit of imploding – see Basis Capital or Absolute Capital Management for an example.  These were levered sellers of volatility – the name of Basis Capital told most the story. 

That said – even the surviving Aussie bond managers are having a rough time.  Very rough.

There is a lot in the relationship between currency and crises.  Much I do not understand and much I don’t grok. 

As for Bill Gross: Pimco hardly looks like the disastrous Australian bond funds.  It is not levered for a start (and that makes a world of difference).  It is mostly in US agency and GSE mortgage backed securities anyway.  And besides the US – unlike Australia – is not a small country.  But the strategy that Pimco employed (own foreign assets swap out of the currency) is widespread.  And in a US currency crisis (if such a thing ever happens) the runs on funds that use that strategy could be large.  It’s a potential issue.

But I am an Australian – and unfortunately I know the truth – this is far more likely to hurt us than the United States.



John Hempton

Monday, November 10, 2008

Naked Capitalism on AIG

 Yves (Naked Capitalism) does an admirable job picking apart the latest AIG story.  

My original calculations on the AIG bailout are being blown out of the water.  I just wonder however what this does to AIG bonds.  The minus side is obvious - AIG is much worse than it appeared in advance.

The plus side for the bonds is that the government is turning much of its injection into preference shares - and that means the Government injection is subordinate to the bonds.  That logically increases the value of AIG bonds.  

Net-net it is probably a wash - but I have not thought through the details enough.


Follow up:  The bonds are well dealt with in this post.

Weekend edition: things that get easier and harder every year

It gets easier every year to read bank balance sheets.  I get a lot of practice and it is not aerobic.  And this is despite the acrobatics banks perform in their accounting.

But on the weekend I did something that gets harder each year – the annual proficiency test to be a volunteer surf lifesaver at Bronte Surf Lifesaving Club. 

Also I took a rescue board for a long paddle with my 8 year old lying on the front.  Not a great sight…

More work required!

Sunday, November 9, 2008

A Krona Problem

There is a New York Times story about what is going on in Iceland – and one thing jarred me – the quoted exchange rate.  They quoted 130 to the dollar which suggests the Krona has only lost half its value. 

This seems a little mild compared given what has happened to the country – it has effectively defaulted on international deposit insurance obligations and had the IMF step in.

But the Central Bank of Iceland gives an exchange rate – and the exchange rate matches the New York Times story.  The NYT however says that the banks are rationing foreign currency – which suggests that the published exchange rate is a nonsense.  Still the IMF money can be supporting an exchange rate - I really do not know.  

Anyway here is the sequence of Krona per Euro exchange rates as published by Sedlibank. 

































































































































































I have highlighted the day of full collapse.  There is a Bloomberg article from the crisis day which quotes the Krona trading at 350 to the Euro – way worse than the official exchange rate. 

In most developing countries a black market develops pretty quickly in foreign currency when this sort of thing happens.  Often the street rates are way different from official rates.  [You want a big difference – go to Burma…]

Are the Icelandic people so law abiding they have not developed a street market or is the official rate real? 

What is meant by banks rationing foreign currency?  The New York Times doesn't give an answer.  Can someone with real experience in trading in Iceland post crisis (or someone from Iceland give me an answer).  I am surprised at the data.

If the Krona finds a freely convertible level at about the level quoted in the NYT then Iceland will not go through the extent of crisis I originally thought.  And if it is freely convertible whoever purchased Krona at 350 to the Euro on the day of the crisis made a fabulous trade.  Find that trader!



John Hempton

PS - Some follow up.

I found a good end-of-October internet post about the situation.  The rationing of foreign currency is indeed severe and the exchange rates are hence meaningless.  I would love to know the extent of the rationing and whether a black market has developed in the currency.   If people wish to add to or correct material here I would appreciate it.

Anyway here is the post material:

Exclamation Iceland situation

I've not written anything about the situation in Iceland for just over a week now. Here is the latest from my perspective as an Icelander.

- The Central Bank lowered interest rates last week from 15,5% to 12%. However, because of agreement with the IMF before the weekend, interest rates were raised to 18% today.
This means companies and individuals, that are already struggling to pay loans, will suffer even more. No new loans at all from anywhere.

- The IMF agreement last week gives us $2.1 billion to prop up our currency. This is not enough, and we're seeking an extra $4 billion from other countries, the Fed, ECB and Scandinavian CB's.

- It is estimated that economic contraction will be around 10%.

It is estimated that 20% of companies will not be able to pay payroll this month. I have a feeling a lot of companies are just "ghost" companies, people still working, but the company is essentially bankrupt.

- Massive layoffs in the construction industry, and the banking sector of course.

Inflation roared to 15,5% this month, expected to rise.

- Our currency is still worthless and still not traded overseas. Although there was a news today that hinted there was some trade with the ISK, where it was less than half the value that our CB claims.

- I must note that there are no shortages (yet) of food, fuel and medicine, or much else I've noticed. But if current situation continues then we could see some shortages, but not of necessities. However, because of rationing of foreign currency other importers are not able to import new supply of e.g. clothes, industry material etc. I expect many companies not being able to continue their operations because of import restrictions.

The sovereign state has not yet defaulted on any loans, despite statements in the foreign media. It requires a lot of help to get back on it's feet, and seems to be getting it soon.

- A lot of families are "stuck" in their homes, cannot sell, cannot move, cannot buy. The mortgage debt is around 10-40% higher then the value of their homes. Home value is expected to drop significantly in the coming months.

- The government owns all the banks, and indirectly owns all the media, and all the debt of the people. With taxes and debt payment the people are in a state of servitude to the government. Not many realize this.

- Some conspiracy theories are on the icelandic forums that the government is censoring the media, directing them to mitigate the news. They own all the media after all!

- Many are considering strategies out of this, e.g. husband and wife divorcing and allowing one of them to default on the debt and go bankrupt, while the other one keeps a clean slate. Some are thinking about fleeing to another country.

- The government has been able to offer a temporary freeze on payments on mortgages, 4-6 months. The depression is expected to last at least 1 year, maybe 2 years.

- There are some protests, but they seem to be minor. There is general calm, but still anxiety, frustration, over the situation. I expect things to get a lot worse when people lose their jobs and have nothing better to do than to protest.

I think the coming friday/monday is the big reveal moment, e.g. who pays the payroll and who doesn't. Just then we'll realize how serious the situation is. I expect thousands to lose their jobs.

How does once a free-market capitalist system, with the highest standard of living in the world, the most freedom of the press in the world, the happiest people in the world and least corrupt people in the world turn into a Orwellian fantasy almost overnight is beyond me.

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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.