Thursday, January 29, 2009

Freshwater and Saltwater: macroeconomic theory and losing money

Background for the non economists. In 1976 Robert Hall christened the central schism in macroeconomic thought as being between the freshwater and saltwater schools. The division was picked by their location (on the Great Lakes and Rivers versus the coastal schools). The division exists today – and indeed is being played out in Krugman’s (saltwater) blog and by the Chicago economists who think he is a bozo idiot.

Having got through the background here is the post

Does everyone agree that Greenspan kept monetary policy too loose for too long?

I thought so!

When I did economics at University (admittedly at that Freshwater school on the Molongolo River called the Australian National University) that was meant to end in inflation – not deflation.

I like my theory to accord at least loosely with reality. Especially if I am going to bet real money on the outcome – rather than pontificate in papers from the ivory tower of academia.

More to the point – I thought (in true Freshwater style) that sustained low interest rates were a sign that monetary policy had been tight and that sustained high interest rates were a sign that monetary policy had been loose.

Given that basic understanding of macroeconomics I thought that regional banks that made more than half their profits out of carrying the yield curve would be carted out when loose monetary policy did eventually lead to higher long term interest rates. I was short a lot of banks – and whilst that was good – I spent a long time being short interest rate plays. I have detailed that mistake here. Bill Gross made a similar mistake declaring the 25 year bull market in long dated treasuries over – so despite Bill Gross’s saltwater location at Newport Beach I was in good company.

Now the subject of freshwater, salterwater and other macroeconomic elixirs is the thing in the subject de-jour amongst economic bloggers – but I have conducted the experiment – with real money – and I can confidently say (brutally backed by less-than-ideal-financial outcomes) that the saltwater guys were right.

John Hempton

Wednesday, January 28, 2009

Scandinavian bank collapse - not all the same

Do not bother reading this post unless you are directly interested in a history of Norwegian versus Swedish bank collapses...

It seems that some central bankers read this blog. I got an email from a senior Scandinavian central banker following the exchanges on this blog (see this exchange for an example).

Anyway he points me to a note by P Honohanen of the World Bank (written several years ago) and which I reproduce here. I think this should close some of the debate. Either way it is useful if you wish to know what actually went on...

For several years it has been fashionable to look to Sweden as offering a policy model for recovering from a banking crisis. And your editors have to admit that, along with most other commentators, they had been inclined to assume that the Swedish case was mirrored by the roughly contemporaneous crises in the rest of Scandinavia. But the Norwegian crisis actually predated that in Sweden and, as we have discovered by reading the comprehensive volume on the Norwegian case which has just been published by Norges Bank (“The Norwegian Banking Crisis”), containment and resolution policy was quite different. Certainly the two countries both made a good recovery: on some reckonings the Norwegian government, like that of Sweden, may have ended up with a small cash profit after selling back into the market bank shares that it had acquired in the crash. Though sometimes thought of as a classic macro boom-and-bust, the Norwegian crisis may be better classified as the result of inexperienced bankers trading in a newly liberalized market with recently lowered capital requirements and a sharply reduced frequency of on-site supervisory inspection. The crisis was a big one: the three largest banks (DNB, Fokus and Christiania) all failed along with many smaller banks including sizable regional banks. The privately owned and managed deposit protection schemes were overwhelmed and had to be nationalized – illustrating a weakness inherent in what is otherwise a good idea: distancing deposit protection from the government. Government took ownership of the major banks – and retains, for strategic or political reasons, a major stake in DNB. But, and this is the first important contrast with the policy stance adopted in Sweden, in no case were shareholders bailed out. (Yes, the authorities were sued by disappointed shareholders, but unsuccessfully.) Two other key points to notice: government did not issue a blanket deposit guarantee and they did not set up Asset Management Companies. These striking contrasts certainly argue for avoiding knee-jerk application of the Swedish policy approach in these three dimensions.

The perfect appointment

I have – framed above my desk – a $100,000,000 note – serial number AA23100220 and signed by Dr G Gono – the Governor of the Reserve Bank of Zimbabwe.

This – it seems – offers the solution to all our deflationary woes.

It seems that no matter how many dollars the Fed prints it can’t induce inflationary fears.  I suggested that the Fed rent a couple of hundred helicopters and (literally) push $2 billion out the window.  That I thought was irresponsible enough to raise inflationary expectations.

Alas real objections can be made – not the least that people might climb on rooftops looking for the booty – and slip and die.  I can’t morally justify the deaths.

But the Zimbabwe note has given me another solution – one that doesn’t require any helicopters or even the printing of any money.  It is more than sufficiently irresponsible – yet nobody will die.

Ben Bernanke should resign forthwith and Dr G Gono should be appointed as Chairman of the Fed Reserve.  

Nothing need change.  Monetary policy can remain in the effective hands of the other governors – but the appointment of Dr Gono will rapidly raise inflationary expectations – and the new inflationary expectations should induce the spending of the massive hoard of saved dollars – providing all the economic stimulus needed.

Dr Gono may be the wrong man for Zimbabwe – and the right hand man of a dictator.  But he is what America needs right now.  

Do you think we can get him confirmed?

John Hempton

What is a non-performing loan?

Once upon a time I saw loan restructurings as code for faking the accounts.  That was with good justification.

Conseco – before it blew up – had a habit of restructuring any loan that was delinquent.  After restructure it was no longer delinquent – and lo – the credit metrics seemed OK.

After Conseco finally went bankrupt the truth came out.  Loan performance went from sort-of-OK-if-you-ignored-the-fact-that-cash-actually-coming-back-in-payments-was-low to utterly desperate.  The AAA strips of Conseco securitisations failed widely.

These days restructuring loans is the stated objective of many powers that be – most notably Sheila Bair.  I never quite got that.  If you show too many non performing assets (NPAs) Sheila Bair will just confiscate your bank.  So the incentive is to restructure and restructure early.  If the borrower can perform to restructured spec then presumably they are no longer an NPA.  What Sheila Bair appeared to be advocating was government sanctioned account faking.

Then of course some banks tell it straight – and count the restructured loans amongst their NPAs.  Here is an extract from the recent Fifth Third conference call.  Fifth Third is a problematic bank and in WaMu fashion I own the subordinated debt – not the common – and in WaMu fashion I probably have reason to be nervous.  Anyway to quote:

Turning to the consumer portfolio, we also continued to be very aggressive in restructuring consumer loans, modifying over $200 million in the quarter. We believe restructuring loans where appropriate will result in significantly greater likelihood of payment and more value ultimately received by Fifth Third. These activities are beneficial not only to our shareholders, but are also consistent with the needs of our customers.  [Sheila Bair’s line precisely – are they pandering?]

As of year end, we had $574 million in troubled debt restructurings and NPAs, classified that way because they hadn't met the six-month consecutive performance threshold.  [Hey wow – they count restructured loans as non-performing – so they are not producing the Conseco fake numbers…  My cynicism is misplaced in this instance.]

Fifth Third has been among the most active of banks in the US in restructuring loans for consumer borrowers, a process we began over a year ago. We've been among the most active among our peers in these restructurings only one of the 15 largest US banks reports a higher dollar amount of restructured loans among its nonaccrual loans, according to regulatory filings.

Now this is very odd.  $574 million of restructured loans in the NPAs is about the highest in America!  But we know lots of banks are restructuring many loans – many billions worth.  Sheila Bair is telling them to do it.  But if you take Fifth Third at its word (and I think you should here) all the other banks are classifying most those restructured loans as performing.

In other words they are – Conseco like – faking their accounting.  And Sheila Bair is not only complicit – she is actively encouraging.

Welcome to modern banking.  

Tuesday, January 27, 2009


By far the best reaction to the helicopter post from one of my favourite bloggers.

See Cassandra.


Reaction to the Helicopter post

The helicopter post has had the most reaction of any post on this blog. I guess that is the territory when you suggest that the solution to the financial crisis is to literally throw money from helicopters. Nonetheless I wish I could get that sort of reaction to a more serious post.

The reaction to the helicopter post fell into three categories:

  • those that didn’t get it
  • those that got it but may have had ethical problems, and
  • those that understood it all too well.

I got one comment – via email – which explained very simply why the helicopter proposal wouldn’t work. I think that commentator’s argument is accurate – so – at the end I will lay it out and (tentatively) withdraw the helicopter proposal.

Those that didn’t get it

There seemed to be several comments (email and on blog) which suggested that it would be better if we just gave everyone a tax holiday (payroll, income, death duties depending on where in the political spectrum the commentator was).

This does not cut it. The purpose of the proposal (throwing money out of helicopters) was not to distribute money (for which plenty of effective mechanisms exist). The purpose was much more radical – to remove trust in money itself.

The proposal I made was remarkably cheap (a $2 billion solution to a multi-trillion dollar problem) and if it works it works for purely psychological reasons – which is that it is so reckless and irresponsible that nobody could ignore the inflationary impacts of Federal Reserve policy. Reckless and irresponsible (and small) was the charm of this proposal.

Indeed I suggested in the comments that it would work even better if Bernanke continuously surrounded himself with buxom prostitutes paid out of freshly minted moolah, but that image was just too horrific – even for this purpose (although it may be effective).

Some that simply got it

There were a couple of posts that simply got it. The cutest came from someone calling themselves the German Trader who put it very simply (if in very poor English):

You only give something away when you think it is worthless and what you get is of greater worth. While seeing the riots after Bens helicopters came past I surely want buy a new car.

Kieren (who I do not know) pointed out that the trick was really to produce inflationary expectations (and hence to get people to spend) without producing inflation. That is why this might work. The amount of money involved is small ($2 billion versus over $2 trillion in money supply) so its effect should also be small – but the expectations effect could be enormous. That was – in theoretical terms – what I was trying to achieve.

Some who got it and raised ethical objections

There were a few ethical objections raised – firstly by people who thought I was right that this policy would cause riots and deaths and then promoted more responsible ways of doing the same trick. The people killed in riots are collateral damage of a deliberately irresponsible policy. I don’t know how to weigh one life versus another – but this financial crisis will kill hundreds of people before it is over – either suicides or more bluntly hunger in some countries badly hit. The ethical objection is real – and I have no solution. The policy proposed is deliberately irresponsible – and irresponsibility causes death in some instances.

The main ethical objection I expected was about property rights and theft. I wrote the post in Australian hours and it was seen by Australian/Asians then English/Europeans and finally by North Americans.

I had to wait until American waking hours for someone to point out the obvious - which is that the policy being advocated was the deliberate theft of property (deliberate inflation being theft). Europeans somehow seem less concerned than Americans about property rights.

I am usually very harsh on government policies which involve the removal of property rights simply because those policies are usually counter-productive. There are plenty of posts on this blog along those lines. However those posts are argued on a facts-and-circumstances basis – the abrogation of property rights is argued as a problem in this instance and property rights are not automatically given full moral status. That is my position generally – honouring property rights is a good thing to do because it generally leads to better outcomes. I understand that some people (almost all Americans and including many readers of this blog) have raised property rights to full ethical status (along with for instance the rights to liberty etc). Not my ethics – but I understand – and the outcomes are usually OK so I am generally happy to leave that form of right wing fundamentalism alone.

I prefer argue for property rights from an outcomes perspective (as incidentally did many Modern Scots - esp Hume - but later Smith with regard to some economic matters*). Your blogger does not really wish to comment on the property rights as a moral precept here – other than to note for some people this really is fundamental. Just leave it at that.

The commentators that got it all too well

The comment on the post which got the most comment from other commentators was someone that got it all too well. The comment was that – as a result of this policy – some right wing “nut” would load a truck with fertilizer and diesel and blow up the Federal Reserve.

Some people objected to calling that person a nut – but I have no other word for suicide bomber of any persuasion. More to the point – this person – and eventually many others – would realise what this policy was about – which is removing all trust from dollars – and hence theft of one ideal that they hold quite dear.

The question which was raised in emails was about how you would reintroduce trust after you have destroyed it. I think that is actually a key problem. Trust is essential for an economic system in general – but trust in money at the moment is quite destructive as people would prefer hold enormous quantities of money rather than build real assets and employ real people. However you can’t build real assets and employ real people without trust either. The helicopter proposal is targeted at getting rid of trust in one place and one time only (the trust in money in the rare instance of a liquidity trap). Whether you can conduct a strike that surgical with a helicopter full of rolls of money is open for question. Military strikes are nowhere near as precise as the pictures on CNN.

Finally – the real objection

This came in an email from one of the most astute commentators on my blog:

It won't work because immediately after the drop, Congress would arrest Bernanke along with the entire Fed board (probably replace it with a money czar)…. Politicians would be forced to promise responsibility and accountability in the face of the threat of civil unrest - don't forget, a lot of people own guns legally in this country. There will be new laws designed to keep the value of the dollar. In the end, the dollar would get stronger, not weaker…

In other words the whole idea won’t work because it is actually not possible to be that irresponsible – that the underlying US system is sufficiently strong – that if Bernanke were that irresponsible he would simply be replaced.

If Bernanke can’t plausibly be quite that irresponsible we might as well park the helicopters.

And if you can’t use monetary policy to solve this recession then alas we are left with what appears to be two inferior choices (a) a fiscal expansion of gargantuan proportions or (b) letting the system burn and winding up in a great depression type scenario. Both are unpalatable – but I would vote for the fiscal expansion.

It would be much better to just load up that helicopter. Alas...


*There is a serious edit to the this post because I have not read theory of moral sentiments for twenty years and then did not finish it. I have pulled out my copy and I was wrong. I wasn't about Hume (who I have always thought right). Smith it seems thought that moral laws within the economic sphere were made by man - but outside Man was not capable of such moralizing. The rights to property seem - from my quick skim fall into manmade lot - but... suggestion withdrawn...


Monday, January 26, 2009

Why the Federal Reserve should LITERALLY throw money out of helicopters

Cassandra (who normally does Tokyo) has a diary note in which (s)he explains – in layman’s terms – why the Fed printing all that money (expanding its balance sheet) is not inflationary.  The key section quotes Perry Merhling (whom shamefully I had previously not heard of).  Here it is.
It seems to me that what we are seeing is simply the balance sheet consequences of the Fed's decision to take the wholesale money market onto its own balance sheet. Banks (and other entities) that used to lend to one another, are now lending and borrowing through the intermediation of the Fed. This is so not just domestically but also internationally (the huge swap line), since foreign banks used to fund dollar asset holdings in the dollar money market.

In this view, inflation seems much less likely. Why not? If the original wholesale money market borrowing and lending was not inflationary, then why should its substitute be inflationary? Indeed, the real question is whether the expansion of the Fed's balance sheet is keeping pace with the contraction of money market credit more generally. If not, then the consequence may be deflationary. 

Posted by: Perry Mehrling at December 22, 2008 05:12 AM

This is of course correct – as far as it goes.  To the extent that Fed balance sheet expansion simply offsets private balance sheet contraction there is no net increase in money and near substitutes – and so the Fed balance sheet expansion cannot be inflationary.  We are – to that end – stuck in our deflationary spiral.

The situation has a name in the economic jargon - a liquidity trap.  An American – not a Japanese version of a liquidity trap – but a liquidity trap nonetheless.  No matter how much “money” the Fed supplies the public will want to hold it.  Monetary policy is thus useless.  

This is usually made out (by Krugman et al) as an excuse for massive fiscal policy.  And I am not averse to that.  

However there is another approach which I detailed in my lessons from shorting JGBs post.  The argument: if you can’t fix the problem with increasing money supply then maybe you can fix the problem with decreasing money demand.  

You need to convince people not to hold money.  You need to convince them that cash is trash.

And to do that you need to convince the public that there will be inflation (the above gross leverage argument notwithstanding).  

To do that the Federal Reserve has to be credibly irresponsible.  It is not enough to print a couple of trillion dollars (which they have) because everyone thinks (with some justification) that they will suck back the money supply when the crisis is over.

No – you have to be more visibly reckless than that.  You have to really convince people that there will be inflation.  

So the suggestion in my title is literal.  The Federal Reserve should hire a couple of hundred helicopters and load each one 10 million dollars in neatly bound parcels of $1000 each.  Total cost $2 billion plus trivial helicopter hire.

It should fly them over 200 randomly picked American cities and throw the money out the window.  It should press release this – but press coverage will be excessive.  Indeed I suspect that the press coverage would give the Fed’s inflation policy greater awareness than the Coca Cola Company.  (The Coca Cola Company’s annual advertising budget is $2.8 billion – so this is already cheap compared to some private sector alternatives.)  

The press release should be simple.  We are doing this to induce inflation.  If there is no inflation as a result we will simply do it again. 

Of course people will fall of roofs after searching for money that might have landed on their house.  They might die.  Of course people might get trampled in the crush.  They might die too.  

All of this increases the visible recklessness of the policy.

But the charm of this.  It may actually induce mass spending of American dollars for (self-fulfilling fear of inflation)– a massive stimulus.  And it will do it all for $2 billon.  Obama has a stimulus package of $1.2 trillion – or about 600 times as large.  This is relatively cheap.

The real case for throwing money out of helicopters is that it looks like it will work better than anything else that anyone has come up with yet.

And it will be cheap.  Much cheaper than alternatives that are actually being implemented.

The secondary benefit is that most of the losses from inflation will be in the hands of the Chinese who have built huge reserves of soon-to-be-deflated US dollars.  

Hey what better – lets kick start the economy and get the Chinese to pay.

I am serious.  At least serious until I can get a credible explanation as to why this won't work at least as well as any of the alternatives being mooted.

John Hempton

Saturday, January 24, 2009

Felix Salmon asks the question: is nationlisation contagious?

The answer to that is YES if it is done without giving existing capital holders the belief that they are being treated fairly.  (See Felix's post here.)  

A bank that loses access to capital eventually fails.  Certainly in a current account deficit country if it loses access to intermediate funding it fails - and intermediate funders are not that keen if the bank has no access to capital.

If private shareholders feel that government will ride roughshod over their rights then there will be no private shareholders.  They will have "fear of government".

So there must be a process which respects the capital that private shareholders offer - and which is seen to honour that capital.  

If done that way - and the Scandinavian countries groped towards such a solution, then nationalisation is NOT contagious.  

As noted in my last post Svenska Handelsbanken did not surrender ANY equity to the government even though it took government liquidity support.  It was seen to have capital and the shareholder capital was respected.

There was - and the histories referred to in my last post - a contagion until the due process was implemented an no contagion afterwards.

I have no objection at all to nationalisation - but it must be accompanied by a process that both respects and is seen to respect existing capital holders.

Can we please get this straight?  Contagious nationalisation - and that is where Willem Buiter et al are heading - is a disaster.  It is also an simply not necessary.

John Hempton

PS.  Notwithstanding the above - a pretty-close-to-complete nationalisation will probably happen in the UK.  Due process will lead us there.

Friday, January 23, 2009

Scandinavian bank nationalisation and due process

The proposal in my nationalisation after due process post the proposal I gave was not new.  I probably should have pointed out it had a precedent - Norway.  Norway was the country with the most pervasive nationalisation in the crisis.

You can find the reasonable history of Scandinavian bank nationalisation here.  Read Chapter 3 if you are interested in this stuff.  The biggest nationaliser was Norway - not Sweden - though Sweden did buy out the minority shareholders for token sums.

The process used in Norway was to assess the shareholder capital of the bank.  Shareholders were given FIRST RIGHT to recapitalise it.  If private money could be raised they kept the bank.  If they were short capital the government loans (which had previously guaranteed liquidity) were converted to equity and the old equity was written down.  Here is the key paragraph explaining the Norway result for the biggest banks:

Amendments were also made to the banking law, enabling the government under certain conditions to write down a bank’s shares to zero. This ensured that share capital really was written down to the extent that capital was lost.

It was soon realised that Christiania Bank and Fokus Bank had lost their entire share capital.  The share capital in Den norske Bank was written down by 90% according to losses.  The banks needed more capital, but private investors were unwilling to invest. All three banks thus received a substantial capital infusion from the GBIF [which was an independent but government owned bank manager] at the end of 1991. Conditions were established regarding balance sheet restructuring/downsizing, cost cuts and other measures to improve results. Share capital was written down to cover estimated losses. In both Christiania Bank and Fokus Bank the share capital was written down to zero by government decision (after shareholders had refused to do so). The existing shareholders thus did not receive anything for their shares, and the GBIF became the sole owner of the two banks. The boards and the top management were replaced. The banks received further capital support from the GBIF in 1992.

What we had here was a recapitalistion by government with rules which were widely understood and where the existing shareholders were given first rights of refusal over the recapitalistion.

In other words it was nationalisation without theft and it was not theft because there was a process which treated shareholders fairly.  Because Den Norske Bank had 10% of the required capital when assessed the private shareholders kept 10% of the equity.  Christiana and Fokus had less than zero capital and the shareholders were wiped out without compensation but after due process.

In Sweden similar processes were involved - but like Den Noske Bank the companies mostly had some capital left and so existing shareholders received some value.  One major bank (the very well run Svenska Handlesbanken) never surrendered any ownership to the government.  It had liquidity problems (it actually needed government money from memory) but it had no capital problem when it was assessed. 

Finland also had a crisis - but as far as I can tell (and know no banking expert that speaks the language) it was handled much worse.

The lessons of Scandinavian crisis are many.  One of them however was that if you want to reconstruct a banking sector post crisis (and I presume most people do) then you probably want to treat the existing shareholders fairly.  Fairly can mean confiscation as per Fokus or Christiana bank - but it is fairly after due process.

I only mention this - and also remention Chapter 3 of this document - because Kevin Drum and Interfluidity are maintaining their argument about what happened and how it should be handled.

Nationalisation probably will happen for some banks.  It has already happened for Royal Bank of Scotland for the most part.  It happened without much process - and the lack of process has put the fear of government into everyone who might fund banks.  Lack of process will wind up meaning that everything gets nationalised because if there is no fair process there will be no private money as an alternative to nationalisation.  In that case nationalisation becomes a self-fulfilling prophecy...  

Will the policy makers PLEASE read Chapter 3.

Pretty please.

John Hempton

Thursday, January 22, 2009

The last bank with an antidilution clause...

Was Washington Mutual. It caused them no end of trouble.

Barclays has one.

Implication - either Abu Dubai waives the clause or it is confiscation for Barclays.

If I were Abu Dubai I would be waiving the clause NOW.

But then I was not long Barclays - unlike SMFG who put almost 700 billion yen in only a little while ago. (Hey what is 700 billion yen between friends?)

John Hempton

Zero in Japan versus zero in America

I don’t have a solid economic model of different types of zero interest rate policies. I guess the number of instances historically doesn’t give us enough material to get a classification. But this is worth stating.

Zero in Japan looks very different from how zero in America looks right now.

How Japan looks

One of the first posts on my blog was about 77 Bank. 77 is a typical mid sized Japanese regional bank. It has vast excess deposits. It has plenty of liquidity – but almost nobody to lend it to. Competition to attract worthy borrowers is intense – and is led by prices. Loans are typically made on less than 50bps of margin.

The banks are bizarrely unprofitable. At 12 times leverage and a spread after costs of about a third of a percent the return on equity – before tax and provisions – is about four percent.

Businesses – at least ones with any claim to be credit worthy – have no trouble borrowing at all in Japan.

There is however a problem with these low spreads – a very big problem. Japanese banks are vulnerable to very low levels of credit losses. A loss rate of a third of one percent wipes out profit. A loss rate of 2 percent sustained over a couple of years would wipe out half the capital.

Summary: Japan has zero rates and the banks can’t make a spread because they have no willing borrowers. The banks have no liquidity problems – but they have a capital problem whenever losses rise to merely low levels from extremely low levels. The reason banks stopped lending was that there were insufficient willing borrowers.

The broken bank in Japan is a “zombie” (living dead). It has insufficient capital and not enough spread to rebuild capital over even a decade. It has enough liquidity to limp on for many years. However it often is attracted to riskier loans in a vain effort to find some spread – and it is prone to blow ups. For a long time Nishi Nippon City bank looked like that.  

Note that Japan is now facing credit losses of a couple of percent - and that is high enough to cause widespread devastation to the low-spread Japanese banking system.  

How the US looks

Most US banks have spreads after costs well above two percent of assets. Wells Fargo for a long time has had an interest spread above five percent. Spreads are still that high or higher.

In the good times background loss rates were one percent or more. Indeed there were plenty of businesses in the US which worked fine with three percent background loss rates (much car lending for instance).

There is no shortage of willing borrowers. Indeed there are plenty of worthwhile projects at the moment that have a hard time being funded because the banks don’t have any money available. Banks can’t fund themselves as the market for senior bank funding has shut down. The reason banks have stopped lending is that there are insufficient people willing to provide funds to banks. In plan parlance banks don’t lend because they can’t borrow.

Some observations

It is trite – but the key difference is between a current account deficit country and a current account surplus country.

The deficit country has to borrow from abroad. Banks intermediate the deficit and the banks are subject to hot money flows.

Being subject to hot money flows the banks are subject to runs – very big and destructive runs.

The banks in those countries fail fast. Japanese banks by contrast remain as zombies (living dead) with insufficient capital but enough liquidity to last decades.

In current account deficit countries nationalisation or part nationalisation is a common end-game for a financial crisis.  

Lots of people talk about Sweden (or better Norway) because they did their nationalisation well. But another example is Korea – where the bank blew themselves up too – and were critically dependent on (Japanese) money which became rapidly unavailable.

Help please

I know how these things look. I don’t have a decent model grounded in facts-on-the-ground.

I am surprised at the tone of the WSJ story about Japanese regional banks needing a bailout. They don’t need it from a liquidity perspective – they need it from a capital perspective. The WSJ story does not make this clear.

In America and the UK the banks have (serious) liquidity problems. I am not sure they have capital problems. Indeed my view is that there is no capital problem in the system – but the banks individually might have issues. The reason there is no capital problem in the system is that the underlying pre-tax pre-provision profitability is about 400 billion per annum.

Am I right that the system has adequate capital?

This view looks really controversial. It is just assumed – more or less by all pundits – that the banks are insolvent. Krugman’s latest piece on zombie banks is just one of many.

But the pre-crisis net tangible capital of the US banks was about 1.4 trillion. About 500 billion has been raised or defaulted since the crisis began. So call it 1.9 trillion. The pre-tax, pre-provision profitability has added another 400 billion per year to the pool – so we are at 2.3 trillion or more. A few hundred billion of the losses are borne outside the banking system.

If total losses get to the 3 trillion numbers that Roubini talks about. the system will get to neutral capital in two years and be fully recapitalised in five. If those numbers are right this is not a capital problem – it’s a liquidity problem.

The problem is serious though – and nationalisation may be the right prescription. It appears – as a matter of fact – to be the end game in countries which have current account deficits and banking crises (see Korea, Sweden, Norway). I am just not sure how to do it right – and when people (like Krugman) borrow the expression “zombie banks” from Japan I think they are substituting words for clear thinking.

I guess the thinking is hard though. If I thought all this stuff through clearly enough I would have that Nobel Prize in economics. Alas I did my last academic economics twenty years ago.

John Hempton

PS.  UK banks have (a) lower spreads and (b) lower starting capital.  The problems in the UK are thus more serious even with a lower level of losses than the US.  I am not sure that Barclays can ever be made solvent.  Barclays by comparison think they are solvent now.  But then I am a noted doubter of Barclays as one of my early posts show.  

PPS.  I was a little quick when I described Nishi Nippon City bank.  It is in fact a merger of two banks (Nishi Nippon and Fukuoka City bank).  Both were zombies.

Decline and fall of the British Aristocracy

Just a link.  A fine book review from the Investor's Consigliere.

Wednesday, January 21, 2009

Buiter's Modest Proposal

It is funny how I spend a lot of my time arguing with people I fundamentally agree with. Today’s blog post by the well respected Professor Willem Buiter has really got my goat. He advocates nationalisation of the UK banking system. I think he is right.

He also advocates the scrapping of anything that looks like process. Here is his “modest proposal”:*

(1) Take into complete state ownership all UK high street banks. This has to be mandatory, even for the banks that still like to think of themselves as solvent.

(2) Fire the existing top management and boards, without golden or even leaden parachutes, except those hired/appointed since September 2007.

(3) Don’t issue any more guarantees on or insurance for existing assets - regardless of whether they are toxic, dodgy or merely doubtful. Issue guarantees/insurance only on new lending, new securities issues etc. A simple rule: guarantee the new flows, not the old stocks. This will reduce the exposure of the government to credit risk without affecting the incentives for new lending.

(4) Transfer all toxic assets and dodgy assets from the balance sheets of the now state-owned banks (or from wherever they may have been parked by these banks) to a new ‘bad bank’. If possible, pay nothing for these toxic and dodgy assets. Since the state owns both the high-street banks (I won’t call them ‘good’ banks) and the bad bank, the valuation does not matter. If the gratis transfer of the toxic or dodgy assets to the bad bank would violate laws, regulations or market norms, let an independent party organise open, competitive auctions for these assets - auctions in which the bad bank, funded by the government, would be one of the bidders. Whatever price is realised in these auctions is paid by the new bad bank to the old banks.

My only real problem here is in step 1. It is spoken with the true arrogance of someone who has never traded markets for a living.**

Now I am as sure as anyone about the parlous state of UK banking. Here are two very early posts on this blog about the state of UK banking – see this post on Royal Bank of Scotland and this one on Barclays. These posts were over six months ago. (I declare victory on them.)

Bethany McLean did a story in Fortune magazine about Royal Bank of Scotland. The story looks fantastic now – have a look. Although I was anonymous at the time (the story pre-dates this blog) I was one of the people she spoke to for that story.

But I wasn’t absolutely sure then that the banks were insolvent and I am not absolutely sure now. Indeed whilst I thought that Barclays would probably fail but that Royal Bank of Scotland might survive. The pair – long RBS, short Barclays was one I talked about but (fortunately) did not do.

The problem. There is no way that I am buying a bank stock – any bank stock – unless I know the new rules. I have no problem with nationalisation – indeed I blogged about it in the context of Norway as early as July– and the feedback was all negative – with the general view being “that it is unrealistic for America”. What I would like however is process for dealing with the residual rights of shareholders and preference share holders. [There was such a process in Norway - and one bank was only ninety percent nationalised...]

Sure: guarantee new funding. You don’t want to guarantee old funding because that increases contingent state liabilities to some enormous level. This buys you time. Use that time for a process to determine (fairly and with a right of refusal to old shareholders) the situation for new shareholders. The sort of idea that I have is that shareholders should be able tip in new capital in exchange for government guarantees on the new funding. There should be substantial new capital required (perhaps an amount determined by a third-party independent accounting structure) in exchange for these guarantees. Moreover the government should be paid an amount for the guarantees. Taxpayers take risk and should be compensate for that risk.

My guess – is that faced with a true accounting – there will be no new capital. But I really am not sure. HSBC probably could raise some. Barclays I doubt. RBS – well – it is too late for them.

A six week process which leads to nationalisation is not a major change to Professor Buiter’s modest proposal – and it can be made to fit centuries of thinking about what constitutes good government.

America’s long nightmare of bold and decisive government is over – Mr Buiter’s suggestion is so yesterday...

It is time for a nightmare of due process.

John Hempton

*For those of a less literate bent the phrase “modest proposal” has form. Jonathon Swift circulated a straight faced pamphlet (titled “A modest proposal”) that described – in harrowing terms – poverty and starvation amongst the Irish. He then – with an equally straight face – advocates that the solution is for the Irish to eat their own children. Is Buiter’s modest proposal a suggestion that the British eat their own (banking) children. If so then I have misunderstood Willem Buiter completely.

**I used the phrase “with the true arrogance of someone who has never traded markets for a living”. The people who are really good at trading markets are firm but modest. They are prepared to admit that they are wrong – and will always entertain the possibility. There is a stereotype of the blindingly arrogant bond trader – someone from Bonfire of the Vanities – or more colloquially the “big swinging dick”. Those people are dangerous in markets – and I suspect they are also dangerous giving policy advice too.

Obama: hotter than sex

The official Whitehouse website is However I am so used to typing a site as ctrl enter “whitehouse” that I was a frequent (if accidental) visitor was a pornography site – selling photos of hot teen sex.

But now it feeds news related to Barrack Obama.

Conclusion: there is more money in politics than pornography.

Stock conclusion: avoid all listed pornography companies.

Tuesday, January 20, 2009

Luigi Zingales has it right

Luigi Zingales knows a few things about how the new administration should behave.

He may be a little too jaundiced about nationalisation - but here is the money quote:

Get a strategy

To begin, you (Mr Geithner) need an overall strategy. Even a mediocre strategy is better than an ad hoc approach that confuses markets and fuels the perception of playing favorites. Legendary portfolio manager David Swensen (who in 23 years transformed the $1 billion of Yale endowment into $23 billion) in reference to the government intervention in this crisis commented “the government has done it with an extreme degree of inconsistency. You almost have to be trying to do things in an incoherent and inconsistent way to end up with the huge range of ways they have come up with to address these problems.”

The cost of ad hocery

The cost of this inconsistency is that it has forced the private capital to stay on the sideline. Short of a complete nationalization of the financial sector (which we hope is not in the plan), the problem cannot be resolved without the help of private capital. But a necessary condition to attract private capital back is a consistent and predictable strategy by the government. Without it any other effort is in vain.

I should note I disagree with a lot the rest of Zingales paper - and will explain why in a later post.

I do not oppose nationalisation - but I would prefer that private money came to the fore. Private money will not pony up if they do not know the rules.

The way to do nationalisation is nationalisation AFTER due process. Due process (anywhere) does not seem to have been a hallmark of the Bush administration.

Confiscation without process (WaMu springs to mind) guarantees that there will be a private capital strike.

With a private capital strike everything eventually needs the government to bail it out. Everything - JPM and Goldies included.


Lest you think I disagree with Krugman too much

Krugman makes the obvious point that being fixed to the Euro hardly imunizes you from financial crises.

I still do not get Willem Buiter's pamphleting for the UK joining the Eurozone.  This post was more softly stated than normal.  

John Hempton

A slogan for the new administration: nationalisation after due process

A lot of my readers mis-understood my last post.  It was only to point out that with a government guarantee even fairly heftily insolvent banks will live.  

In some sense the conclusion is not surprising.  The purpose of capital in a bank is to ensure that the funding sources get repaid.  A government guarantee does that – and so is capital.  The guarantee ensures profitability because it ensures that there is adequate capital.  

Now there is a cost to these guarantees.  They are expensive – especially in an ex-ante sense.  The taxpayers are taking a risk – and they should be compensated for that risk.  That is a basic capitalist principal – but it also is just plain fair.  Real capitalists nationalise.

But there is a cost to nationalisation too.  The cost is that potential capital providers – sometimes with some justification – see it as theft.  I personally see the snitching of WaMu as theft – and nobody has yet come up with a credible argument against that.  

Who cares whether it was theft or not though – it appears to be theft – and that is sufficient to do damage.  The effect of the seemingly arbitrary action of Sheila Bair in confiscating WaMu was to discourage any and all new private capital to banks.  

Once capital providers have decided that the government will arbitrarily nationalise there will be no capital providers.  Nationalisation can be a nasty self-fulfilling policy.  We have – and I have blogged about it before – the opposite of moral hazard.  We (people who as a matter of course might provide capital for banks) are living in fear of arbitrary actions by government.   Believe me - I buy and sell bank stocks and I live in fear!

And if anyone here thinks the process for bailing out financial institutions hasn’t been arbitrary then you haven’t been looking.  Every single major failure has been handled differently.  I would say rules are being made up on the fly – but in fact there are no rules.

So here is a proposal.  Call it “nationalisation after due process”.

An organisation is in deep do-do – and needs a bailout.  Following Paul Krugman we will call it Gotham Bank.  

Gotham has stated $2 trillion in assets and $1.9 trillion in liabilities – a stated $100 billion in capital.  Suppose the required capital is $100 billion according to regulatory rules.  

But Gotham’s accounts are nonsense.  It has an unknown number of bad assets – say something between $100 billion and $500 billion.  If it has $100 billion in bad assets then there really is shareholder value there.  It has earnings potential and is solvent.  If there is $500 billion in bad assets the bank can be so insolvent that even time is not a solution.  

It goes to the government.  Under the Bush administration the government would make a set of rules up for Gotham over a disorganised weekend.  The fait-acompli would be presented before Asian markets opened.  

But it does not have to be that way.  The government could inject some capital into the bank as a temporary subordinated loan.  A third party could then be appointed (new management – or answerable to another arm of government) to produce fair accounts for Gotham.  Ten weeks should do it.  At the end of ten weeks Gotham will be found to have – as a middle estimate – say $150 billion in losses – it is thus negative capital by $50 billion or a full $150 billion short of its required regulatory capital.  

The management of Gotham can go to the markets.  If the management can raise $100 billion (something to get it back to half capitalisation) then the shareholders keep Gotham.  Sure existing shareholders might get diluted - but at least they get to have a decent go at keeping their capital stake.  

If they can't or won't fund the bank in full knowledge of its position then it is nationalised.  It is in that case unambiguosly not theft - shareholders had the chance to keep the bank under fairly administered rules.  

What I want is extreme government action (nationalisation) but with a process to ensure that existing property rights are honoured.  I want the benefits of nationalisation (that it works) without the costs (that it is seen to be arbitrary to capital providers).  

Due process if you will.

Due process is one thing that the Obama administration should get right over the Bush administration.  It is a mark of good government.

Here is hoping.

John Hempton

PS.  Why half capitalistion?  Because bank capital is there to buffer against losses.  Once the losses have occured the bank should be allowed to run to build the capital back up.  Full capitalisation at the bottom of a banking cycle would make banking regulation too procyclic for the general good.

PPS.  When I was a junior public servant (Australian Treasury) I saw the policy prescription - the events of the weekend or crisis - as the important thing.  The longer I looked at it the more I realised that the processes were as important as the outcome.  Indeed they are more important.  Markets work because we have a legal process.  They do not work in Cambodia because there is no process other than he-who-pays-the-biggest-bribe wins.  

A funding market for banks will not reappear until process reappears.  Getting the process right is KEY to solving the financial crisis.

Monday, January 19, 2009

Voodoo maths and dead banks

I am not afraid bank nationalisation.  Real capitalists nationalise – meaning if the taxpayer takes the risk the taxpayer gets (any) upside.  However I want to take issue with Professor Krugman’s NYT editorial today.  Krugman accuses members of the incoming administration of believing in voodoo rituals to keep banks alive.  He takes a worthy shot at the person I most dislike amongst the continuing economic team (Sheila Bair).  But I still think Paul has his maths wrong.
Here is the key part of the article – with Gotham being a thinly disguised moniker for Citigroup.
On paper, Gotham has $2 trillion in assets and $1.9 trillion in liabilities, so that it has a net worth of $100 billion. But a substantial fraction of its assets — say, $400 billion worth — are mortgage-backed securities and other toxic waste. If the bank tried to sell these assets, it would get no more than $200 billion. 
So Gotham is a zombie bank: it’s still operating, but the reality is that it has already gone bust. Its stock isn’t totally worthless — it still has a market capitalization of $20 billion — but that value is entirely based on the hope that shareholders will be rescued by a government bailout. 
PK is wrong.  With sufficient trust Gotham is far from bust on PK’s numbers.  Suppose – and this is an understated assumption – that the normalised pre-tax spread on Gotham’s assets was two percent – say – and for the same of simplicity – the bank would earn 3% on assets and pay 1% on liabilities.
Then the bank (if it did not have the bad loan problems) would earn $60 billion on its (normal) $2 billion in assets and pay out $19 billion on its $1.9 trillion in liabilities.  The pre-tax profit of Gotham would be $41 billion dollars.
But – as Krugman suggests – the real assets of Gotham are not $2 trillion, but in fact $1.8 trillion.  The liabilities are (unfortunately) solid.  They remain worth $1.9 trillion.
Then – if the bank can continue to operate – it will earn $54 billion on its assets still pay out $19 billion on its liabilities.  Pre-tax profits will still be $35 billion.
If the bank runs for three years it will again be solvent.  If it runs for less than six years it will be fully and adequately capitalised.  This is in fact how the Japanese mega-banks recapitalised.  I blogged about it here.  At the spreads in America – which are several percent – the recapitalisation will happen much quicker than this and much quicker than in Japan.  Indeed it is likely that with quasi government guarantees for bank funding and market rates for bank loans the spreads would be over five percent in America right now.
Paul thinks the bank has value only because there is a perception that it will be bailed out.  I think it has value because it still has positive operating cash flow (provided it does not have a run).  The value - which I believe is large - might mean that widespread nationalisation is (ex-post) profitable for government - though it may not be profitable on an (ex ante) risk adjusted basis.  
Paul Krugman might consider it voodoo economics to give implicit guarantees to banks – but the Japanese experience shows – and this post explains – that things that stop a run will eventually recapitalise a bank.  It worked in Japan.  It was not a particularly pretty way to run things from a macroeconomic perspective – though people like Nihon Cassandra think that Japanese capitalism works pretty well.  
Paul is accusing Sheila Bair et al of voodoo economics.  I am inclined to agree with almost anything nasty about Sheila Bair.  But in this case PK is publishing voodoo maths.  
John Hempton

Sweden, Norway and a request for some decent macroeconomic models

Warning – non-stock post – mostly macroeconomics problems.

There is a debate online about what the Swedes did or did not do to bail out their banking system.  See Kevin Drum here and Steve Waldman here.  Having long followed the Scandinavian banks (and once having spoken for 2% ownership of Nordea – the former State Bank) I can confirm that Steve Waldman is closer to the truth.

However the best example is not Sweden – it is Norway – and a full history in English of their banking crisis can be found here – compiled by Norges Bank after their crisis.  

It is the single most useful volume anywhere on the Scandinavian crisis – even though it limits itself to Norway.  I gave a summary here.  

Can people read the Norwegian document before they start professing expertise on this stuff.  Please.  

I only point it out to raise the quality of debate, but more importantly I have an intellectual puzzle.

A lesson from the Scandinavian banking crisis was that you did not want to have a fixed currency.  To this day only Finland has pegged to the Euro – and Finland does not own any of its banks.  Norway, Sweden, Denmark and Iceland had their own currencies – and it has always been my belief – following the Norwegian experience – that if you want to have a banking system and avoid financial crises you better have your own currency.  The Scandinavian central banks would agree with that statement.  Indeed a good part of the problem of the Scandy banks this time is that they lend in the Baltic States – and those are small states with fixed currencies.

This time countries with their own floating currencies are having problems – notably Iceland.  Willem Buiter is pamphleting about the UK joining the pound as a way of avoiding becoming Reykjavik on Thames.  However we have Reykjavik on Liffey (Dublin) and they did everything in Euro.  

My guess is that Buiter is plain wrong – and Norway provides his counter-example.  Moreover the Iceland example that Buiter points to is misleading because the Icelandic banks did a lot of their borrowing in GBP and Euro.  

I find it odd that I am having academic debates with Willem Buiter about macroeconomics.  He might be the most famous macroeconomist in Europe and I did my last macroeconomics course twenty years ago.  Can someone help me out here with a simple model? 


Friday, January 16, 2009

HSBC are thugs (sorry “partners”)

HSBC has gotten a little aggro lately – an analyst dispute widely reported in the FT and other places.   By the standards of the story I am about to tell you the behaviour is quite genteel.  

I know relatively little about HSBC.  I thought they paid an absurd amount for a Taiwanese bank I understood really well.  I later met the guy who was responsible for the purchase and decided that I knew far more about the target than him.  Fortunately I was not short the target.

I never much liked Household (indeed I lost money betting that HSBC might come to its senses and not consummate the Household deal.)

I also had a fairly aggressive argument once with a colleague who wanted to buy HSBC.  But realistically I only knew about a few cockroaches and I wasn’t sure whether the place was infested.

This post is about a really nasty cockroach.  I will leave determination as to whether this is an infestation up to my readers.

The Bally Total Fitness scam

Bally Total Fitness was a favourite of shortsellers.  I sold it short myself and made good coin.  It was a simple scam.

The company ran gyms which had seemingly attractively priced memberships.  Running fitness centres is a notoriously tough business.  Anyway these seemed to work – at least in an accounting sense.  

In fact the company scammed the customer.  Customers thought they were signing a month-to-month gym membership – but – and I am not joking here – they were signing a loan document – and there were huge penalties for not paying.  The documents were often non-cancellable.  The customers were misled.  

There was a website called (now defunct) which told the story.  They were sued by Bally and lost.  The story can still be found here and here amongst dozens of consumer rip-off reports on the web.

Bally managed to report not only overdue fees (for which the customer had falsely been induced to agree) as receivables – but they included penalties as per credit cards.  

Obviously collection was a problem.  Bally filed bankruptcy.

So what has this got to do with HSBC?

Well the Bally scam required a collection process.  It required thugs to go chase the delinquent “loans”.

HSBC provided the thugs – and surprisingly – given the thuggish nature of the activity they have never been pulled apart in the financial press for it.  They didn’t doing it using the glamorous HSBC name.  No it was Orchard Bank.  They used to ring up the customers and say they were a partner of Bally.  Sometimes HSBC purchased this debt (according to Bally at par) which suggests that their due-diligence was lacking.

They were the debt collectors for Bally’s fraudulently obtained loans.  Standover men if you will.

But I will use the word of the HSBC/Orchard debt collectors.  They were “partners”.  Indeed the partnership extended more widely and there were over 100 thousand credit cards issued by Orchard to Bally customers.  

Do you judge someone by their partner?  In this case it was Bally’s customers who were "consummated" in the relationship.

John Hempton

Thursday, January 15, 2009

Riots in Riga

There are times that I would prefer not be right

In the single most famous post on this blog (Hookers that cost too much) I predicted middle class riots in Latvia.  

It is happening as you can see here and here.

Book review – Gerald Stone’s Who killed channel 9?

For the non-Australians out there - Channel 9 is the once dominant TV network in Australia with a "galaxy of stars".  It had the largest revenue base and the largest profit.  It has lost both positions.  It was once owned by Kerry Packer.  It is now owned by private equity firm CVC. 

This is a highly parochial book for me to review – but hey – I do media stocks as well as financials – and Channel 9 is a very salutary lesson.  Further Channel 9 is likely to come back to market as the LBO which owns it likely has trouble.  When you read this book keep in mind the main commercial difference between print and TV.  In print if you do not like what you see you turn the page.  In TV you change the channel.  In print the media company keeps the customer.  On TV they just lost them.  It is the fundamental difference in driving programming and management style.  

And this book is fundamentally about managing a mass-market TV station – a job which – as a first requirement – ensures that people don’t change channel.

As it about management let me start with a management story.  This I think is the key to determining the ultimate success of a big media conglomerate – and it is one of the hardest things for a bean-counting stock analyst (me) to do well.  

Steven Spielberg’s flop and some lessons

Once Steven Spielberg made a commercial flop.  The film was 1941.  The next film he had a constrained budget.  It was Raiders of the Lost Ark.  When making that film they ran low on money – and they had a scene which was going to cost the then princely sum of $2 million to shoot.  Senior cast and crew sat around trying to work out how they could do it for cheaper.  The problem was that there was a baddy out there who Indianna Jones just had to get past – and there was going to be (another) over-the-top battle scene.

Harrison Ford suggests “why don’t I just come out and shoot him?”  Everyone rubbished the idea – it was going to make the hero (Indianna Jones) look like a callous thug, not a swashbuckling Errol Flynn.  But Harrison Ford pulled it off with the appropriate level of disdain – and it is the single funniest moment in the film.  

Now this lets you know what Hollywood has known for a while – which is that Harrison Ford really is a genius.  

But it tells you a few other things:

  1. Budget and artistic (and even commercial) relevance are only weakly correlated, and

  2. Actors, mid ranking staff and all sorts of other people when working collaboratively in an atmosphere of trust can make fabulous decisions which add to the bottom line.
No Taylorist management school or top-down bean counter is going to achieve this.  What is required is a fairly hefty level of trust and mutual respect.

Bean counters and the Nine network

The theme of the book is what happens when a Machiavellian bean-counter is put in charge of a creative enterprise.  That bean counter is Gerald Stone's anti-hero – one John Alexander.  JA runs a minimalist aesthetic lifestye – he is married to a famous photographer and reads high-brow books.  He was a successful print executive and never really got the difference between print and screen.  

It is not that someone like JA wasn’t needed at Nine.  Entertainment figures at a highly profitable enclave (and Nine was such a place) can become ludicrously indulgent.  They are amongst the few who can match hedge fund mangers for seeming petty indulgence.  And even that is alright whilst everything is going well.  But Nine faced the pressure that free-to-air media companies have everywhere – new media and a fracturing audience and advertising market.  

The problem is how do you keep camaraderie and appropriate teamwork whilst ripping out costs?  In other words how do you get Harrison Ford to just come out and shoot him?  

When I put it this way I know why I don’t manage (and never want to manage) a large media company.  It is REALLY hard.  You need to be a hard bastard who people respect (to keep the costs under control) but you also need to inspire the sort of team loyalty that keeps the creative types (who are peculiarly hard to manage) happy and productive.  The people in the industry are paid very well (five to ten times average wages does not appear uncommon) but – except for a few – they are not paid like hedge fund managers.  

It is about as far from managing Walmart as it gets.  Walmart burns through literally millions of staff members (associates) and has a system which keeps their training and hiring costs low.  They would like to build team camaraderie – but not at the expense of paying substantially above minimum wages.  (If you are interested compare to Costco.)  

A lot of America has a first-in, first-out attitude to hiring and firing so expensive (senior, older) people get fired first.  In many industries this is shareholder friendly – but it doesn’t build a sense of lifetime belonging as per Japan.  [Sacking older-female on-camera staff however appears as prevalent at Nine as anywhere in the media.]

Australia has produced a fair number of the likeable and inspiring hard bastards required for the job of managing media companies.  They are throughout News Corp – and are part of the Rupert Murdoch success story.  Rupert himself is one of them – and from what I know the key son (James) has the right stuff.  (Lachlan seems more intellectual - and a little less hard - but that is the perception of someone who has met him only twice even though he lives 200 yards away.)  

Kerry Packer – who controlled Nine until his bad health caught up with him – was of the same type.  Intelligence is not the defining requirement (though it helps).  It is about personality.  Some of the best media executives (Sam Chisolm springs to mind) keep an office which looks like an extended bar.  They drink with the staff – but decisions are made, handshakes are honoured and the staff feel they belong and are valued.  

The book contains a number of Kerry Packer anecdotes.  Anyone who dealt with the (truly frightening) man has them.  Here is an oft told story about Kerry Packer which is the sort of stuff that produces both the requisite fear, loyalty and creative inspiration needed to run a media company.  I quote:

Channel Nine's brilliant head of entertainment, Peter Faiman, remembered that the hardest thing he ever did in his career was to try to tell Kerry he intended to resign to work for Rupert Murdoch. Packer kept demanding to know what Murdoch at Channel Ten could do for him that Channel Nine couldn't. 

At every excuse - more money, wanting to do something new, establishing his own business - Packer kept hammering away with just one powerful line: "I can fix it."

Faiman felt more and more desperate until Packer, the master negotiator, finally brought the tense confrontation to a head.

"So son, what do you want to do now?"

"Oh, Kerry, please, I feel like shooting myself."

Faiman will never forget the next moment. Packer reached into a drawer, pulled out a huge western-style six-shooter and slammed it down on the desk in front of him. 

"Well, I can fix that, too," he smiled.
Well JA might have been the bean-counter that Nine needed – but in Stone’s view he was the Machiavalian anti-hero – the guy who dismantled the culture that made Nine great.

Its hard to see who Packer (probably the younger James who ran it whenever Kerry’s health packed up) should have appointed to do the bean-counter job – the guy that could keep the creative baby whilst throwing out the expensive bathwater.  One executive I can think of is David Hill – then a Nine sports executive – now running Fox Sport for News Corp after a stint as head of programming for DirecTV.  That job requires a lot of negotiating with over-priced sports content providers.  Still whatever – JA had only half the skills required for the job in Stone’s view.  Peter Faiman (The guy who did not shoot himself) should also have been a candidate.  Faiman runs FX for Rupert these days.

Handshakes and stock analysis

Gerard Stone makes the point that once upon a time a handshake was the bond of Nine.  A deal was negotiated with talent (a small production company for a TV special for instance – of with key staff) and cemented with a handshake.  Contract details were drawn up later – but always reflected the handshake deal.  As the internal politics of Nine became worse the handshake became less and less honoured to the point of full dishonour.  In individual deals (screw-overs really) this deal saved Nine money – and added to the bottom line.  But over time it increased the cost of negotiating and (more importantly) created an us-versus-them culture between creative staff and management.  The loss of the handshake as deal was symbolic of the control of the legalistic rather than creative bean-counters and the symbol of the demise of the Nine dream machine.  

Staff turnover is common enough at media companies.  Creative types get fired.  Programs get axed.  Its not a good sign – it pleases me that Jim Gianopoulos – the key executive at Fox Studios – has been there so long – especially as his touch looks so golden.  But firing and change is not necessarily bad.  It leads to renewal.  

If the media types who read this blog – and I know there are a few – could tell me which execs do not honour handshakes – it would be much appreciated.  It would help with the stock anlaysis.

Bean counters and private equity

Now having read a book which was really a few hundred pages of well argued diatribe against John Alexander I have to leap to JA’s defence.

Packer junior sold Nine to private equity.  He did it with indecent haste after daddy died.

He got a fantastic price – and CVC who run the place have probably done their dough.  

JA still works for James Packer – and remains highly respected – albeit disliked by many.  

If the goal was to keep as much of the super-profitability of Nine throughout the next twenty years of fracturing media audiences then JA almost certainly was the wrong man to do the job.  But if the job was to strip costs, keep the contract negotiations in check – that is to promote the bottom line above audience and by implication the bottom line over production values – then there is little evidence that JA failed.

And the billions that young James received for the network is proof of that.

So maybe private equity more generally could be Gerald Stone’s anti-hero.  The desire to flick Nine for lots of money to dumb buyers might be the ultimate answer to Gerald Stone’s whodunit.  

Some hope for the future

Nine – at least the CVC buyout version – has some financial difficulties.  They may or may not be terminal.  But now David Gyngell – a true media creative exec – is back as CEO.  Gyngell may have been best man at James Packer’s wedding – but I think he was probably as close to Kerry as James.  He certainly shared Kerry’s love of TV.  Whether he is the fully fledged inspirational hard-assed bastard required for this job – well I will leave that to people closer to the situation.

The appointment of Gyngell reflects well on CVC.  So I probably am over-stretching to paint private equity as the villain.  In the intersection of finance and media remains more complex than that.  And that is why media stocks are such fun.


Post script: boning Jessica Rowe

I can’t review this book without mentioning the single most famous incident in the demise of Nine.  Mark Llewellyn was demoted as head of news and current affairs and told to eat a “shit sandwich” by management.  He left for a competitor and was sued for breach of contract.

His sworn affidavit included all sorts of juicy bits including editorial interference in news by JA.  In Australia that could cost the TV station its license.

But the most famous bit of the affidavit was the instruction to sack Jessica Rowe – the attractive – but no longer in her 20s host of a fading morning show.  The phrasing: “what are we going to do about Jessica?  When should we bone her?  I reckon it should be next week.”

The expression to bone someone has become so widespread since in Australia that it rates a mention in the Macquarie Dictionary of Australian English.

If you really want to amuse yourself – and you are seriously interesting in media – the Llewellyn affidavit is here.

Jessica Rowe and Eddie McGuire later made up for the cameras.  

Tuesday, January 13, 2009

How diabolically desperate are the oil exporting states?

The oil market is currently in super-contango.  That is the forward prices are much higher than current prices.

Usually speculators fix this.  Buy oil now, store it, sell it forward and make a profit.
But the easy storage is full.  The WSJ reports that people are buying tankers to moor off the coast of Scotland to exploit the arbitrage.  It looks to be a surprisingly good trade.

So given the storage is full it is possible that the super-contango exists.  However a super-contango has implications – both for investment and geopolitics.  This post explores those implications.

What is happening in the oil exporting states?

Not all storage is full.  Most oil is stored in the ground.  It has been for hundreds of millions of years – and the ground storage is mostly stable.  

Surely the oil exporting states (Russia, Saudi Arabia, Venezuela etc) can store the oil and release it later – and hence take advantage of the super-contango.  

But for some reason they are not doing so.  I have a couple of theories:

Theory 1: the oil exporters are diabolically desperate for cash

The most obvious theory (not necessarily correct) is that that oil exporters are diabolically desperate for cash.  They can’t defer today’s cash receipts for much bigger ones tomorrow.

Usually if you have a really good investment idea (oil storage appears to be one) then there is finance available.  But seemingly there is no finance and Gazprom amongst others has liquidity issues.

We know about Gazprom – but most of the oil exporters – certainly the ones alleged to have excess capacity to bring the oil to the surface in the future – are in the Middle East.  If they are all that diabolically desperate for cash it has geopolitical implications.  Collapsed economies are not pretty.

Theory 2: there is insufficient extraction capacity to bring the oil to the surface in the forward period and hence take advantage of the contango

My second explanation is that there really is no ability to store oil in the ground this month to extract extra oil in (say) 18 months because the exporters are short extraction capacity.  This seems unlikely.  Opec claims it is cutting back production – which implies they are leaving some capacity idle.  They could however by lying.  There might not be all that spare capacity around.

In which case you want to get really long the drillers and anyone else who provides oil extraction capacity.  

I have no third explanation.  But in summary either the oil exporters are diabolically desperate for cash (and their economies are about to totally fail) or OPEC is lying about oil capacity and they are really constrained – or a combination of the above.

If anyone has a third explanation I am really keen to hear it.


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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.