Monday, March 2, 2009

HSBC are to blame

Of all the ways to lose money – one of the most painful is to be right and lose money.

It doesn’t happen to unlevered longs.  If you have no leverage (financial and operational) you can buy a share – and if it goes down on the way back up you will be fine.  If you are a trader (who almost always operate with some leverage) that won’t help you.

But on the short side you can be in a stock which goes from 10 to zero via 20.  That is what happened to me with Conseco.  I held on – but it was painful.  Very painful.  In some instances (notably Calpine) I did not do much of a job of holding on.

But even worse is when some bozo idiot (in my case the idiot was often Sir Fred Goodwin) comes in and buys the company out at a massive premium when you are short it because of looming disaster.  Then you can’t recover (except perhaps by shorting the bozo idiot acquirer).

My story

I once shorted Household International from 50 to 20 via the mid 60s.  It took a long time to play out and for a long time I was losing money.  

I covered – not for any particularly good reason but that I wanted my capacity for other shorts.  

HSBC came in and bid for Household subject to due diligence.  I thought that they would find enough on due diligence to make them run (and run and run).  So I reverse arbitraged the takeover – going long HSBC and short Household in the hope that HSBC would come to its senses.  In this case if I was wrong the deal would close and I would lose the spread.

If I was right Household would probably have failed right then.  If HSBC thought Household was not worth buying then its doubtful anyone else would have financed it.  

So if HSBC had come to its senses then I would have made a little over 100% on my position.  Fantastic really.  

But HSBC were bozo idiots and they completed the trade.  I lost the spread.

HSBC are now forced to raise huge amounts at a highly dilutive rights issue to make good the losses.  But their pain does not refund my clients.  Intellectual satisfaction is nice – but I really would prefer that refund.

A counterfactual

Had HSBC done a proper due diligence on Household and understood what they were purchasing they would never have done the deal.  I would have made out like a bandit.

Household – then the biggest subprime mortgage company in the world - would have failed in 2002.  

People would have (correctly) understood that subprime mortgages and securities backed by subprime mortgages were dangerous.  The capital markets would have been (far) less open for dodgy mortgage paper.

And the mess we are in today would thus be far less intense.

The real purveyors of moral hazard

People deride governments and central banks for bailing out bad banks.  The critics argue (fairly) that those bailouts encourage risky behaviour (by failing to punish it) and hence make the next crisis far worse.

All true enough – but by far the biggest bailout last cycle was the bailout of Household – the world’s biggest subprime mortgage company – by the respectable HSBC.  

By contrast the US Government let Ameresco, Conti Financial and a few other mortgage companies fail.  Compared to Household however these companies were tiny.

HSBC are the villains here.  They provided the assurance that got this subprime mortgage thing really rocking.  They are who you should blame.

The shorts

There is a lot of nasty things said about short sellers.  And short sellers say a lot of nasty things about the companies that they are short.

I said nasty things about Household to anyone that would listen.  I had a bet with a UK analyst that HSBC would close or let Household (which was not guaranteed) fail before 2007.  I lost.

But sometimes – just sometimes – the world would be better off if short-sellers were taken more seriously.



Tanmay said...

HI John,
why were you long HSBC? Maybe i am missing something.

John Hempton said...

They were buying Household for stock.

I was long HSBC short Household.

When the deal closed then my short Household position converted into a short HSBC position. As I was already long HSBC that meant I did nothing except deliver the HSBC shares.

If the deal did not close (which was my hope) then HSBC would go up (removal of the takeover effect) and Household would go to zero.

But the deal closed and I lost money.

Anonymous said...

HSBC didnt need any due diligence John, as Sir Bond said at the time they had a "room full of PhD's who KNEW how to default rates were going to turn out"

Anonymous said...

In defence of the rest of HSBC...

As an HSBC employee at the time, what I remember in the run up to the household aquisition was the number of US financials that HSBC were linked with and did not buy.

I.e. it always seemed that they would go for some kind of trophy buy in the US, household at the time felt like the least bad option.

Leaving household and the US aside, my impression was that HSBC's strength was to execute bread and butter retail and commerical banking in difficult conditions (e.g. asia crisis, brazil, argentina etc). Those kind of skills could be valuable again now?


John Hempton said...

The bread-and-butter banking in difficult conditions is the best bit of HSBC.

I agree.

Household was a spectacular own goal. They paid one sixth of the company in stock.

The losses forced a capital raise (5 for 12) and hence increased the cost of the acquisition above half of the whole of HSBC.

Big mistake that. Not quite ABN Amro - but one of the worst acquisitions in banking history.

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