Newsflash: Spain looks dicey

If it were not for Fannie Mae and Freddie Mac going insolvent this would be the biggest financial story in the world today.

Spain can’t sell its sovereign debt reported here and here. The spreads of Spanish bonds of German Bunds is still small - so this is a warning shot. But it is a shot that rings very loudly at Bronte Capital.

Background

Spain is a current account deficit country with large wholesale financed banks. If you can’t sell Spanish sovereign debt the you shouldn’t be able to sell Spanish (mortgage) covered bonds. Moreover it is a current account deficit country with a permanently fixed currency (it gave up the Peseta and joined the Eurozone).

A while back the most liquid bank stock in the world wasn’t Citigroup or JP Morgan – it was Santander. The second most liquid bank stock in the world was BBVA. These are giants.

They are highly dependent on wholesale funding. If they can't raise wholesale funds they will come close to failing - and Spain will wind up in a horrid recession.

And it is very hard for the Spanish government to bail the mega Spanish Banks out because the Spanish government can’t print Euros. (Being unable to print a fixed currency is part of a model for bank collapse I will deal with in some future posts.)

If the Spanish can’t bail out their own banks I guess the Bundesbank (I mean European Central Bank) can – but that would be a call on German taxpayers to bail out the Spanish.

Of course the Eurozone could collapse. Spain can then go back to its old ways printing pesetas.

Alternatively this could all wash over by next week. But the implications of the Spanish pulling sovereign debt auctions are pretty horrible. Even if the spreads remain under 50bps.

Watch this space...

Deflation and bank bailouts in Japan

Given what is happening with Fannie Mae at the moment I should share a little of the history of non-US bank bail outs. I will start with Japan and later do Scandinavia.

Japan was an unusual bank collapse. It happened despite excess savings in the system. This is really strange. Most bank collapses happen when there is a lending binge that drives excess or investment or consumption and with a current account deficit. (See for instance Korea – where there was excess investment or Argentina where there was excess consumption.)

Japanese banks always had (at least collectively) sufficient deposits. [See my post on 77 Bank to see just how much excess deposits they now have.]

But the Japanese banks lent very badly indeed. Part of this lending was to the "Zombie companies" but most was on property. The formalised golf-club membership exchange in Japan at one stage was worth a good multiple of the entire Australian stock exchange (including giants such as BHP and Conzinc Rio Australia). Golf club memberships were of course a pure-play method of speculating on land.

But you need to notice that the Japanese bank collapse looked very different from what is going on in America now. The Japanese bank collapse was not a collapse of funding – it was a collapse of asset values and solvency. [Exceptions noted.]

American financial institutions are now having wholesale funding runs (or finding wholesale funding is unavailable which amounts to the same thing). Japanese financial institutions did not need wholesale funding (most had deposits) and hence by-and-large did not have runs. [There were some institutions such as the long-term-credit banks and similar institutions which had wholesale funding – they were effectively nationalised.]

Many Japanese regional banks (Nishi Nippon for example) were breathtakingly insolvent at the height of the crisis but they remained liquid because they had plenty of deposits. Because they remained liquid they never actually failed.

The zero interest rate policy

Insolvent but liquid banks are the key to understanding Japanese interest rate policy. There are several prominent macroeconomists in America (led notably by Krugman but joined by Bernanke) who argue that the zero interest rate policy was insufficiently expansionary – and that monetary policy should have been eased until it induced inflation. In theory this could be done by flying a helicopter over Tokyo throwing out freshly printed 5 thousand yen notes. Indeed it was in a speech about Japan that Bernanke uttered the famous helicopter line.

The BOJ always thought this policy was “risky”. Krugman’s response was that it was less risky that the endless government deficits Japan ran. Krugman missed the point – the question was who was inflation risky for? My answer: the banks.

A hypothetical insolvent bank

Imagine a hypothetical insolvent bank. Suppose the bank has 90 in funding, 10 in “stated equity” and “stated” 100 in assets. [I have left the currency blank because this could be 100s of billions of yen or billions of dollars.]

And suppose that the assets are not really 100 but 70 good and 30 bad - and everyone knows about the bad assets.

Then the bank “really” has 70 in assets, 90 in funding and minus 20 in equity. This is a realistic picture of insolvent Japan in 1994.

If the bank was in a current account deficit country like America, Australia, New Zealand or the UK there would be an immediate problem. In a wholesale funded market the 90 in funding would be say 60 of deposits and 30 of wholesale funds – and the wholesale funding would leave. The bank would go insolvent quite rapidly (see Northern Rock which was very reliant on wholesale funding).

But in Japan the 90 in funding was all deposits and was sticky. The funding never left and the bank continued quite nicely. Capital market discipline was not imposed – and the hypothetical bank could pretend there was no problem for many years. Banks fold when they go illiquid - not when they go insolvent. No liquidity problem means no crisis.

But the problem is still real. Over time insolvency may turn into illiquidity.

Now suppose that (and this is a gross simplification) that the spread between deposit rates was 2%. But rates could either be 10 and 12 percent or 0 and 2 percent.

If the rates were 10% and 12% the 90 of funding would cost 9 per year. The 70 of “real” assets would yield 8.4 per year. The bank would be cash flow negative. Anything that is cash flow negative for long enough goes illiquid eventually. The insolvency problem would turn into a liquidity problem.

Now suppose the rates were 0% and 2%. The 90 in funding is free. The 70 in assets yields 1.4%. The same banks is cash flow positive in a low interest rate environment. If they are cash flow positive for 15 years the bank will fully recapitalise.

• Summary: zero interest rates were critical to bank recapitalisation in Japan.

The reason why the BOJ rejected the Krugman/Bernanke line was that it was risky to the banks and the BOJ (and the MOF) are totally captured by their bank constituency. It was risky not to the economy but to banks. [Note the practice of amakudari translated as “descent from heaven” where former government officials get to be CEO of banks late in their career.]

Why this form of bailout won’t happen in America

In America it is the wholesale funded institutions that are in the most trouble. Think Bear Stearns, Lehman, Fannie, Freddie.

They are in diabolical trouble.

The funding is leaving them. It does not matter whether rates are 0 or 10 – the funding is still going.

America will look far more like Scandinavia than Japan. Scandinavia was a funding crisis. The posts by Naked Capitalism and others suggesting that Japan’s wasted decade will be the new normal are just plan wrong.

Implications

I still have not worked out what side of the inflation/deflation divide I am. But the people that point to Japan as a likely outcome miss a point. Japan chose deflation because the alternative was nationalising the banks.

America does not have that choice. The American institutions are wholesale funded and hence will nationalised or fail if the wholesale funding disappears.

Nationalisation can be inflationary if it involves printing. The date the Federal Reserve is not printing – but Helicopter Ben has made clear that in Japan the BOJ should have printed. And the institutional imperative to stop him printing will not be present in America.

The Trading Post – a story of slow technological adoption

I walked into the local corner shop in Bronte. In pride of place there was a copy of the Trading Post for sale. Timber that had gone through crushing, bleaching, milling and other machines just to carry classified adverts.

The Trading Post is a specialist classifieds paper in Australia that has been around for a very long time. It is now owned by the dominant phone company (Telstra). It charges for adverts and charges for the newspaper which comes out weekly. It has classifieds in a few hundred categories. There is no content other than classifieds.

It is precisely what you would think the internet destroys. But here it is – still wanting to take your advert.

I should note that it is cheaper to place an advert in the trading post than it once was. The adverts are placed until the item is sold. The car adverts are cheaper than listing a car on Ebay (suggesting Ebay’s ever increasing prices are creating an umbrella under which dying businesses can shelter).

But all of that argues for an electronic trading post. But in my local shop precious retail space is devoted to a newsprint trading post.

Why? And what does this say about Ebay?

MBIA and GICs - a follow up

Heard on the Street takes exactly the opposite view of MBIA credit default swaps as me.

One hedge fund manager also emailed me with the same possibility – that the GICs issued by MBIA (and MBIA) will impact parent company liquidity through cross default provisions.

Not so fast

With Ambac it is easier. Here is a corporate structure of Ambac.

The GICs are written by the a subsidiary of Ambac Capital Corporation – not by the parent. They are reinsured by the main reinsurance entity. After that they are guaranteed by Ambac Financial Group (the holding company).

If the GICs get called Ambac has a simple option. Bankrupt Ambac Capital Corporation and pay out of the insurance company. It won’t touch the holding company liquidity provided that the holding company has not guaranteed Ambac Capital Corporation (which as far as I know it has not).

I believe the same structure applies at MBIA. Indeed this Moody's report notes that the GIC business is carried out by a separate subsidiary. If that is the case then the WSJ is straight wrong. It’s a little harder for me to identify the relevant subs because I have not read the contractual terms of any GIC. If you have such documentation let me know.

Reggie on GE

Reggie Middleton has done a fairly thorough analysis of GE. His picks as to the good bits and the bad bits is not dissimilar to mine. The worst bit is real estate - which he thinks deserves a big write-down.

None of the rest is seriously problematic - but he thinks it deserves low multiples. For some of that - fair enough. For other parts I think GE financial has some truly superior positions deserving of a higher than average multiple. But my disagreements here are minor.

He also puts relatively low multiples on the industrial bit - which he thinks grows but nothing like as much as I think.

In his uber-bearish way he gets GE being fair value now.

I think- and maybe I am just old fashioned - that the infrastructure bit of GE - which grows super-fast and has the most massive tailwind - is worth more than 5% market premium on the average American manufacturing company.

And if the blue-sky bits work (ESBWR reactors, Cameco JV, ultra light jet engines etc) then a 5% premium will seem very light.

And that is the extent of our disagreement.

If you are into GE I recommend reading Reggie's piece.

MBIA holding company credit default swaps

Warning: This post needs serious modification to be correct. Several errors are in it and (like most my opinions) should not be relied on. A follow up is here.

As regular readers know I have no opinion as to whether Ambac and MBIA are long-term insolvent at the insurance company level. I really have no idea whether losses will be 2 billion or 20 billion. [I am long the stocks as of a few days ago - but I have no opinion about long-term solvency and when I purchased them I thought there was a reasonable chance that the end-game for both companies was zero.]

I believe that losses will be lower than is implied in the market prices of mortgages, but higher than is indicated in the loss reserves of most banks. That is a very wide band – and for detail within that band you are reading the wrong blog.

I do have something to say about the insanity of the market at the moment. It is about MBIA parent company credit default swaps… I think people holding that parent company default swap are insane.

Background

It is highly unusual in the US for the parent company of an insurance company to guarantee regulated subsidiaries. Fairfax Financial has guaranteed TIG in exchange for getting some Odyssey Re stock out. However that is the exception rather than the norm – and the (California) insurance regulator got the guarantee in response to a specific deal.

Most the time it is possible for the parent company to go bankrupt without the insurance subsidiary (as happened with Conseco) or for the insurance subsidiary to go bankrupt without the parent company (as happened with Freemont General).

It is possible after the bankruptcy of the subsidiary for the regulator to sue the parent company based on fraudulent conveyance or some other rule. But the regulator has no prima-facie right to go after the holding company. (The California Commissioner sued Fremont General arguing fraud. Fremont settled for a large sum of money - but the holding company is still not on the hook for the insurance company liabilities...)

So how is it with MBIA?

MBIA holding company to the best of my knowledge (and having read a few statutory statements) has never guaranteed the insurance subsidiary.

MBIA holding company has well over a billion in cash (including the recently raised money). It got this with its recent capital raising – and was originally going to inject that cash into the regulated subsidiary to maintain the AAA rating.

The rating agencies told MBIA that would not be sufficient to maintain the rating and so MBIA kept it at holding company. The insurance commissioner is peeved – but there is little he can do unless he can prove fraud.

So the MBIA holding company is loaded. Indeed the net cash holdings of the holding company is slightly larger than all holding company obligations. At some point (somewhat lower than here) MBIA becomes a Ben Graham stock.

The point however is that it is highly unlikely for the holding company to go insolvent. Moreover almost all of the holding company debt is due after 2012 – often quite a long time after 2012.

The credit default swaps on the holding company imply a very high chance (well over 50%) of holding company insolvency.

Is everyone mad?

How can MBIA holding company go bust?

I can think of a few ways the holding company can go bust:

• Well the first way that the holding company can go bust is to inject the holding company money into the insurance company and not be able to get it back. That is what Whitney Tilson – a vocal short – wants to happen. It is also what the insurance commissioner wants to happen but the insurance commissioner motivations are different.

• The second way is that MBIA uses its holding company loot to buy back lots of shares at the current price – and runs itself out of holding company cash. Certainly MBIA has indicated that it is interested in buy-backs – but I doubt they are that interested.
  
  
• A third way is for the company to inject the money into a new (and hence AAA rated) subsidiary and not be able to get it out of the new subsidiary. Ambac is trying to do that with its existing subsidiary (Connie Lee). However that money is to come from the regulated insurance company and not the holding company.
  

• A fourth way is that the insurance commissioner manages to successfully sue the holding company. That seems unlikely to me – but courts are a crap-shoot and anything is possible.

There are probably other ways that the holding company can go bust. I don’t know them all. But the holders of the credit default swap are awful sure that holding company insolvency is inevitable. Too sure.

Full disclosure: the position in Ambac is many times as large as the small position in MBIA. More so after yesterday's trading...

Can someone explain why Fifth Third started taking brokered home equity loans?

Recently I chatted with Fifth Third management.

Fifth Third started taking brokered home equity loans late 2006. They took 2.7 billion of them. They also took loans out-of-footprint (that is where they had no branches). They took 900 million of them.

The loss-given-default (severity) of the home equity loans is rapidly approaching 100 percent on the whole portfolio but the default rate for the brokered loans is many times the branch originated loans even though the branch originated loans are in bad states.

The branch managers at Fifth Third have profit and loss accounts and are remunerated in part on them – so it figures that the branch managers were much more sensible than the brokers in rejecting patently bad or fraudulent credits.

But can anyone (please) explain the cultural change at Fifth Third that allowed them to take out-of-area loans through brokers?

Thanks.

John

Christmas in July: a falling US dollar is just a bowl of cherries

Australia is sweltering hot at Christmas. Everyone sits down with extended family when it is 40C (104 Fahrenheit) and indulges in an excessive roast lunch. Christmas is sweat and family dramas.

The saving grace of a mid-summer Christmas is cherries. The cherries are just coming on in December and are fantastic. You buy boxes at roadside stalls as you drive the long distances to your home town and eat half before you see your family.

A Winter Christmas

There is a new emerging Australian tradition – which is to have a winter Christmas celebration. Christmas in July is hams, puddings and wood fire. This new tradition is really strong amongst Australians who have spent some time in the Northern Hemisphere and pine for a white Christmas.

But Christmas in July is without cherries and that doesn’t feel quite right.

Until now.

On Saturday night my wife and I went to a delightful Christmas in July. This was a stylish affair with fairy-tale lights and good bubbly wine. And we took a bowl of cherries.

The cherries came from California. And they were $15 a kilo (say $7 a pound) at Paddy’s Market. Five years ago they were unaffordable. But then the US Dollar halved relative to the Australian dollar and now we have affordable cherries in the depths of winter.

Cherries and the US current account deficit

And as I indulge in another bowl of cherries I think the falling US dollar is wonderful. And so does some Central Valley farmer. Of course my (incremental) purchase of American cherries drives the price up for most Americans (poor you). And so in the smallest of ways there is a shift in the American economy from US domestic demand to exports.

Exports are the only part of the US economy doing well. Export driven businesses are shooting the lights out. (If you don’t believe me read the Federal Reserve’s Beige Book.) If there is a single really good global trend it is away from US domestic driven businesses and towards US export driven businesses. It is symmetrically against foreign businesses that compete with US exporters. (Think GE over Siemens, Boeing over Airbus.)

The Bronte Capital thesis on this is as follows:

• The US current account deficit is huge

• The subprime crisis has shown that you can’t endlessly and profitably lend to American consumers therefore the economy will need to shift to radically bring down the current account deficit.

• This means you need to avoid US domestic sectors and fall in love with US export driven sectors.

• Alas rising oil prices are driving up the current account deficit slightly faster than the changing terms of trade are driving it down which means we are only beginning on the export driven trend.

If you want a decade long trend its US exports.

You should be on it. And life will be a bowl of cherries.

A blog milestone

This is the fiftieth blog post - a completely arbitrary milestone.

I look in wonder at long-time bloggers who are up to 6000 posts. I have already had to correct one decent mistake (that I have identified). If you can identify more I am very happy to issue corrections.

Since I started tracking visitor numbers we have had 3788 visits and almost 6000 page views. (I did not track readers for the first few weeks - so total visitors are larger.)

There have been just over 2000 absolute unique visitors. That means that most people visit once and do not return.

If you have visited more than twice you are likely to have visited more than 15 times. Also I have about 80 subscribers using feed-burner - so there are some loyal visitors. (The feedburner subscribers do not count in the visitor numbers unless they click through to something.)

Visits come from 672 "cities" in 58 countries. The cities are as defined in Google analytics and include what most people would call suburbs. The biggest concentrations of readers are in the United States, the UK and Australia in that order. Within the US the concentrations are New York, Connecticut, Chicago and New Mexico.

All of these numbers are beaten in a single day by popular blogs. I don't yet have a technorati rank - but Wikio ranks me as the 20,677th most influential blog on the web. There are relatively few investment blogs in the top 1000 but a lot of dodgy blogs have rankings very much higher than mine...

The most popular post is the first post on Barclays. Google correctly identifies that and links to it when you google Bronte Capital.

The second most popular post is the post about the fraudulent hedge fund in Santa Fe. As stated above I have a cluster of readers in New Mexico. Many of those readers lost money in the scam. Its been quite disconcerting to know how hard it is to raise hedge fund money as an honest hedge fund and how many people will willingly give their money to a total fraud. There is something there that I am learning about human nature.

I would like to know more about my subscribers and regular readers. Drop me an email.

And thanks for reading.

John Hempton

PS. There have been 7728 advert impressions served by Google on this blog. Only 32 of you have clicked. My impression - Google targets the adverts very poorly. More about that in a later post.

A correction on Sydney Airport

My post on Sydney Airport missed an important part of the capital structure.

Sydney Airport debt structure includes 1.45 billion in redeemable preference shares stapled to the ordinary shares (held by Macquarie Airports) and hence which are justifiably considered equity. Funnily I knew this from past looking at the accounts and had forgotten it. This is also very typical of Macquarie structures so I should not have missed it.

The coupon on those RPS is 13.5%. The negative cash flow of the airport is roughly the coupon on those debts. Indeed if you don’t include the coupon on the RPS as an interest cost then Sydney Airport was slightly cash flow positive including capex during 2007. That was also true in 2005 when the Airport did minimal capex.

If we were to restructure the RPS as equity (which is fair enough as it is subordinated and stapled to the equity) then Sydney Airport is solvent with flat traffic volumes for a few years. However to be worth anything to MAP holders it remains true that revenue has to go up and hence traffic volume has to rise for Sydney Airport to pay the coupon on the subordinated debt – let alone anything on the equity. It remains true that Macquarie has figured rising traffic volume over the long term into its thinking and it remains true that the oil price is causing them issues.

Sydney Airport will still be insolvent with a large fall traffic volumes but a few years of flat to slightly declining volumes is probably supportable provided that there are no short term maturities and the coupons on the subordinated debt get halted. (The listed entity - Macquarie Airports - would still get smashed under these circumstances - but the bond insurers would be OK.)

It also remains true that the debt of Sydney Airport has gone up more or less every year since the Macquarie takeover - and the distributions have been funded by debt.

That can't continue with (a) bad credit markets or (b) falling or even stable traffic.