I used to be a public servant - but I couldn't have written this!

This link will find you an English Language version of the Memorandum of Understanding (MOU) on how the Swedish, Latvian, Estonian and Lithuanian central banks will work together to solve a financial crisis.

The MOU is a exercise in deliberage vagueness in the mould of central bankers almost everywhere.

Enjoy.

Yesterday's post: a short version

I was discussing yesterday's post with a hedge fund manager (HFM) who gives that useful (and false) impression of being not too bright.

I starting explaining the Swedbank thing to him. You could tell he was only half listening.

Until I got to the statistics for Latvia. His ears pricked up when I said the current account deficit was well over 20 percent of GDP.

HFM: "Who are they stealing that from?"

BC: "Swedbank"

HFM: "So why didn't you say so?"

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Well there is a reason that I didn't say so - which is that you wouldn't believe me if I posted the short hand. But what a 2o percent current account deficit means is that the AVERAGE PERSON spends 20% more than they earn.

This is of course impossible unless they are not going to repay it.

Borrowing without intention or ability to repay is the economic (but not moral) equivalent of stealing... and it doesn't matter what currency that borrowing is in...

This "theft" is so large that Swedbank is nearly insolvent.

And Swedbank management are steadfast in their belief that nothing is fundamentally wrong. Well they would say that, wouldn't they...

Further comments and corrections on yesterday’s post

As expected yesterday’s post drew more reaction (and visitors) than any previous post on this blog. There are a few corrections to make (mostly minor). But I should also share with my readers a taste of the comments that came through the mail.

The only really substantive comment – which came both on the blog and through the mail – was that I underestimated the importance of lending in Euro (rather than Lats) in Latvia (and presumably the other Baltic states).

That is fair enough. Consumers can have a high price loan in Lats or a low price loan in Euro. They take the low price loan in Euro.

However if the currency suddenly halves a lot of distressed borrowers (and I will prove over the next few days that they are distressed) will suddenly owe twice as much as they previously owed. Hansa Bank will then implode in credit risk. Credit risk, currency risk – you pick your poison…

It all reminds me of a flight I was once on between Singapore and Sydney where I sat next to the regional head of credit for Citigroup. He was the perfect upper-mid-level executive – and would only talk about the distant past. However he pointed out that many risks that banks face are equivalent in extrema. For instance if you have lent to people in a currency where interest rates suddenly go to 50 percent (as happens in some devaluation crises), your funding cost (deposits) will rapidly go to 50%. However if you pass that on to your borrowers they will fail. You will suffer credit risk and possibly go insolvent. If however you have offered fixed loans to your borrowers you will wind up with huge funding mismatches – and possibly go insolvent. For small moves there is a difference between credit risk and interest rate risk. For large moves there is no effective difference. The same analysis applies to currency and credit risks.

The second set of comments came down to whether it was possible for Swedbank to go insolvent even if Hansa were a complete disaster. Swedbank has about 40 billion Swedish Kroner in Hansa (including both debt and equity stakes). Swedbank has tangible capital closer to 50 billion Swedish Kroner. If everything goes to zero (which it won’t) then Swedbank still has tangible equity they would argue. And Hansa – no matter what happens – will get some recoveries.

That may be right. Swedbank will look considerably worse than Washington Mutual does now but it may be solvent. Indeed WaMu has blown up considerably less capital than Swedbank does under any variant of that model. But then I think WaMu is solvent. (Regular readers know I own the subordinated debt.)

I used to think – and I made it clear in the post – that Swedbank probably survived. After their conference call and the lack of indication that they will ever pull the plug – I now think they probably fold. However if they pulled the plug now and were straightforward with the risks they were taking the stock would almost certainly stay above zero. [Memo to Swedbank management – now is your time.]

Thirdly there was some objection to my characterisation of the Latvian economy as being driven by sex tourism. Thailand would have a similar objection. But there was a more politically correct way of saying it. One reader wrote:

“A pint of lager costs the same in Tallin as it does in Mayfair, despite earnings power being 4-10x higher in the latter.”

You could argue similar about property prices...

Some noted that I got the currency crises confused when I talked about the fall in the Thai Baht. I did. The Thai Baht only fell by about 60%. The Rupiah fell something between 80 and 90. I never traded anything in Thailand – but I did buy HM Sampoerna near the base of the currency crisis in Indonesia – so I remembered the good side of this (buying really cheap assets). The exact fall is a detail lost in my memory. And I wish all my stocks could be Sampoernas...

Several noted that there was little new in my post. One sell side stock analyst from Scandinavia said that there was nothing new in my post – quibbled about minor errors – and said that it was what he believed but he wasn’t allowed to be so blunt. Several pointed out that the uber-bear Roubini has been saying the same thing. He has – albeit less with less colour!

There were several comments from people who had lived through the Argentine crisis who thought that I had the character of crises spot on. There were a few people from the Baltic republics who didn’t feel it was inaccurate though quibbled about minor details.

Some people noted that the biggest risk to a short position was the geo-political significance of the Baltic States. Simple question: if there is a crisis do you think Putin will take advantage?

And that I think is the real reason this situation is allowed to go on. Nobody thinks the economy of the Baltics will collapse without Western bailout. They are watching the geopolitics. And maybe they are right. I don’t do politics very well.

Further comments much appreciated.

Hookers that cost too much, flash German cars and insolvent banks: an introduction to Swedbank’s Baltic homeland

I have been sitting on this post for a while. It helps if you read my post on the Norwegian bank collapse before you read this.

But otherwise enjoy a post that breaks all the rules. I am loudly calling the likely collapse of a politically sensitive country. Its one of those circumstances when shouting fire can cause the tragedy. To some extent I take comfort in my low readership.

I promised when I started this blog to have a global focus. I haven’t mostly because the most interesting story around is what is happening in the US financial market. But I hope to remedy that in this post as I give you, dear readers, a financial tour of Sweden, Latvia, Estonia and Lithuania.

I shouldn’t shout this story – but it is such a good story I can’t resist. The title is a little sensational too – but not unfair.

Before I start I need to introduce you to a model of bank collapse.

The fixed currency model of bank collapse

First observation: banks intermediate the current account deficit

· Countries that run big current account deficits have banks with loan to deposit ratios above 130. (See Australia or New Zealand for examples.)

· Countries that run big current account surpluses have loan to deposit ratios of 70 or less. (See my post on 77 Bank for an example.)

· Another way of saying this is that banks in current account deficit countries are generally reliant on wholesale funding. [It’s the crisis in wholesale funding that is causing the problems in American banks now.]

Second observation: fixed exchange collapse with currency runs

When a country has a fixed exchange rate that is too high (evidenced by unsustainable current account deficits) they become subject to runs on the currency. This happens as follows:

· Some speculator (eg George Soros) shorts-sells the currency and buys whatever it is fixed to. They do this by borrowing the target currency or by withdrawing lending in the target currency.

· They then take the borrowed currency and give it to the central bank/currency board who swap the domestic currency for foreign reserves at the fixed exchange rates. In doing so they reduce domestic money supply causing short term interest rates to rise. If they do this enough they induce a recession (ugly). This creates pressure (political and otherwise) for a deviation.

· Alternatively the central banks sterilises the money supply change. However if they continue to do this they will run out of foreign currency reserves – and the fixed exchange rate collapses anyway.

Many a fixed currency has been broken this way. George Soros did it with the pound. Nameless speculators did it across Asia. The Mexican Peso and Argentine Peso both had fixed currency pegs that didn’t hold.

Third observation: a currency run results in the banks being de-funded.

· Given that most the lending in the “target currency” is to banks and the banks in current account deficit countries are generally dependent on wholesale funds – the run on the country causes funding pressure to banks.

· This funding pressure when it is particularly intense will cause those institutions most dependent on foreign currency to become illiquid and hence collapse. The currency crisis morphs into a run on bank wholesale funding.

Past currency crises have been associated with bank collapses. In Thailand (which was precisely to this model) the finance companies actually collapsed and the banks almost collapsed. In Korea both the banks and currency collapsed.

But you need to be really careful of countries with fixed exchange rates and huge, unsustainable current account deficits.

Never much fun shorting the banks in such countries

If you had picked the collapse of the Thai Banks you might have cleverly shorted the stocks. It would not have helped much. Suppose you shorted $100 worth of a Thai bank. It collapsed down 95% (corrections in the comments). So you had $95 in profit. The only problem is that you have the profit in the pre-crisis exchange rate. The currency also dropped almost 90%. So you were left with about $10 profit. That is fine-and-dandy but it is not much reward for effort of picking a system that is about to collapse.

You would of course be much better just shorting the currency – or shorting the ADRs of the target stock (the ADRs being priced in a hard currency).

The real exception is that if you find a bank in a hard currency that is totally exposed to the debacle country you can make a fortune. You can guess now that Swedbank is my bank. It is not the only one – but is very spectacular.

Current account deficits, fixed exchange rates and Eastern Europe

Eastern Europe is full of vulnerable currencies. Most of the countries have fixed their exchange rate to the Euro (hoping I guess for Euro membership at some stage) and have massive current account deficits.

Latvia is particularly bad. The exchange rate is pegged (as per this page from the central bank of Latvia). The current account is enormous, almost 25% of GDP. There is no doubt whatsoever this exchange rate is not sustainable. Not close.

As the Latvia economy watch blog will point out Latvia is suffering the results of the beginnings of the credit crisis caused by fixed exchange rates and a run on the capital account.

Estonia is not much better. It too has a large current account deficit and its currency (the Kroon) is also fixed to the Euro.

Estonia’s economy is also suffering the effects. The current account deficit never got quite so bad in Estonia – but it not pretty.

Lithuania is a little better – maybe only marginally more unsustainable than the United States.

Manifestations of the Baltic madness

Argentina in the days of the fixed peso was a party for the middle class. The middle was the main beneficiary of the fixed currency – and when it was over the middle class rioted.

A similar party is visible in the streets of Riga. Mercedes are everywhere. Bentley has opened a dealership. However this ignores my favourite take on Riga. It’s the rise and fall of the bucks parties…

When travel to Latvia opened up it was eye-popping for an awful lot of British lads. Here was a country where the women were Baltic Beauties – and poor. To the London lads this was bucks party heaven. It became more so when Ryan Air put on a Friday evening flight from London to Riga. Ryan Air even tried a Riga-Shannon route to service the Irish lads. The locals even got to classifying all Brits as Ryanair sex tourists as this club review shows.

Well due the crazy exchange rate the bucks parties got too expensive. I am not going to lead your round the internet to stories about over-priced hookers – but the bucks parties are moving to Prague. The Shannon-Riga flight has been cancelled. Ryan Air has recently announced a Friday night Birmingham to Prague flight.

Manifestations of the Baltic Madness in bank balance sheets

The largest Baltic bank is Hansabank – a wholly owned subsidiary of Swedbank. The last Swedbank annual report contains this fascinating summary table:

For the currency challenged – there are about 6 Swedish Kroner to the USD.

The deposits are 102 billion kroner, loans 177 billion. That is a loan to deposit ratio of 174%. That would be pretty high for a country – but it turns out that Swedbank (via Hansa) gets 177% by having a massive deposit share – as seen in the following table:

In Lithuania the loan to deposit ratio looks sensible. In Estonia – despite a 62% deposit share and only a 49% lending share the loan deposit ratio is 163 percent. In Latvia the loan deposit ratio is a 176%.

The observant amongst you might have noticed that the loan to deposit ratio in the two tables doesn’t match. I can’t work out why either…

Whatever Hansa Bank is very wholesale funded. This can be seen in Hansa’s balance sheet (from the English Language version of Hansa’s annual report).

Again for the currency challenged there are 0.45 Lati to the USD.

The key observation here is that deposits are 1.7 billion Lati and loans are 4.2 billion. The loan to deposit ratio is 244 percent.

Again the observant will notice that this ratio is different to Swedbank’s annual report – suggesting that when talking to analysts Swedbank seems to think that a lot of wholesale funding in Latvia is deposits. Other than that (cynical) line I have no explanation.

The main source of funding is in the line: due to financial institutions. There is 2.7 billion Lati due to financial institutions.

Fortunately Hansa Bank tells us more about that. Here is a table from the Hansabank annual report about the money due to financial institutions…

So now we can see it. Swedbank funds the Latvian current account deficit. It funds it in Euro.

So what happens next?

Well if the Lati devalues (as would seem inevitable) then Hansa Bank has to pay Euro to Swedbank – and as its assets are in Lati it would be insolvent.

If the Lati doesn’t devalue its only because people (ie Swedbank) are prepared to continue to fund it. This is not pretty at all. All in Hansa owes Swedbank over 30 billion Swedish Kroner – all denominated in Euro and which can’t be paid. The equity capital of Hansa (roughly 7 billion Swedish Kroner) is also going to default.

This is a very big problem for Swedbank. Swedbank’s equity is 68 billion SEK – but 20 billion is intangibles. Swedbank is probably solvent at the end of this – but only just. Swedbank will (at best) lose its independence. Swedbank is in turn wholesale funded – and the chance of it becoming Swedish Government property is not low.

Having lent that much to a country with a phoney fixed exchange rate in a currency they can’t print – Swedbank management deserve it. Bad things happen to bad banks and this is a bad bank.

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I wrote this post before SwedBank's great looking 2Q results. They made it all work - by lending even more to the Baltics. Latvian deposits are actually falling despite high inflation and rapid (but declining) loan growth.

I used to think Swedbank would probably survive. I now think it probably goes to zero.

Interesting - and negative for Ambac

GE used to be in the bond insurance game. It sold GICs as per Ambac and MBIA.

This news story (repeated below) suggests that GE is being investigated as part of an industry wide probe into the marketing of these contracts.

Presumably that investigation includes Ambac and MBIA - and it differs from other investigations going on into those companies.

This is negative.

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GE finance unit says 2 units probed over marketing
Monday July 28, 10:14 am ET GE finance arm says 2 units are being examined over marketing, sales of financial instruments HARTFORD, Conn. (AP) -- The finance arm of General Electric Co. says two units are being investigated in connection with an industrywide probe into marketing and sales of guaranteed investment contracts and other financial instruments to municipalities.

In a filing Friday with the U.S. Securities and Exchange Commission, General Electric Capital Corp. said GE Funding CMS and GE Funding Capital Market Services Inc. have been subpoenaed for information.

GE Funding Capital Market Services has received notice that the SEC staff may recommend that the agency bring a civil injunction or begin an administrative proceeding in connection with the bidding for financial instruments associated with municipal securities by former employees of GE Funding Capital Market Services.

General Electric Capital said it is cooperating with the SEC and antitrust division of the Department of Justice.

WaMu sub debt

As regular readers know I now am the proud owner of a (scary) position in WaMu subordinated debt. The reasons were explained here.

It is clear that the market disagrees with me. Here is a chart of the credit default swap. Its right up in Ford Motor territory...

I have had one reader disagreeing with my analysis and suggesting that WaMu losses could be $60 billion. They have not explained their estimate - so it doesn't help me much. The market is inherently estimating that 60 billion is possible.

60B strikes me as inherently implausible - but this blog exists so that the diaspora can point out my mistakes. I like being told why I am wrong.

So please - suggestions and quantifications devoutly desired.

Minor update and correction: The Series K is floating rate - but the floating rate is based on the $25 base. The series K is trading at a very small proportion of face. My calculations as to running yield are slightly (but only slightly) wrong. Thanks to a reader for this correction. I also own the series R which is a 7.75% fixed and I confused the coupons. I was more interested in the K (which is cheaper) essentially betting on solvency rather than current coupons... The R is convertible - but I am not that much interested in the conversion. Par is all I hope for...

Subprime improving

The ABX credit data is showing that the rate of increase of 60+ delinquency for 2006 mortgages is clearly slowing. It has been doing so for several months. The worse the pool of mortgages the faster the improvement.

This is also true of other mortgage pools I am looking at – though some 2007 pools are continuing to deteriorate.

Companies that wrote lots of their business in 2006 might now be seeing light at the end of the tunnel. For companies that wrote lots of business in 2007 that light might be an oncoming train.

This is relevant to the underlying books of the bond insurers and others.

I am wondering whether this trend applies to mortgages generally - as some bond insurers stopped writing earlier than others - and some mortgage insurers ramped up their business in 2007 to take advantage of the "opportunities" as competitors left the market.

If anyone has been looking at this sort of data in detail - I would love you to share it with me.

A stroppy social experiment

The Dell Blog I refer to in this post has now been deleted. The reason for the deletion is that I got a phone call from the Australian consumer regulators which pointed out a specific legislative provision that Dell had structured its terms to get into. The post is wrong in law. Law is not my usual thing. Sorry.

Michael Dell has gone back to Dell to solve its problems. The problems are usually described as customer service but that the techs I asked pointed me to faulty equipment being produced and customer service problems are really customers with faulty product overwhelm the system.

• "The Apple model" – make sure it works simply and easily – and then you hardly need customer service. You will wind up with a deserved reputation as the "consumer company"
  
• 'The Dell model" – make it cheap and sloppy and sell overpriced warranties because the customer will need them.

Anyway I spent a whole lot of time looking at Dell stock – and then the Dell problem fell in my lap. I wound up in the customer service vortex – and it was caused by a computer with technically inadequate cooling.

The computer is faulty. The fault is described in no less a source than Wikipedia as the design fault with my computer.

Dell attempted to extort (illegal) warranty fees out of me. The fees are illegal because Australia has a statutory warranty requirement which makes the “Dell Model” as described above illegal.

Anyway – rather than spend more time researching Dell stock – I am conducting a social experiment in analysing Dell. I am going to sue them for breach of Australian statutory warranty – for the faulty equipment that they are knowingly selling.

It’s a small-claims process so it will probably take only three hours of my time. And I don’t have to go very far out of my way – I can file in the local court which is – would you believe – in Bronte Road.

As most of this is going to wind up being computer-technical (and not of much interest to my general readers) I have started another blog.

I will report back on this blog only on the basis that the results have investment implications.

But if you want to follow the saga you can do so here.

Second weekend edition: Le Tour

I am inconsolable.

For the only time in my life I thought an Australian would win le Tour de France.

Cadel Evans looked weak on a couple of the mountain top finishes – particularly the last one where he let the Spaniard (Carlos Sastre) get 2 minutes on him.

I have pre-race odds for the race – and nobody much backed Sastre.

So much for pre-race odds.

But Evans was meant to be so much better than the time trial. But he rode like he was exhausted.

And Carlos rode the best time trial of his life.

One minute over a couple of thousand miles. That was all it was…

And having stayed up to 2am to watch - I too am exhuasted.

John

Weekend edition: A daft funds of hedge funds

I might start a hedge fund one day. So maybe I shouldn’t spend my time tearing into funds-of-funds.

But I got a problem. I get a kick out of pulling wings off butterflies.

One of my earliest posts (and still in the top five accessed on this site) was a post about New World Capital Management – a fraudulent hedge fund in Santa Fe. The fund was a blatant and obvious fraud.

My first email from New World was 17 Jan 2008 – and I smelt a rat immediately.

But obviously not everyone did. Here is a fund-of-funds suing New World Capital Management and Greg Duran. This fund was still promoting New World several weeks after I smelt a rat.

This fills me with amazement. There is only one real reason for investing in a fund of hedge funds – and that is that the fund-of-funds do the due diligence for you. If a fund-of-funds got suckered by something as simple as New World Capital Management then they got no right to be in the business. And their clients should all pull their money now. Go on. Do it now. You should.

So with wonder and amazement I link you (again) to a small court case. It’s the fund of funds (not the management company) suing. It’s only for 750 thousand dollars but you would think the management company would wear it.

Let us review what these people are saying:

• We are a fund of hedge funds.
• We invest your money with frauds.
• We can’t do our job.
• Invest with us.

John

PS. Now if any funds of hedge fund want more simple due diligence – I have an email. Just contact.