Thursday, September 25, 2008

Crash Course

"A sound banker alas is not one who foresees danger and avoids it, but one who when he is ruined, is ruined in a conventional and orthodox way along with his fellows, so that no-one can really blame him." (John Maynard Keynes)

"This is the one. This is the one. This is the one. Oh this is the one. This is the one, I've waited for." (The Stone Roses)

Both Keynes and The Stone Roses might be considered influences in my life, so it's apt that the quotes of the former and the lyrics of the latter, should merge so perfectly to sum up the incredible events of last week.

If you can't face reading my ramblings on this topic (and frankly I couldn't blame you), then at least read this excellent short piece by John Kay in the Financial Times. I had been desperately hoping to read a brief first-hand experience of where it all went wrong, and amongst all of the verbosity, Kay provides it eloquently.

It is difficult to overestimate the enormity of last week's financial implosion. Indeed today seems an appropriate day to try to write something intelligent, because it was the first trading day in the last seven that the S&P 500 index of US shares didn't move at least 1% in either direction. A temporary calm after the storm.

During a brief window last week, the 3-month US Treasury bill posted a negative yield. In other words, participants were so fearful they were willing to pay the US government for the right to lend it money. Meanwhile on Wednesday the gold price registered its largest ever price rise on record, again fear driving investors to the ultimate yield-free asset.

In the space of a single weekend, the remaining 'big Four' independent US investment banks became the 'big Two'. A lesson for Premiership football perhaps? However over the course of the whole of the past year of so, the story has been one of false optimism and the gradual recognition of the scale of the global credit bust. Last week represented a sudden and cumulative acknowledgement.

The collapse of Lehman Brothers was a scandal. A scandal for its employees, clients and to a much lesser extent its shareholders. Someone is probably already penning the story of how this once fabled Wall Street institution with a reputation as plucky outsiders, collapsed thanks to the hubris and arrogance of its management.

Having seen its closest competitor (Bear Stearns) forced into the hands of JP Morgan, it had fully six months to find an alternative to bankruptcy, yet turned its back on them all.

AIG was a catastrophic failure of internal control and risk management, and unlike Lehman was truly 'too big to fail'. Just a few weeks earlier (although it feels like a lifetime), Freddie Mac and Fannie Mae were bailed out, their collapse after all would have brought the already broken US mortgage market to a shuddering halt.

For decades Fannie Mae served a valuable role as a low-cost provider and guarantor of mortgage finance, yet inexplicably was privatised in 1968 (Freddie Mac was created on similar lines in 1970). Not surprisingly the conflict between its responsibility to homebuyers, and its responsibility to shareholders proved impossible to reconcile in the end. Its 'implicit' government guarantee became an 'explicit' one, an inevitable conclusion.

I've written extensively elsewhere about how we got here. I would urge people to understand however that the problem of subprime mortgages was merely the proverbial 'canary in the coal mine'; global lending had got so stretched that by definition it would eventually reveal itself somewhere.

The estimated losses arising directly from subprime lending in the US is 'only' $250billion or so. Yet the total consensus losses from all bad lending exceeds $1trillion, as the extent of the stupidity comes to light across credit cards, leveraged buyouts, commercial property etc..

The 'virtuous cycle' that permitted the bubble to go on longer than many expected (me included) has now clearly turned 'vicious'. Until last summer, rising asset prices (especially residential property) bolstered bank balance sheets, thus permitting more lending thus further driving up asset prices.

Like any asset bubble, the cycle was aided by a good 'story' that the public can get their arms around. The theme of globalisation was central to the story, emphasising the popular idea that inflation was dead, interest rates could remain low, and thus support asset prices seemingly forever.

The economist Hyman Minsky described the moment when such credit-driven asset bubbles pop. Eventually investors reach a point, where the cash generated by their assets is no longer sufficient to pay off the mountains of debt they took on to acquire them. And thus the vicious cycle begins.

Falling house prices, combined with the sheer complexity of many mortgage-backed securities, has meant that liquidity for these instruments has all but dried up. In short, nobody can work out what they're worth, so nobody is willing to bid for them.

Given the extent to which certain banks overloaded on these so-called 'assets', it is little wonder that so many have failed and find themselves under such stress. Their lending is thus curtailed, leading to lower house prices, and thus even greater balance sheet strain.

As the banks have been forced to make enormous write-offs on their 'toxic assets', they are required to find new injections of equity capital. During the first wave of write-offs in late-2007, the banks found willing contributors in the form of the oft-feared Sovereign Wealth Funds (SWFs), certain Asian banks, and to a lesser extent private equity and the usual public markets.

However, having been stung first time around by being early, they will wait for a more attractive entry point this time around. This was the biggest mistake Lehman made....its opinion on an 'appropriate entry point' was different from those with the cash.

If $1trillion represents the total losses that banks will have to write-off (I suspect $2trillion will be closer to the mark), then there is still an approximate $700bn funding gap between amounts raised so far from the sources above, and the amounts that will need to be raised.

There are only three ways that the banks can rebuild in this context. Firstly, they can earn the $700bn required, essentially impossible in this environment. Secondly they can raise the funds, although as mentioned above those with cash are increasingly picky (witness the outstanding terms Berkshire Hathaway obtained in its negotiations with Goldman Sachs).

Thirdly, they can sell assets until their balance sheet shrinks back into their already shrunk equity base. Some of the market panic last week, can be viewed in the context of this third unpalatable option becoming 'consensus', with the much-maligned short-sellers concluding that they simply wouldn't have enough time to do so without an equity-destructive firesale.

In the end, Hank Paulson and his Treasury will instead seek to bail them out with initial plans for a $700bn government-backed purchase of troubled assets. A panacea surely? Not so fast. Firstly, the Treasury will expect to buy assets at knock-down prices, perhaps requiring further write-downs to carrying value on already-strained balance sheets.

Second, their proposals so far appear only to address mortgage-backed assets, but there is likely an enormous wave of corporate defaults (and other losses) coming down the pipe. The spectre of Ford, General Motors and their huge pension liabilities looms large at this point. Will they be bailed out too? Assuming the value of the US Dollar is of some import to someone in authority, the resources are far from limitless.

The Paulson plan should instead be viewed in buying Wall Street even more time (Lehman clearly could have done with more), in order to clean up its act and seek a private sector solution that avoids failure. In just the five days since his announcement, both Morgan Stanley and Goldman Sachs have found new equity investment, and both have agreed to become (more regulated) banks, not merely broker/dealers.

Most importantly however, the very muted market response to the Paulson plan reflects the unavoidable truth that someone has to take the losses. Whilst equity holders in some of the failed and stressed banks have certainly taken their hits, either the US taxpayer will bear the brunt, or else there must be further failures of financial institutions to come (my view).

Wherever the losses end up being realised, the banking sector has changed forever. In return for the philanthrophy of the Fed and the Treasury, regulators will demand stringent new constraints upon banks, most notably their leverage ratio. The days when the likes of Lehman Brothers can leverage a tiny sliver of equity 30 times with highly unstable sources of funding, are over.

It is thus difficult to escape the unfortunate conclusion that the developed world faces a grinding deleveraging, where asset prices fall back to 'normal' levels, and credit is highly constrained for the foreseeable future. Inflation is yesterday's story.

To put some scary figures on it, imagine if the remaining 'stressed' banks could not raise a penny of the required $700bn of new capital.

They would thus be forced to sell the assets that $700bn of equity used to support. Using the 30x example of Lehman (and others), that's $21trillion of asset sales (mortgages, commercial property, corporate loans etc..) into an already highly stressed market. In such an environment, prices can only go in one direction.

The prospects for the most indebted economies of the world are thus rather unappetising, and whilst I've mainly addressed the problems in the US, the equivalent credit bubbles in the UK or Spain were considerably greater. For a taste of what's coming, read this excellent article by Martin Samuel.

As I wrote in my last post, the natural knee-jerk reaction of the media and the public is to seek a scapegoat, the short-seller being the choice du jour. My inclination is to blame regulators and central bankers, whose primary role surely is to dampen the natural urges of bankers to end up as Keynes suggested above.

Bankers do not arrive at their desks in the City or on Wall Street with the intention of bringing economies to their knees. They can all be acting perfectly rationally on an individual basis, yet the sum result can be (was) calamitous.

Yet all the while the general consensus of central bankers (especially the Fed's Alan Greenspan) was that asset bubbles cannot be identified ex ante, so best to deal with their consequences ex post. This is proving harder than they thought.

Nor is the equally maligned bonus system to blame either in my view. Although things are imminently going to change for its mediocre performers, one is forced to accept that banking (like football, Hollywood etc..) is simply an exceptionally scaleable business, and will continue to be so (though its activities will now be curtailed).

Revenues and profits do not rise in a linear fashion with costs. Imagine for example if the transfer system did not exist in football, and thus players were permitted to move to a competing club at any time of their choosing. Would you not expect clubs to create complicated (yet ultimately lucrative) bonus systems to tie their top performers to their clubs?

Speaking specifically about the UK, the disproprortionate influence of the City does represent however a grotesque misallocation of resources, to the detriment of the country's long-term economic prospects.

The shift to a more diverse economy (perhaps one with manufacturing back at its core if the pound continues its descent), will be to our eventual benefit, even if the near-term will be painful.

I have many friends and acquaintances who work in the financial sector despite seemingly having no ability (nor inclination), to maintain an intelligent conversation about finance. This does not make any sense, particularly when you read about chronic skills shortages across entire swathes of the engineering sector for example.

I'd be delighted if my own kids in due course find the idea of working in the City to be exactly what it should always have been......intellectually-demanding, but very hard work and only highly rewarding if you deliver. With any luck, they'll look elsewhere.

The investment banking model of an expansive balance sheet, earnings growth driven solely by said leverage (not productivity), and then the distribution of 50% of total net revenues as remuneration, will now be challenged by shareholders at this time of weakness. Valuations have never been lower as a result of this ephiphany.

It's taken a long time coming, but this really 'is the one'.


At 1:00 PM, Anonymous Anonymous said...

Sobering stuff NYA.

Any thoughts on what we mortals do with our savings and mortgages?

I feel as though am I powerless to take any action to help my family's finaces, other than to keep earning wages, and then die quickly without incurring nursing home fees!

Pembury Addick

At 1:09 PM, Anonymous newyorkaddick said...

Definitely not a time to be taking risks with employment - a lesser-paying safe job trumps a better-paying unstable one at times like this.

Paying down debt if you have any is a good investment option in this environment for sure. In the absence of many better investments for your spare cash, it offers a guaranteed return, often a high one depending on the interest rate you are borrowing at.

If you have any spare cash, then longer-term there will be excellent opportunities to invest (today) in equities, because after all a pretty bearish scenario is already discounted in prices. However it is not for the faint-hearted as there will be considerable volatility in the near-term.

Despite (or because of) the big sell-offs, I think the long-term story of emerging market growth and commodity demand is well intact. On a related point, the energy crisis will only get worse and thus there are interesting funds available to exploit these opportunities in wind (especially), solar, nuclear etc..

Owning some gold (either directly or via a fund) is not a bad idea in the context of competitive currency debasement.

At 1:47 PM, Anonymous Anonymous said...

one thing i am yet to conclude on is wheteher the feckless might actually win. i.e. the rescue packages and resulting policy results in high inflation with lapse monetary policy means debts are (hard but) manageable and the debt gets inflated away.

is this posible or would nominal interest rates and falling asset prices always conspire against people who were highly levaged?

or taxes rise and those with cash/income get heavily taxed to compensate

At 2:30 PM, Anonymous newyorkaddick said...

Probably worth recalling the quote by James Carville, former Clinton strategist: "I used to think if there was reincarnation, I wanted to come back as the President or the Pope or a .400 baseball hitter. But now I want to come back as the bond market. You can intimidate everyone."

The bond market vigilantes are very attuned to any subtle (or unsubtle) attempts to let inflation rise to eat away at the real value of debts.

There are now real winners if inflation takes hold - even those with debts will get wiped out in the near-term by the rise in nominal interest rates, as you imply.

Also worth noting especially in the UK and US that the baby-boomer generation are now in, or approaching retirement. They are a highly politicised group, disproportionately important (by definition) and about to move onto a life on fixed incomes. They won't tolerate inflation (notable and somewhat reassuring that their newspapers of choice [Mail, Express] are obsessed with this very topic.

I also don't see how, barring the central banks literally turning on the printing presses and dropping banknotes from the sky, how inflation can take hold in an environment of rapid credit contraction, rising unemployment and falling consumption (however worth owning some gold just in case).

At 2:32 PM, Anonymous newyorkaddick said...

Sorry should have said, "There are no real winners if inflation takes hold..."

At 7:09 PM, Anonymous Anonymous said...

If you want an 18% return on your money, pay off your credit card debt.

At 3:07 AM, Blogger Chicago Addick said...

A very temporary calm I think after what's been happening tonight.

A thought provoking and intelligent post again NYA.

Btw I invested in GS the same day as Mr Buffett, not to the same extent unfortunately :-)

At 6:48 PM, Anonymous tim said...

Thanks a lot for highlighting the Martin Samuel article on rip off britain, an excellent read.


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