Tuesday, 30 December 2008
The NYT here produces a rough overview of the issues. Great final quote:
“Everybody was thinking Russia had succeeded, and they were wondering, how do you keep water in a sieve?” Ms. Latynina said. “When the input of water is greater than the output, the sieve is full. Everybody was thinking it was a miracle. The sieve is full! But when there is a drop in the water supply, the sieve is again empty very quickly.”
Wednesday, 17 December 2008
Well, if these make for a failing newspaper, then most journalists should worry. And the discussion beneath Yves’ post is full of bloggers and blog-readers complaining about the poor quality of mainstream financial journalists.
As one myself, it is interesting to read others’ views on the industry. However, I’m not sure if Yves or those making the comments add much to the debate.
Financial journalists are always swimming against the tide of facts, events and trends. Basically, there is far more out there than we journalists can ever track, log and explain. Much of our business is educated guesswork and a reliance on simple narratives.
So should we embrace trends and hope that blogs and other free internet sources will do a better job than newspapers? It seems a little unlikely. The only blogs that regularly break news stories are Alphaville, which is published by a newspaper and is run by two senior newspaper-trained hacks, and Robert Peston's blog at the BBC, and he is also an ex-newspaper man.
Most of the other blogs add analysis and views but do little in the way of systematic news coverage. In fact, many of the facts they use as the basis of their analysis come from newspapers and agencies.
One danger is that the newspapers will accept the ultra-modern thesis suggested by hyped up bloggers and so duck their ('boring') responsibility of reporting news and instead drift further to being newsy lifestyle guides. The Guardian has already marched a fair way down this murky track, as has the Telegraph. Any further along and newspapers will amount to little than this nonsensical fluff. If so, then the newspaper industry is really in trouble.
"We just knew that we couldn't have things, and that was it."
"Don't expect any presents, because the banks have closed."
"These kids today are so bright and so smart, but they just don't have any sense of responsibility. If this little downturn can wake them up, they'll be magnificent."
"Nobody in my era splurged. No one traveled."
"The Depression is really hardest on those who can least afford it — the people who are not in great health, the people who are not educated, the people who are not gifted or blessed with good fortune."
Compare that with 2006. When some people spent just for the sake of spending money.
"Paul Levine, Signature’s owner, will 'offer you a glass of Courvoisier while you discuss your cycling habits.'"
Friday, 12 December 2008
However, he admits that while the slur might be outrageous, "the trading strategy can be rewarding".
Looking at headcount gives a good illustration why. Excepting the Financial Times, the national newspapers, combined, probably have – at a guess – around 50 people working full-time as financial journalists. This may sound like a lot, but then there is a huge amount of duplication (and herd behaviour) and the word 'financial' covers not only companies and share prices, but personal finance too.
The majority of the editors of these newspapers have been focused on shares and share prices throughout their working lives. As such, the credit crunch came out of nowhere for them, and many have struggled to catch up. But still, there remains little credit or technical expertise on the desks of these newspapers, though some – again notably the FT (which is itself hamstrung by spending constraints) – are trying to make up for this lack.
But these attempts seem rather pitiful when compared with the scale of the task at hand. London's financial industry is probably the most complex and innovative in the world, as well as one of the leakiest. Without experience, and in the face of the challenge of the internet, many of the newspapers have given up providing comprehensive news coverage, leaving much of the hard news provision to the better-staffed agencies.
I wonder if this trend will change. Will newspapers like the Telegraph, Times, Guardian and Independent ever employ another two or three people to inform and entertain with stories of credit, structured finance and emerging market debt? Will they try to get across to people how the global capital markets work? How London sits at its centre, drawing in money and talent from around the world?
It seems unlikely. Instead, these reporters will too often feel they are the country cousins of their more glamorous political colleagues, perennially looked down upon in the office, and treated with a certain distain at parties.
Something will change this. The demand is there for high quality financial news and information. At the moment, I suspect this will be supplied by the internet, away from the established newspapers.
Wednesday, 10 December 2008
I disagreed: I thought that private capital markets need a variety of structures to work efficiently, and some of these would not always appear useful (like shorting) in the short-term. The alternative to the present system was not an efficient, smaller capital market, but either an inefficient smaller capital market or purely state-based provision of capital.
The conversation stays with me because it was the first time in a while I had thought hard about what the capital market is for. From my personal perspective, a big, rich capital market, full of complexity, is good for my career prospects. And as a Londoner, born and raised here, it is generally a good thing, bringing the city money, ideas and prestige.
However, these should be secondary issues. A capital market's primary function is the efficient allocation of capital, hopefully to those areas of the economy most deserving of it. The latter is clearly something we can debate forever – how to define where best for capital to go? In our present system, the private sector is left largely to its own devices while the state decides where investment should go for the half (roughly) of the economy it controls.
Over the last decade, the financial sector earned increasingly large sums from financial transactions, many of which were useful for companies, some of which were not, and were instead purely speculative. The financial industry is now looking carefully at which financial transactions are necessary and useful, and which are irrelevant, and possibly toxic.
Collateralised debt obligations (CDOs) are now seen to be in the latter category and the whole of securitisation is in doubt. Now, the credit default swap (CDS) is under scrutiny. CDS is a type of financial instrument that allows investors to buy insurance against companies going bust.
If CDS did just that, it would not be so controversial. However, CDS has become entangled in much larger systems where industry players used it to create financial monsters such as synthetic CDOs and wrote huge amounts of insurance for purely speculative purposes. A longer list of criticisms can be found here, including calls for the entire market to be shut down.
Felix Salmon, the prolific blogger at Portfolio.com, has posted a defence of CDS. His post is interesting largely for what he doesn't say – he does not make a strong case for why CDS in particular, and derivatives in general, are good for the capital markets. Instead he appears to be saying that CDS is good for its limited purpose of credit insurance but is no good at anything wider such as being built into speculative financial structures or being used to predict default rates (note how the correlation has broken down in the graph, most likely because the tool has broken). (BTW the comments underneath Salmon's piece are probably as interesting as his original post.)
Certainly there is something wrong with CDS when gullible hacks write stories like this, saying that 'McDonalds is a better credit risk than the UK'. The story should actually be: CDS market broken: produces ludicrous results.
Monday, 8 December 2008
But ultimately private equity's problems lie not with investors' change appetite, but lenders' drastically reduced demand for debt. And without debt funding, private equity's dominant business model in recent years has been made impossible. What is the point of having a mega fund if this money cannot be used to leverage billions out of lenders?
Funds are now going to back to the drawing board, trying to work out new investment strategies. They are likely to find profitable schemes in the future but maybe never quite so profitable (and significant) as taking many large public companies private and then using cheap debt to take out massive dividends. That was frothy, top of the market behaviour if I have ever seen it.
And you knew the scene was dead when the Gulf Sheikhs tried (and failed) to get a piece of the action.
It is a natural human tendency to assume that certain things do stay the time. Not just because it might suit us, but because we must plan and build. If everything always changed then it would be very difficult to do anything complex, such as develop civilisation. Hence our society's focus on property rights and stability.
It is ironic therefore that the result of giving greater significance to the wisdom of the markets, compared with the knowledge of planners in government, or the aristocracy (as in previous times), has been to not just to create much greater wealth but also greater instability. Market society has flattened class barriers and opened up society but has also created new inequalities and uncertainties (cf New Labour). Placing great store in the meaning of the market price meant good times when prices rose but huge uncertainties when prices dropped sharply. Massive volatility in the indexes our society has given great significance means uncertainty spreading throughout the economic system.
Today's recession is a significant turning point in western capitalism. It sees the demise (for now) of debt-led financial capitalism and the return of government dominance of the markets. How long the recession lasts will be significant. If it is short but sharp then it seems likely that the make up of our societies will remain largely unchanged. The power dynamics between the public and private sectors will be rebalanced slightly, but not greatly. This means evolution rather than revolution; a continuation of recent years' unexciting but quite fruitful technocratic rule (in the domestic sphere).
However, if the recession leads to real economic (and then social) strife, we may see real change. And while real change may be the demand of campaigners across the political spectrum, recreating the institutional frameworks to allow all to gain from such a transformation is likely to take many years, and may never be achieved. In short: expect a 'lost decade' of real economic and social pain if a recession lasts longer than two or three years.
Friday, 5 December 2008
This is all above board – no-one is doing anything wrong. In fact, not paying debt is the new taking out debt. Everyone's doing it. No less an institution than the UK government is putting together a scheme where those with the most debt can opt not pay debt for a couple of years so as to get into shape to take out some more debt.
Nils Pratley in the Guardian says that this government scheme to bailout mortgage holders looks like it fails the moral hazard test – ie it encourages bad behaviour.
But which politician cares? The country's rulers are running scared of debt-laden householders. Like weak-willed parents confronted with a very determined and stroppy child, they will make almost any decision, however wrong, just to achieve the quiet life.
Thursday, 4 December 2008
Already, analysts and rating agencies are looking at companies' repayment schedules and identifying maturing debts as key credit risks. If banks choose not to replace maturing credit lines, the companies affected are left with a stark choice: repay, merge or shut down. And for many companies, particularly leveraged firms, the repayment option is simply not possible given the size of the debt involved.
This means that many companies will not survive the next year or so. And already we have seen a wave of firms going bust. While I feel intensely sorry for the staff that have and will lose their jobs, I am not particularly surprised. For one thing, there are a number of firms that have only been keeping going because the economic conditions were so good and credit conditions so relaxed. As soon as anything went wrong, these companies were liable to collapse or hit difficulties.
Tasteless comparison: this is a bit like seasonal death rates. If there is a mild winter then all those people that would have died during a normal cold winter are still going to die, just not yet. The better weather just delayed the inevitable and the next summer and winter see higher death rates than normal.
Woolworths was like this. A frail, confused 99-year-old maintained by the artificial life support of cheap debt (from new entrants to the UK market seeking market share) and profligate shoppers. Without this life support (falling sales, recalcitrant lenders) the patient died.
And so the next few months are likely to see many more companies go under. Unlike John Redwood, I do not see this as a good thing. It is not worth sacrificing people's livelihoods simply to prove an economic theory. However, there is a certain sense of inevitability about bad companies going bust during difficult times. It is something that, unfortunately, we are going to have to get used to in the next few months.
I don't agree, and like to find evidence that suggests otherwise.
The chart to the left shows that death rates amongst the poor in the world have declined sharply in the last fifty years.
It's from UN figures and is part of larger, and interesting piece published earlier this year, on food prices and their impact on death rates.
Tuesday, 2 December 2008
Those that still believe in private allocation of capital are the headbangers while the moderates are those that believe in state allocation of capital. How times change.
Now that we’re fully versed in the annals of market failure, when it is time to lift the equally large tome marked ‘government failure’?
Pimco’s Bill Gross has been looking into these issues too.
“More regulation, lower leverage, higher taxes, and a lack of entrepreneurial testosterone are what we must get used to — that and a government checkbook that allows for healing, but crowds the private sector into an awkward and less productive corner.”
“We are now morphing towards a world where the government fist is being substituted for the invisible hand, where regulation trumps Wild West capitalism, and where corporate profits are no longer a function of leverage, cheap financing and the rather mindless ability to make a deal with other people’s money.”
Lots around today. Am interested in Islamic finance. Here’s a primer on some recent issues.
Am also fascinated by the retail market. Lots of them are worried about going bust, so they are getting in their sales early. Debenhams is having another. Back by popular demand it cries ... what a joke!
Also this FT story on the Magal Group is worth a read. The bank in the dock is RBS, the state-owned bank.
Well, the numbers tell us one place they are putting it - the British equivalent of under the mattress: gilts (UK government bonds), where yields have plunged to less than 4%. (Bond yields move down when demand goes up.)
Monday, 1 December 2008
Democratically-induced politicians across the western world are looking at their electoral chances and weighing up options. The easiest solution to the impending downturn is a fiscal stimulus paid for by tomorrow’s people. And in an ideal world, this will prevent a slump by maintaining employment levels as excess credit/liquidity/money drains away.
The second option is to focus help out all those indebted householders. Firstly, by making sure that there is a mortgage market even as the securitisation market collapses. And then by pressuring central banks to cut interest rates sharply, allowing banks to re-invent their old pre-securitisation business model, while keeping people’s mortgage payments low, and allowing back in a bit of inflation. Deflation, they say, is now the main enemy. A little inflation, on the other hand, is benign because it will reduce debts.
(Those that argue that deflation is looming are not wrong. However, the jury's still out on whether it will actually occur. But what is certain is that policymakers do not mind if there is more inflation in the system than they would have accepted previously.)
Savers and retail investors, meanwhile, are stuffed. Equity prices are through the floor (with little sign of a recovery for at least six to nine months) while banks are not willing to pay for savings.
There was a moment, around the summer, when banks’ wholesale funding costs rose so high they started to pay savers a healthy rate of return for deposits. This has now ended, and rising inflation means that savers have to work hard to make any money at all from their funds. The savings rate for a good bank is around 4-5%, and only if you look around. The retail price index is also around 4-5%. Therefore saving money in an average bad savings account will actually lose you money. (That is, if you can open one!)
The phrase moral hazard keeps springing to mind. Or in normal English: why are people being punished for making the right choices while others rewarded for making bad decisions? Debtors are being bailed out while savers are being stymied.
There are those that say we should simply save more and spend less. But this would be likely to worsen the downturn in the short- to medium-term. The ideal ('goldilocks') solution for the economy would be for the savings rate to steadily increase whilst offsetting the troubles in the economy through sensible long-term fiscal boosts.
Restoring banks' profits by stuffing savers with sub-inflation rates and poor investment options whilst reinflating asset bubbles aint gonna help any. And dumping cash into a bank aint gonna do much. The only option is to invest it somewhere (be brave!) or to spend it. Tough times.
Friday, 28 November 2008
Thursday, 27 November 2008
Of all the various slips, I thought her claim that syndicated finance was a characteristic of the credit boom the clearest indicator that she was winging it. (Syndicated lending is the oldest and most reliable of all the credit markets, in case you were wondering.)
My assumption is that the BBC’s focus when hiring its financial correspondents (as with all others) is to prioritise generalist story-making skills and presentation manner, rather than technical knowledge such as how to read a balance sheet, or how the credit markets work.
This is understandable but rather worrying, given that for the next few months there will continue to be job cuts, companies collapsing etc and these will frequently lead the evening bulletins. I presume that many of these stories will be reported to the country by yet more enthusiastic but largely ignorant reporters, many of whom will have to perform on the national stage before their limited knowledge on the matter, hastily picked up from Wikipedia and one or two sources, has had time to dry.
I am too cynical now to be frustrated by this, but I do wish that one day standards might rise just a little.
Oh, and the prize for the least mawkish and most informative article on the Woolworths story goes to the FT, for this news article and this comment piece.
Wednesday, 26 November 2008
Here's a good intro to the subject, noting how Obama uses skills the Romans would be likely to recognise and admire.
Tuesday, 25 November 2008
"And the scholarliness of her work is a thing to behold: she produces lengthy documents that have an air of "referenciness", with nice little superscript numbers, which talk about trials, and studies, and research, and papers ... but when you follow the numbers, and check the references, it's shocking how often they aren't what she claimed them to be in the main body of the text. Or they refer to funny little magazines and books, such as Delicious, Creative Living, Healthy Eating, and my favourite, Spiritual Nutrition and the Rainbow Diet, rather than proper academic journals."
This approach is more than a little reminiscent of my bete noire, Naomi Klein, who flies around the world lecturing on the evils of being wealthy enough to fly around the world. She annoys me not because of her personal hypocrisy but because she leads the McCarthyite wing of the global left - charging those that disagree with her as guilty of genocidal thought crime. An odious approach to debate if I ever heard one.
One day I'll probably have a proper rant about that but in this post I wish to only accuse Klein of McKeith-ite referenciness. Her latest book has no less than 60 pages of footnotes. "I expect the release of the book to be a battle. And the endnotes are my body armour," she said on its publication. But an argument is more than about footnotes, it's about sense, logic and fairness.
A read of the very sensible Paul Seabright gives you an idea of how Klein veers off the track of reality.
"Sixty pages of footnotes do not add up to rigorous and careful research. Klein appears to believe that "Chile in the seventies, China in the late eighties, Russia in the nineties and the US after September 11, 2001" all had essentially the same economic policy. She writes that the Southern Cone of Latin America is the place "where contemporary capitalism was born". She thinks that Gorbachev's reforms of the Soviet Union were going swimmingly until he caved in to IMF pressure in 1991, which makes it inexplicable why he should have been vulnerable to IMF pressure in the first place. She ignores the contribution of economic liberalization to China's astonishing growth in the past three decades, contenting herself with a sneer about China's becoming "the sweatshop of the world". The recent experiences of India, a democracy that has moved towards liberalization of its economy without massive crises, are not mentioned. More people have escaped malnutrition through the economic reforms of these two countries in the past couple of decades than through any previous economic programmes in history, which makes the omission a large one.
Cherry-picking the evidence is particularly important for Klein's favoured strategy of guilt by association, when she implies, for instance, that since many torturers have been keen on free markets, free-market ideology leads intrinsically to the use of torture. It is not clear what, on this theory, explains the use of torture by Communist or otherwise anti-capitalist governments. Since she never mentions it, she may not be aware that it has ever happened."
Look at Kemp's graph. Look at the volatility in the first half of the twentieth-century. And then see how much calmer life has been in the last 50 years. Here's a general rule of thumb: in a capitalist economy, the less volatility there is the more wealth is created.
And this graph also suggests a reason why ‘emerging market’ economies (China, Russia etc) may not rapidly overtake the economies of Europe and the US. If you take a look at GDP growth in China then you’ll see similarly large swings in GDP, with a recent, and admittedly long, upswing.
During periods of growth, capitalist economies invest, build and implant physical and institutional structures to support further growth. During a downturn, some of this is destroyed. The bigger the downturn, the less stuff (both tangible and intangible) is carried over to the next growth period from the previous one. Hence, volatility is generally (and I'm being very general here) a long-term economic bad.
I think this is how the UK government is approaching the economy. It knows that pumping some extra cash into the economy (sorry, a ‘fiscal stimulus’) is a risk but better for the government to borrow a more now and people feel there’s an economic security blanket rather than there be a sudden, long-lasting and hugely value-destroying downturn.
As Kemp notes: "What made the Great Depression 1929-33 unusual was not the DEPTH of the contraction (which was not abnormal for period) but its DURATION. Previous business downturns had lasted a few months but this one dragged on for years. Industrial activity peaked in Sep 1929 and did not begin expanding again significantly until H2 1933."
Though it is also here worth noting Matt’s point that downturns in economic cycles are often “symptomatic of some deeper cycle in the way that we organise ourselves” and could be seen as a part of a wider more positive dynamic at work.
Friday, 21 November 2008
men are men and
mountains are mountains.
While studying Zen,
things become confused.
After studying Zen,
men are men
and mountains are mountains.
After telling this,
Dr. Suzuki was
“What is the
difference between before and
only the feet are a
little bit off the ground.”
Properly formatted link.
Thursday, 20 November 2008
One trend of the equity market in recent years has been denial. This denial often took the form that rising share prices (and then commodity prices) were unconnected to high levels of liquidity (credit), and so ignoring the idea that a decline in liquidity would lead to a fall in share prices (for instance: when debt is no longer there for private equity buyouts, there is no ‘bid premium’ for companies that might be bought out).
It is interesting now to see many equity investors waking up to what's happening in the credit markets, and some making very similar mistakes. Now they are mistakenly ascribing powers of foresight onto the credit markets, trying to pin significance onto indicators that have little wider meaning, often so divorced from the real world as to only tell a story about the indicator itself. (But analysts need something to write and theorise about!)
There is only a little truth in the myth that credit markets know more than equity markets (a point debated in the link immediately above). The truth is that credit markets have different sources of information and research to those that focus on shares. Credit market news tends not be mediated through bank analysts and PR-driven national newspaper articles. Instead, it tends to be internal, or provided by specialist news organisations that have two-way information exchanges with market participants. The latter pair of reasons help explain how the credit markets could have deluded themselves so much ahead of the crash.
Overall, I do not think that the credit markets provide 'better' information than the equity markets, or vice versa. It is, however, interesting to see that the equity market, which is deeper and more liquid than the credit market, can be just as wrong as the credit market, but in its own distinctive way.
Wednesday, 19 November 2008
Tuesday, 18 November 2008
Monday, 17 November 2008
Wednesday, 12 November 2008
Tuesday, 11 November 2008
In my entire life, I never saw a sell-side guy come in and say, ‘Short my market.’ ” And short Eisman did—then he tried to get his mind around what he’d just done so he could do it better. He’d call over to a big firm and ask for a list of mortgage bonds from all over the country. The juiciest shorts—the bonds ultimately backed by the mortgages most likely to default—had several characteristics. They’d be in what Wall Street people were now calling the sand states: Arizona, California, Florida, Nevada. The loans would have been made by one of the more dubious mortgage lenders; Long Beach Financial, wholly owned by Washington Mutual, was a great example. Long Beach Financial was moving money out the door as fast as it could, few questions asked, in loans built to self-destruct. It specialized in asking home¬owners with bad credit and no proof of income to put no money down and defer interest payments for as long as possible. In Bakersfield, California, a Mexican strawberry picker with an income of $14,000 and no English was lent every penny he needed to buy a house for $720,000.
In retrospect, pretty much all of the riskiest subprime-backed bonds were worth betting against; they would all one day be worth zero. But at the time Eisman began to do it, in the fall of 2006, that wasn’t clear. He and his team set out to find the smelliest pile of loans they could so that they could make side bets against them with Goldman Sachs or Deutsche Bank. What they were doing, oddly enough, was the analysis of subprime lending that should have been done before the loans were made: Which poor Americans were likely to jump which way with their finances? How much did home prices need to fall for these loans to blow up?
All that was required for the BBB bonds to go to zero was for the default rate on the underlying loans to reach 14 percent. Eisman thought that, in certain sections of the country, it would go far, far higher.
“Where are the rating agencies in all of this? And I’d always get the same reaction. It was a smirk.” He called Standard & Poor’s and asked what would happen to default rates if real estate prices fell. The man at S&P couldn’t say; its model for home prices had no ability to accept a negative number. “They were just assuming home prices would keep going up,” Eisman says.
“You have to understand this,” he says. “This was the engine of doom.” Then he draws a picture of several towers of debt. The first tower is made of the original subprime loans that had been piled together. At the top of this tower is the AAA tranche, just below it the AA tranche, and so on down to the riskiest, the BBB tranche—the bonds Eisman had shorted. But Wall Street had used these BBB tranches—the worst of the worst—to build yet another tower of bonds: a “particularly egregious” C.D.O. The reason they did this was that the rating agencies, presented with the pile of bonds backed by dubious loans, would pronounce most of them AAA. These bonds could then be sold to investors—pension funds, insurance companies—who were allowed to invest only in highly rated securities. “I cannot fucking believe this is allowed—I must have said that a thousand times in the past two years,” Eisman says.
That’s when Eisman finally got it. Here he’d been making these side bets with Goldman Sachs and Deutsche Bank on the fate of the BBB tranche without fully understanding why those firms were so eager to make the bets. Now he saw. There weren’t enough Americans with shitty credit taking out loans to satisfy investors’ appetite for the end product. The firms used Eisman’s bet to synthesize more of them. Here, then, was the difference between fantasy finance and fantasy football: When a fantasy player drafts Peyton Manning, he doesn’t create a second Peyton Manning to inflate the league’s stats. But when Eisman bought a credit-default swap, he enabled Deutsche Bank to create another bond identical in every respect but one to the original. The only difference was that there was no actual homebuyer or borrower. The only assets backing the bonds were the side bets Eisman and others made with firms like Goldman Sachs. Eisman, in effect, was paying to Goldman the interest on a subprime mortgage. In fact, there was no mortgage at all. “They weren’t satisfied getting lots of unqualified borrowers to borrow money to buy a house they couldn’t afford,” Eisman says. “They were creating them out of whole cloth. One hundred times over! That’s why the losses are so much greater than the loans. But that’s when I realized they needed us to keep the machine running. I was like, This is allowed?”
“We have a simple thesis,” Eisman explained. “There is going to be a calamity, and whenever there is a calamity, Merrill is there.” When it came time to bankrupt Orange County with bad advice, Merrill was there. When the internet went bust, Merrill was there. Way back in the 1980s, when the first bond trader was let off his leash and lost hundreds of millions of dollars, Merrill was there to take the hit. That was Eisman’s logic—the logic of Wall Street’s pecking order. Goldman Sachs was the big kid who ran the games in this neighborhood. Merrill Lynch was the little fat kid assigned the least pleasant roles, just happy to be a part of things. The game, as Eisman saw it, was Crack the Whip. He assumed Merrill Lynch had taken its assigned place at the end of the chain.
Here's a few I've come across recently:
"Customer dwell time" - The amount of time customers stay in restaurants or pubs.
"Fixed-price discount retailer" - Poundshop.
"Wet to dry split" - amounts of drink and food sold by a pub.
"Dark spread" - difference between the coal price/costs and the power price.
Monday, 10 November 2008
The US government’s credit line to AIG, which was effectively taken over the state earlier this year, now totals USD 150bn. Much of this relates to its CDS and CDO exposures, and this is partly because the monolines acted as conventional insurers in the CDS market rather than swap dealers. It said today in a somewhat apocolyptic release that “Approximately 95% of the write-downs AIG Financial Products has taken to date in its CDS portfolio were related to Multi-Sector CDOs.”
The article – in the New York Times – makes a stab of explaining the near impossible, giving a background to one of the most complex financial products around, as well as a human face or two. However, it falls a little short of providing a fuller explanation of the details. (For more on investment banks failing, here's the FT giving a good insight into the PwC team restructuring Lehman.)
“The synthetic CDO grew out of a structure that an elite team of JP Morgan bankers invented in 1997. Their goal was to reduce the risk that Morgan would lose money when it made loans to top-tier corporate borrowers like IBM, General Electric and Procter & Gamble.”
Normal (or cash) CDOs (collateralised debt obligations) are funds that invest in bonds and loans, and then are themselves parcelled and then sliced up and sold onto bond investors. A kind of bond squared, with a dose of leverage (borrowing) at each turn. Meanwhile synthetic CDOs are like normal CDOs but instead of being made up of lots of bonds and loans, they are packed with credit-default swaps, a form of derivative. (For more detail, here's one prescient essay on the subject, and here's another from 2004, but with the usual industry defence of the product.)
According to the NYT's jaundiced post-credit-crunch eye: “Synthetics could be slapped together faster, and they generated fatter fees than regular CDOs, making them especially attractive to Wall Street.”
The originator of the synthetic CDO would usually retain a stake in the product but sell on much of it to other investors, and it was originally used as a mechanism to offsetting the risk of high-grade corporate lending. But from around 2002 there was shift away from insurance (aka 'balance sheet') to speculation (aka 'arbitrage') CDOs, writes the NYT, when investors were looking for yields after they had sold out of equities but could expect little return from bonds. This led to more borrowing (much of which went into the property market) and more appetite for risky investments with ever-increasing complexity.
These developments were supported by the belief that by spreading risks throughout the system, and cutting these risky investments up into small pieces, would mean that a few bad apples would not, and could not, spoil the whole barrel. The above-linked article from Credit magazine notes the following:
"it is broadly accepted that the risk embedded in the super-senior tranche of a synthetic CLO referencing a pool of investment-grade assets is remote in the extreme. This is because even if a super-senior swap accounts for as much as 90% of a CDO’s capital structure (which is not uncommon), more than 10% of the assets within the reference pool would have to default for losses to be sustained by the most senior tranche – an improbably high default rate for investment-grade bonds when the historical norm has been for a default rate of about 0.3%."
The NYT focuses on Merrill Lynch’s land-grab for mortgage lending, explaining that the bank sought to emulate the profits made by Lehman Brothers. “The firm’s goal, according to people who met with Merrill executives about possible deals, was to generate in-house mortgages that it could package into CDOs. This allowed Merrill to avoid relying entirely on other companies for mortgages.” According to executives interviewed by the NYT, Merrill Lynch focused more on profits than evaluating risk.
And unlike the pioneers of synthetic CDOs, Merrill Lynch “seemed unafraid to stockpile CDOs to reap more fees”. By 2006 it was the world’s biggest underwriter of the products. But the risks began to spread after AIG suddenly stopped insuring the highest-quality portion of the company’s CDOs against default. Merrill Lynch couldn’t find a replacement but continued to create new CDOs, and the company’s unhedged exposure to mortgages continued to grow.
“In 2005, firms issued $178 billion in mortgage and other asset-backed CDOs, compared with just $4 billion worth of C.D.O.’s that used safer, high-grade corporate bonds as collateral. In 2006, issuance of mortgage and asset-backed CDOs totaled $316 billion, versus $40 billion backed by corporate bonds.
Firms underwriting the CDOs generated fees of 0.4 percent to 2.5 percent of the amount sold. So the fees generated on the $316 billion worth of mortgage- and asset-backed CDOs issued in 2006 alone, for example, would have been about $1.3 billion to $8 billion.”
But when the market turned, in 2007, “the impact was brutal”. The market collapsed, and Merrill Lynch was forced to take a USD 7.9bn write-down related to its exposure to mortgage CDOs. Chief Executive Stan O’Neal was also forced out, replaced with John Thain.
“None of the trading businesses should be taking risks, either single positions or single trades, that wipe out the entire year’s earnings of their own business,” Mr. Thain said in January. “And they certainly shouldn’t take a risk to wipe out the earnings of the entire firm.”
In August, Thain arranged the sale of the CDO assets for 22 cents on the dollar. For the first nine months of 2008, Merrill recorded a net loss of USD 14.7bn on its CDOs. Shortly afterwards, Merrill was taken over by Bank of America.
Thursday, 6 November 2008
And I’ve found an obvious one, or at least a candidate. Moody’s downgrade of financial insurer Ambac appears significant and deserving of much greater coverage and analysis than I have so far seen. Bloomberg has this brief article, Reuters output was nothing more than an abbreviated version of the Moody’s press release, while the FT ran only half the story – missing the point that Moody’s has downgraded all the bonds covered by Ambac.
The collapse of the monoline’s AAA ratings has been a steady and pretty grim tale, all through the year. It is having some large, and long-term impacts, particularly on US municipal borrowers, who will see their borrowing costs rise.
Wednesday, 5 November 2008
So it was interesting to come across this rather fantastic New Yorker article which manages to also talk about postmodern economics, and has a good stab at applying Jacques Derrida to high finance. It’s great stuff for all you postmodern economics types (ie all of you!).
Meanwhile, the New York Times takes a less theoretical (but just as postmodern) take on mechanics and economics. It echoes some of my own ideas, which one day I'd love to write about in more detail. In a nutshell, my theory is the credit crunch explodes the modernist over-reliance on numbers and rigid models, so opening the way for a postmodernist analysis to emerge. In this, Taleb and Kay are already working out some patterns.
Along the way, I’ve come across a number of introductory pieces on the subject, such as this one, as well as this piece from a new, rather high-minded and ambitious blog, which I hope will continue to de-mystify finance, one area at a time. If you ever wanted to know about CDS, then it has a great intro on an issue that the mainstream press never fails to describe in scary and intimidating terms.
However, for securitisation, I still like one of my very early attempts to tackle the subject!
Meanwhile, here's a story of another gullible investor that shouldn't have been dabbling in finance.
Tuesday, 4 November 2008
However, the style and substance of the article is very different. Rather than taking the approach of educating readers, bringing forward fully-fleshed personalities making real-life decisions, the FT reporter has opted for the more traditional reportage style where details are left to one side, instead focusing on controversy and relying on hyperbolic jargon to get the story across.
So the article writes that a “Leftwing” council representing a poor suburb has “speculated” in “toxic loans”. Political opponents “branded his Communist predecessors stupid” with banks “seeking to exploit local councils”.
Admittedly the story is a short one so there was limited space to write in details. However, the reader of the FT article is left with nothing more than a sense that something went wrong, something to do with complex financial instruments, and what was a Communist council doing investing in these things anyway? To an informed reader, this is nothing different to what one reads in a tabloid.
Monday, 3 November 2008
Here's one, a rather scary one, about a schools administrator, an Irish-German bank and a rather sharp financial advisor, a Mr Noack, who sold a USD 35m CDO investment on the back of two hours training.
"But Mr. Noack’s explanation of a CDO was very wrong. Mr. Noack, who through his lawyer declined to comment, had attended only a two-hour training session on CDOs, he told a friend.
The schools’ $200 million was actually used as collateral for a complicated form of insurance guaranteeing about $20 billion of corporate bonds. That investment — known as a synthetic CDO — committed the boards to paying off other bondholders if corporations failed to honor their debts.
If just 6 percent of the bonds insured went bad, the Wisconsin educators could lose all their money. If none of the bonds defaulted, the schools would receive about $1.8 million a year after paying off their own debt. By comparison, the CDOs offered only a modestly better return than a $35 million investment in ultra-safe Treasury bonds, which would have paid about $1.5 million a year, with virtually no risk."More of this kind of thing, please!
Wall St Journal have a good one on Taleb's fund. Probably the only hedge fund making money at the moment. Likely that if there were more proper contrarians around then the markets might do a little better at expecting the unexpected.
Here's the full text of the WSJ article:
WSJ, 3 November 2008, Scott Patterson
For most of October, it seemed nearly everything that could go wrong with the markets did. But the rout turned into a jackpot for author and investor Nassim Nicholas Taleb.
Mr. Taleb last year published "The Black Swan," a best-selling book about the impact of extreme events on the world and the financial markets. He also helped start a hedge fund, Universa Investments L.P., which bases many of its strategies on themes in the book, including how to reap big rewards in a sharp market downturn. Like October's.
Separate funds in Universa's so-called Black Swan Protection Protocol were up by a range of 65% to 115% in October, according to a person close to the fund. "We're discovering the fragility of the financial system," said Mr. Taleb, who says he expects market volatility to continue as more hedge funds run into trouble.
A professor of mathematical finance at New York University, Mr. Taleb believes investors often ignore the risk of extreme moves in the market, especially when times are good and volatility is low, as it was for several years leading up to the current turmoil. "Black swan" alludes to the belief, once widespread, that all swans are white -- a notion that was proven false when European explorers discovered black swans in Australia. A black-swan event is something that is highly unexpected.
Assets under management at Universa have neared $2 billion since the fund launched early last year with $300 million under management. While Mr. Taleb frequently consults with Universa's traders, the Santa Monica, Calif., fund is owned and managed by Mark Spitznagel, who worked for several years in the 1990s as a pit trader on the Chicago Board of Trade.
To execute its strategy, Universa buys far-out-of-the-money "put" options on stocks and stock indexes. These are bets that the market will see a sharp, sudden downturn. They become extremely valuable in a market decline of 20% or more in a one-month period.
When times are good, such options are cheap and Universa gobbles them up, taking small losses along the way. When the market makes a quick, steep turn south, as it has recently, Universa's positions gain value as investors scramble to protect themselves in the downturn by buying puts. The strategy, which keeps more than 90% of assets in cash or cash equivalents such as Treasury bonds, either breaks even or loses small amounts in most months while waiting for periodic, infrequent spikes in volatility.
Here's an example of a trade the fund made recently. In late September, when the Standard & Poor's 500-stock index was trading around 1200, Universa purchased put options that would pay off if the index fell to 850 by late October. Since such a plunge was considered highly unlikely, such options cost only 90 cents. On Oct. 10, those options cost $60 as the S&P 500 tumbled sharply. Universa sold most of its position in the high-$50 range.
Universa also purchased a number of puts on financial stocks, such as Goldman Sachs Group. In late July, it paid $1.29 apiece for options on American Insurance Group, the insurance giant that by September was on the brink of bankruptcy. The puts were priced to pay off if AIG dipped below $25 a share by September. Universa eventually sold them for about $21 apiece.
The fund has "done what it was supposed to do for us," says John Salib, a partner at Landmark Advisors, a New York fund that invests in other hedge funds and that invested in Universa in July. "We wanted to protect our portfolio against this kind of environment."
Mr. Taleb made his first killing on Black Monday, the crash of Oct. 19, 1987, as a trader with the investment bank First Boston (now a part of Credit Suisse), with a large position in out-of-the-money Eurodollar contracts. Investors fled into the highly liquid contracts as the market crashed, causing their value to surge.
While the black-swan strategy has paid off handsomely this year, it hasn't always. Mr. Taleb's previous fund, Empirica Capital, which used similar tactics, shut down in 2004 after several years of lackluster returns amid a period of low volatility. The strategy may face another test after the current bout of market turmoil.
The task for the fund's managers is to persuade clients to stick around after their big gains. Historically, such dramatic downturns have been rare events, occurring only once or twice a decade.
Mr. Spitznagel cautions against optimism. "You could say that so much value has been destroyed that there just isn't much left," he said. That is "a dangerous assumption, since things can always get worse."
Friday, 31 October 2008
Jonn's also been hard at work, blogging America. He's a great writer, well worth a read.
Edited to add: Here's an extremely thorough New Yorker recommendation of Obama. If you know you wanted to vote for him, but didn't know why (which is how most people vote), it's worth a read.
Wednesday, 29 October 2008
Often I come across people that I'm glad do not run the world. And no, I'm not talking about John McCain, though that prospect appears to be dwindling (though no counting of chickens just yet!).
One person on the list of those I would wish to have less power include Larry Elliott, Economics Editor of the Guardian. While he may feel his life's opposition to the world of finance has finally been vindicated, I can't find myself agreeing with a word he says. I feel that along the way his strident political beliefs have blinded him to other realities.
The fact that London has built up the world's leading knowledge-based economy, in information, IT, banking and creativity, is nothing to him, only something to denigrated and insulted. This is a difficult one to accept, particularly as many of these insults come from someone whose employer has directly benefited from the 'fake' economy. Hypocrisy is an over-used word but surely the fact that the Guardian is employing the same techniques would give Elliott a moment to think through his prejudices?
Friday, 24 October 2008
"Ultimately, debt is a way that people bet on their own futures, placing a wager on their own ability, cleverness, diligence and luck. When those bets fail, the consequences for the loser can be sad. But the world is a better place, on the whole, if people have the right to make such wagers in the first place."
Thursday, 23 October 2008
Anyway, the US Congress has decided (once again) to give the ratings agencies a kick, looking to make political capital out of their misery and mistakes. It's easy to see why, the agencies have not only been sloppy in their procedures and policies, but have allowed themselves to become inveigled into the global financial markets' regulatory system while taking little or no responsibility.
Because they have become involved in regulatory systems - sometimes one wonders against their own wishes - this gives journalists, aspiring politicians and prosecutors an easy opportunity to gain during these difficult times. Certainly some of the behaviour revealed recently does not look good.
However, I still believe that the agencies are more sad than mad. During the peak of the credit boom they were staffed by junior analysts (particularly in structured finance, where all the party-types worked) were poorly paid (by industry standards) and teams were regularly poached en masse by investment banks, which seemed to believe that agencies were perfect training grounds for up-and-coming deal structurers.
Overall, the problem, as Frank Partnoy argues, was often not the credit rating agencies, but those that decided to believe their ratings. Those in the market knew that rating agencies were not much use, unless you needed a rating to help sell your deal. Rating agencies give opinions on credit, not objective true assessments. Just as journalists on many newspapers give share tips, rating agencies gave their view on debt. The agencies' problem came when their ratings ('tips') became entrenched into the regulatory mechanisms of the emerging disintermediated economy. Agencies profited from this but failed to increase their standards sufficiently in case a time came when they came under intense scrutiny. To an extent they sowed what they will now reap.
However, the blame for the credit crunch does not really lie with the relatively small rating agencies, though they were clearly not perfect, it lies within humans failing to see risks for what they are, and being unprepared for how sudden change might come. Ultimately, the cause of the credit crunch is not criminal, however tempting that conclusion might be.
Secondly, there is a counter argument in favour of covenants, which James must know and does not even address. Covenant tests allow lenders both to know that a company is in trouble and begin a process where lenders and borrow can work together to resolve a borrower's problems, forcing companies to make difficult decisions which they might not do otherwise. They do not just suddenly go bust as he suggests.
Thirdly, there was an interesting note from Moody's yesterday about PIK loans. These loans allow borrower to opt not pay interest at maturity but extend the debt's maturity. The rating agency distinguished between different times when PIK loans are 'toggled' in this way. It might be that the company is in serious difficulty or is just using its cash wisely, and these different uses tells us different things about the company doing the toggling.
Edited to add: Jon Moulton seems to agree that covenant-lite deals aren't a sign of strength with the following delightfully brief reposte.
Sir, I read with interest the Insight column "In praise of covenant light loans, your flexible friend" (October 23) by Tony James, president of Blackstone.
He is right - covenant light loans do extend the life of businesses with over-adventurous capital structures. A respirator maintains life in a seriously ill person too.
I cannot but observe that avoiding disease is generally better than providing for surviving it. Certainly "commending" survivable over-leverage as a capital structure for real businesses is a remarkable view.
Wednesday, 22 October 2008
On a Mediterranean holiday this summer, it was hard to avoid the fact that Europeans are just as flabby as our American counterparts. From all corners of the continent, great heaving lumps of flesh would waddle past. Stomachs on stilts. The reasons for excess weight are complex, as any women's magazine will tell you, but also simple.
The simple reason is that calories are extremely cheap, so cheap that almost everyone in western societies can feed themselves to excess, if they wish. The complex reason is that because price does not constrain, to avoid eating to excess requires self-control. This is because our societies, and brains, are likely constructed and programmed to operate in an environment of food scarcity, because that is all most people have ever known. But it means that to limit weight, people must apply self-control, which is a difficult, and often learned, skill.
This reminds me of people's attitudes towards credit. For almost all of human existence, credit has either not been available or incredibly difficult to receive. This fact permeates all cultures and has shaped economies for centuries. Very occasionally, access to credit has seeped down beyond the incredibly wealthy, as it has done so over the last decade.
And just as with food, many people have been unable to cope with this excess of debt. Our personal and institutional structures were not designed to withstand a culture of cheap debt just as our brains and bodies are not accustomed to living in a world of cheap calories
John Kay: "Banks would normally be wary of lending to someone whose liabilities were 50 times their net assets, but they happily lent to each other on that basis – until, one day, they stopped. If you want a one sentence explanation of the present crisis, that is it."
Sunday, 19 October 2008
An example: today's Mail has found us a couple of millionaires to take pity on. While they drive a Porsche and live in a big house, these are people like us Dear Reader. They sold up their caravan park for a massive profit but then placed their money in a corporate offshore account run by an Icelandic bank. The chances of them seeing all their money again appear rather slim.
"There are hundreds if not thousands thousands of people in our position," the couple claim, before blaming their predicament on the government and asking for a bail-out. It's Gordon Brown's fault these people lacked the financial acumen to know where to safely deposit their money, apparently. I struggle with this one, but partly because there is an element of truth to it.
It is not true that wealthy people should sue the government for their own stupidity and greed. If people bury their head in the sand, understand as little as possible about finances and pass all responsibility for it onto someone else, then it is difficult to believe their claims that the government is at fault for their predicament. If I refused to take any driving lessons and then crashed my car, few would agree that Gordon Brown was to blame for the smoking wreck that I had created.
However, I would like to start playing the blame game. But it is not the government I would point the finger at, but at financial advisors. I have yet to find a financial advisor who has come through the recent crisis well. Examples of such poor advice are legion, I split with my financial advisor after a succession of illiterate advice, which included recommending investing in commercial property just as the sector crashed, investing my pension in shares just as the credit crunch hit, and then arguing with me ferociously when I decided to sell my equity holdings at the top of the market.
But normal people aren't to know better than their advisor, are they? People are told to 'speak to their advisor' before making financial decisions, but what if their advisor talks rubbish? Sue them? Possibly, but the number of disclaimers now makes this very difficult. And you can't sue someone for stupidity. The only real insurance is to know a fair amount about finance, to actually engage in it and think about what it is about.
Finances are boring until the point you lose your life savings. And is this something that the government could help with? Providing financial education and advice, and advising people to be much better informed about their financial choices? Maybe so.
‘The ultimate result of shielding man from the effects of folly is to people the world with fools.’ Herbert Spencer