Wednesday, 13 April 2011

Sailing on the pool of liquidity

During the credit boom, financiers regularly talked of ‘special purpose vehicles’ for their operations and so I started to wonder what kind of vehicles these would be. In my imagination, they quickly became ships sailing on the seas of liquidity, transporting wares over time and space.

So attractive was this idea that it quickly grew details. Suddenly, the ships had a crew – the company directors – and there became ports where these ships would sail to and from. Obviously the biggest port was the City of London, which, just as in times of Imperial Britain, was the hub of international trade. Every day vast numbers of ships from all across Europe, the Middle East and further afield would dock and unload their financial goods, ready to then be repackaged and put on ships sailing elsewhere.

And there were treacherous seas. Ever-changing, the seas of liquidity would in places be broad and deep while at others deceptive and shallow. Ship-ripping rocks were an ever-present menace, appearing to cluster around certain places and times. If a heavily-loaded ship were to sail through a patch of limited liquidity, then its end could be sudden and disastrous. Only a few sailors had the knowledge and experience to know where and when was best to sail, but not all shipowners were wise, or wanted to hear the message of experience.

In port, the loading and unloading of the ships was watched by the regulators. Few of the regulators had ever been to sea, and the sailors did not think much of their ability. However, often the regulators and the ship owners would end up drinking in the same pubs in the ports, and while there, telling tales, the regulators could often be persuaded to see the others' point of view.


So what would these ships carry? Over the years, trends came and went, different ports handled different goods. Over the years, the Chinese ports sent out increasing amounts of goods, especially manufactures. In London and New York, the amount and complexity of financial goods grew and grew. Each load was ever more valuable. Incentives increased to load up each ship with more and more.

A rising tide lifts all boats, they say, and in credit world the same rule applies. So when the central banks began pouring in liquidity to the seas after 9/11 all the boats began to rise. Liquidity came from lower interest rates, pushing down the cost of debt and so lowering the price of risk. This was bolstered by banks and investment funds, seemingly free from restrictions to generate new debt-based products, with each iteration leading to greater liquidity.

By 2005, this was sufficient for the shipowners to declare they were almost drowning in liquidity. For the ships, this meant the risks of overloading grew smaller and smaller. Default (sinking) rates fell and the risks taken by ship owners increased. As each overloaded ship returned safely to port, this encouraged the next ship to be loaded up yet further. And the regulators? They had been persuaded that what was good for the shipowners was good for the port. The shipowners had invested in a range of complex measures to assess their risks, and paid rating agencies for their opinion of them. The regulators believed that the shipowners’ actions had helped stop ships from sinking. However, they rarely looked out to sea, but if they had they would have seen levels higher than ever before.


All good things must come to an end. But before it ends, there must be a final orgy of activity. This took place in the second quarter of 2007. Liquidity became so deep that shipowners started to believe they could do anything. The most elaborate structures set sail on the sea with no consequences. But then the consequences began. This started innocuously, a couple of small boats overturned loaded with goods few people knew about. However, by August the rumours grew. Throughout the month, the shipowners' newspaper had trumpeted “crisis” on the front page every day.

People grew worried. They looked out to sea and noticed the levels, though high, were dropping. And each time they looked, the lower the sea became. Suddenly, all those ships at sea were at risk. The atmosphere in the ports grew ever more fearful. By the turn of the year, the situation looked grave. Liquidity continued to slide away. Everyone had become sucked in to the chase of landing just one more load; one shipowner noted that 'if the music is playing, you've got to keep dancing'. But the music was ending, liquidity was ebbing away. Ships overloaded with complexity and risk were left to battle their way back to port. By the middle of 2008, like a pool of rainwater left long in the African desert, there was no liquidity at all.

Monday, 11 April 2011


Last week I wrote a short piece about the two different styles of political economy writers. I noted that they can take a cautious approach, or be more bombastic and forthright. On reading this, a friend noted this was a quite a difficult distinction to draw, and it was “a bit subtle”.

As this person has an interest in science, I got to thinking that a better word for someone taking the latter approach is often “crank”. In the world of science and medicine, cranks routinely emerge but are usually (sometimes after a period of time) pushed out of normal discourse. If cranks do get taken seriously, and cause harm, then there are a number of institutional mechanisms to eradicate their influence and there is an effort to correct mistakes.

The recent case of Andrew Wakefield and the MMR scare is a good example of this. Mr. Wakefield’s views were, for media-related reasons, taken seriously for a while until eventually he was exposed as a crank. In 2010 he was struck off by the General Medical Council.

Another was the example of Simon Winchester, a science writer. Mr. Winchester wrote an article for Newsweek on 13 March claiming that “The Scariest Earthquake is Yet to Come”. It didn’t take long for geologists to reject Mr. Winchester’s claims, and though his “bogus claim” was picked up by many news sources in the US, punch in “Simon Winchester” and “bogus” to Google and you can see the world of science fighting back.

Politics and finance does not have the same process.  Indeed, often the most sensationalist ideas get picked up while the accurate ones are ignored. The list of cranks writing about political economy, particularly after the financial crash, is long, and many get a lot of attention. However, there is no mechanism or culture of correcting mistakes. People with silly views of the world usually remain uncorrected.

One of the most forthright of these is Johann Hari, the Independent columnist. Here’s an example of what he does. He wrote a story for the Huffington Post in December declaring: “The Banks Have Not Been Reregulated by Our Corrupt Politicians. So Get Ready for the Next Crash”. There was little in the story that was accurate, neither in his general assertions or the details provided.

As an example, to justify the claim that “the banks have not been reregulated”, he said that: “Most economists believe the banks need to hold capital reserves of 30 percent to protect against another crash. The new rules say they have to hold 3 percent, by 2019, if you wouldn't mind awfully.”

Neither of these claims are any way near true. “Most economists” wouldn’t claim a 30% capital ratio to be desirable, and even the article he links as a source doesn’t say this (“equity requirements need to be very much higher, perhaps as high as 20 or 30 per cent”) and he’s the only writer I’ve seen suggesting such a high number. His second point about the “new rules” refers to Basel III, which states that banks have to hold 7% by 2019 not 3%. (As an FYI, today’s ICB report on UK banking says the figure for retail banks should be 10%.)

I wrote to Mr. Hari asking him if he could point me towards his sources for these claims. I didn’t get a response. The article was widely republished and remains on his website, uncorrected (September 2011 update: the article has been removed from his website between July and September 2011). General readers will never realise that the article was misleading and its key facts were wrong.

Friday, 8 April 2011

The Puke Point

What, my wife asked, knowing that sometimes I need an outlet to talk debt, is going on in Portugal? What is this mess they’ve got into?

Earlier that day Portugal’s caretaker Prime Minister had given into the inevitable and started talks with the European Union on a bail-out financing. Reports suggest the country needs financial support of 70 – 90 billion euros.

It’s a tough situation for a country that’s seen several years of hard times. There’s been years of deficits, recession, a failed austerity budget and then, pushing it over the edge, the parliament refused to pass a second austerity budget, triggering Prime Minister Socrates to stand down and call new elections, due 5 June.

The Prime Minister continued to resist help, but the final straw was the threat by Portugal’s biggest banks to stop buying government bonds. They had reached the puke point, where bond buyers lose their appetite to buy debt. On Monday, Portugal held its (semi-regular) auction to sell government bonds and had to pay 5.1% on six-month debt and 5.9% on 12-month debt – far higher than the country can afford over the long-term, and would have to rise further if the Portuguese banks made good on their threat.

And governments cannot choose to ignore the debt markets. Auctions of debt are routine for all large economies, and the results are made public. And in between these auctions there are a variety of ways (primarily secondary trading and CDS) that indicate market appetite pretty much in real time.

For Greece, bond auctions in the first months of 2010 indicated that lenders had grown queasy of buying Greek government debt; the puke point was not far away. By March, Greece had agreed a rescue package from the international authorities.

Last September, the Irish government decided to cancel all planned bond auctions, seeking to shy away from bondholders’ unpleasant message. However, CDS levels rose through October and ended up indicating Ireland would have to pay in excess of 7% to borrow. By November, Ireland had begun bailout talks.

There are differences between Ireland, Portugal and Greece. In Ireland, the government made a rash decision in 2008 to offer a blanket guarantee to the country’s banks. (In hindsight, this was one of the most expensive decisions ever taken by a small country.) By contrast, banks in Greece and Portugal are not in need of a bailout, and in many circumstances are held back by the weakness of the sovereign state’s credit rating.

In Greece and Portugal, but not in Ireland, the banks have traditionally bought a high proportion of the government’s debt. By doing so, governments were given an easy source of funding, but these banks tended to be owned by the state and acting in the interests of the state, so have been stuffed with low-priced – uneconomic – bonds. They had no puke point; the taxpayer would ultimately pay for their largesse through regular banking collapses and financial crises.

Since joining the euro, these countries have been able to reduce their dependence on their domestic banks, finding instead foreign bond investors more than willing to lend. These investors believed that Europe’s periphery offered a ‘convergence play’ – ie that the poorer countries of Europe were on a journey that would see them end up with similar credit profiles to that of the richest, but in the meantime they would pay higher interest rates than countries such as Germany and the UK. Investors’ largesse combined with poor governance, and Greece saw its sovereign debt balloon to more than 290 billion euros, most of it held by foreigners.

So that’s Portugal, Greece and Ireland dealt with, is there anything here that’s relevant to the UK? Only today The Guardian splashed its front page with attacks on Chancellor George Osborne ("desperate ... scaremongering" according to Shadow Chancellor Ed Balls). Critics of austerity at the leftist blog Liberal Conspiracy took Osborne to task. Here is one of the better-informed critics today:

“Tough austerity is a self-defeating strategy.

Several commentators have been quick to point out that Portugal, Ireland and Greece had ‘no choice’ but to adopt these policies. Now whilst there is always a choice, I fully accept that in each of those cases membership of the Euro, the maturity profile of outstanding debt that needed to be refinanced and loss of confidence from the bond markets forced the government’s hand.

But this doesn’t change the fact that austerity isn’t work and is unlikely to work.”

According to this commentator, who at least seems to know the difference between debt and deficits,

“The key difference between Britain and the Euro-Periphery is that Britain certainly does have a clear choice – we have the longest debt maturity in the developed world, the markets are prepared to lend to us at near record lows (and have been for over two years – not just since the emergency budget), our debt/GDP ratio is comparatively low. Whatever the scare-mongers say, Britain was nowhere near the brink of bankruptcy.”

This is a  curious and elusive use of phrasing, concepts and numbers. It is true that Britain was not near bankruptcy, as David Cameron once (in 2009) unwisely claimed. It was untrue then and it’s untrue now. And, yes, the UK has stretched its debt maturity (as have other developed world countries) for the last couple of years, taking advantage of continued investor appetite for UK debt.

So, nothing to worry about then?

Well, not really. What’s noticeable about Mr. Weldon’s peon to the UK’s creditworthiness is that he doesn’t mention the main group of people concerned about the UK’s debt: the credit rating agencies. And these have issued frequent warnings about the UK’s debt position. As noted below, one of these, Moody’s, said last month that the UK’s Aaa rating remained at risk, and explicitly praised Osborne’s plans to cut the deficit.

Until now, the UK has seen its debt climb at a dizzying pace but has maintained investor confidence. The puke point appears some way away. However, and as the Moody’s report makes clear, this confidence is substantially connected to the government’s determination to reduce the deficit. Investors have seen the UK as a safe haven, but there is no law that says this will always remain the case.

If there is one thing we should have learnt from the financial crisis is that high debt levels mean investor confidence can be lost almost overnight. The puke point is never far away. The complacency of the anti-austerity critics, and this includes the Labour opposition, seems breathtaking in this regard. The difference between Portugal and the UK is that investors in Portugal reached their puke point; given the UK’s high level of debt there is no reason to suggest the same could not happen to the UK.

Addendum: the only way that the UK could be sure of continuing to borrow without a care for investor confidence would be turn the clock back and stuff state-linked banks (such as RBS) with government debt. Though such cronyism has long since been banned by Europe, it is one logical extension of the arguments made by the anti-austerity brigade.

Wednesday, 6 April 2011

Number Crunching

£10 million: Amount of tax UK Uncut accuses Associated British Foods, which partly shares ownership with Fortnum & Mason, of avoiding and used as justification for the store's occupation on 26 March.

£60 million: Amount of tax The Guardian's owner, Guardian Media Group, has been accused of avoiding as part of its 2008 deal to sell a stake in Trader Media.

GMG paid no corporation tax in the 2008/2009 financial year, for which it reported profits in excess of £300 million. “The Board (of GMG) ... believes that it has a commercial responsibility to manage the Group’s affairs in a tax efficient manner within those rules as well as to manage the Group’s exposure to tax.” The Guardian has described its tax affairs, which included the establishment of a Cayman Islands subsidiary, as “not abnormal”.

Since 2007, the Guardian has run an investigation to expose how “large corporations are creating elaborate structures to move profits through subsidiaries to offshore centres such as the Cayman Islands, Bermuda and the British Virgin Islands, to avoid handing money over to tax collectors in the countries where their goods are produced”.

Sunday, 3 April 2011

Seek and ye shall find

There are two ways to write political economy. One is to be the intrepid explorer, seeking out the truth and constantly revising opinions along the way. Each new mountain of understanding reveals a fresh vista from which to understand the world. Such a writer must know much about what he does not know; changing conclusions becomes a habit, modesty and an aversion to certainty become key characteristics.

The other approach is the seeker of a distinct truth that lies buried at a known point in the jungle. The style of such a writer is to march in a straight line from here to there, scorching the earth, proving all the way why that journey is correct, and leading inexorably to the predetermined destination. Habits of such writers include certainty from the opening page, declarations of others' weaknesses and failings, as well as claims that their work reveals some secret but vital truth about the world.

In our opinion-soaked age, telling the difference between the two is of vital importance.

Friday, 1 April 2011

Where's the fool?

To mark April Fool’s day, the UK media have a charming habit of publishing plausible yet false stories to entertain their readers. The Guardian, splendidly, once published a guide to the island of Sans Serriffe. However, to my critical eye it’s not just April 1st when it seems difficult to distinguish between fact and fiction. And it’s not just the silly stuff.

Take The Guardian’s recent story on whether the UK can pay its debts - “UK risks losing top AAA credit rating if growth is lower than predicted”. The maintenance of the country’s AAA credit rating is a key economic objective of the present government, and so the story is of significance.

The newspaper’s headline is reflected in the opening of the story, and there is a quote high up the story from Moody’s in support of the opening section of the story (the ‘lede’).

However, the headline of the report was actually: “UK Budget: Continued Commitment to Fiscal Consolidation Critical to Aaa Rating”. ‘Fiscal consolidation’ broadly means cutting deficits - where the government spends more than it receives in tax.

Here’s some meat from the Moody’s report: “The two key drivers of the future evolution of the United Kingdom's credit risk profile are likely to be economic growth and fiscal consolidation. Although the government faces challenges in both areas, the budget announcement on 23 March 2011 indicates that the UK has the willingness to meet these challenges. This conclusion is based on the government's plans to achieve a cyclically adjusted current balance by the 2015-2016 fiscal year, or even earlier, despite the recent deterioration in the near-term economic growth outlook.” (Emphasis added.)

However, this doesn’t fit the centre-left / Guardian narrative about the economy, which is that government’s cutting plans are excessive and will mean the UK economy will stop growing. So, the story effectively hides the fact that Moody’s explicitly praised Osborne’s budget, and specifically his plan to cut the deficit in full by 2015-16, by burying it in paragraph eight (of 10). To get to the truth, readers must first wade through references to Osborne’s over-optimistic growth forecasts, the threat this causes to the Aaa rating and the (spurious) assertion that the Moody’s report directly led to a (tiny) drop in the value of the pound.

Ultimately, the story is misleading, because even the most determined and well-informed reader would have struggled to realise that Moody’s believes it “critical” that the government focuses on cutting the deficit, while the issue of growth is important but of secondary significance.