Market Fallacy #2: too big to fail

Another of the market fallacies doing the rounds is the argument that some institutions, because of their size and their systemic importance, are too big to be allowed to collapse. The logic goes as follows:

The key objective is to maintain market stability and consumer confidence in
financial markets. This would be put at risk by the failing of institutions
deemed to be of systemic importance. That is, it is better to bail out a failing
enterprise than let it collapse and bring instability and chaos to the system.
The damage done by the collapse of one firm could be too great, so we must
prevent that from happening, even if it means using government funding.

In summary, the above is a synopsis of what the proponents of government intervention advocate.

But there is a perversion in the above argument. During the boom times, nobody told us that the key objective was market stability. The objective was growth, and to achieve that, the financial community kept telling us, governments should not meddle in the business of global finance. The less government intervention, the better, as global markets regulate themselves more efficiently, they claimed.

But now that the cycle has turned, the objective is stability. And how is stability achieved? By government subsidies, the very thing that investment bankers and financiers have always lobbied against.

The rules of the game have changed, the goalposts have been moved.

But secondly, the argument that some institutions are of systemic importance, it’s also bogus. Financial intermediation is the most fragmented market I know of. Firms survive with market shares of less than 1%. My own firm has a market share in the UK of less than 1% of the retail funds and pension market. Yet, we are highly profitable and we get paid very well. There are dozens of small financial institutions with a market share that does not even compute in the statistics.

To argue that some firms are of systemic criticality is a self-serving, self-protecting lie to scare inept politicians and a servile, unintelligent mass media.

First, let’s deal with the issue of interbank exposure in the OTC market between investment banks, broker-dealers and institutional funds. Proponents of the systemic-risk argument advocate that the counterparty exposures between all banks are so big that should one fail, it could create a domino effect and bring down the whole system.

This is a lie: I know of no entity that does not use collateral agreements to reduce counterparty exposure. If one big bank fails, the counterparty will be entitled to the collateral pool that was pledged. It is as simple as that. Collateral is what financial firms use to mitigate their exposures to one another. Collateral takes the form of government bonds and AAA-rated bonds, with the appropriate discount rates (haircuts). My own firm had about £200m counterparty exposure to Lehman. But our collateral is worth about £280m. Once the administrators liquidate the collateral pool, and we get our money back, all of it, we will probably have to return money to Lehman as we had more collateral than was required. This is the case for the vast majority of institutions. Since volatility in credit markets started in summer 2007, haircuts have increased so much that hardly any serious players have any material exposure to the investment banks.

So let me repeat this: Lehman Brothers, the fourth biggest investment bank and one of the key market makers in fixed income has collapsed and nothing systemic has happened. No other bank has gone down in a domino effect–because counterparty exposures are collateralised.

The only people that have lost any money are those with uncollateralized issuer exposure: those who bought money markets and bonds from Lehman. However, this is part of the game: debtholders buy bonds because they get compensated by receiving a spread (margin) over government bonds (or more appropriately, the LIBOR curve) of similar maturity. It is an accepted risk for which we (institutional investors) get rewarded. If a bank cannot pay its creditors, then it is too bad. Creditors should have sought to diversify their exposure or to mitigate it with insurance. Or have conducted better analysis and moved business elsewhere.

The “too big to fail” is a way for Wall St to protect itself from downsizing. A calculated scare tactic. Sadly, our leaders in government and the media are too inept or too coward to challenge this fallacy.

Market Fallacy #1: the blame lies with the regulators

This is the one that really irritates me. Over the years, many in the financial services community have lobbied against government-sponsored regulation of the markets. Their reasoning is that the markets are perfectly capable of regulating themselves. This of course is a fallacy of the highest order and a most perverse lie.

After years of successfully lobbing for de-regulation of the capital markets, spreading the message that governments should let business get on with it and stop interfering, now investment bankers are going cap in hand to our governments in the US and UK asking to be rescued. It is a sickening joke.

It is unlikely you will read this anywhere, but let me share a secret with you: the UK regulator, the Financial Services Authority (FSA) did warn the industry in January 2007 that we were likely to experience a repricing of credit risk, a reappraisal of credit risk premia, and the consequent effect of more restrictive liquidity conditions.

Every January, the FSA publishes a wonderful document called Financial Risk Outlook. It is a risk assessment of the next 12-18 months. It is a very valuable document –if you read it. Sadly, the patronising, arrogant, over-paid tossers that rule many financial services companies in the UK do not accept that the regulator may come up with anything worth reading. These business leaders think that the FSA is staffed by a bunch of inexperienced civil servants that cannot get a job in the industry proper. Recent events have shown that the FSA may have very good people in its ranks. Like the people that produce these annual reports.

But read on and draw your own conclusions. These are extracts of the Financial Risk Outlook 2006, 2007 and 2008.

FSA FRO 2006: (pdf)

Given the current environment of high liquidity levels, it is important that market participants consider how they would operate in an environment where liquidity is restricted.
(…)
In addition, some societies have started originating ‘sub-prime’ loans. There is a risk here that the risk/reward equation for these loans is not being assessed correctly by firms which have little previous experience of operating in these markets.

FSA FRO 2007: (pdf)

The combination of low volatility, high correlation and a historically low level of risk premia brings with it an inherently high likelihood of a major shock, especially if an event were to occur that triggered a significant deterioration in market sentiment.
(…)
In addition, global imbalances have continued to widen while investors’ willingness to take risks has increased. This means that even a modest deterioration in the economic environment could lead to an increase in risk premia, and have disproportionate effects on financial markets.

And there was a whole section dedicated to the repricing of risk scenario (p33):

Risks for firms and markets
• If economic conditions were to deteriorate, risk aversion among investors could increase and they could seek to liquidate positions in higher-risk asset classes (as was seen in May/June 2006 when investors sought to exit emerging markets and commodities). This could lead to crowded exits, draining liquidity from the market and causing erratic price swings in commodities, emerging-market equities and debt, and high yield debt.

• Volatility across the markets could increase for a prolonged period of time, resulting in a lasting aversion to higher-risk assets and more complex strategies and products. Volatility could quickly spread to other markets and to assets with lower risk premia.

• The fact that many asset classes and investment strategies that have traditionally tended to be weakly correlated are now more strongly correlated with each other could exacerbate the impact of this scenario on investors, as most of their portfolio will be re-priced in the same direction. Firms could see their balance sheets deteriorate quickly as the values of their portfolios fall.

Later on in the document:

Market liquidity remains abundant (irrespective of how it is measured), but it
is still important for market participants to consider how they would operate in
an environment where liquidity is restricted.

FSA FRO 2008: (after the start of the credit crunch and the nationalisation Northern Rock, pdf)

There is a risk that credit conditions could tighten further over the next 18 months, further exacerbating the already stretched financial market conditions. Financial market volatility is likely to remain high as the financial markets return to a new equilibrium.
(…)
It is likely that liquidity conditions will remain tighter and that financial markets will not return to the conditions market participants have got used to in recent years.
(…)
Liquidity conditions in money markets deteriorated in August 2007 as banks began to store liquidity and became increasingly reluctant to lend to each other in light of
concern over the extent of subprime exposures. Accordingly, term LIBORs rose quickly in both the dollar and the sterling markets to reflect tightening conditions.
(…)
As credit conditions tighten, the lending industry could become more concentrated. In particular, those who rely on wholesale funding could find it difficult to satisfy demand for loans given funding and pricing pressures.

So there you have it. The regulator asked firms to ensure their stress-testing models included a reappraisal for credit risk premia and a change in liquidity conditions. Many firms ignored the FSA’s warnings and now are being nationalised or bought over by competitors, reducing consumer choice. First, Northern Rock, then HBOS was rescued by LloydsTSB, then this weekend Bradford & Bingley is also going to be rescued by the government (ie: taxpayer).
Who will be next? Who knows. Alliance & Leicester has already been bought by Santander...so probably Britannia (a "safe" building society!) could be next.....

But what we know for sure is that we were all warned about it, and most market participants did nothing at all to prepare their firms, or their mutual funds, for the scenarios highlighted by the FSA in 2007 and 2008.

The enduring quality of fallacies

In the same way as I wrote a few entries on the fallacies that dominate Spanish/Catalan politics, I am going to write a few short posts on the fallacies that are being peddled about in this financial crisis.

First, perhaps we should remind ourselves of what a fallacy is:

1. an incorrect or misleading notion based on inaccurate facts or faulty reasoning.
2. reasoning that is unsound.

Fallacies have an enduring quality. Sometimes, fallacies are embedded in an argument in such a way that they tend to become dogma, particularly if the proponent of a cause has much more power than its weaker opponent. These fallacies then become internalised by different actors and it is an almost impossible task to challenge them.

I am of the opinion that there are numerous fallacies that go unchallenged. Fallacies in Spanish/Catalan politics, but also many fallacies in financial markets. The extraordinary events of the last few months are distracting us from looking through the fallacious arguments and flawed logic of many players.

Over the next few days, I will try to debunk some of these fallacies, myths and dogmas that the press, apart from a handful of honourable exceptions, seem unable to challenge.

A market fallacy

And now some graphs that are not funny at all:

You will have read that the press has reported with delight how short-selling has been banned by regulators in the US and the UK. Everyone is happy now. As if this was so simple!
True, a few hedge funds have been burnt and the margin/collateral calls at close today will be absolutely phenomenal, which means a nice injection of cash for the investment banks by the way, what a coincidence! Talk about taking from Peter to pay Paul?

The press, the politicians, the media, the regulators, etc, are now very satisfied that short-selling has been banned. But I can tell you just now (well, it is not me really, it’s those clever chaps at the FT.com Alphaville) that this is not going to resolve the current market turbulence. Not a chance.

Today was triple witching. Today people have rolled over contracts on the assumption that government support will continue. But it can’t and it won’t. When the whole thing explodes, it is going to be a bloodbath. This is quite scary.

Cartoon friday

Man: "If this crash had been caused by Bin Laden, right now we would be bombing out some Muslim country"
Woman: "Thank goodness that it has been caused by American patriots"

Spanish democracy revisited

Well, let’s not get the collapse of the financial system distract us from what the Spanish state does to those who challenge their (Spanish) nationalistic dogma.

In the last few days, the Tribunal Supremo, a legacy high court inherited from Franco’s regime has outlawed two political parties.

Yes, it is not a mistake. In a member state of the EU, political parties are banned. Particularly if they tend to be Basque pro-independence parties.

This is a strategy that successive Spanish governments have pursued for years. Outlawing political parties so support for independence, for a change of the status quo cannot be measured in the polls. By banning all political parties representing the pro-independence socialists, Spanish officials attempt to rig the electoral process, prohibiting a significant section of the Basque people to vote for the party of their choosing.

This is democracy, Spanish style.

I have written about it before.

February 2004
March 07 and again
July 07


For as long as Basque voters are denied to vote for a socialist pro-independence party, Spain is a half-baked democracy unfit to be a member of the European Union.

Yet, as I have written many times, fascist and neo-nazi parties are allowed to participate in the electoral process. What a fallacy: Spanish democracy.


Links:
Avui and Vilaweb (Catalan)
Publico (Spanish), again.

Risky times

Never seen this before in my life:

The graph above shows the overnight USD Libor rate. This is the annualised interest rate at which financial institutions lend funds to each other for a period of one day.
In one day, it trebled from about 2% to 6%.

It implies that the risk of default of A rated (or above) financial institutions that operate in this market has trebled overnight. Talk about efficient markets and rational investors.

Then, Morgan Stanley brings forward one day the announcement of quarterly results. And they look quite decent –if we trust the numbers, that is:

http://www.morganstanley.com/about/ir/shareholder/3q2008.html (PDF)

I know fully well the Firm is on the ball like no other outfit, but these results are surprisingly, suspiciously good. Share prices jumped about 20% in the after hours market, according to the FT. At exchange close however, they were down about 10%.

But the CDS 5Y tells a different story. After Lehman Brothers filed for bankruptcy, many financial CDS spreads have widened to below investment grade levels.
This is Morgan Stanley 5Y CDS curve:

Note: The graph is only upto yesterday's close. It does not include today's highs of 700bps.

It is a frighteningly similar curve to the one Lehman Brothers was exhibiting last week.

Tomorrow we will see what the market really thinks of Morgan Stanley's results.

Today the FED left the base rate at 2%.

In the UK, HBOS is on the receiving end of the market ire. Its 5Y CDS looks like that:

You will notice that the price of the CDS is lower than in many other financials.

HBOS recapitalised a few weeks ago to the tune of approximately £4bn.

The FT has a good article about it.

In my view, the loan/savings ratio is relatively high compared to peers at 177%. But is funding mix, is better than many others, with 55% of funding coming from retail deposits. The problem is going to be the refinancing of the debt maturing in the next few months. And that is the problem.

Given the recent market volatility, there is a real danger that insurance and fund management companies will pull out of the money markets altoghether. Money market is not only overnight or term deposits, Certificates of Deposit and Commercial Paper. It is also the crucial repo market, including the tri-party agreements now so common.

If money managers withdraw from the short-term money markets, firms like HBOS will find it impossible to refinance their short-term debt. It will be absolute pandemonium.

I hope that the ABI and the IMA, together with the Bank of England the the FSA and their international counterparts get together to draw a plan to prevent paralysis in the money markets. Otherwise, we are facing a financial crisis much, much bigger than The Great Depression.

Fasten your seatbelts

This is going to be more painful than we all thought: Lehman Brothers (LEH) has gone bust.

For the best, detailed coverage, read the FT.com website.

For a high level summary, get your news from the BBC News website.

This is the biggest bankruptcy in history.

• On Monday last week, you could have bought protection for Lehman Brothers at about 350bps. Sadly, I did not: I am not Nostradamus.
• On Tuesday it was about 500bps. I am not Nostradamus but I can smell blood.
  Rab said, "yes, I do".
• On Friday it was about 900bps but nobody was really selling. The game was up.
• On Monday, LEH files for bankruptcy protection, a credit event, letters are being exchanged and the CDS contract is triggered. In a few days, the post-default recovery value will be established by a panel of ISDA members. Bond holders will deliver the bonds, physically, to the protection sellers, and these will pay up the nominal value of the bonds. If you bought the bonds at discount to face value, the capital gain could well be over 10% of the nominal for subordinated debt.
• The seller of protection swallows the defaulted bonds in their balance sheet and becomes a creditor to LEH.
• As we say in Catalan, "bon vent i barca nova!" or "See youse later!"

And the question is: who is next? UBS, Deutsche Bank, Morgan Stanley, Barclays?

If your fund manager has not bought CDS protection by now, it's probably too late. Corporate bond funds overweight financial bonds are going to suffer capital losses in investment grade bonds. The credit rating agencies have proven to be incompetent and unfit for purpose. The EU will get their way and will ensure CRAs are properly regulated, like it should have always been.


This is not going to be a quick adjustment, a blip, as the usual cheerleaders of excess are claiming:

Our view: On balance, we believe that the worst is now over for bank
debt as an asset class, but this does not means that some individual
organisations may not come a cropper. Indeed, respected
US economist Kenneth Rogoff has stated that there is a high
probability of a "high profile casualty" amongst the US banks.

We just had two casualties in one weekend, all powerful Lehman Brothers (apparently the best algorithm trading and risk systems) and all-mighty Merrill Lynch (apparently biggest equity capabilities), and AIG seems to be next. For retail investors in open-ended vehicles, the pain of mark-to-market values of debt holdings will last for a while. If your fund is overweight financial equities, I am really sorry for your loss.

I believe we are going to see a reshaping of financial institutions that was unthinkable two years ago. Many of us, not least the FSA (as published in their Financial Risk Outlook 2007), were expecting a repricing of risk, and an increase in risk premia. We adjusted positions accordingly a long time ago. But this is just something else. Highly geared banks dependent on wholesale funding will see their value destroyed. Not even senior debt holders are safe. The CDS market is going to be tested in a way nobody predicted. Good luck to all those participants who bought protection without holding reference assets. The scramble for post-default bonds will push their value above recovery price. The promise of "best endevours" of cash settlement are worth as much as LEH shares. It is going to be a once in a lifetime event.

If you are lucky enough to have serious money (+£100k) invested in cash deposits and savings accounts, I would urge caution. Check out your financial regulator website and find out how much your national deposit protection insurance actually covers. In the UK for example, only the first £35,000 of savings held in a bank account are guaranteed. If you have much more than that with one bank, you should spread the risk by opening savings accounts with other institutions.

Russia’s way

The cat is out of the bag.

Let's recount.
An independent journalist, murdered. A bit of blackmailing regarding energy resources.
After a neat exercise of ethnic cleansing, follows an unnecessary invasion and occupation of a neighbouring sovereign state, and destruction of its military and civil infrastructure beyond the conflict area as a punishment. And a lesson for others: Ukraine.
You set out the rules of the game. States with Russian nationals are within the scope of Russia’s military activity. If I was the Ukrainian, Estonian, or Latvian government, I would be very worried indeed.
Another journalist, murdered.
A chilling threat.

I am no fan of the US foreign policy, as I wrote about in a previous entry. But Russia’s strategy and actions are frightening. Whatever the flaws about the USA’s government, standard of democracy and society cohesion, Russia is not the counterweight the world needs, despite the usual suspects' retorts. There are many people who are nothing more than resentful and bigoted souls whose hatred of the US blinds them to the authoritarian and antidemocratic nature of the Russian government. In their misguided ignorance, they think it is a “good thing” that someone is challenging America’s pre-eminent role in world politics and economy.

These are going to be difficult times.

If you are invested in an “emerging markets” mutual fund, either equities or bonds, I would encourage you to reassess your positions. Many of us have already done so.

If I had time, I would write what I really think about the term "emerging markets". A very nice euphemism for "undeveloped" or "mildly corrupt" countries.
Fasten your seatbelts.