Rotten to the core

A lot has been, is being and will be written about the state of Spanish banks and the Spanish economy.  One of the reasons I do not write more regularly about economics, finance and investments is that there are plenty of very smart and intelligent people already doing so, not least Catalonia-based Edward Hugh. The other reason is because I work in the damned sector (asset management) that bears a great deal of responsibility for the boom, the bust and subsequent economic mess we are all involved with.

A few months ago, I tried to reply to a post in The Badrash about the banking crisis but I think it was far too long...  I was cleaning up my hard drive when I came across the text I had written at the time. So this is a bit of a recycled text from Q4 2009 but still valid nevertheless:

Any published investment research uses ramping to some extent. Everybody talks their own book and it is just a matter of degree how unsubtle some people are. Let’s ignore the xenophobic PIGS slur nonsense and focus on the numbers.

Ramping or not, the banks are not recognising loan losses. That much is clear. 

Whether they are insolvent or not is not the point anymore –the government is always there so it does not really matter unless you are a shareholder or a junior debt-holder. Retail depositors will be fully protected, which is the main thing these days, and rightly so.

This story has been brewing for a few months now, so let’s recap: (taken from FT AlphaVille)

February 2009: FT publishes warning piece on the grandstanding of Spanish banks and the “miracle” of dynamic capital provisions.

http://www.ft.com/cms/s/0/1f9d6fce-dbd7-11dc-bc82-0000779fd2ac.html

April 2009: BdE governor issues infamous list of cajas at risk.

http://www.eleconomista.es/empresas-finanzas/noticias/1184690/04/09/El-gobernador-desliza-una-lista-de-siete-cajas-que-deben-ser-reestructuradas.html

May 2009: Moody’s Capital Markets Research issues report.
http://ftalphaville.ft.com/blog/2009/05/18/55898/the-pain-in-spain-will-be-felt-mostly-by-the-banks/

May 2009 (a week later): Moody’s Ratings division issues release announcing it would review ratings for 36 Spanish institutions.

http://ftalphaville.ft.com/2009/05/19/56032/scrutiny-of-spains-potential-banking-pain-increases/

June 2009: Moody’s Ratings division issues ratings downgrade update/

http://ftalphaville.ft.com/blog/2009/06/15/57101/moodys-bank-downgrades-pain-in-spain-edition/

Questions start to arise about the ability of cédulas to pay out.

http://ftalphaville.ft.com/2009/06/26/57236/forget-latvia-what-about-spain/

During the summer, rumours start to spread in the web about the financial strength of Spanish banks and all kind of wild predictions are made. It all kicks off at the end of August.

18 August 2008:

Expansion publishes famous article about 1 in 5 mortgages at risk of being in arrears or default:

http://www.expansion.com/2009/08/17/inversion/1250540803.html

This is picked up by Edward Hugh in the Fistful of Euros blog:

http://fistfulofeuros.net/afoe/economics-country-briefings/twenty-percent-of-spanish-mortgages-now-considered-to-be-high-risk/

21 August 2009

Variant Research (affiliated with a UK hedge fund) issues gloomy report.

http://ftalphaville.ft.com/2009/08/21/68016/are-spanish-banks-hiding-their-losses/

25 August 2009: Felix Salmon at Reuters publishes article on Spanish banks.

http://blogs.reuters.com/felix-salmon/2009/08/25/spain-crumbles/

2 September 2009

Iberian Equities (Madrid-based) takes patriotic exemption at Variant’s research and issues counter-report.

http://ftalphaville.ft.com/2009/09/02/69596/surprise-spanish-banks-are-not-hiding-their-losses/

3 September 2009

Variant Research replies to Iberian Equities counter-report.

http://ftalphaville.ft.com/blog/2009/09/03/69711/spanish-banks-are-hiding-their-losses-round-2/

11-21 September 2009

Edward Hugh publishes various articles about Spain:

http://edwardhughtoo.blogspot.com/2009/09/there-is-another-shoe-to-drop-in-global.html

http://spaineconomy.blogspot.com/2009/09/how-does-ecb-ever-manage-to-stop.html

http://spaineconomy.blogspot.com/2009/09/three-million-unsold-properties-in.html

9 September 2009

UBS publishes research on Spanish banks.

http://ftalphaville.ft.com/blog/2009/09/09/70826/spanish-catastrophe-datapoint-del-dia/

14 September 2009

Credit Suisse issues less gloomy report on Spanish banks.

http://ftalphaville.ft.com/blog/2009/09/14/71716/spain-catastrophe-otro-datapoint-del-dia/

15 September 2009

S&P issues report on expected credit losses.

http://ftalphaville.ft.com/blog/2009/09/15/72101/sp-sees-meaningful-financial-stress-for-spains-banks-e965bn-worth/

5 October 2009
They are even talking about it in Australia.

http://brontecapital.blogspot.com/2009/10/are-spanish-banks-hiding-their-losses.html

13 October 2009

Moody’s issues updated report on Spanish banks.

http://ftalphaville.ft.com/blog/2009/10/13/77501/moodys-still-negative-on-spanish-banks/

15 October 2009

Nomura issues research report on Spanish banks. Nice graphs.

http://ftalphaville.ft.com/blog/2009/10/15/77956/spanish-banking-crises-then-and-now

So, Spanish banks are fucked, and it is only the political will of the ECB that there have not been in Spain more bank failures like Northern Rock, B&B, etc.

Dynamic capital provisions, prudent lending standards, all well and good and thanks to this it is not worse. An airbag would not save you from a 200 Km/h crash, and the same applies to dynamic loan provisions in Spain.

Let’s stop and think for a second:

Is it possible that Spanish banks are somehow immune and unaffected to the biggest property bubble in modern history and still with an inventory of c3m properties unsold?

So that is what I compiled and wrote around mid-October 2009. 
Since then, a few things have happened. 

 9 Dec 2009: S&P places Spain sovereign debt outlook on negative watch. Edward Hugh expands and explains. But check this older post for a back-to-basics explanation and background on the whole fiasco.


3 Feb 2010: BBVA presented results in Q1 2010 and people started asking questions [again] about NPL (non-performing loans), or mortgages in arrears/default to you and me. 
BBVA.



17 Feb 2010: JP Morgan issues a report on regulatory reform and capital requirements of the banking sector, looking at dynamic provisions, one of the idiosyncratic features of the Bank of the Spain regulation of the banking sector. This report vindicates something I wrote many months ago in someone else's blog and at work in 2008:  "..dynamic provisioning or not, Spanish banks are toast. Would you be saved by an airbag if you were driving at 200Km/h?". 

18 Feb 2010: Credit Suisse publishes a research note on Spanish banks. Top read. 

 And of course we have the whole sovereign debt crisis in Greece and moving westwards across the Mediterranean (and Ireland) into what the europhobe and ignorant anglo-saxon media have termed the PIGS. 

So let's recap:

1) The banks get themselves into a mess of their own and end up insolvent or bankrupt.

2) Sovereign states (ie: taxpayers) come to the rescue of the banking and wider financial sector and inject billions of euro/pounds/dollars into the financial system. 

3) Now the financial sector turns their attention to the fiscal position of sovereign states and demand that spending be curbed or taxes raised to reduce debt. 

4) Politicians across the western world get ready to cut public sector investment (that's schools, hospitals, police, transport, and so on) and/or  lower corporate taxes to attract foreign investment and encourage growth. 


And then when people complain about this rotten state of affairs, they are labelled populist and that banker-bashing is childish. 


If I was a teacher/policeman/nurse/bus driver/social services officer about to lose my job because of the demands of the very people that got bailed out by the taxpaying public I would feel nothing but hatred for any manager/front office dumb-ass working in the financial sector who is still defending the indefensible against any logic.


There is no other "industry" in the world of business that can get away with deception, duplicity, theft, tax avoidance and an absolute disregard for the wider common good in such a massive scale as the self-serving, socially useless banking and investment sector. 


And what can be done about this? 
Nothing, absolutely nothing because our politicians are all in the pockets of the financial sector. It is all very depressing.

The lost decade

Sometimes I wonder why I blog when I enjoy more reading other people's bright and illuminating writing. Perhaps I should just post links to articles and blogs, like a policeman managing traffic at a busy intersection.

Over the last few months, Iain Macwhirter has written brilliant stuff for the Sunday Herald, particularly about the underlying causes of the financial crisis and the inability of the political class to confront the powerful financial services lobby, in particular the banks. He even seems to have stopped his partisan attacks against the SNP. Who knows, maybe one day Iain and other Herald journalists will see sense in Scotland becoming a normal state within the EU as opposed to remaining as an appendix of England…

This article about the imminent demise of the Labour party in the UK is poignant, coming from someone that used to be a party member while at University.

Sunday Herald

A few days ago, my father-in-law made the mistake of mentioning politics during our weekend visit for tea and biscuits. I went onto a rant about the lost decade and why Labour only has itself to blame for their forthcoming electoral disaster. I don’t think he will make such a blunder again and will stick to football and the weather from now on.

For the vast majority of working class Scots like my in-laws, a Tory government is synonymous with public service cuts, mass unemployment and the hated Poll Tax (in Scotland first). The Conservatives is “their” party. The party of the rich and wealthy. The party that will screw the working class living in (former) council houses. Labour is still, believe or not, the people’s party for the vast majority of working class Scots.

However, after 12 years of Labour rule –or was it New Labour- we can now assess what has been achieved. And, sadly for traditional Labour supporters, we know that things have not got much better.

If anything, things have got worse, and the current crisis will only exacerbate it.

Income inequality is now wider than 1997. People in higher incomes have done very well of Labour’s spell in power.

Poverty.org.uk

ONS [pdf, 800Kb]

IFS [ppt]

The working class have remained working for stagnant wages that prevented them from buying assets. These assets became more expensive as middle and higher earners accumulated financial assets and property, keeping them out of reach of lower income households.

Wealth distribution is now more unequal than it was in 1997.

Higher earners have accumulated a higher ownership of assets than ever before, namely property and financial assets thanks to the very generous tax breaks offered to them. Lower and lower-middle earners have not been able to buy assets, as prices keep escalating out of their reach. Thus the poor have stayed poor whilst the rich have become even more richer. The gap is now wider than it was in 1997. (Gini coefficient, ONS, wiki)

Hansard

WSWS

Social mobility is now more restricted than it was in 1997.

Access to tertiary education is now more expensive and difficult for families in lower incomes after the increase in tuition fees and the abolition of grants. Oxbridge and first tier Universities remain the preserve of privately educated, middle-class or wealthy families and any changes in access remain statistically non-significant.

Access to good state schools is now dependant on ability to buy property within schools catchment’s area, which is out of reach to any families in average incomes.

So Labour, the party that looks after everybody, the party that is on the side of the have-nots, and in favour of wealth redistribution has been a catastrophe for the very people it ought to have looked after.

It has been very good however to those in higher incomes who have been able to accumulate property (tax relief of interest), financial assets (tax gross up and relief on pension contributions at marginal rate, etc.)

And this is without mentioning the lies over the Iraq war, semi-privatisation of NHS, Post Office closures, etc, etc.

I am not advocating a vote for the Conservatives but anyone on average incomes who believes that Labour is going to be good for them needs to have a reality check. Sorry.

Bubbles

While I was in Barcelona visiting friends and family, one of my friends asked me (as if I had a clue about anything…) what was the likely outcome of the current financial crisis and what can be done.

I did not venture to suggest any investment strategy or anything like that, apart from avoiding investing in equities unless you had already saved about 1 year of salary. Maybe hedging against long-term inflation by buying gold (via ETF), if you have lots of money spare. In general, my advise for people wondering whether to invest in the stock-market is “don’t”.

But I did try to make the point that in my view we are in so much trouble that the politicians are scared of telling the public. I, like many other people, think that there are no asset bubbles left to burst:

1997-1997: Russian rubble
1999-2001: dot.com
2003-2006: equity
2004-2007: corporate debt
2005-2008: property
2007-2008: commodities
2008-?: government debt

In my view, there are no other assets whose value can be inflated so as to give the general public the illusion of wealth and thus keep consumption going. Every bubble in the last decade has been punctured but as one bubble was burst, another was created and so forth until there is only one bubble standing: sovereign debt.

In order to prevent a banking collapse of unknown consequences, our governments have beefed up the financial system with fiat currency, a posh term for paper money. That is, money that is not secured on any other asset, but on the ability of the issuing central bank to repay the creditor.

In the past, currencies were linked to the gold standard. This system stopped operating in the ‘70s and since then, we have just been in a massive super-bull market lasting over a quarter of a century, navigating our way from bubble to bubble. This is the view of people like Soros in his latest book. From the small perspective that only 34 years of age and some cultured reading can give me, I fully agree with the man. You might think that Gold could be the next asset whose value will be inflated beyond any measure of fundamental value, and you might be right. The problem is that it is not possible to generate the illusion of wealth amongst the wider public by propping up the value of Gold or even Gold derivatives.

As someone said during dinner, if that is true, we are all fucked. Aye big man.

But a few days ago, I read this article in my Bloomberg terminal. I was wrong. There is another bubble left to burst: banking bonuses and salaries.
The author is spot on.

If anybody thought that the current crisis would serve to change the investment banks business model, they are showing that they have never been in a trading&sales floor, or in the bars around Canary Wharf, or have never met anybody working in M&A, or a trader, or a junior Vice-President in an investment bank, etc.

The politicians do not have the balls to let any bank, investment bank or market maker go under so the party will continue for a while.

“Too big to fail”, “systemic importance”, “market confidence and stability”, empty words used by those who would not hesitate sell their mother in a reverse auction if their Excel models told them to do so.

The government has an easy solution to the banker’s bonuses corporate fraud: any employee in a taxpayer supported institution (either by government guarantees of their debt, TARP, etc) should be taxed at 60% on any remuneration exceeding £200k, including pension contributions, and be ineligible for any tax relief over this amount. I think ten times the UK’s average wage should be enough for anybody and if it is not, then they should not be employees of government-funded organisations, but proper business-people and set up their own business without government support.

The usual suspects will bark about “talent”, “highly educated” and the usual protectionist bull. I have not meet more uneducated and uncultured people in my life as when I was working in Canary Wharf a few years ago.

The industry is so powerful and politicians are so weak and spineless that nothing will happen of course. But the industry is rotten to the core, devoid of any ethics or morality, self-focused and detached from the wider society. And you and everybody who does not work in a financial institution are paying for all this.

Noise

Today I am going to write about financial markets and how the press reports financial news.

Sadly, I don’t write much about the markets because I need to be careful about what I say and what message I convey. Conduct of Business Rules and FSA Approved Persons, etc. There are far too many conmen out there and I cannot give you advice that suits your personal circumstances.

If you follow the news, today you will have read that S&P, the credit rating agency, has released a note on the outlook for UK sovereign debt.

The note was received in Bloomberg terminals at about 0924h.
The note is not available to the public but the BBC has a half-decent article about it.
http://news.bbc.co.uk/1/hi/business/8061019.stm

In the minutes just after the announcement, GBP went down against both EUR and USD.

Immediately, the newswires went mad and the media reported that the decline of GBP was a consequence of the S&P note.

Even my favourite financial blog –for now- reported the story at 1000h:

http://ftalphaville.ft.com/blog/2009/05/21/56114/united-kingdom-the-first-rating-alarm-bell-rings/

I want you to look at that Bloomberg graph very closely. Notice that the time in the screen is 0928h, merely 6 minutes after the note release, with the post being published at 1000, just about 30 minutes after the news became public.
The graph only covers the previous 12 hours trading.
At 1008h, yours truly humbly suggests to the journalist to change the time period of the graph to 2 days.

It would have shown something like this:

Yet, this did not stop the FT or the vast majority of the media to make a bit hoo-ha about how the markets were reacting very badly to the S&P note.
Even FT Alphaville (a blog for the pros) kept publishing posts about it, despite my best attempts.

So, in the immediate aftermath of the press release, GBP went down about 1.8% vs USD but rebounding back very quickly so that 2 hour after the press release, the decline was only about 0.8%. Still, it was somewhat above yesterday’s closing price.

And this is the problem with financial journalism: market noise is mistaken as market reaction and since the market just produces noise 95% of the time, lots of effort, time and energy are spent trying to concoct explanations about events that are, the vast majority of the time, just random movements.

Yesterday, Wed 20 May, between 14-17h UK time, GBP went up about 1.5% against the USD, but there was no S&P release or other news item to justify an explanation.

Check out this graph:

As I write this at 2115h UK time, not only has GBP not reacted negatively to this morning’s S&P note, but is actually higher than when the note was published!
And the questions is: will this “market reaction” generate as much media frenzy as was unleashed this morning and early afternoon? Probably not.

The problem I have is thus:
I would also expect the tabloids, or The Times, to have a go at the Government publishing misinformation.
I fully expect uninformed, malicious and politically-biased numpties like Guido Fawkes to post something like “S&P downgrades UK government debt” [link].

In fact, nothing of the sort has happened. Not even close.
S&P has merely updated the market saying that it sees the outlook for the UK economy as negative, and that it is worried about the state of public finances and public debt levels.
When I read the note this morning, the first thing that crossed my mind was: “tell us something we don’t know!”
So, to recap.
+ It is a revision in outlook.
+ Before a downgrade happens, first an issuer (normally) is placed in “negative watch”.
+ After a bit of time in “negative watch”, then the downgrade follows.
+ This has not happened today.

As for the S&P’s record on analysing public (or private) finances, I refer to the sub-prime mess, the CDOs, Enron, Parmalat, etc, etc. Just for the record, S&P did not alter its outlook on UK debt during the ‘90s hyper-inflation years, when debt as a % of GDP was slightly higher than today’s levels.

Notwithstanding the huge problems in the economy and the massive amounts of household, government and, particularly, corporate financial debt, today’s events and news coverage is a wonderful example of what Taleb describes as noise and the narrative fallacy.

Somehow, we have built a system of news coverage where there is an obsession to attach a narrative to events, to seek causality regardless of the logic or empirical proof behind it.

I have only been in this business for about 7-8 years, but being a sceptic has helped me a long way to differentiate between reasoned analysis and logic and crap. Today was a lesson on crap journalism by a lot of media outlets.

If we cannot get a FT or BBC journalist to expand a simple graph to show that, actually, nothing has happened compared to yesterday's trading session, can you imagine when they have to explain something mildly complex to the public?


For the record, I attach below GBP-USD rates for 5 days and 3 years.








Update 11/06/2009

I have officially given up on AV: what a bunch of twats.

Unable to cope with any criticism of their flawed narrative logic, they removed one of my comments on the whole GBP/USD rates saga.

And today, in a trivial story about the signings of Kaka and Ronaldo by Real Madrid, I get yellow-card and then blacklisted for no reason that to write something that is public record –and because some arsehole Real Madrid took exception to it. What a joke.

Happy New Year 2009!

Well, Rab has been rather busy: changing jobs during the most severe financial crisis since 1929, moving home again, DIY, decorations, planning applications and Freedom of Information requests with the useless fuckers in the most incompetent local authority in Scotland, etc, etc, etc.

But Rab is back and from now on I will keep the blog up to date more regularly.

The New Capitalism -by the BBC

Over the last year or so, there is one man that has become a source of pain for some in the financial services sector. Some journalists don’t like him either. It is Robert Peston, BBC Business Editor. [blog]

His idiosyncratic style and general slow delivery (plus mumbling and fumbling and humming) irritates many. Others are irritated by his “attacks” on the financial services sector and the markets. The right-wing blogosphere attack him for being a "leftie" and the mouthpiece of the Labour government. Or so they claim. Stockbrokers and investment managers despise him because he “brings the market down”. I thought the markets were "efficient"?
The FT journos call him Pestowire, or Peston RNS, a reference to the Regulatory News Service used for the public dissemination of financial markets announcements.

It is difficult to convey to anyone living outside the UK how pervasive Mr Peston’s presence in the BBC has become. Since his reports on the debacle of Northern Rock, and the collapse of the banking system and consequent recession, his presence is the main feature of the 6pm and 10pm news bulletins every single day. I remember one day he even broadcast from the garden in his house.

Recently, he has published a short essay with the title “The New Capitalism”. [PDF]
They are summarised in these two videos. [link]

Personally, I don’t have any issues with his reporting. And when someone’s argument is over style, or personality, you know that people are on a loser. So I haven’t got much sympathy for those who blame Peston for anything. The world, or the stock markets, would not be any different, had Robert Peston not reported on the stories we all know about now. Shooting the messenger is not the answer to this problem, and it shows how inward-looking and shamelessly self-preserving the financial services sector (I refuse to use the word ‘industry’) has become: denial has become the modus operandi in the face of an unpleasant reality.

I do have a bit of an issue with this essay though. Not much with the content than with it having the logo of the BBC as an endorsement. So is this the BBC’s vision of capitalism post-credit crunch or Peston’s? It may be trivial and I might be over-analysing, but the presentation of this essay is not clear, and as a license fee payer I object the way in which has been delivered.

I have no issue with Peston’s book “Who rules Britain”. It may read more like a series of articles and it lacks a cohesive argument, a central thesis that it is presented to the reader. But overall, it provides a few examples of how the City and big businesses work, and how tax avoidance, sorry tax efficiency, has been encouraged by the Labour government.

But reading his essay on the new capitalism taking shape, I could not help but wondering about some of the statements and claims made:

“Arguably the global economic crisis will turn out to be more significant for us
and other developed economies than the collapse of communism.”

Well, I disagree completely. The collapse of communism left millions of people in the world, including Europe, ideologically orphan. Suddenly, there was no alternative to capitalism in its various forms. Communism, the egalitarian, collectivist alternative had failed. We went from two competing systems to one. Now we are going from an imperfect system to another one.

I agree 100% on the debt binge ('credit expansion' to be technical about it) as the key cause of the present crisis.

Some of the language is quite emotive:

“To put it in crude terms, for much of the past decade, millions of Chinese
slaved away on near subsistence wages and still managed to save, both as a
nation (China swanks £1,400bn in foreign exchange reserves) and as individuals.
And to a large extent they were working to improve our living standards, because
they made more and more of the stuff we wanted at cheaper and cheaper prices.”

It is naive to say the Chinese slaved away on near subsistence wages. Living standards in industrialized areas of China have risen in a way that was unthinkable a few years ago. If they were “slave” wages, then they could not save as much as they do. Agreed, the wages are low compared to Western standards, but wage differentials should not be measured in absolute terms, otherwise workers everywhere except western Europe are too slaving away. I could even concede that most factory workers in China are on relatively low wages, a byproduct of the excess supply of labour, but average Chinese wages are by no means “slave”. Also, and more importantly, the Chinese were not working to improve our standards or toiling for our prosperity: they were working to improve theirs, like any sensible nation does.
It would be more appropriate to say that we were outsourcing work to China so that we could buy goods at cheaper prices and keep inflation down.

I agree that the savings imbalances and the current account deficits in the UK and US (and also Spain) are unsustainable and that our low inflation in the last few years is the result of excess savings from emerging economies being recycled into UK, US and Euro-area debt.

And I also agree with the culpability. All of us to a certain extent for being addicted to compsumption, but mainly our financial institutions for having failed to protect the interests of their shareholders, creditors and customers, and our governments and regulators for having failed to take the appropriate regulatory (disclosure, capital requirements) and political (current account deficits, allowing outsourcing to countries with unacceptable working conditions, supporting asset inflation) decisions to prevent this crisis from happening.

But Mr Peston forgets to mention the issue of taxation and the use of low-tax jurisdictions by companies and business leaders, and how this Labour government has done nothing to stop it.
He also forgets to mention the use of off-balance sheet vehicles by banks. The Labour government and the FSA did nothing to prevent it. And he does not mention that this goverment has overseen tax changes that favour the megarich and private equity at the expense of middle class earners.

But Peston also forgets to mention the concessions China, India and others will extract from keeping buying our public debt. Just now China, if they wanted to, could bring Western economies to its knees simply by refusing to buy our low-interest, low yield government debt. But the Chinese will not do that. They will keep buying US and UK debt and will extract political concessions from the West.

What these concessions will be is difficult to predict. But I am going to venture a couple of possible scenarios:

Institutional reform: the Chinese and India will demand that international institutions are reformed and the US veto is abolished at the IMF and the World Bank.

Taiwan: Slowly, Tibet has become off-limits for the West. And next it will be Taiwan. If I were Taiwanese I would be crapping myself. Over the next few years we will see how China, slowly but surely, will gain gradual sovereignty over Taiwan as a condition for keeping Western capitalism ticking over. And this way, Mao’s dream of a unified China under one leader and one party will be accomplished.

But will the US accept that they no longer have the monopoly of power in world finance? Will they (we) accept to be humiliated once again over Tibet and Taiwan? Maybe not, since Western governments will be unable to control the press and public opinion as efficiently as the Chinese. So we are heading for a political and economic stalemate of unpredictable consequences.

There is one way out of this problem without the Chinese becoming the new superpower and gaining power over Taiwan: inflation. If the West is unwilling to make so many concessions, China, India, Gulf states and others will demand that US and UK government debt pays a higher rate of interest than it does now. That is something our governemtns can do very well, and technically is called "an increase of the money supply", or as my dad says, "printing more money". This however will fuel inflation in the US and UK and Euro-area which could have a devastating effect on employment and business investment -unless proteccionist measures are adopted to protect "national" industries. But then, protectionism itself keeps inflation high; there is no easy solution.

So over the next few years our political leaders will have to make very “tough” (don’t they love to use the word?) choices.

Do they accept that a new world order is emerging and that there are political prices to pay? Or will they postpone or delay this restructuring of world finance and political power by implementing inflationary policies that will reduce the nominal amounts of national debt but fuel domestic inflation?

In crude terms, the question is: will our (Western) politicians give up the world power mechanisms they have built up over the last few decades?

I know what my answer is. What is yours?

The Best of the Rest: The Black Swan

If you are a regular of this blog, you will have noticed that nowadays I don’t write about Catalan/Spanish politics very often. It is too depressing and there is plenty to write about with the worst financial crisis since The Great Crash happening before us. Anyway, there are plenty of good sources out there (check out the links section) out there that explain what the problems are and how to move forward. I find the Diàleg section of the Avui newspaper a breadth of fresh air and practically the only mainstream media which offers a platform to the pro-independence movement. For example, this article on Sunday’s Avui. If you require a translation to English or another language, use this online translation tool.

Anyhow, back to the topic. I have been reading a few books recently. Even if you are not interested in financial markets and economics, I suggest you read these three books. It is probably one of the best investment decisions you will make in 2008.

First, I read the latest book from George Soros. [Wiki]



This is the second book I have read from Soros, I first read The Alchemy of Finance in 2003 and that was the first time I heard of his concept of “reflexivity”. I had only been in financial market for over a year, doing a crappy back office job, but this book made a lot of sense to me. This was a successful market participant, reviled by the British press for his involvement in Black Wednesday, that was telling us that the system is not as good as everyone think it is.

In his latest book, he delves further in the concept of reflexivity and how it induces vicious and virtuous cycles. One thing that strikes me about this man is how despite all his wealth and success, he still has massive hang-ups about not being accepted by the academic community and not being taken seriously as a philosopher. At a different level, it reminds me of the hang-ups I have about my own education and not having attended a proper university in Barcelona when I should have done all those years ago. If even one of the most successful people in the world has a hang-up about academic achievement, then how am I supposed not to have one about my own mediocre academic background?

So reading Soros again was good. The book is easy, there are no technicalities, and his own admission of fallibility makes him quite endearing. A book that anybody can read and understand.

Then, after years of delay and making up excuses, I found the courage and time to read ‘Fooled by Randomness’, by Nassim Nicholas Taleb. [Wiki]
















And just now I am reading ‘The Black Swan’, his latest book.
Sometimes I wish I had read these two books many years ago, before working in financial markets. Now it is rather late to seek a new career…

These two books contain a bit more of mathematics and certainly more philosophy than Soros’ digestible book.

Before you go and read the reader reviews in Amazon, I would advise you not to do that until you have read the books yourself. When the main criticism of a book is that its style is “irritating” and that the author is “full of himself”, you know there is something going on. I don’t know of any published author that is not full of himself!

The books can be summarised as follows:
+ Trying to apply the Gaussian curve to social sciences (say economics) as if it were a natural science (say physics) is a huge mistake. The use of the Gaussian curve in economics and financial markets is an intellectual fraud.

+ The use of statistical methods in economics is killing off any arguments about logic.

+ Economists, fund managers and consultants that appear in Bloomberg TV, etc, forecasting or giving their “expert” advice are not more than entertainers.

+ The narrative fallacy, how we retrofit explanations to events we never predicted.

+ Because of the above, globalisation of finance, and many other small things, the complexity of our world is ignored in favour of simplification and this leaves us more exposed to risk than we realise. We should learn to live with uncertainty, and accept that not everything can be optimised, rationalised and modelled. Sometimes, it is just down to luck.

Taleb knows his stuff and he is probably the most well read person ever to walk in a trading floor. You don’t need to be an expert on the mathematics of finance or even philosophical movements to read this book, but it helps if you are interested in the basics. Ignore his personal anecdotes, the punctuation, his style, and just focus on the concepts.


These books are demanding but not impossible. As someone who has ended up in this industry (financial markets) by accident, I find his views appealing. Having heard and watched so many charlatans, having read so many “research reports” on economics and markets, having seen how the industry is driven by nothing but self-interest and unimaginable greed, I am hugely sceptical about how the financial markets operate. I have been for a long time but could explain how or why. From a personal point of view, these books have been a great injection of intellectual self-esteem. I knew the dogmas of finance are bogus (equilibrium, rational expectations, Gaussian curve, Value at Risk, historical volatility, retrofit explanations by 'experts', etc), but I did not know how to back up my own views with some intellectual rigour. I always knew it was not right but could not explain it properly or confidently. Now I can. If you read these books, so will you.

Sometimes, I wish I had read his books many years ago, before entering the industry. I should now be something else: a teacher, a bus driver, a tiler, or even a sound engineer. It is hard to read these books and still go to the office everyday knowing full well, as I always did but now with the theoretical back up of Taleb and others, that it is all a big con.

If you are thinking about starting a career in financial markets you should read his books as soon as possible.

Friday funny

Overheard in the restaurant:

Fund Manager: "I'm quite pessimistic about the current financial system. I've been buying gold."
Risk Manager: "Gold? That's not pessimistic enough. I've been buying rice."

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.

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.

An imaginary Russian tale

It feels a bit miserable to write about this, but it was always going to be a winner. In a perverse way, I feel quite smug.

Free financial markets training by Rab:

For a place like Russia, there is no need to hedge corporate bond exposure with its correspondent CDS; it is much cheaper to hedge it using Russian Sov CDS.







I am torn between my fiduciary duty to investors (wait before insulting me: it could be your pension) and personal ethics. Is it morally acceptable to indirectly profit from political risk (war) to directly benefit future pensioners? I somehow think, or want to think, it is, but what do you think? Would you be happy if your pension fund had benefited from the above strategy?

My actions have not been and are of no consequence to events in Georgia but I somehow feel uneasy. Why? Am I just being a pussy with a conscience or I am just trying to justify my own misplaced post-leftie legacy guilt by writing about it...

This communication is not directed at professional investment advisors, retail investors or any other market participants or pesky journalists. It should not be distributed to, or relied on, by private customers or anybody else for that mattter. The information in this article is based on my own understanding of the historical, current and future positions of the markets, and not that of my employer or my colleagues. The views expressed should not be interpreted as recommendations or advice by anybody or as an accepted or rejected house view.
Past performance is not a guide to future performance, but we only brag about it when it is good. The value of investments and the income from them may go down as well as up and is not guaranteed, and if you invest in Russia or any other emerging market you do need to think about hedging your risk in anyway you can because these places are generally a mess.
If you want to take a punt, just buy Euromillions tickets and do not gamble your money in the financial markets thinking that you are going to beat the market consistently over the long term.

Spoilt generation

This is why the Financial Times should be a mandatory read in all schools.

In an editorial published on 6 June 2007, an imaginary "Junior" wrote a letter to his parents complaining about how difficult is to make our own way in this world.

http://www.ft.com/cms/s/ab653780-1625-11dc-a7ce-000b5df10621.html

Today, a tongue-in-cheek reader has replied to Junior with this brilliant response:
http://www.ft.com/cms/s/7cb30c6e-1ba7-11dc-bc55-000b5df10621.html

And another:
http://www.ft.com/cms/s/d16a8f58-1ba6-11dc-bc55-000b5df10621.html

Bloody right.
We (age 20-35) have been spoilt like no other generation in history. Our parents gave us anything we asked them for. And now that some young people have to make their own way, they complain and sulk.
Stop moaning like a little brat.
Read the FT and The Economist often.
Work hard, try harder.