The Best of the Rest: financial crisis

During the last few weeks, I also thought about writing a series of articles about the (financial) mess we are in, and how banks and financial markets participants are irrational, irresponsible and self-serving institutions that need to be closely monitored and regulated by competent agencies, independent of governmental interference.
(Trust me, I work in the industry and I don’t take any pleasure in writing this).

But then I read a few articles and I thought there was no point in writing about something when more qualified and intelligent people have explained the issues much better than I could ever hope to do:

(By the way, I don’t mean the latest Pestowire, more on that one another day…)

In reverse chronological order:
Nouriel Roubini: on what’s coming: Bloomberg video (let’s not ignore the Bloomberg journalist quest for a “number”… and how even a man of the intelligence of Roubini falls for it like a schoolboy), and FT article. And another essay published earlier in the year.
John Kay: Or how governments “passive” ownership of banks is just storing trouble. [Link]

A conversation between Martin Wolf and John Kay on the regulation of global finance.

But most of all, I do miss the regular macro analysis of Stephen Roach at Morgan Stanley GEF.
He may have been early in his calls (tech boom, asset bubbles, current account deficit, subprime), but he was right: macro imbalances sooner or later give way to correction and because of leverage and behavioural issues, corrections in our time are more violent and unsettling than in the past.

The problem is that when your firm earns revenue by trading volatility and hyping up the market, it is very difficult to keep writing about things as you see them. What I mean is that it is an impossible situation when you have the chief economist writing articles explaining we are getting into a big mess, and your sales desks churning structured products like there is no tomorrow.

Very few people know if he was pushed or if he jumped but having Stephen Roach in China as Chairman is like having Messi playing in the reserves for FC Barcelona. I always thought that his realist bear commentary irritated his bosses and colleagues as much as his skilful if somewhat verbose writings.

The real tragedy of banking and financial markets is how talented, educated people with intellectual curiosity have been replaced with money chasing mathematicians, PhDs in astrophysics and the like whose world vision is narrower than a snake’s arsehole.

Do you want to find out how we got into this mess? Then read a few articles by Mr Roach back in the day.

Policy errors – How politicians are no help, May 2007. Shortly after this article, he was dispatched to Asia. Whether you are in an autocratic regime, in a communist dictatorship or in a free market two-party democracy, it is not wise to wind up politicians and embarrass your bosses.
Asset bubbles must burst – January 2007. For some reason, I cannot find this one in the GEF site with the original date of early January. I wonder why some articles are removed and others remain…
Original Sin – April 2005
The Asset Economy – all time favourite, sadly removed from the Morgan Stanley GEF website, June 2004. When I read this article for the first time, I finally got it.

This article by Roach (The Asset Economy) is the one that explains the origin of this crisis. Politicians and their central bankers saw fit to support asset prices as a means to increase disposable income. One asset bubble led to another until there are hardly any assets left to bubble up.
Now it’s payback time.

The Best of the Rest: Obama

For months, I had been planning to write an article about Barrack Obama. Its title was meant to be “Obama and the promise of change”.

But there is no need. I read this article in the Sunday Herald and I think it explains the issue much better than I could ever do.

Notwithstanding that Obama’s bubble will burst sooner than later, it is more with relief rather than joy that I watched the news unfold. The USA now have a mixed race president, something many people said it would never happen, ever. Wrong. The USA is a more open-minded and tolerant country than the ridiculously twisted portrayal we see in the European media. OK, they are a few rednecks still riding, but there are many rednecks in Europe too.

It is puzzling how, collectively, people still believe in a politicians’ word when we have witnessed time and time again that any promises of “real change” sooner or later give way to “pragmatism” (i.e: more of the same) and “realism”, or worse, “incremental change”.

The only consolation is that at least now there is a man in charge who is intelligent, a man who is not going to embarrass the American people with his illiteracy and lack of intellect.

And the sad thing is that’s the best we can hope for.



PS: if nothing else, we can also laugh at the rednecks and proto-racists that are foaming in the mouth at Obama's victory. Read this for a laugh, it's very funny.

PS2: one thing is clear: he's been watched, taped and spied by the usual suspects... Welcome to the White House! [BBC News]

The natural course of democracy

It is rather worrying when the big news is that the democratic process is allowed to happen naturally, normally and without the threat of violence, financial boycotts, or political obliteration.

In Greenland, people have voted to decide their constitutional future.
Without any interference, imposition, threat, from Denmark.
It is just what happens when democracy is allowed to take place.

http://politiken.dk/newsinenglish/article602550.ece

Another borrowed article: anti-Catalan prejudice

It is pandemonium in Can Trenator.

Buying a new house, putting the flat out in the rental market, getting engaged, birth of gorgeous wee niece, getting married, honeymoon, changing jobs, shoddy service from building companies, etc, etc.

Oh, and the financial crisis.

Normal services will resume soon. In the meantime, I borrow the text from a lecture from Mathew Tree on anti-Catalan prejudice.

PDF

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.