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Thursday, 29 October 2009

The wrath of Randall

Jeff Randall was one of the better financial journalists, but now that he is "editor-at-large" back at the Daily Telegraph, he is able to write on other matters, often politics, and there are time like today's article on Tony Blair's suitability to be EU President when he doesn't pull his punches.

"Mr Blair is a fake, a charlatan, a shameless twister. He is not "a pretty straight sort of guy". Who else would play down his faith lest it be seen as a vote-loser?

And if the quality of one's friends is a guide to personal integrity, Mr Blair's pick of Silvio Berlusconi as a holiday chum tells us a lot. Presented with a choice between luxuriating at someone else's expense and the path of righteousness, Mr Blair grabs the freebie."

Don't hold back, Jeff. Tell us what you really think.

Meanwhile, our German neighbours seem to have the measure of Blair and his chances of getting the backing of his Socialist colleagues in the EU. According to the Sud Deutsche Zeitung: "Gegen null".

Under the headline Sozialdemokraten torpedieren Blair, they say:

Die Chancen des ehemaligen britischen Premiers Tony Blair auf den Posten des Präsidenten des Europäischen Rates tendieren seit Donnerstag gegen null. Beim Treffen der sozialdemokratischen Regierungschefs vor dem Beginn des EU-Gipfels fand der britische Regierungschef Gordon Brown kein Gehör für sein Plädoyer zugunsten seines Vorgängers.

Die sechs anderen sozialdemokratischen Regierungschefs forderten für ihre Partei nun sogar ein ganz anderes Spitzenamt in der EU. Sie beanspruchen den Posten des Hohen Vertreters für die Außen- und Sicherheitspolitik.

Damit ist Blair faktisch aus dem Rennen, denn diese Aufgabe will ihm niemand anvertrauen. Der österreichische Bundeskanzler Werner Faymann, der spanische Ministerpräsident José Luis Rodríguez Zapatero und der Vorsitzende der Europäischen Sozialisten (PSE) Poul Nyrup Rasmussen wurden beauftragt, mit der christlich-konservativen Europäischen Volkspartei (EVP) Gespräche zu führen.

Kroes feat

Writing in the other pink paper John Gapper gives three cheers today to Neelie Kroes, the European Union’s competition commissioner, who he says is one of the few European politicians who understands the way to deal with the problems in the banking system. This comes after a similar article yesterday from John Kay,both of which go against the FT editorials which gave lukewarm support for the FSA/ Turner/ Brown approach of more regulation.

Gapper says that "by insisting on the break-up of the ING Group into its banking and insurance divisions – and on it divesting its US direct savings arm – Ms Kroes set a welcome precedent this week. She made a troublesome too-big-to-fail institution shrink."

Gapper says that there is a growing band of experienced hands following the Masterley line that banks should be broken up into at least 3 parts. That is actually one more than the Masterley approach because I hadn't really considered the insurance businesses found in many continental banks, but the same principles apply, and although I know very little about insurance except how to buy it, they are probably correct.

Along with Ms Kroes and his colleague Mr Kay, Gapper lists central bank governors Mervyn King, Paul Volcker and Alan Greenspan, and John Reed. Gapper says that Reed is an improbable advocate having had a hand in the creation of Citigroup, but Reed grew up in Citibank which was long restricted, but also protected by Glass-Steagall. Some might say he was pushed out by the ravenous hordes who joined Citigroup with Salomon.

Gapper says "Some politicians and regulators have argued that modern-day finance is too complex to be divided and those who suggest such divisions are being simplistic." We know this is hogwash. The attraction of retail deposits to people who want to make money from proprietary trading is obvious, as is the one way bet (heads the banker wins, tails the tax payer loses) that results from deposit guarantees. Separating the two would force the investment banks to raise their own capital and manage it wisely.

As for proposed UK and US bank reforms, Gapper quotes Terry Smith, chief executive of the broker Tullett Prebon and famously an equities analyst at UBS where he published a book debunking prevalent mishievous accounting practices, who says that Brown's plans are “like the designer of the Titanic arguing that the provision of extra lifeboats would solve the problem”.

US out of recession, UK mired in spin

Last week, I remarked that the press was full of reports from a "consensus of analysts" saying that the UK was going to be out of the recession by 9;30 that morning when the ONS announced its figures. All media outlets seemed to have independently cottoned on to the idea that everbody thought the recession was going to be over.

Why would they be so consistent? It turns out not surprisingly that they were all briefed by Labour party hacks, and this was to be a main thrust of the attack on George Osborne who the Labour Party see as a weak link. Op-eds and letters to the FT by Alastair Campbell had been prepared and were all set to go. Shame that nobody chose to get the facts from the ONS (prop. HM Government.

Incompetence doesn't begin to describe it.

Westminster house swap: N/S, no pets

The poor grasp of finance demonstrated by many MP's continues to astound me. They are currently whingeing about the upcoming Kelly report, which aaccording to leaks, will prohibit MPs from claiming interest expense on mortgages to cover the cost of second homes but they will be entitled to claim for the cost of renting a property. Some eagle-eyed observers have pointed out that the rental value of Westminster flats is higher than the mortgage interest cost at present, so they claim that this is not necessarily a good idea.

So we have hundreds of MPs who own flats in Westminster, who are moaning that they may have to sell their flats and lease another. Well not necessarily, they could always lease out their flats, perhaps to another MP and lease in a second flat. There may be plenty of flats available for leasing, probably from other MPs. The income from the flat they lease out covers the interest on the mortgage and the cost of the flat they lease in is reimbursed by the government.

OK, so that still requires MPs to move house, which some may find inconvenient, so why not resort to the old financing trick of the lease and leaseback, a mainstay of many tax and accounting wheezes. The MP owns the the freehold or long lease on a flat which he subleases to a third party, who then leases it back, maybe for a shorter term but perhaps not, it depends what the rules say. The third party leases the flat back to the MP. The MP receives enough rent under the head lease to make the mortgage payments, and the sub-lease payments, which will cover the head lease payments and a profit to the third party, will be reimbursed by the Fees Office.

Laying up treasures in heaven

The Wall Street Journal reported yesterday that Lazard will make a one time charge of $86.5 million in the fourth quarter related to expenses of paying restricted stock unit awards to the late CEO Bruce Wasserstein.

At which point the WSJ article breaks off into how that figure compares with Lazard's quarterly revenues from deal doing etc, which kind of misses the point. Wasserstein was top dog at Lazard and it is not surprising that he should have a big finger in the pie with lots of deferred stock - well not that much compared to his total wealth, but big numbers in absolute terms.

But what kind of crummy accounting is that? Lazard takes a massive one time charge because of accrued stock rights that crystallised when Wasserstein died. Was there a clause in his contract that said he got an extra $86.5 million of stock if he died? Of course there wasn't. That was restricted stock that Wasserstein had earned that was not booked as an expense because it hadn't vested.

So what exactly had to happen for the expense not to arise that meant Lazard didn't have to book it earlier? Is it really kept out of the P&L because the Lazard directors honestly though the CEO might quit and forfeit his $86.5 million? Dream on.

Wednesday, 28 October 2009

Burning other people's money

We know that government's are never good with other people's money, but a story emerging from the US on the AIG bailout takes the biscuit.

The story in brief: Before the NY Federal Reserve stepped in to bail out AIG the chief financial officer for the AIG division that oversaw AIG Financial Products negotiated with banks that had bought $62 billion of credit-default swaps from AIG, trying to persuade the banks to accept discounts of as much as 40% on the amounts due to settle the swaps.

By Sept. 16, 2008, AIG was running out of cash, and the U.S. government stepped in with a rescue plan. The Federal Reserve Bank of New York opened an $85 billion credit line for AIG, and took a 77.9% stake in the company and effective control. After less than a week of private negotiations with the banks, the New York Fed told AIG to pay them at par.

The New York Fed’s decision cost AIG, and thus American taxpayers, at least $13 billion. The details of the Federal Reserve's deliberations have not been published. Well you wouldn't expect them to, would you?

Worth mentioning that the chairman of the board of directors ofthe NY Fed at the time was Stephen Friedman, a former chairman of Goldman Sachs. Goldman recovered $14billion from AIG on the swaps, although it was never clear whether Goldman had taken out a CDS as protection against an AIG default and thus got paid out twice.

Tuesday, 27 October 2009

Osborne: right or wrong?

George Osborne has spoken out against bankers taking their bonuses in cash, saying that they should be paid entirely in shares, all but a de minimis figure, probably around £2,000.

"I am today calling on the Treasury and the FSA to combine forces and stop retail banks paying out profits in significant cash bonuses. Full stop. That includes their investment banking arms.Then the cash that would have been paid out should be put onto banks’ balance sheets explicitly to support new lending. This should be a condition of continuing to receive taxpayer guarantees and liquidity support.

Well not quite George. The cash that the banks pay out in bonuses doesn't go anywhere it stays in a bank account, from where it might be spent, but it might be spent, but is generally neutral when it comes to boosting the economy. After all banks have no problem raising cash, even if it is at a price, but if there customers are desperate enough for credit those higher costs can be passed on. So 0/10 for your understanding of finance, on that score.

But that doesn't mean you are wrong. In fact, you have a very good point to make, although if I might make one small technical point, paying bonuses almost entirely in shares is not a good idea unless the bonus recipient is endowed with a large personal fortune, because the bonus will give rise to a tax liability that has to be settled in cash, unless you are suggesting that under a Conservative government the Treasury will accept shares in lieu.

But to get back to the main point, Osborne is right and the several City big beasts rustled together by the FT appear to be no more than an aggregation of free market absolutists and New Labour followers and snipers. The chairman of the IOD is not a City bigwig but a spokesman for a West End based business group representing those people in British business apart from bankers who normally extract the largest annual cash piles so we know where they are coming from.

According to another pink paper Osborne's plan would reduce the value of the state’s multi-billion-pound holdings in the banks, have no impact on the pure investment banks that lie at the heart of the bonus culture, fail to stimulate lending and unfairly disadvantage UK banks against overseas rivals.

Well that's wrong or irrelevant on all four counts, but typical of the shallow thinking that passes for financial journalism these days, so let's take those points one by one.

  1. Forcing the bank to issue shares in lieu of paying bonuses might dilute the government's shareholding but it saves the banks the same amount of cash as the market value of the shares, hence does not reduce the overall value of the government's stake in the company. Moreover, since the banks are currently constrained by a shortage of capital, putting in additional capital allows them to add incremental business against a fixed component of overhead, hence probably increasing profitability and eps. Indeed, we are always told by highly paid board members that large share allocations align their interests with shareholders. As an indirect shareholder through my taxes, I like that idea. And finally if the government really thinks this is a problem, they could require the bank to buy the shares off the government rather than issuing new shares.
  2. It may not have any impact on pure investment banks, none of whom are UK-based (Rothschilds - don't make me laugh), but that is no reason to stop less capable retail banks from pretending they are investment banks and making the same mistakes. A poor straw man argument.
  3. It is completely wrong to say that paying bonuses in shares will not stimulate lending. On the one hand it will ease one barrier to lending (Tier 1 capital shortages), and on the other, if value is tied up in the bank, there is more incentive to lend profitability to produce a return.
  4. As pointed out before, this is hardly likely to disadvantage RBS and Lloyds compared with foreign rivals. So what if a few traders threaten to leave? Where are they going to go when there are thousands out of work who could do the same job, and what makes them think they are anyone special? They could make money for their banks because the bank provided them with capital. The bank pays them a bonus to get them to work. A trader who doesn't need to work for a bank because they can source risk capital from elsewhere is called a hedge fund. Go figure.
So on this point, Osborne is more right than wrong.

Guaranteed to fail?

We all know that QE is not making any difference to the economy. How do we know? Well if the government prints an extra £175 billion of money and GDP still manages to fall by £5.6 billion, it should be fairly obvious that the £175 billion has had no effect.

It isn't to difficult to see why it has no effect. Part of the programme, announced in August was supposed to lend to non-investment grade companies by buying specially issued commercial paper. The purchases would be made against companies’ expected cash receipts from trade receivables, equipment leases and short-term credits to consumers, including credit card loans.

The Bank of England issued its quarterly report on Monday, saying that this particular may have got off to a slow start because borrowers need to create special vehicles to issue commercial paper, which the Bank would then buy.

The Bank also says that market conditions had improved in recent months, possibly reducing demand from companies for ready cash. On the other hand any business you talk to will tell yu that the banks are closed for lending business. Part of the problem is that the BoE will only buy paper issued by vehicles backed by financial assets with no more than nine months to maturity.

So if you think the government will guarantee the credit of small companies read here and weep.

Asset Purchase Facility


This page contains links to the results of individual operations for gilts and corporate bonds, as well as to longer-run time series for each of the APF schemes and facilities.

The table below show the outstanding stock holdings (on a settled basis, net of any redemptions) for each facility. These data are as at close Thursday 22 October 2009.

Commercial Paper
Corporate Bonds
Secured Commercial Paper

Quantitative Easing

A time series showing a running total of the quantity of assets purchased by the creation of central bank reserves is available in the Interactive Database(updated weekly on Fridays).

Commercial paper

Corporate bond


Credit guarantee scheme

No operations have been conducted as yet.

Sunday, 25 October 2009

Blood on the tracks

A driving tip. Apparently, if your car stalls on a level crossing and won't restart, you should be able to get it off the tracks by putting it in gear and trying to start the motor. I have no idea whether this works in practice, but I am reminded of it by the way the governmrnt is handling the downturn/ recession /depression.

Gordon Brown says the battle to prevent a depression was being won and has promised the economy will return to growth by the turn of the year, in his first reaction to news that the UK is still in recession.

His podcast was released on the Number 10 website a day after official figures showed the economy was still shrinking. The prime minister accepted times were tough but said the battle to stop "a second Great Depression" was being won.

Sorry, but I thought we had already been saved from recession, not. The truth is that if the government really wants to they could lift the economy out of recession by playing the game that Brown played before the recession. It was easy to claim zillions of back to back quarters of unbroken GDP growth when he simply put his foot on the spending gas pedal. The problem was that it was largely wasteful spending.

Sure enough he has promised to cut a some point in the future (not that he will be around), but it would be easy to create a upward blip in government spending to push the next quarter into growth, with a later collapse, perhaps by borrowing and spending, perhaps doing nothing more than a few accounting tricks getting PFI schemes to count as government spending or booking the payment of a defence contract in this quarter just to cook the books.

After all finding an extra 0.4% of GDP (£5 billion) can't be hard when the government is already overspending by 15% of GDP. Whatever it is done, it will likely be just enough to get out of the recession for a quarter, before falling into another recession.

Oh, and if you are caught on level crossing, forget the tip above. Just get out of the car and off the tracks as soon as you can.

Saturday, 24 October 2009

Hack hypes hock

Sometimes I really despair of the Guardian, who can't keep up with the delusions of the administration that they ostensibly support. This morning, when they heard the GDP statistics they marvelled that the FTSE hadn't dropped. This they said was a sign that things aren't bad at all. Sorry guys, you will have to do better than that. Do ty to keep up.

First of all we had the news that the FTSE was boosted by mining stocks. There in't a lot of mining in the UK, so this news had nothing to do with he UK economy and everything to do with world commodity prices, possibly connected with the declining value of the pound against the dollar and commodities in general, but that is not the main point.

The main reason the FTSE didn't drop is because it is already overvalued. Does that make sense? No, well then you weren't listening last week when Charlie Bean (of the Bank of England) told the world that the purpose of QE was not to fill the banks with cash, but to raise the value of the assets they held. This would boost their balance sheets and plug them full of Tier 1 equity. [As an aside, if that was the reason, I fail to understand why the BoE didn't simply subscribe for £175m of bank equity paid for in the same way, by printing electronic money transferred into the selling bank's account at the BoE, but I digress].

So QE is all about hyping markets and that spills over into the FTSE. More recession means more QE, and more QE means more cash chasing the same gilts and equity, which means higher asset prices (or lower value of money depending how you look at it). So the economy is still in a mess but the FTSE stays at the same price because the market expects more dodgy government money to be on its way any time soon.

Friday, 23 October 2009

A new British record?

A funny thing happened on the way to the news desk this morning at the BBC. The recession was due to end, they asserted confidently. Indeed they went on in the following vein:

Figures due later on Friday are expected to show that the UK economy grew slightly from July to September, meaning the recession is over.

The figure for Gross Domestic Product (GDP) from the Office for National Statistics (ONS) is likely to show the first economic growth since early 2008.

But analysts have said the result will be close and that the economy may even have continued to contract.

GDP measures the total amount of goods and services produced by a country.

The figure at 0930 BST is expected to show growth of between zero and 0.2%.

But as it turned out they (whoever they are) were wrong, because at 9.30 we got this:

The UK economy unexpectedly contracted by 0.4% between July and September, according to official figures, meaning the country is still in recession.

It is the first time UK gross domestic product (GDP) has contracted for six consecutive quarters, since quarterly figures were first recorded in 1955.

But you have to admire their optimism because they added

"But the figures could still be revised up or down at a later date, because this figure is only the first estimate."

No doubt somebody on the newsdesk is hoping for 0.4% upwards adjustment, ignoring the fact that this is a greater amount than the amount by which they were willing to declare an end to the recession a few hours earlier.

But leaving aside the blatant government bias, the fact that the UK, unlike Germany, France, Australia, Japan, Hong Kong and maybe the US, is mired in recession should have been obvious from the recent data on tax revenues. Despite an increase in government spending of 1.25% of annual GDP in the quarter, (up 5% on an annualised basis), the fact that we have a 0.4% drop in total GDP implies a 2% drop in non-government consumption in the quarter or 8% on an annualised basis.

So we have government borrowing an additional 15% of GDP to stimulate the economy and yet after an unprecedented 6 quarters of recession the "real" economy is still shrinking by 8% per annum. Take away that 15% of GDP that wouldn't be there in a healthy economy with a balanced budget and instead of the 5.9% fall peak to trough there would be a 21% fall. Add in a couple of years inflation and you have a 25% drop in sustainable real terms GDP.

Thursday, 22 October 2009

Turner and Brown prove King right

Gordon Brown added more weight to Mervyn King's argument for the separation of commercial and investment banks, by his answer at yesterday's Prime Ministers Questions when he said Mr King "has got to remember that Northern Rock was effectively a retail bank and it collapsed. Lehman Brothers was effectively an investment bank without a retail bank and it collapsed. So the difference between having retail and an investment bank is not the cause of the problem."

All of which shows that a soundbite is not as good as a few minutes clear thinking. I am sure that Mr King is fully cognisant of the difference. Northern Rock was a mortgage bank that took retail deposits, but it relied to an increasing extent on wholesale funding. If it had been forced to grow organically by growing its branch network and increasing its retails deposits it would not have had the liquidity issues that Mr Brown's FSA failed to spot.

15-love to Mr King.

Lehman on the other hand was a full blown investment bank with little involvement with the man on the street. It failed because it took too many of the wrong sort of bets, but although it is in administration, the losses suffered by its investment bank counterparties on Wall Street are largely survivable. Why is that? Because with constant provisioning and margin calling in traded markets the absolute extent of any loss is likely to be capped. The rest of the market takes some big knocks, but pretty quickly gets back to trading and picking up cheap assets, which is why so many of the Wall Street investment banks are making so much money at the moment.

But the same isn't true of the commercial banks, particularly those that were hit my the Lehman default. Not directly, but by the impact that Lehman had on the credit default swap market, which in turn impacted the banks available risk capital and their ability to lend. If the banks had been prohibited from getting into such a mess by being prevented from using monoline insurance to reduce their equity requirements, there wouldn't be a problem right now.

First set to Mr King.

But then if it wasn't obvious that Mr King is completely right, his point is proven by Adair Turner and the FSA who have today published a 66 page discussion paper on banks that are too big to fail and what should be done about them. The answer is that if a bank is too big to fail, then it should only be allowed to do the sort of business that is unlikely to cause it to fail. The government isn't there to underwrite every risk that a bank wants to make. Well Mr Turner thinks differently and he seems to think that there is some merit in allowing banks to punt on whatever they see fit saying, amongst other things :

"Reform to trading book capital should significantly increase capital requirements and differentiate more strongly between basic market making functions which support customer service and riskier trading activities, with a bias for conservatism in relation to the latter."

In other words value and regulate ordinary banking treasury activities differently from proprietary trading. He also gets worked up about systemic risk and the need for regulators to control that.

Like I said yesterday, keep it simple. Separate the normal banking operations into regulated banks and put the go-go punt-u-like boys in another company and you have killed two birds with one stone.

Game, set and match to Mr King.

Wednesday, 21 October 2009

Brown pitches for retirement job at the IMF?

Mr Brown has rejected the Governor of the Bank of England's view that banks should be separated into investment banking and commercial bank, telling MPs that "the difference between having a retail and investment bank is not the cause of the problem."

Actually that wasn't what Mervyn King was proposing, but in any event the Prime Minister went on to say that "the cause of the problem is that banks have been insufficiently regulated at a global level."

Excuse me, it would be cheap shot to quote the many times that Brown argued against more bank regulation as Chancellor of the Exchequer, so I will be only slightly cheap and quote just one, but it is a good one:

“Last year we set out radical proposals for changing the way we regulate: minimising the administrative burdens of regulation; and ensuring that the realities of regulation, as you experience them on the ground, are transformed -- by moving away from the old blanket approach, of 100 per cent form-filling and 100 per cent inspection that is inefficient and wasteful of your time, to a new approach based on risk… And I believe, too, we should consider how we can continue to extend our risk-based approach, applying the concept of risk not just to the enforcement of regulation, but also to the design and indeed to the decision as to whether to regulate at all… And we will take the fight on deregulation to Europe.” - Brown speech to the CBI, 5 June 2006

Now the moral of the tale, is that if you are going to monitor, control, regulate or guarantee the performance of anything, whether it is a banking system, a complicated piece of machinery or anything else that is volatile and potentially unpredictable. you want to keep what you are controlling as simple as possible. That way there are fewer opportunities for errors, omissions, knock-on effects or systemic failures. Brown, who is just a control freak with little experience of the real world and no sense of operating a reasonable system within a budget (witness the budget deficit) goes for the unwieldy, take control of everything option rather than opting for the simple choice of ring-fencing the activities that can be regulated and guaranteed by the state.

If UK financial institutions want to make leveraged trades in commodities, write side bets on third party creditworthiness (CDS), or shuffle assets off their balance sheet in ways that may come back to bite them, well good luck to them and their shareholders. But I don't want to underpin their funding with tax payer backed deposit insurance. I have no issues with financial holding groups that own banks, provided that the subsidiary bank is, and remains, well capitalised and it is not allowed to play in the same games as the rest of the group.

I don't care whether the chairmen of Barclays or RBS say this makes them uncompetitive with other investment banks. It shouldn't because real investment banks like Goldman and most of the Wall St investment banking firms don't need retail deposits to survive. But I do care if a UK bank's dabbling in things it doesn't understand ends up requiring vast injections from the tax payer or freezes up commercial lending through a shortage of risk capital.

So what is Brown up to? Why is he now in favour of strong global regulation, not for the first time because he was saying the same thing alongside Angela Merkel earlier this year? A politician is unlikely to be invited to head the BIS where most of the bank regulations are formulated, so we can only assume that Brown has what is left of his one remaining eye on a cushy post-election number at the IMF.

Keep it simple, stupid

Mervyn King has come out in favour of breaking the banks into commercial and investment banks. We have been here before, and I must say I approve wholheartedly. Needless to say the idea has been dismissed in the past both by the government (who do not know what they are talking about) and the FSA (who also do not know what they are talking about and one might say that they have a vested interest in maintaining the status quo because that gives them more to regulate), but more on that later.

In the 1930's following the 1929 crash the US Senate decided that it would be wise to separate commercial banks, whose deposits were guaranteed by the FDIC, from investment banks. Hence we had Morgan Guaranty, later JP Morgan, which was quite distinct from Morgan Stanley, First National City Bank and Bank of America, which were noit permitted to undertake the range of activities that they do today as Citigroup and Merrill Lynch. Finance was much simpler in those days with a combination of bank lending and deposits by commercial banks, equity issuance and trading and bond underwriting and trading by investment banks. The only derivatives were commodity trades and limited equity options, and securitisation was unheard of. Listed debt securities were issued by governments, municipalities and large corporations.

Life was much simpler, but the system was effective. To see the effect in terms that a modern trader would understand, correlate the decades from the 1920's to the 200's in which a stock market crash of more than 10% led to a recession (1920's, 2000's) against the decades in which the Glass-Steagall Act was in force (1930's-1990's), and lo and behold we have a 100% negative correlation. We deduce, on behalf of the traders that a Glass Steagall Act heavily implies no economy busting stock market crashes, and it is easy to see why. If state guaranteed banks are unable to over expose themselves to market risk (some exposure is inevitable), then when the markets come crashing down, the banks do not find themselves short of capital and unable to lend.

Sadly, the Act was repealed at the end of the twentieth century. The situation we have at present is worse than that with capital starved banks continuing to pay vast salaries and bonuses to traders and debt repackagers because they generally make a higher return on equity than commercial lenders and their ilk.

Mr. King's comments are interesting because they were made on the same day that the BIS released its analysis of proposed changes, adopted in July, to Basel II capital rules. The report calculates how much more capital banks will have to hold under the rejigged rules, which are due to come into effect in January, and indicates an average increase of at least 11.5 per cent of overall capital requirements and 223.7 per cent of market risk capital requirements.

Some people might say that the new guidelines will cause the banks/investment banks to reduce or close some lines of business that were previously capital-lite, and perhaps to cause some banks to hand back their banking licenses which were so helpful when they were looking for a quick bailout.

But why bother with that level of sophistication? The previous trend towards "innovation" (read that as complexity) has been fraught with problems and the new Basel guidelines just give the bankers another bright-line test to game, and the FSA and their foreign counterparts a new game to police. I suspect that they like to play that game because it makes them feel important and it keeps them in work.

But there is another solution, and it is easier to police. Put all the plain vanilla banking in the regulated commercial banks and give them a state guarantee, but limit the games they can play. Put all the rest in the investment banks, and let them play all the games they like, subject to normal company legislation, standard non-bank financial regulation and shareholder activism, and limit the indirect exposure that guaranteed banks can have to investment banks, whether or not they are connected.

Less to police, simpler to monitor and proven to work.

Tuesday, 20 October 2009

Do you want the good news or the bad news?

Let's start with the bad news. According to the ONS, government borrowing is worse than expected this month. Again. Well that is hardly a surprise. Spending is up again. Not by as much as expected, which might even be taken as `a bit of good news, but it isn't because whereas current government spending rose 4.8% to £279bn from £266.3bn, tax revenues in the first half of the financial year were down 10% £219.1bn from £244.2bn in the same period last year.

Now lets look at those differences again: £279 bn spent and £219 bn taken in taxes, or £60 bn shortfall against £27 bn of spending, and tax revenues down by 3% more than government forecasts.

But looking at the figures in more detail it is even worse than that because for the first time I can recall the receipts from income tax and corporation tax are to be lower than the totals paid out in benefits. Yes, the government gives out more in handouts than it collects in taxes on profits and income. And that is before it starts paying for any "frontline" services such as education, the NHS and defence, which are met out of VAT, petrol duty and the like and the balance passed on to your grandchildren.

There is no good news.

Nice work if you can get it

One year on from the Lehman bankruptcy, and the winners are ... the European administrators, who so far have billed £154 million, or to put that in real terms, more than the GDP of Micronesia.

They say that their average hourly rate has dropped from £329 to £309 over the past six months, but I make that over half a million man hours to date.

They say that is equal 0.6 per cent of total assets managed, realised and returned, but 60 bp is a good fee for originating paper, let alone clearing it up. Actually it is worse than that because they have only returned $13.3 billion of collateral to clients, so I make that a fee of 1.73% for the return of collateral, which is expensive by anybody's calculation.

And that is on top of the other overheads paid by the firm while in administration for buildings, computers residual staff and lawyers, who had billed $112m in fees as of September 14. Linklaters said “This is the largest and most complicated bankruptcy in history, raising many novel legal issues”. Sure. We believe you. These were only traded instruments held by a heavily regulated institution.

The administrators are set to run the estate until 2011. So far they have gained control of $40bn of securities and cash and returned $13.3bn in assets to clients. Steven Pearson, a partner at PwC, an administrator of Lehmans in Europe, said there was no indication how much they would recover on the claims and that he expected significant challenges against them. Yeah, sure. After a year's work and £154 million in billings you ought to know to the last penny.

It might help if the administrators' gophers spent less time surfing the web, which I know they do because of the Lehman IP addresses that end up in this blog's viewing statistics.

Monday, 19 October 2009

Autumnal windfalls

According to The Times:

Banks are being threatened with a windfall tax on profits amid mounting criticism from across the political spectrum of a return to huge bonuses.

Strong financial results from American investment banks have raised the prospect of a bumper bonus season in Britain, even at the state-controlled RBS.

RBS dismissed reports yesterday suggesting that it was preparing to pay its bankers bonuses of up to £5 million each, from a total pool of £4 billion. A source close to the bank said that no decisions had been made.

Well on the last point, they have a point. There is nobody working in Broadgate who is worth paying anything like £5 million a year, but since the government control thebank through their 70% shareholding, the government can control that directly.

As for the rest it is pointless to charge an extra windfall tax. The government already owns large parts of RBS, Lloyds/HBOS, Northern Rock, B&B so a windfall tax is just taking cash out of one government pocket and putting it into another. Every £1 taken in tax reduces the receipts from hte government's sale of its RBS shares by 70p.

Then we have HSBC and Standard Chartered, neither of which have taken the government penny nor have they ever been at risk of needing to do so. Both banks might be likely to continue their move into foreign shores and even to move their headquarters to Hong Kong if really provoked.

Then we have the smaller mortgage based banks and Building societies, Nationwide, Abbey/Santander, Clydesdale, Yorkshire, all of which have escaped the worst of the recession/credit crunch by reasonable lending practices and largely avoiding the dodgier practices that caused problems elsewhere.

Which really leaves us with only one bank: Barclays. Penalising all banks for the sake of Barclays would be vindictive in the extreme, but anything can happen in an election year. But such a tax would be sheer idiocy, for the simple reason that at the moment all banks are constrained by their Tier 1 capital, and the economy is constrained by the lack of lending capacity in the banks.

Sure enough the banks have capital to trade and they will do so because they think the returns are higher from trading than lending , so it is lending that gets squeezed while the banks play the various markets.

For every £1 billion taken in taxes, figure £10 billion lost in lending capacity. For every £10 billion lost in lending capacity, figure £15 billion lost in capital investment, assuming that capital intensive companies are geared 2:1. For every £15 billion lost in capital investment, figure £15 billion in lost annual GDP and £2 billion in corporate profits assuming a 20% operating margin less overheads, or about an incremental £5 billion in annual lost tax revenues taking the current ratio of tax receipts to GDP (£500bn:£1400bn).

If the government wants to penalise the bankers they should simply restrict all bonuses to be paid in shares. and that would make the recovery work even faster.

Brush up your Latin

I was struck this morning by a comment from the non-executive chairman of Barclays in an interview with another pink paper about bank regulation, bonuses and implicitly, windfall taxation and other forms of retribution. Specifically the following comment:

“The same principles will apply in different ways in different capital markets with different outcomes. This is a global financial system. It is fungible. So I am very concerned there should be a level playing field.”

Now correct me if you disagree, but the word fungible derives from the Latin deponent verb fungor, fungī, fūnctus sum (perform or execute), from which we also get the verb function via the French. The adjective fungible therefore means to be of an equivalent utility or value. What he meant was that the locations in which the global financial system takes place are fungible. The financial system and its players are mobile (from Lat. moveo, movere, movi, movus).

We should have expected better from someone who goes by the name of Marcus Agius.

Saturday, 17 October 2009

Button, push to win

A non-financial post, and a gratuitous pun in the title to boot, wishing Jenson Button the best of luck in the Brazilian GP, but reminding him not to be too cautious.

Friday, 16 October 2009

Because I am worth it

There has been a lot of huffing and puffing in the left of centre media, Polly Toynbee in the Guardian and many other outlets, about the relative pay in the private and public sectors. Public sector workers says Ms Toynbee are underpaid compared to the private sector. She then explains that they are actually paid more but that is because they are more highly qualified, so they are actually paid less than they deserve on a relative basis, or some such nonsense.

Oh, and we can ignore the gold plated pension schemes according to Ms Toynbee, that is not a matter of compensation but of prudential provision by the state and mean-hearted fecklessness on the part of the private sector.

All total tosh, of course. In the private sector, we know that you are worth what people are prepared to pay you. What they are prepared to pay you is limited by two factors: the value that you create and the resources available to the company. What you feel you are "worth" is frankly irrelevant. The economic value of qualifications are often overestimated by their holders (and I have three daughters studying at or graduated from the same university as Ms Toynbee, while I studied at the other, more highly ranked in world league tables, blue university).

When it comes to the value of workers in the public sector, the same logic applies. All that a public sector worker is worth is their proportionate share of the income available to the state. Collectively the public sector workforce is worth no more than tax receipts less non salary expenditure, plus or minus a bit depending on the state of the economy.

When government collects £500 bn in taxes and spends £700 bn, it is clear that collectively the public sector is paid more than it is "worth", and that over payment might be any figure you care to think of between £50 billion and £150 billion, depending on what you want to take into account, your view on the state of the economy, structural deficits, wasteful capital spending, acceptable deficits etc.

Two few years ago as the economy was tightening I discussed the state of the financial world with an academic friend at our most highly esteemed seat of learning on the edge of Fenland, and she told me that from her point of view there was no hint of any budget cuts. Now it seems the real world is becoming clear.

There has never been any other basis for value, and much as we admire our highly trained NHS medical staff, who by the way do have the highest median remuneration of any sector, higher than financial services, and are the most highly state paid medical staff in Europe, they have to justify their pay on the basis of what others are willing to pay. The same goes for the community outreach and diversity workers, MPs and their hangers on and quangocrats.

Tax a bit and spend more

We are now at the Friday after the Sunday when we first heard than Gordon Brown hoped to raise £3 billion with various disposals. He hasn't got anywhere with that, but the money is already spent in excess spending, so you would expect the government to be drawing in its horns.

Well, not at all because they have just announced an additional £5 billion measure, due to the fact that we have moved into negative inflation territory. Various allowances, including pensions are linked to the annual growth in RPI, which this year has actually been negative to the tune of 1.5%. But that of course will not do in an election year, particularly with a budget only a few weeks before the elections begin, so the chancellor has proposed that there should actually be a 2.5% increase in pensions and personal allowances, or 4% ahead of RPI and an additional £5 billion.

Which just goes to show that (a) politicians don't stick with their principles when doing so will it hurt their own prospects and (b) they are never too ashamed to try bribing us with our own money.

Thursday, 15 October 2009

Tax payers foot the bill again

As a rule, I don't like to report when banks may have been engaging in tax shenanigans unless I am absolutely certain because (a) I don't want to falsely accuse the innocent and (b) I don't want to give them any good ideas, but I was fairly certain that a lot of the debt buybacks undertaken by RBS, Barclays and Lloyds (I'll put the links in later) had a tax angle to them and it seems that we now have the evidence if not the proof. I figured that there was something strange about the large profits without an abnormally large tax liability and no obvious source of tax losses to cover the difference.

Anyway, Stephen Timms today announced measures to stop tax advantages that have been achieved when companies buy back their issued debt at a discount to the amount borrowed.

Under current law, when a borrower is released from a liability for less than the amount borrowed it is taxed on the difference between the amount it has borrowed and the amount it pays to be released from its liability. Fair enough, but in situations where a company is in real dire straits and its debt is trading at virtually nothing, then any company that rescues it and repurchases its debts at a discount from the lenders and cancels the debt, would be pretty miffed if having bought the debt for 1p in the pound the borrower would get hit with 27.3p of tax for the forgiveness of 99p.

So the law allows that as a tax free event, but to prevent abuse of the exception, the law requires that the purchasing company should not have been connected with the borrower at any time in the three years ending 12 months before the debt is acquired, whch means that a white knight could buy the borrower and qualify for the exemption if the debt was bought back and cancelled within a year.

If we are to believe Mr Timms story, it looks like the banks were simply setting up new group companies to buy back the debts and claiming that the new company did not fall within the definition of connected company for these purposes because they did not exist in the relevant period. Fair enough, but bearing in mind that RBS made a £4 billion gain earlier this year, if it was structured this way - purely speculation, and it could have been Barclays - which UKFI appointed directors approved the creation of any group companies used to facilitate the deal?

Wednesday, 14 October 2009

Consumer help desk

Earlier this week we heard from a Mr E. Daniels of London, an American, who runs a medium sized bank in London. Last year, he may have been missold another bank shown to him by a group carrying on business under the name of FSA. The group and their salesman, a Mr Brown, assured Mr Daniels that the purchase would not be a problem under the UK monopoly laws and in fact Mr Brown would personally see to it that that was so. Unfortunately, Mr Brown omitted to tell Mr Daniels about EU laws that also applied to the deal, and as a result Mr Daniels may have to make substantial disposals out of his expanded business to satisfy the bureaucrats in Brussels.

But Mr Daniels' problems didn't stop there. He realised quite soon that the business that he had bought was not in great shape and many of the acquired assets had to be written down to a more realistic value. In March of this year, Mr Daniels was approached by another group calling themselves HM Treasury selling their Asset Protection Scheme. As it turned out, this group was connected to FSA and the mysterious Mr Brown.

The details of HMT's Asset Protection Scheme were complicated but involved the payment of substantial fees to HMT, in return for which HMT would guarantee the value of financial assets, but only after the customer had taken a 25% first loss. It seems that the main intent of the scheme was not to provide guarantees for the assets but to cover the loans (already secured by assets) with 0% weighted guarantees to allow the the customer to free up capital.

Initially the proposal looked attractive, but after considering it in detail Mr Daniels realised that since he had already taken much of the 25% first loss on many of his assets and they were unlikely to fall much further, he had no use for the downside protection or the preservation of capital which made the fees quite expensive, although Mr Brown's colleague Mr Darling were constantly on the telephone to Mr Daniels that he needed to increase the capital in his business.

Last week, Mr Daniels decided that the Asset Protection Scheme was not for him and that he would seek fresh capital from the stock market. It was at this point that HMT told Mr Daniels that he have to pay a hefty £1 billion "exit fee", even though he had not actually signed up to their scheme. HMT argued that the very fact that Mr Daniels was interested in their scheme meant that there was some sort of insurance for his assets. Mr Daniels on the other hand says that he was only showing preliminary interest, and there was never any guaranteed protection for his assets.

We tried to get in touch with HMT but they were unavailable for comment. It is not certain that Mr Daniels signed any paperwork that would make him liable for any payments, but the message is clear: If you are approached to buy a large bank or to buy into one of these Asset Protection Schemes (and there are a lot of them around at the moment), be sure to consult a good solicitor first.

Mr Daniels is in touch with a leading London law firm. We'll let you know how he gets on.

Tuesday, 13 October 2009

QE: What is it for?

Back in March the Bank of England thought they would tell us about quantitative easing. It went like this:

Quantitative Easing Explained

Quantitative Easing ExplainedIn March 2009, the Monetary Policy Committee announced that, in addition to setting Bank Rate at 0.5%, it would start to inject money directly into the economy in order to meet the inflation target. The instrument of monetary policy shifted towards the quantity of money provided rather than its price (Bank Rate). But the objective of policy is unchanged – to meet the inflation target of 2 per cent on the CPI measure of consumer prices. Influencing the quantity of money directly is essentially a different means of reaching the same end.

Significant reductions in Bank Rate have provided a large stimulus to the economy but as Bank Rate approaches zero, further reductions are likely to be less effective in terms of the impact on market interest rates, demand and inflation. And interest rates cannot be less than zero. The MPC therefore needs to provide further stimulus to support demand in the wider economy. If spending on goods and services is too low, inflation will fall below its target.

The MPC boosts the supply of money by purchasing assets like Government and corporate bonds – a policy often known as 'Quantitative Easing'. Instead of lowering Bank Rate to increase the amount of money in the economy, the Bank supplies extra money directly. This does not involve printing more banknotes. Instead the Bank pays for these assets by creating money electronically and crediting the accounts of the companies it bought the assets from. This extra money supports more spending in the economy to bring future inflation back to the target.

Assessing the Impact of Asset Purchases

It will take time to assess the extent to which the MPC's asset purchases have stimulated nominal spending. The impact is inevitably uncertain, but over time increasing the amount of money in the economy should boost spending. The MPC is monitoring the situation closely to assess how firms and households respond to the extra money injected into the economy. It will pay close attention to the growth rate of broad money, the cost and availability of corporate borrowing, measures of inflation and inflation expectations, and developments in nominal spending growth.

They even printed a booklet

PDF icon
Quantitative Easing Explained Pamphlet
Download PDF (1Mb)

Did that make sense? The Bank of England was going to buy lots of gilts off the banks which would make them flush with cash so they would spend it. Read the pamphlet and it tels you that buying up gilts pushes up the price of gilts so the banks make a profit on their holding of gilts which bolsters their tier 1 equity and makes them full of cash.

Well not quite because in a new speech, Charlie Bean says forget about the bit about making the banks flush with cash. No that isn't the point at all. The idea is to boost the value of gilts, forget about the idea of filling the banks with cash equivalent reserves, apparently that was not the point at all, even though that was what they said in March.

Now this is where it gets interesting because Mr Bean was addressing the London Society of Chartered Accountants, who understand a thing or two about bookkeeping but wouldn't necessarily have a clue about markets, so no tricky questions on that from them. But what Mr Bean did tell them was that the Asset Purchase scheme is booked off the balance sheet of the Bank of England, because all the risk in the structure is taken by the government.

So if the QE programme isn't on the Bank's books, where does it go. With the government's accounts in theory. In practice the government auditors will probably let the balance sheet just float off into space, just like National Rail and a whole lot more, but any analyst would say the government now holds £175 billion of its own paper (which can be netted against the liability), but it also has a £175 billion liability for the deposits created at the Bank of England. So in net asset terms nothing has changed for the government.

On the other hand, maybe it has affected the market price of gilts by taking £175 billion out of the market? Well if that really did have an effect, we would expect the opposite effect from the £175 billion of additional gilts issued into the market to fund the deficit. And so it turns out. As Chart 2 shows at the back of Mr Bean's speech, yields in October 2009 for the 3,5,10 & 20 year gilts are about the same as the yields in January 2009. In other words, no change in yield and thus no change in the value of securities held by the banks.

So that was a £175 billion waste of time.

Monday, 12 October 2009

This Nobel Peace Prize thing

... will probably count against Obama in 2012, but by then he should have won 3 Grammy awards and a Tony, at least one Super Bowl, three NBA championships and a Stanley Cup, Oscars for Best Leading Actor, Best Director, Best Film and Best Adapted Screenplay, the Ordre national de la Légion d'honneur, two Eurovision song contests, GQ's Best Dressed Man of the Year, a Playgirl centre spread and a Christmas #1 in Kazakhstan, finishing his term of office by running the anchor leg of the gold medal winning US 4x400 relay team at the London Olympics.

Breaking with convention

I don’t consider myself a total anthropogenic-global-warming-sceptic, but I do object when I hear politicians, particularly non-scientists, saying that the science is clear, because apart from the basic science that demonstrates that CO2 is a factor in the higher temperatures caused by so-called greenhouse gases, there has been no convincing evidence that CO2 should be such a dominant factor, nor that slight increases in temperature due to CO2 will lead to tipping points.

Tipping points may be commonly observed in chemistry and biology but in thermodynamics and other physical phenomena, particularly energy related they are rare. It is hard enough to keep energy in one place, but if energy is to accumulate (i.e. heat the earth more than before) it needs a damn good reason to do so.

Anyway enough of that, and I will hardly pause to pour scorn on George Soros’ weekend announcement that he will invest up to $1 billion (note the upper limit but no lower limit) in renewable energy and fund $10 million a year to “help” lawmakers. In other words he is going to put money into the industry, but he is also going to lobby for beneficial treatment for his investments. Some philanthropist.

But my main scorn for the politicians has stemmed from a wariness that they may have been told by scientific advisers that the world’s stocks of conventional oil and gas are finite, and that it was therefore wise to plan for a world without hydrocarbons. The supply of oil and gas that we have been able to access easily has come from organic matter that has rotted down, been heated at the right temperature to make the right sort of oil which has accumulated in the right sort of geological formations to trap it in easily recoverable forms.

But for every easily recoverable barrel of oil or cubic metre of gas, there are many more in less accessible forms, the wrong sort of oil or embedded in rocks. The general wisdom has been that there was no point in trying to recover these oils and gases while there was plenty of cheap oil produced in the Middle East or gas from Serbia and Qatar, but with the recent $100 a barrel oils and similar gas price peaks, the oil exploration and production companies have gone looking for unconventional oils, and their progress was discussed last week at the World Gas Conference in Buenos Aires.

According to various speakers, advances in technology for extracting gas from shale and methane beds have happened faster than expected. Tony Hayward, BP's chief executive, said proven natural gas reserves around the world have risen to 1.2 trillion barrels of oil equivalent, enough for 60 years' supply and are rising fast.

Rune Bjornson from StatoilHydro says exploitable reserves are much greater than supposed only three years ago and may meet global gas needs for generations. "The common wisdom was that unconventional gas was too difficult, too expensive and too demanding, This has changed. If we ever doubted that gas was the fuel of the future – in many ways there's the answer."

Now please excuse me a little cynicism, but I won’t be too surprised if governments start to be a little more circumspect about the science of global warming. Expect them to apply more rigour to some of the statistics that have been used to justify global warming claims by UN and IPCC funded scientists, and the same rigour to climate models that seem to be able to predict and particular level of temperature change the scientists might like without giving any convincing reason for why the earth’s temperature should rise by 2% if that implies an implausibly high 8% increase in average heat loss from the surface of the earth.

How governments screw shareholders

The biggest argument against government ownership of companies is that governments bring baggage with them and they do things that don't necessarily fit with the best economic choices. Take for example the sale by Citigroup to Occidental of Phibro, announced last Friday. The sale was agreed at around net book value.

That meant essentially that despite that pre-tax profits at Phibro have averaged $371 million for each of the last 5 years, and $200 million over the last 12 years, the fact that the company has been profitable in every year in the last 12 and in 80% of all quarterly periods in that time - good going for a trading company - all of that was disregarded in the price and the company was sold for the net value of its assets consist of cash, marketable securities and readily saleable commodity positions less borrowings or around $250 million.

Why such a giveaway? Because the company had a contract with Andrew Hall, CEO, that would pay him up to $100 million a year. Remember that the profit record was after CEO pay and bonuses. But that doesn't matter to a government that owns a large part of Citigroup, which is why the directors were happy to sell for such a low price without a risk of shareholder suits.

Of course the one person who could have paid a higher price would have been Andrew Hall, but if having a $100m a year employee on the government payroll was bad, the only thing that could have been worse would have been a $350m a year director/shareholder in a government MBO.

Sunday, 11 October 2009

Gordon goes to the pawn shop

Gordon Brown plans to list a portfolio of non-financial assets that he will put put up for sale, including the Tote, the Channel Tunnel Rail Link, shares in Urenco, the uranium enrichment company, some student loans and the Dartford bridge and tunnel crossings.

For that he expects to raise about £3 billion, or to put it in perspective, enough to get the government through till Thursday.

Friday, 9 October 2009

The Obama Peace Effort

OK, I have now discovered that the Nobel Peace Prize nominations closed on 1 February 2009, 12 days after President Obama was inaugurated.

During that period the only peace or military activity I can find is an executive order signed on January 23 which authorised missile attacks from Pakistani-based CIA-operated unmanned drone aircraft at targets in Pakistani tribal areas. About 20 civilians were killed in the two missile attacks.

The White House press secretary, Robert Gibbs, declined to answer questions on the civilian deaths.

The Drugs Don't Work

More egregious spin from the left-wing press to make us think things are improving when the economy is really in meltdown. This time it is from the Guardian who start an article that starts:

"Britain's trade deficit with the rest of the world narrowed modestly in August to £6.2bn as
exporters sought to capitalise on the sliding pound, and the recovery in overseas markets."

Now you would think that meant that a lower cost of sterling made Britsh goods more attractive to foreign buyers and that our exports were picking up as a result. Indeed the article goes on:

"The trade deficit in goods has been narrowing since the crisis began, and official figures released this morning showed that it was £6.2bn in August, down from £6.4bn in July, and more than £8bn in August 2008."

By this time the average public sector employee has switched off content in the knowledge that Alastair and Gordon are doing a fine job even though those private sector profiteers are wrecking the British way of life, which is why they don't take in the next sentence:

"The ONS said exports actually fell, by £100m over the month, but imports fell faster, by £300m, as consumers tightened their belts. "

And that is after taking into account the fact that the cost of imported goods rose by 1%, so British purchasers acquired even less than the headline drop in imports would imply. So what happened to the much vaunted stimulus? Seems it is not having any effect.

League leader's losing streak

The BBC spin machine whirred into action this morning saying that, despite the promise of a 50% tax rate, the UK had been rated the top international financial centre by the World Economic Forum, overtaking the USA.

A closer examination shows that the UK's point score has fallen by 10%, but the USA has actually fallen by 15%, leaving it behind Australia.

Australia? International financial centre. The country with a 10% withholding tax on deposits by non-residents is a n international financial centre. Well, no it isn't, but with a largely introverted banking system and vast mineral wealth the Australian banks have fared well while the rest of the world has suffered, as previously mentioned.

The WEF survey isn't actually a measure of international banking but of financial development, and includes such measures as the number of ATM's per head of population and the strngth of the banking system which is why the Australians fare well this time.

London remains ahead primarily because of the depth and sophistication of its foreign exchange and derivatives markets, although the latter category is probably not due to the credit derivatives and other exotics but the plain vanilla interest rate and currency trades that run alongside the foreign exchange and debt markets.

The US has suffered because of the failure of several leading banks and the cludging of the debt securities markets, where it formerly held a considerable lead over the rest of the world.

If anything this demonstrates the irrelevance of the exact location of mobile hedge funds to the competitive edge of the City of London, but equally the fact that London is dealing with counterparties throughout the region demonstrates that mobile players don't have to sit in London and get hit with a 50% tax rate.

Financial Development Index 2009 Rankings
2009 Rank2008 Rank2009 Score
Change in score
United Kingdom125.28-0.55
United States315.12-0.73
Hong Kong SAR584.97-0.26
United Arab Emirates20164.21-0.40
Korea, Rep.23193.91-0.64
Saudi Arabia24273.89-0.01
South Africa32253.48-0.51
Czech Republic33353.48+0.05
Slovak Republic37423.30+0.05
Russian Federation40363.16-0.24

Harsher punishment for parole violators, Stan ... and World Peace

Perhaps it is a consolation prize for not winning the Olympic Games after next, but I fail to see the achievements that justify the award of the Nobel Peace Prize to the current President of the United States. Maybe he hasn't started or provoked any new wars, which is an improvement over his predecessor and the one before that who was apt to whip out a cruise missile to lob at suitably remote targets.

It is worth remembering that Mr. Obama was inaugurated into office on 20 January 2009, and nominations for the Peace Prize closed on 27 February 2009. That must have been one heck of a first 38 days, but sadly none of it seems particularly memorable. Still, Mr. President gets to trouser a cool $1.4 million, or $50,000 for each of his first 28 working days in office.

For all Mr. Obama's fine words, one can't help thinking that others with equal claims to aspirations in this field have been overlooked.

Thursday, 8 October 2009

Somali pirate advisory

This is part of a continuing advice column for Somali pirates.

This is a container ship. You can tell it is a containership by the boxes on the deck. They are called containers, because they contain things. Let's not go into what they contain because that's a little bit complicated, but trust me they contain things.

The ship below is a cargo ship. It also also contains things, but in the hold. See those cranes? Many cargo ships have them, which is a bit of a giveaway.

But the ship below is something else. It is a navy supply ship. French. You see the round things sticking up at the front? That's radar. They can see you. And the flat bit at the back? Helicopter pad.

Of course, the way you can easily spot them is when you see one of these.

Mind how you go.

Keynesian bio-engineering

I am not an economist, but .. I have it in my genes as the offspring of two LSE graduates, and many years in the City, so I will have my say on cuts and Keynes. Actually I am more of an engineer by training so I will start here by copying a comment from a real engineer on one of the FT blogs last weekend:

“Economics reminds me of aerodynamics. There you are gaily flying the plane. Open the throttle (increase money supply) and the thing goes up. Reduce money supply and it starts to descend. You think you have it sorted. Then you try the stick. Wow Pull that back, and it goes up, but slowly, push it forward and it goes down. Call that taxation if you like.

So you reason, if you open the throttles wide and keep pulling the stick back, its never ending growth innit? Low taxes, cheap money supply..

Until an engine splutters because you are burning fuel at such a prodigious rate that the system cant keep up..oops you pull the stick back..and the thing stalls and spins and you lose half the altitude.

Why? because your aerodynamics has moved from a zone dominated by smooth laminar flow, to a chaotic one dominated by turbulence and the old rules don’t apply.

What is so hard for economists to understand about the proposition that depending on circumstances, one model or another may at any given time provide the best approximation to economic behaviour? Any engineer is utterly used to dealing with this. Things works smoothly up to a point, and then suddenly, they don’t. Limits are exceeded and the old rules no longer apply. So don’t exceed the limits.”

Now there seems to be a general outcry by pro-big state commentators to the effect that Keynes has demonstrated to everybody's satisfaction that government spending during a recession can mop up unemployment and stimulate growth through "multiplier" effects. I contend that in the UK and the current situation, the Keynes solution may not apply.

Keynes developed his theories at a time where the government played a much smaller part in the economy than today. Government borrowing may have been comparable as a proportion of GDP, but that borrowing was funding assets across the British Empire. Before the first world war government spending (current spending, investment and welfare payments) constituted 10% of the economy. Between the wars it was around 30%. Now it is over 50%. Rather than being an standby engine that can be switched on from time to time to boost the economy with multiplier effects, it is the greater part of the economy. The nature of any multiplier will be very different. That doesn’t invalidate Keynes entirely today, but equally it means that it may not be the most effective model for today.

A second observation is that Keynes did not assume permanent deficit spending, merely the use of deficit spending during recessionary periods to smooth the economy. In the UK we have had deficit spending in the boom times and more deficit spending in the recession. Meanwhile the rest of the economy has effectively been in decline for the last 6 years.

But probably more importantly, it seems to me that Keynes' models assume a more balanced economy that can be stimulated by a combination of lower interest rates and government investment in infrastructure. The theory is broadly that investment by government creates income, which results in more spending in the general economy, which in turn stimulates more production and investment and spending. The initial stimulus starts a cascade of events, whose total increase in economic activity is a multiple of the original investment.

The trouble is that this seems to imply a closed economy where everything is produced here, but spending government money does us little good if most of that money goes offshore. 80% of cash for the car scrappage scheme has been applied to cars that were manufactured overseas. UK car manufacturers may have made more money from the €5bn German car scrappage scheme than the UK scheme. Running a £175bn deficit does little good if a large part of that goes on civil servants buying German cars, Chinese wide screen TV's and Taiwanese iPhones.

Sure enough they might buy some life insurance but very little of the government spending may get through to British industry. If we have industry that is based on oil, petrochemicals, pharmaceuticals and aircraft parts, how is that impacted by the deficit spending? Very little, I would posit. If the problem is that (a) there is no credit capacity in the banks, because although they are flush with cash they don't have any spare risk capital, and (b) there has been underinvestment in British industry because it has become a less attractive place to invest, those are the problems to address.

But using another elegant biological metaphor, Sean Corrigan of Diapason Commodities, an avowed member of the Austrian School of Economics, applies at Keynesian economics to the biology of cells and the role of adenosine tri-phosphate (ATP) in the body:

… consider now the exquisitely complex machinery of the mitochondrion, that tiny organelle nestling inside the larger cell, wherein the process of respiration takes place, by which is meant the oxidative extraction and storage of food energy in those little re-chargeable battery molecules known as Adenosine Tri-Phosphate, or ATP.

Taking as our ‘intermediate good’ a molecule of pyruvic acid (broken down elsewhere from the rather more familiar glucose) and by successively transforming it with the aid of a battery of enzymes and co-enzymes (the ‘machine tools’ of the cell, if you will), while transporting in and out the likes of CO2, oxygen, hydrogen ions, and water (the ‘complementary’ raw materials and their resultant waste products), we end up with a store of useful and transportable energy on which depends nothing less than the very essence of life itself.

In essence the intricate balance of natural processes — which more widely also relate to the finding, ingesting, digesting, transport and sometimes storage of foods in the first place — is essential for us not to get sick. This, in a sense, can be compared to the workings and cycles of the global economy.

So what happens when you take a Keynesian approach to resolving health problems:

… to a Keynesian, the foregoing is merely superfluous detail for, should anything at all happen to go wrong with the system - should a disease pathogen, a toxin, a lack of some essential input, or an error of construction or repair, disrupt the metabolism — he believes that all that is needed is to increase the ‘effective demand’ made upon it by ’stimulating’ end-consumption, regardless of that latter’s composition. In other words, as long as the Krugmanite quacksalvers can get our gravely-ill patient running around the hopsital ward, burning up energy by discharging those little ATP batteries at a sufficiently rapid pace, they have done all that anyone can ever hope to do to secure his recovery, for the relevant capital structure and the requisite passage of ‘goods’ along his subcutaneous pathways will spontaneously coalesce out of what our Hermetic leech faciley presupposes to be homogenous cytoplasmic ‘gloop’ or readily-availhable, self-assembly constituents.

To go back to a mechanical analogy, there is no point in filling the fuel tank if the battery is dead.

Wednesday, 7 October 2009

For where your treasure is, there your heart will be also

The Church Commissioners, who manage part of God's portfolio here on earth, have penned a letter to the House of Lords along with Esmée Fairbairn Foundation, Nuffield Foundation, Paul Hamlyn Foundation, The Henry Smith Charity, and the Wellcome Trust in response to their Lordships' Inquiry on the European Commission Directive on Alternative Investments Fund Managers

It seems the men of the cloth have learnt to serve two masters and are avid free marketeers to boot:

"In our view, the issues described above should not be dealt with by imposing restrictions, which will have the effect of reducing our freedom to invest in a way that maximises the benefit we can provide."

On the other hand perhaps the gospel writer knew all about hedge funds and 2 and 20 fee agreements when he penned:

"Lay not up for yourselves treasures upon earth, where moth and rust doth corrupt, and where thieves break through and steal."

Tuesday, 6 October 2009

Growing pains

Contrary to expectations hype, the UK economy did not grow in the third quarter of the year, says the National Institute of Economic and Social Research (NIESR).

Some economists predicted there would be growth in the three-month period, which would end the UK recession, but those of us living in the real world saw the slackness over the summer and no dramatic pick-up when everybody came back in September, so frankly, we are not surprised. Neither, I suspect has Alastair Darling, who slipped out a quote last week that he didn't expect growth until the end of the year. One can only speculate whether he has seen advance estimates of the numbers, but given the low key reaction to the NIESR numbers, I think we know where we stand.

The ONS will put out its official numbers on October 23, but in the meantime they say that industrial output had unexpectedly fallen in August, dropping 2.5% from the previous month. They say that this is due to a drop in oil production. Car manufacturing was up 11% due to Lord Mandelson's stimulus, but as we now know, 80% of the benefits of that initiative went overseas, while 100% of the costs stayed here.

Still, we can look forward shortly to more inanity and spin from the BBC to say that a 0.2% drop or whatever isn't as bad as the 0.6% drop last quarter. Wrong, it's 0.2% worse.

FSA and liquidity: the wrong solution

The FSA missed the liquidity problems at Northern Rock and Bradford & Bingley. certainly at the latter that was the entirety of their problems although the former had problems with the quality of its assets. But we can be sure that liquidity risk wasn't the FSA's strong point, and by their own eventual admission, they goofed. They thought that the Bank of England would step in if required so they left all the monitoring to them. The BoE quite rightly said that the FSA wanted all bank regulation and supervision to fall under its empire, so it was the FSA's responsibility.

So when the FSA found out they had to do something about "liquidity risk" they ran off to their copy of the Beginner's Book of Financial terminology and looked up "liquid", and "liquidity", and they pretty soon came across the term "mandatory liquid assets", which in the UK were non-interest bearing deposits with the Bank of England that banks were required to hold on their balance sheets. The term was a bit of a misnomer because assets would have been liquid but for the fact that they were mandatory, or to put it more clearly, the banks could have raised ready money by withdrawing the deposit, but it wasn't allowed to.

In fact the mandatory liquid assets had little to do with liquidity and much more to do with monetary policy and constraining bank lending. By increasing the proportion of assets that had to be held on deposit banks could be dissuaded from high volume, low margin lending and over inflating the money supply. That is nothing to do with liquidity risk, which is all about a mismatch between the duration of borrowing and lending in a bank which can result in a cash squeeze if the market declines to roll over short term funding while assets are outstanding.

So what is going on today? The FSA has said that bank's will have two options: on the one hand they can run asset and liability books where the durations of both side of the balance sheet are broadly matched. This reduces liquidity risk because as assets are repaid, the corresponding liabilities can be repaid and there is no risk of a funding squeeze.

That is a conservative form of banking, but bank treasuries have always made a profit by borrowing shorter term than the bank lends and making money on the average lower interest rates for shorter term borrowings - the old borrow at 3, lend at 4, on the golf course by 5 mentality. But that does come with the risk that when the borrowing comes to be refinanced half way through the asset's term the bank cannot source funds at an affordable price - a liquidity crunch. In practice banks can live with this risk so long as they don't get too aggressive and make all their profits from borrowing short and lending long, which is what killed B&B and Northern Rock.

On the other hand the FSA says if a bank runs an unbalanced book they have to hold 15% up to of their assets in government debt. This doesn't cost the bank anything in terms of capital because the gilts are zero weighted for capital adequacy purposes, so the bank could simply go out and borrow several billion on the money markets to buy the gilts, but it does cost the bank to do so because of the spread between the yield on gilts and the banks cost of borrowing. So the bank will try to mitigate that by borrowing as short term as possible compared to the long term gilts.

But, you might think, the gilts are liquid assets, so the bank can sell them to raise if they are short of funding. Think again, the gilts may be liquid, although you could now expect the price of gilts to fall through the floor if there is a bank funding crisis when all the banks rush to sell. It ois worse than that. If the bank is required to hold 15% of its assets in gilts, then it can't sell them to raise cash, so while the gilts are liquid to the market, they aren't liquid to the bank.

Now the theory is that the bank has a buffer of liquid assets equal to 15% of its portfolio, which in extreme circumstances it could liquidate, albeit that at that time the regulators would start to step in, but my guess is that by stipulating this liquid asset buffer and its associated costs, the banks' attempts to mitigate the negative spread between bank funding costs and gilt yields will mean that they will run a much higher degree of liquidity risk than before and probably increase the overall liquidity risk.

Right problem (finally), wrong solution. Think again, FSA. No better still, step aside and let the Bank of England take over. They know what they are doing.

Monday, 5 October 2009

Hard Times

Is your business finding it hard to raise funding? According to the IMF it's going to get harder, but more on that later.

A report published today by the EEF manufacturers’ organisation, says that innovative companies find it harder to get funding and that there is a poor understanding in the financial sector of how and why manufacturers invested in innovation, which left better performing companies struggling to access credit.

The obvious riposte is that companies that rely on technical innovation may not be as good at writing financial proposals or defining their strategy as their less innovative competitors who may have other strategies for survival. Moreover, technological innovation implies higher risk, so the nearly one-way bet for lenders (slight margin over cost of funds upside versus total wipeout downside) doesn't look so good.

Anyway, the real reason for looking at the report is that 40% of companies had found it harder to get bank finance in the past 12 months and none had found it easier. Presumably many of the other 60% hadn't actually needed to ask the bank to increase their credit lines or extend the term of their facilities, because according to the IMF, it should be getting harder.

According to their Financial Stability Report, the UK banks capacity to lend, in other words, the total amount of credit that they are able to supply within limits permissible under capital adequacy regulations has fallen 8.6% in the last year. This isn't new lending, but the total amount they are able to lend, so total credit capacity has fallen and the banks can't start issuing more credit until either existing facilities are repaid or they issue more Tier 1 capital.

But if that sounds bad, the banks credit capacity will decline by 4.5% by next year according to the IMF. But it just gets worse. Michael Geoghegan, head of strategy at HSBC, thinks that the FSA will require banks to hold Tier 1 core equity equal to 10% of risk assets. At the moment his bank has more than 10% Tier 1 capital, but only 8.8% core Tier 1 (real honest to goodness ordinary shares), so for HSBC that would be a further 11% reduction of credit capacity without a share issue, and HSBC is relatively well capitalised compared with other UK banks.

Meanwhile, banks are flush with cash supplied by government debt buybacks, but have no capacity to lend it out to 100% risk weighted counterparties.

Well if you can't borrow from the bank, why not issue shares. Aviva have just a announced plans to list of its Dutch subsidiary Delta Lloyd, tol raise about £1bn before the end of the year, the biggest initial public offering in Europe for at least 18 months. Except that Delta Lloyd isn;'t your typical IPO, having been around in one form or another since the Napoleonic Wars.

For the rest of the world's businessmen, who float companies that have been set up in their own career span, the volume of global IPOs has shrank dramatically after the financial crisis began towards the end of 2007, collapsing completely after the failure of Lehman Brothers twelve months ago.

The total value of IPOs across Europe dropped 83 per cent from €80bn in 2007 to €14bn in 2008, according to a PwC, but so far this year US and European IPOs combined have raised only €4bn.

But to put that number in perspective, that is about the same as the UK government needs to borrow every 6 working days just to keep its vast army of MPs, bureaucrats and other public sector workers in pay and provisions.

So here is a graph showing the ratio of the annual government budget deficit divided by the value of IPO's on the London Stock Exchange. The latest figure shows that while the government borrows like crazy, nobody is investing to ensure that money can be repaid in the future. If politicians don't get the message soon, there is no hope for the rest of us.