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Saturday, 31 January 2009

The two great lessons of the twentieth century

Gordon Brown's latest speech really takes the biscuit:

"This is the first financial crisis of the global age. And there is no clear map that has been set out from past experience to deal with it."

Not so this is straight out of the 1930's. An over-extended and over sophisticated banking system.

"I'm reminded of the story of Titian, who's the great painter, who reached the age of 90, finished the last of his nearly 100 brilliant paintings, and he said at the end of it, 'I'm finally beginning to learn how to paint', and that is where we are."

So the great and good at Davos really want to hear Brown's views on the painter's skill? I doubt it very much.

"We're learning all the time about how to deal with what are real problems for which we have no historical analogies to fall back on, because when the 1930s problems hit them, they did not have the global financial markets that we have today."

The facts are that nothing you have done so far has reversed the economic decline. The precedent in the 1930's is exactly the one you should be following. An over-extension of the banking system led to a general failure of banking and commerce, and was corrected by building up the banking system and keeping its business simple.

The two lessons of the twentieth century are that collective ownership leads to economic stagnation and that whenever regulated banks are allowed to trade with other people's money with low allocations of risk capital, central banks invariably end up bailing them out.

Stories we missed: Fridge magnate jailed

A Chinese tycoon was today sentenced to 12 years in prison following his conviction for falsifying and withholding information and embezzlement.

Gu Chujun, former chairman of Chinese refrigerator maker Guangdong Kelon Electrical Holdings Co., was also fined $636,000.

Gu plans to appeal the sentence.

Friday, 30 January 2009

Some new financial terms you may need to learn

The FT has reported that Morgan Stanley have ventured to suggest that
hyperinflation is a possibility, although this depends on a number of
factors, including the willingness of governments to pump up the money
supply and run the printing presses. We shall not speculate on the
correctness of their analysis, but if we assume for the moment that they are
correct, here is some terminology that may be useful.

We are used to the terms million, billion and even trillion, but thereafter
we may be less familiar with the commonly used terms for large numbers. In
fact, the system used in scientific circles and widely adopted in America
and hence in world financial circles is quite simple once we realise that
the prefixes after one million are sort of Latin: bi-, tri-, quadri-,
quinti- etc.

Or each each name represents 10^(3*(n+1)), where n is the number usually represented by the prefix in the name.

Hence one billion (bi-: 2) = 10^(3*3) = 10^9

One quintillion (quinti-: 5) = 10^(3*6) = 10^18

This has been a public service announcement.

Thursday, 29 January 2009

Madoff victims sue Santander

From the FT:
Victims of the alleged $50bn fraud by US broker Bernard Madoff have filed the first lawsuit against Santander of Spain, the eurozone's biggest bank, claiming damages and accusing the bank and other defendants of gross negligence.
The civil class action suit, filed on Monday in Miami, names Banco Santander — along with Santander International, Optimal Investment Services, the bank's Swiss-based hedge fund arm, and three Optimal managers — as defendants.
PwC, the auditors, and two HSBC units in Ireland are also named for their administration and custodianship of the investments.
Plaintiffs in the case include Inversiones Mar Octava, a Chilean company that lost $300,000 and "paid substantial advisory fees for illusory services", and Marcelo Guillermo Testa, an Argentinian.
Santander has said that its clients around the world may have lost €2.33bn ($3bn) with Mr Madoff, but declined to make any comments on Tuesday about the lawsuit. Only US money managers Fairfield Greenwich and Tremont have said their customers lost more. At least 19 civil lawsuits seeking to recover Madoff-related losses have been filed in four countries since the broker's December 11 arrest.
The Santander suit accuses all the defendants of violating US securities regulations, of gross negligence, of negligent misrepresentation and of unjustly enriching themselves.
"Despite the considerable fees charged to investors and the repeated representations that Optimal Investment would carefully select the managers, all of the Plaintiffs' and the Class' funds were stolen through the Madoff Ponzi scheme," the plaintiffs claim in a complaint filed in federal court in Miami.
"Defendants paid themselves tens of millions of dollars in fees, and perhaps hundreds of millions of dollars, predicated on phoney profits," the claim asserts.
Javier Cremades, senior partner of Cremades & Calvo-Sotelo, the Spanish law firm that announced the lawsuit on Tuesday, said the action related to clients who had invested in the funds through Miami.
The firm is hoping to negotiate for a global settlement with Santander executives in Madrid, according to Mr Cremades.
"They are very willing to talk. We still hope a settlement is going to be possible," he said.
He has estimated that there are around 3,000 investors in Spain — individual and institutional — affected by the collapse of Mr Madoff's scheme.
Meanwhile, a group of French private investors plans to file the first lawsuit there against UBS Zurich, the parent of the Luxembourg arm which ran Madoff feeder funds.
Veronique Lartigue, a lawyer representing roughly 10 people who invested in these funds, told the Financial Times that her clients were demanding €7m in compensation and would file on Wednesday in France. The investors are claiming reimbursement and interest from the parent bank, which they say is ultimately responsible. "In the prospectus the name UBS . . . was the determining element for investor confidence," she said.
UBS has said that these funds were established at the request of clients.

Monday, 26 January 2009

More Famous Quotes

"When I'm shaving in the morning, I often look in the mirror and think if I were a young man I would emigrate" - James Callaghan, 1979.

Saturday, 24 January 2009

Famous quotes

“A weak currency arises from a weak economy which in turn is the result of a weak Government” - Gordon Brown, 1995.

Is the BBC acting like Pravda?

There appears to be widespread civil unrest, particularly in Northern
Europe, caused by the financial crisis as reported by the world's press:

Demonstrations outside the Icelandic parliament have caused Social
Democratic Alliance chief Ingibjorg Gisladottir to hold talks with her party
on Saturday to consider Prime Minister Geir Haarde's call for a May 9
election. Iceland had its worst street riots in 50 years when 2,000
protesters took to the streets of Reykjavik on Thursday, hurling paving
stones at Iceland's parliament building, over the economic crisis. The day
before, protesters threw eggs and soft drinks at Iceland's prime minister.

Dozens of people, including 14 police, injured during riots in Sofia last

Centre-right government likely to call elections after riots over harsh
conditions following IMF bail-out.

Street clashes and 86 arrests after 7,000 people attended a Vilnius rally
called by trade unions to protest at public sector pay cuts, reduced social
security payments, an increase in VAT and an end to tax breaks on medicine
and home heating.

None of this is reported by the BBC (Europe headlines below):

Fatal storms hit Spain and France
Migrants escape on Italian island
EU gives boost to dairy exports
Britons 'bored but happy' - study
Dane guilty of genital mutilation
Belgian creche suspect questioned
France's Dati to quit government
UK in recession as economy slides
Pope launches Vatican on YouTube
S Ossetia 'war crimes' condemned
Norway school shooting kills two
Gerrard denies nightclub assault
Fans clash after Djokovic victory
Spain's jobless rate hits 13.9%
Spanish police seize 'fake' Dalis
EU threat to retained fire crews
Europeans 'seized in Sahara'

North Korea anyone?

Friday, 23 January 2009

Did I hear that right?

Did I hear the dulcet tones of Mr Brown this morning saying that the government had regulated the banks correctly. OK, he admitted, they may have made some mistakes over liquidity, but they got the rest right. Which is a little like a dam builder saying they got the steel reinforcement right but they may have made some mistakes with the concrete. It only takes one mistake for the dam to burst.

Unfortunately that is not the only mistake, although the mistake is common to many jurisdictions and their regulators. The Basel II capital adequacy rules are procyclical, meaning that when things are going bad they are exacerbated by the bank capital requirements and things are going well the burden eases, leaving banks with free capital to support extra lendeing.

Why is this? Because the amount of capital required by banks to be set against an asset is linked to the rating of the debtor. Under the old rules the weighting for a particular asset was determined by whether the debtor was a government, bank or corporation, and to be frank, this was very unlikely to change during the life of an asset. Under the new rules the risk weighting of an asset also depended on the rating of the borrower.

On its face this didn't seem unreasonable. Why should a standby credit facility to AAA rated multinational be treated the same as the subordinated of a leveraged buy out. AAA borrowers from banks were rare because they could get the money from the bond markets at better rates, so it seemed that these rare diamonds were relatively harmless. It was recognised that the rating of the borrower could decline, but AAA borrowers never went bust overnight (if we conveniently forget about Confederation Life) so the bank could always reduce its position by trading it away if it really had to, but in reality it would probably have the extra capital to support the position and a AA or A credit was still very bankable.

The problem was that neither the bankers nor the regulators saw what would happen next. Instead of being a rare jewel the AAA credit rating became a prized commodity that could be used to wrap around inferior credits. Fannie Mae, Freddie Mac and AIG became important not just because their sprinkling of fairy dust over an otherwise dubious asset gave it a higher credit rating, but also the assets became attractive to banks looking to maximise their returns to shareholders. The paper may have had a lowish yield, but it paid at a higher than normal paper with a similar credit rating because of complexity, and jo oy joys because of the high rating banks could hold much more of it per dollar of capital than they could hold of loans to corporates.

The demand for credit wrapped mortgage paper went through the roof until it became clear that there was little underlying credit in some of the assets and the high ratings for the guarantors were looking a little shaky to say the least. Now the regulators were looking at a different problem to the one they envisaged. Instead of looking at rare instances of AAA lending that might have been envisaged, the entire financial market was overhung by vast amounts of structured mortgage assets with likely ratings downgrades and capital requirements that could not be met.

Not all Mr. Brown's fault, but as the Cooke Committee was largely driven out of London, the UK government cannot avoid a lot of the blame, and as the financial regulator for one of the most significant markets for these transaction, the FSA has a lot of egg on its face.

And then there are all the credit default swaps written by AIG in London in an unregulated vehicle...

Thursday, 22 January 2009

Hear no evil, see no evil, speak no evil

According to a report in the FT, the FSA is holding talks with top auditors to "try to ensure banks are not destabilised by accountants making a qualified judgement in annual accounts on their capacity to continue as a going concern".

So what is an honest accountant to do if he spots a big hole in a bank’s accounts? Pretend that it’s not there and be sued 2 months later by the bank’s shareholders when it goes to the wall?

It looks as though the FSA, having failed to supervise the banks, is trying to get the auditors to ignore the problems that the FSA has already overlooked.

Monday, 19 January 2009

Probably the worst deal ever - worse than the Conservatives' Black Wednesday

At close of business last Friday, the UK government held £5 billion in preference shares and a 50% of the ordinary shares of RBS. I calculate the market cap of all of the company’s ordinary shares at £8.33 billion, so the total government holding of prefs and ordinaries would have been worth about £9.16 billion.

At the weekend the government cut what it thought was a good deal to exchange the prefs for ordinaries at a price 8.25% below the Friday closing price, giving the government a 70% interest in the ordinaries. With the discount on the ordinaries, the government would have thought they held about £9.56 billion of shares at the start of business on Monday. Unfortunately the share price fell 67% on the day leaving the market cap of RBS at £4.58 billion, and the UK government’s 70% share at £3.2 billion. So instead of getting a benefit of a £400m discount on the conversion price, the government took a £5.96 billion loss on the day, or rather the tax payer took that loss.

If the rating of UK government debt is downgraded as has just happened to Spain, then the banks will still be short of capital and the whole exercise will have been in vain.

RBS shares fall 70%

Just thought I would mention it.

Gordon Brown is a bit upset

It appears that he has found out that 80% of the assets on RBS’ commercial loan book are loans to non-UK borrowers. In order to get lending to UK borrowers moving again, Mr Brown’s government will have to share the risk in assets that they don’t understand or know about. Mr Brown feigns suyrprise, but given that he was responsible for regulating the banks and understanding how the economy worked he can hardly blame anybody but himself.

Some facts for you Mr Brown.

1. London is the centre of the European capital markets and since the 1980s when the Japanese banks turned up in a big way, the British banks have lost market share, particularly in the large corporate sector to Japanese, US, French and German banks.

2. Large scale capital investment in British industry has been virtually non-existent since 1997. Your pro-globalisation policies and your increasing burden of taxation have driven investment to other parts of the world. Don’t give me any guff about dropping the rate of corporation tax. The last drop was funded (your words) by reducing the standard rate of capital allowances from 25% to 20%, which hit capital intensive businesses disproportionately. The one before that was funded by bringing forward the timing of tax payments. Paying tax at 30% 10 months after the end of the accounting period has the same economic cost as paying a lower rate of tax on estimated payments through out the year. It also gave you an extra years corporation tax revenue. Equally disastrous was the auction of 3G spectrum which sucked capital out of British firms that were expanding rapidly in foreign markets and killed off a lot of British overseas interest in the strongest growth industry in the last 10 years.

3. NatWest, RBS, Barclays, Lloyds and Abbey used to fund a large percentage of the fixed plant and machinery in this country through long term finance leasing, which gave British banks a pricing advantage over foreign lenders and provided certain long term finance to UK companies. For the sake of short term revenue gains you killed this industry with many pieces of legislation in successive Finance Bills. It was your decision, so don’t act surprised if RBS has very few UK customers.

Saturday, 17 January 2009

The bank guarantee scheme

Let’s make a few guesses at how it works:

The banks have some bad assets on their books and are short of capital. They pay an annual premium to the government to cover the banks on any losses above a certain amount on those bad assets. Let us say the figure is 50%. So the banks take the first 50% of losses/risk and the government take the risk on the remainder, which is hopefully an acceptable deal for the tax payer - but don’t count on it.

The advantage for the banks is that with the government guarantee they may expect to be paid out to a limited extent if the assets go bad (although don’t count on it because of the state of the UK economy), but to the extent they are covered by government guarantees they will be zero-rated for capital adequacy purposes. So the banks will pay a premium of perhaps 1% of the amount guaranteed and will thereby avoid using up Tier 1 capital equal to 8 or 9% of the risk adjusted amount that they would otherwise have to pay if/when the bad assets are downgraded. Not a bad deal for a bank that is short of capital.

On the other hand the government gets paid a premium that it pretends represents value for money and in return incurs a contingent liability. The government likes that because not only does it have to come up with any more cash for funding (which needs more borrowing), but it also gets to exclude the liability from the government accounts (on the same basis that it excludes the guarantees it has given against National Rail's borrowings). There is no valid accounting reason to do so. It is simply using its often practised techniques of lying and self-delusion.