Words ought to be a little wild, for they are the assault of thoughts on the unthinking
- J.M. Keynes

Thursday, 26 July 2012

Abandon All Money Ye Who Buy Here

The summer sun seems to have frazzled a few brains. That or the willing suspension of disbelief has reached an extreme. This is where “an undertaking of great advantage but nobody to know what it is parts the fools with their money.

Consider the “positive” news which is providing doses of hopium to a market craving for it.

  1. Draghi says “ready to do whatever it takes”: Really Mr. Draghi? You have suddenly decided to act. And what exactly are you going to do? Well, the details are pretty sparse but you have told us to believe. “Believe me, it will be enough”. Amazing. After 19 summits, 3 full-fledged national bailouts, a second failed Greek bailout, a Spanish banking system bailout followed by the prospect of a full-fledged national bailout, imminent Greek exit, record breaking yields and constant jawboning since 2010 from European officialdom that confidence will return, the problem is isolated, the firewall has been built, the bazooka has been shown, the funds are more than enough and bailouts are unnecessary, we are now to believe. Again.
The last arrow in your quiver is monetisation but that requires stepping around the Lisbon treaty and more importantly getting permission from the northern Europeans, notably Germany. The Germans already seething at Merkel’s surrender in June are in no mood to print. But maybe they’ve told you secretly that they’d like nothing better than some exquisitely printed banknotes.

Some smart analysts say that the real game changer is this statement: “To the extent that the size of the sovereign premia hamper the functioning of the monetary policy transmission channels, they come within our mandate”. What are you going to do? Reactivate SMP, watch all private bondholders dump bonds into it and then watch domestics reload on secondary and primary and kick that sovereign-bank feedback loop into a higher gear as has been done before? The peripheral states are sure going to practice fiscal discipline when they know that anytime bond yields go up a bit, the good old ECB is there to take them down in the name of the “transmission mechanism”. It's like the good old days without the imposition of officious Bundesbank discipline. 

At the end the ECB holds all the credit risk and enables a backdoor fiscal transfer. Good plan. But do check with this guy called Weidmann first. Seems to be a troublesome representative of a minor shareholder.

  1. The eternal China stimulus which is going to rescue the entire world. There is a great story about this in today’s FT titled ‘Changsha unveils $130bn investment plan’. The city of 7m which is the capital of the Hunan province is going to spend 147% (not a typo) of its GDP as stimulus. The FT states in all seriousness (emphasis mine) “Essential numbers were missing from Changsha’s announcement, which made it hard to gauge its potential impact. For example, it did not say over what length of time the money would be spent, nor did it say how many of the projects were new. It was also unclear how the city would bankroll the spending, with the headline target equivalent to 147 per cent of Changsha’s gross domestic product last year. It is also more than one-fifth the size of the Rmb4tn stimulus that China launched in 2008, despite the fact that this earlier money was spent nationwide while Changsha is a single municipality. Mr Shen said that local governments often overstated their investment plans and that the final amount spent might only be a third of the initial target. Changsha said that it would invite “global financial institutions” to participate in the investment, alongside the government and local banks.
You can’t make this up.

  1. Fed is coming to the rescue with QE3. Yes, because just before the election with Republicans baying for Ben’s blood he is going to launch an all out attempt of pushing on a string which even some within the Fed believe carries significant risks. From the last FOMC meeting: “Some members noted the risk that continued purchases of longer-term Treasury securities could, at some point, lead to deterioration in the functioning of the Treasury securities market that could undermine the intended effects of the policy.”
The human brain is hardwired to be optimistic but surely all those thousands of years of evolution might have tempered the optimism. And if evolution didn't, the study of history should have. Everyone wants a happy ending and a tragic one is inconceivable. Just like the First World War could not have possibly happened between economically interdependent and civilised nations.

Tuesday, 24 July 2012

James Bond, Supermodels and the Euro

Somehow I ended up watching Quantum of Solace on TV. It was as awful as when I saw it the first time. But there is an interesting scene towards the end where Dominic Greene, the main villain, pays off the corrupt Colonel of the Bolivian police in Euros. The dialogue goes like this:

Greene handing over the suitcase full of cash: In Euros, as requested.
Colonel: The dollar isn’t what it used to be anymore.

According to Wikipedia, this scene was shot late-March/early-April 2008. Looking at the chart of EURUSD, this was right at the time when Euro was the strongest against the Dollar around 1.6000 (chart below). It has never achieved that level since and looks unlikely to either.

Talk about contrarian indicators!

Another contrarian indicator in hindsight was when Gisele Bundchen opted to be paid in Euros in November 2007. At that time EURUSD was around 1.4500 so she’s probably still better off than the poor Bond villains.

About time the old saying about the shoeshine boy was expanded. The time to get out is not only when the shoeshine boy starts giving stock tips but also when bond villains and supermodels go long.

Wonder if Skyfall makes any pronouncements on Euro’s demise?

Monday, 23 July 2012

Thoughts and trade ideas on Europe

On the 28th day of June 2012, the great leaders of Europe solved the crisis engulfing their cherished elitocracy. It was the 19th time that the crisis had been solved. Unfortunately God seems to be an evil speculator.

Spain is now at the point of no return with 10-year bond yields at 7.5% and the curve flattening fast. Without official intervention or assistance the market is unlikely to suddenly regain confidence and cause yields to revert to sustainable levels. Unfortunately neither is any credible intervention likely nor is there any will for it by the northern European creditor nations. Half-hearted attempts will be made (SMP reactivation is my guess) but apart from causing another short-lived sucker rally they are going to be ineffectual.

The next domino in the line is Italy. After that the barbarian hordes will be at the gates of the “special partner” whose bonds are ironically benefiting from flight to quality. The buyers must be using some complex mathematical formula whose understanding eludes the rest of the world. French CDS at 180bps when Spain is at 620bps and Italy at 540bps is the cheapest short available. The problem of course is that soon after French CDS starts its inexorable rise upwards, laws will be changed and the market made illegal. With this trade, timing is everything.

This is also the moment when the twin bazookas of EFSF and ESM turn into water pistols even in the eyes of the most ardent optimist. Spain guarantees 12.75% of EFSF and 11.904% of ESM. Italy further guarantees 19.18% of EFSF and 17.914% of ESM. The abstract problem of valuing an insolvent state’s guarantee on loans to itself has suddenly assumed practical dimensions.

With everyone concentrating on Spain and Italy, problems from the original schuld of Greece have moved to the periphery. This loss of focus is going to prove costly. IMF has threatened to withhold aid funds (Bloomberg story referencing original Spiegel article) due to Greece missing its bailout targets. If it does follow up on the threat then catastrophe beckons. Argentinian default on 23rd December 2001 happened after the IMF pulled the plug on further aid on 5th December. The remarks of the German Vice-Chancellor that Greek exit “had lost its terror” shows the cluelessness of decision makers. Unless he has turned into a fatalist, the implicit assertion that a Greek exit will be manageable is foolhardy.

Greece is not unique, it is merely the first. A Greek exit will set a precedent which will accelerate a collapse of the Eurozone. Trying to paint it as an isolated case is unlikely to work especially as credibility of Eurozone’s leaders is at its lows. PSI was supposed to be a one-off in Greece, investors are now assuming it for Portugal and others and pricing their bonds based on implicit official seniority. What matters is not whether the Greek precedent is actually followed in future, but the present belief in it being followed.

A Greek exit will result in a complete collapse of the economy as it is deluged by a tsunami of bank, corporate and household bankruptcies. Ordinary Greeks will see their savings and pensions evaporate overnight. Inflation will soar as the newly introduced Drachma plummets. The waves will hit the rest of the Eurozone through both private and official channels. The former will be hit by a redenomination of contracts and default while the latter will be hit by the repudiation of TARGET2 liabilities of the Bank of Greece. Further, seeing the plight of Greeks, citizens in other distressed countries will redouble their efforts in stuffing their mattresses with hard currency. Banks runs across the Eurozone will follow. A truly Creditanstalt moment.

Having dithered for so long and continually put good money after bad, there are no good choices left for European leaders. The silver lining is that there are still choices. If they continue in the same vein and hold a 20th summit and a 21st and so on then those choices will no longer be available. The key question is whether they want to stand their ground or retreat from the European Monetary Union (EMU). Advancing to a fiscal union is out of the question given the mismatch in expectations and the political opposition within member states. Everyone may want “more Europe” but they define it differently. By the time the disagreements can be ironed over, their position would have been overrun.

As I’ve argued before, standing ground at this stage requires monetisation. That will take away default risk and cause sovereign bond yields to drop. A fall in value of the Euro will make adjustment easier for uncompetitive peripheral economies. It is an implicit wealth transfer from Germany and other northern European countries but that is the price to pay for continuing with the EMU.

The second option is of an orderly retreat. Letting states exit the EMU but abide by all the other rules of the EU. This will lead to a disintegration of the Euro but the single market will be preserved. It has to be an overnight big bang exit with everyone who wants to leave out and the remaining nations still in the Euro. A sequential withdrawal will just lead to uncertainty and all the ills outlined above associated with a Greek exit. In practice it means the demise of the Euro since each country would opt for its own currency in order to fully control monetary policy to deal with the shock.

Unhappily, this option is also very costly as contract redenomination and defaults will follow. An initial peg of a national currency to the Euro for redenomination may make it easier but it is likely that capital controls will have to be introduced. Further, a redenomination of TARGET2 liabilities means a wealth transfer from northern Europe. However, de-facto the transfer has already taken place due to the actions till date. Whichever way this resolves itself, Germany is left holding the can. And the longer these continual crisis summits stretch the crisis, the bigger is going to be the eventual wealth transfer. 

Further attempts to buy time are likely to make these choices moot as disintegration starts through market contagion, bank runs and riots (the Argentine case). 

Therefore to an investor bearish on Europe the best way to express that opinion is through shorting the EUR against a basket (eg. USD, DKK, NOK, JPY). The reason is simple – as the crisis intensifies, interference in the market will increase through short selling bans, etc. Today’s announcement by Spain and Italy makes this very clear. Also, this interference is likely to turn nastier over time. Therefore shorts in equity or fixed income are at risk. In contrast, capital controls are likely to be the last option and are usually taken only at the bitter end (Argentina is a case in point). Moreover the liquidity of FX markets enables appropriate positions to be taken more easily.

Disclaimer: All ideas elucidated above should not be taken as investment recommendations. The reader should perform his/her own analysis before making any investments.

Saturday, 21 July 2012

Ayn Rand and the fallacy of individual success

Everyone thinks they’re John Galt. It’s called the self-serving bias. Succinctly, people believe that their success is solely due to their efforts and talent while failure is someone else’s fault. This partly explains the uproar over Obama’s “somebody else made that happen” remarks.

Although he is catering to his left-leaning support base, he has a point. And it is that success is not solely due to the individual. No one enters the world fully developed and functional. There are various people and situations which influence and mould the individual and make him/her into the person that he/she is. Parents, teachers, peers and even strangers shape a person’s worldview and attitude. They also impart the necessary skills for achievements later in life. John Galt wasn’t hit by lightning upon being born and thereby endowed with all of life’s skills and education at birth. His drive and motivation were probably the result of his upbringing and interaction with teachers and friends during his formative years. Presumably his brilliant invention had something to do with the knowledge he gained at college.

For the sake of argument, let us assume that these broad external influences are part of the individual. This way we can re-internalise success and credit the individual for it. Therefore success is due to the individual’s talent in combining advice, help and support from parents, teachers and peers along with acquired knowledge and skill. However it is still not a sufficient condition for attributing success solely to the individual.

In a modern economy, division of labour and the inter-relationships which are spawned by it make the concept of strictly individualistic success laughable. Even the stereotypical hedge fund manager who is considered a practicing preacher of unfettered capitalism and threatens to run to low tax jurisdictions at the drop of a hat depends on others for his wealth and success. His decisions which earn him the combined GDP of several poor countries per annum are based on information crunched by an army of analysts. This information is provided by an army of reporters and both armies use tools built and maintained by a third army of IT workers. This is not even considering the use of electricity, water supply and other infrastructural services. True, the provision of all these services is assumed to be based on voluntary exchange and beneficial to all parties involved in the exchange. But the point is that the very visible success of the hedge fund manager is extremely fragile. Its continuation requires everyone to play their part properly. Poor analysis, incomplete information or systems failure can lead to ruin. There is a reason why the species Hedge-fundus Magnificus is not found in sub-Saharan Africa.

To re-internalise success requires that we again broaden the scope of the individual. It can be argued that successful people have a talent for selecting suppliers, distributors, co-workers, etc which ensures their success. I.e. they largely create their own inter-relationships. But even these heroic assumptions are not sufficient to attribute success solely to the individual.

This is because an individual cannot be the sole cause of his success when his very existence and that of his enterprise is made possible by the state. Humans cannot exist in isolation, collaboration is essential for human survival. The evolution of human civilisation is an evolution of the state and forms of government; starting from a tribal chieftain to the multi-organ government of modern economies. There may be debate on the optimal range of functions that a government can undertake but there is no doubt that the government and public sector are an essential part of the modern economy. Either directly or indirectly they enable entrepreneurs to savour the fruits of their enterprise.

As an example, an island of John Galts would still have to collaborate to ensure a minimum level of public services such as order and defence. Without a police force, some perceptive John Galts will compute that returns to crime have shot up to infinity (as the product of probability of being caught and punishment has dropped to zero). Mayhem will soon ensue. Moreover, lack of an army will entice some failed ‘welfare’ state to expropriate resources from the island without fear of retribution. But only a police and army are not sufficient. They will also have to create some organisation which ensures contracts are enforced and property rights respected. Then they will have to provide checks and balances to the power of police, army and other organisations to stop them from misusing that power. Very soon the island of intrepid John Galts will be drowning in “bureaucratic red tape”.

Stressing on individual rights and limiting the power of government are noble aims which must be pursued. But the debate must not be framed as government versus the individual. Neither extreme is workable. As John Stuart Mill said, everyone who receives the protection of society owes a return for the benefit.

It is unfortunate that Randian philosophy has seeped so deeply into political and economic debates. Despite her high priest committing apostasy, the influence of Ayn Rand on policymakers shows no signs of subsiding. Idiotic attempts to loosen monetary policy in the face of a liquidity trap are a testament to this pernicious influence. When mythical John Galts are too scared to invest, lowering interest rates to zero or guaranteeing loans made to them isn’t going to have any effect. Government expansion, both in peace and war, was largely responsible for ameliorating and finally resolving the tragedy of the last Great Depression. It was then taken to an extreme, setting up the reaction where now practical men of affairs have become slaves of a defunct playwright rather than a defunct economist. What a tragedy.

P.S. I am not a fan of Obama. And I am even less of a fan of the right wingers who seem to be dominating Republican policy. It was well put by JS Mill that conservatives are not necessarily stupid but most stupid people are conservatives.

Tuesday, 17 July 2012

Will China Conform to History?

The noises on China are rising to a crescendo. There is enough analysis for everyone and investors can pick the outcome which best suits their confirmation bias:
  1. Meltdown
  2. Hard landing
  3. Soft landing
  4. Stimulus-led perma growth
I personally veer between 2 and 1. The reason for it is simple: No command economy can achieve sustainable growth without upheaval.

History has shown that all experiments by “wise men” to direct economic growth and achieve a higher standard of living have ended in disaster. Just looking at the 20th century throws up enough examples, the biggest being the Soviet Union. The myth of the Soviet Union was formed during the Great depression which it supposedly escaped unscathed. In the 1960s and 70s it was supposed to overtake and annihilate the west. Instead it crumbled and ceased to exist by 1991. More recently, the Japanese debacle and the Asian crisis show that state-directed capitalism leads only to transient economic strength. The greater the level of interference, the bigger the reckoning and more muted the recovery.

Friedrich Hayek said that it is impossible for a directed economy to replicate the price mechanism which combines dispersed knowledge of all participants in a capitalist economy. Unfortunately this insight escapes hubristic politicians irrespective of whether they are in democracies attempting ‘Keynesian’ micro-management or in autocracies attempting the same old ‘new’ social experiment.

The reason why state-directed capitalism (an oxymoron if ever there was one) does not work is because of five reasons.
  1. Power corrupts: The directive elite forms a kleptocracy increasing economic inequality and imbalance within a country.
  2. Communication breakdown: Messengers are shot so bad news is suppressed from those in power and responsible for directing the economy. Alongwith point 1 above, it isolates those in power from ground realities.
  3. Perverted growth: The economy is directed to hit official targets and ensure promotion through the ranks of the elite. Combined with point 2 above, this weakens the power of the centre over its apparatchiks in the provinces. (A common problem responsible for the fall of empires starting from ancient Egypt).
  4. Malinvestment: The true price of capital is suppressed to ensure social and political goals are fulfilled leading to unproductive assets. Fear of failure and ambition (points 2 & 3) ensure a cover up worsening the problem and enhancing the eventual impact. This also explains the prevalence of banking crises in countries with 'innovation free' captive banking systems.
  5. Lack of mandate: The tension between the in-group of elites and the out-group of commoners surfaces eventually either because the out-group is economically transformed (the rise of middle and working classes post industrial revolution) or deprivation/inequality hits an extreme (most revolutions).
China ticks most if not all the boxes above. While it is hard to determine the exact timing of the denouement, it is easy to forecast its inevitability.

The various narrative threads being spun at the moment seem to indicate that denouement is not far off. Hopes of those looking for a soft landing and/or growth resumption are being pinned on the next round of stimulus. It may succeed in delaying the reckoning but it can’t prevent it unless structural reforms proceed apace. Unfortunately structural reforms are antithetical to any entrenched elite and China is no exception. As John K. Galbraith said, people of privilege will always risk their complete destruction rather than surrender any material part of their advantage.

A reading list of some recent and interesting China analysis (the preponderance of FT Alphaville links attests to their brilliance):

  1. General
    1. Andy Xie: http://articles.marketwatch.com/2012-05-17/economy/31749727_1_global-economy-commodity-prices-export-growth
    2. Michael Pettis: http://www.mpettis.com/2012/07/04/what-is-financial-reform-in-china/
    3. The Economist special report from May: http://www.economist.com/node/21555915
    4. John Hempton, Bronte Capital: http://brontecapital.blogspot.com.au/2012/06/macroeconomics-of-chinese-kleptocracy.html
  2. Dollar shortage
    1. http://ftalphaville.ft.com/blog/2012/07/09/1075431/china-and-those-dollar-shorts/
    2. http://ftalphaville.ft.com/blog/2012/06/26/1060301/chinas-amazing-short-usd-position/
    3. http://ftalphaville.ft.com/blog/2012/06/27/1061531/chinas-foreign-debt-keeps-rising/
    4. Tax cut to encourage overseas investment has to be seen in the context of dollar shortage: http://www.ft.com/cms/s/0/f2bff8ba-ccd0-11e1-b78b-00144feabdc0.html
  3. Falling demand
    1. http://ftalphaville.ft.com/blog/2012/07/10/1077271/more-slowdown-news-from-china/
    2. http://ftalphaville.ft.com/blog/2012/07/04/1071341/the-curious-story-of-sany-and-chinas-booming-inner-provinces/
    3. http://ftalphaville.ft.com/blog/2012/07/02/1066611/chinas-inventory-building-masking-a-bigger-demand-slump/
  4. No rebalancing
    1. http://ftalphaville.ft.com/blog/2012/07/13/1081961/china-doubles-down-on-imbalance/
    2. http://ftalphaville.ft.com/blog/2012/07/06/1073761/chinas-asymmetrical-and-anti-bank-rate-cut/
  5. Dodgy data
    1. http://ftalphaville.ft.com/blog/2012/07/17/1077301/is-chinas-electricity-data-worth-any-of-your-precious-attention/
  6. Kleptocracy
    1. http://ftalphaville.ft.com/blog/2012/07/11/1079141/a-tale-of-two-chinas/
    2. http://www.bloomberg.com/news/2012-06-29/xi-jinping-millionaire-relations-reveal-fortunes-of-elite.html
For those looking for more in-depth analysis, this book is a good starting point.

Although not recent but it provides an excellent account of China's financial system. The tales of financial repression and imbalances are not as shocking to an Indian as they would be to a westerner. Therefore the alarming tone is slightly overdone but it provides a comprehensive argument against sustainability of the Chinese model. The prose could be improved but then it is rare to find Shakespearean financial analysis.

Thursday, 12 July 2012

Why Bob Diamond is winning in the LIBOR scandal

When one’s position is about to be overrun by the enemy there is no point in digging in and becoming a martyr. Lob a few grenades, create a smokescreen and swiftly retreat to fight another day. Bob Diamond, the master general, has done just this.

The politico-regulatory establishment had been waging war against him for quite some time. His aggressive “American investment banker” behaviour and intemperate remarks (“there was a period of remorse and apology [for banks]; that period needs to be over.”) did not endear him to them. Therefore it was only a matter of time before he was outflanked and defeated.

Despite all odds he managed to hold out for a long time until the current LIBOR miscalculation. By racing ahead of other banks to settle he allowed himself to be isolated and outflanked. His position became untenable when even Agius’s suicide mission did not halt the attack. But instead of shooting himself quietly in a bunker, he lobbed a few grenades in establishment’s direction and made a run for it.

It proved to be a masterful strategy. As BoE’s Tucker was knocked off by the blast, attention shifted to the LIBOR shenanigans which took place during the credit crisis in 2008. During the period when Lehman Brothers failed and the banking system was about to vapourise, Barclays admitted to submitting artificially low LIBOR rates. As everyone fixated on this period, it led to two great results for Diamond, Barclays and other banks.

The first result was intended because lower LIBOR submissions during the crisis are more easily defended. The argument is that lower submissions were made by most other banks too and enabled the banking sector to stave off collapse. In times of crisis, saving the system trumps all other concerns. Therefore it is not much different from the subterfuge indulged in by the BoE to save RBS and HBOS. Indeed Diamond implicitly said as much to the Treasury Select Committee chair: “Barclays opinion was that those other banks’ submissions were too low given market circumstances…Even taking account of the abnormal market conditions at the height of the financial crisis, and that the motivation was to protect the bank, not to influence the ultimate rate, I accept that the decision to lower submissions was wrong.” (Emphasis mine)

Moreover, the definition of LIBOR states (emphasis mine): “The rate at which an individual contributor panel bank could borrow funds, were it to do so by asking for and then accepting interbank offers in reasonable market size, just prior to 11.00am London time.” This is not the same as “The rate at which a bank has borrowed funds today from the interbank market”. Therefore artificial submissions can be defended on two grounds:
  1. Vacuous truth: There was no market and no interbank offers in that period therefore the LIBOR submission was correct (it was a best guess estimate).
  2. Accurate estimate: The bank estimated that it could borrow funds around that level prior to 11AM but never borrowed any. Therefore it was impossible to verify whether the submission was correctly representing actual cost of funds or not. The accuracy of submission is now a matter of opinion and cannot determine whether the rate was right or wrong at that time. (Note the 11AM condition is a loophole in itself as costs of funds can change during the day so even if borrowing was done on the interbank market after the submission at a different rate, the two are not strictly comparable). Barclays cannot use this excuse since it has admitted to lower rate submissions but other banks can.
The second great result for banks is that Diamond has succeeded in dividing the enemy’s forces. Diamond’s smokescreen of Whitehall involvement led to Osborne’s ill-judged and politically motivated attack on Ed Balls. This has created a circus which diverts attention from the real issue.

The issue which Barclays and other banks want to bury is the LIBOR manipulation during 2005-2009. The way LIBOR works it is impossible for one bank to manipulate the rate alone. Rate submissions in the top and bottom quartile are discarded and LIBOR is set based upon the average of the remaining. Eg. If there are 16 banks contributing rates then the four highest and lowest submissions are discarded. The average of the remaining 8 is the LIBOR rate. Therefore if Barclays submitted rates which were too high or too low, they would be discarded and thus not influence the actual LIBOR setting. To achieve what Barclays’ traders asked (box) would require banks to cooperate.

“Hi Guys, We got a big position in 3m libor for the next 3 days. Can we please keep the libor fixing at 5.39 for the next few days. It would really help. We do not want it to fix any higher than that. Tks a lot." (September 13, 2006, Senior Trader in New York to Submitter)”
"For Monday we are very long 3m cash here in NY and would like the setting to be set as low as possible ... thanks" (December 14, 2006, Trader in New York to Submitter)”

Furthermore, it is unlikely that the practice suddenly started in 2005. If collusion has been going on for a long time then Diamond’s defence does not hold that “inappropriate conduct was limited to a small number of people relative to the size of Barclays trading operations, and the authorities found no evidence that anyone more senior than the immediate desk supervisors was aware of the requests by traders, at the time that they were made”. This standard ‘few bad apples’ defence has worn thin due to the rate at which bad apples are being discovered.

Apart from the potential to still implicate senior echelons of management, the LIBOR scandal is also going to lead to civil and criminal lawsuits. And it is this 2005-09 period of manipulation which is the most damaging since it is exceedingly hard to defend. It is clear that customers, be it municipalities, funds or individuals, were defrauded of their money through these acts. Since derivatives are a zero-sum game, a bank’s gain is the customer’s loss.

At the moment the threat is being realized in the US even as the UK goes off on a tangent. Banks’ behaviour infringes the Sherman Act and possibly the RICO (Racketeer Influenced and Corrupt Organisations) Act. The former may not be considered that big a deal since banks have become accustomed to lawsuits and financial penalties (after all it is the shareholders’ money). But the potential of criminal convictions under RICO will lead to quite a few palpitating white collar gentlemen.

It is this American advance that banks will find difficult to halt. The British threat seems to have been largely neutralised by Diamond despite the Serious Fraud Office jumping into the fray. He has done Barclays and other banks a great service by confounding the advancing British forces and sowing dissension in their ranks while aggravating their outrage (A 4th of July gift to himself?). Even in retreat he has sought to capture the moral high ground by forgoing a ₤20m bonus. Such stratagems win grudging admiration. Great generals are seldom paragons of morality but war and finance are both immoral endeavours.

Tuesday, 10 July 2012

Spain's Memorandum of Misunderstanding

The memorandum of (mis)understanding on the Spanish bank bailout has been released. Thankfully Rajoy won an unconditional bailout with his hostage taking tactics. Because if this is unconditional then Schauble only knows how painful a conditional package would have been.

The gist is as follows:
  1. Spain has lost sovereignty over its financial sector
  2. Banks will be forced to take losses under pain of death
  3. The gullible retail guy is going to take a bath on his subordinated debt holdings (just as he was coming to terms with his Bankia equity loss)
  4. Spanish regulatory regime has been deemed unsatisfactory
Apart from shocking the perennial optimists, this has the potential to worsen the situation in Spain through negative wealth effect. It also has the potential to spread contagion to subordinated bank debt of other countries deemed to be at risk. A short-lived victory for Rajoy and Monti indeed. 
More detail is below. All emphasis in quotes is mine.

Loss of sovereignty

Loss of sovereignty is made clear in the second paragraph itself. The EC and ECB are now the overlords.
For the duration of the EFSF financial assistance, the Spanish authorities will take all the necessary measures to ensure a successful implementation of the programme. They also commit to consult ex-ante with the European Commission, and the European Central Bank (ECB) on the adoption of financial-sector policies that are not included in this MoU but that could have a material impact on the achievement of programme objectives – the technical advice of the International Monetary Fund (IMF) will also be solicited. They will also provide the European Commission, the ECB and the IMF with all information required to monitor progress in programme implementation and to track the financial situation.

The other conditions are fairly standard for an EU/IMF package but notable due to the big fuss made by Rajoy about unconditional aid and the market’s euphoria. The relevant paragraphs are given below.
The European Commission, in liaison with the ECB and EBA, will verify at regular intervals that the policy conditions attached to the financial assistance are fulfilled, through missions and regular reporting by the Spanish authorities, on a quarterly basis. Monitoring of the FROB activities in the context of the programme will take place regularly.
State-aided banks and the Spanish authorities will report to the European
Commission on the implementation of their restructuring plan via the appointed monitoring trustee.”
“The European Commission in liaison with the ECB and EBA will be granted the right to conduct on-site inspections in any beneficiary financial institutions in order to monitor compliance with the conditions

Banks forced to take losses. No free money

The €30bn EFSF first tranche is not available for use. It is dry powder to be used only in case of emergency. Meanwhile banks have been told to line up for a balance sheet strip search (aka asset quality review and stress test) after which they will be told to join one of four groups given in the table below. Overlord approval is necessary before any funds are disbursed.
For banks in Groups 1 and 2, no aid will be provided until a final restructuring or resolution plan has been approved by the European Commission, unless use has to be made of the funds of the first tranche.

0 (Strong as bull)
No capital shortfall identified; no further action required. (Likely to be Santander, BBVA)
Make shareholders happy and management rich.*
1 (De-facto public sector)
Banks already owned by FROB (BFA/Bankia, Catalunya, NCG Banco, Banco de Valencia)
Restructuring/resolution plans approved by EC by November ’12.
Impaired assets moved to AMC by year end.
2 (Soon to be public sector)
Banks with capital shortfalls which are likely to require state aid
Restructuring/resolution plans presented to EC by October ’12. Approval end-December
3 (Hopium set)
Banks with capital shortfalls which will get private recapitalisation funds
For capital raise of more than 2% of RWA, COCOs to be sold to FROB by end-December ’12. These can be redeemed if private funding is arranged by 30-Jun-13. Lack of such funding results in COCOs being converted to ordinary shares.

For capital raise of less than 2% of RWA, private funding needs to be arranged by 30-Jun-12.
*Not stated in the official documentation

There is also a zero tolerance policy for zombies:
The Spanish authorities and the European Commission will assess the viability of the banks on the basis of the results of the Stress Test and the restructuring plans. Banks that are deemed to be non-viable will be resolved in an orderly manner.

Innocents get slaughtered. Again

The Greek myth of uniqueness has been shattered as the dreaded ‘B’ word appears.
Recapitalisations will only take place after the adoption of a restructuring decision by the European Commission, requiring burden sharing and restructuring, unless funds of the first tranche are deployed.”  

Unsurprisingly the household sector has been handed the bill as Northern European creditors seek to protect their aid.

After allocating losses to equity holders, the Spanish authorities will require burden sharing measures from hybrid capital holders and subordinated debt holders in banks receiving public capital, including by implementing both voluntary and, where necessary, mandatory Subordinated Liability Exercises (SLEs).

Bank debt holders are going to take a bath as legislation forces losses onto them. Is SLE pronounced 'silly' and can anyone smell contagion in the air?
Legislation will be introduced by end-August 2012 to ensure the effectiveness of the SLEs. The Spanish authorities will adopt the necessary legislative amendments, to allow for mandatory SLEs if the required burden sharing is not achieved on a voluntary basis…The Banco de EspaƱa will immediately discourage any bank which may need to resort to State aid from conducting SLEs at a premium of more than 10% of par above market prices until December 2012.

And to add insult to injury, the MoU recommends that the stable door be closed after the horse has bolted.
Consumer protectionshould be strengthened, in order to limit the sale by banks of subordinate debt instruments to non-qualified retail clients and to substantially improve the process for the sale of any instruments not covered by the deposit guarantee fund to retail clients. This should include increased transparency on the characteristics of these instruments and the consequent risks in order to guarantee full awareness of the retail clients. The Spanish authorities will propose specific legislation in this respect by end-February 2013.

If as the FT reports, there is €67bn of subordinated and hybrid debt outstanding mostly with retail investors then this is going to negatively impact consumer spending, mortgage and loan servicing. The negative wealth effect may be quite large. Combined with high unemployment (24.6%) and nonsensical austerity, the effect may be catastrophic.

In case the Spanish try to be cute and find loopholes:
Any capital shortfall stemming from issues arising in the implementation of SLEs will not be covered by the EFSF assistance.

Slap on the wrist for the Spanish regulatory regime

The reputation of the much vaunted Spanish counter-cyclical buffer is in shreds. The lack of confidence oozes out.
 “The current framework for loan-loss provisioning will be re-assessed…the Spanish authorities will make proposals to revamp the permanent framework for loan loss provisioning…Furthermore, the authorities will explore the possibility to revise the calibration of dynamic provisions...To this end, the authorities will submit by mid-December 2012, a policy document for consultation to the European Commission, ECB, EBA and IMF on the amendment of the provisioning framework

Furthermore, Europe will have no more of sinecures (in Spain only; other nations are free until they request aid).
The governance structure of former savings banks and of commercial banks controlled by them will be strengthened. The Spanish authorities will prepare by end-November 2012 legislation clarifying the role of savings banks in their capacity as shareholders of credit institutions with a view to eventually reducing their stakes to noncontrolling levels.

Monday, 2 July 2012

Europe: A House Divided

The market has given two thumbs up to the European summit concluded last week. Those of a cheerful and optimistic nature have argued that this is the watershed which marks the beginning of a transfer union, a fiscal union and a United States of Europe. Others, with less faith, have chosen to see the glass half empty again.

Much has already been written about how EFSF/ESM are sub-scale and that the summit statement’s ambiguity borders on irrelevance. Therefore there is no need to rehash the same arguments (a brief reading list is given at the end). Moreover, almost everyone agrees that the economics of all rescue proposals is nonsensical. A debt problem is not solved by taking on more debt and employing financial engineering to shift debt burden from one balance sheet to another. Everyone also agrees that the final outcome is now determined almost completely by politics. The impact of economic inevitability can be either be aggravated or mitigated by politics.

This is why the way in which the summit agreement was reached is particularly concerning. It was not generosity but ransom which was forced out of Germany and other northern European countries. The strong-arm tactics used by Mario Monti and Mariano Rajoy caused Danish Prime Minister Helle Thorning-Schmidt to question whether the attendees were being held hostage until concessions were made. This explains the ambiguity and lack of detail in the agreement. Germany and others have given themselves enough loopholes to deny in substance, what they have apparently agreed to in principle. In fact Netherlands and Finland have already started backpedalling on ESM bond buying. In addition, Germany has stated that direct aid to banks will require several conditions to be met and require a unanimous decision.

Therefore not only have Monti and Rajoy not achieved anything, counterproductively they have created more ill-will between north and south. A degree in psychology is not needed to understand that their ambush would clearly not have been appreciated by the northern European leaders. Monti and Rajoy were uncooperative in this iteration of prisoner’s dilemma and therefore reaped a short respite for both their countries at the cost of a massive loss of face for Merkel and others. But the game is still in play and the consequences are going to be realised later.  

The backlash is already building. German newspaper headlines like “Europe reaches for our money do not promote solidarity amongst citizens. German voters are already unhappy about being treated as a cash machine. Six complaints against the fiscal compact and ESM were lodged with the Constitutional Court this weekend. And the opposition SPD is trying to tap this discontent before the 2013 elections by opposing direct bank recapitalisations. All of this puts pressure on Merkel to take a hardline stance in future. Ambuscades in summits do not build credibility, they destroy it. The Germans, Dutch, Finns and Austrians may be forgiven for thinking that the southern Europeans cannot be trusted and want their money with no strings attached.

Unfortunately solidarity is being further strained by deterioration of northern European economies. Eurostat's forecasts for GDP growth are not encouraging as the table below shows. This is already being reflected in the PMIs. German manufacturing PMI fell for a third month in a row to a 36-month low. As the graphs at the end show, other economies aren’t doing too well either.

Table 1: Northern European strength is not infinite (nor is their patience)
GDP growth (2011)
Forecast (2012)
Source: Eurostat

Voters and politicians already reluctant to bankroll other countries are going to be even more opposed as their own circumstances deteriorate. Generosity in straitened times requires trust and bonhomie. This is precisely what Monti and Rajoy destroyed with their ambuscade. Economics was already looking dire, now politics has been poisoned too.

Graph 1: German Manufacturing PMI
Source: Markit

Graph 2: Dutch Manufacturing PMI
Source: Markit

Graph 3: Austrian Manufacturing PMI
Source: Markit