What $100B buys you

Floyd Norris makes an excellent point. Quoting Martin Halusa, the chief executive of Apax Partners, he posts that:

In early 2007, the Royal Bank of Scotland led a consortium that included the Fortis Group of Belgium and Santander of Spain. It paid $100 billion to acquire the Dutch bank, ABN Amro.

Had they held on to the $100 billion, those institutions could now buy Citigroup, Goldman Sachs, Morgan Stanley, Merrill Lynch, Deutsche Bank and Barclays. And they would have enough left over to buy General Motors, Ford and Chrysler.

Friday in Fantasy Land with George

I should buck up, I know. The current furore over credit derivatives may well come to nothing. But when I read something like Soros' article in the FT today, my heart sinks. Let's play spot the fallacy.

The second step is to understand credit default swaps and to recognise that the CDS market offers a convenient way of shorting bonds. In that market the asymmetry in risk/reward works in the opposite way to stocks. Going short on bonds by buying a CDS contract carries limited risk but unlimited profit potential; by contrast, selling credit default swaps offers limited profits but practically unlimited risks.

The asymmetry encourages speculating on the short side, which in turn exerts a downward pressure on the underlying bonds.

So how can you explain the growth of CPDCs, who are long risk only CDS investors, or for that matter the long risk portfolios at the monolines and AIG? In reality the fact that CDS allows unfunded risk taking trumps the ability to go short in stimulating demand.

Note too that there can be no asymmetry in the market: you can't sell CDS protection unless someone buys it and vice versa.

...US and UK government bonds... actual price[s are] much higher than that implied by CDS. These asymmetries are difficult to reconcile with the efficient market hypothesis, the notion that securities prices accurately reflect all known information.

No they are not. (I don't believe in the strong form of the efficient market hypothesis either, but this is not evidence for or against it.) CDS spreads include counterparty risk effects and liquidity risk on the possible future margin. Bond spreads include funding premiums. They are literally incommensurate since to have hedged positions (bond plus CDS) you need to be able to fund the bond to term at a fixed cost and to have no counterparty risk on the CDS provider.

I have an unworthy, low conjecture. It is that the age of a commentator is directly related to their hostility to CDS. The older someone is, the later they are likely to have come to the CDS market. And the less likely they are to understand it.

Tim and Josh

Am I the only one to think that (1) Tim Geithner looks a bit like Josh Lyman, and (2) Bloomberg's quote from him We have a financial system that is run by private shareholders, managed by private institutions, and we’d like to do our best to preserve that system,” smacks of ideology rather than the desire to do what works? Why rule out nationalisation - indeed why rule out anything? Josh wouldn't give up an option if he didn't need to.

Actuaries and other scams

I think that someone tried to scam me yesterday. I had gone out for a pint of milk, around 8 in the evening, when a man came up to me. At first glance he seemed well dressed - although the suit wasn't hand-made and the tie wasn't silk - and he had a sob story. His wallet had been stolen. He had no money. Could I lend him a tenner to get the train home? Sadly he rather ruined the spiel by clutching a mobile phone, with which he could have presumably have called a friend or work-mate. And the script was rather similar to one I have heard several times before. But what completely ruined it for me was that he claimed to be an actuary. He even showed me his business card, presumably in an attempt to establish his credentials as a trustworthy person. Now, dear reader, if you know what I think of actuaries, you will know that this back-fired.

What happened next? Well, I didn't steal his mobile. Although I was tempted. But he didn't get the cash. So the lesson, scam artists of E1, is when you are trying a con, pick a profession that your interlocutor doesn't think is fundamentally mis-guided.

Are there any solvent banks in Spain?

Creditflex's story (via Alea) that Spain's banks and cajas are negotiating on a one-to-one basis with the Bank of Spain to "fine-tune" their 2008 accounts in order to avoid taking catastrophic write-downs on loans makes me wonder if anyone knows the answer to this question.

GE cut

The downgrade of GE has long been coming, and long deserved. Now it seems that the agencies will finally do something: see here for Reuters on Moody's warnings and here for Bloomberg on S&P.

As Jonathan Weil says:

The credit-rating companies say they’re cleaning up their act. That will be a tough sell as long as they keep saying General Electric Co. is AAA.

Given how much of GE is GE Capital, Weil has a point. The Egan Jones rating for GE is A-. 'nuff said.

Update. Felix Salmon is insightful on GE too, here. He points out that GE needed its own FED bailout, that GE trades wide (I'm guessing the CDS are at more than 300 today), that GE has more than half a trillion dollars of liabilities, and that GE's accounting need be less robust than it would have to be if it was a bank. I'd add in the lack of a consolidated supervisor for the whole group.

Short at 35

John Hempton had a post that attracted a lot of comment last year pointing out that the fact that baltic state hookers cost too much was a good sign that the currencies were over-valued. Read Hookers that cost too much, flash German cars and insolvent banks: an introduction to Swedbank’s Baltic homeland here and the update here.

Well, I have no idea how much hookers cost in Thailand, but I have recently seen how much wine, food, and hotel photocopying cost there. And I'm short Baht as a result. Purchasing power parity is a crude tool, but sometimes it gives you important information.

Diversity

Diversity is important, not just on grounds of fairness, but also because dissent is valuable. You want different views in an organisation, different perspectives. And you certainly don't want the same culture informing all your decision makers.

In this context it is interesting to see two different storms blowing up. One against the Goldman Sachs -isation of the US Treasury. But the one I'm really interesting is the observation by Nick Cohen (here) amongst others that not only have governments of the left as well as the right been obescient to business, they have not even tolerated any non financiers in positions of power of the City. Think of people like Lady Vadera (why does the architect of PFI have _any_ place in a Labour government?), Mandelson (does judgement no long matter at all in a politician?) or Paul Myners. Is Vince Cable the only person in parliament who knows something about finance and isn't in the pocket of the banks? Even bankers know that hedging can sometimes be a good idea - and a good hedge against coming up with bad policies is having a few people around with different points of view.

The Barclays dilemma

This one is really hard. On the one hand, Barclays announced that they don't need more capital, and that their earnings are strong. (Bloomberg story here: Barclays letter to investors here.) And obviously one does not want to do a Peston, and spread irresponsible rumours. But there is still a nagging suspicion that there is something rank* about their balance sheet -- that they may have been less than honest about all their writedowns. I suppose this is yet another accounting problem: once suspicions arise that a bank might be abusing accrual, it is very hard for them to convince everyone that they are clean.

* But not as rank as a Durian, obviously

Update. Up 73% in one day. Wow. Just wow.

Negative basis hell

There have been a few posts around recently about losses on negative basis trades. These were apparently (one of) the source(s) of Merrill's recent loss. But I had not seen a convincing explanation until I came across this post from Zero Hedge. This picture is particularly eloquent:

At the time of the Lehman bankruptcy, it shows the spread had blown out over a thousand basis points. Now, given there is little liquidity in this stuff, Merrill is unlikely to have taken most of the trades off. So if this is the main cause of the losses, they will come back as the basis gets back to normal.

Office decorations

Note to CEOs everywhere. No one, not your shareholders, not your staff, not your clients, thinks you deserve a $87,000 rug. Buying one shows a spectacular failure of judgment. Buy something cheap and inoffensive instead. But don't go too far.

Update. Thain is paying the $1.2M back, according to a letter leaked to FT Alphaville. Good on him.

A warning from Bishopsgate

More solid, responsible journalism from the Daily Mash:

The Royal Bank of Scotland is just days away from imploding like that house in Poltergeist, it was claimed said last night.

As the bank's share price plummeted, experts said it was now time to bring in a scary-voiced midget to expel the remaining demons before the entire structure is then devoured by a tiny black hole.

Economist Tom Logan said: "In Poltergeist terms, the chairs have been stacked, the little girl has been sucked into the TV and the Beast has been exorcised without his annual bonus."

He added: "This once again demonstrates the folly of building a major financial institution on top of an old Indian burial ground."

Quite right too: I just wish Robert Peston could be this sensible. Now if only we can get extensive exorcism into the FED's armoury of facilities, perhaps we can beat this thing. All together now: Exorcizamus te, omnis immundus decoctor, ...

Update. While we are talking about RBS, I must mention Simon Hattenstone's wonderful and entirely appropriate attempts to get Fred the Red to say sorry, detailed in the Guardian. It harms all of us in finance that `managers' like Goodwin (I use the term broadly) are not willing to admit their mistakes and say a simple `I'm sorry'. It's not just that he screwed up. It's that he screwed up so royally that it is detracting from the public opinion of my business. And that annoys me.

Debt and Uncertainty

An interesting posting by Jonathan Hopkin made me wonder what debt is for, specifically government debt. Of course it allows us to borrow money to meet current needs, especially large unexpected current needs - like nationalising a banking system. But also, crucially, it allows us to fund assets of uncertain, fluctuating value.

Here's what I mean. The problem with ABS is precisely the AB part: the assets back the security. Therefore as the assets fluctuate in value, so does the security. Specifically if the assets are uncertain is value, so are (some or all, depending on the tranching and the credit enhancement) of the issued securities.

But ordinary unsecured debt depends just on the value of the promise to repay by the issuer. If this promise is of good quality, the security is valuable regardless of the assets that are being supported with the liability. In other words, by buying risky assets and issuing sovereign debt, the government does not just take credit risk - it also removes valuation and funding uncertainty from the financial system.

Consider this. (I'm not saying this is a good idea: it is just a thought experiment.) Suppose the government sets up The Office of Security Support. TOSS undertakes to do two things. It will repo risky assets to term at fixed haircuts. And it will provide firm prices on the bid and offer for risky securities in size. Each use of TOSS facilities requires paying a certain equity stake as well as the cash demanded, and the users must covenant to use a certain fraction of the funds raised to conduct new lending. Now undoubtedly running TOSS would be a difficult business and it would have some losing trades. But if the equity stakes required were large enough and the bid/offer spreads were wide enough, then it should be possible to run it without enormous cost to the taxpayer. Would this alone be sufficient to rescue the banking system?

Tarring Taleb

I have always been a little suspicious of Nassim Taleb. He seems to take too much pleasure in discussion of crises. And his first book -- a very conventional account of hedging -- isn't actually very useful for actually running portfolios of options. Now a post on Models and Agents (an excellent blog I have only found recently) gives a more focussed critique:

the current crisis is not a black swan. Alas, the world’s economic history has offered a slew of (very consequential) credit and banking crises ... So not only aren’t credit crises highly remote; they can be a no-brainer, particularly if they involve extending huge loans to people with no income, no jobs and no assets.

Taleb also recommends that we buy insurance against good black swans—that is, investments with a tremendous (though still highly remote) upside but limited downside. For example, you could buy insurance against the (unlikely?) disappearance of Botox due to the discovery of the nectar of eternal youth. And make tons of money if it happens.

And that surely is the point. Yes, the unexpected happens with considerable frequency. But knowing which black swan is more likely than the market is charging for is the hard part. Buying protection in the wings on everything is far too expensive to be a good trading strategy. If all Taleb's observations amount to is the claim that being long gamma can sometimes be profitable, then they are hardly prophetic. What would be much more useful would be his analysis of when, exactly, black swan insurance is worth buying.

Good grief

This is something I never thought I would read in the Economist:

Why not nationalise?

And I agree. For those banks that have lost the confidence of the market - like RBS - the best way to protect the economy while minimising costs for the taxpayer (and moral hazard) is nationalisation. We have a historic opportunity to reshape the banking system. Let's take it.

Your real estate data point of the day

One of the points I have repeatedly mentioned is that it did not take a very large fall in house prices to create the credit crunch. Contagion and widespread bank stress had begun by early 2007 despite falls at that point of only 10% or so nationwide. But of course the falls in the worst affected areas - including Florida, Nevada, and California - were rather worse. And since 2007, as Bloomberg points out, things have got quite a lot worse. In particular rising volumes of foreclosures are driving steep price falls:

A total of 19,926 new and existing houses and condos sold last month in Los Angeles, Riverside, San Diego, Ventura, San Bernardino and Orange counties, up from 13,240 a year earlier... The median home price in the region fell 35 percent to $278,000...

Foreclosed homes accounted for 56 percent of Southern California’s December sales, more than double the amount a year earlier, MDA DataQuick said.

Such transactions made up almost 70 percent of sales in Riverside County, where the median price plummeted 41 percent to $209,000. Sales jumped 77 percent to 4,435, MDA DataQuick said.

Bank capital? Not so much...

Sam Jones has an excellent post on FT Alphaville picking up on a momentous, and well concealed volte face from FSA. The regulator has (finally) embraced procyclicality.

We have continued to give consideration to appropriate long term changes to the bank capital regulatory framework. We believe that it would be preferable for the capital regime to incorporate counter-cyclical measures which lead to banks building up capital buffers in good years which they can draw down during economic downturns.

The well-concealed part picked up by Alphaville is:

we are amending the variable scalar method of converting internal credit risk models from point in time to through the cycle... These changes will significantly reduce the requirement for additional capital resulting from the procyclical effect.

As Alphaville says:

The FSA is authorising a modelling trick

But a particularly expedient one. Welcome to the bottom of the cycle capital regime. Just one thing. What if this is not the bottom?

Bad banks

Not bad as in `bad girl'. Bad as in non-performing. Paul Krugman makes the point that bad banks are not the answer to banking system problem, they are a tool for recovering more for the taxpayer after the banks have been nationalised, cleaned up, and sold on. In other words, wiping out existing shareholders is the first step. Let's begin with RBS shall we?

Update. Interfluidity has a nice post on full nationalisation and the Swedish model. The importance of excluding shareholders from future participation is clearly made:

Suppose that a bank whose true book equity is $0 has failed to mark down some assets, and shows a position of $10B. The bank receives a $90B capital injection, valuing existing shares at book. Then the old equity whose true value was precisely zero prior to the recapitalization suddenly has a real book value of $9B. That is, old shareholders reap an immediate windfall from the recapitalization, and the size of the windfall increases in direct proportion with the amount to which management had lied about the banks losses!

Really...

I leave you lot for a week in Asia, and when I come back, the banking system is broken, RBS has announced the largest UK corporate loss ever, BofA has taken another $20B of TARP money and a $100B asset guarantee, and Ireland has nationalised Anglo Irish Bank. I can't leave you alone for a moment can I?

Country Systems

Which systems work well in a town tells you a lot about the place. The title of this blog was inspired by the wonder of the Italian coffee system, something that provides good, cheap coffee everywhere. In France, it's the trains. They just work. Similarly the New York taxi model - cheap, available, often don't know where they are going - is much better than the London one - expensive, disappear after 11 or in the rain, and do know where they are going (but will take you the long way anyway). That's insightful.

In Cambodia, the tuk tuks are very effective, much like New York taxis. Water is on sale everywhere, reflecting a hot country with a lot of tourists from cooler places doing more exercise than they are used to. (Have you seen how steep those temple steps are?) And petrol is sold in glass bottles, every few hundred yards. You never have to worry about your tuk tuk making it to a petrol station, as the petrol vendor is always within walking distance.

This make me wonder about a variant of google maps where instead of plotting where xs are, they plot the average density of xs. Or even the difference between the density here and the average density in place of comparable population density. This isn't quite a sharp idea, yet, but with a bit of luck you can see roughly what I'm getting at. It would be a kind of 'what's different about here' plot.

Hiatus

I shall be in Asia for a week of so, so posting is likely to be intermittent at best. Wish me luck - while the long haul is with Qantas, some of the intermediate trips are with airlines whose safety record is marginally better than that of a large bank...

Catatonic with fear

A bit of an exaggeration perhaps, but this Bloomberg article has a good point:

“With the banks in a state of catatonic fear now, they’re just sitting on the [TARP] capital,” Blinder [Princeton economics professor] said in an interview. “I don’t fault the banks one bit, since this shows Wall Street they’re safer, but then this doesn’t get you much improvement. If you’re taking money from the public purse, we should get something in return, and we’re really not.”

There is an easy way of fixing it. Make the banks pledge new retail and corporate loans as collateral at the window. For a billion of fresh cash, you must post five billion of lending made in the last month, something like that.

Backtesting quant strategies

Felix Salmon has an excellent post today on quant strategies. As he points out, knowing whether you have something worth trading isn't exactly easy at the moment.

When you backtest, do you backtest through the quant blow-up of 2007 and the stock-market meltdown of 2008? If so, do you really think that's going to give you the kind of trading idea which will make money going forwards? And if not, then what do you ignore, and why do you ignore it, and what makes you think you won't run into a third period of high volatility which will lie well outside any reasonable assumptions you might make?

Up until 2007, the problems with quant funds was that the models didn't remotely conceive of the world as it transpired. Now, the problem with quant funds is that they can't help but conceive of the world as it transpired.

This applies more broadly, of course. No one has any recent data on normal markets because there haven't been any recently...

Professional Liars

What group of people's whole job is lying - hiding their own activities, figuring out other's lies, keeping things concealed? There are a lot of plausible answers - you get a credit for `politicians' - but certainly one reasonable response is `intelligence staff'. Is it really credible to believe that people whose professional lives required them to dissemble and flex the truth will always be honest when dealing with their bosses or overseers? I doubt it, which is why I think that strong, independent oversight of the intelligence agencies is vital. It's too easy for them to play the national security trump card when faced with a difficult question. You need people who can cut through that kind of obfuscation and impose a reasonable level of accountability.

I therefore particularly welcome Barrack Obama's decision to nominate an intelligence outsider, Leon Panetta, to head the CIA. (NYT story here.) We tried that kind of idea once in the UK with Robin Cook: remember `ethical foreign policy'? He was a sad loss to British politics: I hope Mr. Panetta lasts longer.

Recent refutations

John Quiggin has a nice series on economic doctrines that have been refuted by the Crunch. Part 1 is here. Go read: it's good.

Unrealised P/L and Tier 4 capital

Mark to market is great. It gives the users of financial statements the best information available about the value of a company. But, as we have seen over the last year or so, it also has the drawback - at least when applied to banks and such like - of encouraging procyclicality. On the way up, mark to market gains, once audited, form retained earnings, and so contribute to capital. This capital can then support more risk. On the way down, losses reduce capital and so inhibit risk taking just when it is vital for the economy that financial institutions to step up to the plate.

So.... let's split the link between unrealised gains and retained earnings. Specifically, I propose splitting the retained earnings component of tier 1 into two pieces. The first, retained realised earnings, would be as before. The second, retained unrealised earnings, would be the sole component of a new class of capital, tier 4. (Tier 1 is equity and highly equity like capital; tier 2 is reserves and certain types of long term sub debt; tier 3 is short term sub debt.)

Unrealised gains and losses would change tier 4. There would be constraints on the total amount of capital that could come from tier 4, just as there is today on the total that can come from tier 2. Exactly what would work needs some research, but my guess is that, say, having a rule like tier 1 must be 8 times bigger than tier 4 would work. On the way up, this would restrict the benefit available from unrealised gains. That buffer would then be available to absorb losses on the way down without restricting risk taking.

In one place...

The FT reports that The European Central Bank could be given significant extra powers as part of measures to boost eurozone bank supervision, its vice-president has proposed. I don't know whether the ECB has the resources to do this job, but otherwise it seems a good idea.

Certainly other arrangements have proved flawed. The SEC's CSE regime worked much less well than FED regulation. So one regulatory framework is a good idea. The separation between the Bank of England (lender of last resort) and the FSA (supervisor) worked badly in the case of Northern Rock. So uniting those roles is a good idea too.

Three jokes and a purchase

My three favourites from an extensive list at the National Post:

"Get my broker, Miss Jones."
"Yes sir. Stock, or Pawn?"

The problem with investment bank balance sheets is that on the left side nothing is right and on the right side nothing is left.

There's a surgeon, an architect and an economist. The surgeon said, 'Look, we're the most important. God's a surgeon because the very first thing God did was to extract Eve from Adam's rib.' The architect said, 'No, wait a minute, God is an architect. God made the world in seven days out of chaos.' The economist smiled, 'And who made the chaos?'

Normal levels of seriousness will be restored shortly. But in the meantime did I hear correctly that the Munchkins have bought Indymac? Perhaps that is the true route to financial stability: only short blue people who are entirely fictional should be allowed to own banks.

The conforming limit

With rather little fanfare the exceptional high limit for conforming mortgages of $729,750 expired yesterday. The limit is now $625,500 in high cost areas: it remains $417,000 elsewhere. The details are here.

I am surprised this was allowed to happen: I thought that the exception would be extended indefinitely given the state of the US housing market. This cannot be good for California, for instance.

New Year Resolutions

Marina Hyde has a nice column in the Guardian today about new year resolutions. First she makes a good point:

The crucial thing is not to set goals too high. Resolutions should always be incredibly realistic and achievable, so you can despise yourself even more when you fail to live up to them. By way of an example, a friend tells me he "might try and eat slightly healthier snacks when watching sport". See? There is simply no point kidding yourself about thrice-weekly gym visits, but piously denying yourself the fourth tube of Pringles before half-time is a possibility.

She then makes some resolutions for other people:

The rampaging armies of middle-class thrift bores currently laying waste to features sections should resolve to expand their ingenious brainwaves into the sports pages. We've already had our Christmases revolutionised by their suggestions for making our own presents ("Why not melt down 250g of really good quality white chocolate and stir in some nuts and rose petals?" Because it still costs a tenner, you tedious creature.) Now let's see them work their alchemy in the transfer window, starting with solving Arsène Wenger's midfield problems using only a ball of yarn and some really good quality white chocolate.

Hmmm, Frank Lampard in white chocolate? I see him more as a cheaply flavoured soft centre myself, but that could just be me...

Anyway, here are a few more for finance.

• Bankers should resolve to accept that the world has changed now that many banks have significant state ownership. A little humility - just a touch - might be in order.
• Ditto hedgies after Made-off. The regulators are coming: you know it, I know it, and the whole process will be a little less tedious if you could avoid foolish rants about the constraint of free enterprise while it is happening.
• Chicago school economists. The game is up. Please retire somewhere far away and never darken our media again.
• Finance ministers. Just once, for a change, why not actually spend some money on something the country needs. You know, like infrastructure. You might be able to build a credible midfielder from white chocolate, but it works less well for railways.