If you work in US financial markets...

[Handprints]

...it's time to put that wineglass down, take a couple of extra vitamins and have an early night. It's going to be a busy day tomorrow.

 

[AvoidingRealWork]

...it's time to put that wineglass down, take a couple of extra vitamins and have an early night. It's going to be a busy day tomorrow.

I mentioned to my co-workers that we dodged a bullet with the market closed today because of MLK. Someone wanted to know why. I explained about the crash worldwide, and that a day off would allow time for cooler heads to prevail.

Someone said, "Oh crap, I better sell everything and pull out of the market!"

"That's the spirit!" I said sarcastically.

We're fucked.

 

[Handprints]

...We're fucked.

Well, it's probably wise to assume that there are as many idiots owning US stocks as any other kind. I think your banks and insurers are likely to see a bad day tomorrow - the rest are going to live and die with market mood (ie: your co-worker.)

H

 

[BlackShanglan]

I've been feeling the sword hanging since I heard the word from a friend, once a bank examiner - one of dozens recently asked to come back from retirement in order to handle what looks like an impending influx of banks in serious difficulties. I hope he's gotten a good night's sleep.

 

[Handprints]

I've been feeling the sword hanging since I heard the word from a friend, once a bank examiner - one of dozens recently asked to come back from retirement in order to handle what looks like an impending influx of banks in serious difficulties. I hope he's gotten a good night's sleep.

He'll be having fun for a few months yet:
"What do you think you own?"
"What do you think you paid for it?"
"Who do you think you sold it to?"

Ironically, it was the announcement of further (US, mostly sub-prime) writedowns by a German bank (a few days after the banking regulator there announced it was bringing back several retired auditors as a crisis team) that put Europe in a selling mood and got the markets roiling...

Best,
H

 

[GoddessHathor]

Well, it's probably wise to assume that there are as many idiots owning US stocks as any other kind. I think your banks and insurers are likely to see a bad day tomorrow - the rest are going to live and die with market mood (ie: your co-worker.)

H

Here I was trying to forget the hell I'm going to face in work tomorrow..... Though, who am I kidding...it's been hell since the holidays.

Goddess (The Banker) Hathor

 

[rgraham666]

I'm upgrading my weather report to a heavy rain of brokers in the afternoon.

 

[BlackShanglan]

Handprints, I'm curious where you see the balance of the sub-prime situation from your own interesting perspective. Given the wide-spread effects that some dubious practices seem to have had, would you favor closer government regulation of the types and terms of loans being offered, or do you lean more toward letting the market sort itself out even if it creates problems outside of its own niche? Or is there some other way to allow broader liberty of credit while shielding consumers from the fallout of institutional investments they didn't personally make?

 

[Handprints]

Handprints, I'm curious where you see the balance of the sub-prime situation from your own interesting perspective. Given the wide-spread effects that some dubious practices seem to have had, would you favor closer government regulation of the types and terms of loans being offered, or do you lean more toward letting the market sort itself out even if it creates problems outside of its own niche? Or is there some other way to allow broader liberty of credit while shielding consumers from the fallout of institutional investments they didn't personally make?

Shang, I could spend forever and work myself into a rabid froth...

Here's the short version: I think what caused this mess more than anything else is poor design of the regulations (in both the US and Europe) of what pension funds are allowed to own. A huge proportion of their money is required to be held in relatively high-quality bonds. The intent is to prevent them from making irresponsible financial decisions by limiting the investment candidates to securities which have been rated positively by independent agencies (and, to an extent, ensuring they're first in line for a refund if a business goes bust.)

Unfortunately, there are two problems with this approach: first, we've known for more than 25 years now that the best way to reduce risk of losses is broad diversification of holdings, not sticking with high-rated bonds. Second, no-one foresaw the problem of an aging population, whose retirement savings have put so much money into the pension system that it began to distort fair value in the debt markets.

If you've ever seen the term "yield squeeze" in the financial news, you've heard of the result. So many pension funds have been chasing the (relatively) limited supply of bonds in the market that prices for bonds have been driven very high, compared to historic norms, and the returns available from those bonds have dropped to all-time-low levels. In fact, they fell below the return many pension funds require in order to fund their future liabilities to pensioners.

Seeing this desperation to buy anything with a decent yield (that's the annual interest payment divided by the market price of the bond) my clever dick colleagues on the bond floor decided to find new things to sell. What they came up with is called a securitisation package: buy up a few billion worth of credit card/car payment/mortgage debts, sell them all to a specially-created company, then have that company sell bonds backed by the payments on all the little debts. You could, if you designed the package carefully enough, get quite a high rating for these bonds, even if a big proportion of the underlying debts looked iffy. The technical term for this process is "rats into mink."

Because these Collateralised Debt/Mortgage Obligations (CDO and CMO bonds) offered high yields, buyers stampeded for them. Now every regional bank in the US knew it had a profitable way of dumping bad loans off its balance sheets. What do you think the effect was on willingness to lend if the lender knew he could dump the loan within a month of closing it? Fast forward a few years and investors in these packages (plus the businesses who prospered by selling iffy loans) are in a lot of pain.

I think the best way to solve the problem is to let pension funds own pretty much what they like. Their appetite for bad investments isn't going to go away but they're better off owning twelve small piles of different shit than one steaming mountain of sub-prime...

I think it's a shame that it's currently a lot harder to predict financial sector future earnings than usual because of the sub-prime problem but I'm not going to lose sleep over the absence/presence of government intervention. If we believe that Japan, the US and (probably) the UK are already in recession, USD140bn to take the edge off the pain strikes me as the financial equivalent of taking an aspirin before starting six months of physical therapy: it's not a bad idea, but...

Broader liberty of credit is not something that particularly appeals to me as a policy goal: punitive interest rates and scarce availability of credit seem to me to be exactly what the US consumer needs right now...

Hope that's of use,
H

 

[trysail]

In a nutshell, the entire subprime fiasco was caused by a whole bunch of people (Goldman Sachs, Merrill Lynch, Morgan Stupid, Citigroup, Legg Mason, SunTrust, Moody's, and Standard & Poor's plus a bunch of dopes who signed mortgage documents they didn't read and didn't understand all with the wholehearted urging of Barney Frank, Ed Markey, Al Sharpton, Jesse Jackson, Teddy Kennedy, Paul Sarbanes- all of whom were enabled by the [St.] Alan Greenspan regime of insanely low interest rates) doing stuff they didn't understand. All were guilty of violating the first principle of investment: the "KISS" rule.

http://farm3.static.flickr.com/2157/2197070957_eecbfb9b2f_o.jpg​

If you think the subprime farce is a mess, wait'll you get a load of the credit default derivatives circus. It's 2300 hours, do you know who or where your counterparty is?

Warren Edward Buffett has been warning that derivatives are financial weapons of mass destruction for nearly a decade. He's been (at best) ignored and, at worst, scorned.

 

[BlackShanglan]

Broader liberty of credit is not something that particularly appeals to me as a policy goal: punitive interest rates and scarce availability of credit seem to me to be exactly what the US consumer needs right now...

Hah! I couldn't agree more, there. I confess, that's the comment of someone who has a fixed-rate mortgage bought in low, but I thought very much the same thing before I had it.

Interesting thoughts on the retirement funds. It's fascinating how a well-intentioned action in one location can create such an unexpected reaction in another. I wonder, though - wouldn't discouraging some of this iffy lending in the first place be a good plan, so that there are fewer rats to dress up as mink? Something like banning teaser rates on mortgages, or setting a limit on the debt/income ratio?

In response to the rest - I suppose I'm thinking about a situation like Northern Rock in the UK. It seems, at least to ignorant headline-browsing horses, as if the government is stuck between the unenviable positions of bailing out privately contracted debt with public funds (thereby sending the message "Invest in any crap you like; you'll only feel the profits!") and leaving the bank to implode, taking with it the money of unoffending persons who gave it to the bank in good faith and didn't intend it as a stock market gamble. I don't mind so much if investors in the bank's stock get stung; that seems to be part of the nature of investing, however unpleasant the reality might be. However, if there's a disaster such that people who only deposited their money with the bank can't get it back again, that seems very unfair to me, as it seems unreasonable to ask people to do in-depth research into a bank's global investment policy if they just want to open a checking account.

Is there some better balance that lets people use banking services with confidence, yet doesn't leave the government (and taxpaying public) holding the bag if the bank's investments are poorly chosen?

 

[Handprints]

Interesting thoughts on the retirement funds. It's fascinating how a well-intentioned action in one location can create such an unexpected reaction in another. I wonder, though - wouldn't discouraging some of this iffy lending in the first place be a good plan, so that there are fewer rats to dress up as mink? Something like banning teaser rates on mortgages, or setting a limit on the debt/income ratio?

I think it's difficult to create legislation that defeats marketing ingenuity and even harder to find universally applicable financial ratios. I have colleagues in London who, despite being able to afford a mortgage with ease, can't get one from the more conservative banks because a minimum of 50% of their earnings come in the form of a guaranteed bonus: the banks won't count it as income, even though it is as explicitly guaranteed as their monthly pay by their employment agreements... I think it's easier to reduce demand for crap, particularly when the case for pension fund diversification has been so exhaustively made.

In response to the rest - I suppose I'm thinking about a situation like Northern Rock in the UK... Is there some better balance that lets people use banking services with confidence, yet doesn't leave the government (and taxpaying public) holding the bag if the bank's investments are poorly chosen?

Guaranteeing private deposits up to GDP50,000 at licensed banks seems to me like the kind of minimal effort a government in a modern economy can make. I have dinner-party, crocodile-teared sympathy for the Rock's shareholders. In this instance, I have some sympathy for the UK government, who are unwillingly in the position of having to underwrite the Rock's paper because of the sclerotic clot it is causing in UK's mortgage and commercial paper markets. No knighthoods for those bankers!

I have to admit I have somewhat less admiration for the Bush/Paulson USD140bn, primarily because it's being sold to the public as a rescue/stimulus package, rather than an annoying and unwanted cost of keeping the economic engine turning over smoothly...

Best,
H

PS: My wife just called to ask if every market I work in is currently limit down (ie the exchange has closed because loss limits for the day/hour were exceeded.) I told her Nigeria doesn't open for a few hours, so we haven't yet run the table. I must say I'm enjoying my developed-market colleagues responses to this kind of volatility: they're not used to this kind of fun (and don't seem to be getting a taste for it.)

 

[starrkers]

According to my newspsper website (www.smh.com.au) the Aussie sharemarket fell 7% today.

 

[Handprints]

According to my newspsper website (www.smh.com.au) the Aussie sharemarket fell 7% today.

Your lot got treated like Shane Warne treats a lamington today: financial and mineral companies got hit the hardest globally and (speaking only about your stock market) Australia's basically a mine with a bank on top...

Better luck tomorrow,
H

 

[BlackShanglan]

I think it's easier to reduce demand for crap, particularly when the case for pension fund diversification has been so exhaustively made.

Hmmm. Now, I'm not trying to be a difficult or quibbulous horse (yes, I did make that word up, but I like the sound of it and beg that you indulge me), but you did just say that you didn't think that the pension funds' appetites for bad investments weren't going to go away. I see your point on diversification and am rather persuaded by it, but I'm wondering if there shouldn't be a little more "rat" / "mink" clarity worked on as well. Won't there always be a demand for rat so long as one is allowed to label it "mink"?

Guaranteeing private deposits up to GDP50,000 at licensed banks seems to me like the kind of minimal effort a government in a modern economy can make.

I like that idea as well. I'm just wondering if there's any way to fine-tune licensing regulations to reduce the likelihood of that guarantee having to be stumped up, since it's still essentially a public bail-out of private decisions that the people paying the bill had no say in.

I can see, of course, that in some ways this would lead me right back to what you're describing as one of the sources of the problem - i.e., restricting investment to a more narrow field of more stable stocks. But then, I'm wondering if those strictures are the only problem. If there's a shortage of cheese, there are two traditional ways a free market tends to deal with it: one is by raising the price of cheese and stimulating production of more, and the other is selling chunks of congealed vegetable oil and food coloring in packages labelled "cheese." Is there any way to get the market to supply more cheese and less splodge labelled as cheese? Even better, could it provide more stocks with decent stability and less unstable debt packaged as stable debt dressed in mink carrying pails of Stilton?

I have dinner-party, crocodile-teared sympathy for the Rock's shareholders. In this instance, I have some sympathy for the UK government, who are unwillingly in the position of having to underwrite the Rock's paper because the sclerotic clot it is causing in UK's mortgage and commercial paper markets. No knighthoods for those bankers!

Yes, for the stockholders I have only the level of sympathy one has for anyone in a bad financial crisis, however self-induced. I don't feel compelled to go bail them out of it. But like you, I am sympathetic to the UK government because it's got to deal to the consequences of the Rock's actions. I suppose that's what bothers me and makes me feel restlessly about for legislation - that sense that actions the government didn't have a say in are nonetheless creating a monstrous mess for it (and its taxpayers) to untangle. That makes me wonder if there's not a shortfall of accountability somewhere in the process.

I have to admit I have somewhat less admiration for the Bush/Paulson USD140bn, primarily because it's being sold to the public as a rescue/stimulus package, rather than an annoying and unwanted cost of keeping the economic engine turning over smoothly...

Mmmm. I have to confess that I'm being won over to your view, at least on the rescue topic. At first I felt very badly for the poor people who were going to lose their houses in the sub-prime meltdown, but ironically, the more of them I heard from, the less sympathy I felt. Over and over I heard people describing a series of actions I would never have dreamed of taking, traditionalist old horse that I am. But it's the "annoying" and "unwanted" that makes me wonder if there's any way of avoiding a repeat.

 

[Handprints]

Hmmm. Now, I'm not trying to be a difficult or quibbulous horse (yes, I did make that word up, but I like the sound of it and beg that you indulge me), but you did just say that you didn't think that the pension funds' appetites for bad investments weren't going to go away. I see your point on diversification and am rather persuaded by it, but I'm wondering if there shouldn't be a little more "rat" / "mink" clarity worked on as well. Won't there always be a demand for rat so long as one is allowed to label it "mink"?

I think this takes us back to some market fundamentals, particularly the opportunity it provides for people to disagree about something's value. What really was a rat to a bank really was a mink to a pension company: a shitty loan to a no-good borrower really was an opportunity to increase risk in a pension portfolio. The labelling industry (Countrywide et al) doesn't really function all that profitably until that divergence of views exists to exploit.

Pension fund regulation exists, in principle, to limit the investable universe to mink. However, there really are useful benefits to owning a diversified portfolio of rats. Moreover, a daily working knowledge of rats makes you less likely to misidentify a mink. I'd rather the pension fund investors were fully-nicked-up members of the rat-owning community than have them sneaking little rats with mink stoles into their portfolios and hoping they'll somehow acquire better breeding.

I like that idea as well. I'm just wondering if there's any way to fine-tune licensing regulations to reduce the likelihood of that guarantee having to be stumped up, since it's still essentially a public bail-out of private decisions that the people paying the bill had no say in.

I can see, of course, that in some ways this would lead me right back to what you're describing as one of the sources of the problem - i.e., restricting investment to a more narrow field of more stable stocks. But then, I'm wondering if those strictures are the only problem. If there's a shortage of cheese, there are two traditional ways a free market tends to deal with it: one is by raising the price of cheese and stimulating production of more, and the other is selling chunks of congealed vegetable oil and food coloring in packages labelled "cheese." Is there any way to get the market to supply more cheese and less splodge labelled as cheese? Even better, could it provide more stocks with decent stability and less unstable debt packaged as stable debt dressed in mink carrying pails of Stilton?

The problem is that the incentives for companies to take on more debt (thus supplying the hungry pension funds) are pretty abysmal: corporate earnings have been very healthy for most of the last seven years, new projects are easily funded out of cashflow, low inflation means you really will have to pay back your debt, and shareholders don;t see the point of offering hungry debtholders anything decent to buy when they'll just as happily buy the most pungent crap on the market...

Most governments (the US excepted) took a similar view and spent the last decade reducing their indebtedness by paying off bonds, further shrinking the pool of bonds pension funds could invest in. This was particularly true of high-yielding, developing market bonds.

Debt-buyers' hunger wasn't nearly enough (in price terms) to tempt responsible corporates (or, indeed, governments) to issue more debt. The less-creditable stepped in to fill the void.

Yes, for the stockholders I have only the level of sympathy one has for anyone in a bad financial crisis, however self-induced. I don't feel compelled to go bail them out of it. But like you, I am sympathetic to the UK government because it's got to deal to the consequences of the Rock's actions. I suppose that's what bothers me and makes me feel restlessly about for legislation - that sense that actions the government didn't have a say in are nonetheless creating a monstrous mess for it (and its taxpayers) to untangle. That makes me wonder if there's not a shortfall of accountability somewhere in the process.

Whatever else we can say about the Rock, they embarked on their CMO-sales strategy in the full glare of public scrutiny. Their stock was typically about 20-30% lower than the trading level of their peers and no shortage of UK bankers lined up to call them morons (although in the British manner, using words like "untested", "innovative", and "experimental.") I don't think accountability was so much a problem on the bank's side as lack of precedent is proving to be on the regulators'.

Mmmm. I have to confess that I'm being won over to your view, at least on the rescue topic. At first I felt very badly for the poor people who were going to lose their houses in the sub-prime meltdown, but ironically, the more of them I heard from, the less sympathy I felt. Over and over I heard people describing a series of actions I would never have dreamed of taking, traditionalist old horse that I am. But it's the "annoying" and "unwanted" that makes me wonder if there's any way of avoiding a repeat.

People who work in financial markets tend to be much less risk-averse than other people: this kind of thing is more likely to be considered the cost of doing business than a major problem for the system (obviously it gets a higher panic rating at Countrywide et al). Obviously if there's any possibility of government money being made available on the cheap, we (the upstanding members of the financial community) will unite in calling a crisis...

A new thing was tried, it got very popular, it broke, a few bloody noses were the result. This, to my mind, is an insufficient case for closer regulation although it's a very valuable object lesson.

Hope that's of interest,
H

 

[BlackShanglan]

Very much of interest! Thank you for the lucid and insightful responses, as always.

Yours, in a sleepy but at least partially enlightened frame of mind,

Shanglan

 

[neonlyte]

Handprints & Shang (good to see you back) - great stuff.

Handprints, can I give you an example of yield regulation recently introduced in Portugal.

Following the 1974 revolution, property rents (residential and commercial) were frozen. The law favoured the tenant, landlords were effectively deprived of any sensible kind of investment yield from tenanted property. The law had loopholes, for example, a landlord was free to negotiate rent with a tenant and fix a new rent, and new tenants had to pay a market rent on taking up a lease, even so, the vast majority of property was on fixed and inherited tenancies. A commercial tenant could even sell his lease with the old rent in place. About fifteen years ago a right wing government tried to liberalise the property market putting in place a system of setting fair rents through local authority valuers. The local authorities refused to appoint valuers - I kid you not - and the system collapsed. All around, buildings collapsed as landlords were deprived of income to maintain their properties. For some it became a race, would the tenants or the building die first - for a landlord it was the only way out of a liability.

This situation couldn't continue, the health a safety risk alone was reaching monumental proportions, the local authorities were having to sequester properties to protect tenants and passers-by from imminent collapse. Last year, the first socialist majority government since the revolution passed a new rent law. It fixed rent yield at 4% of freehold value simultaneously publishing an index of freehold value/sq metre. For existing tenants, the new rent is phased in over 5 or 10 years depending upon circumstance. The 4% yield is geared to the building condition - if the landlord does the repair work, he gets the full 4%. The 4% yield underpins the freehold value making it possible for landlords to approach banks to obtain secured credit for repair works.

In my specific case, we have 2 tenants paying less than 1€ per square metre per month for commercial premises, there was no way to refurbish a building on a rental income of 2,400€ p.a. One of the tenants has recently sold his lease for 50,000€ - he's been there 40 years and we calculated he received for his lease almost 3 times the entire rent he paid over the period of his tenancy. What can one say except good luck... and possibly good riddance. The new tenant is paying a market rent. His rent underpins the freehold value of both tenanted properties - virtually worthless properties have been transformed overnight and given an asset value that makes sense to the bank. We have given the other tenant notice to quit, also allowed under the new law - he can either start paying a market rent or leave. His tenancy, also granted 40 years ago, is in the name of a company, he could have sold the company and the new owners would have continued paying the same old rent.

The point: there is a point. Fixing rental yields at 4% on all property, annually indexed to the inflation index, sets a foundation that to my simple mind eliminates a degree of property speculation in both the rental and privately owned sectors. I see this as good news... but then I'm a landlord.

 

[Handprints]

...The point: there is a point. Fixing rental yields at 4% on all property, annually indexed to the inflation index, sets a foundation that to my simple mind eliminates a degree of property speculation in both the rental and privately owned sectors. I see this as good news... but then I'm a landlord.

I think what the government there has done is a big, big improvement to what went before and I applaud them for it. Doing the abstract, market-crystal-ball thing, a few potential problems occur to me, although I know next to nothing about the Portuguese property market nor the culture/politics involved.

I think there's going to be a great market for bribable building inspectors. I think (unless there are some provisions in the law I don't know about), really high-quality, high service modern office buildings will continue to be rare in Lisbon, primarily because you need to charge more than 4% of constructed value to pay for the service. I wonder what will happen if consumer price inflation picks up at a time when property prices fall - how do you adjust the mechanism when other prices aren't moving the same way as property values? Finally, I expect there's going to be a lot of land banking, now that the thin edge of a market-value system is in view: people will stockpile developable land and wait for a system to emerge that gives them a more-than-4-% return, counting on land price increases to keep them afloat until the dam cracks.

Since all of those things happened when India tried the %-of-value system, I'm willing to bet on precedent...

But congrats all the same on having a government that's at least trying to give you a workable system!

Best,
H

 

[rgraham666]

Thanks Handprints. You always improve my knowledge on the subject.

I want to say more but it's too early in the morning to write something long winded. Suffice to say, I am not surprised. I blame the delusional nature of the modern business world.

 

[colddiesel]

Your lot got treated like Shane Warne treats a lamington today: financial and mineral companies got hit the hardest globally and (speaking only about your stock market) Australia's basically a mine with a bank on top...

Better luck tomorrow,
H

And as we only represent about 1.5 to 1.7 % of world economic output (depending how it is measured) we get dumped by the big waves from US Japan China & London

 

[colddiesel]

The capacity of Governments

Tomorrow will be a very difficult day at best in US markets but I suspect that one lesson we all may learn is that in a globalised economy and financial markets the capacity of any government to influence significantly those markets with stimulus packages and the like( I refer of course to the $140 billion Bush package) is 50% of five eighth's of sweet FA.

However I also suspect that by the end of his presidency Bush will be as much blamed and ridiculed in his homeland for his economic failures as his foreign policy mistakes.

 

[rgraham666]

I was reading warnings about U.S. fiscal policy five years ago. Sigh.

 

[JAMESBJOHNSON]

The loans created other problems. The loans inflated the price of homes far beyond their worth. The inflated prices increased property tax assessments and the taxes collected. Local government then went on a shopping spree buying goodies, increasing pay (cop's pay jumped 40% in 3 years), building, and investing what was left in credit-card/mortgage debt.

Then the bubble burst in the housing market. People are abandoning their expensive homes. The deflation is wrecking local government budgets, at the same time public employees are screaming for more of the hefty pay increases they got in recent years. The sheriff got 100 new patrol cars in 2006, he wants 10 million in new Harleys this year, and wont likely get them. He's majorly pissed. Tampa wants to eliminate pensions for new employees.

 

[neonlyte]

Fed drops interest rates 0.75% - might help dampen the blow.