An Introduction (and Survival Guide) to Wholesale Global Banking, Trading Desks and The Capital Markets

Postscript+

I promised in the book's Postscript to use this web site to periodically update events, views and opinions. I have added a blog so that comments and discussion can take place. This is at wrollet.blogspot.com

The book's Postscript, written around March 2007, argued that although 2006/7 was another highly profitable year for the markets the immediate future looked more difficult. It is now early October 2007. I thought then that the main difficulties were going to come from 1. Rising trade protectionism 2. Globalised capital markets might spread crisis contagion across markets and countries far faster than in the past 3. Terms of trade moving adversely 4. Trade imbalances between the US and China risked a breakdown in Chinese industry and banking along the lines of Japan 1990 5. The huge growth in collateralised securities, and credit default swaps in particular, looked dangerously unstable 6. Climate change threatening collateral values particularly in coastal areas. The broad thrust of the argument has turned out to be accurate- the capital markets and particularly the poorer quality end of the Fixed Interest debt markets look bleak. My first posting was on 4/10/07. At that time the crisis was just beginning to worry the masses - Citigroup had just announce a sharp drop in profits, a sharp rise in debt provisions and the laying-off of significant numbers of staff. Since then the crisis has spread and deepened like some contagious disease.

Blogupdate 19/08/2008

 

I have not updated the blog recently because events have been depressingly predictable. It is about a year that the full horror of what was likely became public knowledge in the UK with the demise of Northern Rock. The general imminence of a globalised crash was predicted in my book (written 3/2007 but published later) and I thought I would return to the blog now with the aspects that have surprised me.

 

Price Inflation, Asset Deflation, Stagflation, Saving Rates and Exchange Rates

 

I am slightly surprised by the speed at which the management philosophy of our banks changed from ‘go-for-it sweat those assets’ to contract, expand (perhaps replenish is the better word) capital and improve credit exposures. The difficulty, particularly for NR, is that your good credits hop elsewhere and your rubbish ones stay - a sort of inverted convexity for the loan book. Margins go up but default rates stay stubbornly high. As to how far the market may fall? The US gives a worrying leading indicator. Reverting to my suggestion in a previous blog that house prices are set at what a bank will lend rather than some nebulous ‘market/demand’ abstraction the BofE E and Nationwide BS recently suggested that average UK house price is c£180,000 and that represents 6X average earnings. I cannot see most lenders going beyond 4X earnings (if only because they will get swamped with demand) which suggests a first approximation of a fall of £60000 or 33%. It gets worse because no-one is likely to offer mortgages at more than 80% value rather than the historic 90%+ let alone NR’s insane 125%. This suggests a real fear of a recursive cycle as the UK’s savings rate has to go up leaving consumption of housing (and everything else) constrained by a desire to build a deposit. In particular I would expect credit cards to contract once the forced shift towards them and away from banks works its way through. This may be a much bigger problem than currently realised. There is clearly a risk that once house prices have fallen 30+% the state of lender’s Tier 1 capital is so awful that the cycle repeats itself – banks need more capital in a market satiated with their demands leaving only more cuts in the loan book etc. (note the current reserving of US banks). Oddly enough I think the one thing that could save the housing market would be rapid wage inflation but that is likely to remain the most heinous heresy  to our policy makers even in these ‘rock and a hard place’ times. A few rays of sunshine are there – swap rates are back to levels that allow lenders to price fixed term mortgages. These are driven from a steeper yield curve which classically (although I have always had problems with the concept) implies higher future inflation ( but compare the H15 real return data on TIPs available at the NY Feds web which imply that the peak in inflationary fears was about 3 months ago).

 

I have repeated my usual calculation of underlying commodity inflation ( method: take US Bureau of Labor All Commodity Producer Price index and deflate them by Bank of England end month average exchange rates,( bls.gov and bankofengland.co.uk ), and annualise the result). Usual caveats apply – PPI is for June and is provisional, FX relates to end month July, different country weights etc. but in particular the numbers do not include the dramatic recent fall in oil prices. However given that PPI is longish lag to CPI one feels that quite a few commentators are clutching at straws if they expect moderation in inflationary pressures any time soon.

 

 

 

PPI

 

%ann

 

 

 

 

June

200.7

US

Yuan

€

Yen

£

Mar

188.1

26.8

16.9

26.6

44.2

25.4

Dec

181.0

21.8

9.4

7.1

20.0

19.7

June

173.8

15.5

4.2

0.5

18.1

18.1

 

 

 

 

 

If nothing else it shows how powerful FX movements can be and reinforces the difficulties the BofE has between inflation and recession and stagflation.

I though, in the book, that China would go the way of Japan in 1990 adding to everyone woes. Instead China has continued to export deflation via cheap consumer goods. I still believe that the change from exporter with an undervalued currency to supplying your own population with those goods you cannot sell because of a Western recession is fraught with difficulty and danger. I hope the banking/credit structure is a great deal stronger than it was in Japan.

 

 

Regs, Markets and assets categories

 

Readers of my book will know that I regarded Credit Derivative Swaps as a disaster waiting to happen. What I thought was that any market that grew like the CDS market had was bound to be unstable. What I did not realise was that what made CDSs so pernicious (and popular) was the move to VaR reserving under Basle 2 allowed banks to largely offset their loan book for tier 1 & 2 capital purposes. End result – you could keep adding assets indefinitely driving credit quality downwards in a spiral of competitive leapfrog. Basle 1 was a set of awful abused regulations but it did have the virtue of setting a finite limit on a bank’s assets. There has been some speculation that the worst is over particularly in the US (buy banks sell commodities) but personally, whilst I understand the argument, I would want to be absolutely certain that houses were on the way up before dipping a toe in.

 

You will recall that CDOs have had a chequered history being the leading asset class to cause trouble in the Savings and Loans debacle in the 1990s. A few differences this time round – in the S&L crisis the near-equity tranches were bought by the greedy. The problem was localised to the US and was largely solved by the Government throwing money at the bankrupt S&Ls. There was never a problem with the top tranches. This time lending to great hoards of people with no chance of surviving the initial tempter rates seems to have poisoned all classes. The UK had its own variation on when is an asset off-balance sheet. This did surprise me as I felt that the accountancy profession would have learnt lessons from Enron etc. You take your mortgages and sell them to an offshore SIV claiming they are off your balance sheet leaving you free to add a few more assets. So far so good – if the SIV has a curve or credit default exposure and cannot finance the book it goes bust, the AAA tranches are protected and the Hedge Fund instead of making stacks of money takes the hit but the original lender is unconcerned. But if the original lender undertakes large basis swaps with the SIV then it is back with the effective exposure albeit as a class rather than as individual mortgages. I do believe there should be a criminal investigation into whoever signed-off on the compliance but as it is the FSA I doubt very much if there will be any action at all. The disappearance of this liquidity to the housing market will, I think, take years to work through before UK housing finance can reasonably said to be stable.

 

It also surprised me how deep the lack of confidence has gone. Fannie Mae and FreddieMac for all of my working life have been rock-solid institutions. Add to that the problems with adjustable rate coupons you bring in Sallie Mae. I had thought that one way out of the UK problem was to adapt US practice but using Federal Home Loans and Ginny Mae models. Something like allowing people saving for a house deposit to invest in a unitised pot of Treasury accepted old mortgages with some sort of tax kicker.

 

The demise of the rating agencies credibility is a worry. There are clearly lots of rating changes in the pipeline which in itself may well cause flurries of destabilisation. Inspecting current credit default spreads give a very different picture to the classic AAA-CCC model. Ratings are important to both banks and the investment manager because they are a shorthand for where you want to be and what you want to swap. They, with duration, largely define exposure. Investment fund trustees often set percentages and restrictions against them. If one is nominally AAA is really CCC (particularly if it is using its rating to insure others) then the language dies and management control of position and portfolio is something of the past.

 

 

What is to be done?

 

Short term, I fear, very little but for a longer view I suggest:

 

  1. Asset inflation to become a policy parameter of the central banks. Auntie Old Lady telling the children they are far too excited and must take their medicine and go to bed is always going to be less appealing than ‘let the good times roll’ and hope you are receiving your knighthood and inflation-proof pension before it all goes splat.
  2. Really sort out 1.accountancy ( a few of them jail might encourage the others) 2. bank remuneration to take away incentives to martingale a position for your bonus 3. University’s MBA programs/SE Analysts/Fund Manager’s encouragement of short time horizons
  3. Amend Basle 2 to allow accrual accounting (within limits and for a specified transitional time).
  4. Amend Basle 2 to limit VaR hedging to truly liquid securities i.e. trading positions not loan books
  5. I suspect that the UK housing market is significantly larger than our Banks’ etc. capital base can finance. Mortgages ought to be marketable, if packaged properly, to truly off-balance sheet investors particularly the general public.
  6. Drive a new set of credit ratings off CDS  swap rates on a purely arithmetic model i.e. if you had a CDS rate low enough o be within, say, the lowest dectile you are AAA no matter what Moody’s or S&P say etc.

 


Added 26/2/2008.

It was my general intention to add commentary about every 3 months but again I am tempted to act early because I feel the media is misreading the crisis. I noted in my last addition in January that I felt the crisis was essentially about a failure in banking regulations. This is not to minimise the seriousness of it or pretend there is an easy solution. There is certainly a lot of comment about ranging from it’s all about a global shift in power from the West to the East, to what a lot of dangerous idiots there are in banking. Both assertions are probably true but neither explains how we got here at this particular time.

Banking has been shifting from Basle1 to Basle 2 regulations. Basle 2, after long and meticulous negotiations, sought to eliminate the manifest weaknesses of Basle 1. In particular the use of ‘off-balance sheet’ instruments allowing Banks to evade the capital adequacy rules. Some balance items like fees for investment management advice were not controversial but some took creative accounting to new heights (perhaps I mean depths). The most notable abuse of Basle 1 was the growth of derivatives. Basle 2 encouraged a move away from accrual accounting to Value at Risk (VaR) marked-to market exposure. This required 4 basic components 1. assets are realistically marked-to market at least daily 2. that purported hedges should be a long position in one security having a plausible price relationship to a short position elsewhere 3. a mathematical and accountancy model robust enough to keep track of the hedges and the VaR exposure 4. sufficiently robust credit rating data model to demonstrate that a hedge is a hedge. In theory this was great stuff – bank balance sheets would finally assume some element of truth, the bank’s capital would be aligned far closer and faster to the net exposure faced and the banks would have much better one obligor risk exposure stats.

It begins to look like there was one large fly in this ointment. Along comes Credit Default Swaps (CDSs)). Leaving aside the wide elasticity in the pricing of CDSs (a huge worry in its own right) I suspect their expansion into bank loan portfolios and beyond their original bond issuance role is one of the crisis’s main drivers. Now in theory if you had your CDS provide you with a ‘guarantee’ against default and adverse rating moves to your loan book you have a hedge. That will cause your assets to largely fall out of the VaR calculation. Suddenly you have freed up your Tier 1 and 2 capital ratios and can lend some more. Repeat again and again and again. I last looked at the CDS market when it was about to pass 20 trillion dollars (although I have no idea how anybody actually knows what’s going on in that market). Not bad for a market that scarcely existed 10 years ago. The market for new credit creation took on a Sorcerer’s Apprentice appearance. All the while the banks and their regulators smugly reflected that the numbers were behaving very well. What happens when there is a glut of a commodity? Its price goes down or with credit it chases ever more marginal borrowers tempting them with loss leading rates (US sub-prime, UK credit cards, buy-to-let pyramids etc.). The secondary effect is to prop up an asset inflation bubble. When the bubble bursts all that excess liquidity evaporates like morning dew. The first casualties are those directly involved (US sub-prime lenders); the secondary ripple affects those with lop-sided balance sheets who scramble for less-hot money such as retail or term deposits and fail (notably Northern Rock); tertiary ripple affects those that were suckered in with the good times (notably the monoline insurers); quaternary ripples will perhaps be those holding land or dependent on luxury discretionary spending (most of us in one way or another). If you are involved and really want a nightmare ponder whether your CDSs are correctly m-t-m’d. Not much to do then but take your medicine, publish your losses and wait for the credit ratings downgrades. These will almost certainly make your initial loss estimates (horrific as they may seem) look distinctly optimistic. Part of the central banks' current problems is this move to stronger balance sheets with term money and tighter lending criteria (less cover and greater margins) takes away much of their power to ease – throwing overnight money around when the demand is for year+ retail depos just does not work (you are supplying the ultimate in hot expensive money). Another scary thought – perhaps assets are worth what a banker is prepared to lend on them rather than what a buyer is prepared to bid. If so the move from 110-125% mortgages to 75-85% mortgages is a lot more brutal for house prices than most commentators are postulating. The lending institutions have yet to restrict earnings multiples but it is, surely, only a matter of time.

Part of the problem relates back to equity market expectations. When times are booming no-one tolerates sleepy utility types sticking to what they have done for years. So monoline insurers start role expanding and then have their AAA ratings reviewed – a really frightening prospect for US Municipals. No government can tolerate the wholesale destruction of a country’s local government finance but what is coming out of Washington does not impress. The main buyers of AAA debt are funds mandated to keep a minimum percent in these securities. Lose AAA status and investment managers become forced sellers. Credit spreads widen sharply adding to everyone else’s woes and they keep on going getting wider. Monoline insurer's only, and very valuable, role is to stand in the middle fronting the AAA status. Warren Buffets attempt to grab the traditional monoline book and leave the new stuff well alone would clearly leave them with a rump of serious problems.

One aspect that that seems to me to have got out of hand has been the de-facto collective suspension of all securitised mortgage debt credit ratings. Even if you have an AAA tranche of a CDO you cannot easily sell it or price it because of the collective guilt and fear for all CDOs. I know that rating agencies are not the most popular institutions at the present time but I do believe that CDO structures are basically sound. So, say, a $40miilion AAA Tranche secured on the cash-flow of $100million house mortgages was, is and should be treated and priced as AAA debt. This is one of the few positives about the markets I can think of at this time. I suspect there is a lot of undervalued assets in the better end of the CDO market. Lending institutions building stronger balance sheets is also good long-term news but for many months is likely to add to the pain.

The bankers were not being stupid – probably for the first time in their working lives they have excess money to lend and need new markets. If they do not push their assets hard it will be seen, rightly, as lowering their return on equity with horrifying consequences for their bonuses. It makes perfect sense at an individual’s level but is collective insanity when looked at as a herd. This blind spot does not strike me as the fault of any individual bank or regulator. One would have hoped that the regulators had someone old enough to remember the repo pyramid collapse of Drysdale Securities and Penn in 1982 because this crisis has echoes of that time albeit on a much larger and global scale. But it was a long time ago. One would hope they will now add quantitative limits on lending although given the current shortage of reserve capital this would ,short-term, exacerbate the problem – perhaps a VaR regime but with a Basle 1 override in a couple of years time.

Spare a thought for the ex-senior management of Northern Rock. Politicians are naturally huffing and puffing about a flawed business model and the need to protect taxpayer’s money. What NR was doing is, I think, textbook stuff from any decent Business School – sweat those assets, concentrate efforts on greater return on equity, keep your time horizons short and focused etc. Perhaps a review of what is being taught in the country’s MBA programmes is needed. It must be galling to be a champion of modern management thinking one day and a feckless wastrel betting the widow’s mite down the bookies the next. Any thoughts need not be very long nor sympathetic since a lot of people around NR will lose a lot more than their reputations. I think the press and political comments on NR’s SIV ‘Granite’ sounds unconvincing (difficult to be sure because the Government won’t say what is going on). You would expect the SIV to sell on the repackaged mortgages and you might expect the SIV to call on NR for replenish mortgages against redemptions (a management problem if you want to aggressively wind-down your mortgage book but not an unreasonable pre-condition). What is not clear is whether Granite has the right to have mortgage defaults replenished. This would be unusual and deeply worrying. It would make NR a highly unstable imploding sink of bad debt. The classic CDO structure attains its range of credit ratings by tierring the cash-flow passing through but leaving the bottom tranches with the default risk. This is why the pseudo-equity tranche is so high yielding – you bet on few defaults because house prices are rising and if you are right you gather all the excess cash-flow not needed by the other tranches. If the housing markets tanks you get nothing. If that risk is retained you cannot say that the SIV is in any way ‘off-balance sheet’ and a criminal prosecution of whoever signed-off on the compliance should follow.

My regular update of underlying commodity price pressures sourced from US Labour Dept. All Commodity Producer Price Index deflated by Bank of England average monthly exchange rates currently looks like:

US 7.85 Euro -2.12 UK 4.9 China 4.53 Japan 3.41

This is for Dec 06 v Dec 07 (Provisional) PPI against average exchange rates for Dec/Dec.

Added 28/01/08:

against normal policy I add these comments early because I think the media's message is slightly off-beam. Of course questions of whether the latest retail sales figures are a recession indicator, disbelief that a junior SocGen trader could wreak such havoc etc. are all good journalistic fun but to my mind the critical sequence remains –

Regulatory/Accountancy failure leads to

Huge losses lead to

Demand for new capital to replenish reserves

Huge contraction of banking reserves and impaired solvency for everyone with limited access to sovereign wealth funds leading to

Collapse of available credit by a multiple of the reduced solvency margins

I do not know the size of this collaspe but I suspect it is likely to several orders of magnitude greater than any tax cut the US has in mind. Nor do I think it is easy to resolve quickly since the credit ratings downgrades have scarcely begun and with them will come an ongoing demand for yet more reserves and wider quality swap spreads. The central banks no doubt will try to stuff liquidity down the market's throat but I do not think liquidity is the driving problem here. The problems are becoming increasingly hydra-like but to my mind it is primarily a problem of growing solvency deficits and the way to tackle that is to ease Tier Postscript+ and 2 capital requirements. Will this keep the recession at bay? No - because the world has got used to pyramid levels of easy liquidy which cannot be replicated but it might slow down the tentacle growth into other aeas. The hope that China will drag the world onwards and upwards I think is fanciful – their economy is not big enough and in a recession all their inventories will need credit that may not be there.

As for the antics of SocGen; I found the most amusing feature to be the equity rebound on the news. Equity traders rarely fail to surprise me but to assume that the crisis spreading to traded derivatives is good news suggests that they are being even more delusional than ever. Come back Galbraith - your bezzle theory is working a treat!

Added 10/1/2008

The crisis rolls on with few signs that the authorities are really on top of anything. It seems to me that much of the confusion stems from several crises being merged into one big headache. No doubt there are other aspects but I think the main concerns are:

 

  1. Banking Regulations
  2. Credit rating and market distribution failures.
  3. Policy failures of the accountancy profession.
  4. Political lack of concern over the years with the changing economic power axis and the imbalances that brings.
  1. Banking regs :

The crisis is primarily about a rapid and out of control contraction in bank reserves. Prior to the Basle Accords each Central Bank would set its own rules. If one looks at the regulation regime when I started in the City, some 40 years ago, the strengths and weaknesses of Basle VaR methodology are perhaps clearer. Then The Bank of England would react to the cycle of cheap money, faster growth, trade deficit, foreign exchange crisis and crunch-time by using a combination of daily money market intervention via the purchase of ‘eligible bills’ (Treasury bills and trade bills accepted by specially authorised ‘discount houses’); changing the level of reserves required to be held at the Bank (typically eligible bills); quantative limits on what credit terms could be offered ( typically setting a minimum deposit on credit purchases and a maximum repayment term) and even tax increases. Changing reserve levels was used rarely and certainly in the US it could be a draconian measure because unlike the UK reserves were interest free cash deposits. The point of these measures was to control demand and return the economy to ‘balance’. This is far from the current thinking of pouring extra money in to ‘solve’ systemic fears. What is noticeable is that the then regs were under local national control and aimed at curbing demand at all points of the yield curve particularly the curve suffered by retail borrowers. The Basle Accords moved reserving to a common international basis driven by the capital structure of each bank (Tier imbalances & VaR Capital). This has had a couple of perverse side effects 1. Each bank will strive to push much of its assets ‘off – balance sheet’. (Given that investment bankers and their accountants and lawyers are hardworking imaginative types this tends to leave the regulators spluttering for comprehension as hoards prise open one new off balance sheet wheeze after another.) The banks have little choice but go along with the wheeze if their balance sheets are not to suffer – collective insanity it might be but it is also the senior officer’s main hope of survival and a big bonus. 2. The laudable aim of keeping the regs on a level playing field for all does mean that it takes years to agree changes and limits responsiveness to local need. The original fear of competitive devaluing of reserve requirements has been replaced by competitive pleading that the market you are currently making money in should not be touched (London being the main culprit here). Stagnation can result. The consequence has been that central banks have almost lost control of their banks particularly inter-bank and money market lending. On the one hand £20bn+ is advanced against mortgages to one medium sized bank in trouble and on the other several central banks try to flood $50bn+ into the markets. Bank after bank chases new capital from the only sources with the right size of funds – the sovereign wealth funds (SWFs). Clearly the end-year accountancy squeeze has not helped but sadly these sorts of amounts are not a great deal of money in this sort of crisis.

What should be done? I don’t think there are easy answers but I would try to reduce some of the pain and fear by relaxing Tier Postscript+   capital requirements (thereby reducing the scramble for new capital) and relax the marked-to-market rules on ‘non-hedged’ positions. I am loathed to admit it but some accrual accounting might help. I do appreciate that the cynical might argue that the crisis was created by banks having totally inadequate reserves for the risks taken and what I suggest would lower still further the cover but I think from here on, for several years, banks are going to be a great deal more circumspect in their practices. One offset to this might be to progressively increase reserves as a bank funds more from interbank sources plus ratcheting reserves for any significant deviation from market norms for any non-liquid asset class. Certainly all off-balance sheet deals should be published in the accounts with prominent notice given to any ‘residual ‘(?) liability. Longer-term I would hope that when it comes to Basle 3 much greater much greater flexibility would be built-in both to restrain new products created mainly with an eye to reduce reserves and to be able to react with speed to regional imbalances.

The UK’s Chancellor’s has recently announcement that the FSA will be given powers to take over the management of failing banks. It is not yet clear what this might mean but I doubt if it will address what I regard as the FSA’s central weakness. To my mind the FSA is at least partially responsible for the Northern Rock shambles. If you set out a whole set of accountancy hoops banks have to jump through to get assets off balance sheets then you cannot complain when they do just that. If the amounts are say 50 million then no harm is likely but if it becomes so popular that it becomes a trillion $ CDS market you have a huge systemic problem. Alan Greenspan is on record as favouring swaps as a means of shuffling risk exposure towards those that want it but, to my mind, this has distinct limits before the benefits become overwhelmed by global instability. Pretending that the risk is now out of the bank’s profile I think is nonsense – you have replaced visible exposure with totally opaque exposure. It will, at the very least, collectively impact banking. You have also replaced one asset class that is broadly secure (shortish house mortgages) and replaced it with weird pyramids of special purpose vehicles. I think the FSA is great at devising accountancy rule books but I cannot recall any competence in recognising and acting to prevent systemic risk. Nor have they been particularly concerned about protecting the public (they have been very concerned, but not very effective, about protecting banks from themselves).

  2. Credit Rating and Market Failures etc.

  The central principle of CDOs is, I think, plausible. One tranche takes priority over others for incoming cashflow and therefore should have a higher credit rating (perhaps even AAA). The difficulty is that if all are tainted with a sectoral re-appraisal then, to paraphrase Galbraith, just because there is a market does not mean there has to be a bid even for the best of credits. My book argued that credit default swaps would be the main driver of collapse. This I think was wrong in that the main cause was US and UK mortgages but CDSs do look like they have spread losses far and wide and greatly added to the confusion of who owns what and at what price then and now. The lack of transparency in the off-balance sheet vehicles, particularly the residual (?) risk that it all comes back home when trouble strikes, must be addressed. I think buyers of mortgages really have to be independent investors. To this end it might be an idea to explore US mortgage practice particularly GinnyMaes. Perhaps one could encourage real retail participation by a scheme where, for a fee, the Treasury accepts the risk of default and their agent packages mortgages for resale (perhaps call it TraceyMae – TreasuryMortgageCorp). There would have to be a basis swap in place or a tracker rate for investors to eliminate problems as to who had the right to change interest rates on floating mortgages. It would give the Treasury greater flexibility to rein-in any institution becoming a too aggressive lender by the simple means of an increased acceptance fee. Credit cards might go a similar route to US ‘CARDS’.

One of the dramatic aspects of the recent crisis has been the widening of interbank spreads and their lack of responsiveness to official intervention. Some of the difficulties were clearly end-year book keeping but it is still the mechanism most likely to impact the general public fastest. I think some of the comments being made slightly miss the point. One very senior investment manager recently stated that the widening spreads implied that banks think other banks are going to go bust which is probably overstating the case. Post end-year interbank spreads are much less dramatic partly as a result of the liquidity added by the central banks. I think it is far from over – it is quite likely that that the banks (rightly) think the rating agencies   are going to downgrade more or less everyone with CDO exposure and in so doing great chunks of their swap book will have to be revalued to retain hedge status under Basle 2. The credit rating agencies must (if only for their own tarnished credibility). In a perverse way Basle may have intended to set up a laudable attempt to force banks to mark to market non-hedges but it backfires in a systemic crisis when no-one is sure what is hedged anymore. The second area I think is being slightly misunderstood is the emphasis on the problems of UK fixed rate mortgages coming to an end and being replaced by markedly more expensive floaters. What is missing, I think, is the larger problem of ‘tracker’ mortgages also being dependent on the availability of cheap basis swaps. As their terms expires they will also have to replaced with rates that reflect either the much higher swap premiums or the much higher cost of wholesale funds. The lender must either price accordingly or call the mortgage in. This is likely to drag on for 3-5 years and could easily become a powerful drip-drip driver for a downward spiral in house prices. I think it is unlikely that the UK housing market is merely going to have a minor, long-overdue, correction before resuming its upward trend. The third problem I think may be coming is a Catch 22 VaR feedback loop for second tier banks – SWFs have and can supply replacement capital and reserves for the big brand-leader banks but why would they want to get involved with the rest (like Northern Rock)? If the reserves cannot be enhanced then the credit downgrading will be much more severe. If an institution no longer has a sufficient retail customer base then it will rely on the interbank market for survival. Interbank limits are dependent on many things but prominently among them are external credit ratings. Lower them and you are going to get an immediate review of limits to restrict exposure. Result – even if the problem bank thought it had interbank capacity it will evaporate very quickly. Result - a trip to the Bank of England for lender of last resort facilities and with it a risk that the entire system is engulfed in a negative feedback loop.

  1. Accountancy

The chief exec of a major accountancy group recently argued that since ‘only’ a third of their revenues came from consultancy it was impossible to argue that the consultancy side of the practice could influence the audit standards used elsewhere. I think if you said to any CEO that a third of gross revenue (particularly the third with the highest ticket value and lowest unit cost) could be compromised unless some leeway could be found then it would be taken very seriously. There would be a very good chance the CEO would give in to the blackmail. It is surely high time that UK accountancy groups were forced to divest themselves of their consultancy arms. I don’t think it will happen. I expect no criminal charges to be brought no matter how reckless the advice given. I expect the FSA to do a whitewash similar to their lack of action with the Actuaries over endowment assurance miss-selling and miss-reserving. It is however, I think, critical to London’s future that it has a clean and credible accountancy profession.

  1. Politics  

If a couple of countries decide to run huge trade surpluses then it is not surprising that other countries run very large deficits (in particular - the US and UK). It is very hard for politicians to act against cheap imports. The ex-Chancellor built a reputation for prudence by letting the good times roll. Low inflation, expanded government services, expanded government capital expenditures, big pay packets for government managers, low unemployment, stable to rising exchange rate, buoyant housing market, credit induced spending spree on all the super-cheap goodies being supplied by the trade surplus countries are all likely to keep you in power. A few sectors suffer – anyone new to the housing market, much of the country’s manufacturing industry will disappear, a skill-less underclass are priced out of jobs, but overall most people are content. The one thing I do not think you can describe this benign neglect as is prudent. You don’t have an exchange rate crisis only because someone else is stockpiling your IOUs (for the time being). To go back to the cycle described above in Banking Regs– demand will have to be constrained otherwise we could have a 1960’s style sterling crisis. What I do not think is an option is for the Government to pump money to keep an asset bubble afloat. To blame troubled times on some sort of financial influenza blown in across the Atlantic is to my mind convenient but ridiculous. The UK’s troubles are largely of its own making particularly leaving public finance in such a deficit state that tax cutting is not a realistic option. Times that are too good to be true are almost certainly just lucky coincidences and not because you are a financial genius. It will bring grief later. I have no idea how you get spin-obsessed UK politicians to look beyond the next opinion poll but I do hope someone takes the lesson on board. What I do not hear at the moment is politicians announcing which levers of power they are going to use – pushing on a piece of string perhaps? One of the rock-and-a hard-place choices might well be coming close – does the BofE maintain its anti-inflation remit by raising interest rates when the effect of a weaker pound comes through (energy prices etc.) or does it pump money in co-ordinated central bank actions to aid banking? I have never understood what the BofE is supposed to do in a stagflation environment.

Where the trade surplus country goes, particularly China, is interesting. Many expect (hope?) them to pickup growth to counter-balance the west’s slowdown. My opinion remains that China is at risk of an economic breakdown but I would be more than happy to be proved wrong. I suppose the test will be how well domestic demand can be harnessed to replace export demand. I remain far from convinced that Chinese banking is robust enough to cope with any sort of downturn. Any sort of downturn there could bring dramatic changes to the commodity markets. The dramatic fall in the dollar exchange rate has not caused any visible change in the policy of a tied exchange rate but it must be in China’s longer term interest to get more for its exports by revaluing and to replace all the foreign US$ trade/aid packages with local currency. I think any change will be so gradual it will be easily missed and for that we all should be grateful.  

Updating the US Bureau of Labor Statistics All Commodity Producer Price Index given for October last above, deflating for Bank of England average exchange rates and grossing up for 12 months we have : PPI commodity inflation US 11.27%, Euro -.01%, China 6.1%, UK 3.93%, Japan 1.29%. Usual caveats apply but in particular latest PPI is November and is provisional. It is also noticeable that sterling peaked in November and has been falling ever since. If one used the end-December sterling average exchange rate the PPI number jumps to 7.38%.

Added 19/1/2008 : the crisis appears to be spreading. Some UK property unit trusts are, for intents and purposes, adopting a bankruptcy/administration model by increasingly restricting sale rights to some distant date in the future and the US monoline credit insurers look like they are taking increasing rating pressures. It is beginning to look like there is wholesale questioning of what constitutes good credit and with it the fear that erstwhile rock-solid pillars of the capital market are venerable. I am grateful to MarketWatch for the main equity market price graphs - the technical state of the US equity market looks to me like it is on the brink of breaking through just about the last support point of any meaningful level. Perhaps it is time to dust-down all the old Kondratieff Wave Theory articles of old.

I will try and revisit matters in the Spring.

Added 4/10/07.

Rather than try and write a contemporaneous blog I set out my views as of early October. I think it is more interesting to see where things do not work out as planned and in any event I would expect aspiring investment bankers to read the FT, Wall Street Journal, Economist etc. and know the current thinking. The book's publication date has been put back again so I would expect that when this is read events will have moved on. Points Postscript+ and 6 have not, as far as I can see, materially changed. A few aspects of the crisis have surprised me:

       1. the need of some major banks to support their 'off-balance sheet' CDO and SIV vehicles. I really though that post-Enron this kind of problem would be restricted to a few historical throw-backs. Now it looks like more investigations into bent, self-serving and corrupt accountancy practices and practitioners is needed probably in London if not New York. It could have far reaching consequences for Basle VaR and reserving. If 'off-balance sheet' is a fiction then any 'repo' between bank and vehicle is also a fiction. The bank is taking responsibility for the underlying assets and, in theory, should not be allowed to offset the 'collateral' for Basle VaR models. Net result could be a scramble for reserves and a probable contraction in lending, an on-going squeeze on commercial lending rates and a need to really re-structure balance sheets. It is possible that your Central Bank eases rates only to have the rates available to the public continue to rise (UK mortgage lenders are already hinting at this). I suspect that rather than flooding the market with   repo liquidity   it might be more appropriate to tackle   the   growing   need for reserves by   easing   Tier 1 capital requirements for, say, 3 years. The difficulty   with this   is that   Basle rules are only going to change   at a glacial pace.
      2. The action of the Fed is not a surprise - as in the past any conflict between 'moral risk' and a threat to bubbling asset values is resolved by pumping money and to hell with the moral risk. The European Central Bank also eased. This is something of a surprise since I have always assumed that they always did nothing as a matter of high policy - it is perhaps an indication of just how serious matters are (see German banks below). The Bank of England, under pressure from the larger banks to ease-up on money, let it be known, rather sniffily, that it was in the business of protecting the real economy (whatever that might mean) not profligate bankers who fail to take hints. Result - the first run on a British bank of any significant size (Northern Rock) for a long, long time and a rapid reversal of previous policy. My sympathies are with the BoE since central banks ought to enforce moral hazard penalties. I am not so sure about the FSA who seem to have spent years building a huge rule book of accounting minutiae without either protecting the banks from themselves or, more importantly, the public.
       3. Northern Rock's demise made clear another aspect of CDOs. It allows banks to be far more reliant on wholesale funds and can distance them from a depositor base. Any problem then becomes much more urgent (banks have a herd instinct for punishing weakness) and difficult to solve. This should have been in my book since the exact same fear was expressed in the 1980's about consortia banks. At the time of the last major UK rescue package I was a money broker and was alarmed at the speed with which banking limits contracted.
       4. The point about terms of trade worsening needs qualification. Using US Dept of Labor commodity PPI indices for 2007 (data.bls.gov) and Bank of England average monthly exchange rates (BoE 213.225.136.206) annualised up by me for 12 months then commodity inflation is 7.68% in the US,1.8 in the UK,.003 in the Eurozone,2.8% in Japan and 3.32% in China. This compares with broadly stable commodity prices at the time of the last crisis (LTCM) in 1999. Lots of caveats- 8 months of PPI is not enough, Basle months of the PPI are subject to revision, summer months tend to have a dip in PPI, the US and UK data may not be directly date comparable, other countries will have different weights for local use etc. It does, however tend to support the 'rock and a hard place' argument made in the book as far as the US goes -   the Fed pumps money, the dollar gets weaker and the inflationary buildup gets stronger. If the Fed does gets the markets back to some sense of stability then one might expect a sharp monetary tightening. Alan Greenspan gave an interview on the BBC on the 2nd October where one of his points was that inflation may well come back as the 'peace dividend' from the end of the Cold War peters out. I have not noticed much recent turning of swords into plough shares so perhaps it's nearer than   one   thought.
      5. I am surprised at the state of the German banks and the Landesbankes in particular. For all my working life they have been the very epitome of solid boring strength. Rumour now has it that all is not well. It is, perhaps, another example of J.K Galbraith's 'Bezzle' theory - during times   of expansion large amounts   of   dubious   accounting   goes un-noticed   and the 'bezzle' grows (the amount of hidden embezzlement) but hard times bring closer scrutiny and the bezzle falls but actual embezzlement shoots upwards.
       6. Stock markets have rebounded to new highs. It is noticeable that the emerging equity markets are doing particularly well. Asset bubbles need lots of money to keep them going and the Fed is obliging. I cannot help but feel that if the banking/FI crisis is as serious as it appears then current equity values have lost touch with reality. I think it will be a long time before geared equity buyouts return and with that goes a chunk of takeover premiums. The Basle VaR points above cannot be good news for equities. One explanation for the robustness of equity prices might be the co-variance factors used in VaR models -   interest rates down, prices   up. I have never been totally convinced   that   once you are in the wilder bits of a Monte Carlo simulation the   factors are relevant. The factors are supposed to be historic predictive but I suspect that they drive values forward as well. I also think one ought to be careful about which interest rates are going down -just govy repos perhaps?
       7. China shows no signs yet of big problems. Toys being recalled because of lead paint is not in the same league as the Minamoto mercury poisoning scandal that was reaching a climax as Japan's asset bubble burst. Apart from the similarities with Japan c. 1990 I think there is a general tendency for countries undergoing change from agrarian/capital importer to industrial/capital exporter to hit at least one crisis before they fully make the transition. I do not want to push the theory too far but Dutch tulips, English South Sea Bubbles, US stock market crashes, bust Japanese asset bubbles etc. do suggest a connection. I would think it is probably due to sudden wealth chasing an inadequate supply of assets in an environment of poor banking and regulation. My thinking that China would become a crisis via a collapse in local banking looks less likely but China's vulnerability to   a sharp   downturn in global demand for manufactured goods looks, if anything, to be getting worse.

I will try and re-visit events in early 2008.

 

 

 

 
 
 
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