Wednesday, April 22, 2009

Mixed up policy responses and liquidity preference

I frequently get emails suggesting that governments should force banks to lend and that would solve the recession.  I tend to agree but it would be difficult – and the government actions to date have exacerbated the lack of lending.

As it is, there is little to no balance sheet growth at any major bank in America and aggregate bank lending is falling.  Excess cash at the Federal Reserve is building up fast.  The economy is still sour (and getting more so) and bank credit losses are continuing to rise.  

Meanwhile banks sit on cash.  

Bank of America (for recent and topical example) is carrying $173 billion in cash and cash equivalents – a number which immunises them against many but not all ills and is about $140 billion higher than normal.

This excess cash inhibits BofA profitability by maybe 5-7 billion per annum (pre-tax).  They don’t really want that profit drain – but – in a telling comment – they thought it was worth it to have that negative carry because the cost to running short of liquidity was too high.  

The excess cash across the entire banking system probably exceeds a trillion dollars.  If only it could be spent – then we would have the stimulus we need.  

Alas – that is what is meant by being at the zero constraint of monetary policy.  We have banks with a seemingly endless liquidity preference.  It is not that there is no demand for loans (though demand is much ameliorated).  Banks are rapidly tightening lending criteria too and indeed some banks are just not lending to new customers.

Now lending standards needed to tighten.  2006 was insane.  But early 2009 is also insane– and if it were a perfect world lending would have moderated much slower so as to displace maybe 200 thousand workers per month.  (The economy can usually generate new jobs that fast.)  Indeed the whole idea of stimulus is to slow the rate of job loss in the economy down to a level where normal functioning of the labour market can deal with it.

That is not where we are.  We have an extraordinarily rapid change in liquidity preference for banks, an extraordinary tightening of standards and an extraordinary recession.  

Now some people are into forcing the banks to lend.  Willem Buiter (who is often clever and sometimes wrong) suggests confiscating banks that will not lend.  Useless as tits on a bull he says.

That would be fine if he did not want to confiscate marginally insolvent banks too.  A bank that is stretched for capital or liquidity would usually preserve both by restricting lending.  You restrict lending so as not to be confiscated – except in Willem Buiter’s world where you lend to avoid being confiscated.  

Now I thought that the confiscation of Washington Mutual was perhaps the single most destructive government action of this cycle.  That was a minority view – and remains one.  Felix Salmon thinks I am alone – but a paper from the New York Fed makes it clear that the confiscation of WaMu very rapidly increased the liquidity preference of mainstream banks and hence spread the crisis from the Wall Street Banks to Main Street.  

The lesson of Washington Mutual – learned hard – was that you could have adequate capital but a minor run and be confiscated.  The only way to cope was to have massive excess liquidity.  

And so we are in an unusual liquidity trap.  In the Japanese liquidity trap the general populace had massive excess cash savings.  The liquidity preference was the preference of the legendary Mrs Watanabe who liked sitting – in cash – on three years of Mr Watanabe’s salary.  

In America the liquidity preference belongs to banks.  Mr and Mrs Middle America are not swimming in cash.  Indeed all the evidence suggests that they are over-indebted.  It’s the banks that are swimming in cash.  And it is the bank’s excess demand for liquidity that makes monetary policy ineffective.

Now Paul Krugman has argued that it doesn’t really matter why we are at the zero bound in monetary policy – but I think it does.  If we are at the zero bound because Mrs Watanabe wants to save to excess then we should target Mrs Watanabe.  If we are at the zero bound because Bank of America is scared of arbitrary government action (as evidenced in the confiscation of WaMu) then we should address Bank of America’s concern.

The first way to address Bank of America’s concern is for Sheila Bair to fall on her sword.  She should resign because – through confiscating Washington Mutual – she spread the crisis to Main Street.  But regular readers should know I have a very low opinion of her and will not be surprised by that comment.

But I have a second proposal.  It is floated for discussion only as it is obviously risky.  The idea is that the bank capital adequacy requirements be dropped a couple of percentage points – but only if their genuine third party loans fully owned on the balance sheet are growing by more than say five percent per annum.


Friday, April 17, 2009

Welcome to the 21st Century

An AIG business that did not lose (much) money

AIG has sold 21st Century to Zurich.  21st Century is not a bad personal lines insurance company.  I blogged about it here (arguing that the CEO of that unit deserved his bonus).  

Anyway 21st Century was always partly owned by AIG but they took it private in 2007 buying the 39 percent they did not own for 813 million.  That valued 21st Century at just shy of $2.1 billion.

They just sold it to Zurich for $1.9 billion.  Zurich also assumed unit debt.

Hell – they are down less than ten percent.  

It’s a record for AIG.  Much rejoicing was had by taxpayers everywhere.  $2 billion down – 178 billion to go.

Now it is time to watch Zurich.  21st Century – despite (or maybe because) of its AIG pedigree is a far better run institution than Zurich’s Farmers business.  If Zurich is halfway competent they will merge Farmers into the (much smaller) 21st Century and not the reverse.

However there is no sign they are going to do that.  Competence and insurance seldom go together.


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Post script.  Zurich is saying that they purchased more than the old 21st century operation.  

This makes the pricing element of the post wrong.

The old 21st century operation was MUCH better than either Zurich or any prior AIG operation - so it should remain the bulk of the value.

The reserving of Zurich's personal lines business did not make any sense in the 1999 year and adjacent periods.  Nor did anyone esle.  

If you go back and look even Berkshire (GEICO) mis-estimated their profits in 1998 and 1999 and had huge true ups in 2000.  So did Progressive and Mercury General.  In both MCY and PGR the stocks got hammered into 2000.  So - from memory - did the old 21st century stock.

However the degree of mis-statement was MUCH MUCH higher at Farmers.  Farmers true results were 5 percentage points worse than 21st in those days.  Farmers caused big problems.  State farm was (operationally) worse than any but it had (much) more capital.

PPS.  Just to remind those without very long memories.  The old 21st century was a very fine auto insurer and an average household insurer.  (I do not believe that it is possible to create enough difference as a household insurer to be a fine business.  GEICO is a fine auto insurer and does not do household.  Ditto Progressive.)

The auto business once a fine competitor to Mercury (MCY) in California.  MCY however does not sell household insurance.

Both were from California.

With earthquakes.

What was then called 20th Century hurt themselves bad on the Northridge Quake.   From memory that is how AIG got its initial stake.  

On that initial stake AIG made good money.  Better money than on their own business.



J

Thursday, April 16, 2009

Bramdean did reply

My last post about Bramdean Asset Management observed that Bramdean had sent money to an un-named fund and received it back the same day.  This was done for "regulatory purposes".

I presume that there must be a legitimate reason for doing this - but to date I have not found one and nobody has identified one.  I still seek assistance.

Several people in comments have suggested nefarious regulatory purposes are possible - with the best example being a lawyer who transferred considerable trust funds to his own account for one hour (and returned them in full) so as to qualify for better credit at a casino.  
I presume that the fund in question is better than a Casino - but maybe private equity funds from 2007 are in fact glorified casinos and someone just needed to maintain credit.

Anyway I would love somebody to identify a respectable regulatory purpose as I have not been able to do so.

I did ask this question of Bramdean.  And (contrary to what I said in the last post) there has been a reply.
  
I repeat it here in full for your benefit.


Dear Mr Hempton

Thank you for your email and for your interest in Bramdean Alternatives Limited.

With regards to your query, private equity funds are structured and governed within the terms of their stated mandates.


Regards,

Loretta Murphy
Head of Investor Relations and Communications
For and on behalf of Bramdean Asset Management LLP
35 Park Lane
London W1K 1RB
Tel:    +44 20 7052 9272
DDI:  +44 20 7590 2001
Fax:   +44 20 7052 9273
E:mail:-lmurphy@bramdean.com

I am not picking on Bramdean here.  The unnamed fund probably sent the same request to almost all of their investors and the investors all sent money for a "regulatory purpose" and received it back later.  The activity is widespread and almost certainly legitmate.  

I just don't know what it is and a fairly direct email to Bramdean did not produce a helpful reply.  If they do reply I will let you know again.

John


PS.  One of my favourite bloggers - on seeing the Bramdean letter said "regulatory arbitrage is so 2006".  Maybe we are just caught in a timewarp.

Wednesday, April 15, 2009

Goldman’s Orphan Month

Goldman Sachs just put out pretty good results and did a big capital raising.

Here is a table for Goldman Sach’s revenue for the three months ended Feb 2008, Nov 2008 and March 2009 respectively.  The table comes from the 8K dated 13 April 09 – essentially the 8K in which they announced results to raise money.



(click for detail)

Now the observant amongst you will notice that these three month periods are not contiguous.  Indeed the three months to November 2008 and the three months to March 2009 conveniently forget the month of December 2008.

That is right.  Goldman Sachs changed its balance date – and there is a one month period not reported in the usual quarterlies.  An “orphan month”.

Now December 2008 was a pretty bad month.  Probably the worst on record.

Here – also from the same 8K is Goldman Sach’s revenue during the orphan month.



It is hardly linear.  Total revenue for the three months ended March 2009 was 9425 million.  For the one month it was 183 million.  Of course this revenue was offset by some very large charges rammed into the orphan month.  If you click on the attached table you will find that Fixed Income Commodities and Currency (FICC) revenue refers to Note 19.  Note 19 says blandly that it “includes the writedowns of approximately $1 billion related to non-investment-grade credit origination activities and approximately $625 million (excluding hedges) related to commercial mortgage loans and securities”

Ah – that explains it.

There is also another billion in losses labelled as "other corporate and real estate gains and losses".  That line doesn't even occur in the March accounts.

The costs are also non-linear – but not as non-linear as the revenue.  

The net loss applicable to common shareholders for the orphan month was just over a billion dollars.  The four month period was just profitable.

Am I surprised that Goldies had an “orphan month” and stuffed the bad news in it?  No.  If you were – then obviously you are new to investment banking.

But I am surprised at the credulity of the press.  Most stories about the quarterly result simply omitted the December month.  This story though at the WSJ Deal Blog was considerably better – noting that December was really ugly but not understanding why.

They even note that December is seemingly omitted from the official records – but doubt it is deliberate.

The Deal Blog is more observant than most.  

But perhaps they too are new to investment banking.  Note 19 explains about half of it.  The mysterious "other corporate and real estate gains and losses" explains most the rest.


Post script:  The excellent Floyd Norris (New York Times) also picked this up.   There are some journalists way better than average.  

Further postscript:  Krugman has also commented.

Wednesday, April 8, 2009

Farewell Greg Newton

I only spoke to Greg Newton (of the Naked Shorts blog) twice and my email box has about a dozen emails. 

He died suddenly recently.

I want to second Nihon Cassandra's fitting obit.  

http://nihoncassandra.blogspot.com/2009/04/farewell-greg-newton.html

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Post script:  I have rejected several anonymous comments along the lines that he was (a) crooked, (b) revolting, (c) better dead.

I have always seen him - even in the title of his blog - as poking fun at people who deserved fun poked at them.  He was a little more vicious at the people who were bent.

The people who are picking arguments with him I am happy to publish in the comments - so long as the posts are not anonymous and the arguments are detailed.

My view- the nasty(but not rationally argued) comments about a dead guy tend to show he was onto something good.

J

Monday, April 6, 2009

Bed and Breakfast capital at Bramdean Alternatives

I keep an eye on Bramdean Alternatives – the listed fund of hedge funds and private equity funds run by Nicola Horlick’s Bramdean Asset Management.

What really interests me is the capital calls on private equity – these being numbers large enough to potentially bankrupt Bramdean Alternatives.

So far the capital calls have been manageable – but detailed disclosure about how large they are and when they are due is not available.  Without that disclosure I am inclined to think the worst.

Anyway the February "factsheet" contains the following gem (emphasis added):

Four capital calls were received from underlying Funds in February, though one of these was purely for regulatory capital purposes and was refunded the same day. Revaluations were received from two managers of the Company's Private Equity and Specialty Funds and these have been incorporated into the February NAV calculations. Both revaluations were downwards revaluations, reflecting falls in the values of market comparables and adverse currency movements. As stated in previous communications, downward valuations are to be expected given the exceptional market environment and it is likely that the Company will receive further fair market valuation write-downs, including valuations as at 31 December 2008, from some of its managers. As at February, six of the 18 private equity and specialty managers have reported their December 2008 year-end valuations; these have been reflected in the NAV of BAL. One other manager's portfolio is revalued every month.

The first sentence just leaves me gobsmacked.  Bramdean sent a whole lot of money – a capital call – to a private equity fund (or other fund) – and they sent it back the same day – after presumably including it in their accounts.

This was done for "regulatory purposes" – but – for the life of me – I cannot think what the regulatory purpose might be – and why this might be legitimate.  

If it was to fool a regulator or a creditor into believing that the fund had adequate capital on balance date it looks and smells like it was designed to mislead or at least to circumvent some kind of regulatory test.

But it could be another reason – it is just that I can’t think of any real reason why a fund of funds would send its money to some underlying fund for just a few hours without a design on fooling someone.  I sent an email to Bramdean hoping that they might give me a legitimate reason but alas there was no reply.

And I am not picking on Nicola Horlick here.  If Bramdean sends the capital and it comes back on the same day the fund presumably sent this request to several funds-of-funds – and they all complied.  And they all didn’t think it unusual that their money might be needed for a few hours.

So to repeat the question.   Can anyone think of a legitimate purposes for this?

Please.



John


ps.  If you want to spot me a few million dollars for a few hours - then - I am interested.   I just can't think of any legitimate reason why you would want to do that either.

pps.  Someone with no intention to repay may be more interested still.  

That Legacy Word

Toxic assets are no more.  The Geithner Plan is officially a “legacy asset plan”.

Legacy assets sounds so much better than toxic assets.

By contrast Chevron (latest security analysts conference call) has as its first stated goal (in upstream business) to "grow profitably in core areas and build new legacy positions".

Bankers and oilmen leave a different legacy.

Friday, April 3, 2009

The seemingly criminal Sheila Bair*

I am not opposed to the Geithner Plan – but the execution is bordering on criminal.  This article in the FT runs as follows:

Bailed-out banks eye toxic asset buys
By Francesco Guerrera in New York and Krishna Guha in Washington 
Published: April 2 2009 23:20 | Last updated: April 2 2009 23:57

US banks that have received government aid, including Citigroup, Goldman Sachs, Morgan Stanley and JPMorgan Chase, are considering buying toxic assets to be sold by rivals under the Treasury’s $1,000bn (£680bn) plan to revive the financial system.

The plans proved controversial, with critics charging that the government’s public-private partnership - which provide generous loans to investors - are intended to help banks sell, rather than acquire, troubled securities and loans. 

Spencer Bachus, the top Republican on the House financial services committee, vowed after being told of the plans by the FT to introduce legislation to stop financial institutions ”gaming the system to reap taxpayer-subsidised windfalls”.

It is so blatantly obvious that the people that should not participate as buyers in the Geithner funds are the conflicted.  This was first pointed out by Steve Waldman – but I thought his dark thoughts were too dark.  However Clusterstock argues that Sheila Bair is seemingly oblivious to the corruption possibilities.

She isn't seemingly oblivious.  She is totally captured by JPM and Citi.

After all WaMu was gifted to JP Morgan in a reckless and irresponsible manner and she attempted to gift Wachovia to Citigroup.  It should not surprise me that Sheila Bair continues to act as if she is on the take.  That represents no change in behaviour.

Recommendation:  Indict Sheila Bair if she won't resign.  Indict her now.


*Note - I have always believed that Sheila Bair is either incompetent or corrupt.  She seems to be corrupt - but incomeptence in her case is probably a sound defence.  She should resign before she is (perhaps mistakenly) indicted for corruption.  

Thursday, April 2, 2009

A little bit of careful thinking – and why Krugman’s despair is misplaced

I am not an economics academic. I gave that game away for the lure of lucre and funds management. But this job throws up more than a few ideas for publishable economics papers – whereas when I was a student I was desperately short good ideas.

Here is one – a pure throwaway – for anyone that wants it. (It’s a nice paper for a masters thesis.)*

It has also explained neatly the problem of not getting banks to bring assets to the Geithner Funds – and in a way which I suggest is surprising.

It started as I tried to pick apart Rortybomb’s analysis of the Geithner Plan. Rortybomb does – in more formal form what Krugman does – analyse the non-recourse financing of the plan as a subsidy. He suggests that the non-recourse nature of the funding is a put option to the Treasury/FDIC of the assets – and that the correct way to model it is using (standard) option pricing models. Rortybomb’s posts are here and here. Krugman is a little more simplistic – but the idea is the same. Krugman produces a two-outcome model (rather than the range implicit in the option pricing model) and demonstrates there is a subsidy. Krugman’s post is here.

Anyway if you use a standard option pricing model and assume some volatility of outcome it is not hard to quantify the subsidy implicit in the plan. I have borrowed Mike’s (ie Rortybomb’s) diagrams. I hope he doesn’t mind.





The subsidy is dependent – as Rortybomb would acknowlege – on the leverage of the fund, the diversification of the fund and the variability of outcomes (particularly stress outcomes). All of this is standard option theory.

Now this is all fairly convincing until you work out that the party selling the assets (presumably a large and stressed bank) is also subsidized. The policy of the US Government (stated many times) is that there should be “No More Lehmans”. You may argue with this policy (reasonable people myself not included) think that this is the wrong policy. But you can’t argue that it isn’t the policy. The demonstration is that any bank that gets into any kind of liquidity trouble gets a “Sunday Night Liquidity Fix”. The availability of that Sunday Night Fix is a subsidy for the bank – just as surely as the non-recourse funding is a subsidy for the Geithner Fund.

So the issue is whether the Geithner Funds reduce the tail risk for the government – not whether the funds are themselves subsidized. After all the assets being sold are from non-recourse finance banks (losses beyond capital borne by the taxpayer) to non-recourse financed funds (losses beyond capital borne by the government). It depends on the relative solvency of the banks and the Geithner funds.

Thinking carefully there should be four broad outcomes:

Both the bank and the Geithner fund is solvent

Both the bank and the Geithner fund is insolvent

The Geithner fund is insolvent but the bank is solvent

The Geithner fund is solvent and the bank is insolvent


When both the bank and the Geithner Fund is solvent ex-poste there was no cost to the government. Sure there was an ex-ante subsidy but it didn’t cost anything. This case should not worry us.

The second case – when both the banks and the Geithner funds are insolvent the government will lose money – but it will lose less money than it would without the Geithner Plan. After all there was some private money in the fund – and that reduced the end loss borne by the government. In other words subsidy be damned - the plan reduced government losses.

The third case is problematic. If the Geithner Fund is insolvent and the bank is solvent then the Geithner plan cost the taxpayer real money.

The fourth case where the fund is solvent and the bank is insolvent is also problematic – but in a different way. The fourth case is where the banks sold good assets to the fund (presumably for liquidity) and kept the bad book for itself (because it could not sell it). Now in this case the subsidy to the Geithner Funds is not a problem – rather it is the desperation of the banks to sell assets, any assets and only being able to sell good assets. The more subsidy you give the Geithner Funds and the more competition between Geithner Funds you have (bidding up the price of the asset) the lesser the end problem for the banks. Either way however we shouldn’t be that stressed about the subsidy to the Geithner Fund.

Indeed the only place that we should be really stressed about subsidy to the Geithner Funds is the third case – where the fund is insolvent but the banks are solvent.

Oops. The people that are really stressed about the subsidy to the Geithner Fund (Krugman, Felix Salmon, Yves Smith of Naked Capitalism, Mike of Rortybomb) are also worried about or even convinced that the banks are insolvent. Indeed several of these people just advocate nationalisation now.

This is illogical. It is the second time I have accused Krugman of gross illogic – but it is simply illogical to believe that

(a). The banks are largely insolvent,

(b). The right or actual government policy is guarantee big banks (ie no more Lehmans) and

(c). The subsidy to the Geithner Funds is a real problem.

If both (a) and (b) applied the Geithner Fund MUST save the government money - so the subsidy is irrelevant.  

This illogic extends to several of the bloggers I admire most. That is why I think there is a good academic paper in there. Krugman actually expresses “despair” over the subsidy. His despair is misplaced.

I guess the extension is to model it with many Geithner Funds, some of which are solvent, and some of which are insolvent. The situation might wind up more nuanced. Indeed my rough modelling (Monte Carlo rather than rigorous maths) suggests that it is more nuanced – but only slightly. The nuance disappears if the diversity of the Geithner Funds matches the diversity of the banks.

Success of the Geithner Plan

One concern with the Geithner plan is that the banks won’t actually come to the party and sell assets. It’s a concern taken up by Charlie Rose when he interviewed Timothy Geithner and dismissed in the Bronte Capital submission on administration of the plan.

Now – thinking about it I am not quite so sure. There are simple explanations as to why banks won’t bring assets to the plan – see for instance this post from Accrued Interest. But the most obvious reason is that the relatively good assets logically belong with the party with the biggest subsidy. And that might be the banks. The fact that banks won’t bring assets to the Geithner funds is in fact a measure that the relative subsidy of the Geithner funds is too low.






John Hempton



*At one stage I tried to contact Brad DeLong possibly about being involved in a PhD program at Berkley (ideally with him). We managed never to connect. And I have since given up that goal.

Wednesday, April 1, 2009

Rortybomb argues my point (though he didn't mean to)

Rortybomb is a blog where I find myself entirely agreeing with the mathematics and totally disagreeing with the conclusion.  I have added it to the blog roll – and intend on taking a few shots at it.  I consider Rortybomb as providing an illustration of all the things you can do to abuse mathematics in economics.  

Mike (the blogger) posts empirical research suggesting the obvious – that big banks selling loans that can’t be securitised tend to have fatter margins.  When they sell loans that can be securitised they tend to have thinner margins.

He then concludes that we should have smaller banks and more access to securitisation.  Felix Salmon agrees with him and wants smaller banks and more securitisation.

No objection to the empirical fact that oligopolistic banks without securitisation competition are profitable.  I see it in many places.  And I see it today.  Securitisation is being removed and bank margins are going up.  Pre-provision, pre-trading loss profit of banks is rising.

My objection to Rortybomb is to the conclusion.  Fat margins for banks are a good thing.  They lead to the absence of financial crises.  Thin margins lead banks to take more risk – and when they fail they have huge collateral damage.  

Having a few fat rich banks is a small price to pay if you don’t trigger great depressions.  

In the olden days banks used to give out toasters to anyone who would open an account.  Why?  Because new customers were frightfully profitable.  Why didn't the banks compete with lower prices?  Because they were not allowed to.  Bank regulators actually regulated the value of the gifts (then known as "premiums") that banks could give their customers.  They wanted to ensure that the toasters did not cost too much.  Essentially they wanted to guarantee bank profitability.  Krugman wants to go back to the toaster days.  I just want to go back to days when banks were consistently very profitable over a cycle.

Big banks with no securitisation will be sufficiently profitable.

Rortybomb makes precisely my argument for big banks.  That they rip us off.  And that is a good thing.

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The content contained in this blog represents the opinions of Mr. Hempton. You should assume Mr. Hempton and his affiliates have positions in the securities discussed in this blog, and such beneficial ownership can create a conflict of interest regarding the objectivity of this blog. Statements in the blog are not guarantees of future performance and are subject to certain risks, uncertainties and other factors. Certain information in this blog concerning economic trends and performance is based on or derived from information provided by third-party sources. Mr. Hempton does not guarantee the accuracy of such information and has not independently verified the accuracy or completeness of such information or the assumptions on which such information is based. Such information may change after it is posted and Mr. Hempton is not obligated to, and may not, update it. The commentary in this blog in no way constitutes a solicitation of business, an offer of a security or a solicitation to purchase a security, or investment advice. In fact, it should not be relied upon in making investment decisions, ever. It is intended solely for the entertainment of the reader, and the author. In particular this blog is not directed for investment purposes at US Persons.