Tuesday, May 6, 2008

Takes 2 to Tango

Dear Friends,

I know that many of you have probably missed the Ittihad Briefing so much that these last two weeks have been lost in a haze of both depression and disorientation. I assure you that this was not a planned attempt to prove how valuable the Briefing is by taking it away from you. The reason for our absence from your Inbox was quite pedestrian. It was just that I was moving my office to a new location, which resulted in a back injury which required further time off. As that logistical odyssey has now come to an end, my humble self is back at your service. I hope you will forgive this unannounced hiatus.

Quote of the week:
'Particularly egregious, at least to me, was the implicit claim that the capital markets are there in large part to help people save for old age. No they're not, and if regulators or governments ever decided to enforce that particular view we would likely have a market crash. The markets are there to provide liquidity. Period. And if by doing that people are able to buy stock and bonds in companies whose value appreciate, that's great. But markets whose core notion is wealth accumulation for individual savers, and markets whose main object is liquidity creation, are very, very different things, ...' - Paul Kedrosky from Infectious Greed.
People may not like this view but amid the confusion and noise relating to 'the Market', this is an important distinction between the primary function of markets and what we use them for.

Commentary for the Week:

Banks around the world announce more than $100B of losses, but what's the Bad News?

In these past couple of months we have witnessed many admissions of guilt by financial sector types. The CEO of Citigroup resigned, Bear Stearns has announced major write-downs, UBS, Credit-Suisse and now even Societe Generale has announced losses in the tens of Billions. These admissions of losses are meant to reassure investors that company managements are forthright about issues and that problems are being dealt with. This is all well and good, but is it the 'Truth'? More specifically, if the banks and Hedge Fund types are finally being truthful, who is not? You will of course remember that many of these banks spent quite some time denying that the softening real estate situation would have 'significant' effect. $100 Billion and counting in losses later, lawyers are now googling 'significant'. The question for us is - where else in the economy are there undeclared losses that are festering?

To get to the bottom of this, or nearer to the bottom anyway, we have to first discuss what has caused these losses in the first place. This is not generally a simple discussion, but I will attempt the impossible and keep it both brief and somewhat intelligent. Institutions that forward credit used to have a simple role in the economy. They used to take in deposits and advance loans to people based on those deposits. This simple equation has been changing over the last century. Where we are today is that institutions now take in deposits, lend a lot more money than they have on deposit, and then package the loans and sell the package to someone else as an investment. Where it gets positively mind-blowing and makes people dizzy, is that the 'investment' (package of loans) that Bank A just sold to Bank B, can be treated by Bank B as a 'deposit', against which more loans can be forwarded, and more 'Investments' can be manufactured. Also, as these packages were designed to produce income, anyone with a fixed-income need has been a regular buyer. Indeed, one doesn't know whether to laugh or to cry at the ridiculousness of this scheme that passes for the N. American financial sector. As to why people would do this, well - even though simple lending is still profitable, the packaging and selling of loans at inflated prices is where profits are obscene.

This almost makes one wish for a simpler time when the banker was making some money but he was still your friend. Now there are no friends and no enemies, just electrons and financial models. The funny thing about financial models is that they are only worth money if they can show growth. Therefore, guess what most financial models show? If you said growth, you are a genius. If you said the 'Truth', you get to be an Investment Banker - which is yet another kind of genius altogether.

The recent problem of course stems from the fact that the financial models and thus the 'investments' that rest upon them depend on a few simple variables to drive growth. The important ones are 1. cheap credit, or low interest rates; 2. Ready buyers for the investment and 3. Debtors making their loan payments. What has been immensely demoralizing for financial types recently has been that none of these fairly simple assumptions have held. There are few buyers for 'loan packages', interest rates have been cut but by too little too late, and broad swathes of US homeowners are unable to pay the interest on their loans. To add to the general misery, since almost everyone has been using similar models for investment planning, almost everyone has lost money because the assumptions don't hold.

What is truly fascinating in this story, and what makes one's nose all itchy with bad smell, is that only the banks and investment houses (for the most part) have declared losses. This means that only the people who sold these packages and kept a few for themselves are admitting losses. The regular buyers are quite mum. Most of these packages were fixed-income products, which means Insurance Companies and Pension Funds would have been natural buyers. This leads to the inevitable question of why the quietude? If the sellers of a rotten product are declaring losses on their inventory, why are the people who have been buying these for years not saying anything at all? As I am sure the more astute among us realize, it takes two to tango, two hands to clap, and two parties to complete a trade.

Of course, this does not mean that you all go out tomorrow and start to short Insurance Company stocks on margin. That would be exceedingly foolish. Unless, of course, you made lots of money doing that, in which case it would exceedingly brilliant. Just remember, the losses are from the same packages that were called 'Financial WMD's' by Warren Buffet. As WMD's, they have a long radioactive, half-life. The bank losses are only the first stage and you already know my suspicions for stage 2. One could be wrong of course, but I still feel a bit like Hamlet - 'Something is rotten in the state of Denmark ...'

Finance News:
1. The ability of banks to package and sell off their loans to others comes under more stress ... Private Equity firms refuse to back Bond insurers ... read more here

2. Remember the Rio Tinto buyout I spoke about in a previous issue? ... Well, the price just went to $150 Billion. What is interesting is that Rio Tinto management is still rejecting the offer as too low ... read more here

3. Thinking of borrowing for your RRSP this year ... read this first ... read more here

4. The CPP announces very meagre gains for the year. I thought they were the 'smart money' ... read more here

Economic News:
1. National Bank catches up to my opinion of the Gold Price ... (Refer to Issue 3.) ... read more here

2. The Loonie listens to wisdom and crosses back over into above-par territory ... read more here

3. After more than 10-15 yrs plus of overspending, US consumers are taking a break, throwing all sorts of financial forecasts, models and assumptions off kilter. Does the Japan scenario look more likely? ... read more here

4. The funniest financial 'journalist' writes about the connection between interest rates, inflation, the US$, Gold and about the American Economy ... absolutely priceless ... read more here

Islamic & Middle East Finance:
1. One particular and not very well-known vision of the future of 'Islamic Finance' definitely becoming an agenda item in the US election ... not exactly light reading but very interesting nevertheless ... read more here

1. How often do you make a mistake and learn from it? ... read more here

2. A very nice story on a Canadian retailing competitor to the Bay. Many of you who go cottaging or camping up north will recognize the name ... read more here

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