Quotes of the week:
1. "Notionally called hedges, in reality they were a series of free-standing bets that Bear executives dubbed The Chaos Trade"
2. "The Fed's role in the deal suggests federal officials fear a systemic collapse of the U.S. financial system were Bear Stearns to fail. The fear stems from Bear central role in a multitrillion-dollar web of interconnecting derivative contracts." - Roddy Boyd on CNN Money.
3. "Bear is a counterparty to some $10 trillion of over-the-counter swaps. With the broker's collapse, the fear that these and other contracts would no longer be honoured would have infected the world's derivatives markets." - The Economist
Quote 1 is how Bear Stearns was financing its cash flow once their losses became known internally. They were making trades betting against their other portfolios and betting (sorry, 'investing') on things to go really haywire. I think some hedge funds that bet against the financial sector are going to announce amazing results in the next few weeks.
Commentary for the Week:
The Miraculous Catastrophe:
Something so awesome happened over the last two weeks that quite possibly every human on Earth has been adversely affected. No, it was not Godzilla's escape from its wintery prison, nor was it yet another discovery of King Kong. It was something that sounds so innocuous that it probably escaped most people's work-a-day attention. Of course, if I had a life outside that of finance, it would have escaped mine as well, but I am chained to the desk here at Ittihad and am required to know such things. On the surface, what happened was quite simple. An investment bank in the US called Bear Stearns was bought out by a full-fledged bank called JP Morgan for a relatively small amount. This was reported in many places and some surface treatment was given to how there were several 'Risks' in the financial system which were brought to light by the whole episode. The exact nature of the risks, however, was generally left to our imaginations, so here I go.
Let me start by saying that the annual GDP (nominal basis 2008) of the entire world is around $57 Trillion. This means that all of our collective effort as humanity over the course of a year adds up (if one were to use money as a yardstick) to $57,000 Billion. Relative to that, the Bear Stearns buyout, at a mere $1.5B is of course peanuts and quite unremarkable.
But try and look at it from this perspective for a minute and see if you feel a sinking feeling in your gut. Had Bear Stearns not been bought out by JP Morgan and had JP Morgan not guaranteed Bear's obligations, there would have been a ... wait for it ... a bit more ... a $10 Trillion hole in the financial system. How can this be, you ask? Surely it cannot be, you say? How can a company that is worth $1.5B now (and was worth $3.5B before the crisis) create a $10 Trillion gap in the entire system of what passes for wealth, you ask yet again? Well, the official answer is that these are all unsophisticated questions and we shouldn't worry our pretty little heads about it too much. It is best to go back to refinancing the house so we can buy the Broccoli that now costs almost as much as a pound of Silver. The big men (such as Big Ben) are in charge and with their humungous brains, surely they can find a way out of this mess. So much for the official answer. The only-somewhat-varnished truth is quite different, and your earlier questions may not be so unintelligent after all.
A company with less than a few hundred million in actual assets (which were also quite faulty to begin with) is a counterparty to over $10Trillion of derivatives. If you suddenly remove this company from the system, all of humanity would have to work for two whole months to make up for the just the first order loss. As other, second-order losses would surely follow, this calculation does not even include any downstream and domino effects. To your earlier questions, I would add two more - How can be this be a sane way of handling humanity's finances? Isn't there something wrong with a system that allows one company (which was only the 5th largest Investment bank in the US) the ability to enter into performance contracts worth more than 75% of the US economy?
One reason this is difficult to wrap our heads around is that we have been conditioned into thinking that finance is complicated and best left to experts with many ill-fitting consonants behind their name. The other reason that this seems unreal is the fact that there are more zeroes in these figures than there are hairs on my head, which is confusing us needlessly. So let us un-complicate this Gordian Knot and get to the heart of the matter. Let us say I have $200 in my chequing account, which is all I have to pay for all sorts of bills such as the lights, heat, Broccoli etc. Let us then say that I calmly and coolly write people 'certificates' (an easier way to think about derivatives) in the amount of $10,000,000. Even though these 'certificates' are strange in the sense that only a limited amount of people actually submit them for actual payment back to me (think Canadian Tire Money or gift cards), the fact that I have promised $10 Million when I have only $200 to my name is boldness bordering on lunacy. In simpler times, it was called fraud.
In the modern economy, however, what happens if people suddenly wise up to my irresponsibility and stop accepting my 'certificates'? What if they actually ask me to pay up on some of the ones outstanding? Furthermore, what happens to all the people who have used my 'certificates' as assets upon which to write IOU's of their own? In theory of course, there should be a catastrophe of the 'Plagues of Egypt' proportion, but what we have is a miracle instead. This is because, if you are American, even if you make a $ 10,000,000 hole in the assets of the world with your $200, there are no severe ramifications. Instead, someone actually pays you $100 and then takes over the business of writing your 'certificates'. The fact that this someone has also been given a $30B 'loan' from public money makes for the Mother of all Financial Miracles.
Welcome to the even newer economy, where a private $10Trillion loss can be papered over with $30Billion of taxpayer money. This is the New World, where a crack that would bring down the World economy is papered over by empty promises. May God protect us from the crushing blow of Inevitability. But don't panic just yet, this is all probably just my imagination.
Finance News:
1. Bear Stearns was bought out by JP Morgan for less than 20% of the value (Price?) of its Head Office Building ... this is an intelligent discussion of why ... read more here
2. A beautiful and succinct explanation of why Hedge Fund collapses are always spectacular ... (hat-tip to Michael Gassner) ... read more here
3. What a juicy piece of news for those following the Bear Stearns buyout! ... It seems that JP Morgan will have to raise its bid to $10/share from $2/share because the CEO did not read the 'merger' agreement carefully before it was signed ... read more here
4. This came out just as I wrote #3 above ... Its official at $10 / share. The mechanics of the transaction are quite funny though ... It seems JP Morgan does not need the approval of a majority of today's shareholders for the deal to go through ... read more here
Economic News:
1. Prospects for the US$ ... The info on the amount of leverage used by Goldman Sachs and Merrill Lynch is astounding ... read more here
2. The US Treasury congratulates the Fed for putting $30Billion of public money on the line during the Bear Stearns buyout ... (if anyone needed more confirmation that the game is rigged) ... this is the 'Too Big to Fail' philosophy on steroids. Friends bailing out other friends using public money ... read more here
3. Excellent Column on the 'End of Capitalism on Wall Street' ... too funny ... read more here
4. The Economist suggests (a mere hint of a suggestion) that JP Morgan Chase has swallowed a whale / bitten off more than it can chew with the buyout of Bear Stearns ... read more here
Islamic & Middle East Finance:
1. 'Islamic' Bond listed on the London Stock Exchange ... read more here
Miscellaneous:
1. And you thought that we were a developed economy that was beyond worrying about food prices ... read more here
2. Does this mean the end is near? ... The US Defence Department may not know where all its Nukes are ... No less an authority than CNN folks ... read more here
Showing posts with label SubPrime. Show all posts
Showing posts with label SubPrime. Show all posts
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
Miscellaneous:
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
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
Miscellaneous:
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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