Crossing the Rubicon

Francesco Granacci (1493-1494), Julius Caesar and the crossing of the Rubicon, Victoria and Albert Museum, London, UK.

Francesco Granacci (1493-1494), Julius Caesar and the crossing of the Rubicon, Victoria and Albert Museum, London, UK.

February, 12th

How to turn a bad bank into something worse

When economic crisis hit Sweden back in the early 1990’s their government performed a restructuring of the financial system (and of the economy as a whole for that matter), so deep that the paradigm of welfare state became more market orientated than the countries that looked upon the Swedish model with reverence while their leaders cried not enough was being done to be like them. Swedish free-market defendants might object to this view as they still endure high taxes and government intervention but things are better not worse than elsewhere.

The irony is that in order to reform their financial system they had to nationalize, or at least bring the state in as shareholder of their banks. This is very odd as state is the most inefficient of all managers simply because it subdues the mission and values of nationalized companies to the personal and collective ends of bureaucratic elites. A simple explanation might be one that I heard so long ago to remember where: post war politicians talked about socialism but implemented free-market reforms (mostly to pay for their otherwise unattainable welfare state), while post-Soviet politicians talked about free-markets while implementing regulations and restrictions to those same markets.

The point is, from 1991 to 1994 the Swedish state bought their way into the banks, diluting ownership, but allowing the survival of those banks by giving them enough capital to not force the liquidation on their assets. And later, it is even assumed that those shares were sold with profit, although increased taxes and debt used to finance the whole operation are not fully taken into consideration.

Jump 20 years and the Spanish banks find themselves in a similar situation. But this time if the Spanish government thought it could do the same thing, it had to look again as it cannot finance the operation. Credit from abroad is highly conditioned and taxes are already higher than the ones paid in Sweden. But as rulers like to believe that reality is what it seems and tend to scorn upon what Greeks called hubris. They think that by shuffling and moving things around garbage can be turned into gold.

Thus enters Sareb, the “bad bank”, a creature spawned by the Spanish government to “solve” the problem of bad loans related to real estate that uncomfortably lie in broken banks’ balance sheets. This is how the whole thing was devised: The state puts up half the money (up to 49.9% to be more accurate meaning they cannot impose their will against other partners if they act unanimously, this acting as bait of course) and private partners come up with the rest of the money. The troubled banks themselves cannot join as shareholders. Nonetheless they are given bonds in return for their toxic or troubled assets. On paper, this bank is promising a return on equity of 15% for the next 15 years which, in times of imposed low profitability on capital, seems a very attractive deal. This implies one of two things, possibly both: a) assets are bought at an attractive discount and b) the company is leveraged, equity being a fraction of total assets.

The problem with assets being bought at a discount is that it would imply troubled banks taking a loss that would make their delicate situation worse. To put it bluntly, institutions that are otherwise broken can only maintain a semblance of solvency by arguing that the asset side of their balance sheet is enough to meet their liabilities in the long run. A discount on those assets is equivalent to a death certificate. If those banks had no choice, those assets would have been sold at a discount, shareholders wiped out and bondholders brought in to take their place while taking themselves a cut on their principal. If the whole idea is to prevent this from happening, then troubled banks cannot be forced to give their bad loans at a discount.

On the other hand, the only willingly (or maybe not so willing) private partners the state found were the domestic banks (BBVA rather tellingly missing), foreign banks with important operations in Spain (Deutsche Bank and Barclays) and some local insurance companies. These banks are not pleased to buy at book value (or even market value for that matter) but they have themselves a big inventory of real estate to place in the market, so if these assets are kept outside the market long enough it would give them time to get rid of their own pile of manure.

I do not know at what price those assets have been brought into Sareb, but homes are being offered to the market at prices some 30% higher than they had been offered by troubled banks before. Besides, international investors willing to make a buck were dismissed. Papers said “vulture funds” were prevented from taking advantage of the discounts failing to see that in finance, like in nature, vultures play a part in the balance of the whole eco-system.

This leaves us with leverage. The problem with leverage is that it works under two assumptions: a) return on assets is higher than the cost of debt and b) asset valuation cannot drop more than the small equity size, or new capital will have to be put forth. This means effectively that whatever the price being paid (well, bonds issued) the market value of those assets cannot decrease more than 8% and the return on those assets must be enough to pay coupons on bonds. The trouble is I very much doubt those houses are being rented (or mortgage holders are at least paying interest on their loans) so there is a negative carry that needs to be funded. More debt or capital are required.

So after deep restructuring, the Spanish troubled banks own bonds on a company as leveraged as themselves, with negative carry and expensive assets. The not-so-troubled banks invested in that same company expecting (or at least wanting to believe) they would have a 15% annual return that, for the time being, seems like a mirage. To further add to their misery, stage two is drawing near where an additional 2.5 Bln. euros of equity are required (the taxpayer paying for half of it, well 49.9%), vulture funds being put off and domestic banks showing an understandable lack of appetite.

Yesterday big news was Iberdrola coming in with 2.5 million (yes folks, a whole 1% of the total required), this after we had been informed they would probably invest 10 million. Thus a company in a highly regulated market, holding a big government debt already (from the differential between the return regulation promises for their assets and the price it is allowed to charge to their clients) is performing in all likelihood lip service and a very expensive one for that matter.

To add insult to injury, the original bank project said the board would be composed by between 5 and 15 members and I will let you guess how many are there in place. Besides, rumours came out that the troika (whom unofficially run the country) are not pleased and asked for a revised (meaning completely new) plan than is being drafted by KPMG. One would expect bankers chosen by government to be at the bulk of such important reforms being able to make their own business plan.

February, 4th

Modern banking started in Italy in the early 15th Century. Pinpointing the moment is a bit arbitrary, especially since we know a banker had is head cut in Barcelona during the 13th century for not being able to return depositors’ money, the Templar Knights performed the services we associate with banking after the turn of the first millennium and Christ himself expelled from the Temple of Jerusalem the dedicated members of the profession. It can be argued that people have always lent and kept valuables for others thus banks satisfy perennial needs since the dawn of times.

And yet, modern banking began in Italy. In Genoa to be exact, where, by 1407, the Bank of St George became the first (known) chartered bank in the world. Thus, if Italians did not invent banking they have at least invented a cornerstone of modern banking activity – banking regulation. It should come as no surprise that they continue to excel at that and showing the world the path modern banking regulation should trend upon.

A mere 65 years after the Ufficio di San Giorgio was given state permission to operate, in Siena, another such institution was founded under the name Monte di Pietà, later rebranded Monte dei Paschi. So it is only adequate that the oldest surviving bank in the world is the first to receive state aid that is not a really a bail-out since, like the Italian Finance Minister so wisely put, bail-outs are not allowed by the Italian law.

“What’s in a name?” Shakespeare asked. “That which we call a bail-out by any other name would smell as sweet”, Juliet might have said and Hamlet probably added that “something is rotten in the Republic of Italy”. Wasn’t signore Draghi the head of the Italian banking regulator, just before he was appointed head of the institution everybody expects to play that role for the battleship Euro banking sector as a whole? How does this inability (or plain refusal) to see what was going on inside the third largest Italian bank plays into what is expected from the head of the ECB? Is he expected to do the same sort of kicking the can down the road exercise?

Some people might argue that, at the time, it was impossible for Draghi to have anticipated what would happen and they are right to some extent. After all auditors were not informed and no one can foretell the future no matter how many econometric models he has at his disposal. But the question remains: if auditors are only supposed to audit things they are informed of, then what’s the point of auditing something in the first place? It’s not like if somebody is doing something wrong he is going to tell it to the police. A regulator that says, as far as we are informed we cannot see anything wrong, is pretty much useless. On the contrary, it might be argued that it actually adds risk to the financial sector as counterparties and public at large grow complacent.

There seems to be an increase in the number and size of rogue trader activity. Maybe the number of people that do this sort of thing is not increasing, only the size of their blunders, but yet, one cannot but suspect that, as regulation and controls increase, so do the costs and, if something is going to work outside the law, it better pay off big time, same as Chicago mobsters under prohibition. And if it becomes riskier it doesn’t really matter as risk is not being properly assessed by those who ultimately pay the bill – the taxpayers. I was going to write shareholders but bail-outs under any other name are more the rule than the exception these days. The whole financial system grew into a massive credit pyramid based on collateral with almost any institution becoming if not too big, too structural to fall. And how many ticking time-bombs are out there ready to explode nobody can tell. But we can tell they exist because the regulating system fosters its creation. Unfortunately it seems that, by the time they explode, those who held office as regulators, if they are lucky, have already moved on to greener pastures. Coincidently the word “paschi” in Italian means exactly that – “pastures”.

January, 29th

Many years ago, more than I care to remember, I read a novel by Gabriel García Márquez called Chronicle of a Death Foretold (skip the rest of the paragraph if you do not wish to know how it ends, oh well, you are going to find out anyway). This is a story of a vengeance loudly proclaimed in a small town, where everybody knows two men are set to kill another but nobody seems to be able to tell it to the victim-to-be, who inevitably (or not, that is the whole point) gets killed.

Apart from the fantastic way (in both meanings of the word) García Márquez tells the story (any story for that matter), the reason this novel struck me most was because it tells of an event that seems easily preventable but, in all likelihood, inevitably happens. In capital markets this would translate to markets possessing all available information but market prices refusing to move accordingly. This, we are told by some of the best minds, cannot happen. Prices only move immediately after new information is incorporated and, if markets are efficient, no one can consistently outperform the market (produce abnormal returns). The story I’m about to talk about could very well be one of how information moves across market participants allowing some investors abnormal returns (if not consistently, at least in this case) but, any defendant of the EMH can easily show how wrong I am by moving the goalposts on what the hypothesis says. It is not that markets are not efficient. It’s just that, in my view, the Efficient Market Hypothesis is unverifiable and thus unscientific, but that is not what I want to talk about.

What I want to talk about is the collapse of the price of Apple shares, from slightly over 700 dollars to below 450 dollars since mid-September. A chronicle of a death foretold. Particularly the hit last Thursday after the company had posted record quarterly revenues and profit, while margins came down and EPS slightly lower y-o-y. It seems the market was reacting to new information as results, good as they seem, also tell how the company’s growth cannot be extrapolated from past experience. But, this was not something that hit the market overnight. If something, Apple’s financial results forced people to act upon already existing information or, better still, act upon the subjective perception of reality a significant number of shareholders had developed during previous months: that market conditions made of Apple the safest share any portfolio could own but the point had been reached where everybody considering that strategy was already over-weighted. It was public information that a significant amount of hedge-funds held significant quantities of the share in their books. Apple, with virtually no debt, sitting on a pile of cash and selling products in high-demand (and paid for in cash) was the closest thing to a safe-haven in these troubled times for stock markets. But it could not maintain that path forever.

As the stock plummeted analysts came out downgrading the share. The timing was so perfect one must suspect valuations were already in the main draw, all they needed was for a few blank spaces to be filled, waiting for the right occasion to see daylight. It must be said that, at current levels, most of these downgrades show the stock as a buy or even a strong buy. Yet that didn’t stop the fall as markets know that, everything else being normal, stock-analysts are biased. A “Buy” meaning ok and “Neutral” meaning it’s time to sell. It’s the price analysts have to pay for companies to let them have some information to work with (furthermore, almost nobody likes to listen to a good sell story). But more importantly, a lot of articles came out on the papers about how good Samsung, or any other competitor for that matter, are and how, ultimately, Apple fell victim of their own success.

It was only the weekend before I entered my local Apple Store thinking about buying a MacBook. I did not buy it, and yet, I’m pretty sure I will. I used to think Apple was a posh company that made overpriced products until I started buying them. Then I realized that I can afford to be overpriced: their gizmos work, they sell apps at affordable prices (for people that don’t have the time to find freeware or get a pirate copy) and have a wonderful commercial and technical service. Once they gave me a new ¡Phone when they could not understand what was wrong with mine (the guarantee had expired) and reimbursed me for an app I downloaded by fat finger mistake a long time after I had bought it unaware. I do not think these things will vanish now that the shares are worth less than $450.

Furthermore whenever I go into their store the employees are so nice I believe I am in America. But the best thing is they do not act like they are trying to sell you something while being nice, so it’s like being in a perfect America. And another thing, despite being such a motley crew, they have one thing in common: they genuinely seem to enjoy what they are doing. At Nespresso they try to cause the same impression but it always seems a bit phony to me. Maybe it’s because I don’t understand how drinking coffee can be so exciting. It isn’t. At least not for me, and I think I spent more money on coffee than ever will on Apple products. Anyway, the Nespresso brand seems to be doing pretty well.

Then I started to think that maybe, just maybe, it is the other way around. Maybe it is not such a great thing for the company to be worth over $700 dollars a share. Since there is no majority shareholder running the company, who can do whatever he thinks best to serve his clients without really caring how much the stock is worth as he is not going to sell it anyway, the dispersed capital will undoubtedly pressure for the company to improve their numbers to justify the $700 they just paid (or the opportunity cost for not selling), and they are entitled to do so. However, this was more or less why Steve Jobs was fired in the first place and the company (and its shareholders) seemed to come worse off. Yet, unlike a lot of people out there, I don’t think that people that bought Apple at $700 (or chose not to sell) are dumb, at least not all of them.

Maybe I’m wrong but it turns out that massive pile of cash Apple is said to have under their seats is not entirely made of…well…cash. Most companies have funds invested in very-short-term-low-risk securities they can get rid of at short notice without a significant, if any, amount of loss. But the 140 billion dollars that Apple owns in cash and securities surely stretch a great deal along the yield curve and diversify a lot more than your average company. As things are, Apple is a massive investment fund and interest rates on the rise must have produced some damage on their mark-to-market. Wait a minute, do they have to mark-to-market their funds? I don’t think they do, at least not the way investment funds have to produce a daily valuation of their portfolio. So, people were buying into an investment fund whose strategy they ignore, apart from the fact that their main asset is the operational side of Apple but, nonetheless, re-invests the bottom line of that into that same fund? Does this make any sense? When the economy is deleveraging, yes it does, a lot. After all, whatever those fund managers are doing, they are dealing with the money of their own company, they are not leveraged and they most likely do not have performance incentives to take too much risk (not really sure on this last one).

Now, the interesting question about all this is why does Apple do what it does (apart from computers I mean)? Why not distribute their profits to shareholders and let them re-invest or outright spend in whatever it is they want to re-invest? Isn’t that what we all learned made economies more efficient? Entrepreneurs finding or creating new opportunities, capital flowing through trial and error or intelligent insight to where is more urgently needed? The reason why Apple keeps such a large amount of cash is for tax saving purposes and, however competent as investors people managing that cash might be, they will not beat the shareholders of Apple in doing that job. Firstly because shareholders were the ones actually investing in Apple and more seriously because Apple managers cannot withhold, act upon or create as much valuable information. Taxing dividends over capital gains seems like a good idea to force companies to re-invest but it prevents a lot of alternative investment or consumption decisions that, because they will never happen, will never be missed. As Bastiat famously wrote:

“In the department of economy, an act, a habit, an institution, a law, gives birth not only to an effect, but to a series of effects. Of these effects, the first only is immediate; it manifests itself simultaneously with its cause – it is seen. The others unfold in succession – they are not seen: it is well for us, if they are foreseen. Between a good and a bad economist this constitutes the whole difference: the one takes account only of the visible effect; the other takes account of both the effects which are seen and those which it is necessary to foresee. Now this difference is enormous, for it almost always happens that when the immediate consequence is favourable, the ultimate consequences are fatal, and the converse. Hence it follows that the bad economist pursues a small present good, which will be followed by a great evil to come, while the true economist pursues a great good to come, at the risk of a small present evil”

Tax exemptions are usually seen as beneficial as they mean more money is available for private enterprise. Yet they are a political weapon to split between those who easily can and easily cannot be taxed – a political application of the divide to conquer rule – creating grave distortions in the economy. They do not foster economic growth to the same extent. And, in the process, are unintentionally pushing good companies into what they were never meant to be: financial asset managers.

January, 21st

While a new, apparently perpetual, monetary stimulus gives equity markets a semblance of the health they manifestly lack, Japan tries to regain the lead as the world’s most distorted capitalist economy. Bear in mind that this was a place they rightfully owned for much of the 1990s. Back when Americans scornfully though this whole idea of not letting companies sink was oh so Japanese, all those fancy ideas about samurai honour. It could never happen in the US where, of course, no company was too big to fail.

In Japan, Prime Minister Abe said his country will pursue a “bold” monetary policy to set inflation rate up at 2% YoY. It made me wonder what have the Japanese been trying to do since 1991? It seems they had just been aiming at 1% and, since the 1% target inflation didn’t do much good, they seem to think 2% is a lot better, twice as better I suppose. But how exactly does Mr. Abe expect to succeed by doing exactly what is predecessors did escapes me. I expect him to use ever growing deficits to provide for larger quantities of money to run amok in the Japanese economy. Or is he ready to take the next step? Namely to just go ahead and print money without the implicit promise that he will pay back what, at least formally, could be considered a debt?

I don’t think the Japanese are that desperate but the question is, no matter what he does, if he succeeds in bringing inflation up (I mean inflation as measured by consumer prices index, actually a consequence, not a cause of inflation, but never mind), he is declaring that Japan is defaulting on his previous, massively-pilled-up-over-the-years, government debt and would make the prices on those bonds collapse (I mean 0.7% 10 year yield vs 2% year inflation, expectations for the future, worldwide, have to be pretty grim). I know he said he was only aiming at raising mid-term inflation as if inflation was something one could keep in a jar at home. Ironically, if he was to succeed, he would most likely fail to take equity prices significantly higher, in real terms, as equity does not over-perform in inflationary environments unless heavily tortured data is used to corroborate that conclusion. The reason is, quite logically, because inflation prevents entrepreneurs from making right economic calculations as price changes are too much and too varied for market prices to successfully be used for those calculations. It would be very hard to tell what consumers are demanding to satisfy their needs and how capital could or should be employed to satisfy them. There is also the problem of new money coming into the system not being neutral, benefiting the first holders of currency at the expense of the latter and, no matter how rational one’s expectations are, there is nothing one could do about it if one does not hold the right tools to face it. And most likely regulations will prevent the use of those tools, but I don’t want to bring more complexity into the matter.

Needless be said, that this is not what the Japanese government wants. They, like most of the Western economies, are betting these measures bring about a spike in the equity markets without questioning the price of government bonds, something that, like most of his predecessors, Mr. Abe is actually getting: a little short-lived spike on the Nikkei with little or any change in government bond yields (nobody said he would be getting it perfectly).

This brings us to the old debate where the US, the UK and now Japan are doing great because they have their own currencies while Europe, namely the Southern parts of it, are doing poorly because they cannot let themselves go from that straightjacket. I’m afraid it does not work like that.

The reason why increasing deficits apparently are not lagging those economies is simply because they are not being paid, so population at large is yet to suffer the cost of their government. When the Gold Standard was around, a country running a deficit would see their gold possessions reduced as, above the cost of shipping gold, creditors would demand the real stuff being delivered. If, banks were not working on fractional margin, the shipment of gold had no further consequences since gold was just like any other commodity and, if people freely exchanged it for something else, it was because they believed they would be better off with that exchange. So Mercantilist attempts to increase the quantity of gold by prohibiting its export would end in prices of commodities and wages rising. But, in the 19th Century, for industrial nations with sophisticated banking systems, gold was the basis of a credit pyramid, meaning that when gold was exported in significant amounts, the banking system had to reduce the amount of credit accordingly and a contraction of the economy through deleveraging took place. And yet, the threat of gold shipments kept the system in check, preventing governments from running large deficits or, if they did, making them pay the penalty by having to leave the gold standard, like it happened in Portugal in 1891. This system was so powerful that it allowed the international division of labour which, in turn, increased the wealth of people in ways not seen before in the history of mankind in the countries that kept to the Gold Standard rules. Not only that, it also worked an element of international appeasement. Its abolition at the very beginning of WWI was what made this war the mother of all wars seen until then. Paper money allowed governments to divert virtually unlimited resources into the conflict.

After the war, and then again after WWII, the Gold Standard was reinstated but with a fundamental flaw. Only one (or two) currency(ies) could be converted to gold. As foreign holdings of convertible currencies mostly stayed at the countries of origin never to be changed into gold (it seemed a lot better if they accrued interest from local government bonds) this meant the these countries (namely the US after WWII) could run deficits without ever having to pay them or, and this is the interesting part, having to deleverage the credit pyramid. That is of course until other nations began to demand their gold, like it happened in 1931 and then 1971.

The world of fiat-currency is, in a strange way, more democratic. Every single country has the theoretical possibility of running deficits without having to pay them or reduce leverage. Governments just have to make sure people are willing to accept the debt they issue, that is, promises for future goods and services they will exact from taxpayers. And investors are free to choose (with notourious exceptions, like social security pension funds). But I bet the countries of Southern Europe would not particularly appeal to international creditors were they to run their own currencies. And let’s face it, neither will the US, Japan or the UK if and when their importance is reduced in the international scene. They get away because they are rich, but with increasing taxation, regulation, and resources being diverted to non-productive uses, that day will surely come. And to believe the money spent by the state, any state, to trigger economic booms is the path for economic growth is delusional. Meanwhile, capital is being destroyed.

January, 11th

For the last month or so investors have been running away from government bonds, namely the long term ones, as an appreciation of what everybody knew but was afraid to say out loud: that these do not provide adequate compensation for an investment at such maturities or, to put it bluntly, they yield negative real rates.

The South of Europe is a noteworthy exception to this trend as it becomes clearer in peoples’ minds that the European Fiscal Union (a building block of the European Union of the Soviet Socialist Republics or EUSSR) draws nearer. A European 10 year bond at just under 5%, even if issued by the otherwise financially broken government in Madrid, seems indeed an attractive deal. This is why this trend is easier to perceive in the German Bund, where the price movement is more pronounced.

Please bear in mind that the only reason why people even consdered to hold on to most long-term government bonds knowingly was because they presented an unique opportunity to perceive a slightly better return within a near-flat yielding market while a fast exit, if things got tricky, was (is) in place with central bank’s policy of outright buying them or, at least, allowing them to be used as collateral for immediate cash.

Now, the object of any type of debt (credit) is the exchange of present goods for future goods and the difference in quantity between what is received (delivered) at the beginning and what is paid (received) at later stages is what we call interest. In a recessive and deleveraging environment, the pool of goods that will be available in the future is perceived as diminishing and thus people, if not happy, at least resign to settle for a smaller amount of those goods. Especially if that means they can keep their principal more or less intact. Government bonds have thus been seen as the preferred vehicle. Most private companies depend on making things right to earn a profit and pay back its creditors and stockholders, while government has the power, and resorts, to exact private wealth to compensate its own. After all, nobody really expects governments to invest profitably when purchasing bonds. So, does this shift mean the tables are turning and the quest for higher yet more uncertain yields means the world economy is moving out of the recession? Not so fast.

Nobody likes to spoil a good party (well almost nobody) but the problem here, to all those who are moving into privately issued assets, is that there is no magic wand to turn the economy around and the fact remains that a lot of companies look attractive simply because their assets are only so valued in a low interest rates environment. If investors demand additional compensation because of rising interest rates they will find out there is little or none to be given. This probably explains why, for the time being, there is a preference for investing in corporate debt over equity and the selling of government bonds is mostly done on longer-term maturities, knowing that no central bank will dare to increase rates. Anyway, what is commonly known as “risk premiums” for these assets must come down in order for the investment strategy to pay off. For the time being the stronger demand for these assets makes sure this is so and draws more people into it (which is ultimately what “risk premiums” are all about, they tautologically go down as the number of people who wish to hold or acquire a given asset increases).

On the other hand governments seeing funding costs rising, investors who cannot get out of government bonds (because laws require them to hold significant ammounts that type of assets) and the Chinese in case they are not the ones doing the selling, will not be pleased. Although this movement is bounded by the low productivity imposed upon the private sector (ironically partly due to the increased amount of taxes required to service the expanding public debt and the lack of freedom imposed by tighter regulations over businesses) it can draw a lot of blood.

The moral of this story might just as well be: when there is not enough wealth around, little is produced, and capital is being destroyed, preservation depends upon antecipating where the next lifeboard is and swim there first. Then make sure to get out on time as it gets crowded. A cynic might argue that it is always like that when it comes to financial markets. But, in this case, cynics are wrong.

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