Bond Revolution In Singapore : Remembering 2008 Part 2

The second post I found written during the Lehman crisis.

Reading it again, I am not sure if any lessons were learnt from the mistakes of the past. Remember this was written during the time when QE was not conceived yet and the Fed was rushing to get approval for the TARP programme when Bush was still President.

Again, take it as mere entertainment more than education and I hope you enjoy the read.

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Wednesday, September 24, 2008

 

I was trying to explain to a bored looking friend over dinner about the merits of Paulson and Bernanke’s proposed FTC when I realised I was looking at Him – the typical man on the street who comprise the 55% of the population that vehemently objects to the rescue.

Anger is the obvious and instant reaction to most problems which goes in hand with Blame. I was angry that it had come to this even though for years I had thought to myself that the good times will come to end because housing prices cannot just spiral up like that on pure leverage. But, like everyone else on the street, I just attributed it to the government’s problem, for surely, little old me is not going to be the one who makes the difference.

Blame on who then ? Ourselves of course. Majority of us, for that matter, which brings to mind the China food tainting scandal that is, mind you, not the first. Ms China Critic here has been following for years now, the watering of milk powder with starch and the cement mixer added to tofu and, the lead paint in toys headlines. We asked for it.

This is not a new idea. I read it in Bloomberg news last year. That is part of globalisation and relocating production to cheaper sites. China benefited and developed and, naturally, wanted more profits which led to dilution of standards to keep prices low. The article distinctly blamed Us. We wanted cheap and good and companies like LV had to provide or else their shares would be dumped for Prada which was already producing in China. This process is called globalisation, no ?

This is where a plumber in Indonesia makes 100 bucks a month and a plumber in England makes 3 thousand sterling pounds. Local coffee costs the same; 10 cts in Indonesia and 3 quid in England (1000 cups a month) and yet Starbucks in Bali charges 3 quid a cuppa. End of story.
Moral of the story : Its not your job, its your passport that makes you.

What has that got to do with the sub prime crisis ? Well, it is everything to do with it. US citizens all wanted homes and affordable mortgages. Banks had to come up with the solution to that which meant huge leveraging that led to a spiral up in prices which led to increased spending power. This is all part of an economic cycle which more than 90% of America could be faulted for and more than half the world benefited from, for their own countries also experienced real estate booms as US imported goods from them.

In other words, its called greed which is the basis of a free economy in a democratic society. Greed is good.

Back to banking.
It was clearly evident, to me at least then, 2 years ago that the leveraging cycle was growing out of control. Again the “little old me” mentality gripped everyone. Surely the brains from Harvard at those investment houses that I longed to join had it within control ? Or else the larger than life regulatory geniuses we hear everyday are on top of it all ?

Not true, I guess. Everyone was caught up in the same tidal wave.

Paulson and Bernanke’s Plan

Assets = Liabilities + Capital/Equity

Assets, being the loans and CDOS and all that stuff on the left hand side of the balance sheet, were being devalued at the onset of the subprime crisis mid last year. Equity held well which meant things were fine. Equity collapsed this year causing a need for more liabilities to make up for the short fall other than raising more equity. Cost of liabilities rose which meant that assets needed to give more returns for the same dollar.

Analogy : How can Morgan borrow at Libor +600 to lend to Disney at Libor +50 ?

How does an asset give more return ? In a deflationary cycle, it can only mean devaluation. Simply, a bond or a share paying 5% returns can pay 10% if its value drops. But that also means a mark to market loss for the owner of the asset.

Losses eat into equity which meant it had to be replenished. If not, assets would have to be sold which devalues assets more and devalues other people’s asset mark to markets as well.

Nothing is uncorrelated. All asset classes are substitutes for each other and if bonds devalued then equities had to do the same.

Why Banks are Sick ?

Banks work on mark to market. Banks are sick because they are caught up in the cycle of devaluation. Banks have ratios to maintain. Capital adequacy and asset liability ratios are the broad ones. So when their assets are devalued, they need to raise capital to make up for the loss. Can they add on more assets ? Prudency deems no.

This is why there are no takers for the MBS and CDOs that everyone is liquidating at the same time. Liquidation is akin to fire sale which I have witnessed in the past week. You do not care about the price anymore, you need to sell to meet the margin call ! You are already dead, why not bring everyone down with you ?

The mad rush to bolster capital ratios has left many banks selling assets at pretty illogical prices which brings yet another round of liquidation as other banks fall short of their ratios.

I thought to myself. The house is still there, the man is still paying his mortgage but when you lump a few thousand of these together suddenly the price falls.

Americans are slapping themselves in the face when they reject the FTC proposal calling the assets junk because most of the assets arise from them – the underlying man on the street and his mortgage, or the company that he works for, and their debt.

What we need is a giant warehouse to put all these assets, out of reach of capital ratios for the time being. Till banks can properly operate rather than just fire fighting their capital adequacy ratios daily. Till they can start lending money to companies like Disney again and they can offer mortgages to people with need.

But everyone is still angry. Angry with Paulson for making millions when he was at Goldman, angry with all the excesses around us.

If there is anything to blame, I would blame compensation packages of banks and the departments not well compensated enough to break out of the “little old me” mindset.

Maybe stop blaming ?

Yes. We should. Its easy to say its not my fault and I should not suffer. Is there any fairness in the world ? Yes there is. In a social communist state there is. Lehman chaps would be rounded up and put to the firing squad. CEOs will be publicly flogged. But even then, when vengeance is thine, the problem remains.

There is no solution from blame and justice on wrong doers. Spin the wheel and you might find the barrel pointing at you too (read above on milk poisoning and LV’s blame). Paulson said it point blankly right, “the noose is already around the tax payers’ necks”.

Consider the worst case which is do nothing.

Banks will continue to fail. There is no where safe to put your money. Markets are not about fundamentals or technicals, its PSYCHOLOGICAL ! Banks have no money so they cannot lend and business run out of working capital and everyone stops spending. Businesses who employ people will have to make up for their loss in market value have to cut costs. Easiest costs to cut are employees. After cutting costs, they can sell assets which adds to the devaluation cycle. If they cannot cope, then they go under. There goes the rest of the employees. Unemployment shoots up. Crime rates go up. Huge social costs. Countries start closing themselves to the world and move operations home. Countries who lose out panic. Trade embargos and so forth. Cornered rats tend to bite. Maybe a war would be nice.

What people do not realise they are faced with now is, for illustration purposes, a perhaps 50-50 chance of losing their jobs with this bail out with no personal benefits, or 80% chance of losing their jobs but getting the 700 bio as part of compensation. The 700 billion cannot create jobs but its 80% chance of personal enhancement to your pockets at the expense of future earnings. Also note that part of the 700 bio will surely go to paying the social costs of rising unemployment.

People are self centred. That is why they opt for the latter at face value.

The Beauty of the FTC

Mark to maturity. I learnt the meaning of this word today and it has grown on me. Fed borrows at lower costs ie. lower liabilities (Fed had no equity). Which means that they can buy more assets or they can buy more expensive assets for the amount of liability they incur. Sounds good.

Why is the asset only worth 50 cts to the dollar when the Fed is willing to pay 70 cts. Because the cost of our liabilities is higher than the Fed’s!!!

Taking this off your books, and this is a pretty much sound mortgage of a suburban American family, means that banks are lighter on assets and can meet their capital ratios and can start business again.

In any case, the Fed may even turn in a tidy profit on those assets due to their cheaper liabilities and make whole on the asset when it matures.

Risks

What if banks do not start business again ? Then may the laws of capitalism take care of them. Stock price falls and they get taken over.

What if those mortgages that the Fed buys fails ? Slap yourself in the face. Are you going to default on your payments ?

What if companies still retrench workers, people stop spending and default which leads to the prior question ? Chances of retrenchment will be reduced because of bailout (see reasoning above) as chances of corporate failures will be reduced.

Moral hazard is a risk. But these things do happen ever so often in a hundred years. I can recount a few crises myself in my brief 11 years in the market.

Alternative

Yes. Easy.
Listening to all the remarks in congress on limiting executive compensations and short selling. It all sounds like a socialist state is in the making.

Nationalise all banks as they are too valuable and risky to be run by the private sector.

Or the Fed and all the other governing bodies of banks around the world could just relax those capital ratios for a while. Let some restructuring happen at the expense of growth and nature take its course.

Or world intervention ? Group all the sovereign wealth funds together to make this work. But America has none which means America would belong to the world after that.

Most radically. Perhaps all CEO jobs should be pre approved by a governing panel comprising of voting members. Thus when a CEO fails, we can blame nobody but ourselves.

Conclude

Humans love to do it the hard way. No urgency would have been felt if Lehman was not allowed to fail. The crisis could have been dragged out alot longer. We never learn except by falling.

Maybe Congress would not pass the bailout and the worse case scenario will transpire.

Well. We, the “little old me’s”, all live to learn.