mindmoneymarkets

Extended volcanic weekend reading

I've had a lot of time to kill over the last few days thanks to busy travel schedule made even busier by the volcano. We were due to fly from Vancouver at 4 on Thursday via the cheapo Canadian Affair (Thomas Cook airlines). The website kept saying the flight was due to leave for Gatwick at 7.15 PM, just 3 hours delayed. Several phone calls to their customer service claimed the same. This was despite everyone else in the entire world knowing that Gatwick was closed unlikely to open in time for us to land. 

Shoddy customer service is par for the course in my experience with Canadian affair. With low expectations we arrived at the airport, walking past the closed BA desks to a small but confused mob of people at the Canadian affair desks.

One hapless chap was trying to tell us what was going on, not helped by the fact that not a single Canadian affair central office bod had deemed it useful to stay up late, so no-one at their end could be contacted.

The plan was to fly via Glasgow then a 12 hour coach ride down to London. People we confused as to why crappy little Thomas cook was flying and not BA etc. The captain was brought out to explain that Glasgow was open and the cloud had lifted over that airspace. We had been given one of the slots in the lottery.

Eventually we took off for Glasgow, but landed in Manchester with a mercifully shorter coach ride to London. We didn't realise just how lucky we were to make the wedding on Saturday until we saw the news in the UK and saw the full extent of the flight ban.

Anyhoo, on to the book review....

The delays over the weekend weren't too bad and with all the travel we've been doing, I've been able to finish off too very good books. 

Reckless

The first is Reckless: The Rise and Fall of the city by Phillip Augar. I was a big fan of his previous book - Merchants of Greed, written about the dangers of investment banking from a first hand perspective. It was very well researched and prescient given what was to come with the Credit Crunch.

Reckless (also released as Chasing Alpha), takes a wider look at the City of London and how it rose to prominence in the last couple of decades and the implications this had during the credit crunch. Augar takes a look at the political, regulatory and geographic factors that all contributed to the city's success. The FSA's light touch regulatory environment played a crucial role in ensuring business took place through London.

With the election debate raging in the UK, the political implications are fascinating. The book is apolitical, explaining how previous governments all played their part. The biggest blame has to go to the most recent labour govt though as the city boomed to dangerous levels under their watch. It seems the govt was too entranced by the money pouring into public coffers to dare question the risks that over reliance on this sector posed. Rather like the banks and hedgefunds themselves who were quite happy to dance until the music stopped.

I enjoyed the book and thought that the sections on regulation and the history of the city were particularly strong. Some sections were disappointing though with the section on Northern Rock revealing nothing more than has already been reported elsewhere.

I'd recommend it though particularly with the UK general election round the corner. This and the next book I'll be mentioning both give lie to Gordon Brown's claim that Britain has been an innocent victim of a US led global credit crunch.

Far from being an innocent victim, consider the following:

• 50% of the dangerous OTC derivative trades went through London thanks to the light touch regulation. The recent Goldman's headlines involve a trading working from a desk in London.
• The same regulation played a role in the collapse of Lehman brothers thanks to the use of their repo 105 accounting sleight of hand, made possible by lighter UK accounting rules. 
• Many British traders were involved in the creation of the Credit Default Swap market as Gilliant Tett outlines in her book I review below.
• AIG Financial Products was the division of AIG responsible for the Lion's share of the firm's losses due to taking on CDS liabilities. This division based mainly in London. 

Fool's Gold

With irony, I finished Gillian Tett's Fool's Gold, just as the news was breaking on the Goldman Sach's charges. The story chronicles the creation of Credit Default Swaps and other OTC derivatives by focusing on the small JP Morgan team responsible for their creation.

I was absolutely gripped by the narrative. Not only is the book well researched, it is a heck of a good read. We start with the tales of the close knit group excited by the financial game changer their created and move forward through the years as other banks latch on to the idea without fully understanding its implications.

The JPM team originally applied CDS to commercial loans but couldn't figure out a way to apply to mortgage securities due to lack of past data and concerns over correlation. Other banks quickly out paced JPM with their derivatives trades as they applied CDS to the one area JPM couldn't get to work - mortgages. Three times they tried to figure out what they were missing, what other banks had spotted that they couldn't and each time stepped back from the deals.

The truth was quite simple as the Goldman's case implies. Other (investment) banks either did know about the risks and pushed through deals anyway, or just didn't understand what they were buying and selling. 

The are some incredible lessons to be learned for ones personal trading such as not trading markets,  ideas or strategies you don't understand.

I found Fool's Gold to be absolutely fascinating and highly recommend it.

Hung parliament, really?

Apologies, but I need a rant this morning.

This morning I work up in a great mood that was soon dashed. I've thoroughly enjoyed living in Vancouver throughout the winter Olympics. There has been a great atmosphere in the City with residents keen to soak up the atmosphere and get involved where possible. The outpouring of Canadian pride has been a pleasure to behold with all their sporting success.

It's not just the hockey, every medal and has been celebrated with style. What a hockey game it was last night, I barely understand the game but was never high 5'd so many strangers in the bar last night. There were great celebrations and not a fight to be seen despite a crowd crush near Robson square (which I was in the middle of).

I've been embarrassed by the coverage in the British press, like the articles from this poindexter. The decision to host some (emphasis some) of the events at Cypress was a gamble that shouldn't have been made. I understand why they did it, to get as many events as possible close to the city, but it was a gamble at the end of the day.

However, largely missed by the British press is the fact that they soldiered through admirably and the events held there were a great success barring the cancellation of a number of tickets. Speaking to friends back in the UK, you'd think the whole olympics were ruined due to lack of snow, when most of the blue ribbon down hill events were on Whistler which is having a record snow year. 

With regard to the luger, it was of course tragic and there should be a full independent inquiry. Anyone found to be at fault should be held liable. At the same time though, it was one event the games should have stopped because of it. 

A friend read me some criticism of the games from A Russian newspaper. It was a dumb article that veered well away from the games and spoke of Canadas little brother status and colonial overhang. None of which was accurate or had anything to do with the games. The journalist? A British Expat living in Russia.

I raise all this, because I woke up to this:

I currently earn £ but am living in Canada hence my bad mood this morning.

That's the pound vs Canadian dollar exchange rate. My records only go back to 1990, but its certainly the lowest levels since then.

It's not just the Canadian dollar.

I realised I missed off the GBP/ USD, but you get the picture!

According to some commentators, the pound is increasingly trading like an emerging market currency. 

Today's falls have been attributed to fears of a hung parliament and while that may be true, it's not the root cause of the sell off. Why would a hung parliament be so bad? Because the UK's structural deficit would not be dealt with so effectively or so quickly.

Let's not lose focus on that, for that is the real issue here. It's like blaming the short sellers for bringing down RBS and HBOS. The problem was the massive bets those banks made that went sour, not the short sellers (although they didn't exactly help things either). 

The UK's finances are a mess, yet the party that created this mess (a decade in power is too long a time to go back and blame the old lot) is still in with a sporting chance of holding to power in some form or other.

Come on British media, instead of crowing over an amazing sporting event, how about you focus on a real disaster - The UK economy.

Last week, there was a flurry of positive stories after the UK GDP numbers came at better than expected 0.3% vs 0.1%. "strong" was the word being used to describe the numbers in traditionally right leaning newspaper websites such as the telegraph and times. Yet almost immediately the pound sank because traders realised it wasn't an upwards revision at all. It was a downgrade because past data was revised downwards. The recession was worst than previously feared.

The papers led with headlines that the figures boosted Brown's election chances. These were pulled after it became evident that the figures weren't as positive as first thought, but the damage was still done. Why oh why did they go to Brown or Darling for a reaction to the news instead of looking at what the markets thought. I know who I trust for a more accurate reaction. 

Why are politicians on both sides still being allowed to get away with vague answers on budgets? If a business CEO acted in this way, they'd be reported to this FSA.

Here's a recent example:

"In a bad tempered exchange on BBC Radio 4's Today programme, Mr Denham refused seven times to quantify the amount councils may have to cut spending.He insisted that cuts in front line services would not be necessary if councils made efficiency savings elsewhere."

Ah the old efficiency savings chestnut. Why is it left to bloggers like Guido Faulks to do the investigative journalism?

The bookies currently put the odds of hung parliament at 2.25 to 2.5, that's implied odds of 44%. Taking into account the bookie overround, the prediction is currently something like 40% chance. Still too close for my liking.

Tory cuts vs Labour investment. Do we still have a choice? Greece has largely had that choice taken away by the EU because it  was living in a fiscal fantasy world.

Going back to Canada, it's not a perfect country. It has a large government involvement in certain areas of life such as health care. In BC car insurance is largely state run, leading to exorbitant insurance premiums. The downtown East side is  problem brushed under the Olympic carpet.

It's not perfect, but judging by the recent exchange rates, its doing something right. Today Canadian GDP came in above expectations and has been out of recession since November. It's no picnic here in Vancouver, jobs aren't exactly abundant, but people are getting through it.

Back in the 90's Canada was faced with a huge public sector deficit and dealt with it head on. It dealt with it head on with hard, large scale public sector cuts.

It's the Tory's election to lose because they've pussy footed around the issue of cuts. Tell us like it is and for once tell us exactly what you are going to do with real numbers. The Tory poll numbers are quite frankly a disaster given what labour has done to the country. Show us a) you have a clear plan on what to cut b) you're not going to sugar coat the message.

Rant over!

Swimming naked

I love this quote from Warren Buffet:

"It's only when the tide goes out that you find out who's been swimming naked"

For me it kind of sums up this whole financial crisis. From RBS to Greece, the common thread is of companies and governments engaging in a) high risk strategies for short term gain with long term liability b) financial jiggery pokery to hide bad news c) both of these.

There is a quite frankly amazing post from FT Alphaville about the currency swap deal performed by Greece aided by Goldmans which to all intents and purposes hid the truth so they could enter the euro.

The incredible part is the S&P wrote on warning on this deal 8 years ago.

The best quote is here:

"In sum, de facto borrowing swaps do not have a positive impact on fiscal flexibility. If anything, they help to undermine transparency and, therefore, jeopardize trust in official accounting. Where uncertainty about the effective debt exposure of a government increases, an additional risk spread on the concerned issuer’s securities might be demanded by investors, thereby potentially defeating even the intended short-term purpose of improving the cash flow."

Again it brings up another thought from another wise man of finance.

When asked if there have been any financial innovations of use in recent years, Paul Volcker replied.."the ATM".

Richard Thompson has some prescient stories on the misuse of financial derivatives in his old but excellent book, Apocalypse roulette. The standout is perhaps the bankrupting of Orange County CaliforniaI'm an certainly no expert in these complex deals, indeed, I think that's the point. In some cases you have to be a rocket scientist to understand them and their implications. This is fine as long as there are well placed rocket scientists on the side of the speculators/ companies/ governments and on the regulatory bodies. In the case of Greece though, it seems that the regulator was behind the curve, just as the ratings agencies and numerous financial bodies failed to appreciate the real risk with the sub prime market.

Perhaps that's just human nature. If something is arcane and complex, the human mind has trouble fully appreciating risk that it cannot see or feel. We fear a high cliff, adrenaline kicks in, but what about the risk of Greece defaulting due to a complex currency swap?

Whatever the case, history seems to be repeating itself. To quote a not so wise man, it's dejavu all over again.

My own thought is that regulators need to put more stock behind the emerging field of behavioual economics. You can't control people, but with a greater understanding of human biases and blind spots, regulators (and perhaps the public) we might be able to avoid the aforementioned apocalypse roulette.

Animated bank reforms

The FT have put up an excellent presentation on the reforms proposed by President Obama

Clicky

As the conclude at the end, it will be interesting to see what kind of watered down reform gets through congress.

Very interesting interview with Volcker here

Finally - Real, lasting reform

I touched on this in a previous (rather rambling) post. Up until now, there have been no real hard hitting reforms in regard to banking regulation.

Well that all changed today. Just in case you missed it, here's a summary of the news.

In effect, Obama has announced much tougher banking reforms than many people expected. Despite indications to the contrary, he's listened to Ex Fed chief Volcker's arguments about the need for smaller banks with separate investment and retail banking operations (bringing back Glass-Steagall type regulation). 

Chapeau Mr Obama. 

Glass-Steagall was brought in after the banking crisis of the 30s era and repealed in 1999.During this time, the Dow had an annualised performance of 9.1% with a standard deviation of 14%. Since the repeal the Dow has made -1.9% per year with a volatility of 16%.

This is not a great comparison because 1999 marked the very top of the markets, but its hard to argue against the evidence in the form of the credit crisis since the repeal.

Let's hope the UK follow the US lead and announce a similar ruling. Would RBS be in state hands if there was such legislation in the last decade? I seriously doubt it. It might be in trouble, but perhaps not to the extend that it would need to be bailed out.

One problem is that Obama's reforms appear to also suggest a need to keep banks small and not have a few banks dominating the market. In the UK, the Lloyds/ HBOS behemoth would need to be broken which would be no mean feat and no doubt further bad news for Lloyds shareholders.

Change we can believe in?

Change we can believe in?

There was a heck of a lot of talk in the intimidate aftermath of the credit crunch regarding regulatory changes that would be made, but what if anything has actually been done?

Sure there are some capital ratios that have been tweaked, but what about wider, more pervasive changes?

My argument is that the credit crunch happened due to flaws in human psychology - well duh! you might say.

But if this is such an obvious explanation, why are all the proposed changes still ignoring well known and well researched biases from the world of behavioral economics?

In the years leading up to the bust, banks were run with a testosterone fueled target driven culture. Want your bonus? hit your targets! This comes from the top down. Your boss is screaming at you to make the numbers because his bonus depends on it, you in turn scream at your underlings and so on.

Somewhere in this process corners are cut. Risk factors were ignored.

Picture the broker in this situation. He knows he has to turnover X amount to make his bonus.

He could play it safe or deal with the new fangled CDOs. He might question,

"Is this CDO really worth £X million, should it really be AAA rated?"

He gets that feeling of doubt in his stomach. It doesn't feel 100%, but he knows he's got to make his numbers. Anyway everyone else is dealing in them and if they go kablooey in 2 years, he'll still get his bonus.

Maybe it's not his own greed that's driving this. Maybe its the desire to not let the team down, keep his boss happy. Maybe it's not the money per say but his station amongst his peers. Come bonus time, they'll be buying another flat in Chelsea, how will he feel if he can't even take his wife on that holiday?

Now, I'm not for a minute saying all bankers were or are bending the rules like this. I have some good friends working in the banking industry who are fine upstanding fellows. What I'm trying to demonstrate is how easy it is for someone to start cutting corners and trading in assets they wouldn't otherwise touch with a barge pole.

There are two behavioral traits at work here.

1. As explained here, if your peers are bending the rules you are more likely to as well. 
2. No-one starts out believing or thinking they will bend or break their own moral boundaries, but breaking/ bending the rules one bit at a time can lead to a point that you would have thought unthinkable at the outset. When they interviewed the people involved in the Watergate scandal, they asked certain people how they let themselves get to that point. The answer was simple, they did it one small rule break at a time.

Where does that leave us now?

There's nothing wrong with an aggressive bonus/ target driven culture per se. Many business use this model. It works fine most of the time. However, all too often, aggressive targets can encourage some bending of the rules. This might be selling something to someone you know isn't appropriate for them. Most of the time, this will result in a loss of business. If you sell faulty goods, it usually won't take much time for the client to realise they've been duped and complain, then look for someone else to provide the service.

But what if the payback period is over years not months. What if you could sell something to someone that might have hidden risks, but those risks won't become apparent until next year, or maybe 2 years down the line. What if the risks aren't clear? The seller might be able to justify to themselves that they have no way of knowing how the future will work out and the buyer should be sophisticated enough to know this anyway. You might then be temped to sell something you wouldn't want to put your own money in.

You can see that the financial markets could be highly prone to mis-selling in these circumstances. 

The last few major financial bubbles demonstrate this well.

We've had a junk bond frenzy, tech stock bubble, Asian stock bubble and of course mortgage bond mania. 

We can't say we weren't warned, plenty of well placed people have shared their experiences of working inside an investment bank or written about the reasons for past explosions.

Richard Thomson's Apocalypse Roulette from 1999, and Phillip Augar's Merchants of Greed  (2006) provided some clear examples of the culture running within investment banks and how they gave rise to the current crisis.

What's next?

Because unless there are real changes, there will be a next time. China? Oil?

So what is the answer?

Gordon Brown's call for a tax on banking won't work, or at least as well as he hopes. You're dealing with 'the smartest guys in the room' who will no doubt find a way to minimize the impact by driving revenue offshore or using over the counter products. No doubt it will be the retail investors who end up bearing the cost without the added protection it is supposed to be bringing.

Brown is right on one level though, any changes need to be applied across the globe.

Ideally, bonuses from the very top down would be tied to long term results. For example, 10 year stock options with tiered payouts that rover the years reward long term performance. This is in an ideal world though and may be hard to implement.

Perhaps the best option as proposed by the likes of Talleb, and ex Fed chairman Volcker etc is to make banks smaller and to split investment banks from retail banks. The speculative operators can therefore gamble away and fail without bringing down the whole system. The trouble with this argument is that the financial system is now so tightly interlinked that a supposedly small independent operator could cause a ripple effect.

There's probably no single solution and mandatory training on previous collapses and insights into human psychology for new employees would probably help too.

Banks do provide training on the dangers of insider trading and brokers have achieve various qualifications before being let loose with client funds. Adding a compulsory module on behavioral economics and lessons from the past sure won't hurt.

Thanks Darling – Thoughts on the PBR

Some reflections on the PBR

Greece had its sovereign debt rating downgraded this week. It now has the lowest rating in the eurozone, closely followed by Ireland.

So what does this mean for the UK's credit rating and does it matter?

Following the PBR, UK CDS widened. According to CMA vision, the UK's sovereign debt is now riskier than Portugal's and even Chile.

Also the UK is now bottom of the borrowing league tables ahead of Ireland and Greece for 2010 and 2011.

So far, the UK has not had its debt downgraded because of its perceived ability to keep up its payments. Will this last though?

According to FT Alphaville:

"Alistair Darling, the UK Chancellor, said UK taxes would be going up - especially for the rich - and that public spending would be cut significantly. But there was a lack of detail on the latter point and investors are pricing in some skepticism on the government’s projections, both on the deficit reduction and on the 3.5% growth estimate for 2011 and beyond. UK spreads widened significantly throughout the day, as did Ireland’s"

As for the rest of the PBR, my two penneth worth is that it didn't go far enough in terms of cuts and to increase spending right now is not the right thing to do. I don't think we needed to slash and burn like the Irish government, but I can't believe that no savings could be made from non front line services.

We can only afford this on the assumption that Darling's growth forecasts aren't wildly optimistic……….

There was that old classic 'efficiency savings'. How many much money has been saved from efficiency drives from the government in the last few years?

The bankers' tax probably had to be done, politically, but it will serve little purpose and raises little money in the grand scheme of things. It's interesting that most of the money raised will come from the NIC hike and cap on public pensions. The pain from the former won't be felt until after the election and the impact of the latter will only come through in the long run. Yet the bonus tax is implemented immediately.

In my humble opinion, we have to be pragmatic. The financial services industry is still a major part of the UK economy. Together as tax payers we virtually own RBS (84%) and Lloyds. We're liable for 90% of losses above the £60bn in the case of RBS and they've eaten half way through that. If RBS were to step beyond this £60bn or go under, all the 'efficiency savings' will be a drop in the ocean. It would therefore be in the nation's best interests to make sure that RBS can retain talent that will help become a viable business once again.

Shutting the door after the horse has bolted could be harmful to us as tax payers, no matter how satisfying the blood letting may feel.

In the long run, wholesale changes are needed to the industry – changes that have been talked about, but with no concrete action.

Investment banks need to be split from retail banks. The investment banks can then gamble away with the hedge funds without putting our money on the line. The Glass-Steagall act needs to be reinstated. Even Ex Fed Chairman Volcker believes this as does Mervyn King.

As a wider question, do investment banks serve a socially useful function?

Have a read of this book and it's hard to argue the case.