#1 Investment Weekly – No PIIGS to SPRIIIGs

For the Spanish speaking peoples of the world, this has been a rough siete dias. The bad news started with the stunning revelation that 80% of the investors in a real estate fund run by Banco Santander wanted their money back – pronto. The US$2.4 billion in withdrawals was obviously too much to ask and Santander (who, it has to be said, has skirted a lot of pot holes recently) responded with a 10% now, maybe another 10 later offer. South American/Caribbean depositors at Stanford International Bank have not been as lucky, as they bid adios to their unprotected cash and US$8 billion worth of 4.5%pa US$ certificates of deposit (JPMorgan CDs yield 1.75%). Unfortunately, Spanish flu is highly contagious, and, in our interconnected mondo, what goes down in the Spanish Main has a knock-on effect everywhere else.

For instance, the investors (in what appears like a concerted effort) that demanded their money back from the Spanish real estate hedge fund run by Santander must have presumably been quite keen to get their hands on some liquidity. Unfortunately, they seemed oblivious to the fact that a real estate fund invests in physical properties which can’t be sold at the drop of a sombrero. If they were unaware of this basic fact, they were also shocked to learn that a hedge fund can refuse to meet redemption demands. These same, by now shell-shocked investors would have started calling other fund managers they had invested with (including Stanford?), only to find they too were politely saying – perdon. These events triggered two reactions: first the investors would have had to find some other avenue of getting their hands on some cash. Selling equities and bonds and anything else that could be instantly turned into dinero would have been the instructions to their private bankers. The second reaction was from other investors who were unaware that their hedge fund assets were not as readily available as they had thought. They too would then start selling anything at hand. Hedge funds would have started to sell to build cash positions, in case of more redemption demands. Financial markets would have watched this unravel and (mostly long) positions would have been reluctantly closed.

I’m not going to get into the appropriateness of the PIIGS acronym, except to add that including Iceland would be a geographically correct inclusion. However, having three Is in the word would be loco. At the same time, the BRICs acronym should probably be shortened to BIC because Russia (and its economic satellites) is an economic basket case too. But no one seems to be talking much about shifting the R to the PIIIGS – thus completing a circle of woes around middle Europe. This would be too stifling and, anyway, SPRIIIGs (even with three Is in it) would be too pleasant a word, and would suggest that these countries are green shoots sprouting from the old tree trunk of Europe (which they are not). A more apt description would be the play things of middle Europe: either in terms of 1) their dependence on the tourist Euro (Spain, Portugal, Italy and Greece) or 2) political levers (in the case of Denmark’s claim on Iceland, Britain’s claim on Ireland (or at least its Oscar winners, authors and its Northern Province) and the ideological conflicts between the decadent West and Russian stoicism). I should probably draw a line under this game of word association and finish by adding that for the current recession to close there has to be a country failure and one of the SPRIIIGs would fit the bill.

Two important support lines for the Hang Seng Index were broken last Friday, as the Dow slipped to a new low overnight. But the contrast between the November low and the current situation is very obvious. For one thing, financial markets appear much calmer than they were three months ago, when we were supposedly looking over the precipice. Everything seems to be moving in slow motion. Generally speaking bear market extensions are much less violent compared with the first panic realization of a problem. There are calmer heads around now, and sellers are being forced into action only because of circumstances elsewhere. The only crumb of comfort for long-term holders of stocks is that even the forced selling has lessened in magnitude.

By way of contrast, the buying in the Shanghai market has been steadily becoming more frantic in recent weeks. This has meant that Shanghai has nearly caught up with Hong Kong in terms of 12 months performance. This outperformance and lifted the Hang Seng A-H Share Premium index to 160, compared with its close last year 119. It also explains why the China A50 Tracker is 5% higher on the year, compared with a 12% decline in the Hang Seng Index. The optimism in Shanghai stems from a degree of bravada by bored blackjack punters that are unable to get to Macau. They are securing funding and are taking a punt that China’s leaders can stimulate the economy and keep corporate profits growing. However, this is an illusion and, as Nelly Futardo has often sung, “lo bueno tiene un final”.

#1 Investment Weekly – Mr G marks his shorts

I’m having a hard time trying to explain to laymen the mechanics of the so called mark-to-market rule that banks are currently struggling with. I try and explain it, but in the end it sounds more like mark to madness. The part that most people don’t understand is this: if you haven’t sold, how come you’ve lost money? I guess I sort of know how US Treasury Secretary Tim Geithner felt as he was drafting his speech to the House Finance Committee last week. He could have blinded them with the intricacies of wonderfully baffling world of accounting and economics, or he could have decided to give up trying to explain the details because no one would understand him anyway. He obviously decided on the latter, thus providing plenty of ammunition for those horrid, sour-pusses, the seemingly un-cooperative Republicans and, of course, those recent rare-breeds, short sellers.

Here’s a good example of what Geithner s up against. It’s a terribly ignorant headline from The Times of London’s web-site. It frantically exclaimed that Barclays’ total assets and liabilities had both risen by Stg600 million in 2008, thus making the bank larger than the UK economy. To an accountant this is an absolutely nonsense headline because, of course, both the assets and the liabilities of a bank must rise by exactly the same amount: that’s why it’s called a balance sheet! The Times was trying to make out that Barclays had piled on loads of liabilities and was therefore in deep trouble (in fact it’s in so much trouble, the extent was larger than the whole of the UK economy). Again, this is drivel, because, as accountants and economists will tell you, a bank’s assets and liabilities are almost perfectly matched, with net worth the difference. Most of a bank’s liabilities are customer deposits, which is the economy. Also, Barclays doesn’t just operate in the UK (it proudly boasted that half its earnings in 2006 came from overseas). The problem facing banks like Barclays right now is that the net worth part of the balance sheet is not sufficient to cover (up?) paper (or mark to market) losses on its investments.

Here’s how I try to explain the part of the mark to market story that doesn’t make sense to ordinary folk. A student borrows HK$100 from his colleagues and buys a HK$100 investment and holds it for a year, but, because there is less demand for that particular investment a year on, the latest traded price has fallen to HK$80. The student still owns the investment and the loan is still HK$100. Why has the owner of the HK$100 investment suddenly “lost” HK$20? One way to explain it is by telling the listener that the old “income statement or cashflow statement” have recently been replaced by accountants by “a real profit and loss account” with the emphasis on the loss part. I can understand if you point out that the owner has “lost” say HK$5 because he had to pay that much for the HK$100 loan, but I should point out that the cash dividend income from the investment covered this cash expense. The HK$20 is therefore a paper loss. But here’s the really maddening part: if the value of the investment rises at the next accounting date, this so-called “income” does not get put back through the P&L. You can only record a profit if you sell it. Unfortunately, when the notice of the HK$20 loss is posted on the school notice board, everyone believes the student is about to go bust and they ask for their money back. This is despite the fact that his cash flow situation has not changed – HK$100 in: HK$100 out. Why should it be that the accountants have decided that the student lost HK$20? – because the price difference must go through the person’s P&L they hark. The accountants’ logic is that 1) they are protecting themselves from litigation because one of their kind failed to spot asset value manipulation at Enron/Worldcom etc and ended up going bust 2) they also point out that financial market participants (wrongly, in my opinion) use accounting based techniques to value investments – rather than discounted cashflow and 3) marking to market offers better transparency and reflects the real value of the investment at one particular moment (10 minutes past four in the afternoon on December 31 to be precise) – never mind that the student’s cashflow was neutral or how the value of the investment moved through the other countless moments of the year or the fact that the owner intends to hold to maturity and has not crystallized the investment’s value. Accountants around the world have been instructed to sign off on accounts like these as “true and fair”. I believe many accountants will have moral issues when signing off accounts this year.

At the precise moment that US Secretary Tim Geithner signed off on the worst introduction of a US Treasury Secretary in years, short sellers on the New York Stock Exchange were heard to be cheering loudly. The longs (myself included) had assumed that President Obama, Paul Volcker et al were a clever bunch of chaps who could string a few intelligent sentences together (apparently Obama takes on average seven minutes to answer questions posed by the press). The framework that Geitner delivered must have been reviewed by all those clever chaps and they must have agreed that it was what the troubled financial markets were looking for. So, how could such an intelligent group of individuals screw up so badly? The answer: they meant to. There can be no other explanation. If they had tried to lay out the details, they would have had to have spent days talking to uninformed politicians/media folk (the same people who want to close down the OTC markets or write ridiculous headlines about UK banks) about the nuances of the accounting rules that now govern our financial world. Instead, they rolled out the campaign slogan of hope (hope you understand, but we’re your only hope. So I hope you don’t mind, but we’ll take it from here. Hopefully, we’ll get it right). Very polite and to the point, Geithner was telling Congress that he doesn’t trust them with the details of his plan, because it is too important to be used as a political football. He saw what was going on with the stimulus package and knew, no matter what, those sore loser Republicans would have tried to include their own suggestions. This would have bogged down the process and would have cemented the impression that bi-partisanship on Capitol Hill (a key Obama deliverable) is really short of reality.

Not very tall in stature, and slightly alto in voice, Geithner presented his snub in a chair that was way to large for him (which was visually and metaphorically interesting) while the shorts egged him on. But the cheers in the short seller pits would have been no louder than they were in mid 2007 (just before they got caught on the wrong side of the final bull bounce). The chart below shows the drop-off-the-cliff of short interest in the US stock market since the ban on financials was introduced in September.

The chart gives a good idea of how much short selling was going on in the financials during 2008, and gives some idea about how some hedge funds came up with their 26% returns last year.

NYSE short interest (billion shares)

A couple of hints about the lack of sincerity of the equities sell-off during Geithner’s speech were the lack of movement in 1) VIX (which has been hovering around the early forties since mid-December and finished on Thursday at its lowest level since January 6) 2) the dollar index and Libor which barely budged and 3) credit spreads (which were steady). Although long bond yields collapsed, as investors switched to the safe haven of Treasuries, this can be explained by the fact that 10 year prices had just crumbled 30% to a peak yield of 3% on February 9 from just over 2% on December 31. China’s reassurances to the Obama people that they will continue to buy US Treasuries and that the decline in PRC trade in January was due to the early Chinese New Year this year were also factors. Talking of which, I’m glad to report that my children received 33% more Lai See this year compared with last. Restaurants were packed during the holidays and Mongkok’s goldfish market was brimming when I visited recently to purchase a HK$10 blue Siamese Fishing Fish and a HK$300 tank (good fung shui I’ve been told). As my children and I are often heard saying: What recession!

I was going to do some housecleaning of the model portfolio this week, but Geithner, the accountants and the shorts have held up the market – for now.

#1 Investment Weekly – Looking back for clues

If anyone wants to understand what a modern banking system looks like during a major financial crisis, there is no better example than Hong Kong’s experience during 1998. In a sense the causes and effects were similar to what is happening with the current financial crisis – with only one major difference, the impact only affected one portion of banks’ balance sheets.

The chart below shows the aggregate balance sheets of Hong Kong’s banks during 1998 and beyond. On the face of it, the directions of the lines on the chart look counterintuitive.

Hong Kong’s M3, financial institution HK$ deposits and total assets (HK$b)

How is it that banks’ deposits continued to rise, even though Hong Kong’s real GDP was shrinking at rates of 6.9% (3Q 1998) and 5.7% (4Q 1998). You can understand that loans were falling, because the banks were busy righting off most of their exposure to China’s ITICs, while loan demand was shriveling, and bankers were so shell-shocked that they were in no mood to lend in any case. I think China’s decision in 1998 to rescind its obligations to support/guarantee the finances of its ITICs is comparable to the US Government’s decision to allow Lehman Brothers to fold (i.e. the lender of last resort option was dramatically removed – without notice), and of course both the 1998 crisis in Hong Kong and the current global malaise were/are both grounded in the (now-understood) premise that nothing goes up forever – particularly property prices, and that cheap, easily available credit is a recipe for financial disaster.

Returning to the chart, the first question that springs to mind is: why was HK$ M3 (and, therefore, by default, deposits) rising when the economy was contracting? To be followed with: what were bankers in Hong Kong doing with their surplus funds?

Hong Kong financial institutions’ surplus HK$ – 1998-2000

I should explain two issues here that are relevant to Hong Kong’s banking system. First, the data refers to all banks in Hong Kong, so it includes foreign banks. This explains why, until March 1999, banks were net borrowers of HK$. However, that deficit soon reversed to a surplus with the process starting in July 1998 when the attacks on the HK$ began in earnest. Second, the HKMA supplies HK$ liquidity to the banking system that it supervises through the pegged exchange rate mechanism. As the financial crisis hit Hong Kong in 1997-98, the HKMA was printing as much money as it possibly could to ensure that there was an ample supply of Hong Kong dollars. At that time, it did so through direct market intervention. Now, it does so through the convertibility undertaking – which is an automatic function in the market which removes some of the guess work it was doing in 1997-98. The HKMA was performing its function as the Government’s financial markets safety net during a period severe economic dislocation. You could replace the Federal Reserve in that sentence and it would pretty much match the current situation. Fortunately, the Fed is not hampered by a currency peg, but it is still producing the desired effect of lifting money supply, even when GDP is contracting.

Difference in balance sheet items
of HK financials Jan-98-Feb00 US M2 (US$b)

As it would appear the response to the crises from the HKMA in 1998 and Fed currently are the same (i.e. print money – US M2 rose 9.9% in 2008), does that mean that bankers are operating in the same way (i.e. hording deposits and shrinking/writing off assets)? I would guess so. So what were bankers doing with their surpluses in 1998? They were investing them. The table above shows the differences in the balance sheet items of Hong Kong’s banking system on January 1998 and at February 2000. There are three things that stand out here on the liability side of the balance sheet: 1) bankers pulled back on their wholesale HK$ funding activities (due to counterparty concerns – ring a bell?) 2) they therefore became more reliant on (cheaper and much less hassle) customer deposits (just like those Wall Street i-banks grabbing retail banking licenses) and 3) the balance sheet was de-levered (from 7x to 6x) (another bell?). On the asset side, the process was simple 1) write off loans (this process is only just beginning, but the write-down of toxic investments had to come first) 2) investments on bank’s balance sheets in 1998 were confined to Government bonds, so there were no write-offs and 3) bankers were putting their surplus funds into “safe” investments (pretty much the same thing is happening again right now) rather than into loans or the interbank. These strategic balance sheet trends occurred over the whole of the period of time.

However, there was a problem with the strategy – it was not very profitable. In the end, bank shareholders demanded changes in the structure of banks’ balance sheets. First, investing in Government bonds was a license to lose money. Why not in invest in paper that yielded much higher returns, with the underlying structure of the bonds linked to the credit performance of corporates that were also loan customers? These “sure winners” yield enhancers were called CDOs. Also, shareholders were asking: why do banks need so much capital and liquidity? They demanded that these ratios be run down. Regulators agreed – after all there hadn’t been a bank default in Hong Kong or almost anywhere else in the world since the early 1980s. Hoisted by their own petard, the regulators looked the other way, confident in their ability to spot trouble ahead of time.

So now the story has been told, what’s the investment idea? As the Fed will continue to keep liquidity loose, banks will continue to absorb this liquidity on the one hand, and invest it with the other. Despite politicians’ pleas for bankers to lend more, as independent commercial entities, they should not be forced to lend during an economic downturn. So where is this surplus cash going? For now it has been piling into short term US Treasuries. However, there is a problem with this; the returns are not enough to cover the cost. Eventually, banks are going to have to look for more yield; thus starting the process of asset price reflation all over again. This explains why recent new bond issuance has picked up, with issues currently being oversubscribed. Last week was the busiest for new issuance since April last year, with Goldman’s US$2 billion 10 year paper, priced at 480bp over Treasuries, being 6x oversubscribed. It was the first non-government guaranteed deal from a financial name since August. Credit markets have taken on the appearance of stability, which should encourage more demand and therefore issuances. Although these issuances are aimed at institutions, adding good names at 480bp over Treasuries sounds like a bargain and should be added to any balanced investment portfolio.

Right now, bank shareholders are sheepishly demanding that their banks simply try and survive, rather than asking for some sort of return on their investment. But the time will come when shareholder demands for excess returns on their investment will rise. Hopefully, by the time that day arrives, the world’s regulators would have implemented checks to ensure that these demands do not become excessive (the root cause, in my opinion, of the current crisis).

The current bear market has still to run its course, but even in downturns, there are rallies (short covering, a false start etc). Global equities are currently experiencing one of those mini-rallies, and it looks to have some traction this time. I’m expecting the HS Index to hit 15,500 in the next few weeks.