Every crisis has it's unsung heroes. When the history books are written on The Great 2008 Credit Crunch, Bear Stearns shareholders - who today handed over their shares to JP Morgan for an Alexander Hamilton - will almost certainly have fulfilled that role. Investors everywhere owe them their gratitude.
The superheroes of the credit collapse have already been well eulogized. There's JP Morgan boss Jamie Dimon in his pin-striped cape swooping in to buy Bear and save the markets from mayhem, alongside Wonder Twins - New York Federal Reserve Bank chief Timothy Geithner and Treasury secretary Hank Paulson.
But the deal these Wall Street Super Friends structured to avoid Bear's spider web of counter-party relationships collapsing the global financial system would not have been possible without the sacrifice of the firm's equity holders, a third of whom included the company's own employees.
Their sacrifice served two purposes. By allowing JP Morgan to assume the 85-year-old firm - the alternative to a rushed bankruptcy and the liquidation of hundreds of billions of dollars of trades - financial Armageddon was arguably averted. Second, by getting no more than a tenner for a stock not long ago worth $170, Bear shareholders became sacrificial lambs for regulators intent on avoiding the nurturance of moral hazard.
So in addition to their $10, should we award Bear shareholders a Lucite plaque for their saviour status? The answer is no. Though they may deserve our thanks, they would have done a greater good by forcing Bear's hapless board, led by absentee chairman Jimmy Cayne, to better fulfil it's fiduciary obligations. Had they done so, the crisis - and the evaporation of Bear Stearns - might have been averted.
Friday, May 30, 2008
Thursday, May 22, 2008
Crude Misconceptions
Just as the credit crunch seemed to be passing, at least in the US, another and much more ominous financial crisis has broken out.
The escalation of oil prices, which this week reached a previously unthinkable $US130 ($135) a barrel (with predictions of $US150 and $US200 soon to come), threatens to do far more damage to the world economy than the credit crunch.
Instead of just causing a brief recession, the oil and commodity boom threatens a prolonged period of global stagflation, the lethal combination of high inflation and economic stagnation last seen in the world economy in the 1970s and early '80s. This would be a disaster far more momentous than the repossession of a few million homes or collapse of a couple of banks.
Commodity inflation is far more lethal than a credit crunch for two reasons. It prevents central banks in advanced economies from cutting interest rates to keep their economies growing. Even worse, it encourages the governments of developing countries to turn their backs on global markets, resorting instead to price controls, trade restrictions and currency manipulations to protect their citizens from the rising costs of energy and food.
For both these reasons, the boom in oil and commodity prices - if it lasts much longer - could reverse the globalisation process that has delivered 20 years of almost uninterrupted growth to America and Europe and rescued billions of people from extreme poverty in China, India, Brazil and many other countries.
That is the bad news.
The good news is that the world is not as impotent as is often suggested in the face of this danger, since soaring commodity prices are not the ineluctable outcome of some fateful conjuncture of global economic forces, but rather the product of a typical financial boom-bust cycle, which could be deflated - especially with some help from sensible political action - as quickly as it built up.
The present commodity and oil boom shows all the classic symptoms of a financial bubble, such as Japan in the '80s, technology stocks in the '90s and, most recently, housing and mortgages in the US.
But surely, you will say, this commodity boom is different?
Surely it is driven by profound and lasting changes in global supply and demand: China's insatiable appetite for food and energy, geopolitical conflicts in the Middle East, the peaking of global oil reserves, droughts caused by global warming and so on?
All these fundamental points are perfectly valid, but they tell us nothing about whether the oil price will soon jump to $US200, stay at $US130 or fall back to $US60 next month.
To see that these fundamentals are all irrelevant, we merely have to ask which of them has changed in the past nine months.
The answer is none.
The oil markets didn't suddenly discover China's oil demand nine months ago, so this cannot explain the doubling of prices since last August. In fact, China's insatiable demand growth has decelerated. In 2004 it was consuming an extra 0.9 million barrels a day; in 2007 it was consuming just an extra 0.3mbd. In the same period global demand growth has slowed from 3.6mbd to 0.7mbd. As a result, the increase in global demand growth is now well below last year's increase of 0.8mbd in non-OPEC production, according to ISI, a leading New York consulting group.
Why, then, are commodity prices still rising? The first point to note is that many no longer are. Rice, wheat and pork are 20 to 30 per cent cheaper than they were two months ago, when financial pundits identified Asian and African food riots as the first symptoms of a commodity super-cycle that would drive prices much higher. And the price of industrial commodities such as lead, zinc and nickel, supposedly in short supply a year ago, has now dropped by 40 to 60 per cent.
In fact, most major commodity indices would already be in a downtrend were it not for the dominance of oil.
But oil is the commodity that really matters, and surely the latest jump in prices proves that demand really does exceed supply? Not at all. In the late stages of financial bubbles, it is quite normal for prices to become completely detached from economic fundamentals. House prices in Florida and Spain kept rising even after property developers built far more homes than they could possibly sell.
The same thing happened in credit markets: mortgage securities kept rising even while banks created special purpose vehicles to acquire vast inventories of bonds for which there were no genuine buyers; and dozens of similar examples can be cited from the bubbles in internet stocks and Japan.
Similarly, the International Gold Council reported this week that gold demand for commercial uses and investment fell 17 per cent in January, just as the gold price surged through $US1000 for the first time.
Now consider the situation today in oil markets: the Gulf, according to ISI, is crammed with supertankers chartered by oil-producing governments to hold the inventories of oil they are pumping but cannot sell.
That physical oil is in excess supply at today's prices does not mean that producers are somehow cheating by storing their oil in tankers or keeping it in the ground. All it suggests is that there are few buyers for physical oil cargoes at today's prices, but there are plenty of buyers for pieces of paper linked to the price of oil next month and next year.
This situation is exactly analogous to the bubble in credit markets a year ago, when nobody wanted to buy sub-prime mortgage bonds but there was plenty of demand for financial derivatives that allowed investors to bet on the future value of these bonds.
In short, the standard economic assumption that supply and demand drive prices is only a starting point for understanding financial markets. In boom-bust cycles, the textbook theory is not just slightly inaccurate but totally wrong. This is the main argument made by George Soros in his fascinating book on the credit crunch, The New Paradigm for Financial Markets. In this book Soros explains how financial bubbles always start with some genuine economic transformation: the invention of the internet, the deregulation of credit or the rise of China as a commodity consumer.
He could have added The Netherlands' emergence as a financial centre triggering Tulipmania or Britain's global dominance as a naval power before the South Sea bubble of 1720. The trouble is that these initial perceptions of a new paradigm tell us nothing about how far financial prices will adjust in response: will Chinese demand drive oil prices to $50 or $100 or $1000?
Instead they can create a self-fulfilling momentum of rising prices and an inbuilt bias in the way that investors interpret the world. The resulting misconceptions drive market prices to a far from equilibrium position that bears almost no relation to the balance of underlying supply and demand.
The people who tell you that commodity prices today are driven by economic fundamentals are the same ones who said that house prices in Britain were rising because of land shortages. The amazing thing is that just months after losing hundreds of billions in the housing and mortgage bubbles, investors and governments across the world have reverted to the discredited fallacy that financial markets always reflect economic reality, instead of the boom-bust cycles and misconceptions that Soros's book vividly describes.
The escalation of oil prices, which this week reached a previously unthinkable $US130 ($135) a barrel (with predictions of $US150 and $US200 soon to come), threatens to do far more damage to the world economy than the credit crunch.
Instead of just causing a brief recession, the oil and commodity boom threatens a prolonged period of global stagflation, the lethal combination of high inflation and economic stagnation last seen in the world economy in the 1970s and early '80s. This would be a disaster far more momentous than the repossession of a few million homes or collapse of a couple of banks.
Commodity inflation is far more lethal than a credit crunch for two reasons. It prevents central banks in advanced economies from cutting interest rates to keep their economies growing. Even worse, it encourages the governments of developing countries to turn their backs on global markets, resorting instead to price controls, trade restrictions and currency manipulations to protect their citizens from the rising costs of energy and food.
For both these reasons, the boom in oil and commodity prices - if it lasts much longer - could reverse the globalisation process that has delivered 20 years of almost uninterrupted growth to America and Europe and rescued billions of people from extreme poverty in China, India, Brazil and many other countries.
That is the bad news.
The good news is that the world is not as impotent as is often suggested in the face of this danger, since soaring commodity prices are not the ineluctable outcome of some fateful conjuncture of global economic forces, but rather the product of a typical financial boom-bust cycle, which could be deflated - especially with some help from sensible political action - as quickly as it built up.
The present commodity and oil boom shows all the classic symptoms of a financial bubble, such as Japan in the '80s, technology stocks in the '90s and, most recently, housing and mortgages in the US.
But surely, you will say, this commodity boom is different?
Surely it is driven by profound and lasting changes in global supply and demand: China's insatiable appetite for food and energy, geopolitical conflicts in the Middle East, the peaking of global oil reserves, droughts caused by global warming and so on?
All these fundamental points are perfectly valid, but they tell us nothing about whether the oil price will soon jump to $US200, stay at $US130 or fall back to $US60 next month.
To see that these fundamentals are all irrelevant, we merely have to ask which of them has changed in the past nine months.
The answer is none.
The oil markets didn't suddenly discover China's oil demand nine months ago, so this cannot explain the doubling of prices since last August. In fact, China's insatiable demand growth has decelerated. In 2004 it was consuming an extra 0.9 million barrels a day; in 2007 it was consuming just an extra 0.3mbd. In the same period global demand growth has slowed from 3.6mbd to 0.7mbd. As a result, the increase in global demand growth is now well below last year's increase of 0.8mbd in non-OPEC production, according to ISI, a leading New York consulting group.
Why, then, are commodity prices still rising? The first point to note is that many no longer are. Rice, wheat and pork are 20 to 30 per cent cheaper than they were two months ago, when financial pundits identified Asian and African food riots as the first symptoms of a commodity super-cycle that would drive prices much higher. And the price of industrial commodities such as lead, zinc and nickel, supposedly in short supply a year ago, has now dropped by 40 to 60 per cent.
In fact, most major commodity indices would already be in a downtrend were it not for the dominance of oil.
But oil is the commodity that really matters, and surely the latest jump in prices proves that demand really does exceed supply? Not at all. In the late stages of financial bubbles, it is quite normal for prices to become completely detached from economic fundamentals. House prices in Florida and Spain kept rising even after property developers built far more homes than they could possibly sell.
The same thing happened in credit markets: mortgage securities kept rising even while banks created special purpose vehicles to acquire vast inventories of bonds for which there were no genuine buyers; and dozens of similar examples can be cited from the bubbles in internet stocks and Japan.
Similarly, the International Gold Council reported this week that gold demand for commercial uses and investment fell 17 per cent in January, just as the gold price surged through $US1000 for the first time.
Now consider the situation today in oil markets: the Gulf, according to ISI, is crammed with supertankers chartered by oil-producing governments to hold the inventories of oil they are pumping but cannot sell.
That physical oil is in excess supply at today's prices does not mean that producers are somehow cheating by storing their oil in tankers or keeping it in the ground. All it suggests is that there are few buyers for physical oil cargoes at today's prices, but there are plenty of buyers for pieces of paper linked to the price of oil next month and next year.
This situation is exactly analogous to the bubble in credit markets a year ago, when nobody wanted to buy sub-prime mortgage bonds but there was plenty of demand for financial derivatives that allowed investors to bet on the future value of these bonds.
In short, the standard economic assumption that supply and demand drive prices is only a starting point for understanding financial markets. In boom-bust cycles, the textbook theory is not just slightly inaccurate but totally wrong. This is the main argument made by George Soros in his fascinating book on the credit crunch, The New Paradigm for Financial Markets. In this book Soros explains how financial bubbles always start with some genuine economic transformation: the invention of the internet, the deregulation of credit or the rise of China as a commodity consumer.
He could have added The Netherlands' emergence as a financial centre triggering Tulipmania or Britain's global dominance as a naval power before the South Sea bubble of 1720. The trouble is that these initial perceptions of a new paradigm tell us nothing about how far financial prices will adjust in response: will Chinese demand drive oil prices to $50 or $100 or $1000?
Instead they can create a self-fulfilling momentum of rising prices and an inbuilt bias in the way that investors interpret the world. The resulting misconceptions drive market prices to a far from equilibrium position that bears almost no relation to the balance of underlying supply and demand.
The people who tell you that commodity prices today are driven by economic fundamentals are the same ones who said that house prices in Britain were rising because of land shortages. The amazing thing is that just months after losing hundreds of billions in the housing and mortgage bubbles, investors and governments across the world have reverted to the discredited fallacy that financial markets always reflect economic reality, instead of the boom-bust cycles and misconceptions that Soros's book vividly describes.
Friday, May 2, 2008
Banks - The Next Dot-Com Crash?
Accounting was invented by a Franciscan monk in the 15th century, but its First Rule - called "matching" - is still good today. It says that to compute true profit, you must match revenues with all costs that gave rise to these revenues. If you neglect even some costs, intentionally or otherwise, the resulting "profit" is incorrect, and may even be imaginary.
As an example, in the 1990s many tech companies wrote off cost of capital (mainly research and development) instead of amortizing it - and so did not include its portion in the price of the product. As a result they underpriced their gizmos, which, because of their low prices, then sold in large volume until the R&D "ran out" (became stale), and the companies had no money for new products. The products died, and the stocks melted.
When you sell below true cost, sooner or later you come to grief, whether you are a tech company, or a bank.
We already saw what happened when banks sold subprime mortgages below their real cost (which should have included the high risk of default): The imaginary "earnings" that banks booked over many years suddenly had to be wiped out in one year.
But what of bank loans to legitimate corporations? And what of derivatives - daisy-chain obligations to other banks or financial institutions? Are they priced any better? The answer is, most likely not. You see, most bank loans and derivatives today are based on a benchmark called Libor - the London interbank overnight rate. That's the cost of money that banks charge each other for overnight loans. Every morning, banks report the interbank rates they charged the previous night, then compute an average after tossing out the highest and the lowest rates. (This is done so no one bank can manipulate the average by reporting an extreme number.) Normally this works well. But recently, with the near meltdown of the financial system and the failure of Bear Stearns, banks have often been reluctant to lend to each other, even overnight. Because of this, the U.S. Federal Reserve Board had to lend to banks even against junky assets - subprime mortgages that may never be paid off in full - and the Bank of England even took over a failing bank. But banks still need to borrow from each other. Only now they do it at higher rates than they report, apparently.
How do I know? Because the BIS (Bank of International Settlements - a sort of central bank for central banks) said so. There is an apparent fudging going on, the BIS said, and the result is that Libor is likely higher than reported.
Why is this important? Well, Libor is the base rate on which almost any serious money being lent today is priced. A large industrial mortgage, say, may be priced at 2 per cent more than Libor, a corporate bond at an extra 1.5 per cent, and some derivatives at 3 per cent more.
Thus when Libor goes up, so does the cost of borrowing - as does the revenue of the banks, based on interest payments. But what if Libor goes down? Or even worse: What if Libor actually went up, but banks reported it as going down? What happens to true bank profits then?
Let's focus on the profit. Because what if banks, too ashamed to admit they have to borrow at high costs, understate these costs? What if they collectively, allegedly, start fudging Libor? Then, like dot-com companies that ignored cost of capital when they computed the cost of their gizmos and deluded themselves into thinking they were making money, banks, too, might be deluding themselves into thinking they are making money on Libor-based loans and derivatives, when in truth they are making much less, or perhaps even losing.
And if this is indeed the case - if the BIS is right and Libor is understated - then more bank writeoffs may be coming.
Just how much?
Well, here's a quick calculation: There are about $600-trillion (U.S.) in derivatives outstanding. The BIS thinks that Libor may be understated by about 0.3 per cent. Let's see now: 0.3 per cent of $600-trillion is about $1.8-trillion, or about 13 per cent of U.S. gross domestic product. This equals about four to five years of U.S. economic growth, or about twice the cost of subprime writeoffs to date. If Libor is repriced properly, surely there will be an impact.
Just how soon will this impact be felt? Perhaps not too far off. First, a BIS committee is now looking into the alleged fudging issue, so this may cause reported Libor to go up. But second, since it's unhealthy for North American loans to be based on European rates, something called NYibor has been suggested - the New York interbank overnight rate, an average based on overnight lending costs of North American banks. I suspect, however, that instead of alleviating the problem, this would only expose it: Once true overnight North American lending costs are shown, the base rate for all loans may go up, and more writeoffs may follow.
By that time the next leg of the bear market will very likely resume.
So continue to be wary of dicey financial stocks, stay liquid and bide your time. The real panic is probably yet to come.
As an example, in the 1990s many tech companies wrote off cost of capital (mainly research and development) instead of amortizing it - and so did not include its portion in the price of the product. As a result they underpriced their gizmos, which, because of their low prices, then sold in large volume until the R&D "ran out" (became stale), and the companies had no money for new products. The products died, and the stocks melted.
When you sell below true cost, sooner or later you come to grief, whether you are a tech company, or a bank.
We already saw what happened when banks sold subprime mortgages below their real cost (which should have included the high risk of default): The imaginary "earnings" that banks booked over many years suddenly had to be wiped out in one year.
But what of bank loans to legitimate corporations? And what of derivatives - daisy-chain obligations to other banks or financial institutions? Are they priced any better? The answer is, most likely not. You see, most bank loans and derivatives today are based on a benchmark called Libor - the London interbank overnight rate. That's the cost of money that banks charge each other for overnight loans. Every morning, banks report the interbank rates they charged the previous night, then compute an average after tossing out the highest and the lowest rates. (This is done so no one bank can manipulate the average by reporting an extreme number.) Normally this works well. But recently, with the near meltdown of the financial system and the failure of Bear Stearns, banks have often been reluctant to lend to each other, even overnight. Because of this, the U.S. Federal Reserve Board had to lend to banks even against junky assets - subprime mortgages that may never be paid off in full - and the Bank of England even took over a failing bank. But banks still need to borrow from each other. Only now they do it at higher rates than they report, apparently.
How do I know? Because the BIS (Bank of International Settlements - a sort of central bank for central banks) said so. There is an apparent fudging going on, the BIS said, and the result is that Libor is likely higher than reported.
Why is this important? Well, Libor is the base rate on which almost any serious money being lent today is priced. A large industrial mortgage, say, may be priced at 2 per cent more than Libor, a corporate bond at an extra 1.5 per cent, and some derivatives at 3 per cent more.
Thus when Libor goes up, so does the cost of borrowing - as does the revenue of the banks, based on interest payments. But what if Libor goes down? Or even worse: What if Libor actually went up, but banks reported it as going down? What happens to true bank profits then?
Let's focus on the profit. Because what if banks, too ashamed to admit they have to borrow at high costs, understate these costs? What if they collectively, allegedly, start fudging Libor? Then, like dot-com companies that ignored cost of capital when they computed the cost of their gizmos and deluded themselves into thinking they were making money, banks, too, might be deluding themselves into thinking they are making money on Libor-based loans and derivatives, when in truth they are making much less, or perhaps even losing.
And if this is indeed the case - if the BIS is right and Libor is understated - then more bank writeoffs may be coming.
Just how much?
Well, here's a quick calculation: There are about $600-trillion (U.S.) in derivatives outstanding. The BIS thinks that Libor may be understated by about 0.3 per cent. Let's see now: 0.3 per cent of $600-trillion is about $1.8-trillion, or about 13 per cent of U.S. gross domestic product. This equals about four to five years of U.S. economic growth, or about twice the cost of subprime writeoffs to date. If Libor is repriced properly, surely there will be an impact.
Just how soon will this impact be felt? Perhaps not too far off. First, a BIS committee is now looking into the alleged fudging issue, so this may cause reported Libor to go up. But second, since it's unhealthy for North American loans to be based on European rates, something called NYibor has been suggested - the New York interbank overnight rate, an average based on overnight lending costs of North American banks. I suspect, however, that instead of alleviating the problem, this would only expose it: Once true overnight North American lending costs are shown, the base rate for all loans may go up, and more writeoffs may follow.
By that time the next leg of the bear market will very likely resume.
So continue to be wary of dicey financial stocks, stay liquid and bide your time. The real panic is probably yet to come.
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