Robert Paterson's Weblog

Messy World - Financial Markets - Insurers

At the root of the mess is how all the subprime credits have been structured. The complex securities all have a slice of "Insurance" that makes them prime.

The fear that is gripping Wall Street is that the key insurers are going down - this has the effect of taking all the category down.

Bond insurers could face more pressure today as the stock markets open. Just after midnight Thursday, MBIA reported that it lost $2.3 billion, or $18.61 a share in the fourth quarter, compared with profit of $181 million, or $1.32 a share in the quarter a year ago.

Together MBIA and Ambac guarantee more than $1 trillion in municipal, corporate and mortgage debt and carry a mark of distinction — a triple-A credit rating — a boast that even the most well-heeled of corporations like I.B.M. cannot make.

It's not over by a long shot

Financial Markets - Too Complex to "Manage"

Societe Generale just won an award for risk management in its derivatives area - Now they have taken a $7 billion dollar hit there. CIBC's Chairman sensed there was a problem with CIBC's exposure to subprime - but it took weeks to tease it out.

Most people are aghast at the scale of the damage done to banks and wonder how the control systems could have been so poor. Was it just greed?

I don't think so. I think we are past a threshold of complexity where bank management can comprehend and control risk.

After more than 20 years in a dealing room - I learned one thing. No matter what controls you have, in the end you have to rely on the people. It is always possible to game the system for a while - especially if you are clever and there are few stupid people who have large books on the desk.

My sense is that the leverage implicit in derivatives and the ability to postpone a reckoning makes it possible for the rogue to have the power of taking down the bank. In a simpler world you could mark to market and see where you were and you could look at the long term history of spreads and get a sense of your position. (Traders do not bet whether markets go up or down only punters do that, they like Casino owners bet on spreads that are more predictable)

As derivatives add layer upon layer, the complexity scales in a non linear fashion. Not only can the rogue hide his shit - but the book itself cannot be comprehended.

For me a lesson for all of this would be for the Fed to pull a brains trust together and examine this issue of complexity - is there a way to pull back to a level where it can be understood and hence controlled?

The Mortage Crisis Explained Very Simply

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Some people have the ability to be very clear about complex things. This is a diamond like explanation of how we got into the subrpime mess. Thanks to Maureen McCabe in Columbus who found this at Teri's site who is linked to the author Dan Green whose site is here.

Dan is a real find - there is a lot of great material that helps make sense of what is going on in a clear and straightforward manner. You would never find this in a newspaper and rarely on the site of an agent. Dan is remarkable.

Recession - Must it be stopped? Can It be stopped?

Recently there has been a shift in understanding of forest fires. We are beginning to see that they are an essential part of the lifecycle of a forest. They clean out all the rubbish and they allow the new to emerge.

Today all I read in the policy area is how we might be able to avoid a recession. I wonder, are not recessions also part of our natural cycle? Do they not clear out all the rubbishy ideas about what is possible and then allow the new to emerge?

Is it not healthier, though it hurts, to get rid of a lot of the silly ideas? Silly ideas such as life is all about consumption, that my house is an investment and that credit is free and get back to a more real life where life is about my relationships with others, my house is my home and where I have to be responsible about the obligations I assume?

One of the silliest ideas of all is that economics is everything.

Here is how Henry Mintzberg sees it:

Our narrow view of ourselves as "economic man" has driven a wedge of distrust between our individual wants and our social needs. A distorted view of shareholder value has driven a wedge of disengagement between those who create economic performance and those who harvest it. Our obsession with heroic leadership has created a wedge of disconnection between leaders and everyone else. The glorification of the "lean and mean" organization has driven a wedge of discontinuity between short-term and long-term goals. And the convenient, widely held notion that "a rising tide lifts all boats" has ratified a wedge of disparity between the prime beneficiaries of stock-price increases and the large numbers of people disadvantaged by the corresponding actions.

The authors challenge and deconstruct each of these flawed premises and offer an alternative. Real prosperity, they say, combines economic development with social generosity — and that requires a new philosophy of social and managerial engagement. (via Hugh)

Who got this from Mark - who nailed this today here.

Is it OK now? - Financial Crisis

Here is the DJI since 1960. I posted this to help us get some perspective.

I started at Wood Gundy in the fall of 1972. In 1974 the market had a major collapse and as you can see, it took until about 1983 to come back. My timing was shit and of course none of us made much money then. But the important thing for us today is not my story but to remember what happened to cause the market to go nowhere for a decade.

By 1974 the war in Vietnam was all but over - except that the bills had to be paid. America had gone to war but had operated a peacetime economy. At the same time the oil producers had got control of oil from the oil companies. With the debt from the war and the huge shift in cash from the US to the middle east that took place, the dollar crashed. The Saudis, by this time I was WG's man in Saudi Arabia, could not spend this huge windfall at home so the  oil money flowed back into the  banking  system.

Not having any large demand from credit-worthy customers, the banks lent this mainly to the developing world. 

The result was "stagflation" no growth and high inflation and the default of the developing world debt.

Fortunately this was an era before financial engineering. So the worthless debt was on the balance sheets of the banks but could be carried as sovereign debt being worked out. Earnings were affected but not the viability of the banks.

I can't help seeing a resemblance to today.

A war waged while America went shopping. Huge wave of cash going out to the ME and now to the folks who make our stuff - China. Oil has to go up for other reasons. The banks have lent to the underclass at home this time.

What makes it all more dangerous is financial engineering. No one can get to the underlying assets. I think that a lot of the gains in the market since 1984 have not been about good companies doing well but has been driven by financial wizardry - LBO's vs real growth.

My feeling is that we now have a market that is too complex to comprehend and too disconnected from reality. Why would companies like Merrill lose so much? Because it is no longer possible to know what your real risk is.

This then is where the big risk lies - Is this mainly a pack of cards? In the 1970's most companies in the US and Canada made real things or were linked to real assets - wood, coal etc. Now few are linked to something real - so the downside could be so much greater.

Hope that I am wrong

What would Capitulation look like?

To be close to 1987 - a Drop of the Dow of abut 1,000 points

Want to Understand the China/US Issues? - Jim Fallows makes a major contribution

Jim Fallows who writes for Atlantic Monthly is one of the most thoughtful journalists writing today.

If you wish to get a better understanding about the linkages between China and the US and how our market problems are related - here is an outstanding analysis. (Thanks to a link by John Robb)

What are the linkages - how does our trade end up producing so much cash invested in Treasuries and not investment in China's own economy? How did China's poor end up supporting America's life style? Who is going to make the decisions in China about what to do next and are they equipped? What are the risks of such a tight coupling - a bit like the the nuclear stand off? Will logic rule or may there be a wild card?

For me - the bottom line is fragility and risk. This huge pile of money is "critical" - it could change the world over night depending on where it falls. It reveals again a law of nature - that systems advance to become increasingly inter connected which makes them vulnerable.

When a game of Pick Up Sticks has reached its climax - one move will cause the whole pile to collapse. As the financial markets are telling us - everything is so connected that there are no safe ports in this storm.

The China/US connection is one of the key vulnerabilities in the world today - knowing more about it is I think important to any of us who wonder what is going to happen and what should be our response and or lesson.

The Markets on Jan 22?

Will it be like this tomorrow? The long weekend and the drop in Asia, Europe and Canada presages a dramatic opening on Wall Street.

Financial Crisis - How the flows work

What is going on? How big a problem do we face? here is Rob's simple guide for the perplexed.

It's all about flows.

The money leaves America through two main channels:

Our addiction to oil which is priced in dollars.

Our addiction for stuff - which is mainly made in Asia and paid for in Dollars. Americans hardly make stuff anymore we just do important things like marketing and working in McDonalds.

We buy so much stuff in dollars that the makers of stuff are loaded with dollars. So are the folks who have oil.

They have mountains. They have oceans of US cash. So they push it back into the banking system that is now awash with cash.

The banking system is floating in money - they have to get a return. So what do they do - they lend it to people. But most of the good risks have all the credit they want. So they find a way of lending to people who should not be borrowing.

They think that they are reducing their risks by financial engineering. They take a block of shit mortgages, credit card debt or car loans and package them up and add a "layer" of insurance equal to what they think the normal risk of default might be. The insurer is AAA and the rating agencies rate the package AAA. This works - for a while - when there is not too much of this paper around. But when the market is flooded with this type of paper, the underlying idea of the "normal Risk" covered by the insurance goes out of kilter.

When all the housing market stops going up, then all this paper is under water and the insurance cover is not enough. What was AAA is now shit. Meanwhile, this late in the cycle, everyone has loaded up on the paper.

Everyone wanted a high return when there was so much liquidity that this was impossible. Lender A got rid of its shit but bought Lender B's shit. So did your town and your pension fund.

Worse it was not just the subprime mortgages but the sub prime credit cards and auto loans.

Now what do you do if you are an Oil Sheikh or the Chinese. The value of the dollars that you own is going down as the full extent of the mess becomes visible.

Simply owning the cash is of no value. Selling your dollars will increase your losses. What do you do?

You "Invest" in the underlying assets in America. As you buy in effect control of the banks, you get control of their underlying assets. You buy prime real estate. You buy mines and forests.

What we will see soon is a fire sale of prime assets and a transfer of real wealth - not just cash - from America to China and the oil producers. What we are seeing is a huge transfer of power.

I don't think there is any way to put the pieces back - we are just going to have to live though this.

PS My name is Rob and I was such a banker for 23 years

Merrill Goes to the well again - Financial Crisis

Having just raised 6.2 billion, Merrill has just raised another $6 billion (NYT)

NEW YORK (AP) -- Merrill Lynch & Co. said Tuesday that it is getting a cash infusion of $6.6 billion from three foreign investment funds.

The Korean Investment Corp., Kuwait Investment Authority and Mizuho Corporate Bank will receive a special class of stock for their combined $6.6 billion investment. All will be passive investors and none will have any rights of control.

Both the Korean and Kuwaiti investment groups are owned by the state governments. Mizuho is a Japanese investment bank.

Working with the foreign investors will allow Merrill Lynch to broaden its relationships and operations around the world, Merrill Lynch's new chairman and chief executive, John Thain, said in a statement.

The investors will receive a 9 percent dividend and their class of stock will be convertible to common shares in two years and nine months.

This is the second round of capital raising Merrill Lynch has announced in the past month. On Dec. 24, Merrill Lynch said it would sell a stake in itself of up to $5 billion to Singapore's state-run Temasek Holdings and an additional $1.2 billion stake to Davis Selected Advisers.

Like CIBC - key to get refinanced now while there is still room. Note there is no US money available - we are seeing a significant transfer in power.