Thursday, 2 August 2007

Here We Go Again: The One-Way Bet

So a number of financial institutions that ought to have known better – nay, did know better – wagered the farm on sub-prime debt or derivatives thereof. As the skies darken with chickens coming home to roost, the usual cry goes up, “a Banking Crisis !”, and out come the financial mountain-rescue teams across the banking centres of the world.

So what happened to the Investment Services Directive, Capital Adequacy, Basels I and II ? Why do we give these greedy buggers their one-way betting slips ?

Let’s be clear: banks know what they are doing. Whenever there are serious penalties on offer for ignoring risk – e.g. when preparing a prospectus for a flotation – they all know how to fill out the ‘Risks’ section, in elaborate and blood-chilling detail. Curiously enough, though, when it’s day-to-day business, largely conducted out of sight, suddenly their risk management expertise goes out the window: it’s all too complicated and … well, if we lose enough, they’ll bale us out.

Why do we indulge them ?



Old BE said...

Indeed. And whether the market and pension funds are rising or falling there still seems to be enough money for Ferraris!

Mark Wadsworth said...

"Bail out"

Apart from that, agreed. The gimmick is that the banks can lay off most of the risk with hedge funds, which in turn are run by clever people at the expense of rich, stupid people.

So actually this is a good thing, the whole package is quite redistributive, from rich to not-so-rich and from stupid to clever.

Garbo said...

Thanks for you kind words on the poliblogs CityUnslicker - much appreciated

Anonymous said...

Surely the basic problem is that a mortgage lender can do only one thing - lend to home buyers. When it reaches the point where all the homebuyers are maxed out on their current "reasonable" earnings multiples the market for mortgages shudders to a halt - but there may still be plenty of liquidity searching for a home, if the liquidity has been sourced on global finance markets at low rates. So the lenders just change the rules to widen the market to riskier investments. They did this during the 80s with 110% mortgages and they are doing the same now. Abbey is leading the charge by offering mortgages at 5x income - no big surprise as Abbey has been struggling for some time and matters can only have got worse since Santander bought them up.

Problem is that the increased risk of investing in the mortgage market has suddenly become apparent, thanks to what is happening in the US, and so liquidity is becoming more expensive. Thus UK mortgage rates will start to rise regardless of what the BoE rate is simply because of this apparent increased risk.

The real fear has to be that so much money is invested in housing both here and the US that a collapse in the market created by bad lending will result in banking failures on a wide scale, a collapse in dollar and sterling values and a collapse in global credit markets leading to a massive global recession.

Buy a small farm and a shotgun....

CityUnslicker said...

anon - sound comments, not sure about the total meltdown as the risk IS so widely spread as part of the problem. Nonetheless it is unlikely this will be a blip.

CityUnslicker said...

Mark - Are you srue hedge funds are run bys such clever people, or just people clever enough to know ho wot make a quick buck?

I don't know the answer myself.

Anonymous said...

Not sure I agree with you CityUnslicker. Sure, in the short term the problem seems manageable, but the problem is that the US economy has been pretty unhealthy for a long time and is propped up by cheap finance from outside the US. You've got to remember that the problem in the US has come from large scale loan defaults. This means a lot of individuals going personally bankrupt. This means they have lost their jobs. It also means that they aren't feeding cash into the consumption side. So what you have is cheap foreign money flooding into the US for many years and financing quite a property party - until the economic fundamentals hit home. The liquidity couldn't keep on flowing. Now we see US lenders hit, US builders hit, people losing their jobs, less cash spent on the US high street, and the whole thing spirals downward until it hits bottom. I think the US will see its economy taken back a good ten years to the time before they started getting into massive budget deficits, and shipping jobs to China at the same time. That simply couldn't go on for ever. It was like finacing debt by taking out more debt. Sure, the US had growth - thanks to the Chinese dong all the real work.

You couldn't go more indebted forever as an individual because eventually no-one will give you the money because you can't pay the interest - and we are about to see that the US can't do it either. There were some economists claiming the US was some sort of special case and could do it forever - but really you can see now it wasn't and the economics were really pretty simple. Individual borrowers couldn't make their payments and we will see this right across the board. Lenders see the risks growing as the debt grows and get nervous. Pretty soon no-one will want to loan money to any US institution and we will be looking at a massive correction. The US won't get hurt as much as those that lent them the money of course.

Anonymous said...

If Cameron were clever, he'd say that Tory policy is to rescue broke banks, but at a cost to their shareholders of taking all the equity and handing it out to the taxpayers. Vote Tory and get a free punt on those banks recovering!

CityUnslicker said...

Anon - I take your point, the long term economic situation of the US is not a good position and the Uk is closely tied to this.

However, the risk is spread around and all the money in OPEC and CHina will have to go somewhere. You see the Euro gowing up and gold, but US treasuries are a natural home.

When you owe the bank £100 you have a problem, when you owe them £1 million, they have a problem. The US is broadly in this situation.

CityUnslicker said...

Dearime - What a radical plan economically. You can be sure the Tories won't take it up for that reason alone!

Mark Wadsworth said...

City, the hedge fund chaps are no intellectual giants, but they're clever enough to fleece even richer people, so they must be pretty sharp.

Nick Drew said...

A lot of sound points here, folks, and personally I am unable to form a view on whether the impending problem will be of the 'cyclical downturn' sort, or more fundamentally unsettling. I posted earlier this week that private equity (& perhaps also hedge funds) is often rather smart when it comes to arbitraging valuations and warehousing assets in the meantime.

However - my original point was that we have Capital Adequacy rules for financial institutions, and risk-quants galore to make the required calculations. Accepted, there are some flaws in the framework, when it comes to extreme events and systemic risk.

But individual banks being over-exposed to a single risk-class without adequate & liquid risk-capital in hand, should be a complete no-no, with heads to roll at the said bank, and the relevant financial regulator. At very least the bank's shareholders should take the primary hit.

Instead, everyone rushes to make the problem everyone else's. It's a cosy club!

Anonymous said...

I still don't agree with your analysis CityUnslicker.

There are several problems here - one is the US housing market slump itself. This is very real. Homes get re-possessed only when someone can't make their payments AND find they cannot sell their home. This in itself is indicative of the start of a severe recession.

A second problem is that investment houses dealing in CDOs have effectively insured them to turn them into quality bonds by backing them with their other bond funds - without indicating that these bond funds are now at greater risk due to the investment company now having holdings. Naturally this widens the risk that failure of CDOs will also take out other funds.

Another problem is that both the UK and the US have become addicted to increased liquidity. The underlying economies do not stand much scrutiny. The UK has a trade deficit but is spending money in the public sector at an exhorbitant rate (much of which is off-balance sheet in the form of PFI), the US has for a long time been living beyond its means. The growth we have seen in both markets has been purely due to overseas cash being injected into these markets, which has caused asset values to rise simply to absorb the extra liquidity. US and UK companies are now chasing this injected cash rather than sorting out their economic fundamentals and ensuring they remain competitive on global markets. Remember also that if you owe the bank 1million quid and you default - the bank does have a problem. But it sure as hell will think twice about giving you a million quid a second time round.

Just seeing a reduction in liquidity in the US and the UK would start a recession, because growth would turn to contraction, more people would get thrown out of work, more people would then default on their mortgage repayments and so on with the whole situation spiralling out of control.

Don't forget also that with both equity and bond markets suffering, commodities may seem like a good bet for investors. But pushing up commodity prices due to excess liquidity in those markets will cause inflation and reduce the impact of cheap labour in China on holding prices down, just at a time when consumers in the West are feeling a lot poorerand less secure.

The big concern I have with the UK is with mortgage equity withdrawal. With house prices maxed out the temptation to take out that equity as real money is very great. You could spend it on a home in Spain perhaps. But maxed out property prices have only one way to go - down. And that equity is NOTIONAL. If everyone tried to sell their houses on the same day it would cease to exist. The danger is that mortgage equity withdrawal may expose the UK. This could expose the mortgage market to even greater risks than during the 80s simply because the total amounts of equity held in the UK housing market may be much lower than we think, and more people may be maxed out on their mortgage than would normally be the case. The second risk I see for the UK is PFI. Just how much has been spent on building new schools and hospitals and is financed by debt? Many UK companies have been chasing this easy source of business that the Chinese and others can't get their hands on. Take it out of the picture and where would the UK PLC be without it? Sure the oil sheiks may come to regret giving us the cash to build lots of news hospitals if they don't get their money back - but what are we going to do without it?

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