The Banks KIlled The Golden Goose... What Next?

The crisis in the financial system reached epic proportions over the last few weeks. The collapse of Lehman, Bear Stearns going, AIG bail-out, Goldman and Morgan changing status and the "RTCII" bail-out being discussed at the moment has changed the landscape for the industry, but how will it look after this?

Whether you agree with the recent government moves on short sellers or not, we have to get used to the fact that this is the tip of the iceberg for knee-jerk regulatory moves, or should we say 'political moves'.

The situation is not just US based, it world-wide. German Finance Minister Peer Steinbrueck told parliament the turmoil would leave "deep marks" on both sides of the Atlantic, but called it primarily an American problem.

"The world will never be as it was before the crisis," Steinbrueck, a deputy leader of the centre-left Social Democrats (SPD), told the Bundestag lower house.

"The United States will lose its superpower status in the world financial system. The world financial system will become more multi-polar," he said.

Chancellor Angela Merkel, says "the days of laissez-faire capitalism are over".

French President Nicolas Sarkozy, whose country holds the rotating EU presidency, has called for a global summit to overhaul a "crazy" financial system.

So what have the politicians got on their minds? Steinbrueck proposed eight steps to prevent a recurrence of the turmoil, including an international ban on "purely speculative" short-selling, new rules to hold individuals accountable for financial missteps and an increase in capital requirements for banks in order to offset credit risks.

Higher capital adequacy I can live with and is a good idea, but the other stuff just shows the mentality of politicians who don't really understand the financial world.

How would you identify 'purely speculative short selling' and how would that 'fix' the financial system?

Just a few pointers to Herr Steinbrueck:

When is short selling not speculative? Would this be when a company is, in the eyes of some faceless bureaucrat, actually over-valued?

Would there then be a 'list' or a warning system saying it’s now OK to short this company? Wouldn't you like to be the first to get that list!!!!

Perhaps it’s not speculative if it’s a 'hedge'. But then you are allowing some speculators to short but not others. How would that work and who would you decide this? Would you have to submit your trades to a regulator before you placed the trade?

Let’s face it, it is a silly, naive suggestion, but remember, this is coming from a politician who actually has the powers to do this, at least in Germany.

How scary is that?

Also, shorting, far from being a 'financial weapon of mass destruction' is a way to limit risk. Lest say I am trading in the banking sector. One bank looks good to trade, the other looks a little over valued. So you 'pair-trade' them. You go short on one and long on another. If the sector as a whole takes a dive while your trade is on you win on your short and lose on your long, this risk based trading stops people losing more money than they normally would.

The problem is that short selling is an easy thing to point at for a politician. Something that is easily digestible for the average non-financial guy. The simple message is 'short sellers profit from your pension fund going down'. Easy sell n'est pas?

But if you believe in banning short sellers who profit from driving prices down, then you must ban buyers when shares are driven to unrealistic prices.

The issue that is being missed on the short selling rules is this. If a company has been driven down to a point where its shares price is way below its asset value then the market will correct it. If I saw a stock trading at a discount to its assets then, all things being equal, I would be buying like crazy. The shorts would have to cover and 'hey-presto' we have priced the stock.

The ban on short selling does not address the wider market and fundamentally avoids the real issue because saying it would be the death knell to a politician. That is that credit was too easy, people borrowed too much and now they are feeling the pain... It is not a popular story but it is at the crux of this mess.

If you want to stop this happening again, restrict credit to people who can actually pay it back, make mortgages a mandatory 20% deposit and no more than 3 times single or joint earnings.

Problem is this would hit the housing market, hit first time buyers and make property less lucrative. Is that a bad thing?

What politicians also fail to grasp is that creating or changing rules that open the doors to the creation of huge banking and trading institutions is, frankly DUMB!!

How many times have you heard this phrase in the past 6 months; 'Too big to fail'. Hello, McFly is there anybody there?

The latest round of consolidations is needed but not desirable. The easiest way to regulate this situation is not to change the law and investigate every merger/acquisition. All the regulators need to do is increase capital adequacy. Basically if you want to go ahead and merge yourself into a giant firm then the risk you pose to the market should be minimised.

Have the banks in a situation where they can only leverage once over their asset base.

Whoah! Have you any idea how much liquidity that would take out of the market? I hear you say.

The answer is yes I do. But the one thing we know about the financial system is that where there is a gap another firm will move into that space. What is wrong with spreading the liquidity/risk across 1000 firms instead of one giant one? It would be easier to manage and it would be less of a risk to the system.

But the firms wouldn't make as much money.. I hear you, but they were the ones who killed the Golden Goose, why should they be allowed to dominate the market once again?

What about hedge funds, will we see and end to them? I don't see how. Maybe they will be called something else but the genie is out of the bottle now. How will you stop them?

OK, tomorrow they ban 'hedge funds'. How do you define that? A hedge fund is simply a company that issue shares and then invests its capital. Are you going to ban investment companies?

Increasing capital adequacy for banks and traders would limited hedge fund borrowing, limit bank trading, and, ultimately make the system less volatile. Limiting credit to the credit worthy would end the ponzi scheme of the housing markets and credit cards, this is where the focus needs to be.

Think about it. How can a 20 year old straight out of university get 50k in credit from the card companies? How was that going to end well?

It is not a popular thing to say. We have all got used to the fact that we can have a slice of the dream of wealth and it was housing that drove this. The game should be over, but it is such a political hot potato. Who will be strong enough to tackle it? If Obama gets the US Presidency and the Tories win in the UK and make the painful moves necessary to restrict credit, then there will be a back lash from the public, why? Because standards of living will go down.

More expensive credit and less of it, for traders, banks and the public alike, is the key to solving this problem, anything else will be a political band-aid aimed at pulling the wool over the public’s eyes and the game will just start over again.

If we really want to change the financial system it does not mean bankers and traders will be thrown to the dogs and told they have salary caps. It will be everyone buying a cheaper house, a cheaper car, saving more, buying less and returning to a society where credit is something you earn, not simply something that is given to keep the merry-go-round going.

Who Is To Blame For This Mess? It Is Not Who You Think.

I have to say, reading the press recently is beginning to get right up my nose.

The sanctimonious ramblings of so-called financial journalists intent on hoodwinking the public into believing that all this mess is caused by greedy speculators trading the markets and making money at the expense of the little people.... What a crock of s***.

In the Telegraph today they were saying that the markets would be 'perfectly affective' if there were 'far fewer' traders. These 'talented people' could then get a real job in the 'professions'.

What, like a journalist? Who, from the stuff I have read recently, are at best, deluded, at worst corrupt. After all, selling newspapers is their game right? Months ago profiling hedge fund rocks stars was selling newspapers, now nailing them to the wall is flavour of the month.

First of all I will agree that the over use of leverage has contributed to the wild swings we have seen in the markets and private equity and hedge fund speculation has created short-termism in the minds of many a CEO leading to overly risky company strategy in some cases.

BUT (and it is meant to be in capitals) speculation is not to blame for the route causes of this mess. We all know that the route cause is the US housing market, and, to a certain extent, the UK housing market.

Both of these sectors have been, and no doubt will continue to be, a massive ponzi scheme in which everything is OK as long as new money is coming in. Just like a game of musical chairs, when the music stops and the new cash disappears the whole thing collapses and some people do not have a seat.

So who is to blame? For me it is the banks, mortgage brokers, the media, the regulators and the one that will make this post unpopular, Joe Public.

When I say Joe Public I mean a certain section of the public, those who thought that the housing market would go on forever and so it was worth lying about your income to get in on the game. It is not only the market speculators or traders who had over used leverage but the house buying public.

I will give you an example. I lived in a flat that was in a converted hotel. In 1999 this flat was offered to me for £180,000. Two bedrooms, paper thin walls and an odd shape. That same flat was on the market 8 years later at £600,000. Six hundred grand for a two bedroom flat? If inflation had taken it to that price, fair enough.. but it didn't.

What caused it? Cheap money from the banks, eager/greedy mortgage advisors/estate agents and some dim buyer thinking the housing market was going to go up for ever and was prepared to pay something for a flat that was no where near worth it.

Where was the trader in that equation?

When it looked liked this Ponzi sham may be over the banks came up with ever more schemes to keep it going. How about 125% mortgages from Northern Rock? What about self-certification 'liar loans' in the US.

The trader’s job, be it in a hedge fund, investment bank, or sitting at home trading online is to spot anomalies in the market and bet on making money when the price corrects, is that evil? If you saw a listed company with no income trading at a £200 million pound market capitalisation and you are able to trade it would you buy or would you short?

The housing market and its component parts was just one huge price anomaly waiting to be corrected by, yes, traders. Who else would have done it? Blaming them now is like blaming a vulture for killing an already dead animal. (Probably not the best analogy, but you get my point).

Traders are no more responsible for the housing crash and the tsunami sent through the markets as a consequence, than the guy who bought his house with a 30% deposit and mortgage payments well within his affordable income.

Journalists will no doubt say that Joe was hoodwinked into this scheme buy greedy mortgage advisors and banks giving 'teaser rates'. I would agree with that, but I find it a little incongruous that the media is getting all high and mighty after pumping out page after page of stories on how great the housing market is, and how safe an investment property is. The TV media was awash with shows such as the BBC's 'Million Pound Property Experiment' where two interior designers borrowed £100k from the BBC and would renovate and sell properties until they had a million pound house.

There were a million other shows which all gave the impression that property was a never ending game. Even the National Housing Federation is predicting, still, that house prices will rise 25% from 2008 - 2013. They may be right, but that growth is at the long end of the scale and if the cheap money system is crushed under the weight of this crisis, I would predict that 25% is 'optimistic'.

On the other end of the scale Jeremy Grantham of GMO, the $126-bn US investment fund, notes that UK house prices "could easily decline 50% from the peak, and at that lower level they would still be higher than they were in 1997 as a multiple of income!"

The blame game is, indeed, well underway. What will follow will be a slew of regulations/legislation aimed at curbing the 'excesses' of the 'greedy bankers' and 'evil' traders. This will be shouted from the roof tops by lame-ass politicians trying to cling on to power or gain power. It will be repeated gleefully by the press in a mass love-in of schaudenfraude and lapped up by a gullible Joe Public.

What they will not be shouting about is that some of these regulations (the ones that will actually work) will be aimed at Joe Public's addiction with the property market. Cheap money and easy loans are going to go away for a long, long time.

Far from it being the traders who suffer from this new regulatory world order, it will be Mrs Miggins who had dreams of buying-to-let a hundred houses on cheap leverage.

The new governments in the UK and the US will blame this all on the previous bunch, send a few bankers to jail for good measure and then say "Sorry Mrs Miggins, that was a corrupt system and the game is over".

A few years down the line when the banks recover, traders are happily making the free market work and money abounds again, the government will need a shot in the arm to get re-elected. Being the dim wits they are they will point to the housing market, do something silly and the whole game will start all over again.

I just hope that this time, the public will show a little restraint... somehow, however, I very much doubt it.

Hedge Funds and the UK Property Crash

One of the quirky things about the UK economy of recent years has been the inexorable rise in the property market. In 1998 I lived in a 2 bedroom riverside apartment in a converted Victorian hotel. The views were fantastic and for a young man with a plan it was the perfect location. The walls were paper thin and the whole building needed some work, but all in all it was a great bachelor pad. So I decided to buy it.

The lady who owned it wanted £180,000. I explained to her that there was zero chance it was worth anywhere near that and offered £160,000, she declined. That very same flat is on the market today for £450,000, the building still needs work doing and the walls are still paper thin..

This is not even in London, where the story is even more crazy. What a lot of people have forgot, however, was the early nineties property crash when you could not give property away. The rumour is that hedge funds think that this state is on its way once again..

According to the Sunday Telegraph, Hedge funds are aggressively short-selling shares in U.K. home builders, developers and landlord companies in anticipation of a drop in Britain’s housing market. Big bets have been placed on shares of Persimmon Plc, the U.K.’s biggest home builder and Grainger Plc, the nation’s biggest quoted investor in residential property. Data Explorers research shows that 13% of Grainger’s shares have been sold short, nearly four times the average short for companies on the London stock market. Short-selling of Persimmon’s stock has grown from 2.5% to 8%.

“Investors have significantly increased their short positions on property stocks across Europe,” William Duff Gordon of Data Explorers is quoted as saying. “Residential property stocks are now some of the most heavily shorted shares in the market. This reflects an increasingly gloomy outlook for the residential property market among some investors.” According to property investors who spotted the short-selling, the hedge funds seem to be taking positions on the basis of sentiment about the wider residential property market rather than the individual companies.

The chart certainly doesn't look good, but if there was an unravelling of the UK housing market, what would be the factors?

Firstly, Northern Rock were one of the biggest lenders in the UK to people of low credit. They will lend up to six times earnings and have a product that gives a 125% mortgage..still, believe it or not.

I can only imagine that whomever takes the company over will be reviewing those particular situations very carefully and if you take products such a these out of the market it starts to look bad for first time buyers. If first time buyers are squeezed out of the market there will, obviously, be trouble.

Also the market in the UK has been fuelled by 'buy to let' mortgages where people were buying everything that came onto the market to rent out. I would imagine that a lot of people will be looking at these properties and wanting to consolidate their portfolios. According to Bank of America's Matthew Sharratt, buy-to-let property prices relative to rents have surged to an unsustainable 60% above their long-term average.

With UK property being so expensive and therefore purchasers having to extend themselves to the limit in order to afford property, then any interest rate hike could be a killer for these property speculators and it looks as if we are in a period of interest hikes.

The bottom line is that property prices have been outstripping earnings for many years and a correction is well overdue, with the credit crunch starting to bite, interest rates moving up and sentiment changing to one of caution by buyers then a price fall is inevitable. We have already seen a slowdown and in some parts of the country even a fall in prices.

There are, of course, mitigating factors such as higher immigration and high demand etc but the question is; will these factors be enough to avert a crash or just enough to give the 'correction' a soft landing?

This BBC report is good additional information:

Or for a more amusing take... those of you in the UK will recognise the ever positive people on a certain housing program.