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.

Yanked By The Shorts

Right now is a great time to be a pessimist about the markets. There are so many factors helping you out it is unbelievable. The oil price, instability in the middle east, jobless figures, housing markets etc etc. But the best comments I have seen from a pessimist is Albert Edwards, strategist at Societe General in London.

“America is leading the way, diving into deep recession as a collapse in consumer confidence induces the great unwind,” he said. Edwards compares the economy with a pyramid scheme that is poised to crash to earth and interest-rate changes can do nothing to avert it.

He thinks Wall Street and the other main markets have a lot further to drop, and will end up 70% below the peaks of last year. That would imply a level of just 500 for the S&P 500, which was at 1,280 on Friday, and 4,500 for the Dow, compared with Friday’s closing level of 11,346.

The FTSE 100, which closed at 5,530 on Friday, will plunge to 3,000, he predicts. The good news is that he expects the oil price, which was above $142 on Friday, to slump to $60 a barrel. The bad news is that he sees this occurring as a result of “deep” recession in the advanced economies and a sharp slowdown in emerging markets.

Crickey. Shorting just 1 contract for $10 a pop on each of these markets would be a nice $100,000 profit if he is right. But is he the only voice in the wilderness?

Not really, the gloom on Wall Street, where the stock market dropped again on Friday, is almost all-pervading. Veteran banking analyst Richard Bove of Ladenburg Thalmann said there was “an absolute unwillingness among clients to talk about anything other than how bad things are”. Investors wanted to know which bank would be the next to blow up or be forced to raise capital. Even though there were hopeful signs of recovery in the sector, albeit from a low base, many in the market had “lost perspective”, he said.

“The last time loan losses were at these levels was 1934,” he added. “I don’t believe we are going back to a 1930s environment with people living in tents.” Bove predicts bank losses will at least stabilise in the coming months.

However, Scott Anderson, senior economist at Wells Fargo, summed up why the markets are so gloomy. The economy is caught between the twin problems of near-recession and sharply rising inflation. “Consumer confidence levels are at their worst since the early 1980s, we have record oil prices and the Fed will have to react to that and start raising rates by the end of the year if they don’t recapitulate soon,” he said. “That would certainly drag out the housing correction and be a further drag on consumers.”

He has scaled back his forecasts for the end of this year and into 2009. “One half [of Wall Street] is worried about growth, and they are scared,” he said. “The other half are worried about inflation, and they are scared too. Sell in May and go away may have been the best strategy this year.”

A drop in the oil price would be the best remedy for jittery markets and a shaky economy, though it could also cause problems. One fear is that a sharp fall in oil and other commodity prices would bring a new wave of troubles for investment banks and hedge funds. As it is, most have been revising up their forecasts for the oil price.

A survey by Reuters shows that analysts expect the price of American crude to average $113 a barrel this year, remaining around that level next year, before increasing to $115 in 2010. Last year the average was $72.

Some analysts, though, are much more aggressive in their forecasts. Fortis, the Belgian-Dutch financial group, sees crude averaging $125.70 this year, $171.50 next year and $224.90 in 2010. In contrast, Royal Bank of Scotland sees a price average of $86 next year.

So what can you do, as an investor, sit around and wait for Armeggeddon?

I was alkig to a client the other day about the state of the markets and he said that he was staying out of the markets for 'the foreseeable future'. This, from a conservative investor, would be a predictable comment and one which could not be argued with, however, this particular client has been a massive bull ove the years, buying what he ca when he can and he has done very well. However, this bullish attitude was always based on the press he had read, or his feelings on a particular sector. He gets extremely excited about 'things moving by large amounts'.

I pointed out, that if these analysts were talking baout the markets going to the moon, he would be a buyer, he did't disagree. Now that that they are talking about a deep decline in the markets should he be a seller? I suggested.

This then became a discussion about shorting the markets using various instruments and my client is now intent on doing just that. I guess it is just a case of whaht perspective you have. In our business, if the markets are falling... short them... if they are going up, go long. A simplistic view, I know, but I was always taught that volatility is our friend. It is when the markets are going sideways that we should worry...

As a follow on to this, this was an article in the Times that showed up some shorts on the market with new rules implemented by the FSA:

THE HEDGE FUNDS THAT ARE SHORTING UK PLC

A NEW RULE came into force last Monday obliging hedge funds to disclose short positions they had taken in companies that were raising money from shareholders, writes Kate Walsh.The rule, announced by the Financial Services Authority on June 13, lifted the lid on the funds that were betting against companies such as HBOS, Bradford & Bingley, Johnston Press and UTV Media.

Going short involves borrowing shares and selling them straight away - in order to buy them back later at a lower price.

The names that came out last Monday included well-known fund managers such as Lansdowne, GLG, Fidelity Investments and Odey Asset Management alongside the not so well-known Oceanwood Global and Steadfast Capital.

These were the main positions disclosed last week and the men behind the funds. Harbinger Capital: 3.29% short on HBOS Harbinger’s Phil Falcone, the so-called Iron Man of the New York hedge-fund world, is renowned for making a fortune out of others’ misery. Early last year he had determined that the American housing market was on the brink of plunging and shorted nearly 60% of his $20 billion (£10 billion) fund on sub-prime-backed bonds. The bet paid off and he subsequently paid himself $1.7 billion for a good year’s work. This year, Falcone bought a stake in The New York Times, where he is calling for a radical shake-up.

Lansdowne Partners: 0.58% short on HBOS Lansdowne partners Peter Davies and Stuart Roden are regarded as among the best in their field. They have worked in tandem for well over a decade and left the asset-management division at Merrill Lynch in 2001 to take over what was then a $2 billion fund; it now has $19 billion under management. Lansdowne has a reputation for being cautious and is known for the thoroughness of its research - for example, it is believed to have taken a short position on Northern Rock some four years before the bank’s crisis began.

Meditor Capital Management: 0.3% short on HBOS Talal Shakerchi, born in Birmingham but of Kurdish descent, is the main force behind Meditor. Even within the hedge-fund community little is known of Shakerchi other than that he is an aggressive fund manager who does very well in bear markets. He left Old Mutual in 1998 to set up Meditor after poaching his entire former team. Last year, Meditor was one of the hedge funds, along with GLG, that was fined by France’s financial watchdog for allegedly misusing information in a convertible bond issue by Vivendi. Meditor said it didn’t breach any regulations.

GLG Partners: 4.14% short on B&B The founders of GLG - a fund with $24 billion under management - are Pierre Lagrange and Noam Gottesman. They are among the highest-paid hedge-fund managers in Britain and their lifestyles reflect it - the pair are leading lights on the London social scene. GLG made headlines this year when its star trader Greg Coffey resigned, forsaking $250m of shares. Industry sources said that Coffey was a “sizeable” trader on the short side although his main focus was emerging markets.

Odey Asset Management: 0.28% short on B&B When Crispin Odey quit Barings in 1991 to launch his own fund-management firm he admitted he did not even know what a hedge fund was. Early backing from the billionaire George Soros and Lord Rothschild quickly turned Odey into one of the first hedge-fund stars.

In 1993 he paid himself a £10m salary but the abrupt turn in the world’s bond markets in February 1994 hit the fledgling fund hard. Last year, Odey’s $4.9 billion fund made a killing on wheat, though he is always on the prowl for distressed assets or, in his words, “the company that has no chance in hell of meeting the market’s expectations”.

Funds that disclosed short positions in Johnston Press were Lone Pine Capital, Trafalgar Asset Managers, Fox Point Capital Management and Valinor Management. Old Mutual Asset Managers revealed it had taken a short position in UTV Media.

Scary stuff for the housing market...interesting opportunities for the short trader....