How could a bank nationalization / reorganisation work?

Misha over at http://globaleconomicanalysis.blogspot.com/2009/02/nationalization-revisited.html had some good questions about US bank nationalisation.

OK my 2 cents worth on what would be a less bad outcome - as opposed to what may happen.

1. Are all US government guarantees of bank debt null and void? They should be. At a minimum, taxpayers are currently on the hook for $300 billion of Citigroup's debt and $100 billion of Bank of America's debt.
Answer- Yes guarantees null and void for banks restructured. Let them bid for company if they think the debt is worth more than the money buyer’s offers for the assets.

2. Are we going to end up creating another banks that is "too big to fail" out of this mess?
Answer- Possibly depends who well sell them off to - how about selling bit off to different bidders (I would assume they are current better managed and solvent banks) depending on what they want and what they're willing to pay

3. Will stock holders and preferred shareholders both be wiped out?
Answer - Stock holders - yes wiped out - they would have already been so if not for government intervention. Preferred - depends on what you sell it for just like bankruptcy - if asset values don't cover debt as is likely then then wiped out.

4. In a normal bankruptcy process one might expect to see significant changes in management. Will the nationalization process allow the clowns who wrecked these banks to stay in control? For how long? Under what capacity? And what person or committee gets to decide those questions?
Answer- You sack the head honchos to start with - you sell off the parts, who keeps their jobs depends on the new owners, they presumably will be cutting.

5. Will the CDS liabilities be wiped out in entirety regardless of consequences? Clearly they should because otherwise taxpayers will be footing the bill. Unless this is spelled out I suspect measures will be taken to protect Goldman or whoever else is on the right side of those CDS and derivative contracts.
Answer- I don't understand the logic about canceling existing contracts other than it was an unregulated market out of control and it's costing the relevant parties an incredible amount of money. Canceling contracts selectively on this scale sounds a dangerous precedent.

6. What kind of bidding process will be put in place and in what time frame for the assets of the banks? Who decides and why?
Answer - Bigger scale suggests it may take longer than normal FDIC workout. That's why you need some extra government involvement. I don't know if this means 1 week or 1 year. In the interim the government body responsible (FDIC+help) takes control but you do business as usual (well usual in a sane world).

Summary
The way I see it you go as close to the best current model that actually works in the real world in the US (i.e. FDIC workout) and beef it up and give it more time so the scale isn't such an issue. If you try something new you don't know what may go wrong.

In addition get in there and investigate and make a few prosecutions where management has been negligent or dishonest. This serves both for moral hazard purposes and makes taxpayers feel better for making up any shortfall on the asset sale.

Stock markets - medium term trends

I blogged here http://reflexivityfinance.blogspot.com/2009_01_01_archive.html exactly one month ago on January 18 about where I see international equity markets going in the next 3-12 months. I concluded then that..

"So in summary, the all the balance of probabilities is for more downside in stock markets all over the world for at least the next 6 months and possibly considerably longer.In a word if you're a trader - short . If you're an investor I would dump companies that have a lot of debt (even if prices are fire sale it's better than holding on while they go bust) and stay away from the banks and finance companies, commercial property and builders that are directly exposed to the largest problem areas. Personally I'm short the SP500 index in the US and 85% cash and only 15 % invested in stocks in (this is my primary home market Australia). Most of these stocks are held based on a strategy of buying stocks that are trading at a 30% plus discount to their marked-to-market net asset value (a Buffet type strategy) and have no debt. Generally I try to to be 90% invested in the stock market so here actions speak louder than words."

So how are things panning out?

Let's look at some major countries equity markets performances over the last month since I posted.
1. US - SP500 - down 8%
2. Germany - DAX - down 1%
3. UK - FTSE100 - Down 5%
4. France - CAC40 - down 1%
5. Japan - Nikki 225 - Down 10%
5. Australia - my home market - flat

So basically being short the SP500 has been a good choice the US has been one of the weakest big markets over the period. Not being heavily in the Australian market hasn't hurt me. I've made a little money on short term trades there with minimum risk. I'm now down to 10% invested in the Australian market after closing out some fundamental trades that aren't going anywhere anytime soon. There was a small rally in early February in most markets but this has died now.

Also the areas I identified as having most downside - builders, banks, other financials, commercial property - all down significantly more than the index in the US and here in Australia. Not sure about elsewhere but guess it would be similar.

So have there been any significant changes in the 9 factors I looked at in January? Not many. Taxpayers money still being put into stimulus packages or associated bailouts. Economic news still gloomy and getting gloomier - particularly in terms of contractions in international trade. Prices still too high compared with earnings and asset values, long term technical trends clearly still down etc. Possibly the one thing that appears to be changing is that the US market is not rallying as hard on stimulus and bailout plans - the faith in magic fixes is waning. As that was the main source of positive short term moves in the market that tends to make the case for being short stronger.

The one real change has been the strength of gold stocks. This bares watching both as a trading
opportunity and as an indication of the loss of confidence in US treasures as a safe haven or due to inflation fears based on government debt and the desire to inflate it away in the future. So far I have only traded gold stocks short term. However if gold gets past strong resistance at US $1000 I plan to buy gold stocks and look to short US treasuries.

So the strategy is:
1. Short SP500
2. Continue to short term trade Australian market with small positions.
3. Watch gold and treasuries markets especially around gold at US$1000 resistance.

US recession - Febuary update - still bad

In January I blogged about a graph on US employment comparing all postwar recessions. My thoughts basically came down to - "So employment held up well early but it’s going to get uglier than in living memory and looks like living up to the “worst post war recession” hype." "

See the updated graph for the Federal Reserve here.
http://www.minneapolisfed.org/publications_papers/studies/recession_perspective/index.cfm

Basically employment continues to worsen at the same rate as the previous few months as I expected so things still look grim.

Interestingly the other graphs on the link above also show that output actually kept growing during the early stage of the recession - this has a lot to do with countries the US exports still having good growth up to mid 2008 and this coupled with the low US dollar meant US exports were still booming up to mid 2008. As the recession has spread worldwide, and the US dollar rallied, this export boom has turned around dramatically so output in now decreasing.

The longest USA post WWII recession has been 16 months. So far this one has lasted 13 months and so there is little doubt that this one will be longer. It also seems likely that the decrease in employment will be higher than any other post WWII recession. This is troubling as it suggests a somewhat different (and more damaging) dynamic in this recession than other recessions. The global nature of this recession is no doubt a large part of this and a negative for the short term while the twin consumer and government debt burdens are also troubling from a medium to longer term perspective.

Given unemployment started from a low level there is some hope it may not peak at much above 10% which at least gives some hope for a situation that may not be too disastrous in terms of people's lives and social cohesion even if output growth is slow after the recession and unemployment fails to decrease for some years.

Bank bailout - risky plan - macroeconomic scanarios

I number of commentators have called for the temporary nationalisation of insolvent banks rather than the current approach. These include those who saw the crisis coming such as Robinini and Soros. The people that said there wasn't a problem (Paulsen, Bernake and now Geithner) now say the problem can be fixed but without radical changes in approach to the ones that have so far failed to address the underlying issues. I believe this approach is to risky to be the one relied upon. Too risky for the for the US and world economy in the medium term.

At the moment the plan is basically to:
- provide government, loans and capital but keep banks in private hands,
- facilitate mergers as more solvent banks buy less solvent ones (often with government of Fed guarantees against losses),
- try and encourage private investors to buy the risky bad assets off banks by limiting the downside by providing government guarantees if things get worse etc.
Basically socialising the losses.

There are a number of other parties that could be bought to the table to assist before the government is required to tip[ in more capital. At the very least pressure needs to be bought on other relevant parties: management, creditors, stockholders and employees to come to the party before funds are provided. This is the usual approach when a company is insolvent and this is what banks do to their customers all the time. They need a stick to do this - usually this stick is bankruptcy. This appears too risky in this situation so the stick needs to be nationalisation.

The financial stress test that decides nationalisation is supposed to be forward looking. If so it would need to take into account:
- housing prices are going to continue to go down in the foreseeable future and then in 1 year all those ARM's reset and there's another 2 years of foreclosures based on that
- companies are going to start going into Chapter 11 as the recession goes for longer
- unemployment is likely to be higher rather than lower

It seems unlikely that many banks would pass such a stress test so presumably the banks will be pressing for a less stressful and transparent stress test that they can pass. Then when things get worse they can say it wasn't our fault the government checked us out we were just unlucky that things got worse, and can we have some more money please.

The big risk of the current approach is that if things continue to get worse despite this plan the government is in a much weaker position to go the nationalization route. You then risk the loss of US dollar safe haven status. This means a drying up of loans for treasuries and either mass insolvency for the banking system or the Fed having to print money. As presumably the Fed would print money we would then have high inflation and high interest rates to go with the high inflation. The impact of high interest rates would drive down already depressed asset prices and weakened corporations etc. It's a whole other reflexive (ie. self reinforcing) cycle) down. Then we do have something like great depression II.

Taking too much risk is what got everyone into this mess. Temporary nationalization of US banks might be less palatable in the short term but it takes much of this big risk away.

Gold prices have rallied strongly on the current Geithner plan suggesting other also see loss of US dollar reserve status is real risk in the medium term. So what are the broad macro economic scenarios going forward.

1. Best case. The plan works well (or they bit the bullet and go down the nationalisation path)along with other stimulus and banking bailout plans worldwide. The world resumes solid growth in 12-18 months. Obviously the banking systems still got some issues and governments have large debts but nothing some gradual inflation and fairly low real interest rates can't fix over 5-10 years. Presumably China and India come out of this stronger than US and Europe and the opportunities are more in developing countries as the US and Europe have to stop leveraging up.

2. Deflation case. After the US come out of negative growth there's Japan 1990's style 8-12 years of slow growth, continued asset price deflation and high unemployment.

3. Inflation case. Scarier option of high inflation, double dip severe recession and loss of confidence in US dollar if the US dollar looses safe haven status and Fed has to print money and so inflates. A lot of turmoil in currency markets as countries unpeg from dollar.

As far as what this means for asset prices.
A. Stock prices
- Best case is OK but probably no turnaround within 6 months so no hurry to be in the market. Worth watching to see which countries markets/sectors look stronger as if there is a new bull market in the next few years its' dynamic will be very different to the last one.
- Deflation case is bad for stock prices.
- Inflation case - gold stocks the obvious pick

B. Commodity prices
- Best case OK for commodity prices particularly if China and India are the stronger economies
- Deflation case - bad for commodity prices
- Inflation case - good for commodity prices

C. Gold
- Best case - bad
- Deflation case - bad
- Inflation case - very good

So no change to my general conclusion that it still makes sense to be short stocks and to have plenty of cash and to watch how things play out. Each scanario leads to radically different conclusions.

Defaults on government debt - starting now?

Economist Brad Delong has put together an excellent compendium of academic papers to illustrate the history and relevance of past financial crisis. http://delong.typepad.com/sdj/2009/01/financial-crises-in-historical-perspective.html

The one I found most interesting wasn't on the list "This time it's different - A panoramic view of 8 centuries of financial crisis." http://www.economics.harvard.edu/faculty/rogoff/files/This_Time_Is_Different.pdf

This long (125 page) paper looks mainly at sovereign debt defaults. The following summarises my reading of it and it’s relevance for the current situation.

1. Very high default rates across all regions in all time periods apart from short lulls of a decade or two.
2. In situations were gov debt is domestic rather than external there is still default on external debt - this seems contrary with IMF views.
3. Defaults in countries happen in waves and generally flow big decreases in commodity prices that impact these "emerging
“Economies.
4. There are also peaks in defaults after there have been large financial flows from eh financial centers to the "emerging" economies. I.e. the money is spent then the flow stops and then the defaults occur.
5. There is particularly high inflation in the defaulting countries during and after defaults. I.e. the gov inflates to reduce indebtness
6. Inflation crises and exchange rate crisis go hand in hand.

To me, the current situation is a classic illustration of a typical scenario just before a large wave of defaults occur. I.e we have had the prerequisite large capital inflows (which are now rapidly drying up or reversing) and the collapse of commodity prices. The fact that much of the debt is local rather than external is no protection.

This also suggests we are going to have high inflation and big drops in exchange rates in the emerging commodities that have been impacted.

The difference this time seems to be that the largest capital flows have been into what most would consider the financial centre (US). This may change the dynamics of things but I don't think it will change the sovereign debt defaults in many emerging markets.

If this does occur this is going to cause:
1. Serious stresses on governments in non defaulting countries supporting bailout efforts in other countries through the IMF etc
2. Defaulting countries will be unable to support their own economies during the current downturn – indeed the usually proscribed austerity packages will exacerbate the issues given the global downturn and the difficulty of exporting your way out of the crisis when export markets are very weak.
3. Geopolitical tensions, due to the battle between debtors and creditors over repayment schedules, austerity packages etc.
4. Political instability in defaulting nations.
5. Further strains on the solvency of the banking systems in a wide range of countries (US Europe Asia etc) as more bad loans are written off.
6. A great deal of suffering in countries with high poverty levels.

Clearly a rather worrying picture on top of the current problems in private markets.

From a trading perspective the best options here would appear to be to short emerging currencies that have significant government debt and "commodity" exports over the coming few years. I'll talk more about the implications of this and any early signs of a wave of defaults occurring in a follow up blog.

Misconception 3 – Easy credit caused the housing boom

This one is more an oversimplification than a misconception.

There have been very similar credit conditions across all housing markets in the US. However vast differences in changes in price by city/ region. So while easy credit conditions during the boom certainly had a significant impact they are only one part the whole story. The economic literature and my 5 years experience studying speculative forces in housing markets suggest the following factors.
- Local economic growth rates
- Housing supply restrictions
- Expectations based on local past experience

Economic growth rates (and the associated changes in wages, economic migration, employment etc) make a significant difference in the demand for housing. We can see this most dramatically in looking at house price figures for a city like Detroit where house prices have been decreasing in real terms for many years due to a decline in their traditional industries and a subsequent migration out of the city. Fundamental economic factors are likely to have been at work to early in the booms in growth areas in the Sunbelt.

Supply restrictions on land and building are also likely to have resulted in the inability of the market to quickly supply relatively affordable housing and stop prices from increasing quickly as demand increased. See http://www.demographia.com/dhi.pdf for a detailed international perspective. This study shows booms in prices across hundreds of cities worldwide overwhelmingly occurred only in cities with relatively tight planning restrictions.

Studies of what investors and home buyers expect to happen to house prices in a particular housing market indicate that most people project recent past prices changes (over the past year or two) into the foreseeable future. So once prices begin to discernibly rise potential buyers scramble to buy quickly before prices rise further. They are willing to buy at prices greater than similar homes have recently sold for as they believe prices will be higher still in the future. Without this factor house prices will generally appreciate only slowly as buyers and sellers are looking at prices of similar properties in deciding a reasonable price to buy and sell. Once prices stop rising potential buyers stop believing that prices are going to continue to rise in the short term and the bust begins.

How can this knowledge help policy makers? Clearly once a boom has run it is largely to late for policy makers to contain damage such as:
- builders having built houses that people do not want to buy
- investors/home owners financially overstretched
- banks and others find their loans are not being repaid and the loan is worth more than the collateral

1. As booms are local phenomenon the use of broad nationwide monetary instruments (e.g. interest rates) or fiscal policies (e.g. incentives to homeowners/builders) is not advisable.

2. Supply side restrictions need to be decreased as much as possible so affordable housing enters the market in a timely manner.

3. Decrease unrealistic expectations about future house prices. This requires the provision of strong public education through all available channels to dampen down unwarranted speculation based on unrealistic expectations. Channels could include media, industry groups, investment advisers etc. Furthermore a government pre commitment to take credible actions to decrease prices in speculative bubbles would send a message that the boom will swiftly end and make the educational message more credible. Such commitment could include temporarily increased taxes on capital gains from housing, or swift decreases in restrictions on supply in the case of increased prices.

4. However, perhaps the most effective deterrent to future housing bubbles is simply to let this bubble deflate without the kind of support which will stop prices from returning to more realistic and normal levels. House prices in many markets are still far above pre boom levels and well above historical levels when compared with incomes or rents. To stop house prices from returning to economically sustainable levels would be:

- expensive

- unfair to those who have not benefited from the previous boom and

- counter productive; as without expensive and ongoing artificial support prices will still fall at a later date and the lessons of the boom and bust would not have been learnt thoroughly enough to prevent a repeat.

How can this knowledge help homeowner and investors?

1. If you live/own in a market that has had a large boom and have equity in your home and selling is an option you would consider then it's probably better to sell now then wait for a few years and sell at lower prices. this is particularly so if you currently have some equity in your home but might be forced into foreclosure (and hence loose all your equity in the house) at a later date.

2. If you're renting and looking to buy in a city that has boomed and boom prices are well above what they were before the boom began then there is no hurry as houses will probably be significantly cheaper in the coming years.

3. If in the future you see people making a lot of money by investing in housing (or anything else) during a boom time - don't be panicked into buying or think this is the way to make easy money . The boom will end and those that made a lot of money will probably loose a lot of money. In the long term the price of housing will remain in line with rents and prices. We don't' know who long it will take this to happen -sometimes prices zoom back down in two years and sometimes it takes 15 years of house prices standing still while inflation and increases in real wages catch up.

For an excellent source of both insight and data from an international perceptive see http://www.jensks.com/

Misconception 2 – Housing market inventory

Misconception 2 – Housing markets won’t recover until the inventory is gone

Once we accept the idea that there are lots of separate housing markets rather than one market (see my blog "Misconception 1 - One Housing Market") it’s clear that the huge amount of inventory of unsold homes in one market doesn’t mean much for another market. So there could still be a huge backlog of inventory in many markets while other markets may need new supply. i.e. those with reasonable economic growth, no huge backlog of inventory and affordable housing.

This is good news for builders and residential housing market investors in these areas. For stock market traders/investors this suggests it will be highly profitable in the coming year or two to buy beaten down builders who are active in stabilising housing markets. Don't be put off by headlines about inventory gluts and falling prices in "the housing market".

However there is bad news for investors in markets with a big overhang of inventory and for holders of CDO’s and other housing market debt that was issued based on these markets. The real value of these (either in an auction or on a “hold to maturity basis) will most likely continue to drop as prices continue to fall and as foreclosures continue to mount. This bad news for the solvency of the financial system in the year ahead.