October 3, 2008 | posted by Michael Baxter in Banking | comments (1) |

So what do you think about on the way to work in the morning ?   And if you ever have a smart idea,  what do you do next ?  Well,  here is a thought.  One man,  had this idea the other day,  which was so good that US lawmakers will be talking about it tonight when they have their second go at voting for the Paulson plan.  Mind you,  even if you suddenly work out how to make the elixir of life,  it seems unlikely you will be able to get straight on the phone,  and get Congress’s attention.  That’s the difference.  For this particular man with a brain wave,  just so happens to be Warren Buffett.

It was less than a year ago when Mr Buffett enjoyed elevation to the stop slot in the world’s rich list.  Since then he has done rather nicely,  while his two main rivals for the mantle of world’s richest man,  Bill Gates and Carlos Slim have seen their personal fortune tumble,  with Gates losing billions quicker than you can say Sergey Brin and Larry Page.

Mr B,  has certainly played a blinder of late.  He it was, who talked about selling US stocks at the beginning of last year,  and warned of an imminent fall in the dollar.  It is hard to dig out evidence that he predicted a banking collapse,  but maybe money talks louder than words,  and his fortune has actually grown over the last year.

He it was who injected $5bn worth of relief into Goldman Sachs recently, and this week agreed to make an investment into GE.  In an interview on the Fortune TV channel,  he said that he is getting a lot of phone calls from CEOs, these days.  He says that they say,  my company may look like a toad,  but if you were to kiss it,  then it would turn into a Prince.  The trouble is,  he says,  if he were to give in to every request for money,  he would become a toad himself.

But then the other day,  while driving along in his automobile – on his way to work – well actually he was on his way to a summit – it was Fortune’s Most Powerful Women Summit in Carlsbad,  California,  he had this idea,  and he described his plan to the ladies of the summit.

He reckons this.  The US Treasury should give any hedge fund, bank,  or any Wall Street institution,  or even a private investor,  a massive helping hand for buying one of those distressed debt securities.  He says that the US Treasury should lend out up to 80 per cent of the cost,  with the caveat that if the security goes bad,  the Treasury gets first call.

“Now you have someone with 20 per cent skin in the game,”  said the sage of Omaha. “Believe me,  I won’t be overpaying if I’m buying with that kind of leverage”

His idea comes down to this.  The best way for calculating the true value of securities is via the markets,  the snag is,  there’s no money around,  so the markets are simply unable to fork out what they think an asset is worth.

When senators were discussing Paulson plan 2.0 last week,  they got Mr Buffett on the phone,  asking for his advice.  He urged them to agree to the deal.

The world’s richest man has described the current banking crisis as an economic Pearl Harbour,  and says Congress has to move fast.  “It will cost more to solve this problem today than it did two weeks ago,” he said.

But feel a certain amount of sympathy for the guru.  He says that if Congress does not take action soon,  “I may go back to delivering papers.”

Now there’s a thought,  Mr Buffett delivering newspapers.  Can you imagine all those bankers who messed up so badly delivering newspapers ?  Probably not.  No doubt,  within a few years they will be raking in massive bonuses, while the tax payers are still left with the bill for cleaning up. 

October 2, 2008 | posted by Michael Baxter in Banking | comments (1) |

You know what it’s is like arguing with a child.  You say,  ‘yes, you must,’  and then the child replies  ‘no, no, no.’  So you say,  ‘yes, yes, yes, yes,’  and the  ‘no’s  get louder and more frequent,  and then you end up threatening to take toys away from the child. Eventually,  after a cool off period,  in which the child is sent to bed,  you get your own way,  or at least,  sometimes you do.

Last night,  senators voted to accept the Paulson plan.  This time they voted 74 to 25 in favour of the plan.  Here is the curious bit,  the plan wasn’t changed by that much,  the only really significant change is that it has got more expensive.  And yet,  somehow it is thought this time it will get through.  Friday night is when we will know,  that is when the House of Representatives votes.  Last time it was 228 to 205 votes against.

 The consequences if the plan was voted down would be disastrous for the markets of course,   a negative vote would lead to massive falls on stock markets across the world.

So these are the changes to the Paulson plan,  and this is what is wrong with them.

First off,  the maximum guarantee for money on deposit is being increased.  Now,  you can have up to $250,000 on deposit in the US,  and if the bank goes bust,  your money is still protected.

Secondly,  there are going to be changes in tax breaks for US companies and individuals using renewable energy.  Just re-read that.  The Paulson plan mark 2,  designed to save the global economy from a catastrophic banking meltdown,  will include tax incentives to invest in renewable energy.  Now there is nothing wrong with the idea per se of tax incentives to use renewables,  but it is not exactly relevant,  is it ?  So the child won’t go get off the swing at the playground and you offer to buy her a milk shake if she does.

The plan will also see one year’s worth of extra relief from what’s called the Alternative Minimum Tax.  This scheme was supposed to tax higher income earners more heavily,  but due to inflation was hitting more people than originally intended.

The new plan is also supposed to put curbs on executive pay.

But really,  it is just tweaking.  This is a plan that was supposed to save the universe, and its modifications are really not significant.  Well,  they are significant in one way.  The original plan was 4 pages in length,  the revised plan 451 pages.  So,  at least US lawmakers are getting more reading matter for their money.

George Dubya is doing his best and has been getting on the blower, ringing Republican members of the House of Representatives,  and the salesmen reckons he has already got four more votes.  No doubt,  he has got some hot leads too.

One snag is that while both Republicans and Democrats are against the plan,  they are largely against it for different reasons.  So changes designed to appease some, may antagonize others.

Yet here is the odd thing.  The biggest worry with the first plan was that it was so expensive - $700bn.  The new plan will be more expensive.

But the fundamental problem is this.  It is still the wrong plan.  The Paulson plan still amounts to little more than a bigger version of all those others plans that were implemented to save banks in the early 1980s and 1990s.  View those previous plans from a longer-term point of view,  and it appears they have not been successful at all,  because surely the roots of this crisis lie in the solutions to the last crisis.

To work effectively,  capitalism needs failure.  You need to get rid of the dross,  and let poorly run businesses fail.

The snag is,  that a wholesale failure of the global banking system would lead to a major economic depression with all the horrendous social consequences of that.

The right plan, would be one that sees government money used to recapitalise banks,  in exchange for equity.  The equity would come at a massively discounted price,  it should do,  you always get bankrupt stock at rock bottom prices.  The shares will also be available to the public, and sovereign wealth funds.  This plan would be the right plan because firstly it deals with the fundamental problem of solvency.

It would also be the right plan  because it punishes the owners of the banks,  and thereby makes it likely the same mistakes won’t be repeated in a hurry.

It is also the right plan because it means tax payers will enjoy a share in the recovery of the banks,  when this happens.

The reason why this eminently superior plan is not being considered is because it smacks of socialism.  But that is really missing the point. Socialism is when companies are nationalised,  because it is felt that the state should own business because it is socially just, and because the free markets can’t be trusted.  

Rather, the plan described above would just be temporary,  designed to reduce the social costs of capitalism working efficiently. Capitalism says investors in a business should be rewarded.  Because the Paulson plan does not reward tax payers with equity,  it is in fact the antithesis of capitalism.

It is as if socialism has become a naughty word - and anything that in any way bears any resemblance with that word is bad.  It is like a asking a parent what sex their child is,  and then another child who overhears the conversation sniggers because they heard the ‘s’ word.

The reason why the right plan is not being considered,  is down to semantics, and for that reason,  US Congress are making a big mistake.

September 30, 2008 | posted by Michael Baxter in Banking | comments (2) |

So,  when the history books describing this time are written will they really look back at yesterday’s decision by Congress as the pivotal moment?  Will the decisions of those 228 Law makers really send the global economy into a 1930s style depression?  Was this really a one off opportunity to fix the problem?

Last night,  EU Commissioner Peter Mandelson was interviewed on BBC2 Newsnight.  He said  “I feel they’ve taken leave of their senses and I hope that in Europe we will not see politicians and parliamentarians replicating the sort of irresponsibility and political partisanship that we have seen in Washington.”

And yet,  consider this.  The Paulson plan had many flaws.  There are strong arguments to suggest it was the wrong plan.  Some say,  well,  at least it was a plan.  Any plan is better than no plan.

But is that right ?

Most successful business people will tell you it is a mistake to make split second decisions. If you enter into a hire purchase agreement to buy a new TV,  you are given a seven days cool off period.  If you are buying a house,  the lawyers seem to do their best to slow the whole process down,  with their due diligence.  In business,  it sometimes feels as if lawyers call the shots – their  “moreovers”  and  ”whereupons”  can be irritating,  they can slow transactions down,  but most would agree they are essential.

Sometimes you may find yourself under pressure.   We are usually suspicious of take it or leave it deals.  Here is some advice for a would be buyer subjected to a high pressured sales techniques: walk away.  Anyone who tries to persuade you the deal won’t be available tomorrow is usually bluffing.

Now we are told we face financial Armageddon.  That it is 1929 all over again,  that yesterday’s no vote by the House of Representatives spells the end of prosperity.  That the US is a third world economy in the making.  And markets do their headless chicken impersonation.  Paulson wanted $700bn,  yesterday the US stocks markets had more than $1trillion knocked off their value,  therefore goes the argument,  Congress’s reticence has already cost more than the money Paulson wanted to spend. 

Yet,  you know that’s not true.  Markets rise and fall,  even the US government has only limited opportunities to spend $700bn.

Right now,  what is really called for is thought,  a considered response to the financial crisis.  Those who can keep their head while others panic,  should be the ones who set the pace.

Yesterday’s decisions by Congress does not spell disaster.  And this is why.

The first thing you need to bear in mind is this.  Congress acted the way it did,  yesterday because that is what the electorate wanted.  Your average US American was not impressed by the Paulson plan.  Bankers have lost the confidence of US citizens,  well they have lost the confidence of most citizens everywhere,  and this was a plan hatched by an ex banker.  Bankers failed to see this crisis coming,  and former chairmen of Goldman Sachs turned Treasury Secretary are no exception to this.

George Dubya’s loss of credibility in the US is almost as bad as the loss of credibility he suffered from in Europe a few years ago.  If George likes the plan,  it must be bad,  went the reasoning.  This point is perfectly illustrated by the comments from one US politician, comparing the argument that the Paulson plan will save the economy with claims that there were weapons of mass destruction in Iraq.

But,  set aside the emotive response,  there were major flaws with the Paulson plan.

Nouriel Roubini,  high profile Professor of economics at New York university pointed out that in an IMF study of 42 systemic banking crises,  only seven,  Mexico, Japan, Bolivia, Czech Republic,  Jamaica,  Malaysia,  and Paraguay,  saw the government purchase bad assets,  in the style of the proposed Paulson plan.  None of these seven Paulsonesque plans were especially successful.

By contrast,  the banking rescue that seems to have been the most successful – if you like the model rescue,  was seen in Scandinavia.  This saw no buyout of bad debts,  instead,  the governments in Sweden,  Norway,  and Finland,  injected capital into the banks,  and in return the governments acquired substantial equity.

Yesterday,  when it was assumed the plan would go through,  Capital Economics said  “The root of this crisis is not the lack of liquidity in that market,  it is the lack of capital in the banking system.  As it stands,  the Treasury’s plan to buy the illiquid assets on banks’ balance sheets will do almost nothing to prevent the destruction of bank capital and the resulting reduction in lending and economic activity.  We still expect the economy to endure a torrid recession over the next year,  forcing the Fed to slash interest rates to only 1.0 per cent.

“In using the government’s money to buy assets,  the Treasury will be working against the leverage on banks’ balance sheets.  What the Treasury should be doing is working with the leverage,  using its money to inject capital directly into the banking system.”

Mr Roubinu,  perhaps one of the biggest critics of the Paulson plan said  “the claim by the Fed and Treasury that spending $700 billion of public money is the best way to recapitalize banks has absolutely no factual basis or justification.  This way of recapitalizing financial institutions is a total rip-off that will mostly benefit – at a huge expense for the US taxpayer - the common and preferred shareholders and even unsecured creditors of the banks.”

The big snag with the Paulson plan,  of course,  as was pointed out here yesterday,  is that it is based on the assumption that mortgage debt is undervalued.  The Treasury was in effect supposed to second guess the market,  buy assets on the cheap and sell them at the market price down the line.

But supposing Paulson estimate of the true value of debt was wrong.  His plan mounted to little more than asking tax payers to fund speculation.

This is what we know.  The global finance sector is in crisis.  The last few days has seen two of the largest US banks go down – Washington Mutual and Wachovia,  (Wachovia did not go bust as such,  it was bought by Citigroup at a rock bottom price.)  In Belgium,  within hours of the nationalisation of Fortis,  news broke that the Belgium bank Dexia SA,  the world’s largest lender to local authorities was on the verge of collapse.  In Iceland,  Glitnir,  the islands third largest bank has been nationalised.

But the underlying problem behind all of this is the collapse in house prices - around the world.  The house prices crash was not caused by the credit crunch,  the relationship is the other way round.  Implicit to the Paulson plan is assumption that house prices will stop falling – then go up,  which in turn will get the US tax payers off the hook.

But this may not be the right thing for the long-term.

The best possible solution is for all governments,  US,  UK,  and Eurozone,  to inject banks with capital - and in return acquire substantial equity.  When things recover, maybe in several years time,  government shares should then be sold.   The rejection of the Paulson plan was the right thing, because a better plan was needed, and if that takes a bit more time, then so be it.  

September 26, 2008 | posted by Michael Baxter in Banking | comments (0) |

The Hank Paulson plan is quite possibly the most important business plan ever written. It seems it will get tweaked, it may even get tweaked quite a bit, but it will get through.

At the time of writing, it appears all is recrimination. Republicans are blaming Democrats, Democrats are blaming Republicans. Hank Paulson is at once a hero and a villain. Bankers have become evil incarnate, and even America’s poor, with their subprime loans and trailer homes, are getting the blame.

But eventually the blame game will end, and it will dawn on senators that unless some kind of Paulsonesque plan gets through, and gets through quick, the US economy will face catastrophe, and even US politicians will finally see their urgency and need for that, even the ones who double up as hockey mums.

But just because a Paulson-type plan is vital for saving the global economy, it doesn’t mean it is a good plan, it is just the best plan anyone can come up with.

But it does have major flaws: some we are stuck with, some are more serious, some, well, watch them unravel.

When the South Sea Bubble craze was at its height, one business plan famously had the following description: “For carrying-on an undertaking of great advantage but no-one to know what it is!!”

The Paulson plan, by contrast, was written in 21st century speak, but it kind of said the same thing: “Decisions by the Secretary pursuant to this Act are non-reviewable and may not be reviewed by any court of law or any administrative agency.” And oh, by the way, Paulson doesn’t know yet how the money will be spent.

Okay, so US taxpayers, and in a way, the rest of the developed world, have got to trust Hank. So, let’s put our faith in Mr Paulson, he is after all a former chairman of Goldman Sachs, he knows his onions. The likes of George Dubya are just out of their depth, so are most senators. In a way, Paulson is to US politicians what Vince Cable is to Liberal Democrats.

But the snags are these:

First of all, wasn’t it bankers who created the whole mess in the first place? Do you really want an ex-banker to sort it out?

Secondly, Hank will be starting a new job soon; do you really want to charge someone with the responsibility of bailing out banks, when that same person may be looking for a job at one of those banks next year?

Thirdly, isn’t the problem too much pay and too much reward for failure? Isn’t it the problem that bankers have been bailed out every time there is a catastrophe, from Third World debt, the savings and loans disaster, to Tiger economy debt, the Russian crisis, Long Term Capital Management? Isn’t it the problem that banks keep getting it wrong, because they never learn from their mistakes?

Well, all of those arguments may be right, but maybe there is an even deeper problem too. And the problem this time is not so much bankers, politicians, or even economists, this time the guilty part comes in the most innocuous of forms. When you were at school, did you ever know anyone who was brilliant at maths – really brilliant? Not A-grade at Further Level Maths type brilliant, but capable of getting a maths degree at 12 sort of brilliant.

Mathematicians have been running Wall Street.

But this is the snag with mathematicians, they may be good with calculus, or whatever it is that geniuses concern themselves with, but they still make the same old human errors that afflicts us all.

The author, Nassim Taleb put it well in his book The Black Swan. There are two countries in this world, Mediocristan and Extremistan.

In Mediocristan, not much ever happens. There are no surprises. To consider an example of what this country is like, consider a statistical survey to calculate average weight. The survey’s sample is, say, 999 strong. Then it is joined by one other person, but this person just happens to be the heaviest man in the world – how will the average weight be affected? Answer, actually, not that much, even if our fat man weights 100 stones, this will only mean the average weight will be increased by a couple of pounds.

In Extremistan, extreme things happen, and when they happen, the whole calculation is thrown out of kilter. When black swans were discovered in Australia, we had to re-think our definition of what a swan looked like. Or take another example, a statistical survey calculating average wealth. We have our 999 people, and have calculated their average wealth. Say the average comes out at £10,000. Then the list is joined by the word’s richest man, who, right now, is Warren Buffett. Our average person is now worth around £50 million. The extreme event, in this case the inclusion of the word’s richest man in the survey, has completely thrown out the result.

Now consider the world of high finance. Mathematicians make their assumptions based on prevailing conditions. They assume we more or less stay as we are. Risk does not change. We all behave in a certain way, and their view of how we behave is based on how we usually behave.

The mathematicians with their complex algorithms looked at the risk that the banks had insured, and reasoned that since it was insured, failure is highly unlikely. They looked at the laws of chance, and put a probability of systemic collapse at something so small that, by comparison, the one-in-fifty million odds that are supposed to reflect the probability that the Hadron Collider will throw up a black hole which will swallow the Earth, seem high.

In an article in this week’s New Scientist, the whole concept was explained well: “Models typically assume that market prices will continue to behave much as they have in the past, and that they are reasonably predictable,” says the article.

But, it then goes on to to quote William Perraudin, director of the Risk Management Laboratory at Imperial College London who says: “These models mostly overlook how bad news can affect banks’ ability to raise funds. The real risk,” he says, “turns out to be a cycle of drops.”

So, rumours gets out that a bank is in trouble, so others stop lending it money. The fact this bank can no longer borrow money creates problems for the bank, even if the original rumours were wrong. But this in turn can reduce the value of assets at the other banks, and the whole thing goes into a downward spiral.

What these mathematical models are singularly bad at doing is allowing for the fact that the various risks out there relate to each other. If one bank hits trouble, all the banks panic.

What is the probability that all Northern Rock customers will wake up one day and decide to withdraw their money from the bank? Answer: tiny. But the model fails to take into account that one person’s decision to withdraw money can affect someone else’s decision.

It was faulty logic like that that lay behind the Long Term Capital Management failure. That could have ended up as a major banking crisis – but Alan Greenspan gathered together leading banks and orchestrated a bail out. Disaster was avoided, but the lesson was not learnt.

Over the last few years, bankers thought they were living in Taleb’s Mediocristan. In fact, they were living in Extremistan.

Take as another example, the citizens of Pompei in Italy during the Roman Empire. No doubt it never occurred to them that one day the sky would quite literally rain fire, but it did. They too thought they lived in Mediocristan. The mistake the citizens of Pompei and Wall Street made is that they assumed their experience would never change.

In the case of Wall Street, events became self-reinforcing.

Mathematicians erred, and the result has been catastrophe.

The snag with the Paulson plan is this. It is not clear he has understood this. He is assuming that by throwing $700bn into the pot, everything will go back to normal.

But supposing Americans treat their home as if it is a home, rather than a cash cow. Supposing Americans learn to be more cautious with credit spending. Supposing bankers conclude risk has become too risky. With every financial disaster arrests follow. After the South Sea Bubble, the South Sea Company Directors were arrested. It happened again after 1929, it happened earlier this decade.

In Nazi Germany persecution of Jewish bankers turned to the Holocaust.

Right now, if they have any sense at all, bankers are completely changing their attitude to risk.

Who is to say that, post-Paulson plan, everything will be back to normal?

And that is the problem with his plan.