Tuesday, May 29, 2012

The Bank Run Deposit Insurance Doesn't Protect Against

A slow motion run on banks in Greece, Spain and other distressed Euro bloc nations has been taking place ever since the sovereign debt crisis blew up two years ago. Recent news reports indicate it has accelerated, particularly in Greece. The top 1% and others in distressed nations have been moving money to banking havens such as Switzerland and Luxembourg, and stable nations like Germany and the UK.

Depositors have two reasons to flee banks in troubled countries. One, those holding deposits exceeding the 100,000 Euro limit on deposit insurance in the Euro bloc have much to lose if their local bank collapses. Two, depositors in any nation that potentially may depart the Euro bloc confront the risk of compelled conversion of their deposits into a new, depreciated currency. Greece presents a vivid example of the latter problem. Conversion back to the drachma could sharply reduce the value of Greek bank deposits. There is no deposit insurance that protects against losses sustained when one's home nation drops out of the Euro zone and adopts a depreciated national currency. Some Greeks have been withdrawing Euros from ATMs (presumably to pad their mattresses). Others have been moving Euros electronically to safe haven nations.

The capital mobility created by the adoption of the Euro facilitates such bank runs. Since the Euro bloc, by definition, eliminates the problems of currency conversion, moving funds from one Euro bloc nation to another is easier than in the bad old days of national currencies. The upside of increased capital mobility is that money was supposed to go where it could earn the highest return, which was thought to promote economic efficiency and greater overall prosperity. The downside is that capital can more readily flee ugly situations, even if it's needed to help finance a nation's way out of ugliness.

The European Central Bank might be able to stop the burgeoning bank runs. The core mission of central banks is to promote depositor confidence. The ECB seems to have been lending many billions of Euros to Greek and Spanish banks. But it won't print money, and that limits its options if the run quickens. The Euro bloc, a 21st Century financial innovation, may have laid the foundation for an old-fashioned 19th Century financial panic. Time will tell.

Sunday, May 20, 2012

Winners and Losers in the Facebook IPO


Billionaires and Millionaires.
Some Facebook investors and employees had a very good day. A few of them became billionaires and quite a few became millionaires.

Facebook. The fact that there wasn't much of a pop in the stock after trading began means that Facebook left little money on the table when it priced the offering at $38 per share.

Selling shareholders. More than half the stock offered was sold by investors and employees who had gotten their stock privately before the IPO. The lack of a big pop means they, too, left little money on the table when they sold.

California. The State of California stands to collect something like $2 billion in taxes from sales of Facebook stock by state residents. With the state's finances in the fiscal ICU, that's like manna from heaven.

Short sellers. The fact that the stock closed barely above the offering price indicates that many shareholders are looking at Facebook as a short term play. Like wolves scanning a herd of caribou for any animal displaying signs of weakness, short sellers are always on the alert for flagging shareholder interest. They may find a juicy target in Facebook.


Nasdaq. The opening of trading in Facebook was delayed for "technical" reasons that are now being poked into by the SEC. Press reports indicate that order execution for many investors was sloppy and slow. Not the kind of publicity Nasdaq needed from the highest profile IPO of the year.

Morgan Stanley. MSCO got the highly coveted lead underwriter position. Then it had to earn its fee when the stock began threatening to drop below the $38 IPO price. MSCO may have bought a shipload of stock toward the end of Friday, when trading opened, in order to keep the price above $38. Tomorrow, the second trading day for Facebook, could bring more challenges.

Money managers. Mutual fund managers and other money managers like IPOs with big opening day pops. They use their market connections to score a big allotment of the IPO, and sell some of it into the pop, getting a fast buck that's needed. Most money managers don't match the S&P 500, and non-typical gains like IPO pops are important to help them stand out from the crowd. Facebook wasn't a good IPO for them.

Tech companies planning IPOs. The tepid Facebook pop may put a damper on IPOs planned by other tech companies. The "technical" problems encountered by Nasdaq, market of choice for tech companies, won't add to anyone's enthusiasm. If investors don't have a good time with a high profile IPO like Facebook, they'll be wary of other, less glamorous ones.

Mark Zuckerberg. Billionaire, just married, he's got to feel like he's at the top of the world. The market will disabuse him of that notion in a couple of trading days, at most. He'll learn that public company stocks are traded short term, which means that he's expected to deliver, every quarter on the quarter end. Whatever his long term goals for the company, the short term performance will have to be gorgeous, and then more gorgeous the next quarter, or the stock price will be hung, drawn and quartered (pun intended). It gets personal, too. One lousy press release from the company, and bad things will be done to his effigy. He'll be made to understand, not in a fun way, that short sellers will be a permanent presence in his life, trying to financially actualize schadenfreude. Sooner or later, one or more of Facebook's officers, directors and employees will leak inside information to family and/or friends, and embarrass the company when federal authorities swoop in. He'll feel betrayed, but he won't be able to prevent it. He'll feel every uptick and downtick of the stock's price, because shareholders will make sure he feels ticks. Any significant failings by the company will lead to his introduction to the most prominent class action plaintiffs lawyers in America. As SEC rules compel him to make disclosures about his compensation, perks, transactions with the company, holdings of company stock and a variety of other things, he might end up feeling like he has less privacy than the most effusive of Facebook users. Surely, Zuckerberg has already been counseled by his advisers about all of the foregoing. But the reality of his new life running a public company won't sink in until he lives the full, graphic experience. There's a price to pay for going public, and the bill collectors are gathering.

Monday, May 14, 2012

J.P. Morgan's Big Problem

The baseline problem underlying J.P. Morgan's recently announced $2 billion loss on a credit default swap bet gone bad is that big banks face virtually all economic risks. Banking, as conducted by major money center banks, cuts across essentially all economic sectors, all lines of commerce, all financial instruments, and all asset classes. There are some exceptions. For example, big banks rarely dabble in penny stocks or business startups. And they tend to limit their exposure to junk bonds. But they directly or indirectly play in almost all sandboxes in the economy.

The essential conceit of contemporary financial engineering is that risk somehow can be controlled. It is believed that if you find a clever enough math whiz with an MBA from a sufficiently fancy school, s/he can fashion a derivative for any purpose that will magically (albeit for a fee) transport risk to a distant land from which it will never return. With such magical powers, one need not be prudent and limit exposure to risky assets. One need only have a smart enough financial engineer to fashion a seemingly appropriate hedge.

Derivatives can work, and work well, when the risk they're meant to mitigate is narrow and well-defined. For example, futures contracts for red winter wheat serve salutary purposes when appropriately used by farmers, grain companies and speculators.

But when derivatives are deployed to mitigate wide-ranging and vaguely defined risks, their limitations come into play. Press reports indicate that J.P. Morgan's management directed its chief investment office to mitigate the risks of economic deterioration in Europe. This, to say the least, is a rather large, complex and wide ranging problem. Things in Europe can go downhill for a variety of reasons, not all of which are easily defined or predicted. The murkier a situation, the more difficult it becomes to fashion appropriate hedges. And if the hedges aren't entirely appropriate, their imperfections may have be hedged in turn. Reports in the financial press indicate the mandate from J.P. Morgan's management seems to have morphed into a net position that bet on improved financial health for a number of major corporations. Such a bet wouldn't seem the intuitively obvious way to hedge against a downturn in Europe.

As with all financial firms, J.P. Morgan's most important asset is its reputation. Since the 2007-08 financial crisis, its reputation has been golden. J.P. Morgan avoided unduly large real estate risks. It bought Bear Stearns at the government's behest, quelling incipient panic in the financial system. Its earnings were relatively stable, compared to its competitors. While the latter downsized to ditch hinky assets and offload risk, J.P. Morgan became the largest bank in America.

But such golden reputations become a burden, because the market expected J.P. Morgan to remain golden. Given that big money center banks face virtually all economic risks, this becomes a harder and harder job as time passes. Skilled risk managers and corporate executives might be able to anticipate most risks most of the time. But no one can predict all risks all the time, and a financial institution facing the length and breadth of economic risks borne by major money center banks will stumble sooner or later. Indeed, the longer a bank's winning streak, the greater the chance the next quarter will be a bad one.

Management sitting on a winning streak will understandably want to keep the streak going. But they must consider whether or not they can. Not all risks can be hedged or managed. Much of the "hedging" that goes on in the financial markets consists of using apples to hedge oranges. The two sides of the hedge are not mirror images of each other, but approximations. If the approximations are pretty close, a well-capitalized firm can get by. But that "if" gets bigger and bigger as derivatives positions get larger and as some derivatives are used to hedge risk factors in other hedges (which may have been the case at J.P. Morgan). When risk managers and management fail to recognize that the magic doesn't work in all situations, they get a morass.

Recognizing one's limits is an ancient and highly effective means of risk management. Not taking a risk, or offloading it, eliminates the possibility that it will later bite your butt. Being the biggest bank doesn't necessarily mean that you're the best bank. Appreciate that derivatives are imperfect financial instruments, and because of their newness, their imperfections are imperfectly understood. Given the inability to comprehend all risks or hedge them, having a shipload of capital may be best way for a bank to safeguard its future.

Banks typically trade at comparatively low multiples of earnings per share. That's because of the plethora of risks financial firms typically face. The siren call of the derivatives market is that, for a fee, a bank can hedge its way out of problems instead of having to manage them. These sirens have claimed a number of victims since the 2007-08 financial crisis, and now they appear to have lured J.P. Morgan onto a rocky coast.

Tuesday, May 8, 2012

Fools Among the Holders of Greek Debt

A couple of months ago, most holders of Greek government debt reluctantly agreed to a deal to take a loss (called a "haircut" by the financial cognoscenti) of about 75% of the nominal (i.e., face) value of the debt as part of the second bailout package offered to Greece by the EU. Another aspect of that deal was the Greek government would institute austerity measures in order to reduce its future need for debt. The coalition government then governing Greece, a pushmi-pullyu shotgun marriage of two opposing parties, solemnly agreed to the austerity measures.

Just a couple of days ago, Greek voters gave the coalition government something like a machine gun divorce, placing bootprints on the behinds of the coalition parties and effectively putting a Communist politician in the position of calling the shots. It's been decades since Communists in any democratic nation have had a scintilla of political power. But there's never a dull moment with the ongoing economic and financial crisis.

Needless to say, the Communist leader, Alexi Tsipras, isn't of a mind to embrace austerity. He does say he wants Greece to remain in the Euro zone. And why not? Since the beginning of the EU sovereign debt crisis, Greek governments have made promises about fiscal probity and austerity, gotten promises of bailouts, not quite fully lived up to their promises to throttle back spending, and gotten bailed out anyway because the wealthy EU nations always blinked first. The Greek Communists might as well play the same game, and take credit for any blinks they can induce.

Meanwhile, back at the ranch, those holders of Greek debt who agreed to the 75% haircut must be wondering how foolish they now look to the people on whose behalf they manage money. It's well understood that there is political risk associated with speculating in sovereign debt. Politicians will, when push comes to shove, favor their constituents over money managers in the top 1%. Nevertheless, professional financiers dabbling in sovereign debt are supposed to be able to assess political risk astutely. Just two months after the second bailout deal, they've lost the benefit of their bargain because of a political risk that was staring them in the face when they agreed to the haircut.

Private investors will be reluctant to play in the EU sovereign debt sandbox in the future. It's not a winning strategy to take a big haircut and then find out two months later that you have to deal with a newly risen Communist politician.

With the evaporation of private investment interest in the sovereign debt of weaker EU nations, the European Union will have a problem. A fairly large one, in fact. Its member nations can't function without debt. But, with natural investors unwilling to lend their savings, EU sovereign debt (at least for the weaker member nations) would have to be financed by the European Central Bank. The ECB would protest that this violates the letter and spirit of its charter. But what choice will it have? The EU doesn't have a mechanism for defenestrating a member nation, however badly it behaves. And its undercapitalized banking system is up to its ears in the sovereign debt of weak EU nations and can't afford to keep booking losses.

But if the ECB starts to monetize the debt of weaker EU nations (which it already is doing in shadow form with its three-year loans to large member banks), the debt of the wealthier EU nations will become less attractive to private investors. A big money print by the ECB will inflate the Euro in Germany just as it inflates it in Greece, and no creditor wants to hold debt denominated in a potentially inflationary currency. If private investors step back from German sovereign debt, the EU game will be up.

In the end, the wealthier nations will probably leave the EU, and possibly create a smaller currency union with each other. Or they may just go it alone. Either path will garner the interest of private holders of capital. And that would be the way to restore true financial stability.

Sunday, May 6, 2012

A Farewell to European Union

The stock market's penchant for taking the short term view has never been so evident as tonight, with Japanese stocks down over 2% and U.S. stock futures down around 1% following anti-austerity elections in France and Greece. These election results are hardly a surprise; they've been predicted for weeks. Yet, the market is acting like it is shocked--shocked--that electorates would put their personal well-being ahead of the bond market's interests.

The market, as it so often does, allowed itself to be lulled into complacency by the EU's bailouts, which were just kicks of the can down the road with maximum PR effort. Press release politics, it was, and the market took the press releases at face value.

But the problem with the EU sovereign debt crisis is that debt must ultimately be repaid. It can be repaid by debtor remittances to bond holders. Or it can be repaid by forcing bondholders to take partial losses, with debtors kicking in a few pennies for the sake of principle (or principal, if you will). And most typically for the EU, it can be repaid by rolling the debt over, with the help of bailouts from wealthier nations. The last was the EU's first choice, although Teutonic imposition of austerity policies was the EU's way of trying to make debtor nations share some of the burden.

Austerity by itself is likely to produce only economic deceleration. It reduces spending and therefore economic stimulus. The workable form of austerity--austerity along with currency devaluation--can work. It was a formula for recovery by various Asian nations following the 1997 financial crisis there, albeit with substantial short term pain. But Greece's and France's citizens aren't willing to bear the pain of austerity, and the ECB and Germany aren't willing to devalue the Euro. So the EU's brand of austerity isn't destined for success.

The absence of true political union within the EU made it too easy for member nations to ask, not what they could do for the EU, but what the EU could do for them. Europe's political leaders bear much responsibility, presenting the EU as an great opportunity, while downplaying the risks. If the EU were selling securities in the U.S., the SEC would have serious questions about the completeness of its disclosures.

A true currency union can't realistically be a goal by itself. It must be accompanied by true political union. Witness America's Civil War, which not only unified the United States. It also made the U.S. dollar America's sole currency, when federal legislation in 1863 taxing state issued currencies--and federal victory over the Confederacy two years later--effectively eliminated all competing legal tender.

But Europe is too diverse for true political union. Unity requires a willingness to share burdens, to pay an economic price so that political unity can be maintained. Europeans don't have enough in common to contemplate such generosity with any degree of equanimity. So the EU as it now exists cannot survive. Some nations will exit. Those sufficiently similar in outlook and economic strength may stay together in a smaller currency union. But the recent collapse of the Dutch government, due to the growing strength of the right in the Netherlands, raises doubts about the potential for even a smaller currency union.

In one sense, the Euro was part of Europe's effort to prevent another world war. Both world wars of the 20th Century imposed almost unimaginable costs on Europeans. Postwar leaders sought economic union in order to diminish national differences that had fostered the hostilities. But Europeans remain tribal, something that economic interests and market forces have not overcome. And European tribalism will take its toll on the financial markets.