The Great Debate UK

from The Great Debate:

Don’t bank on clients to punish Goldman

So remind me, why will clients continue to do business with Goldman Sachs?

I know, it is a stupid question; investors and corporations will continue to do business with Goldman even after the bank has been charged with an alleged fraud for the same reasons they always have: because they hope, like every gambler, to beat stacked odds and because they flatter themselves that they are not the sucker at the table. There is also the small matter that for most of the clients of Goldman -- or more particularly the people at those institutions making decisions -- the money really isn't theirs but the rewards definitely will be.

Goldman has been charged by the Securities and Exchange Commission with alleged civil fraud for, among other things, failing to disclose a juicy detail to investors in a security it helped to create -- that a hedge fund firm that was betting against the security also played an important role in selecting the underlying instruments on which its performance was based. A bit like selling tickets for a ride to the moon on a rocket designed by an engineer who had bought insurance that would pay off when the rocket exploded, as it did, more or less on the launch pad. It meets my definition of material.

Goldman appears to understand its clients and their motivations and thus has decided to fight the case, maintaining that the way in which it operated in this instance is just fine. The strategy, I would guess, is to hope to beat the rap on the basis that this is how business is done and wait until outrage is, as it always is, overtaken by greed. Either that or the people who are making the decision to fight are the same ones who would have to step down if they admitted they did not or could not manage the risks of a large complex institution.

"I do not believe that institutions will stop trading with Goldman Sachs over this issue. The company's presence, systems, capital, and expertise in trading markets make it number one in the world in this activity. It cannot be easily replaced. Similarly, I do not believe that the company will lose its corporate customers," Dick Bove, bank analyst at Rochdale Securities, wrote in a note to clients.

Regardless of whether the actions of Goldman meet a legal hurdle of fraud, they very easily clear a very low hurdle of immoral and unethical behavior. Seriously, would you let these guys repair your car or treat your house for termites? And yet, still they come.

THERE OUGHT TO BE A LAW

from The Great Debate:

Embrace reality, not fight speculation

Stock up on canned goods, the authorities appear to be opening a new front in the War Against Speculation; this time taking aim at the people who might profit from Greece and its European partners' woes.

Just days after the U.S. Securities and Exchange Commission voted new limits on short selling, Germany is investigating the credit default swap trading of speculators to try to prevent them from profiting from any bailout of Greece.

"It would be bad if it were to emerge after a rescue that the money had gone into the pockets of speculators," a source with knowledge of the efforts told Reuters.

"The result of the 'Greek tragedy' is that the political environment has become such that the Credit Default Swap (debt insurance) problem has come to the fore."

French Economy Minister Christine Lagarde on Sunday said that derivative trades on sovereign debt should be tightly regulated, limited or even banned.

That's right, apparently there is a big problem out there and it is that greedy speculators are betting that governments that look like they will have difficulties paying their debts might, well, have difficulties paying their debts. Even worse, some are betting that since there is no tenable alternative to Greece being bailed out that it will be, well, bailed out.

I'm not sure if this is a war against speculation, against lese majeste or just against reality.

from The Great Debate:

At least U.S. has Japan to fall back on

(James Saft is a Reuters columnist. The opinions expressed are his own)

The bad news for holders of U.S. debt, in case you missed it, is that China has sold so many Treasuries that it is no longer America's leading lender.

The worse news is that there is a new creditor-in-chief, and it is Japan, an aging country with its own government debt bubble to contend with.

China sold about $34 billion of Treasuries in December, taking its holdings to $755 billion, while Japan increased its purchases and now is in the top spot of the Treasury Department's scroll of merit, with $768 billion. China's holdings peaked in April, since when the trend has been gently downward.

From a demographic point of view, though, the United States making a long term borrowing plan based on access to Japanese funding is a bit like my daughter making a retirement plan that has me continuing to work when she stops at its centre.

Japan is a wonderful country with many strengths, but one salient feature of Japan is that it is aging, or should that be aging, deeply in debt and dependent upon very low rates to continue to make those debts manageable.

Japan's government debt to GDP ratio is 190 percent, as against 84 percent for the U.S. That huge debt, which has nearly quadrupled in the past 15 years, is made tenable because the Japanese are great savers and own the vast majority of their government's stock of debts, unlike Americans, who own instead the vast majority of stuffed animals made in China. Japanese debt is also manageable because market interest rates are so low -- just a 1.32 percent yield on 10-year government bonds.

from The Great Debate:

Icelandic, Greek sagas show sovereign risks

-- James Saft is a Reuters columnist. The opinions expressed are his own. --

Developments in cash-strapped Iceland and Greece nicely illustrate two themes for 2010: sovereign risk and financial balkanization.

Iceland is balking at crushing terms demanded as part of its making whole overseas depositors in its ruined banking system, while Greece is involved in a game of chicken with the euro zone authorities over how, when and with whose assistance it heals its fiscal difficulties.

Like so many of us paying bills in January we ran up last year, they face a depressing prospect and no easy way out.

First, Iceland, whose president vetoed an agreement with Britain and the Netherlands to pay about $5 billion towards the costs of reimbursing depositors in its failed Icesave bank, saying he would put the bill to a referendum. While British and Dutch officials have mustered up a good show of outrage, President Grimsson's move should not surprise; he was petitioned by a fifth of the population, each of whom can look forward to helping to pay back their individual $17,000 share of the costs.

Iceland is not refusing to repay the debt, which it acknowledges, but wants repayments tied to gross domestic product through 2024 with the possibility of a renegotiation if the full amount is not repaid by then. It is a brave move, and maybe a foolhardy one, given that the rejection puts in doubt an aid package from the International Monetary Fund and Scandinavia, as well as potentially hurting its bid to join the European Union. Iceland's debt has already been downgraded to junk status by Fitch Ratings, with similar moves likely.

No one looks good in this saga, certainly not Iceland, which was effectively a hedge fund with a small fishing fleet attached and, you have to say, vastly better controls on overfishing then overlending. The Netherlands and Britain also look silly and incompetent; neither took effective steps to protect their citizens from the menace of Vikings offering higher rates of interest. Last but not least is the credulousness and cupidity of the British and Dutch depositors, including some local governments which not only chased the highest rates of interest but sometimes concentrated the vast majority of their funds with one bank.

from The Great Debate:

Dubai not a canary but another miner needing oxygen

- James Saft is a Reuters columnist. The opinions expressed are his own - Taken all in all, Dubai's debt crisis is the most significant financial development of 2007. Here in late 2009 it amounts to far less. Back in the day it would have been a newsflash that apartments ultimately require occupants, that investment needs to be ratified by cash flows, and that debt, Sharia-compliant or garden variety, someday must be repaid. Dubai's difficulties are being sold as the commercial real estate debacle somehow morphing into a sovereign debt crisis and it is true that the effective borrowing rates of the more raddled national borrowers such as Ireland have been driven up in recent days. Dubai's government said on Monday that it is not responsible for the borrowings of Dubai World, a state-controlled development conglomerate saddled with huge debts amid a property market where the going rate has halved. Dubai last week applied for, or imposed depending on your point of view, a six-month repayment freeze for Dubai World and its property developer Nakheel. "Creditors need to take part of the responsibility for their decision to lend to the companies. They think Dubai World is part of the government, which is not correct," said Abdulrahman Saleh, director general of Dubai's department of finance. Quite, and hopes that credit extended to Dubai World would be made good by the state of Dubai or by the richer emirate of Abu Dhabi seem to be foundering. This is bad news for those creditors, with the worst potential losses traceable to banks in Britain and Europe, but its probably just not that big of a deal. For one thing, the amount potentially at issue, even if you allow for an extra 50 percent off balance sheet taking it to circa $125 billion, is simply not big enough in the scale of things to tip significant players over the edge. And it tells us very little about the state of the world or the likely outlook for real estate. It is very hard to call something a canary in the coal mine when you are already cleaning up after a mining disaster. For a time the magical thinking behind Dubai, "build it and they will come", worked and despite it being remote, having an inhospitable climate and little inherent commercial reason for existing, the city boomed. It's a bit like having a feast so the harvest will be good rather than when it actually is, but it was effective for a time as prices rose and investment was attracted. DUBAI WORLD MEETS MORAL HAZARD WORLD The nub of the meme in financial markets is that this is about sovereign exposure and that creditors will be shocked if the state support they thought they had coming never arises. But is it terribly bad news for the rest of us? Probably not. Investors should have seen it coming - there have been quite a few headlines recently about the real estate crash-  and should not have conflated "implicit" with "explicit". Dubai has made clear in its own bond prospectuses that it might lend support but that it was under no obligation to do so. Teaching investors the difference between "quasi-state" and "state" is a good thing. So why then did the cost of borrowing for Greece and Ireland, as expressed in insurance contracts against default, go up? Nothing about Dubai's predicament will have much of an impact on Irish or Greek tax revenues clearly, and the banks and the pool of lendable capital has not been diminished by much. Nor is it easy to draw a new connection between Dubai and the emerging European countries which represent a muchmore substantial and potentially grave threat to banks in Europe. Perhaps this is ultimately about moral hazard - risk taking under the belief that you are "insured" -  as are all stories involving the words "quasi," "government," and "debt." Fannie Mae and Freddie Mac's quasi-government status fed moral-hazard driven risk taking, as did Dubai World's, as is most certainly the case where government insurance allows for cheap borrowing. Markets went down on Dubai because they have become addicted to moral hazard and anything that doesn't conform with the idea that all shall be bailed out is scary. It is apparently terrifying that a government should say "hard luck" to anyone anywhere, no matter how difficult the government's situation is or how ill-founded the investors claim to relief. None of this is to say that the commercial real estate crash isn't terrifying, or that countries like Ireland and Greece don't face difficult times and huge risks, but only that Dubai tells us little new about those things. There is definitely a moral hazard trade out there, but Dubai is not the event which will cause it to unwind.

(At the time of publication James Saft did not own any direct investments in securities mentioned in this article. He may be an owner indirectly as an investor in a fund. Email: jamessaft@jamessaft.)

from The Great Debate:

Dubai not a canary but another miner needing oxygen

- James Saft is a Reuters columnist. The opinions expressed are his own - Taken all in all, Dubai's debt crisis is the most significant financial development of 2007. Here in late 2009 it amounts to far less. Back in the day it would have been a newsflash that apartments ultimately require occupants, that investment needs to be ratified by cash flows, and that debt, Sharia-compliant or garden variety, someday must be repaid. Dubai's difficulties are being sold as the commercial real estate debacle somehow morphing into a sovereign debt crisis and it is true that the effective borrowing rates of the more raddled national borrowers such as Ireland have been driven up in recent days. Dubai's government said on Monday that it is not responsible for the borrowings of Dubai World, a state-controlled development conglomerate saddled with huge debts amid a property market where the going rate has halved. Dubai last week applied for, or imposed depending on your point of view, a six-month repayment freeze for Dubai World and its property developer Nakheel. "Creditors need to take part of the responsibility for their decision to lend to the companies. They think Dubai World is part of the government, which is not correct," said Abdulrahman Saleh, director general of Dubai's department of finance. Quite, and hopes that credit extended to Dubai World would be made good by the state of Dubai or by the richer emirate of Abu Dhabi seem to be foundering. This is bad news for those creditors, with the worst potential losses traceable to banks in Britain and Europe, but its probably just not that big of a deal. For one thing, the amount potentially at issue, even if you allow for an extra 50 percent off balance sheet taking it to circa $125 billion, is simply not big enough in the scale of things to tip significant players over the edge. And it tells us very little about the state of the world or the likely outlook for real estate. It is very hard to call something a canary in the coal mine when you are already cleaning up after a mining disaster. For a time the magical thinking behind Dubai, "build it and they will come", worked and despite it being remote, having an inhospitable climate and little inherent commercial reason for existing, the city boomed. It's a bit like having a feast so the harvest will be good rather than when it actually is, but it was effective for a time as prices rose and investment was attracted. DUBAI WORLD MEETS MORAL HAZARD WORLD The nub of the meme in financial markets is that this is about sovereign exposure and that creditors will be shocked if the state support they thought they had coming never arises. But is it terribly bad news for the rest of us? Probably not. Investors should have seen it coming - there have been quite a few headlines recently about the real estate crash-  and should not have conflated "implicit" with "explicit". Dubai has made clear in its own bond prospectuses that it might lend support but that it was under no obligation to do so. Teaching investors the difference between "quasi-state" and "state" is a good thing. So why then did the cost of borrowing for Greece and Ireland, as expressed in insurance contracts against default, go up? Nothing about Dubai's predicament will have much of an impact on Irish or Greek tax revenues clearly, and the banks and the pool of lendable capital has not been diminished by much. Nor is it easy to draw a new connection between Dubai and the emerging European countries which represent a muchmore substantial and potentially grave threat to banks in Europe. Perhaps this is ultimately about moral hazard - risk taking under the belief that you are "insured" -  as are all stories involving the words "quasi," "government," and "debt." Fannie Mae and Freddie Mac's quasi-government status fed moral-hazard driven risk taking, as did Dubai World's, as is most certainly the case where government insurance allows for cheap borrowing. Markets went down on Dubai because they have become addicted to moral hazard and anything that doesn't conform with the idea that all shall be bailed out is scary. It is apparently terrifying that a government should say "hard luck" to anyone anywhere, no matter how difficult the government's situation is or how ill-founded the investors claim to relief. None of this is to say that the commercial real estate crash isn't terrifying, or that countries like Ireland and Greece don't face difficult times and huge risks, but only that Dubai tells us little new about those things. There is definitely a moral hazard trade out there, but Dubai is not the event which will cause it to unwind.

(At the time of publication James Saft did not own any direct investments in securities mentioned in this article. He may be an owner indirectly as an investor in a fund. Email: jamessaft@jamessaft.)

from The Great Debate:

While the music plays funds gotta dance

(James Saft is a Reuters columnist. The opinions expressed are his own)

With just a few short weeks until the end of the year, look for many fund managers to take on more risk in an effort to salvage their annual return figures.

This is not about fundamentals, this is about something far more important: career risk.

Hedge Fund Research's Global Hedge Fund index, which is broadly representative of the industry, is up just 11.9 percent year to date, while its Equity Hedge index is scarcely doing better, up 12.6 percent. The HFR Macro Fund index is actually down 8 percent, indicating the best paid minds in the business did not see the astounding emerging markets rally and dollar fall coming.

Given that global emerging markets are up something on the order of 60 percent this year, that all global shares are up 30 percent and even the S&P 500 is up 22 percent, we can conclude that a lot of managers are heading into the year-end reporting season with a lot of ground to make up.

There are also lifeboats full of institutional fund managers and mutual fund managers in the same position.

What all who have missed the rally have in common is not a common failure of analysis -- there are lots of different ways to get it wrong -- but a collective vulnerability to finding themselves waving their clients goodbye. Letters detailing 2009 performance will have to be posted, ranking lists of funds will be published and there will be consequences.

from The Great Debate:

A rally that is both rational and crazy

(James Saft is a Reuters columnist. The opinions expressed are his own)

Stocks and other risky assets are rallying around the world this week because the Group of 20 nations said on the weekend they would keep the economic stimulus flowing, a state of events which illustrates where we are and what a very strange place it is.

The G20, the only group of big hitters that matters because it is the only group which includes the Chinese, met in Scotland over the weekend and, as is the way of these things, did very little with immediate consequences for anybody.

In the communique they issued, the Group of 20 finance ministers, after congratulating themselves on the recovery, more or less admitted that the measures we once thought of as heroic are in the process of becoming commonplace.

"However, the recovery is uneven and remains dependent on policy support, and high unemployment is a major concern," the statement said. "To restore the global economy and financial system to health, we agreed to maintain support for the recovery until it is assured."

Let me put that in human terms for you:

"We've spent untold trillions saving the economy, but, er, we've really only saved the financial system and that only to the extent that we keep on saving it. Jobs, well, not so much. We therefore pledge to continue doing this thing that may or may not be working until we are sure that it is."

from The Great Debate:

UK takes right step on too-big banks

(James Saft is a Reuters columnist. The opinions expressed are his own)

So it can be done after all.

Britain is poised to take tough steps to break up the large banks it rescued, setting it in stark contrast to the United States, which seems set on a policy of shoring up the unfair advantages it grants its too-big-to-fail banks while regulating around the edges.

It is quite a change for Britain, which has a sorry history of self-serving self-regulation in financial services combined with limp and outgunned official control.

Chancellor of the Exchequer Alistair Darling on Sunday told the BBC that Lloyds, RBS and Northern Rock would be partly broken up and assets sold to new entrants into the banking market. Large existing competitors such as HSBC are expected to be blocked from making bids for the assets.

Britain took over Northern Rock after a run on the bank and its rescue of Lloyds and RBS left it with stakes of 43 and 70 percent, respectively.

It is worth noting that if anything Britain is more dependent on its financial services sector than the United States.

from The Great Debate:

The death of the “punchbowl” metaphor

(James Saft is a Reuters columnist. The opinions expressed are his own)

Don't expect the year-long rally in risky assets to be undermined any time soon by the Federal Reserve becoming concerned about inflation.

The old metaphor -- that the Fed's job is to take away the punchbowl just when the party starts getting good -- just doesn't apply in the current circumstances. That's not to say inflation isn't a threat in the medium term -- it is virtually a promise.

But punchbowl thinking dates from a time when firstly the Fed was presumed to have a degree of control over events we now know is not true and secondly to an era when asset prices were the caboose rather than the engine of the economic train.

Even with an economy that is now growing, the risk of a self-reinforcing de-leveraging spiral is enough to ensure that the Fed will not pull the trigger on tightening any time soon.

"Asset prices are embedded not only in our psyche, but the actual growth rate of our economy. If they don't go up, economies don't do well, and when they go down, the economy can be horrid," Pimco bond chief Bill Gross writes in his most recent letter to investors. Gross argues that leverage inflated the price of assets even as investment in the U.S. real economy flagged. As this happened the U.S. economy became ever more dependent on asset prices and on the sectors, such as finance, which intermediated the borrowing. When the debt and asset bubble is pinched, the whole edifice is threatened, leading to a response like the one we've seen: massive and overwhelming aid trained on markets irrespective of the costs.

Pimco data shows that the prices of assets in the United States over the past 50 years have gone up 1.3 percent a year more than would have been expected given nominal growth in the economy, leading to a putative 100 percent overvaluation if you reason that the assets which depend on the economy for income shouldn't outgrow it.