How the banking system works... 2

Courtesy of todays Sunday Star Times we have yet another example of the BSC (Banking System Crisis, or is it really BS Crisis?) and the kind of operation being run by many of the banking institutions.

AN ELDERLY grandmother with no known assets or income was lent $4 million by a mortgage fund company chaired by former prime minister Jim Bolger a transaction now under investigation by the Serious Fraud Office.

Mortgage documents obtained by the Sunday Star-Times show that Trustees Executors, a trust company chaired by Bolger, advanced $4m to Maria de Magalhaes, a 73-year-old Portuguese speaker originally from Mozambique, who was only in the country on a visitor's visa.

After explaining that the $4M loan is part of a total of $33M lent to a “property developer”, SST comes up with this very brief paragraph.

Sources dealing with the fallout of the saga say it raises serious questions about the lending practices of Trustee Executors. The money was part of the $242m Tower MortgagePlus fund, administered by Trustees Executors and frozen last April. More than 5000 investors had savings tied up in the "low-risk" fund, of which about 40% has been returned.

For more on the Tower saga, you can read up here, but the primary statements are –

Tower said the NZ$242 million TOWER Mortgage Plus fund, which is owned and issued by Trustees Executors, will shut after a surge in redemption requests and a jump in the proportion of mortgages in arrears to 9.1 per cent.

The Trustees Executors-owned 1st Mortgage Fund, branded TOWER Mortgage Plus, was being wound up, Tower Investments Chief Executive Sam Stubbs said. The fund lent on a diversified portfolio of residential and commercial first mortgages and was no longer relevant given heavy competition from banks, Stubbs said.

“Given heavy competition from banks”? Given that it seems over 13% of their total assets have gone down just one drain, I would hold little hope for a good part of the remainder.

But that is not the major point...

The bulk of the investments in the Fund (in TMP) were in the “low risk fund”. Let’s just think about that for a moment.

I have my super (401k equivalent) in a “cash and low risk” category. From that I expect to earn no more than about 3% nett of tax in a good year. On the other side of the ledger, I don’t expect to earn less than 1% nett of tax in a bad year.

It seems that if the same expectations apply to TMP, we can start with a mortgage interest rate of (say) 7%. Take out “expenses and administration” at 0.5% (not unreasonable for keeping a computer account straight). Take out tax at 35% and we get 4.5% ROI. So the bank is paying me 3% for their “good year”. Who is getting the other 1.5%??

The same calculation from a savings bank interest rate of 5% (not too high for a good year) we get a ROI of 3.2%; very much in line with the actual return.

So, there is a matter of Trust involved here.

Personally, I do not think that the investment policies of TMP and many of the other superannuation and unit investment funds have ever been any different. What is going to emerge from the ashes of TMP will be some very questionable investment decisions by all manner of people from Board on downward. Investment decisions that are all driven by the pursuit of personal wealth, rather than the benefit of the investors for whom they are purportedly supposed to be acting. High returns for the Company, means high bonuses at the end of the year....

And, I most sincerely hope, there will be some very high heads in many of the other "investment funds" who will losing significant amounts of sleep over the next few months until they are sure that their own patchs are cleaned and seemingly kosher. The shredders will be running...

Deja vue?

Listed at ALD...

With those who yearn for "the old days" and the freedom of open markets is this little piece of history.

Fueled by easy credit, the real-estate market had been rising swiftly for some years. Members of Congress were determined to assure the continuation of that easy credit. Suddenly, the party came to a devastating halt. Defaults multiplied, banks began to fail. Soon the economic troubles spread beyond real estate. Depression stalked the land.

The year was 1836.

The nexus of excess speculation, political mischief, and financial disaster—the same tangle that led to our present economic crisis—has been long and deep. Its nature has changed over the years as Americans have endeavored, with varying success, to learn from the mistakes of the past. But it has always been there, and the commonalities from era to era are stark and stunning. Given the recurrence of these themes over the course of three centuries, there is every reason to believe that similar calamities will beset the system as long as human nature and human action play a role in the workings of markets.

Yes, Al, much of the cause can be sheeted home to "government interference". That as much as anything is my point.

The result was a credit crunch. Interest rates that had been at 7 percent a year rose to 2 and even 3 percent a month. Weaker, overextended banks began to fail. Bankruptcies spread. Even several state governments found they could not roll over their debts, forcing them into default. By April 1837, a month after Jackson left the presidency, the great New York diarist Philip Hone noted that “the immense fortunes which we heard so much about in the days of speculation have melted like the snows before an April sun.”

The longest depression in American history had set in. Recovery would not begin until 1843. In Charles Dickens’s A Christmas Carol, published that same year, Ebenezer Scrooge worries that a note payable to him in three days might be as worthless as “a mere United States security.”

All manner of good quotes -

Many people, especially liberal politicians, have blamed the disaster on the deregulation of the last 30 years. But they do so in order to avoid the blame’s falling where it should—squarely on their own shoulders. For the same politicians now loudly proclaiming that deregulation caused the problem are the ones who fought tooth and nail to prevent increased regulation of Fannie and Freddie—the source of so much political money, their mother’s milk.

and

Herbert Hoover famously remarked that “the trouble with capitalism is capitalists. They’re too greedy.” That is true. But another and equal trouble with capitalism is politicians. Like the rest of us, they are made of all-too-human clay and can be easily blinded to reality by naked self-interest, at a cost we are only now beginning to fathom.

The "Global Financial Meltdown" explained...

Full credit to yesterday's Business section of the Herald. They have given one of the most cogent, and hence rational, explanations of the liquidity crisis within the global (not just American) banking systems.

Included in the main article was this graphic which I have had to scan as it does not seem to appear anywhere on the digital version of the articles...


To fully understand, and to make it clear -

75% of global liquidity is made up of "Derivatives". The value of this portion of the pyramid is over 8 times the global GDP. The importance of this "top of the pyramid" will become apparent when we look at what it is made from.

13% is "Securitised Debt". The value of these "securitised debts" is just under 1.5 times the global GDP.

11% is made up of "Broad Money". The value of this part is just short of 1.25 times global GDP.

1% is in the form of "Power Money" - what you and I carry in our pockets.

So we can say, with a little simple addition, that the total global liquidity is somewhere in the vicinity of 10.8 times the total world income. How much of a worry should that be? At this stage I am far more worried about the top end of the pyramid.

What is that "top end"? The Herald graphic defines it was "Futures, options, swaps etc". Putting into my own words, this is the world of "financial products"; of units and risk and literally gambling with other people's (read thine and mine) money. I quoted Liam Dann at some length a whiles back here and concluded (my words) -

we are seeing what happens when the economy is run by snake-oil medicine men and itinerant side-show freaks.

So, 8 times the global income has been sunk into what is little more than betting slips that are owned and traded between the snake-oil medicine men. They end up back in the open market in forms such as the "Unit Share" of a superannuation fund. They are funded (as far as it is deemed neccessary) from the term deposits and savings accounts of the simple minded people who believe (in their naivete) that bank money is secure.

Read through Brian Gaynor's analysis in full. I want to quote just this piece -

Forty years ago there were almost no investment banks, securitised debt or derivatives. The huge increase in global liquidity and credit since the early 1980s has been almost exclusively driven by investment banks through the creation of securitised debt and derivatives, which now represent nearly 90 per cent of total liquidity.

At the beginning of the year there were five major US investment banks - Goldman Sachs, with assets of US$1061 billion (or US$1.06 trillion), Morgan Stanley US$1045 billion, Merrill Lynch US$1020 billion, Lehman Brothers US$689 billion and Bear Stearns US$424 billion.

Bear Stearns and Lehman Brothers have disappeared and Merrill Lynch is being taken over by Bank of America. These companies created a huge amount of toxic securitised debt and derivatives that have plunged in value.

The conversion of the two remaining investment banks, Goldman Sachs and Morgan Stanley, into bank holding companies is significant for a number of reasons:

* As commercial banks they will be subject to regulation whereas they were almost totally unregulated as investment banks

* Their lending capabilities will be severely restricted because commercial banks have strict capital adequacy requirements. Morgan Stanley's debt to equity ratio is 30:1 and Goldman Sachs 22:1 whereas banks are generally restricted to no more than 15:1.

Now that kind of difference is the stuff that makes my blood run cold. Morgan Stanley (to take that example) has borrowed 30 times its owner equity to fund financial market operations that are no more than betting slips that they hope to validate by winning the battle to influence the value of currencies, the value of future contracts.

This is not Capitalism 101, nor is it Capitalism 201.

This is Master Degree stuff; the kind of Capitalism that was never dreamed of by the likes of Friedman, or the early designers of the principles. It is Capitalism as was never dreamed of by the politicians of the US, or any other country.

___________________________________________________

In another article, the Herald records the demise of WaMu - Washigton Mutual - in "the largest failure ever of an American bank".

The Government measures bank failures by an institution's assets; Seattle-based WaMu has roughly US$310 billion in assets.

The previous record was the failure of Continental Illinois National Bank in 1984, with US$40 billion in assets when it closed. IndyMac, seized in July, had US$32 billion.

WaMu was searching for a lifeline after piling up billions of dollars in losses because of failed mortgages. WaMu has seen its stock price plummet by 87 per cent this year, and it suffered a ratings downgrade by Standard & Poor's earlier this week that put it in danger of collapse.

The Bush Administration's proposal for a US$700 billion bailout for distressed financial institutions was believed to have given fresh impetus to a buyout and new allure to Washington Mutual. Besides JPMorgan Chase, Wells Fargo, Citigroup, HSBC, Spain's Banco Santander and Toronto-Dominion Bank of Canada were all mentioned as possible suitors. WaMu was also believed to be talking to private equity firms.

The FDIC was seeking a buyer willing to bear a large burden of WaMu's losses, to lessen the impact on the insurance fund.

In a statement, JPMorgan Chase said it was not acquiring any senior unsecured debt, subordinated debt, and preferred stock of Washington Mutual's banks, or any assets or liabilities of the holding company, Washington Mutual Inc.

JPMorgan Chase's chief executive, Jamie Dimon said in a conference call, the "only negative" related to the deal was "how to handle some of these bad assets". He did not elaborate.

WaMu had "$310 billion in assets". Right. What kind of "assets"? The article says "billions of dollars in losses because of failed mortgages". Well there goes some of the assets. How much was "owned" and recorded as "assets" in derivatives? My guess somewhat more than the thus far "failed mortgages". If I were a betting man, I would accept even odds that WaMu has 6 times the value of its total mortgage portfolio in the form of derivatives. If 50% of the mortgages failed, that means that likely 16 times that value is held in derivatives.

Little wonder that JP Morgan Chase is quoted as saying -

In a statement, JPMorgan Chase said it was not acquiring any senior unsecured debt, subordinated debt, and preferred stock of Washington Mutual's banks, or any assets or liabilities of the holding company, Washington Mutual Inc.

JPMorgan Chase's chief executive, Jamie Dimon said in a conference call, the "only negative" related to the deal was "how to handle some of these bad assets". He did not elaborate.

A weekend roundup...

The weekend started with Herald running a series of articles on the probablility of a "dirty election". Not that the election might be won fraudulently (in the direct sense) but the emergence of the "dirty trick brigades". Think, if you are American, of the SWIFT boat saga in the last elections or Richard Nixon and Watergate for extreme parallels.

Rochelle Rees' background with the Labour Party was revealed by bloggers yesterday after news stories she was behind a ploy to ensure Mr Key's website link was the first to appear when people searched for "clueless" on Google.

Yesterday, National leader John Key said it was another example of petty attacks on him by Labour.

Link to the Labour Party or not is not the issue here. The real issue is the denigration of the electoral process.

The second theme was run by the business pages of Sunday Star Times. The headline "Gluttons Table Set by Central Banks" was a good hook to a Gareth Morgan analysis of the weeks' crises in the international finance markets.

If you think that global financial "crises" seem to be happening with increasing frequency, congratulations - you're right.
...
It was back in 1996 that Fed chairman Alan Greenspan, who was really at the centre of the liquidity flood, declared the sharemarket was suffering from "irrational exuberance".

The market ignored his warning and it wasn't till two years later, in 1998, that it suffered its first setback. When hedge fund manager Long Term Capital made some wrong bets and was staring down the barrel at bankruptcy, the US central bank decided this institution was too big to fail and organised a consortium of investment banks to absorb its assets.

The Long Term Capital episode was the first big indication that the financial system was getting sick. If a single institution that was only four years old was too big to fail without bringing the US financial system down, then something was wrong with the system. But it would get worse.

Nice to have the 20/20 now, but let's follow a bit further...

Oh oh! Here's the problem. Central banks, and the Fed in particular, have become so addicted to the need for economic growth each year that they have sacrificed a tenet of sound central banking. It seems they no longer care whether lending by banking is within prudential bounds.

Indeed, it is their effective prudential supervision that they have sacrificed at the altar of this newfound, but ultimately false, belief - that you can have continual economic growth and low inflation. This shows a surreal confidence in the private sector's ability to constantly deliver sufficient productivity gains so that inflation isn't an issue, plus deliver more income to everyone in the economy year after year.

Not covered here, but a strong echo of the 1929 crash - which was fuelled in part by the fervor for stock - any stock - as long as it earned more than the money borrowed to buy it.
Also in the same section this morning was this news item.

Now I spoke of "derivative trading" in my last bit on the subject.

In the past two weeks billions of dollars have vanished as the shares in Australia's Macquarie Group have fallen 45 percent, America's Morgan Stanley 47%, Goldman Sachs, 35 percent.

Their plummeting stocks appear to be following other financial giants into the abyss, as Bear Stearns, Lehman Brothers, Merrill Lynch and HBOS suffered such meltdowns they were forced to sell to rivals.

Bear, which hit trouble in March, was acquired by JP Morgan Chase in May. Lehman filed for bankruptcy protection on Monday and its core businesses were acquired by British bank Barclays the following day. Merrill Lynch is now owned by Bank of America after watching its shares dive 38% in less than a week. HBOS went to fellow British bank Lloyds TSB on Thursday after its shares fell 40% in a matter of days.

The screaming headlines say these institutions were victims of a financial meltdown as their dangerous punts on speculative debts turned septic.

There's another story and it's not pretty either.

Sydney-based Macquarie Group believes it is the victim of a concerted campaign to manipulate its share price and Australia's market regulator has started an inquiry into allegations that short-sellers who profit from falling shares are spreading false rumours.

Now hang on a sec!! What's this? Spreading false rumours to create loss in value on specific stocks?

An inquiry immediately announced by the Australian Securities & Investments Commission was echoed by New York attorney-general Mario Cuomo, who announced on Thursday a probe into possible illegal short selling in financial stocks.

"This investigation will not only encompass short-selling of Lehman Brothers and AIG but also short-selling in other companies that may be occurring, like Morgan Stanley and Goldman Sachs," he said.

In Australia, short-sellers are required to report their positions to the stock exchange daily. "Clearly some haven't been doing that," said one market source.

OK, so what is "short selling"?

TO "short sell" you first borrow someone else's stock. You sell it on the open market. You then wait for the value of that stock to fall. Then you buy back the same stock - at hopefully a considerable gain. The apparent risk is that the stock does not fall - which is where the dirty tricks brigade come in to play.

But, it gets worse -

In practice, in Australia only "naked" short sales are being reported to the exchange - these are deals where the short seller has not yet borrowed stock. A legal ambiguity means "covered" shorting, where the seller has borrowed shares, is not reported to the ASX. As a result, no one knows how big those positions are.

Say WHAT? Selling stock you don't own, or haven't even borrowed yet?

Executives at Bear Stearns believe they were the victims of just such a calculated attack by short sellers. In a detailed exploration of the fall of Bear published last month, Vanity Fair journalist Bryan Burrough uncovered signs of deliberate efforts to undermine confidence in the firm.

He quotes a senior executive at a rival firm: "If I had to pick the biggest financial crime ever perpetuated, I would say, Bear Stearns."

Proving someone was behind the Bear collapse, or any other share price death spiral, is tough. The firms that are targeted are vulnerable precisely because they are highly leveraged and it may be easy for a short seller to point to evidence supporting their negative view of a stock.

You betcha it would be. Super tough.

The article concludes -

CRACKDOWN

UNITED STATES: September 18 - New York attorney-general Mario Cuomo announces probe into alleged illegal short selling of shares in giant investment banks Lehman Brothers, Goldman Sachs, Morgan Stanley and insurer AIG. Short selling is a share trading strategy where a trader borrows shares and sells them on market in the hope they can be bought back more cheaply later. September 17 - Securities & Exchange Commission bans "naked" short selling, in which traders sell stock without first arranging to borrow it.

UNITED KINGDOM: September 18 - The Financial Services Authority bans all short selling in financial companies until January 16. It said anyone creating a net short position in a financial sector company is "engaging in behaviour that is market abuse [misleading behaviour]."

AUSTRALIA: September 17 - Australian Securities & Investments Commission announces extension of inquiry into market manipulation and false rumours, citing specific alleged false rumours against Macquarie Group.

Anyone hearing stable doors being slammed on empty stalls?

And Roundup? Very popular here in the agricultural community for some years. There was a bit I caught during the the week on the use of glyphosphate on roses imported from India to stop their propagation in this country, and just how easy it was to do just that.

"On Wall Street..."

(Sung to the tune of "On Broadway"...
From Dave the Justus

It is not from the benevolence of the butcher, the brewer, or the baker that we expect our dinner, but from their regard to their own interest.
Adam Smith

Extreme valuation of ’service’ and a denigration of the private sector is something that bothers me about both McCain and Obama.
The is, of course, nothing wrong with charitable acts and serving one’s fellow man. It is extremely laudatory and certainly we should encourage it. However, it is capitalism and the free market, not public charity that it the engine for generating growth, raising living standards and yes, increasing equality. Both McCain and Obama lack experience in the private sector, which isn’t necessarily disqualifing, but when it contributes to the distain of the private sector that I have seen from both camps this campaign season it is troubling.
I wish that both McCain and Obama would take a little time to read Adam Smith and Milton Friedman.

The problem of social organization is how to set up an arrangement under which greed will do the least harm, capitalism is that kind of a system.
Milton Friedman

Dave the Justus posted this up Monday. His extremely efficient spam filter has been “fixed” yet again or so he informs another making comment on a different post.

But, given the impossibilities, I shall post here (what I can remember) of my comment made Tuesday perhaps brought up to date in the light of the events of Tuesday on Wall St.

I have little time for Friedman. His purity of Capitalism has no consideration of the fact that to operate the system must have human participation, and that that brings with it the weaknesses that saw the failure of so many economic, and political, systems in the past (going right back here to the Greeks, the Romans and beyond.).

So, Tuesday’s comment ran along these lines –

Let us just suppose for the moment that Friedman is right.

If the current “meltdown” of the US economy is the result of greed, what was capitalism doing to countervail?

If the current “meltdown” of the US economy is the failure of capitalism, what might replace it?

There was a bit more, but my recall does not do the original words justus.

What is becoming apparent, in the commentaries coming out of NY and Washington over the news down this way at least (and it seems the FT and others read it the same way) is that “greed is good” as the foundation for the global economy is about as sustainable as the war in Iraq. It might sputter on for another twenty years without really solving the problem. Then like the old worn-out Vespa, it will have to be pushed to the top of the hill so that it can be given a suitable farewell as it is pushed off the cliff.

Now, before you get in to me for being “anti-capitalist” consider this. I am not proposing any solutions. As I intimated when I responded to Al’s “greed is good” post some months back there is some truth to that sentiment. It does not, any more than Rand or like true communism (not the American hate word but the actual system), make a sound basis for an honest and fruitful economic system. So I can not promote either of those as a replacement. As I have said, the fundamental capitalist system is sound. It is in the nature of humans to exploit systemic weaknesses and opportunities to maximise their individual wealth – and that can only happen at the expense of others.

That of itself creates a conflict between those who promote American Capitalism as the global economic wonderland, and those who do not believe it to be the “God-given freedom”. For some, that is their justification for protesting (in some cases violently) at meetings of G8, WTO, and other fora.

But can I leave you with this thought -

Is there any difference between the failure of Enron, Globaldotcom, and the rest when compared with the strife of Freddie Mac, Fannie Mae, Lehman, Merrill Lynch, and all...

...Is this the end my friend?...

I tried to google the lyrics I was thinking of - "...so let's keep dancing... let's have a ball..." and the only song that it turned up was a little ditty about the suicide of a friend. Most depressing but, for that reason, perhaps also a propos.

Readers will know that Freddie Mac and Fannie Mae is a topic that I have been banging on about for some while now; most recently here.

From Bloomberg 11 July...

07.11.08, 11:55 AM ET

NEW YORK (Thomson Financial) - U.S. stocks fell further Friday after U.S. Treasury Secretary Henry Paulson indicated that a bailout of troubled mortgage giants Fannie Mae and Freddie Mac was not on the horizon.

A somewhat short-sighted Henry Paulson.

Oh, what a different tune today! Bloomberg again...

Sept. 7 (Bloomberg) -- The U.S. government seized control of Fannie Mae and Freddie Mac after the biggest surge in mortgage defaults in at least three decades threatened to topple the companies making up almost half the U.S. home-loan market.

``Our economy and our markets will not recover until the bulk of this housing correction is behind us,'' Treasury Secretary Henry Paulson, who engineered the takeover along with Federal Housing Finance Agency Director James Lockhart, said in Washington today. ``Fannie Mae and Freddie Mac are critical to turning the corner.''

Now, in times gone past, NZers used to have access to government mortgages. They were "means tested" for interest rates - the lower your income the better the rate; they were in general fixed interest rates for the full 20 year term. The mortgages were available only for a first house. Most importantly, the proceeds of the loan were strictly controlled - by the lender. But then, about 20 years back, the government of the day decided that this approach was far too socialist. The portfolio was sold off to "private interests" who in their turn made quite a good profit from the deal. Now, I could if I had the inclination, mortgage both my properties to 100% (more if I had a friendly valuer) and use the proceeds for anything from more properties to a permanent global tour. Naturally, failure to make repayments and interest obligations would result in fairly rapid foreclosure, but if the funds were safely tucked away and I was in Brazil why should I worry.

What was wrong with Freddie Mac and Fannie Mae stemmed from the "government guarantee" that accompanied the privatisation back in the late '60's early '70s. There was no risk to either borrowers or investors; the government would stump up if things went pear-shaped. Because there was no commercial risk the twins effectively became lenders of last resort for all and any hare-brained idea that a person wanted to hang from a loan on their house.

And so it is.

For a nation that promotes "capitalism" as the ultimate goal of humanity, there are a lot of things wrong.

UPDATE.
Found those lyrics, too.

Peggy Lee -

Is that all there is, is that all there is
If that's all there is my friends, then let's keep dancing
Let's break out the booze and have a ball
If that's all there is