Ishrc � Discussion Threads

[simon gordon] 04/10/2008 11:57

Daily Mail - 2/10/08:

Rothschild: Banks turned a blind eye to sub-prime

One of the banking world's most respected grandees criticised the City today and called for a massive overhaul of regulation.

At fault?: Was a lack of ethical behaviour in the City to blame for the credit crunch?
Sir Evelyn de Rothschild said there had been a collapse in ethical standards among banks in recent years, which had been ignored by watchdogs, rating agencies, shareholders and accountants.

The 77-year-old head of the banking dynasty issued a sombre warning that the crisis would get worse before it gets better. 'We should not be under any illusion in this country that sub-prime is only an American problem,' he said.

It came as another senior City figure, private equity boss John Moulton, said it could take seven years for the British economy to recover from the crisis that has brought the world's financial system to its knees.

The outspoken comments were made on another day of grim economic news pointing to increasing damage to the 'real economy' from the credit meltdown.

A survey from the Bank of England suggested that banks plan to rein back their lending to families and small businesses over the coming months.

The report said: "In the three months to mid-September, lenders reported that they had reduced the availability of credit to households and corporates by more than had been expected three months ago. Lenders anticipated additional reductions in credit availability in the next three months.'

There were also bad figures from the construction industry, record falls in house prices reported by the Nationwide-and a six per cent fall in sales from Marks & Spencer.

The only good news was that City economists now believe that a cut in the Bank of England's base rate to avert a slide into a deep and long lasting recession is likely. That would cut the rate from 5% to 4.75%, bringing instant financial relief to millions of borrowers on tracker mortgages.

But the worsening economic outlook increased recriminations over how the City landed the economy in such a mess.

Sir Evelyn, speaking on Radio Five Live, accused the banking community, including the regulators, of turning a blind eye to the explosion in the British sub-prime mortgage market.

He also declared that investors in the banks should have acted to control bankers' pay and the risk-taking of management. 'What are shareholders for? I think shareholders have not been speaking up.'

He added: 'You can also look to the accountants. It is their job to dig deep into the accounts and assess the risks a bank is taking. I mean, some of these American banks were 20 to 30 times leveraged - that is something I have never heard of.'

De Rothschild said the only way out of the crisis was to improve regulation and license anybody involved in financial services.

The veteran financier, who has seen many crises, added: 'You have to have regulators who are properly paid and who properly understand the situation. And you should have a licensing system like you have in pubs where if you break the rules, they take away your licence.'

[simon gordon] 03/10/2008 20:04

WSJ - 3/10/08:

How Government Stoked the Mania

Housing prices would never have risen so high without multiple Washington mistakes.

By RUSSELL ROBERTS

Many believe that wild greed and market failure led us into this sorry mess. According to that narrative, investors in search of higher yields bought novel securities that bundled loans made to high-risk borrowers. Banks issued these loans because they could sell them to hungry investors. It was a giant Ponzi scheme that only worked as long as housing prices were on the rise. But housing prices were the result of a speculative mania. Once the bubble burst, too many borrowers had negative equity, and the system collapsed.

David KleinPart of this story is true. The fall in housing prices did lead to a sudden increase in defaults that reduced the value of mortgage-backed securities. What's missing is the role politicians and policy makers played in creating artificially high housing prices, and artificially reducing the danger of extremely risky assets.

Beginning in 1992, Congress pushed Fannie Mae and Freddie Mac to increase their purchases of mortgages going to low and moderate income borrowers. For 1996, the Department of Housing and Urban Development (HUD) gave Fannie and Freddie an explicit target -- 42% of their mortgage financing had to go to borrowers with income below the median in their area. The target increased to 50% in 2000 and 52% in 2005.

For 1996, HUD required that 12% of all mortgage purchases by Fannie and Freddie be "special affordable" loans, typically to borrowers with income less than 60% of their area's median income. That number was increased to 20% in 2000 and 22% in 2005. The 2008 goal was to be 28%. Between 2000 and 2005, Fannie and Freddie met those goals every year, funding hundreds of billions of dollars worth of loans, many of them subprime and adjustable-rate loans, and made to borrowers who bought houses with less than 10% down.

Hear No Evil

What some Congresspeople said about Fannie and Freddie.

Fannie and Freddie also purchased hundreds of billions of subprime securities for their own portfolios to make money and to help satisfy HUD affordable housing goals. Fannie and Freddie were important contributors to the demand for subprime securities.

Congress designed Fannie and Freddie to serve both their investors and the political class. Demanding that Fannie and Freddie do more to increase home ownership among poor people allowed Congress and the White House to subsidize low-income housing outside of the budget, at least in the short run. It was a political free lunch.

The Community Reinvestment Act (CRA) did the same thing with traditional banks. It encouraged banks to serve two masters -- their bottom line and the so-called common good. First passed in 1977, the CRA was "strengthened" in 1995, causing an increase of 80% in the number of bank loans going to low- and moderate-income families.

Fannie and Freddie were part of the CRA story, too. In 1997, Bear Stearns did the first securitization of CRA loans, a $384 million offering guaranteed by Freddie Mac. Over the next 10 months, Bear Stearns issued $1.9 billion of CRA mortgages backed by Fannie or Freddie. Between 2000 and 2002 Fannie Mae securitized $394 billion in CRA loans with $20 billion going to securitized mortgages.

By pressuring banks to serve poor borrowers and poor regions of the country, politicians could push for increases in home ownership and urban development without having to commit budgetary dollars. Another political free lunch.
Fannie and Freddie and the banks opposed these policy changes at first through both lobbying and intransigence. But when they found out that following these policies could be profitable -- which they were as long as rising housing prices kept default rates unusually low -- their complaints disappeared. Maybe they could serve two masters. They turned out to be wrong. And when Fannie and Freddie went into conservatorship, politicians found out that budgetary dollars were on the line after all.

While Fannie and Freddie and the CRA were pushing up the demand for relatively low-priced property, the Taxpayer Relief Act of 1997 increased the demand for higher valued property by expanding the availability and size of the capital-gains exclusion to $500,000 from $125,000. It also made it easier to exclude capital gains from rental property, further pushing up the demand for housing.
The Fed did its part, too. In 2003, the federal-funds rate hit 40-year lows of 1.25%. That pushed the rates on adjustable loans to historic lows as well, helping to fuel the housing boom.

The Taxpayer Relief Act of 1997 and low interest rates -- along with the regulatory push for more low-income homeowners -- dramatically increased the demand for housing. Between 1997 and 2005, the average price of a house in the U.S. more than doubled. It wasn't simply a speculative bubble. Much of the rise in housing prices was the result of public policies that increased the demand for housing. Without the surge in housing prices, the subprime market would have never taken off.

Fannie and Freddie played a significant role in the explosion of subprime mortgages and subprime mortgage-backed securities. Without Fannie and Freddie's implicit guarantee of government support (which turned out to be all too real), would the mortgage-backed securities market and the subprime part of it have expanded the way they did?

Perhaps. But before we conclude that markets failed, we need a careful analysis of public policy's role in creating this mess. Greedy investors obviously played a part, but investors have always been greedy, and some inevitably overreach and destroy themselves. Why did they take so many down with them this time?

Part of the answer is a political class greedy to push home-ownership rates to historic highs -- from 64% in 1994 to 69% in 2004. This was mostly the result of loans to low-income, higher-risk borrowers. Both Bill Clinton and George W. Bush, abetted by Congress, trumpeted that rise as it occurred. The consequence? On top of putting the entire financial system at risk, the hidden cost has been hundreds of billions of dollars funneled into the housing market instead of more productive assets.

Beware of trying to do good with other people's money. Unfortunately, that strategy remains at the heart of the political process, and of proposed solutions to this crisis.

Mr. Roberts is a professor of economics at George Mason University and a scholar at the Mercatus Center. His latest book is a novel on how markets work, "The Price of Everything: A Parable of Possibility and Prosperity" (Princeton University Press, 2008).

[simon gordon] 03/10/2008 15:13

Hi Al,

Sounds wise.

The HBOA are not actually cumulative but it would be an act of desperation for the dividend to be cut.

I bought some corporates today:

AXA - 2037
Citigroup - 2018
GE - 2017
Halifax - 2014

These yield between 8% and 9%.

I also bought some HBOA which is the icing on the 'distressed debt' cake.

Earlier this year I was investigating distressed debt hedge funds but I was put off by the lock-ins. Now you can buy loads of distressed debt, which is government backed, for a bargain price. With interest rates likely to be savagely cut and the real economy entering a severe recession, thus leading to equity being highly volatile and trending lower, credit is the place to be.

[simon gordon] 02/10/2008 20:17

Hi insipiens,

I had a look at the bank bonds but the spreads are wide and it is difficult to get daily pricing. So, I am now seriously tempted by SLXX as these are now quasi government bonds as no government will let a big bank go down. Lehman's has had traumatic side-effects and it was a tiddler.

7% yield and upside capital growth - SLXX looks so much better than buying equity which still has to deal with an economic slump.

[insipiens] 02/10/2008 11:42

Simon, you turned bullish?

However, there won't be much point having money (as opposed to Gold) if this isn't the bottom.....

[simon gordon] 01/10/2008 15:09

Matthew Lynn - 1/10/08:

Bankers Working for Government Are More Dangerous: Matthew Lynn

Maybe we should call it Red Monday. Sept. 29 turned out to be the day that big chunks of Europe's financial industry got taken over by the state.

The U.K. government stepped in to rescue mortgage lender Bradford & Bingley Plc. In Brussels, Fortis received a lifeline from the governments of Belgium, the Netherlands and Luxembourg as investor confidence in the bank evaporated. Iceland bought a 75 percent stake in Glitnir Bank hf.

Don't expect them to be the last. Before this crisis has played out, much of the financial system may be in state hands.

The trouble is, the cure is almost as bad as the disease. The state-run banks will be just as risky as the private ones we have now. They will spend money on just as many stupid things. In a few years, we'll be thinking about taking them private again.

It looks like bankers will have to get used to working for the government. The nationalization of Bradford & Bingley and the earlier takeover of Northern Rock Plc mean that two of the biggest lenders in the U.K. are now part of the public sector. The country that led the privatization charge in the 1980s is now taking the world in the opposite direction. The Fortis bailout will give the Belgian government 49 percent of the domestic banking unit: It will be state-owned in every meaningful sense.

Yesterday, the Irish government moved to guarantee the deposits in its banks. Lenders such as Bank of Ireland Plc and Anglo Irish Bank Corp. Plc seem just as vulnerable as U.K. mortgage banks, and the share prices have been savaged in the last few weeks. These companies, too, are now effectively state- controlled.

Spanish Banks

Meanwhile, no one wants to look too closely at the big Spanish banks. Spain has had a steep decline in real-estate prices, so there must be big losses in the system somewhere. Like a hardened gambler at the casino table, Banco Santander SA keeps doubling its bets, taking on more and more of the failing British finance industry. Perhaps it is making itself too big to be allowed to fail -- not a bad strategy under the circumstances.

Even Germany, which managed to skip the property bubble enjoyed by much of the world, has banks in trouble. Hypo Real Estate Holding AG, the country's second-biggest commercial- property lender, received an emergency loan guarantee yesterday.

No one knows where this crisis will end. Whether it's complete or partial nationalization of the banking system, the state will be the dominant force for years to come.

In time, we'll come to resent that. Here's why.

No Constraints

First, without shareholders, there won't be any effective pressure to perform. We think that means the banks will take fewer risks. The truth is that without shareholders, the new state-owned banks will take just as many chances as the old bonus-driven ones did. After all, they won't need to worry about profits anymore. And with the governments behind them, they won't be constrained by a lack of capital. So why not expand rapidly? After all, that's how you make yourself more important.

Next, the banks will be exposed to constant political interference. With governments as their main shareholders, there will be nothing to stop politicians meddling in financial decisions. They won't be foreclosing on dud loans -- and certainly not if they are in sensitive constituencies. They won't cut staff when they need to. They will hand out loans to ``national champions'' that probably don't deserve them. That will end in more losses, not fewer.

Don't expect to see much in the way of innovation in the next 10 years. Once they are run by the state, there won't be any genuine competition forcing banks to offer new products. In time, that will start to hurt. Europe has an aging population that will need more financial innovation to meet this challenge. But it won't be getting any new thinking from state-dominated banks.

Different Ways

Lastly, with the banks run by the government, access to money will be determined more by connections than by commercial astuteness. It is a myth to imagine that state-owned banks will allocate capital more efficiently than shareholder-owned ones. They will still blow it, but in a different way.

Let's not forget that the record of state-run banks is grim. Credit Lyonnais SA was one example when it was owned by the French government. Amongst other terrible decisions, it ended up owning the MGM movie studio. Don't be surprised if Fortis executives are running around Hollywood in a few years.

A bailout may well be needed now because there are too many risks involved in letting banks go bust. Yet putting them into government ownership fixes today's crisis at the cost of creating a new set of problems. Bankers like nothing better than to spend other people's money, and they have just been handed a bottomless pit of the stuff. The results won't be pretty.

[simon gordon] 01/10/2008 15:09

Hi Guys,

I've started looking at the long dated bonds of HSBC 2023, Citigroup 2026 and Barclays 2026. They are paying c.7% and if they go down so will we all. There could be a 17% return over the next year.

Any thoughts?

[insipiens] 30/9/2008 20:26

bill, you might be right but I suspect there's a good reason for the yield - so many bank bonds with double digit yields.

Lloyds/HBOS/Morgan stanley/Citigroup etc.

This ETF is a partial bet (quick count 50% of it is banks or their ilk) on the banking industry.....

[borderbill] 30/9/2008 16:43

At these price/yield margins I am finally attracted by SLXX. This is a decent investment now.

[insipiens] 28/9/2008 06:48

for the record SLXX is not a structured derivative - some less well informed people have confused ETNs (Exchange traded notes) that are structured derivatives, with ETFs (exchange traded funds) which are not structured derivatives.

I think you'll find ETNs are usually used for commodities, currencies etc.....



Barclays ishares are ETFs, their ipath products are ETNs

The recent fall is not due to counter party concerns on ETFs but the underlying bonds have fallen, so much so I've started picking up a few more :)

[simon gordon] 27/9/2008 19:46

Avner Mandelman - 27/9/08:

Perhaps this rout, too, will stop at the gates of Rome

After Hannibal had crossed the Alps and beaten the Roman army twice, the alarmed Roman Senate spent the nation's treasure and sent eight legions against the invader. Up to then, Rome had rarely thrown more than two legions into battle. But when the state was in danger, there was no limit to what the authorities would do.

And so it is today. The financial system has just buckled before a financial marauder - Freddie and Fannie's huge debt - and to save the system, the U.S. government took over their $5-trillion (U.S.) of debt, annihilating its own balance sheet. It is just as the eight Roman legions that gave battle to Hannibal in Cannae in 216 BC also were annihilated. And, just as after Cannae the moneyless Roman state lay defenceless before Hannibal, so does the broke U.S. government now lie defenceless before the remaining debt - which is a hundred times bigger than F&F's.

Yes, you read it correctly: A hundred times bigger. F&F cost $5-trillion, or 8 per cent of the $60-trillion global GDP; but there are $600-trillion of derivatives out there, or about 10 times the world's GDP. What would happen if some of these crumbled, as did F&F?

AIG had a "mere" $1-trillion of derivatives, which was enough for the U.S. Federal Reserve to pale and renege on its vow not to bail out anyone after F&F. And AIG is small compared with, say, JPMorgan, which has perhaps $20-trillion of derivatives; or other insurance companies and banks each of which has half-a-trillion of derivatives here, half-a-trillion there.

Almost every exchange-traded fund has derivatives (called swaps), every insurance company and every bank. It's a huge daisy chain of obligations. What would happen if a few trillion cracked? How would the now-broke U.S. authorities fight the problem? Back to Rome then, for clues.

When, after Cannae, the Roman state had no more money or soldiers, the Senate sent collectors to confiscate private citizen's horses, food and money for the coming battles; then sent out impressers to draft any able-bodied man into the army. Because when the state is at risk, no private wealth, nor private body, is safe.

And so it is today. The market just had its Cannae; the U.S. Treasury is broke. Foreign governments won't hand over their cash. Yet an even larger debt problem - derivatives - is looming. And so the authorities must gather money from wherever they can, any way they can - and they are already doing it.

First were resource stocks. The U.S. Treasury, in concert with the Fed, bumped the U.S. dollar up, drove resource prices down, and so sucked money out of anyone who was long commodities and short financials, thus giving broke banks breathing room to refinance. (BMO's Don Coxe has written a terrific piece about it.)

The authorities then forbade shorting most financial stocks - and bang! The shorts had to rush to cover - contributing a piece of their hide to the debt battle's costs. What's next?

Probably no shorts allowed at all - the California Public Employees Retirement System already announced it won't lend its stocks any more (after the Feds allegedly leaned on it), and so more shorts should rush to cover (helping the market rise - perhaps a lot).

And after this rascality, just about anything is possible, because the authorities are desperate. Thus one by one, sectors of the market, parts of the economy, whole asset classes, are likely to be raided for fresh money - just like the Roman Senate did, post Cannae.

Will this be enough? Not very likely - there's just too much debt. So the coming war against it must eventually resort to a Fabian strategy: The Roman general Fabius knew he could not stand up to Hannibal in direct battle, so he let the invader destroy the Italian countryside with impunity until the invading army dissipated its strength. (Foolhardy Roman generals who tried to fight Hannibal directly, lost.)

Similarly, today's debt tsunami may have to be allowed to exhaust itself by eating up the only store of value left: Everyone's savings (including foreigners'), following massive money printing. And so inflation must come back, the U.S. dollar must decline, gold must rise, and bonds must tank - eventually. And if bonds fall, they would take the market down with them - and the economy.

Unless. Unless.

Unless this financial debacle ends the same way the previous one did in the late Thirties - in a large-scale war. Because with so much capital destroyed, democracies look mostly inward, their will to respond firmly and early to mad rulers and evil dictators is diminished, and so evil can run unchecked for a while - until it becomes intolerable and war becomes inevitable. And a large-scale modern war, unfortunately, boosts the economy - at least for a while.

Will the late Thirties' history repeat? I hope not. But time will tell. Meanwhile, see gold as an inflation substitute for cash, and get ready to enjoy the market rise after this lengthy, scary bottom. Hannibal, remember, stopped at the gates of Rome, and so will this market slide stop - very soon.

[simon gordon] 23/9/2008 14:27

Barron's - 20/9/08:

The Pain of Deleveraging Will Be Deep and Wide
Felix Zulauf, Founder, Zulauf Asset Management
By LAWRENCE C. STRAUSS

AN INTERVIEW WITH FELIX ZULAUF: A bleak long-term view on stocks.

AS THE CREDIT CRISIS INTENSIFIED LAST WEEK, radically altering the Wall Street landscape and the government's role in stabilizing the financial system, Barron's sought out Switzerland-based Felix Zulauf for a global macro perspective. A longtime member of Barron's Roundtable, the founder of Zulauf Asset Management is now equity-averse -- he prefers gold and government bonds -- but further out, sees untapped growth potential in emerging-markets.

Barron's: It's been an unprecedented time in the financial markets, with Lehman filing for bankruptcy protection, Merrill Lynch being bought by Bank of America and AIG getting rescued by the U.S. government. What's the fallout going to be?

Zulauf: The leveraging-up in this cycle is reversing, and we are now deleveraging. When a huge system -- that is, the global credit system dominated by the investment-bank giants that have been the major creators of credit in the last cycle -- turns down, the fallout is going to be terrible.

Deleveraging is a very painful process, and will run longer and deeper than anybody can imagine. I've been fearful of this.

So far, what we're seeing is the pain in the financial system. Later on, we'll see the echo effect of the pain in the real economy. I can't understand economists talking about no recession or mild recession. This is the worst financial crisis since the 1930s. It's different than the '30s, but is the worst since then, and the consequences will be very, very painful for virtually everybody in our economies.

B: So it's a global downturn?

Z: That's right. It started out in the U.S., but it is a global event, led by the [excessive lending practices that grew up in the] housing boom in the U.S. But we also had housing booms in some of the European countries, and in some of the emerging countries. People are already talking about a glut of unsold homes in China.

B: How will these countries fight this severe downturn?

Z: Governments, particularly those in the industrialized economies, will use fiscal stimuli to prop up the system and prevent them from collapsing. Usually, those stimuli are a little too small to really have a lasting impact, which is usually spent after two to three quarters. So we could have a pop in the market in '09 and the economy into 2010, and then it disappears again; then there is the next fiscal program, and so on. That can go on for a long time.

By issuing more debt, all of these governments are trying to stimulate deteriorating economies. But what do you see as some of the other consequences of all that additional debt?

Government debt is going to rise dramatically over the next five to 10 years. Government debt is at 300% of [gross domestic product] in most industrialized countries, if you calculate correctly. That can increase to 400% and 500%, but at some point the government-bond market will not take this without any consequences. That will lead to rising long-term interest rates. But because the economy is not on solid footing yet, short-term rates will stay low for a long time. So you will have a very steep yield curve for many, many years, and this is bearish for bonds since their prices keep falling.

B: What's your take on the inflation outlook?

Z: Most governments and central bankers are still concerned about the inflation rate. I think for cyclical reasons that inflation will probably drop sharply into '09, partly due to lower commodity prices. But what's more important thereafter is that there will be a secular rise of the inflation rate, because governments and central bankers will be forced to reflate these economies in a big, big way, and this will be bad for nominal assets, whose value decreases because of less purchasing power. But it will be good for real assets at some point of time in the future. For example, companies can adjust by raising their prices and growing their incomes.

B: What does all of this deleveraging, in which firms try to get various forms of debt off their balance sheet, mean for those involved?

Z: When the deleveraging starts due to declining asset prices, there is no one there to reverse it. I cannot see the private sector stopping this and turning it around. It has to be the government, together with the central banks, and they are starting to do that.

B: What's your assessment of the steps Federal Reserve Chairman Ben Bernanke and U.S. Treasury Secretary Henry Paulson have taken to stem these problems?

Z: It's a challenging job. Bernanke and his team and Treasury are doing the utmost, but doing the utmost means they're always one step behind. So far, it seems that the Fed is constrained by not being able to expand its balance sheet. It has replaced a lot of Treasury paper with other paper of lower quality, and the level of Treasury paper on the Fed's balance sheet has now reached such a low point that it cannot expand more without really monetizing debt.

You can't stop this [downturn] or turn it around without going to monetization, a step the central bank hesitates to take. But eventually the developments will force the Fed to do it.

B: What's your reaction to Friday's announcement that Paulson is crafting a plan for the federal government to buy illiquid assets from various financial firms?

Z: Treasury, together with the Fed, is taking a big step forward to keep the system from melting down. It will work, but it has to be at least $1 trillion in size and the Fed has to help by cutting rates. The idea is good; now the Treasury has to make it solid and the Fed has to lend its support. This is probably the beginning of a medium-term bottom. Usually a good bottom, even medium term, doesn't stand on one leg. In the coming three or four weeks, the low will be tested, but from there we have a chance for a good medium-term rally.

B: Could you elaborate?

Z: What the Fed has to do is buy paper in the asset market, including Treasuries and corporate bonds, and create new money in the financial system -- because the deflationary process created by the deleveraging is at work. Deflationary power is growing dramatically, and the Fed has to replace the dollars that have disappeared into a black hole. The private credit system cannot do that anymore. The Fed and government are really the lenders of last resort.

B: From your vantage point, what do you see happening to the Eurozone's economy?

Z: Short term, it will probably get a little bit worse in Europe, because we have a different policy mix than in the U.S. Your central bank has cut rates. They've been aware of the problem. The fiscal situation is expansive already, whereas in Europe we have tightening fiscal policy, and we have still a restrictive central bank that's looking at holding the value of the euro. So Europe could get hurt a little more than the U.S. in the short term, but I think it will do better over the medium term.

B: Why is that?

Z: First of all, Europe can finance itself, meaning it's not dependent on outside money. It runs a slight current-account surplus and, net-net, it is not indebted to the rest of the world. The U.S. is indebted to the rest of the world; that's a major difference. Also, Eurozone households [collectively] run a financial surplus, while U.S. households have deficits. So when you look at the large European economies such as those in Germany or France, the consumer is in much better shape and the banks are probably in a little bit better shape than in the U.S., although some internationally active banks and investment banks are like their U.S. competitors.

B: What about emerging-market economies?

Z: Even emerging economies are getting hurt. We have seen how real-estate prices in some emerging economies, from the Baltic States to some Asian countries, are coming down. But these countries have a better situation from a very, very long-term point of view because of demographics. They are much younger nations. They are much lower in their standard of living, they are going up the ladder, and they are competitive.

Another thing to consider is that current-account and trade deficits will shrink. So what used to be a big stimulus for emerging economies will be curtailed and it will hurt those economies in the short run much more than the markets assume.

B: What do you see ahead for the U.S. economy and elsewhere?

Z: The U.S. economy goes flat for several years, and from time to time there probably will be major fiscal programs, each one bigger than the previous one, to help the economy. Europe will be similar; its potential growth is relatively low, with a stagnating population.

The emerging economies have much higher potential growth rates. They are going through a down-cycle, but they will come up again in the next cycle and have higher growth rates. But it is going to be a very tough 2009, a global recession. Whoever gets elected president in November will come through with a fiscal program. Monetary policy is really ineffective in this situation. When you have a balance-sheet recession and everybody is deleveraging, monetary policy cannot do the trick. It doesn't work because there is no one willing to leverage up their own balance sheet.

B: Around these parts there has been a lot of focus on Merrill, Lehman and AIG, not to mention Fannie Mae and Freddie Mac, which the U.S. government bailed out recently. What does the future hold for financial firms globally?

Z: Bankers have to learn that banking is an industry like any other industry. The financial sector has grown dramatically over recent decades, and I think it has grown to a level that is too big in proportion to total GDP.

Global financial-sector debt has gone up fivefold in the last 25 years relative to GDP. So what you now see is a reversal back to the mean. That means that the financial sector as a profit generator, as an employer and as a provider of services will shrink over many years -- back to a level that is more normal than in recent years. The financial-services industry has been treated extremely well for a long time and people made a lot of money and created careers, etc. But it is going to be much, much tougher in the next 10 years globally.

B: Do you see any industries that look promising at the macro level?

Z: First, we go through a down-cycle, and it will affect virtually every industry. After that down-cycle is over, particularly in the emerging economies that have higher growth potential, it will turn up again. It could again be infrastructure-related assets or commodity-related assets that will perform very well. If I'm right in this scenario, what will happen is we will create a stimulus to grow in the future. And those who grow the best in a world of stimuli will be those that have the highest growth potential, namely the emerging economies. And then we will see rising bond yields. They will go in cycles, of course, and they will not shoot up straight. But they will go up.

B: What investments look interesting to you?

Z: In this environment, those who do not lose win. For the average guy, I'd say go into the most defensive position. I'm not really interested in any longs in equities. I'm holding a lot of government bonds on the long side. I suggest that American investors stick to shorter-term Treasuries with maturities of up to two years.

B: Any other suggestions for equity holdings?

Z: If you have extra money left and want to be more aggressive, you can play the markets short-term. There are going to be a lot of runs up and down in a declining market.

B: This is all sounds very bleak, Felix.

Z: I'm not interested in any longs in equities. If you are an optimist by nature and if you want to be long, the one area that you should look at is daily necessities, notably consumer staples. Companies like Procter & Gamble [ticker: PG], General Mills [GIS] and maybe Johnson & Johnson [JNJ]. Those are the defensive names. But I have absolutely no interest in investing on the long side in anything that is cyclical in nature, because this cycle could last longer on the downside and go deeper than most investors assume.

Thanks very much.

[simon gordon] 22/9/2008 14:22

FT - 22/9/08:

The shadow banking system is unravelling
By Nouriel Roubini

Last week saw the demise of the shadow banking system that has been created over the past 20 years. Because of a greater regulation of banks, most financial intermediation in the past two decades has grown within this shadow system whose members are broker-dealers, hedge funds, private equity groups, structured investment vehicles and conduits, money market funds and non-bank mortgage lenders.

Like banks, most members of this system borrow very short-term and in liquid ways, are more highly leveraged than banks (the exception being money market funds) and lend and invest into more illiquid and long-term instruments. Like banks, they carry the risk that an otherwise solvent but liquid institution may be subject to a self­fulfilling and destructive run on its ­liquid liabilities.

But unlike banks, which are sheltered from the risk of a run – via deposit insurance and central banks' lender-of-last-resort liquidity – most members of the shadow system did not have access to these firewalls that ­prevent runs.

A generalised run on these shadow banks started when the deleveraging after the asset bubble bust led to uncertainty about which institutions were solvent. The first stage was the collapse of the entire SIVs/conduits system once investors realised the toxicity of its investments and its very short-term funding seized up.

The next step was the run on the big US broker-dealers: first Bear Stearns lost its liquidity in days. The Federal Reserve then extended its lender-of-last-resort support to systemically important broker-dealers. But even this did not prevent a run on the other broker-dealers given concerns about solvency: it was the turn of Lehman Brothers to collapse. Merrill Lynch would have faced the same fate had it not been sold. The pressure moved to Morgan Stanley and Goldman Sachs: both would be well advised to merge – like Merrill – with a large bank that has a stable base of insured deposits.

The third stage was the collapse of other leveraged institutions that were both illiquid and most likely insolvent given their reckless lending: Fannie Mae and Freddie Mac, AIG and more than 300 mortgage lenders.

The fourth stage was panic in the money markets. Funds were competing aggressively for assets and, in order to provide higher returns to attract investors, some of them invested in illiquid instruments. Once these investments went bust, panic ensued among investors, leading to a massive run on such funds. This would have been disastrous; so, in another radical departure, the US extended deposit insurance to the funds.

The next stage will be a run on thousands of highly leveraged hedge funds. After a brief lock-up period, investors in such funds can redeem their investments on a quarterly basis; thus a bank-like run on hedge funds is highly possible. Hundreds of smaller, younger funds that have taken excessive risks with high leverage and are poorly managed may collapse. A massive shake-out of the bloated hedge fund industry is likely in the next two years.

Even private equity firms and their reckless, highly leveraged buy-outs will not be spared. The private equity bubble led to more than $1,000bn of LBOs that should never have occurred. The run on these LBOs is slowed by the existence of "convenant-lite" clauses, which do not include traditional default triggers, and "payment-in-kind toggles", which allow borrowers to defer cash interest payments and accrue more debt, but these only delay the eventual refinancing crisis and will make uglier the bankruptcy that will follow. Even the largest LBOs, such as GMAC and Chrysler, are now at risk.

We are observing an accelerated run on the shadow banking system that is leading to its unravelling. If lender-of-last-resort support and deposit insurance are extended to more of its members, these institutions will have to be regulated like banks, to avoid moral hazard. Of course this severe financial crisis is also taking its toll on traditional banks: hundreds are insolvent and will have to close.

The real economic side of this financial crisis will be a severe US recession. Financial contagion, the strong euro, falling US imports, the bursting of European housing bubbles, high oil prices and a hawkish European Central Bank will lead to a recession in the eurozone, the UK and most advanced economies.

European financial institutions are at risk of sharp losses because of the toxic US securitised products sold to them; the massive increase in leverage following aggressive risk-taking and domestic securitisation; a severe liquidity crunch exacerbated by a dollar shortage and a credit crunch; the bursting of domestic housing bubbles; household and corporate defaults in the recession; losses hidden by regulatory forbearance; the exposure of Swedish, Austrian and Italian banks to the Baltic states, Iceland and southern Europe where housing and credit bubbles financed in foreign currency are leading to hard landings.

Thus the financial crisis of the century will also envelop European financial institutions.

[simon gordon] 22/9/2008 12:28

JP Morgan's view on UK banks - 22/9/08:

Brevity of downturn depends on addressing capital shortage –
JPMe £38bn for the system; Lloyds TSB/HBOS (£16bn), RBS
(£12bn), Barclays (£10bn). We remain UW until action is taken.

• Analysis of pro-cyclicality of 'total' capital demands reveals (i)
banks will limit credit exposure to corporates; (ii) higher pricing,
but limited profitability gains; (iii) returns in investment banking
to remain under pressure due to higher capital demands.

• Cutting sector estimates by 39% in 09E, 47% in 10E to reflect
full downturn (see summary in Table 21. With the sector trading
on 1.7x 09E JPM P/NAV we have ranked UK banks, by least
preferred:

1. B&B – Remains UW – Removing TP – We do not believe it
is a viable standalone entity;

2. Lloyds TSB – D/g from N to UW – New TP 180p -
Unattractive combination with HBOS, high risk of revenue
attrition. Top UW in Europe;

3. RBS – D/g from N to UW – New TP 120p - Capital
constrained, suffers from a poor earnings mix and ABN
synergies do not appear feasible;

4. Barclays – D/g from N to UW – New TP 210p - More
investment banking means lower returns. Economic profit
target looks unattainable;

5. HSBC – Remains UW –TP 720p - In a Global banking
context, but within UK, we believe healthy capital gives it a
competitive advantage.

[kiwi2007] 19/9/2008 11:28

Quite a lot of trades early this am at 120'ish which seems odd ...

[kiwi2007] 17/9/2008 15:46

"The price of SLXX will be backed by derivatives rather than holdings of the underlying securities."

I'm not sure whether that's a statement or question but, as far as I'm aware, only around 4% of the holding is in derivatives? I would like to know though!

Posters elsewhere seem to believe the fall today is at least partially down to the exposure that most of them have to CDSs underwritten by AIG.... as another points out though the issue is really to what extent that exposure impacts on their ability to pay their bond commitments...

[jonwig] 17/9/2008 12:06

Is the fall in SLXX inspired by counter-party risks as mentioned with some of AIG's ETFs?

The price of SLXX will be backed by derivatives rather than holdings of the underlying securities.