Season's greetings

It has been a challenging year. Whilst some have been brought down by their own greed, many families face difficult times through no fault of their own. If your circumstances allow it, please take some time to offer whatever support you can to someone you know who may be facing such challenges, or to a good cause - an investment that I can guarantee will be valued and appreciated.

This blog is normally focused on financial markets and the pursuit of wealth creation. Yet at this special time of year, let us put that to one side briefly and cherish the blessings of friendship and goodwill - the greatest wealth of all.

I'd like to wish all my readers a very Happy Christmas. I hope that 2009 brings you good health, happiness and success in your endeavours.

Have a peaceful and enjoyable holiday,

"Capital Novation"

Quantitative Wheezing

Several pundits are at pains to point out that there is a key difference between the US quantitative easing programme and the prior art of this technique (i.e. Japan in the 1990s). The argument is that the Fed is buying a range of non-government assets (MBS, commercial paper, loans...) rather than just Treasuries. Unlike Japan, this should spur a broader economic boost rather than simply rebooting bank lending. In other words, it's different this time.

"Different this time?" I've heard that one before. The problem here is that all these measures are of limited firepower at this stage. Every macroeconomic indicator of note is pointing due South, and it would be naive to assume that the consumer will suddenly revert to type as unemployment ratchets up. The economy is simply out of breath, and force feeding liquidity to the patient is not going to help.

However, all this liquidity will have a long term impact. Unless the Fed can snatch it back the second the economy starts to turn, we will face a horrible rise in inflation. Given their past record (thank you Mr Greenspan) I have my doubts that the Fed has the nerve to slam the brakes once prices start to move.

Trichet gets a lot of stick for his hawkish position on rates. Well we'll see - 2009 will either break the ECB's credibility, or seal its reputation as a new reserve currency manager.

Core Concept 2 - Total wealth picture

In this week's core concept, we'll look at the foundation for your wealth management plan. This is based on a getting a complete picture of your current wealth position. All your investment decisions should be based on this.

As I mentioned last time, you need to make a full list of all your assets. This includes all the usual financial pieces (savings, brokerage account, 401ks), any property you own, and other major assets (e.g. a car). And don't forget to add your own human capital (your skills, experience, current job).

Then scribble down your major commitments. For most people this will revolve on loans (mortgage, college tuition, credit cards). Add in any major expenses you are planning over the next ten years (such things as college fees, for example).

There are two principles when planning out future expenses. First, if you can pay down as much debt as you can. Second, always pocket a small amount each month for an emergency fund to cover the unexpected (e.g. additional medical costs). Life can throw lots of curve balls, so having some cash to tide things over is no bad thing.

Putting these two things together will help you understand how much "liquid" assets you will need at various points in time. It should also help you rationalise what is "necessary" versus "nice to have" spending. Be ruthless - there are always more things we'd like. Stick to the essentials - if things turn out better than planned, that's a bonus.

The end result of these lists is the raw material to start steering your investment decisions to meet these future needs. This will involve planning what investment strategy makes sense for each major "purchase" you need to fund. We'll walk through this in more detail in the next core concept.

A picture perfect company

Or so the banner says on Polaroid's press release web page. There's a tragic irony to the story, as a company founded on a great innovation lost its way and failed to invent itself a future. In this instance, there seems to be a nasty fraud coming out of the Petters venture capital group.

Of course, it pales into comparison with the Madoff debacle. Yet a common theme is emerging of relatively large organisations pursuing fraudulent activities without any of the supposed governance/audit controls being triggered.

A lesson from these recent failures is that the whole regulatory approach needs to change. Policymakers thought that Sarbanes-Oxley had solved the issues that were found in the Enron failure. Unfortunately all those reforms achieved was a huge fee windfall for consultants and auditors - fraud and governance failures seem to have continued more or less unchecked.

A central banker's Christmas Carol

It was the night before Christmas, and a dark shadowy figure sulked away from the festive crowd to his home (recently assessed in negative equity by the lender). The man was Ebernanke Screwed, the Fed Chairman.

After supping over a tepid bowl of gruel, he fuelled his measly log fire with copies of his recent testimony to Congress. “Best use for it!” Screwed chuckled.

All of a sudden, he heard a slithering sound and a rasping tone. “Eeeebernanke….” said the voice. Screwed turned, and to his horror was faced with a ghastly apparition. A gaunt man was standing beside him, wrapped in a heavy chain of rare unsigned copies of the Age of Turbulence. Those horrible, fashion-tragic glasses…

“Greenspan!” shrieked Screwed.

“Helloooo Ebernanke. I have come to intercede on your behalf, for you are currently on the path of doom and eternal despair…”

“You mean my policymaking?”

“No, I was thinking of your interior decorating. But now that you mention it, perhaps we need to discuss your recent statements.”

“Oh, I remember this part. Three spirits will come to show me the path to redemption.”

“Err, actually 2 and a half. We need to watch our expenses, so the third is part-time. Now I must go….”

“Back to the underworld?”

“Worse. An interview on Fox news. Farewell Ebernankeee….”

With that, Greenspan faded out of sight after turning a whiter shade of greenback. Screwed gulped a glass of his favourite wine, a vintage Two Buck Chuck. As he put the glass down, the first spirit appeared before him. To Screwed’s surprise, he was standing before a shadowy ghost of Bill Clinton.

“Are you Mr. Ebernanke Screwed?” it asked.

“Former President Clinton? You are the ghost of Christmas past?”

You betcha!”

“But you’re not dead yet!”

“Hey, since when have rules stopped me? Hillary can attest to that! Anyway, I’m here to show you the past, so here we go…”

They found themselves in a cheerful conference room at the US Treasury. A smiling Greenspan was at the head of the table. “Things are going brilliantly” he mused.

“But what about the risk of an asset price bubble?” quipped someone at the back of the room.

“Lighten up Shiller, sometimes you’re just tragically intense. All those numbers of yours make no sense. Quit worrying!”

The troublesome Shiller was bundled out of the meeting room to be given a cold shower at the Fed. In a quiet corner, a young Screwed was taking careful notes and nodding to all Greenspan’s platitudes.

The scene then faded away.

“What Greenspan said made so much sense. All those intelligent sounding words…” sighed Screwed.

“And look where you are now” laughed Clinton. “By the way, have you seen my cigar anywhere…?”

“Get away from me Clinton!” jumped Screwed.

“OK, OK, you’re not my type anyway. Hey, gotta go! You’ll be seeing my colleague soon…” With that, Clinton faded away.

Screwed shook his head. No sooner had the ring of Clinton’s voice gone from his ears than a trio of businessmen popped out of the garbage can.

He stood up and confidently introduced himself “I am Screwed.”

“Yeah, that sums it up!” quipped the first.

“Mind you, we should now!” laughed the second.

“Takes one to know one!” roared the third.

“Hold on…I know you. Nardelli, Wagoner and Mulally. The Detroit Three”

“Ho ho ho! Yes, or better known as the three Stooges!” they chorused.

“You can’t teach me anything - you’re the heads of bankrupt companies.”

“And you’re the head of a bankrupt central bank. Hahaha! Now that’s an achievement!”

“You’re idiots. You can’t even count. There’s only supposed to be one of you, not three. I read books, you know.”

“And you can’t read financial statements! We’ve been written down so much that it takes three of us to make one spirit!” they laughed.

All of a sudden Screwed found himself in a grubby tavern. A group of bedraggled central bankers were huddled around a table. To his amazement, he recognised his business partners: Mr. King of England, the snooty Baron de Trichet of France, the sneering Hank Paulson and the Financial Shogun Shirkawa.

“We’re doomed…what the hell is Ebernanke doing? Parachuting bailouts…” groaned King.

“It is tres bizarre. He’s crashing straight into le zero interest rate world” mused Trichet.

“For once we’re ahead of everyone else!” laughed Shirakawa.

“I tell you boys, that Ebernanke wouldn’t know finance if he tripped on it. Fiddling with the Fed Balance sheet whilst corporate America burns” snarled Paulson.

“Still, no one will miss him when he’s gone” whispered King.

“He’ll be the first Fed Chairman to have worse book sales after his time in office!” mused Trichet.

“Back to academia for Ebernanke then” added Shirakawa.

“Yeah, I hear Detroit Business School is hiring” laughed Paulson.

The tavern then faded into the mist. Screwed felt crushed by what he had witnessed.

“Woe is me! I thought they were my friends! Yet they laugh at me with contempt. I even gave them signed copies of my last book” he wailed.

“So that’s how they send themselves to sleep at night!” quipped Nardelli.

“OK Screwed, we hope you’re starting to get the picture” added Mulally.

“Your next visitor will be here shortly. We’ve got private jets to catch!” said Wagoner.

“But you promised Congress you’d drive from now on” wailed Screwed.

“Nah! We’re just using the hybrid SUVs to ship our books of excuses to Washington. After all, we’d have to hire a cargo plane otherwise. Time for us bail out…Hahaha!”

With that, the jovial executives disappeared in a cloud of airplane kerosene. Screwed was still reeling from the shock when another ghastly apparition materialised. The faint sound of news jingles seemed to surf around him.

“Nouriel Roubini!” gasped Screwed.

“Yes, it is me, the great Roubini! After years of predicting the credit crisis, and seeing stocks fly through the roof, I have finally been proved right! I can see the future…”

“Houdini has nothing on you. Wait a minute…you’ve been wrong before then?”

“Details, details. Yes, but at I least I’ve been proved right now! Unlike that turnip Anatole Kaletsky, and the ghastly Irwin Stelzer! Haha! They won’t be getting invites to CNBC anytime soon! Unlike me, the Great Roubini…”

“Can we get to the point?”

“Ah yes. Well, let me show you the future…”

Screwed suddenly found himself in a huge factory. Sullen individuals of all ages and creeds surrounded him, toiling away on a tractor assembly plant.

“What is this place? Communist Russia?” asked Screwed

“No, Washington DC. With your reckless policy actions, the United States became a basket case country, and the state had to takeover all commercial enterprises.”

“NOOO! I must stop this” screamed Ebernanke.

“The solution is simple, Ebernanke. “

“And it is…?”

“Sorry, I only work part-time. Got to go – I have another party in my uber-trendy New York apartment to go to. Gloomy macroeconomics is the new rock and roll, you know. Ciao”

With those parting words, Roubini vanished and the news jingles faded. Screwed looked around his empty house in total panic.

“We’re doomed! We’re as dead as corduroy!” he yelped. He rushed around the house, and crashed into a long object rapped in a tarpaulin. Curious, he took the cover off, and beheld…a printing press!

The next day, the town was awash with currency. Screwed was a changed man, smiling to all as he tossed bundles of fresh banknotes into mailboxes. All seemed to be well again, and Screwed felt he had learnt the true meaning of central banking Christmas: bailouts and banknotes for all.

Perched on a rooftop, the Detroit three were watching the newly pressed currency floating in the breeze.

“Haha! There’s a spelling mistake on your banknotes Ebernanke!” they laughed.

Unfortunately their voices were lost to Screwed, who was wrapped in the praise of his many, many bailout recipients.

“God bless the printing presses, every one and all!” sung Screwed.

Madoff and frenchmen

It is striking that up until a few quarters ago, the french banks were often criticised for not adopting a more "anglo-saxon" model, particularly in investment and risk management. With hindsight, this has probably positioned french banks quite well for the post-Lehman era (Kerviel aside).

With respect to Madoff, my previous point about due diligence has received an appreciated (although unconnected) boost from Societe Generale. Apparently a routine due diligence by Societe General picked up something awry in Madoff's track record nearly 5 years ago. Bernie went straight on their internal blacklist. It just goes to show that the boring number crunching pays off.

Madoff's mess

Even by the standards we've become used to during these interesting times, the fraud uncovered at Madoff this weekend is rather staggering. Having built up his pyramid scheme on the capital of wealthy US investors (in particular from Florida), Madoff snared them all. Reports hitting the wire today are reporting several institutional investors being caught in this pickle - BNP Parisbas, Santander and Pioneer to name a few.

I'm not sure whether this has anything to do with the Irish government's sudden decision to prop up its listed banks with a massive recapitalisation effort. People have been asking me this weekend how "sophisticated" investors could have fallen for Madoff's scam.

The reality is that investors tend to get seduced by the "investment" story (track record, strategy etc). It creates this weird mindset where people get so excited by the idea that they get too lazy to do the (boring) due diligence that is vital to weeding out the crooks. An unglamourous task, but essential to preserving wealth.

The worst offenders are actually so-called "sophisticated" private investors who setup their own family offices. Think of the toy train version of asset management. You have people with far more money than sense, who often have never had to work in truly commercial settings (if they did, they only got the job through their father/mother's good offices). They hear about "smart investors" putting money with a fund manager, who seems to generate great returns. They pile in with little or no time spent actually kicking the tires.

One example springs to mind. I bumped into the son of a wealthy patriarch on Friday, who was whining about being caught in a similar situation. I asked him how he'd decided to invest. "A very good friend who invests his own money recommended it", came the response. I then asked what analysis he'd done of the manager's middle and back office operations. A blank stare. Come on, you did ask for an operations manual? "No". Not even an audit of some recent trades? "No".

I have trouble sympathising with such amateurs. Yes, Madoff appears to be a fraudster according to the news, and if proven he should be held accountable for that. Yet supposedly "sophisticated" investors wrote their cheques without the most basic due diligence. This may sound unfeeling, but let this be an abject lesson to these people - don't have delusions of grandeur. It's the quickest way to erode your wealth.

Core concept 1 - Portfolio and Wealth Management

Let's roll! I'll take things from the top for our core concept chapters. Today's focus is on two key terms which are often used (mistakenly) to mean the same thing. Before you make any financial decision, it's important to make a distinction between them. The following is not the only way of defining these terms, but I've found this approach quite helpful in the past.

What do people actually mean by "wealth management"? The way I look at wealth is to combine an individual's entire asset base. Not just financial assets (savings, retirement accounts, brokerage accounts etc). I add in cars, property, personal possessions - all the tangible stuff. The final piece is a bit controversial, but I think too many people ignore it - your own education, work experience and knowledge. I'll come back to this last point later on.

"Portfolio management" is generally used to describe how people manage financial assets, for example how much to put into equities in a 401k plan, and whether to use a fund run by Fidelity, Vanguard etc. It's a subset of wealth management.

Why do I add in things like work experience and education into the definition of "wealth"? Let's be clear here - all the fancy theories inside "portfolio management" don't run themselves. The way you look at information and act on it drives every decision you make, including how to manage money. Not appreciating that leads people into all sorts of trouble.

Unlike the talking heads you see on TV, I like to stick to a few simple rules. And the most important one of all (and the one that we all struggle with) is to understand our own biases. How we look at the world is based on our experiences (good and bad).

As an example, when I try a new trading strategy and I hit several home runs, I have a tendency to think "I'm really good at this". Sooner or later, a reckless decision stops me in my tracks. The trick I've learnt is not to get disheartened. I cut my losses, pause for a while and reflect on what actually happened. Total honesty can be painful, but it's the only way to learn. Then I pick myself up and try again!

You might ask "So what?". You need to have a picture of your overall wealth and how you plan to manage it. Diving straight into managing a portfolio of financial assets (stocks, bonds, options etc) is the way most people proceed - but I believe that's simply wrong. If you haven't got a full picture of your circumstances, how can you manage each "piece" properly. Or to put it in sports terms - a team of individuals (however well trained) can't win without an overall game plan.

In the next Core Concept, we'll take a look at how you build that game plan.

Suits and us - UBS

OK, so it's a bit cheap of me to poke fun at UBS' carefully crafted (and no doubt expensive) slogan - but you have to laugh! Stepping back from things, the sheer hubris of those ads in daily newspapers and TV slots should have been a warning that the once-prudent private bankers had gone completely off the rails.

Still, let it not be said that the Swiss don't have a sense of humour. A Zurich suit boutique is offering clients the option of paying for their purchases in UBS shares - at a 40% premium to Friday's closing price. I hope it goes well for that shop owner - at least someone might make some money out of this mess!

Canadian cool

It's taken an eternity, but the BCE buyout is officially history. As a reminder, this was a plan by a club of private equity firms to acquire BCE (the owner of Bell Canada) with an enormous $35 bln in debt. The deal was toast when the auditors finally saw sense and pointed out that such a level of borrowing would render the firm insolvent.

Whilst the Ontario Teachers Pension Plan (the lead acquirer) will be disappointed, they shouldn't be. It was a crazy deal to do in any climate, and you have to wonder whether pension plans are the best qualified people to be doing direct deals (after all, if they were that good why aren't they working for a private equity firm?).

Of course, the real winners are the banks who had so unwisely signed up to this, and are now free from having to fund the deal. The fortunate trio is RBS, Deutsche Bank and TDC. You can almost hear the bankers bursting into song. All together now: O Canada...!

A new initiative for Capital Novation

I've been doing some thinking about the situation we find ourselves in. I had originally designed this blog as a commentary on headlines and emerging trends in capital markets and business. I intend to keep that as my main focus, but I think it's time to expand the agenda.

Yes, there are many "exciting" headlines, but I've become concerned at how the severity of this crisis is impacting the wealth of so many ordinary citizens. People who have worked hard and saved are seeing their capital eroded, in large part due to poor advice and simplistic "investment ideas" touted in the media.

How do you manage your portfolio in this new world we find ourselves in? What assumptions still hold, and what "theories" have been shown to be wishful thinking? Starting this week, I will add "Core concept" posting each week on this topic- to help you adapt your investment thinking to these circumstances.

Of course, I can't offer individual advice - but what I will try and do is help you look at the investment world from a different perspective. The end decisions are always your own, but I'll give you a different angle from which to look at things.

Why this new initiative? One of my favourite academics is Robert Shiller. Whatever you may think of his economic theories, he made a brilliant point that citizens need some truly independent (i.e. not sales commission-based) advice to help them make sensible investment choices. Sadly none of the TARP billions have been committed to that great idea. So I'm donating my own time in order to plug that gap, albeit at a very modest level.

My first "Core Concept" item will be online this weekend, but feel free comment with any areas of investment that you would find useful to look into.

United in discord

So much for European unity! The threadbare "common front" on economic stimulus packages is unravelling in style. The UK government got a very public dressing down from their German counterparts, who deemed the UK Labour Party's record borrowing as "breathtaking".

At last! Someone in the political space has come out with an iota of common sense. It's great politics (in the short run) to try and spend your way out of recession, but the ballooning debt burden could take decades to work off. A fine legacy indeed. Thank goodness that Gordon Brown has saved the world - talk about delusional!

Of course, there is a political agenda here. Within the Eurozone, there is great tension between the fiscally efficient German economy and some of the more "basket case" members (such as Spain, Italy and Greece). Berlin is reluctant to weaken the euro as a quick fix for less efficient Euro countries, and rightly so.

Retail nightmare

In the midst of the retail gloom, I'm surprised at how the media can overlook some deep structural problems that have popped up in specific countries. Take the UK, which is lurching from one retail setback to another.

There's very little coverage (if any) of the fact that credit insurers have virtually disappeared from the market. For reference, these are firms that provide insurance to retail firms. For example, when a shop purchases stock on 30 day terms, the insurer provides protection in the event of the purchaser failing to meet the obligation.

In the past six months 90% of that capacity has vanished, led by large players such as Euler Hermes. Why does this affect retail? All of a sudden, suppliers can't get that insurance, so they demand payment at time of shipping. Suddenly your shop has to come up with the money there and then, rather than in 30 days. It may simply not have that cash, particularly in a period where they need to buy a large amount of stock (such as the Christmas season).

Add in the 24th December rent payments that come due on many commercial leases, and you have a recipe for retail disaster. I spoke with a distressed investor this morning, who is aware of hundreds of small and medium businesses that are two weeks away from going under. It's a frightening scenario, and in this festive season a harrowing one.

Chinese currency whispers

Hank Paulson had to undertake (another) difficult assignment this week with a visit to China. The meeting is technically an annual summit between Chinese and US economic representatives, but the agenda is much more pressing this time round.

Having belatedly woken up to the fact that China is one of the largest holders of US government debt, Paulson is in effect meeting one of his chief creditors. An ever-awkward discussion revolves around the yuan valuation.

The Bush administration has been keen to press for an appreciation against the dollar, thus encouraging American exports. Yet in the current climate this is a bit futile, given that China's economy is decelerating fast. As most Chinese citizens have no affordable access to welfare systems (a visit to hospital will easily cost more than a whole year's wages), it's naive to expect a material fall in the savings rate.

It's doubtful that the Chinese will be enthusiastic buyers of further US corporate assets for now, given the disasters of some of their investments (e.g. Blackstone). And even if they did want to tip their toe in again, will the US be a bit more open to this capital this time. Remember the xenophobic reaction to Sinopec's 2005 offer to buy Unocal?

You can bet the Chinese haven't, Hank.

Renewable capital?

Although I tend not to put too much currency into coincidences, two recent articles about the UK did stop me in my tracks. I'm now concerned that the dangerous alchemy being put in motion in London might move stateside.

Here are the two stories: first, the UK government is expecting to issue records amount of new debt to fund a foolhardy and short-lived sales tax rebate, amongst other goodies. Story number two: the UK regulator for financial services (the FSA) has indicated that it is considering a change in solvency rules for banks, forcing them to hold far higher amounts of sovereign debt.

So let's see, a spendthrift government issuing so much debt that buyers might be scared away. Forcing the banking system (which is by the way quasi-nationalised) to hold more government debt? Even your average investment banker could put that together.

Has the inept duo of Gordon Brown and Alistair Darling come up with financial alchemy? A financial perpetual machine? Unfortunately not - given that the banks are now government controlled in all but name, the funding to buy all these new gilts is itself government money! Still, it has a certain symmetry to it.

Of course in the medium term this cranky trade will break down, and damage the commercial value of the banks in the process. But it plays well to the peanut gallery with a possible election looming.

In dire straits

There's no way to sugar-coat it: today's US payroll data was simply awful. Dire. Catastrophic. I thought I was pessimistic with a forecast of -450,000, but the reality was even worse. Over 530,000 jobs were lost last month, and digging into the details shows how the recession is spreading across all sectors.

The figures show the emergence of a deep and painful spell for white collar workers, as services bore the brunt with cuts of 370,000, of which 196,000 were in professional services. A graphic demonstration of the white collar recession we're entering (assuming that the carmakers dodge implosion with a Congress bailout).

Things are unfortunately not going to get better anytime soon, with the twin storms of mortgage delinquencies surging and further job losses announced today. It is unfortunate, to the say the least, that the hubris of a few has affected so many.

Regular readers will know that I have a deep-seated suspicion of regulation and state intervention, but I can't argue with the need for some recalibration of the system. One can only hope regulators don't go too far, which could potentially damaging the United States' commercial reputation for decades.

But for now, I hope that Congress shows restraint in bailing out inept management teams - where a restructuring needs to take place, use funds to give a safety net to the innocent instead. Our external credibility rests on accountability - the people who got their industries into this mess should not be allowed to walk away.

Bernanke's Waterloo

It's come about even faster than his most ardent critics could have predicted. Ben Bernanke has finally fallen off the helipad of his ivory tower. In his latest statement, Bernanke is urging yet more government action.

Having realised that the series of uncoordinated and half-baked responses aren't making any difference, the Fed Chairman is more or less shrieking desperately bad ideas to anyone who'll listen. Something along the lines of "buy delinquent mortgages, approve the FDIC mortgage guarantee proposal, subsidize Ginnie Mae rates!"

Let it not be said that these ideas haven't been evaluated by Ben. True to his academic roots, he has carefully analysed the sources of fund. They will require "some commitment of public funds" - i.e. even more taxpayer capital at risk.

It goes without saying that running the money press 24/7 may help fund the paper game of buying up all this mortgage debt junk for the state balance sheet. Yet in the long run you can expect inflation to roar back to life. I wonder if the Fed will rack up the rates as fast as they cut them? In any case, those treasury yields will be moving back north soon.

Raise the drawbridge!

As if to illustrate how bad things are for hedge funds in spite of all the policy fiddling by lawmakers and central bankers, Fortress announced today that it is suspending redemptions on its flagship Drawbridge Macro Fund. Now those redeeming investors besieging Fortress have to wait out by the legal moat generously provided by the partnership agreements.

The figures are scary. Taking the fund's reported size of $8Bln as read (no mean assumption in this day and age), the amount that investors are trying to take out amounts to c. 40% of the entire portfolio ($3.5 Bln).

The optimists will say that this is a temporary move to preserve capital and prevent forced sales. Yet it doesn't take much to puncture that bubble - assuming credit markets remained in limbo for a few more quarters, those valuations aren't going to move up any time soon.

If you're having trouble keeping up with the hedge fund quagmire, check out this site which is keeping a tally on the mayhem.

Debt crossing

An interesting little headline ran across my Bloomberg terminal today about the stress in the credit markets. The iTraxx Crossover Index has soared to a record of 10%, compared to c. 3.4% at the end of last year. For those of you who aren't derivatives fans, this index represents the cost of buying insurance against credit default for a basket of sub-investment grade debt.
The trend isn't a surprise given the economic mess we're in. However I was curious enough to dig into the index composition, and I started to appreciate just how awful some of the debt sitting on banks' balance sheets must be. For example:

• HeidelbergCement - Overleveraged german conglomerate wrecked by nutty family patriarch: 3654 bps
• DSG International - A UK version of Circuit City with worse customer service: 1700 bps
• Alcatel-Lucent - Telecoms manufacturer disconnected from reality: 1240bps
• Nielsen BV - Levering up a ropey market research firm (brilliant idea Blackstone!): 1042 bps
• Virgin Media: Another vanity project from Richard Branson: 940bps

Having said that, the yields on some higher quality names are really starting to look attractive. Rather than rushing in, I'd suggest being quite careful and do some thorough credit analysis, as I've bumped into several "smart" private clients and institutions who jumped on the trade way too fast, and got hit by recent corrections. And I'd avoid the passive vehicles, as the indices they use are so overweight financials.

Mr Detroit goes to Washington (again)

The Detroit carmakers, in true Three Stooges fashion, are back in Washington with yet another bailout plea...sorry, I meant "viable plan for survival". It looks like Chrysler will be the sacrificial lamb, with its remnants carved up between GM and Ford - although I wonder if the US might allow (heaven forbid!) a foreigner to buy some of these beleaguered assets?

One of the bizarre proposals is to siphon off funding for fuel efficiency programmes to rescue the carmakers. I might be missing something, but Honda and Toyota got their promising hybrid/electric businesses up and running under their own steam.

It took them a decade of R&D investment, but they innovated and created a great product that is in demand. Doesn't this sound familiar? Yes, it's free enterprise, and the Japanese carmakers should be admired for being so forward-thinking. Of course, if helps that they can build cars that work, unlike the cobbled junk coming out from the US carmarkers.

In comparison, the gruesome threesome of Detroit are a pretty rotten lot. Like a manufacturing Dorian Gray, the reality is actually a long history of laziness and efficiency. They all deserve to hit the wall, and the sooner the better, so that they can be restructured into a half-decent business.

How Gordon mortgaged Sterling

It's been a stealthy decline till now, but the Great British Krone has taken another hit today and is now surfing near its record lows for the year. Of course, part of that is driven by worries of recession in a country that's forgotten how to make anything tangible. The only thing I saw manufactured the last time I was there were "services" (i.e. memos, meetings and committees).

There's a much darker force at work however - the catastrophic level of government debt that's been hived off the state balance sheet. The architect of this lunacy is the insidious Gordon Brown, who has managed to bend the rules for years.

In the spirit of public service (as the BBC doesn't seem to care about it any more), I've had a read of some tedious information on the UK government sites. The table below starts with the "official" government debt figure, then adds back the two main sleights of hand: PFI (off-balance sheet public works finance) and the cost (to date) of those generous bank bailouts.

So, even excluding some other liabilities (such as unfunded public pension deficits, future costs of the wars in Afghanistan and Iraq), the UK is twice as levered up as the official figures. So from about 40% of GDP, we're sailing north of 80%!

That uncomfortable fact is the root cause of the pound's slide. Sterling used to have a connotation of strength - it's now becoming a bit of a joke unfortunately.

Secondary effects

The fact that many US and overseas endowments, including the much-lauded Harvard fund, are seeking to sell large chunks of their private equity portfolio is old news. What has surprised me is the lack of focus on why the problem surfaced.

True, there may be some marginal need to raise capital given the rapid falls in the listed markets. Yet a prudent asset allocation would have never exposed these funds to such a liquidity squeeze.

There are two factors at work. The first is plain old hubris - alternative assets, real estate and private equity all seemed to be heading ever higher, so Investment Committees put less and less into boring bonds, stocks and cash. This reached a point where some endowments had hardly any liquid assets at all: distributions from private funds were providing the cash to meet their obligations. Heavens, some pension funds even took stakes in the General Partners themselves!

The second factor was over-committing to some of the asset classes, particularly private equity. When the public markets turned, endowments and pension funds suddenly found themselves horribly over-exposed, with large capital calls outstanding. Hence the stampede into the secondary market. Although don't believe the public bid quotes - take that number and halve it, at the very least.

Efficient market hysterics

The past several months have shown that the naive assumption of capital market efficiency is the road to ruin. You could also add the blind faith in diversification, so beloved of ill-trained and lazy financial advisers, to the mix.

Several people have challenged me to justify these beliefs. I've been in the business long enough to see that human nature is wondrous but fallible. It is easy to be seduced by the elegant simplicity of a straightforward "academic" solution to the investment puzzle. I've learnt at my own personal cost that relying on those sirens is lethal.

The chief villains are the "efficient market" and "diversification" mantras. I'm not saying that they haven't got some limited truth (some of the time). The problem is that they were so easy to pump into an Excel model: any idiot could churn out a reasonably literate asset allocation. Experience and judgement became a distraction - the canned solution was much less tiring.

The better (but more difficult) route is to base these allocation decisions on liquidity and risk. Sure, diversifying is common sense, but don't let it override your judgement on current market price trends. And although most vanilla news is priced in fairly well, in these uncertain times people are trading in a messy herd, clouding pricing.

Of course, some optimists are calling a turnaround with some handy data mining. Take the latest examples in this article. The thesis (if you can call it that) is that investors are not getting "gloomier", so we've reached the bottom.

My advice is to take that statement with extreme caution. First, there is far more bad corporate news to come in the new year, as central banks run out of ammunition. Second, the people coming out with this facile reasoning are long-only shops. Talking up their books, no doubt.

Trump bondholder? You're fried!

I have to confess a sneaking admiration for the Donald. Trump Entertainment has announced that it will not make a scheduled interest payment on its $1.25 Bln note in order to "conserve liquidity". The article skates over the fact that there is probably little liquidity left to conserve, but full credit to Trump for keeping his own net worth out of the mess.

As with many other industries, the gambling/hospitality sector got into a heady (but ultimately painful) cocktail of leverage, real estate and hubris. Trump's issues shouldn't come as a surprise, given the recent troubles of Las Vegas Sands. Interestingly (at least in Macau), Steve Wynn's operation is relatively healthier, but that's probably due to its different target market.

Whilst it is true that people still gamble in a recession, the industry can't insulate itself completely from the real world. As a result, there are several prime property assets that will be on the block shortly.

The best trade to do is probably to buy the senior debt on assets you like. The worst case scenario: things recover, but you locked in a good yield. Best case: equity holders hit the wall, and you get your paws on a trophy asset. Faites vos jeux...

Bailout time story

On a cold wintry weekend, one of my personal pleasures is to muse on how the interesting times we live in compare to history. My fad interest at the moment is government bailouts. With TARP, TALF and several other equally bizarre acronyms, I'm spoilt for choice.

Imagine my joy when I came across this fascinating chart comparing past government "bailout" programmes against the chimera created by the Bernanke/Paulson tandem (aka the gruesome twosome). Thanks to Paul Kredosky for this one.

Even if you quibble some of the math (for example adjusting for inflation), the sheer size of government intervention in 2008 has been amazing. And the best part kids? It's far from over , since many of these bailouts (e.g. Citi, AIG) have huge additional writedowns on the way.

Of course, at some point the government will be unable to fund further bailouts - the trigger will probably be a sharp snap back of Treasuries to a saner level. Unfortunately in these bizarre times, the sheer amount of investor fear may keep those yields down for a few months yet.

Merrill Lynched

As Merrill Lynch awaits for its fate to be sealed by Bank of America shareholders, I took the opportunity of the relative calm of Black Friday to look back on the Blundering Herd. After all, this was once a great name on the Street - up until the late1980s, it was still a firm that I felt pretty comfortable doing business with.

Then it all started to go wrong as the top brass at Merrill decided to push itself ever higher up the greasy pole, equating firm size with quality. The truth hurts, but Merrill Lynch staff by then were simply not as good as comparable firms. If you wanted (and could afford) the best, you'd look elsewhere. At every major screw-up in the capital markets over the last decade, Merrill was there. Orange County, auction rate bid rigging, subprime...to paraphrase the old saying, "cherchez le Merrill".

BoA shareholders might still get a sudden attack of common sense and ditch the deal next week. After all, they could buy ML at a fraction of the price agreed in September. Let ML hit the wall, buy it up at distressed pricing, scorch the (corporate) earth and pick off the few valuable assets left. If BoA goes ahead as is, their neck will be in the noose for a long time.

Talking Airhead

Commenting on monetary policy is seldom a measured affair - between the ideological hobby horses and political allegiances, rational thinking rarely comes into it. Stepping across the pond to Olde England, a particularly damaging form of delusion is taking hold, courtesy of a nefarious perma-optimist called Anatole Kaletsky.

In his latest piece of sanctimonious claptrap, Mr. Kaletsky contends that the UK government is "right" to be ratcheting up the borrowing to a dizzy 57% of GDP. Poor Anatole, he fails to realise that the quasi-nationalisation of the banking system has two very nasty consequences to his quaint academic theories.

First, bankers will be "guided" to lend based on political expediency - especially if a Spring election is on the cards. As an example, in normal times a bank may well lend to a sound private-equity backed firm, and not to a group of credit-naive households. But with a state-run lending system the priority becomes votes, not rational loan underwriting.

Second, banks need to de-leverage. Even if you set aside the massive writedowns from the upcoming bankruptcy tsunami, banks would be crazy to be lend more - math tells them to make net lending negative, in order to repatriate funds and rebuild the balance sheet.

So Oliver Brown and Laurel Darling have completely misunderstood the problem, and lumbered an already imbalanced economy with a debt millstone.

I actually met a client of Mr. Kaletsky's research services yesterday. A key selling point was that the reports concerned were "straightforward - simply A to B". Just like a train heading for a crash, I guess.

PS: Anatole, just for your information - it's now cheaper to buy credit protection on Unilever than UK government debt. Your piece states that this borrowing binge is "not a serious problem" - the market seems to be pricing in something horribly different.

Snags on a plane

With the bad news literally raining down, I was heartened to see that industrial America is raising its game. Take Boeing as an example. They have now committed to "improvements" following a spate of screw-ups in their military division. They included goodies like slashed wires, errant washers and rogue rivet caps.

If that's the way Boeing treats its key customer, I dread to think what's going in the commercial division. And yet the stock is trading at pretty hefty multiples - there's mystery in the stock market air.

For everything else, there's Bernanke Card!

Do you have problem assets on your balance sheet? Discovered that the only collateral in your "Collateralized Debt Obligations" is in the title? Are your calls to your friendly bankers not being returned (or their telephone line disconnected)?

Well fear not my friends, for liquidity is available quickly and easily with Bernanke Card (tm). Yes, your friendly Federal Reserve will take those troublesome assets, no questions asked. Your liquidity problems will be over before you can say "bailout" - it's like subprime loans without the stringent lending criteria.

So what is the Fed buying from those desperate...sorry, decisive sellers? Well, it's a Christmas surprise that Ben and his chief elf Hank are working on. In fact, to keep it a secret, they are saying nothing. Bloomberg has been forced to sue the Fed to try and get that data released under the Freedom of Information Act.

However I can promise it'll be one hell of a surprise!

Artful dodgems

One of the quirks of wealth management is that there's always some oddball or shady type trying to flog a fancy new investment idea. An area that seemed to be the pitch du jour in recent times was the concept of the art fund.

In a nutshell, you invest with a fund manager with excellent taste and market knowledge to buy fine works of art and sell them on to some naive buyer. You get nice returns, low correlation with other asset classes (I know, who would be nutty enough believe in that idea?) in exchange for the usual 2/20 fees for private funds.

In many cases, particularly in London, the people buying had no concept of taste or value - this was showing off, pure and simple. Anyway, the game seems to be up. I can't claim to have predicted the art market would go into a severe reverse gear, but it never was an asset class.

My advice to clients (suitably refined and smoothed by marketing) was simple: if you like art, find an antique dealer you like and get him to buy you a few pieces. If the price moved up, great - but at worst you were left with a work of art you'd be happy to have in your home. Not that bad really.

The lesson extends to a lot of "fad" asset classes (coins, stamps, wine to name a few). People should not confuse hobbies or interests with investments, least of all advisers with a fiduciary duty to their clients. Putting serious money to work in a hobby is a one-way ticket to mayhem.

Reversion to the mediocre

Well, that didn't take long did it? Only 24 hours ago, there was much self-congratulation at the "brilliant" rescue of Citi by the US Treasury. Or as Citi's CEO put it with faultless mendacity:

"We reached an agreement based on an innovative market solution to further strengthen our capital ratios, reduce risk, and increase liquidity."

Actually, I can see his point:
1. Innovative: Humm, a government bailout with no strings attached in a capitalist country? Check!
2. Market: since nationalisation is becoming fashionable, I guess the whole economy will be state-run at this rate.
3. Solution: well, until the next set of writedowns in the New Year.

Fast forward to today - the FDIC has published a report on the state of the banking nation, and it is not pretty. The mayhem has spread deep into both the commercial and consumer loan books, with provisions and charge-offs at record highs. The number of banks in trouble jumped from 117 to 171 during the quarter. Perhaps this is the sort of growth the Fed and Treasury are keen to promote?

Take this statement from the FDIC website: "Congress created the Federal Deposit Insurance Corporation in 1933 to restore public confidence in the nation's banking system". It is amazing how the mediocre economic leadership of recent times has destroyed that legacy, and confidence has now reverted to Depression era levels. What a waste...

Management Indemnity

As the credit market continues its see-sawing, some home truths are finally surfacing. One of the most bizarre trends in the past few years was the insatiable appetite of large institutions for structured investment vehicles, particularly CLOs and CDOs. I saw this at first hand, as I used to work for an insurer who bought inordinate amounts of this stuff, as it offered the magic combination of relatively high investment income with investment grade credit (or so S&P thought), as well as the "right accounting" treatment.
Now, I'll confess I didn't foresee how bad the underlying loans could go. The issue is only now beginning to surface, and will probably get far worse. However at the time I did wonder that this might be too much of a good thing, and suggested a minimal ticket in CDOs and CLOs. Unfortunately, Investment Committees in insurance firms are refugee camps for the financially inept. At best they are people who couldn't hack it in asset management, and at worse actuaries or accountants without a clue about how markets really operate. Dull, backward-looking and technically naive: a car crash-inducing combination.

The end result was that I was overridden, and seduced by those juicy (and quarterly results-friendly) returns, my employer invested ten times the recommended amount into structured vehicles. I soon after, and have watched the sorry tale unravel from afar over the past year. And yet, just like Citi, the management that got the firm into this mess are still in place.

The obsession with accounting results is bizarre. My opinion has always been that investment should be seen as an economic proposition - pushing it into accounting buckets merely creates perverse incentives to either trap liquidity or take inappropriate risks. This is a particular sin of insurers - most of the time they actually lose money underwriting insurance, and it's the investment income that comes to the rescue of the P&L. It's a pretty dicey bit of financial brinkmanship, and the sector is now reaping the results of that bet.

Ford Ward Motion / Grand Debt Auto II

As discussions rumble on about what to do about the Detroit automakers, some people are already taking a Treasury bailout as a given. A great example of this is a piece of PR puff by William Ford. Whilst his CEO was (rightly) getting grilled by Washington, Mr. Ford seems to have already moved across the fjord of illiquidity to a new era of energy-efficient vehicles.

Please, spare me the platitudes! From a financial perspective, Ford is only behind GM and Chrysler by a few quarters, and does not have the luxury of fantasy. Even if government support is forthcoming, turning around Ford will involve a "scorched earth" restructuring.

Nostalgia is great, but it is time for the Fords to be separated from the business great-grandfather created, and that they have now wrecked by years of lazy, inept and paternalistic management.

To show the mountain that Detroit has to climb, just think of the quality gap between them and their foreign rivals. Given the choice, would you prefer driving a clunky Ford truck or a German-built SUV? No contest, of course. This simple truth may be unpalatable, but until US manufacturers face up to it they are on a road nowhere.

If the government wasn't breaking the rules with bailout promises, the Detroit carmakers would be left to adapt or fold. Individuals have to do this all the time in the job market, and there's no reason to grant the autoworkers any exemptions from that rule.

Tax-fiddling while the economy burns

Over in the UK, the latest wheeze to try and get the highly leveraged consumer back into the shops (and into even more trouble) has been announced by the government. This is in large part based on a one year reduction in sales tax (VAT) from 17.5% to 15%.

Let's do some quick math on this "major" stimulus package. According to the UK National Statistics, the average UK household spent about £21,000 per year (I've removed food from the equation, as it is VAT exempt). So that tax rebate is equivalent to a whopping £525 per year!

Laurel Brown and Oliver Darling strike again - this means that every household can treat itself to a nice cafe latte every workday for a whole year. Forgive my cynicism, but it will take a lot more to encourage Joe Public to forget the existing bills and go buy another flat screen TV.

I confess to being mystified as to how so much taxpayer money can be funnelled into dead-end temporary gestures like this. It makes TARP look like a carefully crafted and balanced strategy. If the government is intent on spending, why not do so on a useful investment programme, such as a high speed train network?

Instead, the UK government seems intent on wallowing in economic ineptitude by flooding the bond market with record levels of gilt issuance. The lesson from the subprime disaster isnot to extend lending to borrowers who could not afford it. Granted, the UK is not (yet) there, but that AAA rating is becoming a bit of a joke. Although in this day and age, perhaps ratings themselves are going the way of Bear Stearns?

Citiday Night Live

Yes, the skies are rather dark (both in a physical and financial sense), but that's no excuse not to see the lighter side of things, as this joke Bloomberg story on Citi does the rounds.

I'll admit that having read it a couple of times, it suddenly doesn't seem so outlandish a possibility - a testament to the interesting times we live in. Perhaps Citi is taking too many lines of this blog at the moment, but it's a poster boy for the mess we're in.

Looking ahead, a government rescue is still a distinct possibility, but rebalancing a $2 trillion monolith would be a stretch to the best turnaround specialists, let alone the flat-footed troops at the US Treasury.

One thing that can be said about the Somali pirates is that they would bring some blue sky (or should that be water?) thinking to the situation. Given that all the classical fixes have failed, it would be no bad thing...and it distract them from nicking oil tankers for a while.

Decline and fall

As the talks continue about the Citi situation, several pundits already seem to be getting the draft obituaries out there. I think the funeral arrangements are premature, but they don't seem to have any options left to them apart from either a radical restructuring or a government rescue (or maybe both).

Having dealt with Citi several times in a transaction mode, I've always been struck by their particular way of deal making. Their pitches were generally very slick, and they were never short of foot soldiers to deploy. The problem was always one of substance and quality control. Relatively flimsy modelling was a regular occurrence, as was a tendency of brush aside the risk of "off-the-wall" responses from the opposition. The result being that we always seemed two steps behind on every deal...

Yet the deadliest sin was, in my view, their sense of manifest destiny. They equated their size and past successes as natural, and assumed the music would keep playing. That arrogance is common to all Wall Street firms, but in the case of Citi meant they were in denial about the limits of their organisation. Citi's "integrated business model" is actually a car crash of distinct (and often warring) franchises - the only integration is in the marketing literature.

While Citi struggles on its knees, the government might want to reflect on how much rope they might give them, given that the demons assaulting them are largely of their own design.

Type "C" for Total Freakin' Catastrophe

We've been here before. Once again, the great and the good of the banking/Treasury complex will be scrambling over the weekend on a possible rescue, this time of Citi. I don't think there's any need to repeat how Citi got themselves into this mess.

A TV headline earlier screamed "Citi denies breakup plan". In other words, they're busy going through spin off options as we speak. Thinking of banks generally, this post made me pause and reflect on a couple of European banks, which seem (relatively) unscathed.

I'm quite nervous about Santander, given that they have such a large domestic loan book - take a drive through parts of Spain, and you'll suddenly think Florida real estate isn't so bad. One firm that stands out is BNP Parisbas. More generally, why do french banks seem to be more resilient?

Elementaire! The french banks were very slow in getting a taste for racier debt securities - it might be a side effect of that country's natural disdain for leverage (try getting a buy to let mortgage in France!). Hence they were late to the CDO party and missed the shrapnel.

As an aside, a similar "slowness" in taking on more aggressive (read North American) debt investments also saved the smaller Swiss banks from the misfortunes of UBS. Sometimes not making a decision is the best decision.

Grand Debt Auto

Just when I feared that the Detroit automaker executives were going to carjack TARP with ease, Congress finally started doing its job by pointing out the weakness of their case. The ineptitude of these managers is breathtaking - if you're pleading poverty, flying in on private jets is not the best signal to send. Mind you, given that a fair part of the blame lies with unrealistic past demands, the mendacity of the United Auto Workers union is equally astounding.

Let's take a step back and think of the endgame. Taking GM as an example, their existing bonds are trading at yields north of 50%. At those levels, you are well into distressed territory. As of their latest accounts, GM's retirement obligations amount to $58Bln. Assume that GM needs to pay 10% per year on that liability amount - not unreasonable given the ageing population and rich benefits of that scheme. Ignoring any inflation uplift, that's $6Bln per year. So under the heroic assumption that GM's restructuring was cash neutral (!), a $12Bln loan would be burned in 2 years by simply servicing the retirement liability.

The ultimate (although politically difficult) solution is to decide what is most important to the US Treasury; either a) protecting automaker retirement benefits and union contracts or b) restructuring a hopelessly outdated and inefficient manufacturing facility. It can't do (or afford) both.

I have a modest suggestion. The private equity managers I deal with (particularly on the mega cap side) are frankly bone idle. Pop all these automakers into a fund vehicle, hire a couple of them to manage it. Offer a 0% management fee and 25%. You get focused and highly motivated managers with no vested interest apart from making these operations profitable again.

A bailout would be nothing short of mugging the taxpayer. The executives would make a clean getaway - although as they probably would be driving a Detroit-built SUV, I think that's a bit of a contradiction in terms.

Citi twists again

Although it's been a while since his foxtrot out of the Citi boardroom (or should that be ballroom?), Chuck Prince's dancing shoes are still making an impact on their balance sheet. As well as being forced to have $17 Bln of SIV assets waltz back onto their balance sheet, they were forced to close an internal hedge fund after a 50% loss.

I'll admit that this time last year, a hedge fund raking up such a poor result would have caught my attention - now it's a daily recurrence. Now it the nerve hedge fund managers are showing that amazes me. Several of them tap-danced into my office this month with great offers of temporary "management fee reductions" if we don't redeem, even as the prices continued to shine red on my screen. One of them even offered a "rare opportunity" to access their new distressed debt fund.

At this rate, it might be more fun to put the money into Citi, just to see what mess they get themselves into next. At the very least, it'll be one hell of a (con)tango!

Yo-ho-ho and a bottle of TARP!

The media's ability to miss the parallels between news items never ceases to amaze me. The past few days have seen a lot of coverage of the modern-day buccaneers seizing ships off the East African coast, and extorting ransoms from the owners. These latter-day Long John Silvers have got their grapple hooks on a (full) oil super-tanker - for context it is about the size of an aircraft carrier. Such crimes have been going on for years, and in other major shipping lanes too- the South China Sea and Malacca Straights spring to mind. The Somali pirates have 14 vessels anchored in their port right now, including - I kid you not - a shipment of over 30 T-72 tanks.

Anyway, I digress. Back in Washington, a bunch of Detroit Pirates are trying to pillage the TARP. Having sailed up the Potomac in their rusty barge, they are now waving their brittle cutlasses at Congress. They are demanding a $25 Bln ransom from taxpayers to avoid "catastrophe", although they seem to ignore the fact that the problems are mostly of their own design (have they never heard of inventory management?). "Surrender the bailout", you might say.

Yet fear not, for I have a solution that will make both the Somali pirates and Detroit carmakers happy. This interesting blog item highlights the mountain of unsold vehicles coming out of container ships at Long Beach. The only people making hay out of this are the port land owners renting out car parking space.

So here is my solution - get those container ships to cruise along the Horn of Africa, and wait for the pirates to do their raiding party tricks. Result: car inventories drop, and pirates get their boarding practice. Aargh-hargh! GM SUV shipments ahoy!

Bladeblunder

Let me start by saying that I fully endorse the goal of generating as much of our electricity from renewable energy sources. It is a scandal that we have sabotaged the creation of a global carbon trading scheme, and put our energy security at risk with an insane dependence on volatile regimes. Instead, we spent a fortune on the lunacy of corn ethanol.

Nevertheless, I have to take issue with the hysteria about wind power. I have witnessed this at first hand in my organisation, with significant investments going into speculative wind farm developments. Everything hinges on fiscally unhinged government subsidies and (foolish) utility firm buying up these farms. It has all the makings of a pyramid scam...someone will be sitting with a lot of idle turbines quite soon.

I won't get into the technical side of things, but wind can never be a core source of power. It's a physical impossibility (aside from putting turbines on Capitol Hill- there's plenty of hot air there). The industry has acquired the tainted aura of a confidence trick, but reality is now catching up with investors.

I'm not saying all wind turbine farms are bad, but at best it's a small part of a much bigger change in energy policy. We certainly shouldn't be bankrolling turbine makers and development speculators with subsidies. It's a long way away, but the ultimate goal is to get ITER commercially viable. My advise is to steer clear of those blades...

The Sorcerer's bailout apprentice

On Mickey Mouse's 80th birthday, there's a poetic irony that the hapless Fed is bumping into the unintended consequences of its leniency to the banking sector. It turns out that some of Fed's commercial paper and short term debt facilities are being used by banks to avoid recognising losses on their loan books. I recognise that the liquidity crisis needs some sort of government response, but polluting the Federal Balance sheet is not a smart way of getting there.

When this state of affairs is challenged, the standard response is that it is necessary to get the interbank lending system unblocked. Unfortunately, according to the Fed's own figures, this is simply not true - lending has actually grown. This crisis is too complex for blunt force measures, but instead policy makers continue to pump valuable liquidity into the wrong areas. What is needed is a reload of the corporate debt market. In a prior posting, I suggested using those TARP funds to support fresh and clean investment grade issuance. As a taxpayer, would you rather own senior GE debt or a junk pile of subprime mortgages?

So what should we do? Frankly, I'm tempted to drive down to Anaheim and stock up on Disney Dollars. At least they might still be worth something in a year's time...In Mickey we trust?

Buyouts squared

Although the hubris has died down a bit, some of the recently listed private equity/hedge fund companies could be where the next round of M&A action kicks off. Setting aside some fairly atrocious investment decisions in recent times (and worse to come), there is a case for shaking up some of these entities.

Fundamentally, is there any economic value in (say) keeping an asset management business and a corporate finance advisory business under the same umbrella? Even if you ignore the governance issues that generates, wouldn't the incentives (and behaviours) work better with two separate entities?

Take Blackstone - I'm intrigued that no one has considered the idea of spinning off their corporate finance division and merging it with another M&A franchise.

Having said that, this is not as pressing as clunky insurers holding asset management firms in their structure. Of course, they like the annual management fees those franchises generate, but you end up with double-barrelled mediocrity: lousy underwriting and second-rate fund managers.

Insurers in shadow banking clothes

There has been quite a bit of press recently on the demise of the so-called "shadow banking system". As a reminder, these are institutions that fund themselves through short-term borrowing, investing the capital into longer term (and sometimes highly illiquid assets).


Up until recently, the culprits behind this highly risky (but in good times very profitable) trade have included hedge funds, structured investment vehicles, conduits, private equity funds and even money market funds.


I don't think anyone can now dispute that the unwinding of this trade will be nasty. What I want to point out is that there is one group of non-financial firms that have so far been left out of the debate: insurers.

The reasoning is as follows. How does an insurer make money? Well, if you believe their own financial statements it ain't through commercial judgement. A glance at the past 5 years combined ratio (a proxy for profit on insurance underwriting) shows that insurance per se has been unprofitable at some point, sometimes tragically so.

The white knight is investment income flowing from the balance sheet. When markets cooperate the returns are healthy, as in spite of regulation insurers can invest in some pretty racy vehicles (CDO equity anyone?). Their motivation is simple - to boost the P&L, you need high octane investments for your surplus capital.

AIG may be a special case, given that they were involved in heavy credit derivatives business. All the same, I think it is safe to assume that insurers will be paring back the rpm on their investments - expect more unwinding for some time to come.

Bail it out and they will come

Now that TARP has given up the ghost and become a vanilla stimulus package, the queue of industries lobbying for a piece of the action grows by the hour. The latest group to the join the party are retailers, who are urging government action to boost consumer spending.

We've sadly been here before, and the reality is that a temporary rebate to consumers is at best a damp squib. In the current climate, any sane household is more likely to warehouse a rebate into cash, or maybe pay down some of their (extensive) debts. A bit of healthy de-leveraging would be the logical step, but I am making the assumption that households will resist that additional flat screen TV purchase.

Retailers should look to Japan, where similar initiatives have failed repeatedly. The nightmare scenario would be if consumers did go and spend the rebate - thus storing up even more problems for the future, and making the endgame even worse.

Watch and learn

Only a few quarters ago, commentators were agonizing about the impact of sovereign wealth funds on western economies. Whilst some saw it as a threat, the optimists saw these investments as a way for emerging economies to gain insights in the best in corporate finance and governance standards that the West had to offer.

Let's have a look at an example, the China Investment Corporation (CIC). It made three investments into leading US firms: Blackstone, Morgan Stanley and VISA. The results are shown below - at $6 billion in losses, insight appears to be an expensive business.

Heaven knows what CIC must make of our corporate finance and governance standards now, let alone our "open market" system free of government intervention. You have to laugh at the irony of all those years lecturing China on the joys of our system. Watch and learn, China, watch and learn.

Property sandstorm

Readers who have passed through London in the past couple of years (or flicked through the local papers) might have noticed the large number of ads for property investment opportunities in Dubai. Lavish brochures, an apparently low tax regime and dazzling architecture...enough to make even the coolest investor swoon.

Fuelled by speculative buyers, apartment lots changed hands several times before the building was even built. Whilst the music played it was good fun, and no one wanted to spoil the party by asking the inconvenient question: who is going to actually occupy the mushrooming number of apartments coming on stream?

Sadly it's proving to be a pipe dream. The glossy wallpaper is peeling off to reveal nasty stains of corruption and excess leverage. The excess debt is a real problem, as the government financed its ambitious building plans with mountains of foreign debt. Hardly a great recipe for speculative real estate.

A parting thought - why build all these skyscrapers, only for them to be prematurely worn down by sandblasting from desert winds?

Cometh the hour, cometh the bailout

Well that didn't take long did it? That carefully crafted, focused troubled asset relief program (TARP) is officially history. Welcome to a brave new world of government handouts- in reality a pretty undignified scramble for a slice of a $700 billion pie.

I had hoped policymakers would back away from this, but the emphasis has now shifted to car manufacturers and credit card loans. I know sinners need forgiveness, but do you really want to spend your limited capital on serial offenders? Since everyone else is sticking their oar in, I thought I'd share my idea for using that money.

It goes as follows. Forget buying existing debts - the covenants are likely to be leaking like sieves, and agreeing a market-clearing price on highly illiquid assets is simply too time consuming. Instead, start afresh and purchase new issuance - on terms that are clear and unencumbered with any baggage. If need be, let the existing debt crater - it will help guard against the charge of rewarding people for failure. At least the newly issued debt has a better chance of making it to the maturity finish line without further collateral damage.

It's not too late to get the original (good) intentions of the TARP program back on the table. If we continue down this meandering path the results could be disappointing at best. The road to catastrophe is paved with good lobbying...

Private Equity goes to plan B, C, D...until they find one that works

It was nice while it lasted, but reality is finally catching up with the mega-cap private equity funds. The party reached its apex with those public offerings, but now the hangover of (a lot of) debt is now on the rampage. Freescale or ProSiebenSat equity stakes anyone?

Yet the diversity of reactions between these fund managers is interesting. Take Blackstone's quarterly update. Not much in the way of details, but writedowns are creeping into the equation. Fear not - management fees came to rescue to offset the nasty details of over-leveraging companies with dubious added value potential.

So where to go from here for the mega-cap funds? I tried the following suggestion with one of them, which went along these lines: for new funds, just waive the management fee! Existing funds provide more than enough annual charges (quaintly known as "Revenues" in investor relations land) for costs. Then you're magically aligned with your investor's interests, since to make any profit on the new fund requires you to beat your hurdle. Simple.

Needless to say, the blank stare I got from them was a Kodak moment. Which takes me to KKR Financial - did you notice the strategy drift in their CEO's comments? In the good old days KPE was described as a loans, high yield and distressed debt vehicle. Based on today's announcement, it still is, kind of - but depending on how things go, it might become a bank...or something else...still working on the plan. In the meantime, they're revoking the dividend. I guess they need the cash to spend on all that planning...

Remember the fallen

I acknowledge that this blog is normally focused on finance and capital markets, but on this special day I felt that a small digression is reasonable.

Irrespective of one's view about conflicts (both past and present), I hope that readers will join me in reflecting on the sacrifice our armed forces make every day in our name. Lest we forget.

The downside of optimism

It was only a matter of time before the perma-optimists came back in force. Step forward several analysts predicting a record year end rally for the S&P 500. Yet a bit of rational thinking pours cold water on that theory.

Optimism is a real liability right now, as it's a comfortable refuge from the facts - things will get a lot worse. Right on cue, Circuit City (a good retail bellwether...or should that be clunky shell?) came clean that it's game over.

I'm not saying that a positive attitude is a bad thing. It's the engine that drives free enterprise and productive labour - but calling the end of our woes now is simply delusional. The sooner we come to terms with the true scale of our problems, the quicker we might (just) be able to address them before it's too late.

Das (Car) Kapital

I'll admit to being surprised to see General Motors in the weekend press. Not the fact that they are in deep trouble; that's been a well-trodden story over the past few years.

Isn't it interesting that there's no talk about cars, merely about how fast automakers are burning cash? When you look at GM's accounts, their pension and benefit liabilities are a cast-iron millstone around their neck. Any cash they make from that quaint activity of selling cars rushes out of the door to fund those liabilities. Add anaemic sales (at best) and you have a recipe for disaster. It was merely a matter of time before reality caught up.

We might be nearing that point. The bizarre part of the story (aside the impact on their employees, of course) is that policymakers are contemplating a rescue of automakers from...you guessed it, the rescue fund for financial institutions (also known as the TARP Fund).

Yes, the fund set up to rescue financial institutions might get raided to prop up automakers. My question is where will this end? OK, it'll end when the $700 billion is spent, but who will win the race to grab a slice of the taxpayer pie? Airlines? Farmers? The TARP's terms kept its remit to financial firms only, although in these politically charged times the temptation to broaden the terms might be overwhelming - who'd have thought nationalisation would become fashionable?

Absolute madness. On a closing note, I tried to get a copy of the TARP Bill text from the US Treasury web site. The web link at the Treasury pops up a fitting message: "Sorry...is not a valid site". I couldn't have put it better myself.

You can bank on meddling

It might seem a bit ungrateful to question the behaviour of the UK government in these difficult times, yet the situation in Olde England is increasingly surreal. Having rescued banks with that flexible friend (i.e. the taxpayer), the Chancellor then decides to read them the riot act for not passing on the benefits of the last interest rate cut.

I think there's a broader issue here, in that people overestimate the actual power of this policy tool. By all means cut the rate, but banks are still hoarding cash, and interbank rates remain stubbornly out of whack. Think of it this way -if rumours are swirling around that your counterparty might be heading for the wall, would you lend money to them under any circumstances?

The fundamental issue with the interbanking system is trust, not the absolute level of interest rates. Until policymakers wake up to this truth, I'm afraid there will be many more angry and pointless exchanges on this issue.

Every blog starts with a single post

Hi there everyone, and welcome to Capital Novation!

The aim of this blog is to provide some entertaining and hopefully informative commentary on news and events in the global financial markets. I'll also provide the occasional anecdote from my experiences of working in the investment industry - within the limits of confidentiality and regulations, of course.

Needless to say, no one individual can cover all the bases (heavens, even the Financial Times misses the occasional item!). However I'll try and cover a broad range of markets and themes over time. And last but not least - this blog represents my own opinions only, and is not an invitation to consider or undertake any investment action of any kind.

Right, that's the legalese done. Now let's begin...