Civil stupidity

It would be charitable to call it eccentric, but the UK government's latest pay action is simply crazy. In the midst of the downturn, and with the ghastly state (and worsening) state of their finances, they still decide to award their public sector workers a pay rise of 1.5% next year. Deflation? Schmeflation, says Gordon Brown.

Devalued, discredited and delusional. Jim Rogers might be a tad hyperbolic at times, but it's hard not to view the UK as "finished". At the very least, it's on the floor and gasping.

Brace for default impact

GM bondholders have been bracing themselves with the increasing likelihood of a default. What has caught them off-guard is the speed of the decline, which government intervention has failed to arrest. They are now facing up to even lower recovery rates, possibly in the 20 cent on the dollar range.

The above recovery rate explains why this business is spent - when the assets of the business are worth such a small fraction of its debt, any further cash to fund GM is simply money down the drain. Other commentators have been hammering this away since the crisis began, but Washington blinked in the face of the political dead-weight of bankruptcy.

I think there is no longer an "if" on bankruptcy proceedings, merely a discussion on the form of these proceedings. It is hard to be optimistic that GM can suddenly face up to its 20 year lag behind its Asian and German rivals and make cars that a) work, b) have style and c) incorporate 21st century manufacturing processes.

Sadly, it's best to admit that it's over. Wind this spent force down as soon as possible. If something can be salvaged from the wreck of GM, so much the better. But General Motors' time has passed - prolonging the agony is quite cruel in the long run.

The commercial property (falling) clog

News that a local landmark in my former home of Boston is going for a fire sale price didn't come as a surprise. The Hancock Tower is (apparently) the tallest skyscraper in New England, and is about to go on the block as its current owner Broadway goes under.

Just to add spice to the equation, the lenders to this deal (purchased from Beacon Hill Partners) were Lehman Brothers and Royal Bank of Scotland. I'm slightly annoyed that my usual technique (just find where Merrill is doing deals - that's where trouble will come) has been jinxed by this one.

Some of the side comments around this auction are interesting. Apparently, Broadway felt that some reduction in vacancy rate (it was 99% at purchase) would be good, as it would allow the option to re-lease space at higher rates. The Hancock Tower wasn't the only thing that was high...

Dunfermline the crumbling building society

In the great scheme of things, the collapse of the Dunfermline building society in Scotland (a UK version of the mutual bank/credit union) is a relatively small ticket item. What is interesting is the apparent laziness of civil servants to push through a rescue deal in time.

It's slightly alarming that after all the previous (and far larger) rescues that have taken place, the response from the UK continues to stumble. Although the irony is that this bust firm is based in the backyard of Gordon Brown's constituency. Quite appropriate, on reflection.

Core Concept 3 - Inflation noise

Coming back to my "Core Concept" series, I thought I'd spend a little time looking at the implications for inflation on your investment decisions. With the near-constant mention of the term, I thought I would be useful to look at this in a bit more detail.

Inflation seems to make sense intuitively. After all, when prices change it's hard not to notice it. Recent talk has been about the spectre of "deflation", where prices spiral down a la Japan lost decade. The behaviour of the Japanese makes sense - if you know prices are going to fall, you'll wait a week or so expecting the price to fall. When that takes place, you decide to wait a little longer for another price cut. And so on, until you enter a deflation spiral.

This fear has haunted the Fed and other central banks, as well as governments, and is behind the recent stimulus packages to kick spending up.

What people don't always appreciate is that "inflation" figures are a very coarse approximation. They are based on a basket of goods that are deemed representative of the population, but your personal inflation rate might be very different from (say) the CPI. This is because the split of your expenses (say % on food, energy) may vary a lot from the average.

From an investment perspective, inflation can be very destructive. After all, if a dollar suddenly buys you less, you need your investments to earn more to make up the shortfall. Too much inflation destroys your purchasing power. Too little, and the economy may start to slow.

So how do you defend yourself from inflation? Stocks have long been touted (and I use the term deliberately) as a way of hedging inflation. But it's not strictly true. Take a single company as an example. If it can pass 100% of a rise in inflation to its customers without hitting the bottom line, then you are effectively hedged. However in reality, to stay competitive, firms can't always up their prices, so the rise in costs into their profits, hence earnings, hence your stock value.

Bonds are normally poor at inflation control, as they are fixed return instruments. The exceptions are inflation-linked bonds, such as TIPS and Index-Linked Gilts. However don't expect a perfect hedge, as their payments are keyed off an official rate (CPI) that might not be your personal inflation rate.

Over a long term, real assets such as property do tend to track inflation, but again you can't take it as a given that it will be a perfect correlation. So in summary, inflation is something you have to factor into your portfolio decisions, but don't assume that simply buying inflation-linked instruments alone will work. It makes sense to have some exposure to them, but it ain't a panacea.

State of Hypo-action

The headlines have focused largely on US and UK banks recently, but a slow-motion car crash is taking place in the banking sector across Germany, Austria and Eastern Europe. A graphic example of this decline is the state of Hypo Real Estate, which is going through the motions of handing the keys to the German Federal government.

To add a bit of context, Hypo used to have a relatively (if dull) business of public sector and infrastructure financing. Over time, their commercial lending practice started to balloon, offering everything from mezzanine financing to RMBS/CMBS. Their favoured hunting grounds included eastern Europe, where they funded many an over-leveraged deal where the equity now been wiped out (and some of the junior debt holders too).

I actually went to see them at the high of their (shaky) business in London. A shiny new office in the Swiss Re building in the City (pretty expensive for a mid-sized wannabe investment bank), and a frighteningly gung-ho attitude. I was taken aback, as the only prudence there was in a dictionary.

A 93% fall in market value speaks for itself - this business is a dead bank walking. What interests me is that we haven't yet seen too much newsflow of this type from Austria, whose banking system has equally worse exposure to this mess. Stay tuned!

The Browning (Drowning?) Version

I was going to write a post about the insane spending plans being touted by the UK Prime Minister Gordon Brown, but this rapidly spreading youtube video of British MEP Daniel Hannan does a far more eloquent job. He does have the luxury of having Gordon Brown in front him though.

To get an example of how things should be done, take Chile. Sure, they enjoyed their revenue windfall from the boom in copper prices. The difference versus their "developed" peers is that they saved the money. As the Chilean President put it, her country is in a better place "because of our decision during the good times to save some of the money for the bad times."

It's a sad reflection on the state we're in that such basic financial sense seems to have evaporated. The fact that most financial blogs (including my own) have to spend so much time commenting on political statements is, I confess, a depressing development.

Gilt-edged swords

The failure of the latest UK Gilt auction today could be down to several factors. Aside from the odd maturity date (40 years), it didn't help that the Bank of England governor came out with some negative comments on stimulus packages the day before.

Having said that, the inevitable front-runner is investment sentiment. With tax receipts about to fall through the floor, the Treasury's forecasts are not optimistic - they are fantasy. In that situation, you can understand the caution of buyers.

One swallow doesn't make spring, but the UK government needs to take heed that selling Gilts is not a free ride. But to put things into context, the recent fall in Gilts pretty much erases the recent "pop" in the market following the quantitative easing announcements. The real danger is that policymakers are deploying quantitative easing with little understanding of its negative effects.

Dead air stock market bounce

It's amazing what a government initiative can do for short-term sentiment. Witness the rocket-fuelled rise of major indices today, driven up by the US Treasury's announcement of its latest (greatest?) plan to get private capital to co-invest into its toxic debt rescue plans.

Whilst the administration is (slowly!) starting to move towards action, I fear that the plans are still vague and far from solid. In this case, it will be a while before we find out if private investors are playing the game. To a large extent it depends on the Treasury's rules, which they are still tweaking.

Why am I so bearish on stocks? This rally simply doesn't have any strength behind it, aside from fumes. Corporate earnings are going to be awful for a while yet, with a rising unemployment trend. Not a healthy brew for an equity market.

Eurozonked output

Absolutely dreadful figures from the Eurozone on industrial production this week. Year to year, the drop was a staggering 18%, with a 3.5% decline from January levels. The damage was particularly severe in the manufacturing powerhouses of Germany and France.

It has to be said that the strength of the Euro has been causing carnage for these export-led sectors. Given the relatively heavy weight of the Eurozone to manufacturing, it makes the ECB's hard stance of holding up rates (thus the Euro exchange rate) all the more perplexing.

With production spiralling down, I don't think inflation is a big concern over the coming once. The potential bankruptcy of swathes of Europe's manufacturing (and intellectual capital) base is.

Lehman Brothers - calling former employees, clients

I've been gathering information on Lehman Brothers' demise over the past few months. The more I learn, the stranger the tale becomes. Whilst it may take a while yet for official documents to surface, I firmly believe that the "official" sequence of events misses many points.

Several colleagues and friends have finally convinced me to start writing a book about these events. I don't intend it to be a "screaming and raving" attack on individuals (unless I find out it's warranted, of course).

But I would be very interested to hear about any experiences from former Lehman employees (or clients) about those eventful few weeks. If you are in those categories, I am sure you have some valuable stories and points to share, whatever your role at that time.

Please feel free to write in (or email me if you would prefer to keep the communication private from public eyes). Confidentiality and anonymity will be honoured in all cases.

Office nomads

I don't normally comment too much on individual company trading updates, but recent comments from Regus, a UK office rental firm, opens up some interesting points on the asset management business and the office property market.

In case you haven't come across them, Regus effectively allows companies (or individuals) to hire out meeting rooms or offices on shorter-term leases. In many cases you can also hire some IT support and catering (all for a fee, of course). Taking London as an example, they have several sites dotted around the city, particularly in the the major financial hubs of the West End and the Square Mile (Canary Wharf is dead right now, fyi).

When it works, it is a high profit margin business, since the rates being charged are sky high. And you get charged for EVERYTHING, including sugar for tea or coffee (I kid you not!). They provide fairly lacklustre business support, as they know you are dependent on them - after all, it does a firm no good to its reputation to keep moving addresses.

The more subtle point is that these buildings are a good barometer of the fortunes of financial firms, particularly small and mid size ones. Whenever I have to attend a meeting in one of these places, I wander about a bit to see what sort of firms are there. Trust me, the names on the board at reception change every week! And up until recently an alarming number of them were one room affairs...not exactly confidence-boosting. Yet a Regus office in (say) Mayfair offers a veneer of respectability - a nice postcode to have.

Needless to say, many firms are disappearing in the current climate. And as the nearby office blocks (with ever increasingly large "to let" signs) are not filling up, it either means landlords haven't started to lower their rent demands, or many firms are simply going bust. In all sincerity, I think it's a combination of both right now.

The bottom line is that if you are looking to rent offices in London, hold out - the yields have far to widen.

Long and Weavering road

That a few hedge funds are turning out to be fraudulent is not a great surprise. The moment the good times cease, there's no more momentum to keep the deceit running. In the case of Weavering, which crashed and burned today, it appears to be a fairly straightforward con.

What is surprising is that anyone would have invested in that product in the first place, if they'd done some basic due diligence. After all, isn't it a bit odd for this type of strategy to have such a large trading volume with a Cayman entity, rather than with its brokers?

Amazingly, the auditors of the fund (Ernst and Young) signed off the accounts - including a statement there were no related parties able to exercise significant influence. And yet two swaps were on the books with a notional in excess of 75% of the entire fund.

You'd have thought that after the demise of Arthur Andersen (RIP) in the Enron debacle, the remaining auditor firms would have learnt the lesson.

Federal Unreserved

Apocalyptically insane, as one of my colleagues would say - the Federal Reserve has thrown all caution to the wind and decided to roll into the last chance saloon. In addition to buying an additional $850Bln in mortgage bonds, Bernanke's crew are also going to buy $300Bln in Treasuries.

Sure, we duly got a pop in the Treasury market today as the Fed put its foot on the quantitative easing accelerator. Equity markets also got a kick up as a result.

It is a real shame that the US is following in the misguided footsteps of the Bank of England down the quantitative easing route. The structural changes that the economy needs to right itself cannot be absorbed by monetary policy. There is an inconvenient point of view that all these bailouts are merely postponing the necessary corrections - the final reckoning may yet prove higher.

That being said, PIMCO's Bill Gross proved to be right on the money - they suggested buying what the government will buy ahead of them. I admit to regretting not following that advice to a sufficient level. On the other hand, I take some comfort from the fact that even in these turbulent times there are ways to make money - one of which is simply not to watch the ghastly and naive CNBC.