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.