The Parallax Brief


Unrepentant Subjectivity on Economics, Politics, Defence, Foreign Policy, and Russia

Barclays Beggars Belief

Barclays have officially entered ga-ga land. Desperation and efforts to bolster the balance sheet have overridden common sense.

From Willem Buiter’s Maverecon blog on the Financial Times website:

In its report today on Barclays’ Annual results for 2008, the Financial Times writes:

“The bank confirmed it had written down its exposures to complex debt instruments by £8bn in 2008, though the impact was reduced by a £1.66bn gain it booked from the reduced value of its own debt.”

My immediate thought was: surely that report cannot be true. When your market-traded debt becomes worth less because the market considers you less creditworthy than before, and prices your debt to reflect that perception of increased default risk, this does not add to your profits – it simply makes you a worse credit risk.

This is mark-to-market gone mad.

Of course, as Willem points out exasperatedly, this does have a certain basis in real life — a real life scam. A company can make a pretty packet from the bond market by issuing bonds, spending the cash, and then persuading the market that it is highly unlikely to pay back the bonds. The value of the bonds plummets and the company then buys back the (by now valued as next to worthless) bonds for a nominal sum. Hey presto! Free money.

But to imagine that one’s declining credit risk — and therefore declining value of debt — counts as a mark-to-market profit is truly absurd. Barclays still has to pay back the full amount, if it wants to maintain its good reputation and wants access to reasonably priced debt in the future — quite important for a bank, I would imagine. So when will these ‘profits’ be realized? Never. The real value of Barclays’ debt is the same as it was; only its credit worthiness has gone down.

Who does Barclays’ accounting? Arthur Anderson?

And we wonder why it went so wrong.

Filed under: Economics, , , , , , , , , , ,

Financial Crisis: 2009 Equals 1931?

Ambrose Evans-Pritchard (pictured right) is the Stephen King of financial columnists: his articles and blogs for the Daily Telegraph (London) are terrifying.

Evans-Pritchard reports on each new squall of dire financial news with élan and wit, and his remaining readers (surely, I assume, many must have liquidated their assets, bought gold, and fled for the hills) have been rewarded with what has been one of the most prescient columns around: Evans-Pritchard foretold the armageddon long before the true reality of this horrific mess hit home to the rest of us.

This makes is latest column petrifying – and perhaps relieving:

“Barack Obama inherits an economy already contracting at an annual rate of 6pc, much like the mid-Depression year of 1931 (-6.4pc). This may beat Germany (-7pc) Japan (-12pc) and Korea (-22pc) over the fourth quarter. But that merely underlines the dangers ahead as the collapse of global trade chokes the mini-boom in US exports, setting off another stage of the crisis.

The US is losing 500,000 jobs a month. Brazil lost 650,000 in December. Beijing says 10m Chinese have lost their jobs since the crunch began. Japan’s exports fell 35pc last month, year-on-year. The central bank is printing money furiously, buying bonds to prevent a relapse into deflation.

It is like early 1931… But it is not yet like 1933.”

Evans-Pritchard paints an arresting picture of the America Franklin D. Roosevelt took over in March 1933, and in doing so provides a startling allegory for the dangers facing us now. Those libertarians and Hoover-Mellon acolytes still appalled by the brazen use of budgetary deficits and monetary easing should read on to get a picture of what happened the last time we did things your way:

“That second leg down [between ’31 and ‘33] was the result of “liquidation” policies by a Dickensian leadership blind to the dangers of debt deflation. By then the Gold Standard had degenerated into an instrument of torture. It forced the Fed to raise rates from 1.5pc to 3.5pc in October 1931 to stem gold loss, with predictable results for shattered banks.

It is worth glancing at the front page of New York Times on Monday March 6, 1933 to see what the world looked like three days after Franklin Roosevelt moved into the White House.

The newspaper splashed with the story that FDR had closed the US banking system – invoking the Trading with Enemies Act – and ordered the confiscation of private gold. From left to right, the headlines read: “Hitler Bloc Wins A Reich Majority, Rules Prussia”; “Japanese Push On In Fierce Fighting, China Closes Wall, Nanking Admits Defeat”; “City Scrip To Replace Currency”; “President Takes Steps Under Sweeping Law of War Time”; “Prison For Gold Hoarders”.

President Obama faces a happier world. The liberal economic order is still in tact, if fraying at the edges. Capital and ships move freely. North America and Europe talk the same political language. China has so far proved a dependable pillar of the international system.

Roosevelt took over a country where the economic machinery had completely broken down. The New York Stock Exchange and the Chicago Board of Trade had closed. Thirty-two states had shut their banks. Texas had restricted withdrawals to $10 a day.

Few states could borrow on the bond markets. Illinois and much of the South had stopped paying teachers. Schools closed for months. An army of 25,000 famished war veterans squatting in view of Congress had been charged by troopers of the 3rd US cavalry with naked sabres – led by a Major George Patton.

Armed farmers threatening revolution had laid siege to a string or Prairie cities. A mob had stormed the Nebraska Capitol. Minnesota’s governor was recruiting Communists only for the state militia. Lawyers attempting to enforce foreclosures were shot.”

We must not allow the second leg to happen again.

Filed under: Economics, , , , , , , , , , ,

Global System More Fragile than we Think

Much of my recent reading has been dominated by the financial crisis sweeping the world. Working in an investment bank at the moment feels rather like being a office cleaner for the Pentagon during the Cuban Missile Crisis: there is no respite from the torrent of apocalyptic news but there is little one can do to influence the situation.

However, while the effects of the current credit crisis and financial turmoil on economies, job markets, and businesses are difficult to underestimate, there is also a broader, global issue at play. Until recently, I had assumed that globalization was a new phenomenon, driven by modern developments in logistics and communication. But if you, like me, assumed this, you’d be wrong.

Paul Krugman, Nobel Laureate for Economics takes up the story:

“…our grandfathers lived in a world of largely self-sufficient, inward-looking national economies — but our great-great grandfathers lived, as we do, in a world of large-scale international trade and investment.”

I first heard of this ‘first great globalization’ when watching Naill Ferguson’s excellent television series, The Ascent of Money. In it, Ferguson alluded briefly to a world which was, in relative terms, as financially interconnected as it is today.

Serendipitously, I stumbled on Krugman’s op-ed at around the same time, and what makes the first great globilization such a frightening story is the tightly corresponding similarities to the world of today: technological advances, increasing integration, and full blown globalization that fueled unparalleled economic growth.

Further, people of the time, like now, assumed that war would be so unprofitable and economically damaging that it would never happen. Of course, we now know understand the fallacy of this thinking, but the story has some sobering implications for the world of today. Krugman explains:

“But then came three decades of war, revolution, political instability, depression and more war. By the end of World War II, the world was fragmented economically as well as politically. And it took a couple of generations to put it back together…

Can things fall apart again? Yes… the belief that economic rationality always prevents war is an equally great illusion. And today’s high degree of global economic interdependence, which can be sustained only if all major governments act sensibly, is more fragile than we imagine.”

Certainly worth a read for those interested in history, economics, and geo-politics and foreign affairs. And something else that is of interest is Ferguson’s recent review of a book covering a related subject for the Financial Times.

The point I’m trying to make is that while we live in a stable, interconnected, increasingly prosperous world, it only takes one financial or economic shock handled in the wrong way to bring nationalism back into vogue in one or two places, encourage countries to pull up the barriers, and, at the very least, lead to a domino effect that sends us drifting away from the model of increasing integration and division/specialization of labour which has made the world more prosperous than ever before. Conflict is unprofitable, but it didn’t stop us last time, and to think it will this time is folly.

I would hope we would now be more mature, but I’m not so sure. It is well known, for instance, that the Smoot-Hawley Act expedited the onset of the Great Depression, yet China and Russia have both overtly sidestepped toward a more protectionist stance of late, and dark rumblings of an Sino-American trade war can be heard just over the horizon.

You have been warned.

Filed under: Economics, Foreign policy, , , , , , , , , , ,

Ruble Devaluation Enters Endgame

The Russian ruble finished stronger against the bi-currency basket yesterday (Tuesday 20 January), and has this morning strengthened again, perhaps signaling that ruble devaluation is approaching its end.

The ruble is ‘pegged’ by the Central Bank of Russia (CBR) against a currency ‘basket’ of 55% US dollars and 45% euros. The CBR intervenes in the market — either by selling rubles or buying them to weaken or strengthen the currency, respectively — in order to keep the ruble within a designated trading band against the basket. However, even a pegged currency must bow to economic reality, and with Brent crude at USD41 instead of USD141, the ruble had to be weakened.

But instead of a one-off drop of, say, 25%, the CBR embarked on what many viewed as a costly fudge: a step-by-step devaluation. Economists didn’t like it. Chris Weafer, chief strategist at Moscow based investment bank UralSib argued,

“If the government had actually announced a one-off devaluation of around 30 percent in the autumn the issue would probably be done and dusted by now. Instead, the salami-slice approach that the central bank is using has created considerable uncertainty and the expectation of further weakness”

The managed devaluation was a mechanism born not out of economic orthodoxy, but political expediency. It was designed to avoid spooking a population thrice savaged by devaluation – which might have led to a run on the banks – and as a face-saver for the government. But paradoxically, Russia’s slow devaluation ended up increasing the pressure on the ruble by raising expectations that more would follow, encouraging both speculators to place bets on further slippage and the population to switch savings into ‘harder’ currencies.

Further, the CBR still has to use its dollar reserves to stop the ruble dropping more than a percentage point or so every day, meaning that reserves are eaten up almost as fast as they would have been holding steady.

We are now approaching the point where the ruble must be held at a sustainable level. Russia may have had the third largest reserves in the world, but they are not infinite, and by the end of last week, which saw the fastest rate of devaluation so far, the real amount available for defending the currency had dropped to around USD200 bn.

At the same time, the ruble has lost between 20 and 25% of its value against the basket since the process started, approaching a valuation that makes economic sense, and is sustainable. The CBR now needs to force speculators to close their positions against the ruble in order to relieve pressure. It also needs to signal that the end has arrived, and the ruble will be defended at a position of the central bank’s choosing.

But how would it achieve this?

The CBR has two options: First, it can hold the ruble steady against the basket, sending a strong, if tacit, signal that the process is over and short positions should be unwound. Second, it could squeeze ruble liquidity. The Russian banking system as a whole owes the CBR vast quantities of money, and at the same time the CBR is the main source of liquidity. If the CBR tightens supply, demand for ruble liquidity will increase.

And in the last two days, we have seen something like option two. For the first time in years (perhaps ever) short term indebtedness to the CBR exceeds the liquidity banks have available in CBR deposit accounts. Further, the CBR plans to offer ‘only’ RUB80 bn at its ‘deposit auctions’ this week. Ruble liquidity is being throttled. Yesterday, the ruble actually gained against the basket for 50 minutes, during which time, according to my contact, only a few hundred million dollars were traded – a miniscule volume.

The problem with this method is that banks are already gasping for liquidity. If the CBR squeezes too hard, large swathes of the banking system – even those who haven’t been playing ruble devaluation arbitrage – may go bust.

Readers who have been converting savings or wages into ‘harder’ currencies may want to pause. Those with money saved in smaller banks might want to watch carefully what happens next.

The slow drift of devaluation is coming to a close.

Filed under: Economics, Russia, , , , , , , ,

Toxic Bank a Supine Move to Avoid N-Word.

Britain has become the first nation to attempt to resuscitate its banking system through the creation of a so-called ‘toxic’ or ‘bad bank’. The government hopes to transfer to an ‘aggregator’ those assets which are dragging the banks down, leaving the banks free to perform their usual economic duties, and, fingers crossed, leaving the tax payer with a nice profit once the world economy recovers from its economic heart attack.

The business community breathed a sigh of relief when it learned of the government’s plan, but is it a really good idea?

I’m afraid the obvious answer is no, it is not a good idea. The government should have bitten the bullet and nationalized all banks of systemic importance. It should have nationalized them back in October instead its of original bailout. And it should have nationalized them instead of this latest bailout. Ultimately, it’ll probably have to nationalize the banks anyway.

The government’s chosen alternative, the ‘bad bank’, in effect argues “even though the market says these assets are worth X, we are willing to pay Y,” because the only way the government can make these banks solvent again is by paying more than the market would. Of course, it hopes prays that in doing this it will finally purge the financial arsenic from the banking system’s blood stream, allowing for recovery, while getting valuable assets at an ultimately profitable price. But how likely is the government to be able to successfully second guess the market? And will this really prepare the ground for recovery?

Nobel Laureate Paul Krugman is skeptical:

“Now, maybe private buyers aren’t willing to pay what toxic waste is really worth… But should the government be in the business of declaring that it knows better than the market what assets are worth? And is it really likely that paying “fair value,” whatever that means, would be enough to make [the banks] solvent again?”

Krugman believes that the government, in effect, is handing the banks a huge stack of tax payers’ cash, while taking risks that the banks cannot.

“What I suspect is that policy makers — possibly without realizing it — are gearing up to attempt a bait-and-switch: a policy that looks like the cleanup of the savings and loans, but in practice amounts to making huge gifts to bank shareholders at taxpayer expense, disguised as “fair value” purchases of toxic assets.”

Clearly, something had to be done. The banking system is currently on life support, breathing only through the mechanisms the government provides. Last time things were this bad we tried turning off the machines, causing the Great Depression. Doing nothing, therefore, was not an option. But gifting the shareholders and management of the banks should not have been the first course of action.

Of course, a Labour government nationalizing banks is a public relations open goal for the Conservative Party, and this government is nothing if not supine, so perhaps we should have expected Brown and Co. to writhe and thrash a bit before succumbing to the inevitable.

But the sooner the government plucks up enough courage to use the N-word, and makes an announcement that it is nationalizing the British banking system for a strictly limited period of time, the better it will be for everyone.

Filed under: Economics, Politics, , , , , , , , , , , , ,

Time for RBS, HSBC, and LloydsTSB-HBOS to become British Sberbanks

News slithered uncomfortably down the wires yesterday that the British government had agreed to convert its GBP5 bn of Royal Bank of Scotland preference shares into ordinary shares, taking its stake in the beleaguered bank to 70%. RBS is now, effectively, a nationalized government bank.

Predictably, the denizens of the Right have savaged the decision. On his excellent blog, John Redwood, made some wholly rational points about the move:

“…RBS will announce losses of over £6 billion, or one third of the government capital… The government is now risking huge sums of money. Of course I hope they get the terms of the scheme right and that credit starts to flow again. Even if that were it happen, I will still worry about the high risk…”

Mr. Redwood is reasonable, but wrong. He is right to argue that we don’t really want the government to be risking our money. He is also correct to question, as he did earlier in his piece, whether the government should be dabbling in nationalization in this day and age. “Didn’t we,” Mr. Redwood and many others from the Right seem to be asking, “get past this in the 70s?”

But the Right is completely missing the point. In ordinary times, people like Mr. Redwood would be right. But these aren’t ordinary times. This process is not ideal, but given the alternatives, we must hold a pomander under our noses and plough ahead.

Willem Buiter, Professor of European Political Economy at the London School of Economics and former chief economist of the EBRD and member of the MPC, argues in his latest blog for the FT that the banks are:

“…dead banks walking, held up both by actual government financial support (directly through capital injections and indirectly through such facilities as the Special Liquidity Scheme and the Treasury’s guarantee on new bank debt) and through the anticipation of future government financial support.”

And he’s right. These banks would have gone bust but for implicit or tacit government support. We tried doing nothing and letting banks go bankrupt between 1929 and 1932, and it led to the Great Depression, so I would respectfully suggest that repeating that course of action would not necessarily be best for the country. This leaves us with two options: bail outs or nationalizations, of which nationalization is surely most desirable.

Nationalizing the banking system, along the Swedish model, would give us the best chance of defibrillating inter-bank lending, boosting credit provision, and, most important, would provide tax payers the best chance of getting a return on their investment in the long run, while avoiding moral hazard by wiping out current shareholders and the banks’ egregious management.

What the Right need to understand is that we who argue for nationalization aren’t communists, and would never countenance such actions in usual circumstances – even in a ‘normal recession’. But without government support, the British banking system will collapse, consigning the country to untold misery and hardship. None of us wants that. Given the remaining options, nationalization best fits the bill. And better nationalize now than try injecting capital, buying up bad debt – and generally throwing the kitchen sink at the problem in the hope of avoiding the inevitable – only to have to nationalize every major bank anyway.

Filed under: Economics, Politics, , , , , , , , , , , ,