Friday, 26 March 2010

is that a bail out?

It appears that the Greeks have been given a deal by the EU, where Germany have agreed to a package rumoured to be up to €25bn of support if the IMF comes in on the deal. Now it appears to the Raven from looking at the IMF website and doing his maths that the IMF will be able to lend €10bn at a blended rate of 2.7% (below where Germany could borrow). One would imagine that the Germans would be canny enough to argue that they (and France) should lend the remaining capital at a higher rate, say 4%? which would give Greece an average cost on €25bn of 3.48%.

The Raven thinks this is a ridiculous plan, which only serves to increase moral hazard and does nothing to either clear up the problem or to really stop the risk of contagion.

First lets but €25bn in context, thats pretty much the debt that Greece needs to roll over in the coming two months, and is ~8% of the total government debt.

Secondly it doesn't solve what really is becoming a solvency issue. Greece has moaned very loudly that is having to pay 6%, one has to wonder really whether they are good for the money they've borrowed already if they can't deal with a 6% interest rate. Its entirely irrelevant what what interest rate other EU governments have to pay on theirs.

The Economist had some numbers this morning that highlighted that the percent of GDP that would be taken up with interest payments will grow from 5% to 8.4% from 2009 tp 2014. They also highlight that government debt will be ~ 350bn which as a % of today's GDP is 147%. As a long term investor the Raven really doesn't think that the Greeks will ever be able to pay that back or grow their economy quickly enough to shrink that number relatively.

The structure of this "support" from the EU appears to be that they will step in when Greece can't borrow from the market. Surely Sarkozy can see that this encourages speculation? The real question is if this package is big enough and scary enough to make the market feel that Greek paper is safe and that you'll be bailed out if you buy it, in which case Sarko won't be firing his bazooka just yet.

Personally the Raven thinks this announcement will cause a small rally in Greek paper, but the market will come back and push the hand of the EU, either on Greece or another one of the UPIIGS.

Thursday, 18 March 2010

the FSA "business plan"

Hector Sants has come up with a new business plan for the FSA;

Basically Sants seems to believe that by adding 460 new "high quality staff" to the FSA and increasing their budget overall by 9.9% that they'll magically be able to spot asset bubbles. One would imagine that the "high quality staff" that they intend to hire will be among those made redundant in the credit crunch.

The FSA has only recently found the ability to find and bring mildly punitive action to 3 cases of insider trading. Odd that its been said that approximately 1 in 5 m&a deals are thought to have been traded on before being publicly announced. 3 cases in 9 years, good job guys?

Does £455mm represent good value annually? especially as that money is going to come from consumers of financial services, ultimately the UK public. The UK treasury estimates that the governments assistance in the financial crisis cost ~£10bn, given this crisis was about 1 in 20yrs event then actually the cost of having the FSA is going to be equal to the cost of the crisis, except the Raven would imagine that the chance of the FSA stopping a crisis accurately without predicting 5 out of the last 1 recessions before hand to be rather low.

The Raven thinks that Buffet's maxim that the firm should be simple enough for an idiot to run because one day an idiot will run it should be applicable to a regulator, because clearly and idiot does run it already. Rules should be simple and easy to enforce and should aim to do less harm than good.

Monday, 15 March 2010

UK Household balance sheets and inflation

The Raven chose his lunch break yesterday as an opportunity for mastication of the proverbial cud. He chose to reread the weekend's Economist in a state more awake and alert than he had been on Saturday morning, sans coffee. The Economics Focus section had a couple of comments which he disagrees with, but had blithely slipped under his radar;

"Spending in rich countris, such as America and Britain, will flounder as long as householdslook to pay down debts they aquired to buy expensive homes. A burst of inflation would speed up this process by eroding the real value of mortgages".

Well this may well be true in the US, but the Raven takes issue with applying the same logic in the UK. In the US its pretty normal to take out a fixed rate mortgage, whereas in the UK its a small percentage of people that fix and when they do its usually for 2yrs or less. Therefore this glib statement that inflation and the associated higher interest rates would be beneficial to UK household balance sheets is not only wrong, but dangerously lazy in its thinking.

Lets look at the effect on the 'average' or more precisely median household in the UK of inflation of the 1970s style.

HBOS survey "average houseprice" of £160k.

median household income of £30k.

current floating mortgage rate of 5% for a first time buyer with LTV of 90%.

so mortgage payments of £8k a year, approx 26% of gross income. lets say inflation is 10% for one year, and lets say our first time homeowners are especially skilled at wage negociations, they manage a 5% real wage increase so that their household income is £34.5k (+15% gross). But lets also be kill joys and say that perhaps the BoE acts and raises interest rates to 8% (only!), so mortgage rates go to 12%, which would then make the mortgage payments £19k, 55% of gross wages. You don't have to be a genius to see that consumer spending would get shafted and house prices would be smashed by a wave of foreclosures and reposessions. In fact at that point one would imagine that house prices would face a really serious fall, and a proper buyers strike, and unfortunately that would be the same time that a lot of home owners would be locking in their exposure to houseprices, because after they've been forced to sell if prices rise they're not going to be participating.

Its not like the Raven has been dramatic with his assumptions there, what happens if the worker only got inline with inflation wage rises? and if the BoE had to raise rates the same amount? then we're talking £33k, and mortgage payments of £23.5k, so approx 71% of gross income. Now that is negative convexity and something that could destroy households in the UK.

Yet its something that has happened in living memory and very very few households would be prepared for. So perhaps readers can see why the Raven thinks that the commentary from the economist this weekend is a liiiiiiitle dangerous.

at 17% inflation it doesn't matter what a household in the UK does, they are broke. Yet most households would take that risk, and for what gain a 1% or 2% difference in their mortgage payments? speculation indeed...

BoE 2.0?

No the Raven is not suggesting we introduce another version of the BoE, however today he has been reading quite a bit of commentary that questions whether 2% is a sensible target for the BoE to aim at for inflation.

Some pundits suggest the government would choose to change the inflation target; reducing the need for short term interest rates to rise in response to the UK's rather persistant inflation. Such a change in the perception of what would be acceptable/desirable/legislative target inflation would have to effect current long term bond yields. Obviously good for the Raven's bearish bet on UK gilts.

Great, but rather unlikely and certainley a long time away even if it were to occur.
The Raven has attached a chart of approx where a classic taylor rule and a simple 10yr rates + output gap against BoE base rate. There are some interesting features, namely how much higher BoE rates were than that suggested by a Taylor rule or a modified Taylor rule in the early 90s. Perhaps this was due to the political desire to support the GBP against the DMark, which the UK hasn't attempted to do this time around, and perhaps also explains some of the facets of this recession that have puzzled the Raven.

UNITE continue to astound the Raven in their ostrich like behaviour, he's pretty surprised at how little critism they've had to face in the media, given their funding of the Labour party, given the fact their leaders seem to get safe seats, given that they want to strike when their members are the best paid and have the best working conditions in the industry at a firm that is loss making you'd think they would be capable of realizing they are trying to protect an unsustainable position, but apparently not!?

Thursday, 11 March 2010

questions for the UK

The Raven has spent some time over the last few days going over the specifics of UK recessions and recent economic figures and it strikes him that there are some questions he doesn't really have the answers to:

1) Why is unemployment so low?

He mentioned a few days ago that according to Okun's "law" (ie that unemployment is approx. proportional to change in GDP) that UK unemployment should be a lot higher. Looking at the last two recessions in the UK as calibration points we'd expect to see unemployment at more like 14%, which is vastly different from 8%, even with government massaging, that's a big difference!

2) Why given that unemployment is so low relatively, is UK labour so uncompetitive?

Looking at the trade data that came out on Tuesday; it shows that the UK's deficit in the trade of goods being way higher than expected, and on an increasingly negative trend, and running a deficit with every EU country apart from Ireland.

The UK does export a lot of services which tend to be high margin, high skill and specialization. Its hard to export much in terms of minimum wage services. So the question really is why are UK workers so uncompetitive at producing goods?

Although minimum wages are only a small part of the benefit/cost of working its illustrative to see that in France the minimum wage is €8.82 /h, whereas in the UK its £5.80 /h or €6.44 at current exchange rates, 36% lower. The Raven is going to dig around and work out a rough cost of employing a minimum wage worker to see whether Gordon Brown's NI taxes etc make that cost a lot higher in the UK.

The Raven has a few ideas as to what lies behind these two questions; the central thesis being that the UK has a larger service sector than it did in the early 90s and so there has been greater flexibility in the labour market (perhaps reflected in fewer hours worked and lower wages) but also that UK businesses haven't been caught in a viscous inventory cycle. That would agree with the lower number of business liquidations in this recession. Also that monetary policy has been far more responsive, which have really meant households haven't faced anywhere near the same level of repossessions (again a trend that we've seen), it also ties into why consumer spending has turned so bullish in the UK.

These questions struck the Raven as he's been shorting 10yr gilts, because he knows he'll get spanked if the BoE introduce another round of QE. As always its better to be playing defence and trying to work out why and how you'll get killed than looking to throw hail mary passes.

The Raven is short at 114.45.

Tuesday, 9 March 2010

UK interest rates

The Raven went through the latest version of the BoE inflation report, he's surprised that there isn't more commentary and musings in the media as to why UK inflation is so "sticky" and why unemployment has remaind relatively low during this recession (say compared to what would be expected based on the previous relationship between a fall a GDP and unemployment ie. "Okun's law").

It appears that the BoE is now following the Fed and paying particular attention to "the persistant margin of spare capacity". This fits well with Hugh Hendry's observation that China has continued to expand its export capacity and stockpile commodities during the recession. There is a difference in mandates between the Fed and the BoE, with the BoE much closer to the ECB in just being there to explicitly target inflation, logically the Fed can therefore tolerate more inflation before raising interest rates.

So what has caused this recent surge in UK inflation?
  1. GBP getting beaten with the ugly stick. there is a rough rule of thumb that says that a 10% fall in GBP equates to 1% increase in inflation

  2. It appears that the UK consumer has learnt nothing and continues to bid for housing (houseprices in the UK had ~10% bounce last year after falling only 20%)

  3. Fiscal expansion by the government has created jobs, increased pay deals and generous redundancy terms (ie. 4yrs salary!!)

  4. Exceptionally low interest rates have bailed out most mortgage holders and unlike in the US most UK households are on floating rate schedules, so this monetary policy has very directly put a lot more slack into household budgets than similar moves have been able to do in the US.

  5. Company liquidations have been lower in this recession in the UK (the Raven believes because of 2,3 & 4 above).

  6. Household inflation expectations weren't lowered, purely speculatively the Raven believes this is because commodity prices and food prices were still rising in the first stage of the recession, and we know how much the consumer likes to extrapolate price changes!

We have an 'interesting' event on the horizon in the UK, a general election which could make a massive difference to markets. If the ruling Labour party were to "win" a hung parliament (~40% likelihood according to bookmakers), they have proposed changes to the electoral system in a referendum that would guarantee their participation in future governments, additionally they have indicated that they intend to carry on with their expansion of the state and would run a budget deficit of Greek proportions for the next few years, eventually cutting it back to ~6% by 2012?! Without making too much of a political judgement it should be noted that the government net debt coming into the recession was almost double the level it was coming into the recession of the early 90's. The opposition party on the other hand have made many comments about reducing the deficit and imposing some fiscal restraint and according to the bookies have a 60% chance of winning a majority.

To the Raven its pretty clear where GBP/USD should trade in these two events, Conservative majority ~ 1.80, hung parliament ~ 1.05, Labour victory, well you could at least use £5 notes as toilet paper. Given this a "fair price" would then be 60%*180+40%*105 => 1.50 where we are now, yup those fx monkeys don't do a bad job.

Instead of being glum that the markets looked fair, the Raven looked again at gilts. Regardless of who is to win the next election, they are going to have to run a 13% budget deficit for at least a year or two. Especially when redundancy terms are so stupidly generous for the public sector.

The government borrowed about £200bn last year in the gilt markets, the Bank of England had also been running its QE programme buying about £200bn of gilts, so in reality there had been no net issuance of gilts. Doing a simple regression of net issuance as a % of debt outstanding and looking at the real return on gilts showed a weak relationship for small changes, however for large changes the results were stronger. SO? what would happen with a government of whatever stripes, needing to borrow £400bn over the next two years, but also the BoE having to change from a net buyer to a net seller? well this comes out with a little prediction that 10yr gilt yields would rise to 5.2% by the end of 2010, 6.2% the year after and 7.5% the year after that. Without saying anything about inflation, the output gap, BoE base rates, etc, its pretty clear to the Raven that there is substantial risk in owning 10yr gilts and he's been putting on a small short position that he intends to increase as it goes his way.

Monday, 8 March 2010

part II

Announcing cuts in the deficit of €5bn and the world is supposed to tremble at the tough austerity measures that the Greeks have put in place? Yet ironically on the same day their statistical department is on strike (although who would be able to tell the difference), that their taxi drivers went on strike when they were told to keep receipts, or that their pensioners feel hard done by having the retirement age shifted to 63 from 61, Spartan indeed.

It appears now that Merkel and Sarkozy will backdoor the bailout for Greece by using state owned banks and institutions to buy Greek debt, and provide enough rhetoric to make the market believe they are standing behind the Greeks, without making their tax payers too aware of how much it could potentially cost them.

This raises the point that the Raven wished to make about speculation. That Sarkozy is encouraging speculation, by telling the world that they will support Greece, that they will pick up the tab, he is saying to the market, take that 6% yield, make that bet, because if there is a default we’ll bail you out. Heads, somehow Greece muddles through, you get paid back with 6% interest, or tails, the French tax payer will pay you back your stake. Worth a punt if that’s your bag.

It is a very common misconception that value is destroyed when a bubble bursts. The Raven would contend that value is destroyed when a bubble is being inflated, that money is wasted on unproductive investment, that when tulip bulbs sell at the same price as houses that value is being destroyed, rather than when the tulip price returns back to the earth. Its this stomach turning hypocrisy which Sarkozy is full of when he denounces speculators and yet from the
other side of his mouth encourages reckless bets on terrible speculative fundamentals."

bad speculators, honest spectators part I;

Although expected, the rhetoric from le petit Emperor Sarkozy makes no sense at all. He said that he wants to “be very clear: if it were necessary, the states of the euro zone would fulfil their
commitments”, the Raven thought that the euro zone had committed that it wouldn’t bail out a failed state, but who is the Raven to say that past legislation should be something that leaders keep to, especially when manifesto pledges are mere guidelines, and listening to referendum results entirely optional.

EU leaders seem insistent that it is evil speculators that are causing Greece’s problems; it has nothing to do with it being a morally bankrupt state that lied its way into the EMU, only meeting the entrance criteria in one year (the year that it entered), that its serially cooked it books; booking EU grants as government income, ignoring military spending in their budgeting, using OTC trades to hide debt, etc. The fact that the country also has net debt exceeding its GDP and intends to run a deficit of UK proportions ~13% might have a little bit more to do with the problem than a few side bets between hedgefunds, (estimated to be less than 5% of the Greek bond market).

Sarkozy is not alone in making ridiculous comments, it appears there is at least one German with a sense of humour: