The Bankwatch

From one spreadsheet geek since the early 80’s, to all the others out there …

http://googledocs.blogspot.com/2011/10/celebrating-visicalcs-32nd-birthday.html

Some stories burning the headlines tonight on MF.  There is a criminality element creeping in here now, which would conveniently make this an outlier situation, rather than evidence of a systemic problem that I believe it still is.    Lets see what the final headlines are tomorrow.

http://www.zerohedge.com/news/panic-behind-mf-scenes-company-refuses-disclose-information-regulators-even-death

http://www.zerohedge.com/news/someone-going-jail-mf-global-caught-stealing-hundreds-millions-customers

http://dealbook.nytimes.com/2011/10/31/regulators-investigating-mf-global/?ref=business

http://www.ft.com/intl/cms/s/0/8c81053a-03cc-11e1-bbc5-00144feabdc0.html#axzz1cOQ3SoMc

There are more than a few nervous people on Wall St, Threadneedle St, La Défense, Ōtemachi, and all the other financial centres of the world held their breath Friday when MF Global, a Prime Broker in New York announced they were in trouble and selling their assets.  That fell through over the weekend, and today MF Global are bankrupt. 

This is a big deal and might be another Oliver Stone movie in the future when we look back. 

http://dealbook.nytimes.com/2011/10/31/mf-global-files-for-bankruptcy/?hp

http://www.ft.com/intl/cms/s/0/138241f6-03dd-11e1-98bc-00144feabdc0.html#axzz1cOQ3SoMc

The bad part of this is how it could be allowed to happen.  MF were downgraded by the ratings agencies when, as reported in the NY Times:

The agencies said they were concerned that MF Global lacked a sufficient capital cushion if its $6.3 billion in European debt went bad.

Well, just is how much?  They are publicly traded so I looked up their balance sheet.  As usual it is horribly laid out, as is the case with all banks, and clearly designed to ensure basic items such as revenue, capital, liabilities and assets are as hard as possible to locate.

Anyhow, here is their fiscal year to Mar 2011 results:

Annual revenue:                                           $2.2 Bn

Gross revenue after transaction expenses   $1.0 Bn

Total Assets                                               $40.5 Bn

Equity                                                         $  1.4 Bn

So we can calculate Debt to Equity at 27.9:1 (39.1/ 1.4) so we are certainly in bank territory there.  To a traditional banker sense this company is unbankable.

Next and most important, being the thing that brought them to down, lets look at off-balance sheet items.  Again from their own financial statements here is their derivative position.  There are $1.1 Bn on the asset side, and $4.5Bn on the liability side or $3.4 Bn or two and a half times capital base.

Then on page 104 there are $5.1 Bn in stocks with the ubiquitous title of “Total Securities sold, not yet purchased” – this is perfectly legal ”short selling”. 

The ratings agencies marked MF down when they discovered $6.4 Bn in Euro derivative exposure.  So it seems that since March the company has become even more extended.  But lets stick with the Financial Statements amount.  The derivative liability and the short selling amount to $9.6 Bn.  If there is a 10% movement, they lose $1 Bn, 25% 2.4 Bn etc.  This potential for loss must be co-related to the capital base of $1.4 Bn or even total revenue at $2.2 Bn.

Relevance to Bankwatch:

This is a classic example of why banks make regulators make governments nervous.  The entire financial system (banks & brokers) is based on a set of liabilities which no one member of the financial system can manage and pay for alone.  In normal business, if one person or business goes bankrupt there is some disruption, but the ripple effect is very limited, and generally life carries on. 

When a bank or broker goes under the impact is felt across the entire financial system.  The good news, is that this one was allowed to go bankrupt.  The more interesting news is yet to be heard.  Financial markets are renowned for their lemming type behavior.  If MF were caught offside with too much derivative exposure against the Euro, how many others are in the same or similar category.  Clearly the ratings agencies are watching this very closely and are not going to get caught out as they were 4 years ago.

First the Tsunami in Japan and now the floods in Thailand.  There are downsides to sourcing product from world countries with extreme weather capabilities.  The fact the 1/4 of the worlds hard drives come from Thailand and a relatively concentrated area around Bangkok is astounding.

Computer makers caught in wake of Thai floods

The Euro leadership and in particular Merkel and Sarkozy deserve some credit for the key Euro deliverable earlier today.  There has been much criticism and most of us would agree that more will be required to be done, but there was an important step taken here.

It became a showdown between banks and government.  (For government read taxpayers paying up).  Merkel has been consistently speaking of bondholders taking a haircut for a year now.  The message was clear and she won today.  But is it that simple.

Calling Bankers’ Bluff, Merkel Got Europe a Debt Plan | NY Times

But Mrs. Merkel called the bankers’ bluff, said officials present at the discussions. Accept the 50 percent write-down, she told the bankers, or bear the consequences of default. In effect, she was willing to risk a credit event, and to place the blame for any fallout on them.

Relevance to Bankwatch:

The inconvenient truth is that modern banks lie in dangerous economic shadow zone that is part government and part commercial company.  Let me explain.  Banks operate with razor thin capital bases.  Even at 9 or 10% capital, no normal independent company could survive. (Ask GM).  Banks operate with a tight and close interaction between themselves and their respective central bank. 

Lets go back to Merkels ‘victory’.  Banks will accept a write down of debt with Greece but who pays?  Banks whose capital is (more) inadequate following the write down, there is already an agreement in Europe to re-capitalise the banks by yes, government.  This re-capitalisation will result in greater government ownership of banks. 

This is simply shifting money around, and banks become another method for government to borrow “off balance sheet”.

Not much room for consumer financial services innovation in this conversation.

I have been thinking a lot about cloud computing for a while now.  The advantages are clear.  You never have to worry about data loss, and you can access your information from any device, mobile, laptop or PC.

People worry about security, but this is more (to use a banking analogy)  of a cash under the mattress worry.  Lets leave that for the worriers.

On a more practical level.  I have a pretty fast laptop (ThinkPad, 2.7ghz, SSD) and I have constant access to decent bandwidth speeds.  Lets suspend reality and assume there is nothing faster.

What is in it for me in that scenario to use Bitcasa which promises the ultimate (to date) in cloud by providing my hard drive in the cloud.  My superfast laptop is by design, built to not need Bitcasa.  No matter how fast a Bitcasa is, it will never beat the speed of hardware between my CPU and my SSD drive.

hmmm

Yet the cloud seems intuitively the right thing for the moment.

I use Jungledisk/Amazon AWS for all my data backup/ sync, and Dropbox for all data shared with others (ironically Dropbox also uses Amazon), but anyway I have not the slightest fear of losing my laptop, nor having a drive crash.  Give me a new laptop and I will be up with my existing data in minutes.  I have done this enough times with different operating systems and devices to be quite confident there.  Yet …

Yet still there is an intuitive seductiveness about Bitcasa and the notion that my information is always there (even more) instantly.

Why is that?  At a minimum there must be a different design concept for hardware laptops and mobile that we have yet to see which levers the conjunction of bandwidth, cloud and processing capacity which we have yet to see.  Perhaps the Amazon Fire is a glimpse into this future where the cloud and the device interact in ways that could not exist in the old hardware <—> internet model.

hmmm

Niall Ferguson on how the Europe situation comes right down to Germany gaining control and the weaker nations (Greece, Spain, Portugal, Ireland) ceding control.  Also the European banks and their need for capital being even greater than the amounts we have heard to date.

http://www.businessweek.com/video/#video=xqdTd4Mjp7CxKGmKD9-r0NsqYMqZCmQO

Banks are required to hold capital relative to their assets (loans).  Different types of loans have different capital requirements,

Banks turn to financial alchemy in search for capital

The result is that banks and the most outspoken hawkish banks are quite outspoken about it are actively managing their balance sheets to minimise capital requirements resulting in a classic case of unintended consequences and certainly not the consequence that was intended which was to reduce bank balance sheet risk.

What is this, may you ask and why on this blog?  A piece from the New Scientist.  (ht – jpg)

This graphic shows the 1,318 inter-connected companies that represent a disproportionate concentrated control over the global economy.  There are 43,000 transnational companies.

It was produced by three complex network scientists working in Switzerland.  Their report is here (pdf).

The 1,318 represent 3.2% by number of all transnational companies.  The thing that is most illuminating is the dramatic degree of control exercised by banks (40% of ownership).  This actually surprised me until I read deeper.

Here is the report abstract “The network of global corporate control” – emphasis mine.

Abstract
The structure of the control network of transnational corporations affects global market competition and financial stability. So far, only small national samples were studied and there was no appropriate methodology to assess control globally. We present the first investigation of the architecture of the international ownership network, along with the computation of the control held by each global player. We find that transnational corporations form a giant bow-tie structure and that a large portion of control flows to a small tightly-knit core of financial institutions. This core can be seen as an economic “super-entity” that raises new important issues both for researchers and policy makers.

The analysis defines control using ownership as the proxy but that is not the point.  I see this is further insight into why the banking crisis occurred in Sept 2008.

Institutional ownership, including mutual funds have become the largest corporate owners and that is why Banks as issuers of Mutual Funds are so highly ranked in this ranking.  Although it is worth noting for the conspiracy theorists, the US mutual funds represent only a small fraction of all global financial institutions.  Much of the institutional ownership is centred in Banks.

The chart demonstrates clearly the concentration of control within a small number of companies and that those companies are banks.  If we repurpose this chart from the report to align by country we get the pie chart shown.

A staggering 97% of ownership within this group is centred in US, UK, France, Switzerland, Germany and Japan.  In fact 83% are represented by UK, UK and France.

Despite all the talk of GDP shifts to the East, India and China barely show on this chart.

Fast forward to todays headlines and the worried brows in France and Germany.  It is this concentration of interconnectedness of ownership that makes for shakey ground when one or more of their joint assets (Greek, Italian and Spanish sovereign debt) is going to be written down by a substantial margin.  The demonstrated interconnectedness of banks guarantees ripples that are not well understood, but this report is an important new view into this murky world.

Relevance to Bankwatch:

Banks’ motivation is driven by reaction to risk and for the large banks, global risk.  This kind of new analysis suggests some insight into why we saw the panic in 2008 and the reaction when Lehman Bros went bankrupt.  This uses 2007 data and therefore includes Lehman Brothers which is useful.  At 0.43% of the top 50 (representing 40% of all world transnational corporate ownership) , Lehmans owned 0.17% (o.43% * 40%)  of all world transnational companies as defined here.

Yet when Lehmans went down in Sept 2008, the worlds banks were already distrusting each other.  This was not a regional phenomenon, nor a large vs small one.  Literally all banks stopped trusting any other bank, and looked only to their respective Central Banks.

It strikes me that the other dimension on the top 50 here is whether they have any additional risk that effects them which is non-systemic and specific to their bank.  Bank of America with its enormous iceberg of bad debts and derivative liability springs to mind.  The difference with Lehmans was they were not trusted and that was why they were allowed to go under in 2008.  The lesson was that despite best intentions, the international banking system cannot easily survive such a test.

This is a bank phenomenon, and none of the increased capital requirement from Basel 3, nor increased oversight from Dodd Frank deals with the core matter of power centralisation that is demonstrated in this analysis.  It represents an important contribution to the debate on the Volker Rule and Ring Fencing.

We are getting closer to the dose of reality in Europe, and it is becoming abundantly clear why it is taking Germany and France so long to decide.  Once you start looking at write offs of 60% it is s slippery slope to a) more than 60% on the thinking that can Greece even repay the 40% remainder, and b) write offs for other Euro countries.

EU looks at 60% haircuts for Greek debt

The financial effect is to raise the amount required to $252 Bn versus the $109 Bn predicted earlier.

For impacts to consider, here are a couple of earlier posts.  There will be knock on effects in North America.  Remember the largest holders of Euro sovereign debt are banks.

http://thebankwatch.com/2011/10/13/the-great-unwinding-is-coming-closer-to-the-endgame/

http://thebankwatch.com/2011/10/10/who-would-lose-money-in-a-bank-liquidation-take-a-guess/

http://thebankwatch.com/2011/10/20/this-time-is-differentmckinsey-interview-with-kenneth-rogoff/