The End of Wall Street's Boom

Here's an excerpt from an article on www.portfolio.com, by Michael Lewis, whose Liar's Poker was one of my inspirations:

When a Wall Street firm helped him get into a trade that seemed perfect in every way, he said to the salesman, “I appreciate this, but I just want to know one thing: How are you going to screw me?”

Heh heh heh, c’mon. We’d never do that, the trader started to say, but Moses was politely insistent: We both know that unadulterated good things like this trade don’t just happen between little hedge funds and big Wall Street firms. I’ll do it, but only after you explain to me how you are going to screw me. And the salesman explained how he was going to screw him. And Moses did the trade.

Read more.

A primer on subprime (2 of 5): Why governments had to bail out the banks

The virtuous cycle was trundling along. The economy was doing well (thanks to consumers spending on borrowed money), asset (house) prices kept increasing which meant default rates hit all-time lows as even the sub-prime borrowers were able to either flip their houses or service their loans at the low rates. The low default rates made financial institutions even more confident and they offered increasingly attractive loans to consumers.

At the peak, banks offered “No money down” mortgages and arrangements such as ARMs (Adjustable Rate Mortgages). ARMs allowed borrowers to pay very low interest rates for periods of two to three years. After that, market rates would be charged and principal repayments also started, but borrowers were convinced that by that time property prices would be higher. They would just sell their property, repay what was necessary and still reap a healthy profit.

Some alarm bells were raised. Some pundits suggested mortgages were increasingly being offered to people who couldn’t afford them. But regulators, lead by Alan Greenspan, said markets had found new ways of dealing with and pricing risks and there was no systemic problem (ie individual institutions that took on too much risk may go under, but the entire financial system was robust)

With hindsight, Greenspan was proven hugely wrong at enormous cost to the taxpayer. All good things must come to an end, eventually.

There are only so many people and so many potential housebuyers. After years of scraping the bottom-of-the barrel for the marginal borrower, to the point where lenders closed one eye as borrowers over-stated their incomes so they could go for bigger mortgages, there were no more new borrowers to be found. No new borrowers meant reduced demand for properties, which meant asset prices started to fall.

The house of cards started unravelling. Default rates on the CDOs turned out to be higher than expected. Even AAA-rated CDOs turned sour. Not surprising – considering the mortgages on which these CDOs were based were given to consumers with poor credit histories or to consumers who could not afford them.

Wait! Weren’t some CDOs backed by credit default swaps (CDS)? The CDSs turned out to be not worth the paper they were printed on. The institutions that were supposed to pay-up were woefully under-capitalised!

The problem was made even worse by the absence of open markets for these CDOs. These were traded over-the-counter with valuations based on complex mathematical models. But investors had lost faith in the assumptions going into the models so values could not be determined with certainty.

Also, it turned out that the banks were also liable for some of these CDOs. To entice investors to take the CDOs, the banks had agreed to buy back at least some of these if default rates turned out to be higher than expected. No-one expected the default rates to be that high, but when they hit that level, the banks had to buy back, incurring losses.

This lead to inter-bank credit markets freezing. Any bank, on any particular day, could be a net borrower in the inter-bank market. It is not bad management, it is just a matter of cash flow. For example, a company the bank had already approved a huge loan to draws down that day. The bank knows another borrower is due to repay tomorrow, but in the meantime, it has to borrow today to cover the gap. Tomorrow, when a loan is repaid, it may become a net lender in the inter-bank market.

But the inter-bank market froze. Banks became reluctant to lend to each other as they could not tell if the other bank would still exist tomorrow. Imagine if you were the bank lending to Bear Stearns or Lehman the day before they went under!

Initially the US Federal Reserve and the European Central Bank tried to restore the inter-bank market by making funds available for banks to borrow on more favourable terms and cutting interest rates. This did not help: 1) Banks were unwilling to take Federal funds because it would indicate weakness; and 2) cutting interest rates did not help because it did not address the core issue – banks were unwilling to lend to each other at any price.

The financial problem was turning into a real economy problem. Because banks could not tap the inter-bank market to cover short-term cash shortfalls, every bank wanted to be net cash. They started cutting back on loans to companies and individuals. In turn, companies and individuals would also want to hoard cash. The curtailing of credit facilities threatened the foundations of the economy – business activity would slow leading to job losses, bankruptcies and recession.

British Prime Minister Gordon Brown in the end got it right. Contrary to his long-held views, he extended government backing to the banks. This led to a flood of central banks around the world, including Malaysia, to guarantee deposits. With government guarantees, banks became willing to lend to each other again and credit markets were restored.

Next on Saturday: Brace for tough times

Open forum on global financial crisis and Malaysia

On Wednesday evening I participated in an open forum on The Global Financial Crisis and its Implications on Malaysia, organised at Universiti Malaya by the Centre of Public Policy Studies. The 5 member panel of Datuks, Drs and one Encik (me :-) had a very good 2 hour dialogue with members of the public, very ably moderated by Tan Sri Ramon Navaratnam. The Nut Graph was there …

A primer on subprime (1 of 5): On CDOs, SPVs and CDSs

I prepared this in anticipation of a forum that ultimately did not materialise. It’s not so topical now, but better late than never ….

The roots of our current crisis are in the US housing and consumer-credit boom. This was fuelled by the Wall Street innovation called CDOs – Collateralised Debt Obligations.

The amount that any financial institution can lend is constrained by the capital it has. Historically, banks kept the mortgages on their balance sheets – these are their assets on which they earn interest income. Against these mortgages, they had to keep a certain level of capital aside to insulate against defaults.

Then, Wall Street invented special purpose vehicles (SPVs) just to buy and pool thousands and thousands of mortgages together. These SPVs raised the money to buy the mortgages by issuing their own securities – the CDOs. Banks were happy to sell their mortgages to the SPVs because it freed up their capital to make new loans.

Basic financial/statistical theory is that it is hard or impossible to predict if any single mortgage will default. But if you have a pool of, say 10,000 separate mortgages, you can be reasonably sure that, say, 98% will be fine and 2% will default. So the SPVs issued CDOs with varying risk levels. If you had a senior CDO, you got paid before everyone else. Of course you also received a lower interest rate than another investor buying a junior CDO, which would suffer first if the default rates were higher than expected, but that interest rate was still more compelling than other alternatives.

Wall Street and the SPVs managed to convince the credit ratings agencies (like Moody’s and Standard and Poors) that the more senior of these CDOs deserved AAA credit-ratings, suggesting they were very safe for pension funds and insurance companies to invest in. And on top of that, a new market in credit derivatives (CDS – credit default swaps) allowed buyers of CDOs to purchase insurance against default.

Markets were working like a dream. Banks rushed to give as many mortgages as possible. Millions of poor Americans who were hitherto considered poor credit risks (sub-prime) became new homeowners, millions of existing homeowners got to upgrade and others were able to “unlock home equity” ie take a mortgage on the rising value of their houses to spend as they wished.

Banks’ profits went up from the mortgages they generated. They didn’t care about the risks because these mortgages would quickly be sold to SPVs. The SPVs had no problems selling the CDOs to investors. Investors were happy because they got higher interest rates on the CDOs, at apparently little incremental risk. Even the junior CDOs did well. Everyone was happy. Investors made high returns and financial institutions and CEOs reaped billions in profits and millions in bonuses.

Then the gears jammed ….

Next (on Wed): Why governments had to bail out the banks

Forex reserves plunged 7% in 2 weeks

Our foreign exchange reserves plunged by or RM26.2bn in the last two weeks of October. This was a 7% fall in just a fortnight, taking our reserves down to RM345.6bn as at 31 Oct 2008.

Given that we are still running a trade surplus, the reserves must have fallen due to capital flows.

Foreign investors had been leaving Malaysia. Data on the equity market is impossible to find, but debt market data shows foreign investors sold RM19.1bn of debt papers in Aug, accelerating from RM4.2bn in July. I’m sure the outflow continues, not helped by inflation at a 26-year high, the government saying the 2008 deficit will be worse at 4.8% (from 3.1% initially forecast) despite record high oil revenues and raising the 2009 budget deficit forecast to what many consider an optimistic 4.8% (previously 3.6%). Foreigners now hold just RM81.5bn of debt paper as at end Aug, down from RM100.6bn in July and the peak of RM126.5bn in April.

Perhaps locals too joined in the exodus. You would be worried if you could be arrested "for your own protection." The ringgit continued to plunge against the US$, down another 2.7% in Oct, after falling 7.3% in the 6 months ended Sept. Yes, it’s true investors have been exiting emerging markets generally, and the dollar is finding unexpected strength, but we are doing poorly even when compared to Thailand. Last month, a bank offered me 8.7 baht to the ringgit. I was shocked. Last year I got 10 baht. I had expected 11 or 12 baht this time because quite literally there was blood on the streets in Thailand.

What does this say for confidence in the ability of the Barisan Nasional government?

RM7bn stimulus plan – effective only if execution is transparent

I am among those who still don’t understand Budget 2009 as presented by the BN government; and I certainly believe its forecasts and base assumptions are way too optimistic. However, the BN is the federal government with a comfortable majority in parliament, so the Budget will be passed. And I may, happily, be proven wrong and the world and Malaysian economy will rebound sharply next year.

So let’s focus on the Budget, and specifically, the RM7bn stimulus plan announced last week by Finance Minister Datuk Seri Najib Razak. A leading investment research house put it succinctly: “.. based on past experience … economic packages introduced by the government have not been effective in preventing the economy from rapidly slowing.”

Let’s look at the plan again, starting with the bits I like.

1) RM1.6bn is allocated to various small scale projects – village roads and community halls, repairing schools …. Excellent. This is the type of spending I advocate – locally oriented with maximum immediate impact to the community and local economy.

2) RM1.0bn goes to education and skills training programmes. Another excellent move. Now is a good time to retrain and improve local employee productivity.

3) RM1.0bn towards bolstering public transport and better facilities for our men-in-uniform. Again, wonderful

So that’s RM3.6bn (about half the package) going to projects that should directly help Malaysians. I say should because I fear for the implementation. Take public transport for example. There have been huge allocations already in the past few years, but the system is still atrocious. Some might say it’s gotten worse, what with LRT accidents!

Taking another case, who decides which private institutions get to run the training programmes? Forgive me for being cynical, but I see many “consultants” and “advisers” already counting their fees. To maximise the impact of these programmes, I call on the BN government to make public the specific project awards and the contractors. Better yet, put the projects out on open tender. Make it easy for anyone to apply. Let’s cut out the middle-men and the “consultants” and “advisors”.

Moving on the bits I am ambivalent about, RM1.5bn is going to building low and medium-cost houses, reviving abandoned projects and increasing the number of business premises in small towns. I fully support decent, affordable housing for all. But there is also a huge overhang of unsold properties. Instead of building more and adding to the supply, how about finding a way to utilise the existing stocks? And what is this about increasing the number of business premises? Commercial property development is best led by the private sector, not government.

Finally, RM1.9bn (a quarter of the RM7.0bn) is earmarked for an investment fund to attract strategic industries and high speed broadband. Government should get out of the business of funding businesses. It’s investment record isn’t particularly good, and entrepreneurs with good ideas should be able to find capital on their own. Government’s role should be to facilitate setting-up businesses – streamline the bureaucracy and cut out the red tape. As for broadband, I would love to have broadband, but I think the cost is over-stated and Telekom, with its atrocious service record, should not be leading this.

So there you have it, only half the package has direct impact on Malaysians, if properly executed; and I would appreciate a report next year on the performance of the investment fund.

Tenaga runs on gas and coal, not oil

Electricity tariffs were raised 24% in June. Oil prices have since fallen dramatically and people are now demanding Tenaga reduce power tariffs. But our electricity is generated using gas and coal, for which prices are still high.

In fact, the main beneficiary of the 24% electricity tariff hike is Petronas, which more than doubled its gas price to Tenaga – to RM14.31/mmBTU, from RM6.50/mmBTU! Besides higher gas prices, Tenaga is also incurring higher coal prices, which at about US$95 today are still 25% higher than the average US$76/MT Tenaga incurred in its last financial year ended Aug 08. The pain will be made even worse by the depreciating ringgit.

Some numbers will illustrate this. That 24% tariff hike will add about RM5.5bn pa to Tenaga’s revenue. Of that, RM5.3bn goes to third parties, leaving Tenaga with just a measly RM200m of the RM5.5bn additional revenue:

1. RM4.2bn (76%) goes to Petronas to cover the increased price of gas;
2. RM1.0bn to cover higher coal prices:
   a. RM0.3bn because of the the US$ increase in price to US$95; and b. An additional RM0.7bn due to the weaker ringgit, assuming an average RM3.70:US$1 instead of RM3.30
3. RM135m for capacity payments to new IPP Jimah.

In fact, by next year, Tenaga will be in a negative situation again because capacity payments to Jimah will rise to RM 700m! If you want lower power tariffs, the appropriate targets are the IPPs which have earned exorbitant returns and Petronas, not Tenaga.

Tenaga is under-appreciated. Its services have improved tremendously in recent years. So tremendously that we don’t appreciate how much effort goes into delivering that stable and reliable power supply. If Telekom were running the power sector, we would still be suffering frequent brownouts (noisy fixed lines is the telecoms equivalent), blackouts (unstable Streamyx connections) and some areas without power at all (sorry, tak cukup kapasiti di sana untuk talian baru).

And yet Telekom gets a RM2.4bn handout of taxpayers’ money to do high-speed broadband while Tenaga is pilloried for high power tariffs which are not its fault in the first place.

If there’s one GLC to target for inefficiency, it’s Telekom. Why do we still have to pay Telekom RM25/month for fixed line ‘rental’? My housing estate was built in the 1970s. Surely after over 30 years Telekom has already more than covered its capital cost of laying down the telephone lines. And then there are the huge issues with Streamyx ….