Thursday, 10 April 2014

One more time with feeling . . . 200km in the rain

No one, just no one on the planet Earth is so important that they alone control their entire destiny. Granted, at certain moments you can make a decision that can be path defining, but essentially there's always someone or something else that can throw a spanner in your "works".  At the moment I'm in somewhat of a twilight zone and I can't do a lot about it and that's why it's been a few weeks since the blog had a new posting. Apologies to long time readers and casual web surfers.

One of the big themes of this blog since inception has been the recapitalisation of the banking sector. I've been preparing a presentation on this and in it I was arguing that the current cycle of equity issuance was in fact not over. Confirmation of this leaked into the FT on Tuesday when Fed Governor and regulation supremo Dan Tarullo "signalled that the Fed might impose an additional risk-based capital charge on the biggest US banks, bringing it “to a higher level than the minimum agreed to internationally” to discourage short-term wholesale funding." Right now the banks have to hold a minimum of 3% equity to assets, but the Fed is indicating that it would like an additional 2% for the eight systemically important ant banks (SIBs) in the USA (Bank of America, Bank of New York Mellon, Citigroup, Goldman, JPMorgan, Morgan Stanley, State Street and Wells Fargo). That means that they will have to hold an additional $68bn in equity or shrink to match what they have. Without doing that numbers yet some of these banks are probably well on the way to either having or raising this equity.

The significance of the Fed adding additional capital requirements is that other central banks will be forced to look in a similar fashion to their own SIBs. Central bankers no matter how independent they are from their political masters are nothing if not risk averse. Think about it this way, say you're a central banker and you decide that the 3% requirement is enough and one of your big banks gets into trouble; surely the first thing that happens is that politicians are going to knock on your door and ask how come you didn't follow the Fed? No central banker will want that and if the payment for this is a lower return on equity amongst the banks administered by that central banker then so be it.

This brings me back to Australia, which has formed the basis of the presentation that I've been doing. The Reserve Bank of Australia (RBA) helpfully puts out a statistics pack to give you an idea as to the capitalisation of its' own banks and financial institutions. The theory here in Australia is that most of the capital raising is over after a deluge of hybrid issuance (CoCo type structures) was approved by local regulators to be a suitable substitution for common equity, with any additional top-ups being possible via the retention of profits or use in underwriting their own dividend re-invest plans. Here's what the major Australian banks looks like in respect of Tier 1 capital (i.e. equity and "equity like"):

The RBA is probably quite happy with this, but given what the Fed is saying and taking for example what the Swiss are doing in respect of their own SIBs that might not be enough going forward. I would consider that Australia runs a banking system closer in nature to (say) Switzerland in terms of concentration, than the USA. In Switzerland the law goes beyond the Basel III rules and requires Credit Suisse and UBS to have capital ratios of at least 19%, of which 10% would be common equity because of their systemic importance to the country. Australia at least has the argument that the four major banks here tend to concentrate their business locally and thus external shocks might not have the same effect here as they will to the Swiss. Even allowing for this the argument for adding to the current capitalisation buffers is persuasive. The question for bankers is can this be done through the current earnings or not?

Given Australian banks are amongst the best in terms of RoE and profits have been rising it's hard not to take the view that there's nothing to see here. Having said that the RBA is already signalling that the easing of the interest rate cycle is over and that with the institutions down here focused on housing financing it seems to me that they might be inclined to require a bit more issuance. Consider this; charges for non-performing loans are at multi-year lows. In the G7 countries this is because the system shock of the crisis has passed, meaning probability must be that if a loan was going to go "sour" it probably already did. This is not the case in Australia where charges during the crisis topped out at only 0.5%.

Maybe I'm being a bit too "glass half full", but rates have only gone down. If rates kick-up you're reliant on the RBA's modelling to say what might happen to the banks. I tend to think they'll ere on the side of caution. Investors should expect more equity to be issued.

While on the subject of issuance I think it's wise for investors to review their holdings in Hybrids. CoCos have become a kind of deposit substitute here in Australia and in several other major economies. Investors in my mind have somewhat ignored the short optionality imbedded in these instruments and a recent event in the UK should see some novices in the area to start re-examine prospectuses. On January 20 one of the worlds biggest steel companies Arcelormittal announced that it was calling a $650m hybrid bond paying a 8.25% coupon it had issued less than 18 months beforehand. The trigger for the call was a "Ratings Agency Event" that occurred when Moodys said it would give zero equity credit to sub-investment grade hybrids, effectively handing the company's balance sheet a $325m increase in debt. The result was that a bond that had been trading above 108 in the secondary was immediately repriced in the market at 101 (the call price), effectively handing a mark to market loss to holders. The same thing happened in respect of a Telecom Italia hybrid bond only a week later, though the loss was not as large. Leaving aside the specifics of these two companies the lesson for investors is that you need to read the documents, as holding lower graded hybrids trading at a premium to their call is asking for trouble. In the case of Mittal that was 7 bond points. It could have been worse as in the case of a bank that looks to be in trouble and has the ability to convert debt to equity in a falling market. Either way you're short an option and need to understand the risks. 

During a break in the charity bike ride I was participating in last Friday I got a call from someone who heard about hybrids being called and as I was an old hand in the convertibles market wanted to get some advice from me. I was actually a bit too wet and exhausted to be much, if any use. I had already ridden 120kms in dark overcast skies, including a rain shower right at the events start at 7am. 

The ride was for the Children's Cancer Institute of Australia and I was on a team of six ridding for a maximum of 12 hours. It was a last minute thing and I had been asked if I could make up the numbers. Luckily for the team CCIA was an old family favourite as my father had specified them for donations instead of people bringing flowers to his own funeral when cancer took his life. I was the weakest of the six riders in the team, but still managed to grind out 201kms before giving up with about 90mins to go. I hate the rain and even though I'd filled my kit bag with 4 pairs of socks, two back-up jerseys and two rain jackets I really wasn't enjoying things.  It was pretty pathetic of me not to be able to get to 250kms, but I did what I could. I rode the race on my Cannondale, shod with Campagnolo Boras. In fact I was surprised how many participants chose to ride carbon wheels with tubular tyres. Perhaps like me they wanted to take advantage of the fact that as we were riding a motor racing circuit (Eastern Creek 3.9kms) a puncture was really not the end of the world as walking back to the pits was not likely to be anything too severe. Of course the rain meant that braking was problematic and for those who haven't been to motor racing tracks they're not as flat as they seem on TV. This one had a couple of nasty little climbs, including a 9%'er that was easy in the early going, but somewhat more annoying later with shoes full of water and 7 hours on the bike. I did 2300m of climbing which is proof of the constant rolling nature of this particular circuit. Anyway it was for a good cause and I did get to meet some really nice people. Would I do it again . . . mmm part of me just wants to write a check, but that's a little weak right? 


Monday, 17 March 2014

A cycling tour and the bankruptcy that might not have been . . .

Being gainfully available for employment means that you have the flexibility to make yourself available for various events and causes. That means I've been asked to ride in a 12 hour "enduro" charity event in aid of Children's Cancer in April. Normally I'm not great one for exchanging exercise for causes, but my father who passed away from cancer had specifically referred to this particular charity as being his favourite. I guess going through months of fruitless treatment gave him a greater appreciation for the reality that cancer brings to lives of all lengths, but obviously there's a special poignancy to it all when placed on the back of a child who is facing a short painful life. Given this I really couldn't dodge it with a mere donation.

The reverse of riding for a cause is riding for personnel pleasure, as was the case for the last three days when I travelled for about 4 hours west of Sydney for my club's Tour d'Orange. This year we combined with a group of riders from the north side of Sydney and some local lads to ride a 68km prologue (Friday), a 110km group "sportive" (Saturday) and finally a team time trial on Sunday. For the record that took my weekly total just short of 290km's. 

The prologue was a bit of a surprise as we'd originally intended for it to be a shorter 50km version. I should explain that on Friday some did an 80km morning prologue as they'd arrived on Thursday night. The dozen of us who arrived on Friday had been hoping for a short flat stretch after the journey, but instead we lengthened it to really blow out the cobwebs from the drive to Orange. Funnily enough a few of the guys had set off without spare tubes and clearly the cycling gods were not happy with us as one of our more seasoned riders flatted within the first 10km's on the side of a pretty busy and narrow highway. Without going into details it took a fourth tube and a good 20mins to get back on the road leaving us all a little frustrated in the process. Rule 1: Everyone carries at least two tubes . . .

Saturday was fantastic, except for the roads. I don't know whether its irony or coincidence but one of the local riders was also the chief town planner for Orange and as such he had to take a lot of good natured ribbing about potholes and token road edges. Aside from that we had good weather and only sporadic traffic as we took the north westerly road out of Orannge to Molong. Obviously someone flatted in the first 5km's before we reached the town limits, but given what could have happened during the day the cycling gods saved us any more tubes, broken spokes or cracked rims . . . for which our peloton of 26 men and woman were all eternally thankful.

Molong sits some 70km's NW of Orange and provided us with a good spot to park for lunch. The rolling hills on our way in through up a number of challenging pinches. I fell out of the fast group with 28km's to go and surrendered the luncheon bragging rights to others. Out of Molong those undulating hills became ever more regular and there were quite a few annoying 500m pinches at 8 or 9% to cut into any tired muscles. The plan was to regroup at the main highway into Orange and split into two groups, one of which would extend their ride by 14km's to take in the "Pinnacle" climb of an additional 400m's in elevation. By the time we reached the point of separation my legs were feeling every peddle stroke and my cadence had dropped sharply as the easiest gear I had 39 X 27 was not quite enough to keep me spinning freely. Given this I chose the direct route home, which while hardly flat still gave me enough trouble. The group who continued on had the pleasure of riding home in the rain. We had only one semi-serious incident when a rider in the "Pinnacle" group came down on the desent off the top of the climb. Rule 2 : No "hot-dogging" if it starts to rain . . . he was fine and luckily we had a support car to help him regain his dignity.

Sunday was something new for me; a team time trial. Two teams of four and one team of three did a 14.4km time trial on rolling country east of Orange near the airport.

It was quite deceptive because there was a couple of sharp climbs on the way. Luckily my group had some pretty like-minded riders and as such even though I was clearly the slowest of the four we were able to hold it together for just long enough to claim the first prize in just under 27mins:

I highly recommend the format we used for the weekend, though maybe without the Friday and Saturday night wine extravaganza? If we do it again next year I think my fast ageing legs might stick to a limit on the wine and a premium on sleep. Great fun for all.

Writing this blog always gives me time to reconsider past events, not because a dwell on these things, but rather for the same reasons that caused Edmund Burke to conclude that:

 “Those who don't know history are doomed to repeat it.”

One of those significant events came to mind last week when I read in The Guardian that Lehman Brothers International, a subsidiary of Lehman's Inc, was left with a £5bn surplus after creditors had been paid. I remember when Lehman Brothers collapsed that there was much schadenfreude at the time from bankers in competition with this very entreprenneurial institution. I was no great fan of their operation in Asia especially after being bailed up in a Hong Kong bar in 2007 by one solidly built member of the Lehman's team who wanted to take at least one of our hedge fund's staff outside for a muscular review of why we hadn't paid them enough brokerage. Leaving that aside many years after the fact it's clear now that Lehman's was just a badly organised institution that possibly could have been saved with time and greater clarity by bankers who gave a damn. In those heady days when the Fed was grappling to understand the complexity that was before them the path of least resistance was to cut off the obtuse and save the clear thinkers. If Dick Fuld had presented a cooler, more controlled front to the Fed, he like the heads of a number of other investment banks would have been saved the indignity of handing the keys to the administrators.

The real hero in the eyes of creditors to Lehman Bros. International must be the Bank of England and the the Exchequer that ring-fenced the assets before Lehman Bros Inc. had a chance to strip the company to meet obligations elsewhere. As a derivatives trader the first thing you think of before trading with an entity is their ability to pay you. I mean this is not like betting on a horse race, often time you'll be looking at scenarios involving 100's of millions of Dollars, Pounds, Euros or Francs. As a funds manager you're not only responsible to yourself, but also to your investors. The idea of Lehman Bros International or any number of a dozen or so major investment banks wholly owned UK subsidiaries was to take advantage of UK regulations and laws that enabled flexible dealing conditions, good dispute resolution and solid governance in respect of capitalisation of these companies. The difference between dealing with Lehman Bros International (LBI) and some SPV set up in a tax haven was you could draw on the resources of all the groups assets and not just a small pool of funds providing minimal protection in event of insolvency. It was the gearing of Lehmans Inc., through various under capitalised structuring businesses that caused the cash crisis within the group and not the operations of LBI itself that led to the collapse. What the whole event shows is that London as a centre of finance did it's job well for those who understood what they were doing.

Job well done? I guess so . . . (source: The Guardian)
Probably the one thing that leaves me somewhat upset about LBI is that fact that administrators have been paid a billion pounds to do the unwind in what must be one of the biggest bills in history to a client for saying your money was there all along. Live and learn.

While you're battling with deciding where you want to sit in the capital structure of a company for the purposes of insolvency investors might want to pay attention to some disturbing signals coming out of Asia. On Friday as I was driving up to Orange I received an email telling me that the Chinese were widening the trading bands on the Yuan (CNY). From March 17 the daily trading band would be expanded from +/- 1% to +/-2%. Why does this matter. Well the CNY is pegged to the US dollar and in the past the fact that the Chinese had to, like other pegged currencies step in to the market regularly allowed for a liquidity shock absorber. By widening these bands the point at which buying or selling enters the market in the case of a news event becomes less supportive and therefore adds to the crisis. I know that sounds strange to some of my US readers as it's generally their currency pair that takes the hit, but in general it helps the smaller markets even if I believe as was the case in Korea and Thailand in 97 (to name but two) can lead to some serious problems if the central bank in question does not have sufficient foreign reserves. The end result must be more volatility. Investors have been warned.
(Source: Financial Times)
In both the US and the UK we're seeing a return to the pre-crisis IPO levels. In the US the IPO market is at a new peak since 2007, with 50 companies raising just over $9bn. The UK is doing historically even better with $5.52bn so far this year leaving it on track to exceed the previous first-quarter record of $5.87bn set in 2007. Investors need to remember that people who spent years building businesses tend not to sell them at cyclical lows, rather when you see this kind of activity it should be seen in a cautionary light. Think back to Asia in 97, the dot com bubble in 2000 and of course the general credit crisis of 2007, all of which saw exceptional activity in IPOs.

This week I have a number of meetings and even an end of week lunch. I'm hoping to get back on the bike, but these old legs of mine just might appreciate it if I keep the hills to minimum and staying on smooth roads.