Monday, May 31, 2010

The ECB Bond Desk Flees as the EU/IMF Rescue Package bursts into flame.

Apologies for the hiatus but I have been like a deer in the headlights these past few weeks. Events have occurred in the markets and in Dubai which have absorbed my time and attention and come more swiftly than I have been able to write about them. Thus this will be a limited post about what I think is the most important thing going on in the world right now.

It seems to me that we are in the middle of an extended speculative attack on the Eurozone. I have described the mechanics of this attack in an earlier post. The initial weak point was Greece and the markets have effectively shut Greece out of the capital markets and triggered the bailout by the IMF and the EU. This obviates the need for Greece to access the capital markets for at least two years which is good news but the stresses on Greece remain. The five year CDS on Greece still indicates that the markets have severe doubts about the ability of Greece to successfully implement its austerity package without damaging the economy so much that it cannot recover.

More seriously the obvious reluctance of the EU to help Greece and the riots in Athens that accompanied the vote on the austerity package necessary to secure the aid and avoid default massively undermined market confidence in the Euro and the panic quickly spread from Greece to the Iberian peninsula. This necessitated the “nuclear option” of a much bigger package to reassure the markets that the Eurozone would not come apart. The Europeans produced this package but it has come under attack almost immediately.

I think at this point it might be helpful for me to define what I mean by "shut out of the capital markets" and a "speculative attack." By "shut out of the capital markets" I mean that when a combination of CDS demand and a reluctance on the part of investors to buy newly issued debt of a country either chokes off all borrowing or pushes the cost of borrowing up so much that the interest on the debt alone would be more than the country could bear. For example a country whose economy was growing at 3% that was forced to borrow at 15% could never escape the debt trap and so would stop borrowing. The reason this is bad is that most defict countried rely on their capacity to borrow to fund government spending. If the capital markets close for a country the government has to shut down essentially enacting overnight the kinds of austerity that Greece plans to implement over a period of years. This can result in some serious social unrest.

I really like the phrase "speculative attack" because it is descriptive of the violence with which the markets assualt fixed regimes but to the general reader it may conjure up the wrong image. I think it might conjure up a group of hedge fund managers "speculators" in wearing frock coats and twirling their waxed mustaches while in an oak panneled study somewhere in mayfair they sip sherry and plot the downfall of the countries on the European periphery. This is not what I mean. Regardless of the paranoiac dreams of Angela Merkel the calamity which is affecting Southern Europe is not the result of a plot of some evil speculators. There are in fact very good reasons not to own Iberian bonds right now that have nothing to do with human avarice.

The markets are not driven by a single person or even a coordinated group but they do have definite behavior patterns. I'm going to go out on a limb with an analogy here. Imagine the international capital markets as an inflatable above ground swimming pool with a flexible bottom. Imagine that the water in the swimming pool is all the investable capital in the world. Further imagine that instead of resting the the ground the swimming pool is being held up by a group of men standing underneath it. These men are the worlds central bankers. Ideally all the men holding up the swimming pool would be graduates of a Charles Atlas Program and the bottom of the pool would be level. But that is not the case, the Central Bankers and Treasurer holding up the bottom of the pool vary widely in strength. The weaker they are, the lower thier corner of the bottom. This corresponds to the interest rates they have to pay. Think of a speculative attack as one of the weaker Central Bankers not being able to hold up his corner of the pool very well, and as he lowers his section (raising interest rates) the water in the pool flows toward him making his burden ever heavier. A successful speculative attack occurs when virtually all the water in the pool flows to where the weakest guy is holding it up and then bursts out of the bottom. It's an imperfect analogy but you get the idea. The water does not plan what it does, it simply obeys the laws which govern it. The same is true of investment capital on a macro scale.

Whether this attack succeeds or fails will determine whether we enter a new phase in the credit crisis, a very serve one I think, or whether we shamble on towards recovery and a return to normalcy. A successful speculative attack would involve the markets succeeding in raising the cost of funding for Portugal to such an extent that, like Greece, it was forced to draw down the new EU/IMF package. Now if it did so, also like Greece, it would not have to access the capital markets for several years and therefore would be safe. In fact, Portugal’s funding needs are light enough that it might not even have to go further than the $110 billion balance of payments fund which the EU used to rescue Hungary, leaving the EU/IMF with all EUR 750 billion of their ammunition. The problem would be that once the markets had beaten Portugal, they would move on to Spain.

By the time the attack on Spain began in earnest the markets would have already forced two EU members out of the public markets and would probably have gathered strength from that. If the markets succeed in shutting Spain out of the capital markets then we are in for some serious action. Spain will then have to trigger the EU/IMF funds in order to keep the government running. This will mean that all the EU members will have to go to the capital markets themselves in order to fund the project. This may be no easy task. For example, the German share of the bailout is about 5% of GDP. Given that it’s total debt to GDP ratio is already 80% Germany itself will, after the bailout, have a dangerously high debt to GDP ratio. This is the dark side of the bailout, it blurs the balance sheets of the European governments and makes a speculative attack on Germany a possibility. If that happens, it’s game over.

So right now the most important thing to watch is the Portugese CDS. A lot of people are watching the Euro as a proxy for this but I don’t think its appropriate because ultimately the level of the Euro will have little effect on the availability of capital for Portugal which is the true catalyst for Armageddon. If the markets can push the Portugese CDS over 750 then I think it’s only a matter of time before the gig is up. So if the Portugese CDS is the canary in the mineshaft for Armageddon when will we know that it’s safe to go back in the water? Sadly this is a much harder question to answer and is why I think any rally from this point in world equity markets is likely to be subdued. There is no obvious thing that would make the Portugese problem dissipate. Even if the Portugese CDS comes in the most likely outcome will be further political wrangling within Portugal as to who should bear the costs of austerity and this will likely push the CDS back up.

Personally I think the most likely outcome is that Portugal muddles through, it’s true that it’s in bad shape but it is nowhere near the position in which Greece found itself. It seems also to have learned the lesson of Greece and is actually taking tough measures to bring its deficit under control. Of course if that happens then equity markets will begin to react more to the strong data that has come out of the US and the fact that all this madness means that Bernanke is even less likely to take his foot off the gas. Thus if Portugal calms down enough, there could be a big rally. That said, Iberia is not out of the woods yet and is still very vulnerable to a general flight from risk assets that might be caused by something unrelated to its own finances such as tensions on the Korean peninsula. This thing is not over by a good long way. The only certain thing is that we face significant uncertainty.

Sunday, May 16, 2010


The photo above was taken at the moment of the DIFX launch on September 26th, 2005. Pictured are the Governor, the CEO and the Chairman of the exchange touching the magic globes which launched the exchange. What you can’t see in the photo is me in the back of that room. I’m there with cell phone ear pieces in each ear communicating with my trading desk and with that of another firm engineering what would become the first trade on the exchange. It was kind of like the Wizard of Oz. There was Dr. Omar the Great and Powerful and I and my colleagues were the men behind the curtain. It was as a man behind the curtain that I got to know Dr. Omar.

Not that Dr. Omar would have any idea who I am. The few times I met Dr. Omar he gave me a handshake and a cold smile which said “kindly disintegrate” as if someone had obliged him to shake hands with a garbage man at the end of a long day of work. Dr. Omar had no desire whatsoever to shake the hands of the people who were actually doing the work that was keeping him in the spotlight. That’s what we were paid to do, we should get on with it. He has a point there. But I think it we also made him a little uneasy. The reason for this was that those of us down in the engine room of the DIFC Technocracy had much insight into what Dr. Omar was, and what he was not.

What he was, was a seducer.

Dr. Omar’s gilded tongue lured virtually the entire London banking community to Dubai and enabled it to eclipse Bahrain as the regions financial center. It was not a hard sell. Oil was on its way from $50 a barrel to over $150. Most of that money was going to Saudi Arabia and a fair amount to Kuwait, Qatar, and Abu Dhabi. These people were piling up money faster than even the Chinese. They were going to be in desperate need of some serious banking. Who better to do it than the London Banking community? But who wanted to live in those crazy places? Surely not Londoners.

What about the DIFC in Dubai? Well, in Dubai you have nightclubs which have liquor in them as well as a healthy complement of young ladies from Eastern Europe and Southeast Asia. Heck, it’s practically the East End. And what is this DIFC business anyway? Oh, it’s a legal zone with UK Law as opposed to Sharia? Now that’s an even easier sell. What’s that? Zero percent tax for the next 50 years? Outstanding! Our non-US nationals can relocate there and pay zero percent tax (Sorry Americans, you’re globally taxed. The war on terror is not going to pay for itself as it turns out.) Wow, the DIFC/Dubai is like The City, plus the East End, times the reciprocal of your tax rate!! Sign me up Dr. O. And just like that Dr. O built the DIFC into what is: the largest concentration of international financial expertise in the Middle East. By miles. As a seducer Dr. Omar did his job well and in spades.

What Omar was not was a technocrat.

He’s described this way in both the local and the international press. The story seems to be that during the crisis Sheikh Mohammed removed the “technocrats” to replace them with “loyalists.” Dr. Omar was neither of these. Dr. Omar may be guilty of having expensive tastes in cars. He may be guilty of some spectacularly poor investments. He may be guilty of being a bit haughty toward us unter-menschen down in the DIFC engine room. But, and I can say this from my interactions with him and his staff, he was totally innocent of any knowledge whatsoever of what it would take to make the DIFC a successful center other than as a real estate venture to which he was able to lure international banks as tenants.

He did not concern himself with the minutia of what precisely was necessary for the credibility of the legal system. He did not busy himself with what it would take to ensure the success of the DIFX or how it should interact with other exchanges in Dubai or the region. He also did not consider the possibility of locking in the commitment of the international banks to either the center or the DIFX by parting with equity in them. Rather he had the DIFC take a large equity position in one of the main supporters of the DIFC. This and other investments that Dr. Omar made ultimately came to grief to the great embarrassment of himself and Dubai.

I don't blame him for any of this. He did not have to be a technocrat because he lured acutal technocrats such as myself to the center and we did the boring job of haggling over the Personal Property Law and the DIFX exchange rules. He did what Dubai wanted which was rent real estate to banks so that other Emiratis could rent apartments to bankers.

But was he a criminal?

As I write this Dr. Omar is languishing in jail in Dubai. He has been arrested on the charge that he appropriated public funds for his own use. In their article the Abu Dhabi newspaper The National says that he disguised this misappropriation as “annual performance bonuses.” I’m troubled by this for several reasons. First of all it was not a big secret that Dr. Omar was paying himself a kings ransom for doing his work in the DIFC. I’ve written an earlier article on this and my chief source was an article that was published in Bloomberg in 2005 about Dr. Omar’s Ferrari collection. If you are secretly engaged in embezzling from the state and disguising your income you don't give interviews to Bloomberg about how you're taking delivery of your second Ferrari.

Second Dr. Omar worked for the state. Therefore any funds derived from his work were therefore “state funds.” It seems to me that “annual performance bonuses” that you spend on yourself are not therefore “misappropriations” they’re “appropriations.” You’re supposed to spend your bonus on yourself. That’s what it’s there for. You can’t criminalize something simply by putting quotation marks around it. If he spent a bunch of money on himself personally and called it “real estate investments” or he pulled an Abdullah Brothers and engaged in some “unauthorized transactions” then I could see it. But it seems to me that the transactions that Dr. Omar engaged in were all “authorized” if not entirely successful. The question to ask is “Did Dr. Omar put Dubai on the map as a financial center in the Gulf?” Yes he did. Is it reasonable to believe that Dubai would pay him based on his performance which was a success? Sure as you’re born.

So one of two things must be true: either Dr. Omar paid himself performance bonuses which were approved by people higher up in the Dubai hierarchy in which case they should be faulted not him, or there was no oversight of the DIFC compensation regime whatsoever in which case Dr. Omar was perfectly justified in paying himself whatever he saw fit and if Dubai is unhappy with this they have no one to blame but themselves. In either case, Dr. Omar should not be in prison. Unless there is something the Dubai authorities are not telling us about the deeds of Dr. Omar he should be freed.

I think the more likely explanation is that Dr. Omar’s investments lost a ton of money and he may not have fully understood some of the more complicated transactions into which he entered. He therefore may have not been totally candid with the Ruler with regard to the financial position in which the DIFC found itself. This is bad but if it is a crime there are any number of other people in Dubai who should be standing tall before the man. Chief among them Sultan Ahmed bin Sulayem the Chairman of Dubai World and the former Chairman of Nakheel who has set his son up in business with the creditors funds only to spin him out with no compensation, obliterated tens of billions of dollars of investor funds, and given Dubai it’s largest black eye so far.

But I am not advocating jail time for either Dr. O or bin Sulayem. Dubai has serious governance issues but this is more a lack of oversight than criminal activities on the part of the managers. In order to recover Dubai needs risk takers and entrepreneurs who operate within a predictable and well governed system. Throwing people in prison for overpaying themselves for doing what you asked them to do and using powers that you gave them is not the way forward. The way forward is to make it clear to the people who are the Stewards of Dubai in what incentive structure they operate then let them go without having to fear prison in the event that Dubai changes its mind. It would be an important step for Dubai to either better explain why Dr. Omar is in prison, or to free him.

In my opinion, since they cannot do the former, they must do the latter.

Wednesday, May 12, 2010

The ECB Bond Desk plans it's next moves...

Ok, so the markets have had a few days to digest the EU’s newly erected defences against the speculative attack on the Euro that has been launched. What has happened?

On Monday the Euro popped, sovereign CDS spreads tightened a lot indicating that the risks of sovereign default had lessened substantially, and finally the European equity markets screamed higher and took the rest of the world with them though not as aggressively. Yesterday the Euro sold off and the European equities markets came off their highs but the sovereign credit markets continued to tighten. Today the Euro is a little higher but still near the lows, the equity markets are catching a bid on some good earnings news, and the credit spreads continue to come in.

So what does all this mean?

The EU has won a tactical victory and regained the initiative but is still in very serious trouble at the theatre and strategic levels. The delivery of the EU-IMF package to Greece combined with the outright purchase of Spanish and Portuguese bonds by the ECB has blunted the immediate speculative attack its’ main routes of contagion. It is true that this has not brought a bid to the Euro but the proper way to judge the success of this program is through the sovereign CDS markets all of which have tightened every day regardless of the direction of the Euro or the equity markets. One could even consider that the declines in the Euro are an expression of confidence that the ECB bond purchase program will be robust enough to function as quantitative easing despite the ECB pledges to withdraw liquidity elsewhere.

This tactical success has enabled the EU to regain the initiative and will buy time for the EU governments to pass the remainder of the package. The main problem is that neither the package nor the bond purchases address the intermediate or strategic issues which plague the EU. The theory is that the existence of a EUR 750 billion fund for the stabilization of the government finances of the weaker countries will deter any other speculative attacks on the EU. For the time being this seems to be working.

At the intermediate level there remain two very serious problems. The first is that the economies of Southern Europe remain weak and globally uncompetitive. Think about how freaked out Americans are about the rise of Chinese manufacturing and Indian service outsourcing. The marginal productivity of an American worker is almost 1.5 times that of a Spanish worker and more than twice that of a Portuguese worker. If Americans are in trouble, Iberians are doomed. Keep in mind that the governments are all committed to austerity measures to reduce their budget deficits even if the stabilization facilities are not draw upon. In all these countries the government share of GDP is 40%, if you embark on a massive program of reducing that, you are going to harm the non-government sector as well. All these countries have serious recessions on the way.

The second problem they have is that there does not seem to be a political consensus in these countries that the austerity measures are even necessary. The Eurozone as a whole had a near death experience this weekend and the Greek unions are already calling for more strikes. I can imagine that the Spanish and the Portuguese unions may feel the same when the time comes for their salaries and pensions to be on the block. I think the mere existence of the EU rescue package will exacerbate these tensions. Since the worst possible outcome now is not bankruptcy but a drawdown of the EU facility the unions have even less reason to compromise. They should basically press the government for a slightly better deal than they would get under the EU conditions but they have a lot more room to play chicken because they know that in the worst case scenario they don’t have to ask the markets for funds, they have to ask the EU which has already promised them.

The EU governments are hoping that the existence of the EUR 750 package means that it is unlikely to be used. I think the opposite is true, its existence guarantees that there will be more resistance to local government austerity measures which will force its deployment. Once that happens the balance sheets of the governments of Southern and Northern Europe will be linked and then the speculative attack will move North. Then the crisis of willpower will be not that of the Spaniards to take wage cuts but of the German taxpayers to finance them. This will be an even harder test, and the markets know that.

The photo at the top of this was taken during the battle of Kursk, this was an attempt by the German Army to encircle an extended Soviet Army in Central Russia in 1943 after the battle of Stalingrad. It was a bold and expansive plan which, if successful would have trapped and destroyed 20% of the Soviet Army and restored the initiative to the Germans. The Germans underestimated the size of forces opposite them, and had their best units chewed up in the largest tank battle in history. Afterwards the Russians were on the offensive until they reached Berlin. In the end no amount of tactical brilliance was enough to overcome the strategic dilemma the Germans had undertaken.

Monday, May 10, 2010


Apologies for the tabloid headline. I’ve been wanting to use that photo for months and I just got the chance.

So while I was distracted by watching the Eurozone melt down and then today melt up I missed a very important story in Dubai. The Abdullah Brothers have missed their first payment of $55 million of the $165 million and two tons of gold they stole from their public shareholders.

If you have been reading my blog for a while I have written extensively about massive theft from the shareholders of Damas by the Abdullah Brothers. I began with a two part article about how the theft was undermining the confidence of the DIFC. I wrote a few other pieces about the ridiculousness of the fact that the Abdullah Brothers were allowed to negotiate with themselves the terms of their repayment. I begged the DFSA to do something and then I celebrated the DFSA when they did in fact take action.

Well, it might be time for a bit more action to be taken. The Abdulla Brothers were supposed to make a $55 million payment at the end of April and they have not done so. In fact from what I can gather from the various news sources they haven’t even made a partial payment. Damas put out a statement saying that the payment was missed because of the complexity involved in liquidating the assets. They also point out that under the terms of the confidential agreement between the Abdulla Brothers and Damas the missed $55 million did not constitute an event of default.

Now let me get this straight. In their Enforceable Undertaking with the Abdullah Brothers the DFSA mandated that they had to repay the money they stole from Damas according to the terms of their original agreement. At the time that agreement was written one of the Brothers was in fact the Chairman and another was the MD responsible for daily operations. The CEO was non-Emirati and so presumably had little say. Now it comes out that A.) missing a payment of $55 million does not constitute an event of default and B.) the agreement is secret?

You have got to be kidding me. The DFSA signed off on a secret agreement whereby non-payment is not an event of default? If non-payment is not an event of default what the heck is an event of default. Of course we’ll never know for sure BECAUSE THE AGREEMENT IS A SECRET! Was it a secret from the DFSA at the time they agreed for it govern the restitution to Damas? I do have to say that it was very forward thinking of the Abdullah Brothers to negotiate this agreement WITH THEMSELVES and then make it confidential.

And what is the reason for the delay? Complexity? You have to be kidding me. According to an earlier article in the National they own four boats. How complicated is it to sell a boat in Dubai? I’m pretty sure they get sold all the time. What is this about Damas “working with the Abdulla Brothers?” Why are they working with them? Why are they not simply holding a massive auction and blowing out of all the Abdullah Brothers assets to the highest bidder until they get to $165 million? How complex would that be? There’s even a company in Dubai that Damas could hire to do it. Or better yet the DFSA should be doing it.

The signatory to the Enforceable Undertaking (EU) on behalf of the DFSA is Steve Glynn. I know Steve and I think he’s a good guy. I think he should do the following. I think he should find the nearest telephone booth in the DIFC. He should enter said telephone booth as his mild mannered self and emerge as his regulatory super-hero alter ego: THE ENFORCMENT UNDERTAKER and he should enforce the enforceable undertaking.

He should make the repayment agreement a matter of public record first of all so that the poor long suffering shareholders of Damas can know what they’re in for. Then if there is in fact no circumstance in which the Abdullah Brothers can be put into default he should declare that the agreement does not meet the requirements of the Undertaking and should invoke article 17 of the Undertaking. This would enable him to declare them in default and use the remedies he has under law to enforce the lien on their assets and start auctioning them off until they get to $165 million and the shareholders are made whole. If the Abdulla brothers are bankrupted or reduced to penury by this then those are the breaks. Maybe the next guy who does an IPO on the DIFX won’t rig the book building process and then steal the proceeds.

Sometimes I really don’t understand Dubai. Here you have Dr. Omar in jail and all he did was pay himself $15 million dollars for what, at the time, seemed like a good job of attracting firms to the DIFC. These guys STEAL $165 million, more than ten times what Dr. O gave himself, from their shareholders and are walking around free men with the liberty to choose among their four yachts on which to indulge their passion for fishing all the while missing the first payment deadline imposed on them by the regulator. The Damas fraud is a bigger black eye for Dubai than Dr. Omar times a thousand.

Dubai is worried that firms are leaving the DIFC and have hired McKinsey to find a way to attract firms to the Center. I’m going to write something more in depth on this but I’ll save them a few million dollars on their McKinsey fee right here: the only advantage that Dubai has as a financial center to counter the fact that it has NO money is the idea that the DIFC has a regulatory regime which is more attractive than any of the other Gulf States.

The letter of the legal and regulatory system really IS qualitatively better for executing financial transactions than the surrounding jurisidictions. But in law as in life the letter is only as good as the spirit. By letting the Abdullah brothers make such an obvious mockery of it that I can write articles like this for months Dubai is destroying its only advantage. If you want to keep people in the DIFC don’t let favoured Emiratis rob shareholders blind and then so obviously get away with it that I can write article after article for months saying out loud what everyone in every bank is thinking.

Come on Dubai. It’s time to step up, there’s a game on here. You took the crown from Bahrain, do you have what it takes to keep it?

The Germans and the EU roll out the big guns.

So it looks like the rumors I discussed on my blog last night did not go far enough. I was off both with regard to the breadth of the measures and their magnitude. I still think they are likely to be tested but it may be some time off before they are and the sheer size as well as the speed with which they were negotiated will probably make the Bond Vigilantes take a step back. It’s kind of like the EU went into the weekend as Clark Kent and then came out of it Superman.

So what are the packages?

1.) EUR 60 billion gets added to the Balance of Payments fund by all EU governments. This was a fund that was created in 2008 to help non-Eurozone countries cope with the financial crisis by extending them credit.
2.) EUR 440 billion is provided in bilateral loans and guarantees among the Eurozone countries. This package needs to be approved by the parliaments.
3.) The IMF will contribute EUR 250 billion to the enterprise.
4.) The Federal Reserve Bank of the US has extended swap lines to the European Central Banks in order to add dollar liquidity.
5.) The ECB agreed to potentially purchase government bonds. If/when they do so they will also engage in “sterilization” so that the purchases are not inflationary.

So what does it all mean?

Well the main thing is that I think the EU successfully demonstrated its resolve and its capacity to respond to a crisis of confidence. That’s the most important thing. Behind that I would say that the most important element is the ECB agreeing to buy bonds. The big numbers involved in the package are big but the money won’t even be available for a while and as I mentioned in my previous post to even get at it a government would have to agree to some stern measures so most will not ask until it is too late to do anything else. But the ECB stepping in as a buyer of last resort for the sovereign credit markets, that’s a big deal.

So what effect is it having?

Well, interestingly after a pretty big initial rally the Euro has fallen off. This should not be surprising because what the EU is really doing is making it easier for countries to run their deficits knowing that they can access these funds if they make mistakes. Think of it as creating massive moral hazard on the national level. The weaker countries in Europe now know that they are too big to fail.

The credit markets and the stock markets love it. Greek, Spanish, and Portugese CDS markets are all massively tighter. You would expect this now that the ECB is probably out there buying their bonds with both hands. European equity markets were all up HUGE and the US is up about 3.7% right now.

What’s the big picture here?

I think in the short term the EU has scared off the speculative attackers and has given some breathing room to Spain and Portugal. On the other hand they have made it harder for the political systems in those countries to compel the kinds of austerity that they’ll need to implement in order to get out of the hole they are in. It also ties the stronger economies to the weaker ones by enabling them to tap the capital markets in the name of the stronger economies. The current crisis may abate but it is sowing the seeds of the next.

Sunday, May 9, 2010

German/EU Air Cover Arrives in Greece

I have to be quick about this as I have to head off to mass. So the rumor is that the EU is coming up with a $500 billion package for use in the event that any other Eurozone governments get into trouble with regard to thier finances. It sounds like EUR60 billion of it is hard cash raised by the EU centrally backed by the member governments and EUR440 billion is in the form of bilateral loans and loan guarantees. There is also talk that the ECB will engage in a program of quantitative easing by buying up the EU government bonds. There is also a possibility that the EU may throw its hat in the ring and there has been talk that Fed will reinstitute its successful swap line program. Much of this is speculative and some of it (the ECB QE part) is directly counter to the last statement made by the relevant person.

Right now the markets are loving this. S&P futures are up 20 points and the Euro is up )$0.135 to $1.2891.

So is that it? Let me tell you I'd like to think so but I don't think the bond vigilantes. Are going to give up that easy. So what do we really have here? The headline number: EUR500 billion is certainly designed to impress but there has to be a lot of fine print in there and once the markets get thier hands around that they'll be probing for weaknesses.

What does a problem debtor have to do to qualify for the guarantees? What conditions are involved? Are they conditions that would likely induce the governments to put off asking for help for as long as possible? Also what kind of domestic approval is required to get this done? Given the circus in Europe this past week with regard to the IMF deal for Greece I am not filled with confidence that the voters in Europe will go for it again. If this mechanism is a gun but requires voter approval for the bullets, it's not really a usable weapon tomorrow at noon is it?

Far and away the most effective thing would be some kind of facility that would enable either the ECB or the EU to just start buying the hell out of Spanish or Portugese bonds and crush the CDS speculators and create a short squeeze there and in the Euro. I understand that there are massive issues with the ECB engaging in that kind of activity. If the EU doesn't do it then there will be continuous pressure on those bonds until the governments are forced to ask for the guarantees. Then we'll know if it worked.

The EU is trying to lead with a strong hand, trouble is, the doubters have a strong hand too. Oh, look here come the bond vigilantes now...

Saturday, May 8, 2010


This is a bit out of the ordinary but I just listened to this thing and it’s so awesome I had to share it.

There has been a lot of talk about how the crash on Thursday was driven by electronic trading, and it was. But a lot of non-electronic trading still goes on and sometimes tells you more than a straight line down on a screen.

This is a recording of an Phone Clerk in the S&P 500 futures pit in Chicago describing the 10 minute long crash on Thursday. Given the massive reliance on machines a lot of people never hear this kind of thing anymore but it really gives you an emotional sense of what is going on. This has a personal note for me because what this guy is doing is what my first job in finance was way back 21 years ago in 1989 when I was 16. The Chicago floors have a language and culture all their own which might (pardon the pun) be Greek to the average listener so I will try to explain what the guy is doing and the language he is using.

The financial instrument which he talking about is the S&P 500 index future traded on the Chicago Mercantile Exchange. The index futures represent $250 time the value of the index and they expire every three months. Basically if you buy a future and at expiration the S&P 500 is lower you have to pay the seller $250 times the number of points lower it is on expiration day, if it’s higher the seller pays you $250 times the number of points by which it is higher. Given that the S&P closed at 1110 Friday each contract as a notional of $277,500.

The mechanics of pit trading are a bit arcane, and indeed they were invented in 1848. If you look at the photo above you can see what the pit looks like from above. In the center are the market makers, traders who provide liquidity to “paper” the big brokerage firms. They’re called “paper” because their orders used to come to the pit on paper tickets whereas market makers used cards. The way they provide liquidity is by “making markets” to the brokers. A “market” is composed of a “bid” price he is willing to pay and an “offer” or “ask” price at which he is willing to sell as well as a quantity. The traders stand in the pit and with a combination of shouting and hand signals broadcast their bids and offers to the ring of guys you can see in yellow jackets around them. Those guys are Arb Clerks. They communicate with the guys standing in the booths you can see surround the pit called. Those guys are called Phone Clerks because they are on the phones to customers telling them where the markets are. The guy in the audio file is a phone clerk telling you what is going on in the marketplace.

In order to process the massive amount of information and to avoid confusion the arb clerks use a kind of verbal shorthand. The S&P trades in ten cent increments and ordinarily they would tell you where the markets are using only the cents column, and whole points are referred to as “handles.” So if the market drops 5 points you might say “we’re down 5 handles.” So a market quote of 1115.20 bid to buy offered for sale at 1115.80 would be “20 at 80” and it would be presumed that you knew the handle was 5, the last index digit. When the market crosses a whole index point its differentiated with the term “even.” So a market 1115.80 bid offered at 1116 would be “80 bid at 6 even.” 50 cents is abbreviated as “half,” and sometimes whole numbers are designated with “the figure.” So 1118.5 bid at 1119 Might be called “eight half bid at 9 the figure.”

In addition to telling you what the markets are the phone clerk will also tell you what’s trading. This is very helpful because it tells you something about the direction. If the buyer crossed the bid offer spread to pay the offer that’s a sign that things might be going higher. So it’s very important for the phone clerk to tell you what is trading. OK, have a listen and then I’ll give you some more color.

If you don't get the above widget try this:

The conversation begins at about 1:38 in the afternoon Chicago time when the S&P 500 was trading at about 1140. At that point the market was already down over 20 points and someone must have asked him where the limit was. The CME has momentary trading halts if the S&P goes down about 10% but its a fixed number on Thursday it was 110 points. It happens so rarely people forget and the opening conversation is the Phone Clerk and another guy talking about how far away the limit is and the speaker doesn’t believe it’s all the way down at 1053. Which “90 handles, or like 1000 dow points away.” Of course this is ironic because five minutes after they have that conversation it’s a few points away.

In a few minutes a few “HUGE” paper sellers come in and sell it down 25 points in a few minutes to 1115, this is probably panic selling based on the Greek issues. Then once if goes through 1110 the figure the bids just get hit like a steam roller, 1106, 1105, 1104, 1103... crushing them when he gets down to 1070, and 1065 there are offers and no bid down to 1060. For a while it’s 1060-1070, a 10 point wide market in a product which so liquid that it normally a dime wide. That gives you a sense of how massive the uncertainty is. People don’t have any idea what the market should be worth that the bid offer spread on the most liquid US equity product is 1% wide.

To give you an idea of scale, the US market cap is about $11 trillion so each point represents about $10 billion of market cap, so as he’s rattling off the points on the way down each new lower trade represents $10 billion of destroyed value. When the markets are 10 points wide the market can’t properly value the US stock market to the nearest $100 billion.

What is interesting is how little trading actually goes on at the bottom and then how fast it comes up, the offers just start disappearing on the way up, by the time the bid comes back up to about 1090 there are no offers. At one point he talks about how this is going to “blow people out like you would not believe.” At one point he talks about how someone sold a 100 lot at 1060, by the time the tape ends four minutes later that trade would have lost $1,250,000 for whoever did it.

I have to say that the exchange floor culture is one of the coolest places to work ever. The world is melting down and this guy is so high on adrenalin he can’t get enough. My favourite phrase comes at 10:13 when he screams out “WE NEED TO DO THIS EVERY DAY DUDE!”

That’s the Chicago way.

Thursday, May 6, 2010

The good news is the IMF Money Train has arrived at Athens Central Station...

OK, that had to be one of the craziest days in the markets ever. So much was going on I almost don’t know where to begin.


Think of it this way. The governments of Europe, the European Central Bank and the IMF are acting out a drama in front of three separate audiences who are responsible for judging them and who communicate with each other through price signals. These audiences are the foreign exchange, credit and equity markets. Generally a credit trader will trade only credit and or an equity trader will trade only equity so the markets have different personalities.

Generally the credit markets tend to be filled with more analytical long term thinkers than equity markets do because its’ easier to change your mind in equities. Foreign exchange is dominated by people who are actually moving money around for a commercial purpose: trade, cross border investment, that sort of thing as opposed to credit and equity markets which are investments in their own right. The foreign exchange market is by far the largest and followed by credit followed by equity.


The drama as that is being played out is how the Eurozone is going to cope with the massive fiscal deficits of the countries on its southern rim. Today there were several acts in that drama. The European Central Bank held a meeting. Spain held a bond auction. Greece voted on the austerity package.

The ECB kept rates unchanged but some people thought that they might consider some kind of monetary easing either through a cut in the rate or some kind of quantitative easing such as the Federal Reserve has done in the US. The ECB announcement and the remarks of the Chairman said the topic was not even discussed. I think their objective was to show the world that they are confident that the IMF package will work so they are not considering drastic action. There are quite a few market participants who are deeply sceptical of the efficacy of the IMF package and have thier eyes on Greece and Spain, those people were disappointed with the ECB.

The Spanish bond auction went well I thought. They had to pay a higher rate for their bonds than they did the last time they went to the market but their credit has been downgraded since then and they did have an auction the day after the riots in Greece so I think this is understandable. The bid to cover ratio, or the ratio of amount of buyers relative to the amount of bonds for sale was 2.5 to one the highest in years meaning that there was a lot of demand at that higher rate so it would seem that Spain is not in the same position as Greece.

Finally, after a day of riots the Greek parliament voted on the austerity package. The Prime Minister and the Finance minister gave impassioned speeches about the need for unity. The opposition laughed. There are 300 members of the Greek parliament of whom 160 were members of the ruling Socialist party. In the end 172 members voted for the measure and three of the Socialists turned in blank ballots and were promptly expelled from the party. In any case, the motion carried.

This vote was significant because the opposition, by voting against it can score points when the austerity begins to bite safe in the knowledge that no one will know what would have happened had they won, which is that instead of people taking 20% pay cuts the government would have stopped functioning altogether. This is great domestic politics but pretty terrible international finance. Because now if you are a potential Greek bondholder you know that almost half the government has no skin in the game with regard to actually carrying out the austerity program. Greece already has credibility issues this did not help.


So how did the markets take the news. Well, at first the credit markets took it OK. They had really given the European governments a beating yesterday while the Greek riots were in full swing but once the Spanish got their bond auction off with a big bid to cover the credit markets tightened. The equity markets liked this even more and bounced into positive territory early in the morning before trading off on the fear that perhaps the Greeks would not pull off a win for the austerity program. When the Greeks approved the plan, equities had a brief bounce.

The FX markets however called bulls**t all day long. They slowly ground lower with each new news item. Keep in mind that the FX markets trade $3 trillion of value a day and people in the markets have been using dollar/euro as a proxy for the general perception of the success that policymakers are having with their efforts. The FX markets gave it a thumbs down and then the credit markets joined in. CDS markets for Spain and Portugal began to widen out. This is bad news for Portugal because they have to go to the markets to roll some debt that matures at the end of May. If they get that done they don’t have to do any more refunding until 2011 but you only need one auction to go wrong before its lights out.


The equity markets soon enough began to sell off after watching the FX and the credit markets booing and hissing the powers that be in Europe. There was a selloff into the European close, then a little rally once the Americans were on their own. The view in the US thus far has been that this is a European problem, that Greece is small and we don’t really have to worry about it. European markets have wiped out all the gains from 2010 in the past few weeks on the back of the Greece problems and America has outperformed. Not today.

Today the markets began to think that perhaps all this credit trouble in Europe might tighten credit markets generally and smother the nascent American recovery in the crib. I think that American equity markets are probably the least well informed of the triumvirate as to what is going on in Europe but they could not ignore the Euro, the CDS for Spain and Portugal and the fact that the European equity markets have traded a lot lower than the US has. So they began to sell, and sell hard. Then something interesting and deeply disturbing happened.


A lot of people when they think of the stock market in the US think of those scenes from the movie Wall Street with a bunch of guys gathered around a specialist hollering buy and sell. That image is as close to today’s reality as tin cans and a string are to the internet.

In the US the equity market is made up of both the famous stock exchanges of which you have heard and several dozen ECNs or electronic crossing networks. The old line exchanges have market makers or specialists who are responsible for making a continuous two sided price all day long. These guys generally and specialists in particular long abused their advantageous market position to shave cash off of most market participants. Believe me. I know.

People got so fed up with the specialist system people came up with all kinds of alternative trading venues called ECNs. These ECNs had all kinds of rules, fee structures, or special features to entice market participants to trade on them and pay the owners a transaction fee. These venues have proliferated and have fragmented the market to some extent. The government tried to link them up with a rule called Reg NMS but has so far had mixed results.

Another interesting feature of modern stock markets is the role of high frequency traders. These are automated trading systems whose orders to buy and sell are generated electronically using a formula and which hold positions for extremely short periods of time. These types of firms have been slowly displacing the specialists and the market makers as the primary liquidity providers to the marketplace. The key difference between a market maker and a High Frequency Trader is that a market maker or specialist has an obligation to maintain a two sided quote subject to certain conditions while a HFT firm does not, they are pursuing an opportunistic strategy which contributes liquidity as a side effect.

As the markets came apart today it looks like some of the HFT guys contributing liquidity may have backed away from adding their liquidity to the system. Some trading algorithms which were written with certain liquidity assumptions sent market sell orders into the market and overwhelmed what bids there were. This had the effect of pushing the prices of some stocks on some ECNs to a penny a share. These orders should have been routed to an exchange where there was a bid but for some reason this didn’t happen.

Now most people don’t have the ability to watch all 14,000 listed stocks in the US so they watch indexes as a proxy the most notable ones are the Dow Jones, the S&P 500 and the NASDAQ. The indexes themselves are calculated by machines which take the prices of trades in the component stocks, add them up, divide by a divisor and publish the index. If you have a few stocks in which some trades are all of a sudden executed near zero, the index seems to have fallen quite a lot and that’s what happened this afternoon.

Once the zero prints went up in a few stocks artificially creating lower prices in indexes people could not tell just by looking at the indexes that there were erroneous trades being used in their calculation, they thought that there was a massive panic. And then they themselves panicked. Also computer programs designed to limit losses if indexes or shares decline to a certain point also kicked in and the markets completely fell out of bed.

It's actually hard to exaggerate just how much they fell out of bed. It was the largest point decline in the history of the market and the largest percentage decline since 1987 which was the all time record holder by miles. And the whole thing happened in less than 10 minutes and was over just as fast. Granted we recovered quickly and well but you can tell that there are a lot of very nervous people out there. It would seem there are also some very nervous computers out there as well.

There is a lot going on in the world, and you don't have to go far to find reasons to panic, but it was exacerbated massively by the fractured market structure of the US equity markets. Rest assured, Congress will address itself to this issue.

Oh Boy. And the casino opens again tomorrow at 9:30AM...

Wednesday, May 5, 2010

Now these Greeks were not afraid of a little austerity!

Today the world was treated to a (and I know this phrase is much overused) Greek drama. As is well known the Greeks have been living beyond their means for quite some time and at last the German Ants have decided to rescue the Hellenic Grasshoppers from the fruits of their own fiscal profligacy. Whether this drama becomes a tragedy or farce for the bondholders will largely become clearer tomorrow when the Greeks vote on whether to accept the austerity measures that the EU and the IMF will demand of them as conditions for their aid. There is an EU summit tomorrow to discuss this and then the German Parliament has to vote on it Friday which should put it over the top.

In the interim the world has been treated to the spectacle of the Greek public sector unions raising a ruckus over the deep cuts in their salaries and pensions that the austerity package requires but which will still leave Greece with a 150% debt to GDP ratio by the end of 2013 so even with the $145 billion it’s still touch and go. It’s hard for me to understand what these guys are so mad about. The austerity measures the IMF and the EU are asking for are Draconian (another classical Greek reference) but they are nothing compared to what would happen in the event of an actual default. I think that these protests are more likely to do with general frustration rather than a specific policy which means they are likely to blow themselves out and the Greeks will get on with it.

That said I think there is something to be learned from all this. I tend to agree with most pundits that even if this particular episode is resolved sovereign credit issues are with us to stay both in Southern Europe and eventually throughout the developed world. At the end of the day the problem is this: Western societies are built on the assumption that the standard of living that developed here during the period of Western supremacy is a permanent state of affairs. For this to be true, the addition of several hundred million industrial and service workers to the global economy in India and Asia should have no effect on the standard of living. Naturally this is not in fact the case, the global market clearing price for a year of work in a factory is now well under $10,000 per year.

This is a disaster for the West, particularly the uneducated who are likely to take to the streets. Unable to cope with reality, our politicians have decided to try to use the relatively sophisticated financial infrastructure we have in the West to transfer the wealth of current bondholders and with them future taxpayers into the present to maintain the old living standards. This can be done for a little while, but not forever.

What Greece and its’ angry mobs are telling us is that the game is up.

Sunday, May 2, 2010

It may be a storm in a teacup, but it can still kill you if you live in the teacup.

So the Dubai World Drama continues. The powers that be at Dubai World are grudgingly considering raising to 2% from 1% the interest rate they’ll pay on the extended loans. Analysts say this would result in a 20-25% loss to the creditors. This is because while they would nominally get their principal back the amount of money they would earn in interest would be far less than they are expecting or could get elsewhere if they were paid back in full on time. Nakheel suppliers on the other hand are getting cash this month plus an Islamic security that will yield 10%. Reuters is reporting that the Bankers are not happy. Perhaps not unhappy enough to try their luck with a declaration of default but unhappy enough to push for more. The drama is not over.

Support for the deal is coming from an unsurprising source: Dubai itself. In a letter to the editor Nasser Al Saidi, the Chief Economist of the DIFC, has published a rousing defence of the Dubai World restructuring and has attempted to draw some lessons from it. While it is not surprising that Dubai is praising itself for its handling of the crisis two things are disturbing about the letter. The first is that the crisis is far from over: the Dubai World creditors have not accepted the plan, the losses elsewhere in Dubai continue to be staggering and Dubai has no room left to manoeuvre without another appeal to Abu Dhabi because they have completely drained the DFSF. The Second is the very disturbing sense I get from reading the letter that the powers that be in Dubai have neither a sure grasp of reality nor an awareness that, here in the future, their bold assertions of the impossible inspire laughter rather than awe.

Dr. Al Saidi says that the restructuring proposal “removes the cloud of uncertainty” which has hovered over regional markets of late and points to the recent declines of the Dubai CDS spreads from their crisis highs. Unmentioned goes the fact that Dubai CDS are still 150 bps higher than they were before the crisis began, are higher than either Portugal or even Lebanon both of which are in serious fiscal trouble. At 414 are right about where Greece was before its’ spike to 1000 and then forcible bailout by the IMF. It would seem that some uncertainty remains.

He goes on to say that the “main message emerging from the restructuring proposal is that the Government has treated both foreign and local creditors equitably and fairly, without discrimination, a clear refutation of some misinformation.” I find this hilarious. So, there are three main groups of creditors here: the banks at the Dubai World level (mostly international,) real estate investors at the Nakheel level (mostly Emiratis as they were given first pick of the land,) and trade creditors at the Nakheel level (also mostly Emiratis.)

So where does the money go? $8 billion goes to Nakheel, $1.5 billion to the parent, clearly favouring the Nakheel Creditors who are largely Emirati at the expense of the creditors of the parent company who are largely foreign. The banks (largely foreign) who extend their loans get 1%, the trade creditors (largely Emirati) who have to take some of their payment in newly issued bonds paying 10%. This is to say that the foreigners and the few Emirati banks involved lose 20-25% of the value and the trade creditors get paid a little something extra for their time. The good Dr. seems to think that just because they are not taking a principal haircut that the banks are not losing anything. On the contrary they are losing a great deal.

This is not to say that the Emirati trade creditors will not lose out as well. Even after another $8 billion is poured into Nakheel it is still a real estate development company in the worst performing and most overbuilt real estate market in the world. I would bet that despite the fact that their tradable securities will carry a 10% coupon that the Nakheel certificates will trade at a substantial discount in order to reflect this.

Dubai through the voice of Dr. Saidi goes on to congratulate itself for resolving the issues of ownership and taking on itself the burden of the equitization rather than compelling the creditors to do so. This is also a bit disingenuous because Dubai had no choice but to do so or else face a general insolvency and an involuntary equitization of both itself and the creditors. This plan as it stands drains the DFSF to zero and still clips the Dubai World creditors for 20% of the value of their investment. Had Dubai insisted on taking maintaining its position in the capital structure there would still be an equiziation but they would have also lost control. The restructuring allows them to pass losses to the creditors at the parent company level, drain the DFSF to try to revive Nakheel and pay off Emirati real estate investors and trade creditors and maintain control. Personally I think this is unwise because I do not believe Nakheel can be revived but this was not a selfless act by Dubai by any means.

He goes on to describe the restructuring as a triumph of federalism. This is also difficult for me to understand because the restructuring is entirely a Dubai only affair. Dubai drains the DFSF, which admittedly was originally from Abu Dhabi and converts its debt to equity. No new Abu Dhabi or UAE funds are involved. Indeed, the rescue of the trade creditors has enabled Dubai to maintain the independence of Arabtec. Now that the trade creditors are getting paid off in front of the creditors at the parent company level Arabtec does not need the Abu Dhabi lifeline and so has broken off its merger talks. It looks to me like this is the opposite of federalism, it is the reassertion of Dubai’s autonomy from Abu Dhabi though I think it is likely to be temporary.

After this Dr. Saidi draws a few conclusions:

1.) The middle east needs a better insolvency regime.
2.) Countries in the middle east should work to enhance the quality of their local currency debt markets
3.) Dubai should not borrow short term for long term projects.
4.) There should be more open communication by Dubai about the health of its state owned enterprises.

I think these are all reasonable suggestions though personally I think that the best way to achieve the first would be to actually put Nakheel into insolvency. Given that the local currency is pegged to the dollar by the vastly stronger power of Abu Dhabi I’m not sure I understand why there is a need to enable Dubai to borrow in AED. While its true that one should not borrow short term for a long term project that’s not really what happened here, they borrowed mid-term and then lit the money on fire with profligacy and corruption so that after several years of marketing and office redecorating there isn’t much left for the creditors.

The real problem with the essay I think is the last two paragraphs which I reproduce here:

Looking back at the last four months, the reaction caused by Dubai World’s debt restructuring announcement is best described as a “storm in a tea cup.” The facts are that the UAE, the GCC and the MENA region countries with access to international capital markets have never defaulted on their debts and obligations and have much stronger economic fundamentals than those of so‐called ‘advanced countries’ which were addressing criticism and ‘advice’.

So why the doubts and invidious questioning? One concludes that much of the media hype is politically motivated. Dubai’s Arab economic success story as a multi‐cultural, multi‐ethnic and multi‐religious hub and melting pot is clearly not to the liking of some countries with different geostrategic ambitions and outlooks and of some of the countries that were actively promoting the interests of their own companies against those of Dubai and DW.

The Dubai financial crisis has been many things over the past six months. One thing it has not been is a storm in a teacup. It was in fact a near death experience for Dubai’s sovereignty and it’s not even over because the success or failure of the restructuring, if it is even approved, turns on the successful resurrection of Nakheel. Furthermore Dubai is not stronger financially than either its advanced or its emerging critics. Dubai should not group itself fiscally with the rest of the GCC. Dubai CDS are trading today at 414 bps. Abu Dhabi is trading at 102 and Saudi Arabia is trading at 70. The markets see that Dubai is not in the same boat as the others, Dubai would be vastly better prepared to cope with what’s coming if it could come to terms with those facts as well.

Then there is the bizarre idea that this is all politically motivated by some unnamed countries which want Dubai’s multi-cultural multi-ethnic model to fail. This is preposterous. Dubai has engaged in massively self destructive economic policies. Those policies have destroyed tens of billions of dollars of value for both Emirati and international investors. If the foreign press was motivated by anything it was schadenfreude. The fact of the matter is that Dubai is simply no longer important enough for someone to go to the effort of manufacturing a crisis in order to bring it low. Indeed, Dubai’s most active enemy is itself. By perpetuating the fiction that its travails are the result of fear-mongering by invisible enemies it only lengthens the time it will take for it to take the bitter medicine and move itself forward.