Sunday, 20 January 2019

Exposing the truth

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The Dow surged through 26,000 to close at 26,115.65, now up 1,786.94 points or 5.65% in just 11 trading sessions. 

Of the 322.65 points that the index put on, 109.134 came from Boeing while at the other end of the scale Goldman Sachs was responsible for a loss of 33.119. Despite yet another sterling showing the whole thing still looks a bit unhinged. The equity rally began with the Trump election victory and the anticipation of a more friendly tax environment. Now we have it enshrined in the law, stock prices continue to rally. Buy on rumour, sell on fact has turned into buy on rumour, buy on fact.


What shores? 

Apple’s announcement that it will be following the Trump call and will be on-shoring stacks of its overseas earnings can’t have been bad. It reckons it’s facing a tax bill of something in the region of US$38bn but it has also promised to invest upwards of US$350bn in the US economy over the coming five years. That must be music to the president’s ears although the way markets are trading gives the impression that investors are expecting the bulk of repatriated funds to go into share buybacks rather than into investment in production capacity. Why, after all, would any self-respecting CEO want to invest in his successor’s bonus package when, by buying stock, he can perfectly legally and with the explicit and usually enthusiastic consent of the shareholders, themselves mostly professional money managers with an axe to grind on the price performance front, contribute to his own retirement fund? 

Yes, markets are unhinged; not in the conventional sense of being headless but in that the link between companies’ ongoing business performances and their dividend/buyback policies look to be broken. Sure, the majority of companies don’t have hundreds of billions of offshore earnings parked in Dublin or Guernsey or Curaçao which they will surely now be motivated to bring home although it looks as though the tide is raising all of the boats in the harbour and there is no law that prevents any of the tax savings to be used to “tidy up the capital structure”. 

Goldman, by the way, disappointed. Funnily enough it was a US$4.4bn tax charge that sank the earnings although the low level of market volatility was held up as the main culprit. Investment banking revenues beat forecasts but both FICC and equity trading missed their targets. Thus, with the tax charge, Goldies reported a Q4 loss per share of US$5.51. The other big financial name to report was Bank of America, my old alma mater. The tax reform act has done it no good either although gross revenues were strong. As a big lending bank it will be licking its lips at the prospect of higher rates which, for the benefit of the uninitiated, enables lenders to sneak in the odd extra basis point of lending margin without it being noticed.


Hedge trimmer 

With a world full of political activity and company reports dropping on us like autumn leaves there was something that caught my eye on a very different front and one that causes me deep concern. In the context of the collapse of Carillion, the FT reports this morning, oh horror of horrors, that HSBC has hedged most of its exposure to the failed construction company by buying CDS protection from credit structures such as CDOs. The way the Pink’un phrases it is that HSBC has deceptively sold the failed risk to poor little pension funds, wrapped in an opaque format. 

No, no and no again! 

I recall an article in the Economist many years ago, just as the CDS market was developing, in which it sang all the praises of a product that enabled banks to hedge some of their credit risk exposure and to distribute the risk more evenly across the financial system. Credit risk, as I repeat until I go blue in the face, is like energy. It can be converted but it cannot be destroyed. That a lot of lenders went into the big boom in structured credit in the early years of the last decade with their eyes wide shut and that many of the banks took ruthless advantage of them is hard to dispute. The principal “crime” was, just to recall, the credit ratings arbitrage that had been undertaken more than anything else. But in the aftermath of the financial crisis there can be nobody in the investment industry in general, and in the credit space in particular, who does not know exactly what the risks of buying tranched synthetic credit are and the knowledge necessary as to how to assess the risks is no longer a secret. 

As a principal lender in the UK banking community, HSBC had little choice but to appear on the tombstone of Carillion’s loans. But the whole idea of credit derivatives is to hedge risks one is not entirely comfortable with. On the other side of the trade is a counterparty who is prepared to buy exposure to a risk which they might not be able to acquire in any other form. There is only one quoted public bond issue and that, just for fun, was a convertible issue. 

HSBC’s protection will be, unless we learn to the contrary, nothing more than a covered hedge and the bank should be congratulated for being farsighted in minimising its exposure to a company it might well have quietly had its doubts about. Turning the situation around, imagine the outcry if HSBC had publically said that it thinks Carillion is a dead man walking and refused to participate in any of the loan offerings. Imagine the outcry if other banks had followed suit and imagine the headlines: “Thousands lose jobs because greedy UK lenders refused to lend”. HSBC had a social responsibility to be seen on the docket but was also perfectly within its rights to find somebody else who had appetite for Carillion exposure.


Tranche warfare 

After 2008 there should be nobody out there who has bought a CDO tranche who does not know exactly what the risks are, what credits are embedded in the structure and exactly where and how the excess returns on which tranches are generated. Personally, I think this article is trying to stir up collective guilt and a Fawlty Towers-esque “Don’t mention the war!” 

On the whole the asset management industry, poor little innocent pension funds included, employs more CFAs and generally better trained individuals than does the banking sector. If reaching for yield – that is the investment industry’s euphemism for vicarious greed – is the motivation for finding oneself exposed to tricky and occasionally failing risks, so be it. If anyone is to be castigated in this case, it’s the money managers who haven’t done too well at managing other people’s money and not HSBC, or any other bank for that matter, which has completely legitimately protected its position and managed its risk exposure just as its shareholders and the regulators would expect it to. HSBC douze points; FT nul points. 

Alas, I am out tomorrow so for me at least it is that time of the week again. All that remains is for me to wish you and yours a happy and peaceful weekend. Last week we had the Lauberhorn ski races in Wengen, this weekend it’s the Hahnenkamm in Kitzbuehel. I once, in my early/mid teens, had the privilege and was mad enough to ski down the Lauberhorn race track, albeit shortened and gated for juniors but that was, trust me, quite enough for me to lightly discolour my underwear. The Streif track down the Hahnenkamm is a very different kettle of fish and perhaps the most scary and maddest thing in world sport, Marathon des Sables included. To ski that hill in anger one needs to have thighs like tugboats and an ability to switch off one’s brain before launch. I, for one, will be glued to the TV on Saturday lunchtime. Diving off that hill is a risk that cannot be hedged. Not CDS or CDO but DHO – downhill only.

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