From stock to flow- the Enron story repeated

I have a sense of deja-vu. In early 2001, I joined Enron Broadband Services only to leave after a couple of months, shocked at a company culture that had an unhealthy focus on accounting earnings above any other consideration. Three months after my resignation, the company filed for bankruptcy in the largest case of its kind in history. Essentially, the company had booked uncertain future earnings upfront through the use of clever accounting structures, which kept the debt-fuelled growth off-balance sheet. When the uncertainty turned into reality, the whole structure unwound in record time.

Today, it is happening all over again, in what the press have incorrectly dubbed the "sub-prime crisis". Sub-prime loans are only the tip of the iceberg in a business (financial intermediation) that has changed dramatically in the last 15 years. I have been employed in the financial services industry for that time and have been intimately involved in many aspects of that change.

When I started in banking in the early 1990s, the business was all about prudent use of funds which were primarily backed by depositors and a capital base. The philosophy underlying lending was that "we were handling other people's money" and, as such, we had a fiduciary duty to depositors. In addition, any losses would first hit the limited capital base of the bank. Annual profits were predictable, since the prevalent accounting systems would ensure that returns would accrue over time, as the loan portfolio amortised over time. Given capital constraints, new lending was limited to available capacity, which freed up as the loan book matured. In summary, banking was a solid, stable and conservative business in regulated environment (much as Enron's gas pipeline business had once represented).

In the early 1990s, the concept of securitisation was developed. In essence, this entailed the repackaging of loans from bank balance sheets and their subsequent so called "true sale" to investors in exchange for an origination fee, which was booked upfront. Appetite for these securities was supported by institutional investors' demand for fixed income assets, themselves fuelled by favourable economic conditions and the growth of private pension systems. Initially, this business was a small niche which allowed banks to selectively originate loans beyond what their capital base would allow. It also meant that the profit made on a portfolio of loans could be booked upfront on its sale, instead of accruing over time while it matured in the banks' balance sheet.

The traders and investment bankers in banks realised that by changing the banking business from "stock to flow", much larger origination volumes could be underwritten and offloaded ("distributed" in the industry jargon) to investors via securitisation and syndication of loans. Furthermore, and, in order to address investor bases concerned with long tenors and liquidity, special vehicles were created which would issue short term commercial paper to fund long term paper. When traditional investors found themselves full of this asset-backed paper, banks would encourage more aggressive investors (such as hedge funds) by lending them money to buy the instruments they had originated. Huge profits were made as revenues were booked upfront, but the stability of earnings once provided by accrual accounting was foresaken.

As a result, bankers in the late 90s and early 00s were incentivised to focus exclusively on loan quantity and not quality. The mantra over the last couple of years in front office areas has been to originate, originate and originate. Damn credit quality- loans would be offloaded anyway.

Gradually, banks' balance sheets started to accumulate loan inventory that was designed to be temporarily warehoused in anticipation of future sales to investors, as well as loans to investors who would themselves buy the offloaded paper. Also, off-balance sheet liquidity commitments were provided to commercial paper vehicles to guarantee to investors that liquidity would be forthcoming, in the "highly unlikely case of a liquidity crisis occurring". Of course, as these commitments grew, so did the likelihood of such an event occurring.

Then came the summer of 2007. Investors realised that the quality of the underlying loans had become so poor ("ninja loans" or loans to borrowers with no job, no income, and no assets being just one example) that no amount of financial structuring could compensate. Also, asset prices (primarily property) fuelled by this indiscriminate lending had stopped rising. Investors stopped buying new securities and renewing commercial paper, and the "virtuous circle" created by the move from stock to flow turned into a vicious circle.

Banks suddenly found they could no longer sell what they originated. Furthermore, they were stuck with inventory whose poor credit quality they were only too aware of. Market prices plummetted. Their inmediate reaction was to hoard cash in anticipation of future credit problems and obligations to fulfill liquidity commitments provided to commercial paper vehicles.

The consequences thus far have been twofold: first, a liquidity crisis has ensued as banks are forced to fund special purpose vehicles at a time when the interbank market has dried up, and; second, an asset credit quality debacle has occurred as banks are stuck with loan inventory of poor credit quality that they never intended to keep in their balance sheet.

However, this crisis will have longer term consequences. The stock to flow model has been questioned and future profits are likely to be lower than recent ones. Sub-prime loans are only the first in a pyramid of loans that have been granted with little or no regard to willingness or ability to pay. Credit cards, car loans, LBOs and other leveraged loans are likely to come next. The almost limitless and reckless lending which we have seen and which has fuelled much of recent economic growth will dramatically slow down.

A moment of reflection here. Note that poor quality assets are still in the system beyond those reflected in banks, mainly in pension funds, insurance companies, mutual funds and other unsuspecting investors who are investing savings of the general public. Once the music in the game of musical chairs stopped (to paraphrase Citigroup's haplesss former chairman Chuck Prince), the whole house of cards started to collapse.

So, we find ourselves in a position similar to the one experienced in the Enron debacle, except on a systemic scale. Fomer accounting and rewards systems designed to make a sensitive and strategic industry conservative are replaced by a system which incentivises speculation and risk- from stock to flow or from caution to greed.

Orwellian Regionalism in Catalonia

I have just moved to Barcelona, in Catalonia. I love it here- the weather is great, as are the food and the people. However, something is not quite right. One of the first things that struck me, as a non-Catalan, is the amount of energy spent in proving that Catalans are different. Different from what? Different from the rest of Spain, primarily. It is almost as if Catalans (or a certain sub-set) define themselves by exclusion, i.e. by what they are not, instead of what they are.


As a consequence, in a great number of the social events that I have attended, the issue of Catalonian politics has come up as a major discussion topic. Inevitably, the conversation starts by someone asking me how I have settled in and is then followed by long tirades explaining why my perceptions are manifestly incorrect. This is something that I have not experienced in other discussions, with the exception of the Israeli-Palestinian conflict where one or the other affected party was involved.


I think that a certain part of Catalan society relies on a sense of grievance (real or perceived) to justify a series of actions that would not be reasonable under normal circumstances. Given this "persecution", legislators feel compelled to enact discriminatory legislation which limits personal freedom or eschews meritocracy by valuing nationalist credentials above any other criteria. As a result, regional governments spend a substantial part of their budget in working against central government initiatives instead of cooperating with them. Witness the creation of Catalan cultural institutes, development banks, sports federations, foundations and other "duplicated institutions" which lead to a shameful waste of resources. Given the pervasiveness of regional government intervention, the emphasis on knowledge of the local language above other technical criteria is leading to a society of poor technicians with strong language skills.


In my opinion, the current political situation reflects poorly on a region of Spain that was known for its common sense, its love of freedom, and a flourishing entrepreneurial class. The bureaucrats must learn to encourage personal and economic freedom by using their resources to do just that instead of attempting to duplicate what the central government is doing. One of the competitive advantages of Catalonia is that it is probably the most attractive region in a country of 44 million people and a focus on the similarities as opposed to the differences would undoubtedly lead to a more competitive approach to the challenges posed by globalisation.


Mind you, this is not an exclusive problem of Catalonia. The excessive decentralisation of the Spanish government has led to some autonomous regions depending almost exclusively on regional governments for economic development. Andalusia is a well-known example. Catalonia is heading the way of Andalusia by depending more and more on government hand-outs and less on private initiative. The irony of this state of affairs is that twenty years ago the aspiration of many poorer regions such as Andalusia was to converge with Catalonia...today it seems as if Catalonia wants to converge with Andalusia.

Immigration? Yes! But Let's Be Smart About It

One of the social and economic issues facing Spanish society today is that we like to enjoy ourselves...maybe too much. We are not having enough children to replace populations in our societies. On the other hand, we also live in a society where there is relative economic and political freedom, and, as a result, there has been a tendency to "import" people from more populous countries who come to our own looking for the economic freedom which they lack.

However, I believe that Spain and many other developed countries are going the wrong way around this problem, and, through flawed immigration policies, are importing not only people, but also the social problems from their countries of origin.

In Spain, for example, most immigrants are unskilled workers who come to do jobs that Spaniards will not do at the price that Spanish entrepreneurs are willing to pay, mostly in the services industry. What does that mean?

In my opinion, all this means is that Spanish entrepreneurs have found a class of worker who is willing to work for a wage that Spaniards will not work for, though there are plenty of available Spanish workers. Immigrants work longer hours, have less social benefits, and pose less problems than a "first world worker". The argument in favour of this state of affairs goes that if we did not engage in importing unskilled workers surely Spain would suffer given competition from lower wage countries.

This argument is manifestly flawed. The industries that cheap unskilled workers are involved in are eminently non-tradable, primarily construction and tourism. You cannot trade a coffee in a bar in Majorca or a block of flats in the coast of Spain with China. Therefore, the benefit of cheap labour accrues mainly to the entrepreneur...notice the boom in wealth derived from residential construction and the service industry in Spain.

On the other hand, Spanish society has to bear the costs implicit in paying people a wage which is below what local or European citizens would work for. Remember we are talking about unskilled workers from emerging markets. In general this are people with little education, few democratic or liberal values, fundamentalist religious beliefs, no family connections in their host countries and, in many cases, imported health burdens. These costs have to be borne by Spanish and European welfare systems. Take a walk around a public hospital or school if you don't believe me...

So, first message: when we import unskilled workers to serve in non-tradable sectors of the economy, we are also importing the social problems of their countries of origin. The benefits accrue to the entrepreneurs in these sectors while the costs are spread across society.

At the same time, however, it is incredibly difficult for skilled workers to obtain legal permits to work in Spain. I read a case in Expansion newspaper two days ago of two Japanese biotech researchers who, in view of the long delay in obtaining their visas, and under encouragement from the Spanish subsidiary of a Japanese company, worked in Spain under a tourist visa, only for them to be fined by the tax authorities for fraud. They eventually got their visas, ten months after the request, and some months after they had returned to Japan. This type of immigration benefits tradable sectors of the Spanish economy and society as a whole, yet because these immigrants traditionally respect immigration laws, they often find it next to impossible to come and work in Spain.

To conclude, unskilled workers are coming in droves, ignoring the legal requirements to work in the country and importing their social problems while benefitting a minority of the Spanish population. On the other hand, skilled workers, who usually respect the legal requirements to work, find it increasingly hard to work in Spain where they would work in tradable sectors which would benefit Spanish society as a whole.

Are we mad or what?

Raise Your Hand If You Think Inflation Is Dead

Yes, the chickens are really coming home to roost. Yet there is one chicken we have not heard much from lately and her name is "Inflation".

Official statisticians would have us believe that inflation, as measured by CPI, has been under control for many years, but you only have to notice a few tell-tale signs to predict that it is paving a way for a glorious re-entrée.

One of the strongest points in favour of globalisation was that it permitted the export of disinflation from low production cost countries to high production cost countries. The latter's governments have been extremely quick to take advantage of this by hitting the print button on the money machine faster than ever. Under normal circumstances "too much money chasing too few goods" would lead to an increase in the price of the latter. However, with China and India making many of those goods, the inflationary impact of an expansive monetary policy has been offset by lower production costs. Many consumer goods have experienced little inflation over the last 10 years or so.

But what about non-tradable or non-traded goods, such as real estate and local services- restaurants, housekeeping, and some agricultural products. Have they followed the same path? My hypothesis is that they have not and, in fact, asset price inflation has been on the rampage, only mitigated by the expansive monetary policy (i.e. low interest rates) which has made financing these assets historically cheap.

Thus, you have a combination of cheap consumer goods and expensive non tradable assets financed by cheap debt. It is obvious that such a combination cannot be sustained indefinitely and there are signs that the "times they are a changin' ". Disinflation from China and India seems to have run most of its course. There are limited productivity gains and increased wage pressures in both countries which will eventually lead to inflation. The maxim of "everything that China buys will go up and everything that China sells will go down" cannot hold for much longer.

The boys and girls in the central banks are not doing their job either. Faced with irate politicians that are scared of bursting the bubble, they have not increased interest rates enough and are, in fact, lowering rates as we speak. After all, inflation is a tax that is borne by many and therefore attributable to indefinite and nebulous causes. Bubbles bursting are sharp and painful and the victims loud and influential. Try guessing what the politicians choice will be.

I recommend the following article by Spanish professor Trías de Bea- a genuine gem:

http://img219.imageshack.us/img219/1134/triasdebescopiahb4.jpg

My prediction is that tight trousers with bellbottoms and over-size collar shirts are back. Yes, dust off those wide ties and lacy shirts- the 1970s with their glorious stagflation will soon be back in vogue.

Ladies, gentlemen...prepare for landing.

And the chickens come home to roost- Real Estate Fiesta in Spain (II)

OK, if you've read the first blog you are probably wondering how and who is paying for the "Fiesta". After all, Spain was a relatively underdeveloped country in the 1980s and now it boasts a AAA/Aaa3 rating from the rating agencies (more about these later) while the BMWs and €500 notes are prominently in display.

The simple fact is that Spain as a country is addicted to debt. It has been running a current account deficit for years, as large in percentage terms as that of the US economy. The rest of the world, especially those countries with ageing populations, has been financing that deficit, as retirees and their trustees (pension funds and other institutional investors) look for places to invest their money. Individual Spaniards cannot, of course, borrow money from the Netherlands or Germany...this is conducted through the "oil that greases the economy"; domestic financial institutions.

The growth in assets of the Spanish banking system over the last ten years has been astonishing but more so has been the net production of loans. What do I imply by this? Not all loans, and especially mortgage loans, are kept on the balance sheet of banks. Most are packaged and on-sold to the trustees of those Dutch and German savers in the form of residential mortgage backed securities or covered bonds. In effect, Spanish financial institutions act as a mere conduit between non-resident savers and domestic borrowers. The lenders, via their trustees, are happy to buy these financial assets because the are highly rated by rating agencies- above investment grade in their jargon. This rating relies primarily on two aspects: (i) loan to value; i.e. how much debt to the appraised value of the property and (ii) debt servicing ratio; i.e. how much of the family income is consumed by the service of such debt. But, if you believe, as I do, that the "value" has been artificially inflated and that a great deal of the income of Spanish families is directly and indirectly derived from the construction and real estate sectors, themselves fuelled by cheap debt, then doubts begin to emerge about the credit quality of such financial instruments.

So why have investors not shunned Spain and taken their money while they can? For one, Spain is now within the Euro-zone. Prior to the introduction of the Euro, investors did just that on a regular basis; witness the devaluation of the peseta in 1994 after the previous real estate fiesta finished. Another important point is that the world is looking for borrowers; many countries are net savers and debt addicts such as the US and Spain are in high demand. Savings, after all, have to be invested.

Yet the chickens are coming home to roost. In the US, investors have finally realised that, as interest rates have risen, the value of the paper they were financing was not what they thought, given that an increasing amount of borrowers were now facing difficulties to service their debt. As a result, they have sold these assets and their price has come down. As the price falls, the loan to value covenants in many of the vehicles which finance these residential mortgage backed securities have triggering further selling. And so the cycle goes on. Furthermore, many of these vehicles were also funded by short term renewable money market loans also known as asset backed commercial paper. Of course, investors have also shunned this type of investment, leading to draw-downs under liquidity facilities provided by banks which were in place precisely to face this situation. But no one expected that they would be drawn all at the same time...which is what has been happening lately in financial markets.

So, remember those loans which the banks happily offloaded via securitisation? They are now back on the balance sheet of banks who had long forgotten about them. And yes, the banks need money to fund those drawn liquidity facilities. Yet, as the whole system faces increased liquidity requirements, few banks are willing to lend to each other, either because they expect to need the liquidity themselves or because they know that the assets which have been recently reacquired are not of good credit quality.

What does this mean for Spain? Well, everyone is focusing on the US and some of those German investors at the moment, but it is just a question of time before someone starts pointing a the "little US"- Spain. Unlike the much larger and monetarily independent Americans, Spain cannot devalue its currency to share the pain with its lenders (note what the US dollar has been doing lately). My prediction is that there will be a strong credit crunch in Spain over the coming years as banks try to sort out the mess implicit in those mortgage portfolios of recent vintages (aged mortgages usually have much lower LTVs). And then it will be time to pay for the fiesta, not with additional debt, but will real income...time to turn in those €500 notes and sell the BMWs.

The largest scam in modern history- Real Estate Fiesta in Spain (I)

I moved back to Spain from the USA in March 2003- over four years ago- with a view to buying a house and putting a foot in a country that I enjoy living in tremendously. Back then, I was shocked to find that prices per square metre were around EUR 6,000 in good areas of Madrid (Chamberí, Chamartín, Centro, etc.) and even more in the exclusive neighbourhoods of Salamanca, El Viso and La Moraleja.

In any case, I had a good job working for a bank, had saved some money after ten years working, and thought that I needed to settle down. I purchased a 60 year old 55 sq.m. apartment in the Chamartín area of Madrid for EUR 300k (of which only 250k was declared- the rest was paid in cash). At current exchange rates that was c. USD 450k for an apartment in Madrid! Not London, nor New York, nor Tokyo!

Anyway, I had just landed in Spain and was fairly naive as to how the Spanish economic miracle was being wrought. Gradually, and mostly due to my work (large corporate banking) I was able to gain some insight as to how some of the real estate and construction companies were performing the largest scam in Spanish economic history with the connivance of politicians and political parties.

It works like this, you see. Spain is a "democracy" which is run by political parties, not individual politicians. The latter's influence is solely determined by the extent to which they are able to influence the party they adhere to. It is normal, therefore, that once a politician comes to power he or she owes a debt of allegiance to the party that placed them there. Elections are, after all, expensive to run, and their success is largely driven by spending power.

Since legal funding for parties is limited by law, alternative (illegal) funding sources have to be found. An easy route is to use political power to change the zoning for certain plots of land. By decree, a local council can change an almost worthless plot of agricultural land into an urban plot worth exponentially more. This, of course, comes at a cost (bribes) which is paid to the politicians who in turn use the funds to pay their debts to the parties (and skim something along the way).

An extension of this little trick is the concession regime for public private partnerships, whereby a certain consortium gains the right to exploit a public good (motorway, waste treatment, airports, etc.) for a limited amount of time- in exchange for a "contribution" of course. This was particularly poignant in the Catalan region, where a 3% fee was the standard ticket.

Coming back to real estate; you may ask: how do the beneficiaries of the new zoning come by the large wads of cash (the EUR 500 notes which are notoriously abundant in Spain)? Well, the owners develop the land and sell the finished product (usually flats) for inflated prices, a part of which is settled in cash, outside legal settlement procedures. This whole game explains why buildable residential land in prime areas can cost up to EUR 12,000 per square metre- in a country with a low density of population and in some cases, like Madrid, with ample geographical expansion space.

On the demand side, the Spanish population has been blinded by the artificially low interest rates that were available during the 2003-2005 period, mostly due to the slump in Germany. Most mortgage loan borrowers only look at the monthly payment, regardless of how much they pay. Thus, they sign up for mortgages and happily take up to 40-year debts which they will pay when they are in retirement homes or pass on to their children as an inheritance.

Therein, lies the scam; millions of Spaniards taking on billions of mortgage debt to pay for artificially high residential real estate which is to be repaid over decades while being egged on by the retail banks, low interest rates, and greed fuelled by an irrational belief that house prices will increase indefinitely.

The reason why this scam has not reached public awareness is that there is limited interest in disclosing this. Think for a minute- the state collects taxes from the real estate transactions (barring the cash part of the transaction), politicians become immensely wealthy, parties are able to fund increasingly expensive elections, a belief sets in that real estate will increase forever, and consumer good providers prosper. Meanwhile the poor mortgagee doesn't realise that he or she is funding this corruption because the bribes implicit in the inflated purchase price of the house are spread over 25-35 year periods

Maybe the above will also provide some insight into the following questions
1. Why is Spain the EU member with the largest amount (in absolute and per capita terms) of EUR 500 notes in circulation?
2. Why do you see so many new BMW, Aston Martins, Mercedes Benz, Bentleys in large urban areas of Spain?
3. Why are Spanish companies in the construction sector purchasing electric utilities and other utility type companies outside of Spain?
4. Why are Spanish real estate speculators landing in droves in Romania, Poland and Bulgaria?
5. Why is a normal dinner EUR 60 in Madrid, which is more expensive than New York City?

As you reflect, keep this in mind. In 2006, a 30 year Ponzi scheme consisting of investments in postage stamps finally collapsed (Forum Filatélico Group). This time around the damage will be far more serious.

Interested in 100 sq.m. flat in a reasonably good area of Madrid for EUR 600k (USD 800k), anyone?