Monday, 21 March 2011

Quote of the Day: Greenspan's reputation dead as a parrot

“Greenspan is an ex-Maestro; his reputation is pushing up the daisies, it’s gone to meet its maker, it’s joined the choir invisible.

He’s no longer the Man Who Knows; he’s the man who presided over an economy careening to the worst economic crisis since the Great Depression — and who saw no evil, heard no evil, refused to do anything about subprime, insisted that derivatives made the financial system more stable, denied not only that there was a national housing bubble but that such a bubble was even possible.”

- Paul Krugman

Hat tip: Barry Ritholtz

"You can't build a car with 97% of the parts"

The title statement summarises the challenge for the global manufacturing sector with Japan's industry and logistics disrupted for an unknown span of time.

Power shortages threaten global supply chain

Ford Motor Co., Samsung and The Boeing Co. are waiting for suppliers in quake-stricken Japan to increase one key export: information.

A top supplier of high-end components for the global technology and auto industries, Japan may need weeks to recover output lost as a result of the country's strongest earthquake on record, according to a forecast by Barclays Capital. . . .

“Our production won't be affected this week, but then we'll see,” Volvo spokesman Per-Ake Froberg said.

Supply of batteries, Blu-ray compact discs and magnetic heads used in hard drives also may be affected by the quake and power shortages, according to a report by Taipei research company TrendForce Corp.

“The reality is, the companies don't know the full extent of what's happened,” said economist Kim Hill at the Center for Automotive Research. “You can't build a car with 97% of the parts.”

Damage to ports, railroads, and factories in northern Japan has yet to be fully assessed - not least because engineers, corporate management and insurance claims adjusters have been kept at bay by radiation leaks from the Fukushima crisis-hit nuclear complex. Fuel shortages, power blackouts and disrupted land and mobile communications further stymie any effort to document damage or predict reopening schedules for stalled manufacturing plants. Rolling blackouts occasioned by damage to power generation and electricity grids mean even undamaged industries across the nation are producing less than expected. The scale of human tragedy - with half a million displaced refugees and 21,000 lives lost - mean many workers will be unable to report to work, or too concerned with rebuilding their homes and comforting their families to work more than regular shifts.

We have a highly interdependent, global manufacturing sector for modern goods, particularly high end electronics and automobiles. Japan may only account for 3 percent of the modern product, but it is usually the high value components that will be very difficult to source elsewhere. And as the title suggests, a failure to supply the 3 percent might result in halting production for the rest of the supply chain.

As this week rolls on, and the scale of disruption becomes better understood, I expect a lot of companies worldwide will start evaluating the implications for their operations of a disrupted supply chain. Without more precise information from Japanese suppliers on the expected scale of the disruption, few businesses elsewhere have been able to issue statements on the implications. As the information begins to flow, we can expect more than a few negative shocks about Q2 and Q3 earnings as inventories of parts run down globally.

So far as the media has noticed the issue, concern has been limited to supplies of the iPad 2. We may find that the implications are more serious for our economies than delayed gratification of Apple fans.

Intererestingly, the Japanese companies most directly affected are the only ones likely to be able to claim insurance for business interruption. Companies elsewhere reliant on Japanese-sourced components might have comparable losses, or even greater losses, but have no recourse except their reserves and such corporate finance as might be available in already tight markets.

Magnitude of insurance claims still almost impossible to measure

While analysts and risk modellers are daily raising their estimates of the economic damage, with the latest Barclays Capital estimate coming in at $US185 billion, many insurance experts believe it will be well over $US200 billion.

In terms of insured losses, risk modeller AIR Worldwide estimates it at $US15 billion to $US35 billion.

But some big-name brokers are quietly suggesting it could be $US70 billion, making it one of the biggest losses to the insurance and reinsurance industry.

Claims adjusters have poured into Japan in the past few days trying to grapple with the size of the damages and their clients' exposure, but cannot get near the radiation-affected area. Japanese insurance companies are also being hampered by power cuts in Tokyo that make it virtually impossible for them to appraise the damage.

A growing concern is how the tsunami is covered by general insurance policies. For example, AIR's estimates for insured losses do not factor in tsunami-related damage, business interruption costs or potential losses from nuclear damage.

Adding to the uncertainty of losses and disruption is the likelihood that insurers may contest coverage for some damage or disruption. After Katrina, many hurricane insurers asserted that their policies did not cover flood damage to properties. Similar disputes may arise in Japan where a trifecta of catastrophe has complicated claims assessment. The longer companies are kept from rebuilding and restarting production, the longer and deeper will be the losses for the industries dependent on them for their own operations, production lines and profits.

Friday, 18 March 2011

Inflation and Deflation revisited

In December 2008 I came off the fence and plumped for deflation as inevitable. Mostly I reasoned that debasement of accounting practice, mismanagement of financial intermediaries, captured regulators that collaborated in perpetuating failure, and extremely poor market pricing of risks and fundamentals meant that there was litte incentive to save and no place safe to invest. I predicted that when the last great bubble in sovereign debt popped, deflation would work its cleansing power to restore fundamentals.

It is now clear to me that policy makers in the West are determined to apply every available resource to underpinning failure, misallocation and executive excess. As this discourages the honest saver from parting with cash, policy makers are ensuring that deflation will wreak its havoc on the financial and real economies of the world. Only when that deflation has played out and rational policies that reward market-based management and returns are restored will it be worthwhile to invest again.

The Fed permitting dividend hikes at bailed out banks only deepens my cynicism about the poor quality of regulation and the inadequacy of management controls.

Obviously, I was premature about deflation as events in 2009 and 2010 proved, but I am not convinced I was wrong in the longer term. Events this week in Japan, and political upheavals this year elsewhere, have me thinking that we are at a turning point in many ways. When the numbness that follows such a mammoth series of tragedies wears off, the public in Japan is going to be very angry. They have suffered three great catastrophes in one week: the 8.9 earthquake, the tsunami that swiftly followed, and the failure of safety controls at six nuclear reactors. We still don't know the scale of the final disaster, or what it will mean for the country or the world.

The Japanese state is to be congratulated that strict building codes preserved much of the physical infrastructure from the earthquake, and regular tsunami drills doubtless saved tens of thousands of lives during the tsunami. The most serious failure was in management, risk assessment and regulation of the nuclear industry. The anger will be that an industry critical to the economy, with powerful lobbyists close to government, was able to capture its regulators and erode safety standards until a crisis revealed the tragic short-termism. The anger will increase when the Japanese come to appreciate that the serial depredations of the banking industry have left them over-exposed with few fiscal policy options to meet the financial challenge of rebuilding and resettlement of refugees.

If the government and institutions of Japan are forced to liquidate and repatriate foreign assets, then fears of rising Yen and destabilisation of G7 economies are well founded. I believe it was the collective self-interest in preserving stability that motivated today's central bank interventions. The Yen appreciated 20 percent in the three months following the Kobi earthquake, and the scale of the current disaster - particularly with the risk of nuclear contamination of some part of the country - is likely to dwarf the Kobi effect.

As radiation reaches California from Fukushima today, we might all consider that regulatory capture places us all at some degree of risk. The crisis in California sub-prime real estate was borne by the currents of international finance to the pension funds of Norway and the savings banks of Germany. Both the nuclear energy industry and the banking industry had parallel patterns of political influence leading to regulatory capture and debasement of best practice, and ultimately ruination for a suffering public. It will be interesting to see how much accountability is demanded of management and regulators in the nuclear industry in Japan, and compare this with the lack of accountabiity for serial financial failures and bailouts.

Japan has 20 years more experience of financial sector accounting abuse and bailouts than the rest of us. And the result has been almost continuous deflation - even in the face of mounting deficits, ZIRP and quantitative easing.

Another factor that leads me to fear deflation over inflation is the risk of popping of the great China bubble. My view is that the Chinese economy slowed markedly in Q4 2010 as monetary tightening and administrative regulation of bank lending began to bite, and that the slowing has accelerated in 2011. This view has been confirmed by Gavyn Davies on his FT blog. With another rate rise today by the PBOC, and the supply chain shock of Japan's industrial disruption and power shortages, we could be in for a sharp, deflationary global contraction in the next few months.

UPDATE 20/03/11: Days before quake, plant operator admitted oversight

Days before Japan plunged into an atomic crisis after a giant earthquake and tsunami knocked out power at the ageing Fukushima nuclear plant, its operator had admitted faking repair records.

The revelation raises fresh questions about both Tokyo Electric Power Co (TEPCO)'s scandal-tainted past and the government's perceived soft regulation of a key industry.

The operator of the Fukushima No. 1 plant submitted a report to the country's nuclear watchdog ten days before the quake hit on March 11, admitting it had failed to inspect 33 pieces of equipment in its six reactors there.

A power board distributing electricity to a reactor's temperature control valves was not examined for 11 years, and inspectors faked records, pretending to make thorough inspections when in fact they were only cursory, TEPCO said.

It also said that inspections, which are voluntary, did not cover other devices related to cooling systems including water pump motors and diesel generators.

The report was submitted after the regulator ordered operators to examine whether inspections were suitably thorough.

Tuesday, 15 March 2011

Sympathy and concern for Japan

Children of Adam all come from the same source,
When one is wounded, all share the pain,
He who cannot feel the pain of others,
Cannot call himself Son of Man.

- Saadi

Thursday, 3 March 2011

Insurance and Banking: Risk, Resiliency and Harmonisation

I attended an interesting discussion of risk management in the City this week, bringing together insurers with bankers. The two sectors manage risk quite differently, which is why there are rarely insurance crises and frequently banking crises. Insurance crises tend to occur when insurers act like banks (AIG Financial Products, MBIA and other monolines). Bank crises tend to occur when banks act like investment banks.

Insurers must not underwrite risks that they will not be able to cover in the event, and must therefore have reserves sufficient to perform at all times. This makes the insurers much more cautious about taking on risk, about pricing risk accurately at the time of contracting, and about managing reserves to be liquid when claims require payment. Regulation is fundamentally about solvency and selling.

Banks undertake risks on their books that they can only cover so long as they continue to have access to liquidity (funding, deposits, repos or central bank support). Bank capital is never enough to ensure performance without market liquidity for reserve assets. Banks are generally much less cautious about taking on risk, rely overmuch on incomplete models to price risk, and manage capital to optimise returns rather than ensure survival. Regulation focuses on capital (never enough on its own) rather than conduct, common sense and functional suitability.

One risk manager observed that in insurance the risks are exogenous, generally independent in occurrence, and finite. In banking the risks are too often endogenous, correlated in unpredictable ways, and of unknowable magnitude. As a result, a single bank failing has systemic consequences for the banking system, where a single insurance company failure has no systemic consequences for the insurance sector.

An interesting observation both insurers and bankers agreed on was that international harmonisation of regulation had driven formerly diverse business models and management preferences toward uniformity by enforcing preferred models for capital and solvency. As a result, the risks of total systemic failure are much, much higher than before Basel II and Solvency II, because when the models are wrong, the whole financial system is compromised.

Models are always wrong because they are partial, approximate, and use historic data and correlations. In internationally harmonised regulation, the failure of models is even more assured as many domestic factors which have great implications for financial risk are ignored or discounted. Quite simply, models are illuminating, not correct.

What this means is that the 25 year drive to harmonise regulation using financial models is almost certainly counterproductive if the aim was to ensure wider financial integrity and stability. Instead of a global financial system constructed as a spider's web, such that the breaking of one strand does not compromise the whole web, we have a system that has bound all the threads into a single cable. And if that cable frays under stress . . .

There was controversy around the idea of functionally segregating the pedestrian but systemically important functions like payments and mortgage intermediation from the riskier eccentricities of modern of investment banking. About half the room thought it perfectly sensible, and half thought it couldn't be done. I'm of the view that "narrow banking" for some functions might be a very reasonable way to secure the taxpayer from future losses by reducing the scope for contagion in the banking system. And if we could do that, we could allow bad banks to fail, restoring some morals and some hazard to the management of banking.

Wednesday, 2 March 2011

Sap rising, a new job and the NHS

I’m starting this month mildly optimistic. Those who have laden our societies with inequality and our economies with debt are being repudiated wherever the public is permitted to speak or vote. No longer dulled by panic, policy makers are realising there are other options than doing as they are told by their bankers, and their duty to their enraged public requires them to at least evaluate other options before caving into further banker demands. Emboldened by examples of bravery and solidarity in the Middle East, many publics are re-evaluating their relationship to the state and the service they receive from their political elites, and then finding a new voice to demand better.

The corrupt political machine that surrendered Irish sovereignty to a more corrupt banking system has been voted out of office. Denmark has allowed a bank to fail, imposing real losses for the first time in this crisis on bank bondholders. The governor of Wisconsin is being reminded that he works for the people of his state, within the bounds of its constitution and its laws. Signs of a shift toward accountability perhaps? It is spring, and I choose to hope.

I am in England, where a fine mist softens the air and birds sing in the budding trees outside my window. Contributing to my good humour is the imminence of a new challenge that will not require me to travel further than central London. I spent much of the autumn looking at the world, looking at my country, and searching for a way to make a difference here at home that will endure as a lasting contribution to economic stability. I have been fortunate enough to identify such a role, seek appointment, and be given the chance to fulfil my aims. It will be another adventure, but one I pursue in familiar surroundings and among friends.

Wish me luck.

And now a word about healthcare, a subject I rarely write about. I saw a chart at Wall Street Cheat Sheet this week that forced me to realise how blessed I am to be British. If I were an American, I would be shamed by this - especially when more than 30 percent of citizens have no entitlement to healthcare.

Here's an example of what I get for the money spent on the NHS.

In December I received a form letter from the NHS (National Health Service) saying that the time had come around again for a routine diagnostic procedure to detect a condition fairly common to people my age. It was the run-up to Christmas and I did nothing at the time. Yesterday I received a reminder that I had not had the test, urging me to schedule it. My GP (general practitioner doctor) is at the surgery (doctor’s office) on the high street five minutes’ walk from my door. I called the surgery’s appointments line, and the friendly receptionist gave me an appointment for later in the morning. I showed up, was seen within five minutes, and back home twenty minutes later. The doctor was even happy to chat about another minor matter that had been on my mind. The test results will be sent by post within two weeks. This was as easy, convenient, stress-free and professional as anyone could ever wish. And no one ever mentioned money.

The NHS is one reason why there is unlikely to be a revolution in Britain. Each of us living here can actually see the benefits of having a government that provides for the people in the ways that truly count. I never have to worry about whether I can afford a medical procedure. When my children are sick, they are seen quickly, often the same day. I can get urgent care 24 hours a day. I have even been pleasantly surprised by a Sunday house call. When I took my children to the emergency room (long ago now), they were seen and treated with all the professionalism and concern any loving parent might wish. All of this is provided by my government, and I never worry even for a moment about the cost. As a taxpayer, I enjoy a tangibly better life because my government provides for my care and the care of my family whenever it is required.

The NHS is far from perfect, but it is a great deal better than any insurance-intermediated system I could imagine. And it is infinitely better than no insurance and no entitlement to healthcare at all.

Not all taxes impoverish me. Some of what I pay enriches me too.

I've just received a form in the post to permit me to register for patient management over the internet. I'll be able to book and change appointments online with my doctor or other doctors at the surgery, and I can request prescription renewals. This is my NHS delivering value and efficiency to me as a taxpayer, and I am again grateful.