KnowledgeFarmer.com

“I wish you to live in the interesting times”, goes the old Chinese course. In times when there are fundamental realignments of interpersonal, economic, social and international relations. From psychological point of view, those realignments are very important, as the tendency of man is not to change something if it works. The only time that something needs changing, improving or fixing is when it is broken.

Crises enable us to reflect, to identify the elements that caused it, and work towards eliminating or modifying those same elements.

If there are too many of such elements, or they are such that they would fundamentally change the product or activity, sometimes this activity has to be discontinued, or rebuilt again on stronger foundations and by keeping the new facts in mind.

If the crisis is strong enough, we quickly start examining the strength of foundations themselves. Then, we examine if the axioms and assumptions on which we have built the foundations still hold true, and whether they should be adjusted accordingly. Every now and again it happens that the foundations lay on so far outdated foundations that in order to move forward, those foundations need to be demolished and rebuilt from scratch on new assumptions. Such examples were the French and October revolutions.

The fact is that today we are at one such breaking point. We realise that some things are fundamentally wrong. We can only hope that the things can be adjusted without demolishing the foundations, as when the old foundations crumbled, and the new ones have arisen to prominence yet, there is Chaos. Chaos is necessary for the Catharsis of mankind, but can be very painful from the point of view of individual person, as people lose the anchor on which their whole life was based.

Chaos happens also when the foundations for decision making are destroyed. One of such events happened when, under enormous political pressure, American agency for accounting standards, agreed that the banks can keep their losses off their profit and loss statements if they claim that they do not intent to sell underlying assets at current valuations. Even more, they are allowed to include those assets in their capital at full value. This can quickly bring the crisis of trust, as capital is sort of warranty that enables bank to cover certain degree of losses. If market value of this capital is considerably lower than the book value, then in case of liquidation, all indicators are wrong as they do not account for the case of liquidation.

After adjusting to new accounting rule, most of the big banks have published profits amounting to a few billion USD each. At the same time, US Treasury is stalling with the publication of the results of the stress test. If there would be even a glimmer of hope that the banking sector is solvent, the treasury would rush to publish the results and calm the markets. Since there is no such hope, we can see slow, drop by drop release of methodology and incomplete disclosure of data, which will happen in may, at least a month after the conclusion of the tests.

It is quite possible indeed that we will also witness an explanation, which will inform us that we had understood one of the rules too strict and that this criteria meant something completely else. After such a “massage” of criteria, we will see that apart from small exceptions (which will remain undisclosed), most of the banking sector has successfully passed the stress test.

Frederick Cannon, an analyst of KBW, claims, based on simulated in-house stress test by KBW, that the US banking system needs at least $1 Trillion ($ 1 000 000 000 000) of additional capital. Many analysts are convinced that if we use strict interpretation of criteria, 16 out of 19 banks would fail.

In an independent world, monitored by an independent regulator, publication of enormous profit, followed by capital raising exercise to cover the losses would immediately send the alarm bells ringing. Even if we leave the moral questions aside, logic claims that those two data are either un-comparable (due to methodology) or that one is an outright lie.

Such “data massage” should cause extreme concern with the majority of investors and cause that they, as rational beings, withdraw from the market due to lack of trust in the data provided.

This is an English translation of an article by Mitja Sadar that was published, in Slovenian, in the leading Slovenian Investment Magazine KAPITAL, on 27.04.2009. Original article is available at the following URL:http://www.revijakapital.com/kapital/poslovnefinance.php?idclanka=6695

Politicians are, in a hurry to decrease swelling budget deficits, seeking new and new taxes and clamping down on tax heavens. The issue of taxation went that far that every citizen of Slovenia is taxed at least twice on the same money. First, at the source when he earns money and pays income tax, and then, at the point of consumption, when he pays VAT on whatever he spent (and the money he spent had already been taxed via income taxes). But, since during the credit crunch, budget shortfall keeps increasing dramatically, we can see new taxes, excise duties, environmental compensations and “voluntary contributions” whose sole intent is to close or at least decrease the yawning budget gap.

But still, compared to the UK, we have been quite lucky. On top of all the other taxes, they have the Council Tax, a tax for the right to live in a property, which costs between 1000 and 2000 Euros each year, depending on the property value, and goes straight to the council budget.

While, on the other hand, most of the politicians keep on forgetting that budget deficit can be decreased not only with increased taxes, but also with decreased public expenditure. There is a way to decrease the expenditure, while at the same time increasing the amount of money available for given service.

With the tax relief on voluntary donations to particular non-profit NGO’s the state can efficiently and on the basis of market mechanism transfer most of social and health services to such non-profit NGO’s, while at the same time decreasing its own expenditure on the services and increasing the total pool of money available for those same services. It only takes a few short steps. First, the state needs to prepare a public tender for the provision of service, limited to non-profit NGO’s. The state then transfers to them their obligation to fulfil government goals and guarantees them the minimal resources to fulfil them (those minimal resources shall be no bigger than the current expenditure). At the same time, the state shall publish the tax relief for voluntary contributions to organisations that won the tender (has to be more than 1 to ensure competition). This would encourage citizens to donate money to such organisations. Since the income from the donations is higher that the lost income from lower taxes (since we luckily do not have 100% taxation yet), the state saves money, as it does not have to pay for the services if NGO’s raise more than minimum in donations, while there is more money to improve the quantity and quality of the service. If we enable more non-profit NGO’s to compete in the same field, this introduces the efficiency of market mechanism into the equation, by automatically channelling donations towards the highest quality provider. We can add that later on the state recoups most of the money that it lost as a consequence of tax relief, in the form of VAT receipts on the total amount of donations, higher wage taxes and higher taxes on profits from suppliers of those NGO’s.  This mechanism thus enables the state to lower expenditure, increase the quality of services and increase tax collection. We can quickly see that this is a WIN-WIN situation.

This does not mean that taxes should be eliminated altogether, as we need the state to ensure law and order, enforcement of legislation, protection of competition and protection of external borders. On top of it, we need different government department that are responsible for setting the strategy in education, health and social policy, while the tactical implementation is better of being done in private sector, supported by donations.

This is an English translation of an article by Mitja Sadar that was published, in Slovenian, in the leading Slovenian Investment Magazine KAPITAL, on 27.04.2009. Original article is available at the following URL:http://www.revijakapital.com/kapital/poslovnefinance.php?idclanka=6696

In the last month, we have heard a lot about quantitative easing, a method that is currently being used by central banks of Japan, England and USA to combat the credit crunch. Japan first tested the method during their lost decade. Lately, European Central Bank has come under a lot of pressure from analysts who claim that it is falling behind the curve and failing to rescue European economy by quantitative easing. Main goal of the method is to increase the amount of money in circulation and thus start inflation, which will then send the information to producers that certain goods are in short supply, thus needing increase production, so they will employ more people and increase economic growth. Latest increase in the SDR, agreed during G-20 has similar goal. SDR is a virtual basket of large world currencies.

What is Inflation and why do we want it so much?

If we increase the amount of water in the lake, without widening the lake, the level of water is going to increase. Money works the same way. If we increase the amount of money, without increasing the amount of goods, level of prices will increase. Money starts losing value, prices of goods are increasing. The biggest losers of unexpected inflation are the savers, while the biggest gainers are the spenders, as the goods cost more and more. This adjustment is short term, but in high inflation can be very sharp. Then, people adjust and start expecting inflation.

When inflation is expected, people adjust and include inflation in their plans. Business people see that their product is not competitive, but they calculate that at current inflation, it will be in three years, so they invest today to lock in today’s prices. If they save, it will cost them much more in three years time. Consumers do not want to stay behind and watch the inflation eat their earnings, so they rush to the shops and spend it all, as tomorrow they can buy less with that money. In the short term, this increases the economic growth, as people spend the majority of their income. Long term effects of inflationary growth can be observed in the case of former Yugoslavia, where everybody lived happily in the short term, buying property on loan that was quickly worthless, and enjoying inflationary growth.

What about deflation?

Deflation is just the opposite. If the amount of money decreases or the quantity of goods increases, the level of prices decreases as well. The main gainers during unexpected deflation are the savers, as their savings are worth less, while the main losers are spenders. Deflation thus increases savings which in the short term depresses economic activity. This means that in the short term, there are more unemployed and less tax receivables for the state, which causes problems to the state budget.

Is there a middle way?

The answer is yes and no. There is no method that would keep all the prices at the same level all the time. And it is neither desirable. There is a way to keep the real value of the money that would send entrepreneurs reliable signals regarding the relative rarity of goods. Currency whose amount is fixed and unchangeable is the solution that sends such signals. If we are producing too much of goods A, their price will fall and people will start removing the capacity to produce those goods. Analogously, is we are producing too little of goods B, their price will increase, thus encouraging the people to invest more in producing the goods B.

The way to keep the quantity of money constant and thus keeping the value of money is the same as with the publicly traded companies. If the quantity of shares outstanding is constant, shareholders keep all of the excess value that the company creates, so they are worth more. If this company issues new shares, it has partly diluted old shareholders, especially if the old shareholders have purchased shares at a higher value that the new ones, so there is less of excess value created by the company left for the shareholders. Nobody is encouraging publicly traded companies to keep on issuing new shares year after year. On the contrary, shareholders are avoiding them. Yet the countries are doing exactly that with their currencies.

Throughout history we can see that only real excess value (savings) can be the basis for sustainable economic growth and economic development. Any other growth, such as inflationary or credit based growth, has quickly been proven to be unsustainable, as people have been spending the excess value on unnecessary goods and thus have been destroying the foundations for the economic growth. If the quantity of money is stable and unchangeable, there is no danger that the country or the central bank will, by increasing amount of money in circulation, inflationary dilute our savings. This security increases saving and, in the long run, sustainably increases economic growth.

This is an English translation of an article by Mitja Sadar that was published, in Slovenian, in the leading Slovenian Investment Magazine KAPITAL, on 14.04.2009. Original article is available at the following URL:http://www.revijakapital.com/kapital/poslovnefinance.php?idclanka=6654

I am sorry, so sorry that it happened that way, despite the fact that I have done nothing wrong. The mortgage meltdown in the USA is responsible for all the troubles of RBS. I am sorry it happened. The takeover of ABN-AMRO was a mistake, but not due to any wrong decision, but because later the markets collapsed.

This is a summary of the response of Sir Goodwin, former manager of RBS, as to what he thinks about the reasons for crisis, in front of the Treasury committee. RBS has grown with aggressive takeovers to become one of the leading players in world financial markets. Their last big takeover was a purchase of ABN-AMRO just before the collapse. It is now owned by the UK government (it has a stake of 58% with options for up to 70%), without whose help it would have collapsed entirely.

The responses of other banking representatives were strikingly similar. It even went so far that the president of the committee asked them if they are sorry because they feel that way, or because their PR managers have suggested that. They all have emphasised that all of their bonuses are invested in the stocks of the banks and that they are one of the biggest victims of the meltdown.

The highest unemployment in the last 10 years

Credit crunch in the UK is getting stronger and stronger. At the end of December, there were 1,97 million unemployed people. The number of unemployed is increasing rapidly and it is quite possible that it has breached 2 million already. Almost daily, we can see reports of new lay-offs, so we expect the number to grow. It might even reach 3 million people.

Ed Balls, former adviser to Gordon Brown has said that the depression is the worst in the last 100 years, and that it will be deeper than the Great Depression of the 30’s.

On Wednesday, British statistical office has, controversially, for the first time in its history published that the number of foreign born workers is increasing while the number of local workers is falling. This has added fuel to the protectionists which demand from Gordon Brown to fulfil his pledge “British Jobs for British People”.

The negative attitude towards foreigners is increasing, especially in the industrial north, where there are currently quite a few ongoing strikes against foreign labour on British construction sites and oil fields. We can only hope that those responsible will manage to calm the situation before it explodes.

Fortis shareholders have said NIET!

Fortis shareholders have, by a slim majority, rejected the sale of Fortis, which was published in September. This is a big win for the shareholders, who were long fighting against the decision of the state. The assembly was called after Brussels appeals court ruled that Belgian government had no authority to sell the bank without consulting the shareholders, despite the fact that without that intervention, the bank would no longer exist.

This decision is very important from the point of view of protection of shareholder rights and the rule of law. If investors believe that they will be able to influence the company, they will invest. If state can at any point take their stake away, or diminish, or sell key elements of the company without their approval, the investors will stay well clear of such investments and investment climate.

When we look back in a few years, we will say that this small, unnoticed event was one of the key building blocks that returned the investor confidence and brought recovery.

Sarkozy earns EU disapproval

French assistance for carmakers has caused laud protests from representatives of other EU countries, as well as the EU commission, when the word leaked out that there is a clause that the carmakers must use only French components, when possible, and that there was a hint that it might be beneficial for future access to aid if they moved their factories back from Slovakia and Czech republic to France.

EU competition spokesman Jonathan Todd has clarified that state aid must be compatible with the EU competition and state aid policy, and that, if the aforementioned clauses are present, it would not be compatible. Current EU president, Mirek Topolanek was much more direct when he said that responses of Eurozone countries to the crisis have done much more damage to the Euro than anything else.

Way out …

All this sends us a mixed message of the current EU situation. In many countries we have truly farcical apologies and claims “it’s not my fault, really”, while economic growth and employment continue to slide. Protectionists impulses are growing stronger and stronger, not only towards third countries, also towards other countries within the EU. There is only a small step from here to the protection of residents in one region from the residents in the other region within the same country (England vs. Scotland) and omnipresent fall in commerce and economic activity.

Luckily, all is not black. The decision of Belgian court to demand assembly regarding the sale of banks proves that the EU is still the zone of Rule of Law and that investors have to mind operations risk, but need not worry about political risk.

When this word spreads, and it is confirmed a few more times by the court rulings, investors will feel safer and will start buying the banks and financial institutions , aggressively sell their bad debts, unclog the banking system and earn a fortune in the process.

You can read more about the topic in the book “Saving the Sun” from Gillian Tett, describing the sanation of Long Term Credit Bank and change to Shinsei.

This is an English translation of an article by Mitja Sadar that was published, in Slovenian, in the leading SlovenianInvestment Magazine KAPITAL, on 15.02.2009. Original article is available at the following URL: http://www.revijakapital.com/kapital/poslovnefinance.php?idclanka=6482

Every morning we can see different economic analyses that, depending on the author, either claim that the bottom of the crisis has been reached, or, to the contrary, we are still very far away from the stock-market bottom.

Latest hits are the forecast that use Graham’s method and proclaim that S&P will hit bottom at between 400 and 500 points, down considerably from the current 700. If we read old news, we can see that analysts were moving the bottom from 1200, to 1000, to 900 etc. After each big fall, the bottom moved lower.

How can well educated economists be so wrong? It is a fact that all economic theories and models big explanatory powers after the event, when the models are corrected and it is plain for all to “foresee” such an event, but this was not yet visible from the theory and model before the event.

Economics as a science is based on premise that there are certain economic laws that are stable and unchangeable. Let me just mention two: All individuals are always acting rationally, so emotions, such as fear, panic, uneasiness, happiness or euphoria have absolutely no impact on their investment decisions. The second premise to mention is that all individuals have access to perfect and full information, so they can make truly rational investment decisions.

On average, in normal circumstances those premises are correct, since statistically and in the long term there is around one half of people that are too optimistic, and around one half are too pessimistic, so those extremes are cancelled out and the optimal remains.

When the circumstances are not normal, such as in the case of great euphoria during the boom, or great panic during the crash, those two premises fail miserably, as there is either too many optimists or pessimists respectively. This then biases average investment decision to either too optimistic or too pessimistic.

This is the main reason that economic models in the current format can not properly forecast what will happen in exceptional (not normal) circumstances. The models do not allow for the market sentiment, which does not show in the case of individual investor, but it becomes painfully obvious one you aggregate the actions of those individuals (when everybody is euphorically buying or panically selling, no matter what the price).

The idea of market sentiment, or animal spirits in the market, is far from new, and was already mentioned by J.M. Keynes. Unfortunately, due to the complications that it brings to mathematical formulae, it has never caught up, despite some serious efforts in the last two decades.

Very good analysis of market sentiments was made recently by Prof. Paul de Grauwe from the University of Leuwen in Belgium. You can find the analysis at the following URL: http://www.ems.bbk.ac.uk/research/Seminar_info/DeGrauwe

In the analysis he claims that the equilibrium of pessimists and optimists is only coincidental and that the market reaction to exactly the same impulse is vastly different if optimists or pessimists prevail. As an example we can take the news that company A has lowered the dividend. Optimists would believe that the company sees more internal opportunities for growth and would therefore buy the stock, while pessimists would believe that the company is going for broke.

From this we can see that the market bottom is not where the technical indicators show it to be, but rather when a majority of people believes that a stock is a good investment at the current price.

There is one more problem with the stock market bottom. We can only call it such when sufficient amount of time has passed and the price has moved significantly higher.

We all remember the growth of stocks from September to December 2008, when everybody was convinced that the worst is already behind us. Then, we had the request for help from Citibank, investors got scared and we have seen another big fall.

When to buy?

To buy, or not to buy, that is the question. The basic theorem of investing says that you need to buy low and sell high. Whoever is waiting for bottom will miss the chance, since before we can seriously consider it as a bottom, the prices will be at least 30% higher. This is the reason why investors have to believe themselves and their analysis, because they are the only ones that know their capacities to invest and their needs.

If investors see that the stock is a good buy at 30, it is better to buy it at 30. If the stock then falls to 25, before rebounding to 50, they can be happy with the profit, and they should know that if they were waiting for bottom, they would not buy the stock at 25, but rather would still be waiting for it to reach it, and thus miss the chance.

An investment for which investor can not set an appropriate price should not be made. The most important thing to know is that we believe in ourselves and our abilities, as if those were not present, we would not have the money to invest.

This is an English translation of an article by Mitja Sadar that was published, in Slovenian, in the leading SlovenianInvestment Magazine KAPITAL, on 16.03.2009. Original article is available at the following URL: http://www.revijakapital.com/kapital/poslovnefinance.php?idclanka=6569

In the last few days, we have seen many events that will have long-term consequences. The most visible was the cut-off of Russian gas, which travelled via Ukraine, that had an impact on most EU member states.

Many political analysts, and Ukraine, have been trying to portray the crisis as a Russian attempt to make Ukraine submit to its will, and to show the world that Russia is still the superpower it once was.

Russian side had, on the other hand, always emphasised that this was a commercial disagreement, and that politics plays no part in it.

A simple fact is, that Ukraine was paying $179 for gas, while EU customers were paying an average of $450 for the same quantity. Russia was thus greatly subsidising Ukraine. Because Ukraine has started to move towards West and was during the war in Georgia openly hostile to Russia, it is normal to expect that Russia does not want to subsidise Ukraine anymore.

Russia has suggested a price increase to $250, still considerably lower than the $450 that the EU is paying, but Ukraine has rejected the offer.

Moreover, it even did not pay for the gas it received at the price of $179 on time. It only did so when Russia has threatened a cut-off.

Just imagine yourself having a contract with a Utility company, failing to pay for the gas you consume and would reject their price increase. They would turn switch your gas off in the blink of an eye.

But if there would be pipelines crossing your land, and you would be tapping that energy, which was meant for your neighbours, you would quite quickly get a visit from the police.

Because there is no international police, Russia was left with no choice but to switch the gas off, rather than to let Ukraine steal it. They demand EU observers to monitor the flow of gas through pipelines as a condition for restarting gas supplies.

There is also an issue of “technical gas” that is used to operate the pipeline. If Russia keeps on paying Ukraine a transit fee, it is most probably the duty of Ukraine to ensure there is enough technical gas in the pipelines.

In other significant development, General Motors has, less than a month after receiving government subsidy, made a prognosis that the volume of car sales is going to be significantly lower than their projections, which opens up a possibility for another round of subsidy requests.

There were also some events that were not front-page, but will carry long-term consequences.

Most significantly, interest rate spread on ten year government bonds of Germany on one side and Spain, Greece, Italy and Portugal on the other side, has widened considerably, to the highest level since the adoption of Euro. This means that the market participant have started to differentiate between the risk of German bunds and bonds of Italy and Spain. The spread now stands at 115 basis points, up from the lowest level of 13 basis points.

This is a punishment for the countries that have, after joining Eurozone, lost their zeal for reform and, at the same time, encouragement for new reforms. Italy finds itself in the hardest situation, with public debt greater than their GDP, and for which the increased interest payments mean considerable worsening of their macro-economical situation.

On Thursday, ECB has lowered their interest rate to, as expected, 2%, which shows that the crisis is deepening and that not even the EU is immune.

Investors of Madoff have had mixed successes, while he languishes in house-arrest. Those who invested via banks have a chance of reclaiming their money from them, as they did not do proper due diligence.

Those who withdrew the money from him in the past few years might receive a court order to repay their money, so that it can be divided equally among all the investors.

Forex markets have gone haywire as well. Eur/Usd, which traded at 1,42 USD for Euro at the beginning of the year, has fallen to 1,3, and traded at 1,32 on Friday.

Even bigger swing happened with Eur/GBP, from 0,97 to 0,885 pounds per Euro.

All this shows that the crisis is still strong and that we will still see some interventions before the crisis is over.

This is an English translation of an article by Mitja Sadar that was published, in Slovenian, in the leading SlovenianInvestment Magazine KAPITAL, on 19.01.2009. Original article is available at the following URL: http://www.revijakapital.com/kapital/poslovnefinance.php?idclanka=6420

A little more than 80 days is all that is left from this year. A year that most small and big investors alike, as well as bankers and brokers, are very eager to put behind. We have seen many breaks with current practice, from complete collapse in faith in American subprime to the failure of big investment banks that were one of the main pillars of economy. We have seen nationalisation and government intervention in USA, which has, with barely concealed pleasure, lecturing Russia (1998), Japan (1990-2000) and others that the capitalism should be let to do its work, and that they should let the markets to cleanse itself of the bad practices. According to their lecture, countries should not intervene as they would only increase the losses. Of course they see things in completely different light if they happen to a neighbour, rather than themselves, especially right before the elections.

We have seen state intervention to save the biggest banks. Currency markets went completely mad and volatility has increased greatly. While in the previous years, we have barely seen a move around 1%, we have, on Tuesday, seen 7% fall of the AUD versus the USD. Stock markets show similar picture. On Tuesday, Brasilian index Bovespa fell 15%, while most of European indices fell around 7%. This clearly shows panic. Investors are so scared, that they are purchasing the safest US government bonds at prices that bring negative real return. Every new information causes wild trading swings.

To calm the situation a bit, FED, ECB and four other central banks have issued a joint statement to lower their respective interest rates by 0,5%. New ECB interest rate is thus 3,75%. All countries are increasing the deposit guarantees. Ireland now guarantees unlimited deposits. In Slovenia, deposits are guaranteed up to the amount of 22.000 Euros per depositor per bank. Financial ministers of the EU have agreed to increase the coverage to at least 50.000 EUR throughout the EU. We can expect an announcement in the coming days. You can find more about Slovenian deposit guarantee scheme at the following URL: http://bsi.si/jamstvo-vlog.asp?MapaId=150

Nobody knows what will happen until the new year. There is a high probability that the credit crunch is going to intensify and panic increase. Almost certainly we will see some more interventions, probably nationalisation of one of the biggest American banks and the transition of most of European financial sector back to state ownership.

Slovenia is a small country, but its banks are part of international economic arena, so they can feel a lack of liquidity and possible state intervention if the crisis intensifies. This goes even more so for the foreign owned banks, dependent on their mothers. While I do not expect any larger collapse of Slovenian bank, I can not say this about Slovenian stock exchange. I expect SBI20 to continue its slide and bottom out at around 3500 points. This will be the right time to buy, as we will be able to buy stocks with large “SALE up to 75% OFF” stickers on them. Whoever buys the shares then, he should see an average annual growth of at least 15% for the following few years.

Most of the experts agree that we have not even reached the half of the crisis. Louder and louder are reports that the oil prices are going to slide under $30 per barrel. Banking sector will come out of the crisis very different and much more regulated. At the moment, the safest bets in Slovenia are government bonds and bank deposit up to the guaranteed amount. Liquidity has a very high value at present and it can happen that the banks will be offering very high guaranteed returns in exchange for long term deposits.

This is an English translation of an article by Mitja Sadar that was published, in Slovenian, in the leading Slovenian Investment Magazine KAPITAL, on 13.10.2008. Original article is available at the following URL: http://www.revijakapital.com/kapital/poslovnefinance.php?idclanka=6101

In august 2007, American, European and Asian indices have started losing value in what most economists call a burst of bubble. We have been able to see quick reaction of Citibank , which has quickly found new investors, even before the news of their loss has reached the general public. Other banks have not been so lucky and most people expect that there are many that have yet to fall.

Buying a property is an American way of saving. By paying off a mortgage, mortgagee is actually building value. Instead of paying rent, people pay a mortgage and own the home. When they pay off the mortgage, they own the whole property, which has gained in value in the meantime. Mortgages are easy portable and can houses can quickly be remortgaged with original mortgage being paid off if the market conditions change and rates become lower. Bank approves mortgages for purchase or construction of property, guaranteed by the said property. If mortgagee defaults on the mortgage, bank can repossess the property and sell it on the open market, for profit. Banks bundle such mortgages and create complex financial securities (collateralised debt obligations (CDO’s)) that they sell on to investors, thus offloading the risk and freeing the money for future lending. Due to this mechanism, Japanese and other foreign investors have enabled cheap bank financing of mortgages. Banks were able to quickly sell on all the mortgages, and hunt for new clients, new profits.

This has been going on for many years. Every year, there were less and less people that have fulfilled strict lending criteria. Because the banks have wanted to keep this source of income, they have found a quick and easy solution – lower lending criteria.

Apart from cheap prime mortgages, banks have started to offer a bit more expensive sub-prime mortgages for people with lower credit score. This erosion of standard has progressed so far, that, in 2006, new category of loans was created, so called Alt-A mortgage with stated income (later dubbed Liar Loans) that was never checked. We have also witnessed the division of the CDO’s into various tranches, where the lowest level took the first 10% of loss, a bit higher level the next 10% etc. This splicing has resulted into 85% of all CDO being classed as AAA by the rating agencies, thus converting very high yield/risk Alt A and Subprime mortgages into very safe, low yield securities that were then sold on to investors. Banks were happily skimming the difference and lending the money to even more customers.

All this creative solutions have sent very wrong economic signal to the construction companies. When there was enough property on the market, rising prices that have, at least partially, been the consequence of easy credit, have sent the signal that there is not enough property on the market. Because of the demand, construction companies have started many ambitious projects that have now stalled.

Due to the trick of securitisation, many institutions that have been restricted to only invest in high quality assets have been able to participate in the market. Even more, because this was classed as triple-A quality asset, many institutions have used leverage to boost returns.

Leverage is a simple instrument where we cover only part of our investment with our money, the rest we borrow. If investment returns more that the cost of money that we have borrowed, leverage enhances returns on our money. 1% growth in investment with 1:100 leverage returns 100% on our investment, because each move is enhanced 100 times. Exactly the same and opposite happens in case of 1% loss. In this case, we have lost all our initial deposit. If investment with such leverage falls for 5%, we owe 5x our deposit.

Exactly this mechanism has worked in case of collapse of mortgage securities. When property prices collapsed, we have seen a domino effect in leveraged instruments that contained at least some mortgage securities. Losses exceeded capital and financial companies were liquidated. Banks stopped lending money to each other, liquidity has been decreasing and crisis has been deepening. Banks and financial institutions that were deemed too big to fail have started failing.

Liquid banks with safer investments have been taking over banks that were solvent, but illiquid. Central banks have selectively started solving the crisis. Northern Rock in UK has been nationalised, JP Morgan Chase has, with government guarantee, taken over Bear Sterns, Fanny Mae and Freddie Mac have been nationalised, Lehman Brothers has been allowed to fail, Bank of America has taken over Meryl Lynch, the last remaining investment banks have asked for universal banking licence that allows them to collect deposits and gives them access to FED discount window, Insurance giant AIG has, in return for 79,9% stake, gotten 85 billion USD in emergency loans.

American government is preparing a stimulus package, where USA will create a bad bank that will purchase most of mortgage securities and thus both stabilise the market and clean balance sheets of banks, thus helping with the sanation of banking sector. In UK, the crisis has followed the American blueprint with around 6-month delay. Since the beginning of the crisis, USD has lost around 10% versus the basket of currencies, even though it started regaining some strength lately. GBP has loyally followed the USD on the way down, just like the property prices, even though, admittedly, a bit less.

In Europe, the crisis has been spread selectively. It has hit Spain very hard, as their Costa del Sol was a true construction bonanza, where prices have been reaching 4 or more times their construction cost. They were, of course, finance by 90+% mortgages that have suddenly ceased to become available. Construction there has fallen by more than 40%, which is quite noticeable both in the increase of unemployment and decrease of economic activity. Large European banks have also been busy writing off investments in American subprime. Despite that, we have not seen any large banking failures in Europe, apart from small German banks. There is so far no evidence that property prices have started collapsing throughout the EU, even though it is fairly obvious that, in current economic situation, they are probably not going to increase much anywhere in the world, apart perhaps in Russia that is basking in the money from Oil and commodity bonanza. India and China still continue with their high growth, but we can already observe early signs of slowing growth there as well.

In Eastern Europe, the crisis has so far not left any marks on the property market. In Slovenia, we do not expect serious collapse in property values. There is a big difference between property marked in Western countries and Slovenia. Despite that fact that property ownership is around 70% both in USA and Slovenia, the average value that is mortgages is 15% in Slovenia and 60% in the USA. If there were more properties built in the USA than there was actual real demand, this is not happening yet in Slovenia. High quality property still finds customers in Slovenia.

The crisis is far from over, and will not be the last crisis ever. Even though we hear dramatic words that value is being destroyed, underlying value remains unchanged in such crises. It only changes the owner and revalues. As long as there will be rewards for taking extreme risks, where the state covers the losses, and shareholders keep the profits (moral hazard), such booms and bust cycles will repeat themselves. Less than 20 years have passed since the collapse of Japanese property bubble. The consequences were huge, far reaching and obvious. On 29.12.1989, just before the crisis hit, Japanese index Nikkei 225 was worth 38916 points. On 28.12.2007, 18 years later, its value was 15307,78 points, a loss of 60%. On 22.09.2008, after the turbulent week of Lehman failure, its value was 12090,59, 69% less than on 29.12.1989. Can we expect something similar?

This is an English translation of an article by Mitja Sadar that was published, in Slovenian, in the leading Slovenian Investment Magazine KAPITAL, on 28.9.2008. Original article is available at the following URL: http://www.revijakapital.com/kapital/poslovnefinance.php?idclanka=6047