Wednesday, 24 September 2008

Have Banks Bottomed Out? What is the Future of Banking Globally? And Where to Invest for Growth.

The past 10 days have been “the most dramatic in Wall Street’s 216-year history” seeing Lehman Brothers collapse, AIG fall into critical distress, and the US Federal Reserve creating a c. US$1 Trillion rescue plan to “save the world”.

While many investors were caught in this crisis, the leading economists in the world saw it coming. In this article, we talk exclusively to Kenneth Murray who is Chairman & Executive Director of Blue Planet Investment Management, and a renowned banking economist about the factors which caused the crunch, whether banks have bottomed out, the future of global banking, and whether it’s the right time to invest in banks.

September 24th 2008 – Vikas Shah

In early 2008, if a journalist had written that Lehman brothers would fall into Chapter 11, AIG would become critically distressed, and the federal reserve would be forced to create a c. US$1 Trillion rescue plan to, "save the world", they [journalist] would have openly been ridiculed for making such 'far fetched' predictions (with the same vigour as scholars who argued the earth were round were ridiculed during the Classical period).

Today, only eight months later, we are confronted with a situation where market observers are calling September 2008, "the most dramatic in Wall Street's 216-year history".

While many investors were caught in this crisis, the leading economists in the world saw it coming.

In this article, we talk to Kenneth Murray who is Chairman & Executive Director of Blue Planet Investment Management, and a renowned banking economist.

In a privileged question and answer session, we discuss the mechanisms which caused the ‘credit crunch’, look at the future of banking in the UK, US and Internationally, and understand where to invest in Banking.

Mr. Murray studied economics and computer science at Stirling University, and with an interest in financial markets he joined the city as a banking analyst. Mr. Murray quickly ascended the career ladder, becoming a Director of Fulton Prebon International Limited, one of the World's largest money brokers (which had operations in London, New York, San Francisco, Tokyo, Hong Kong, Singapore, Sydney, Bahrain, Luxembourg and many other financial markets). In 1990, he founded the Bank of Edinburgh Group plc, with the aim of rationalising the building society sector. His bank was the first to purchase a building society (The Heart of England Building Society, 1992, with assets of £1 billion). In 1994, following the sale of his bank, Kenneth Murray created Blue Planet Investment Management, with the aim of becoming, “the best manager of financial stocks in the world”.

For me” says Mr. Murray, “Economics is a greatly rewarding intellectual challenge, like a game of chess, where along with the satisfaction of winning, you have a constant desire to play the game better”.

Q: What fundamentally went wrong in the markets, and what do you think to those who are “calling bottom” on the markets, and betting on an upside?

We predicted this back in April 2007, and the first question you have to ask yourself is “what gave rise to the increased activity in banking in the period from 2003-2007”. This is a fundamental question. The main driver of this growth was the rise in personal consumption, which has a number of elements. We can only consume at the rate of the growth of incomes, and we saw that consumption was exceeding incomes. The savings ratio reduced from a historic 5% to currently less that 1%, and finally people were “borrowing to spend” (which increases consumption). Not only were people borrowing, but they were borrowing multiples of their earnings, so the level of consumption dramatically increased. As inflation fell, interest rates followed, and people could therefore leverage (borrow) more, assuming their primacy asset (property) would hold them in retirement.

What we are seeing is a correction. As people ‘maxed out’ their borrowing curve shifted upwards. People can borrow and spend, but ultimately, they have to pay it back, and that’s when the consumption curve falls. The increase in demand is seen as money is spent, but then income is set aside to cover the borrowing, and hence the consumption curve falls. This is a particularly strong phenomenon in over leveraged economies such as UK, USA and Denmark. Elsewhere in the world such as India and Russia, personal debt as a proportion of GDP is much lower.

In terms of those who say the market is bottoming out, the first thing to look at is the track record of the people. To use an analogy I learnt at University, it doesn’t matter how nice or unpleasant they are, it’s the results that count. The overwhelming majority of analysts failed to see “what was coming”, this, in my eyes, discredits them. You are very unlikely, if you didn’t see it coming, to understand what happened.

Q: So where is the value in banks?

There will be virtually no growth for UK/US banks going forward. They may be able to exact efficiencies, and shifting bad debts to governments will de-risk the sector and re-rate stocks, but the economies will still slow down in the UK/US but by a smaller rate than a few months ago. This may create the question, “if we normalise risk, where’s the value?” In my opinion the earnings growth is in the developing market which is underleveraged, and as has budget surpluses, these are the regions where the top-lines will grow.

In terms of the US and UK, we will certainly get a rally of banking stocks due to the de-risking and unwinding of short positions, but this will also initiate mergers in both countries. Goldman Sachs and Morgan Stanley will certainly go out to buy retail banks, and we must watch out for the ‘clever’ banks such as HSBC who have steered through the markets very intelligently meaning their relative positions have shot up. Once we see this kind of activity, the rest of the market will typically head back ‘in the water’.

In our own funds, we allocate similar methodologies to our investments. Banks are a proxy for economies, and we look for well run economies, sector growth, under-penetrated economies, and solid leadership.

That strategy, though, has not worked well in the past 12 months, as the economic sentiment is non-discriminatory. URSA bank in Russia has profits up 200% last year, 60% up this year, but the share price has dropped 80% even though they have not put a foot wrong. Consider even their economy (ignoring politics) which shows the third largest foreign exchange reserves in the world, abundance of land and natural resources (mostly unexplored and unexploited), trade balance and budget surpluses, and over 7% GDP growth. This represents a perfect balance sheet, versus the UK and USA which read more like an IOU.

Q: What are your aims as a fund manager within these turbulent markets? and how do you make salient financial decisions in a market which is behaving, as Bob Diamond from Barclays said, "without a rulebook"?

We are not in a market “without a rule-book”. It is worrying when people say that.

This is economics. There are, in economies, times when madmen take over who understand nothing about anything but operate on emotion. The laws of economics always come into play.

Where we are at the moment is the tail end of a banking crisis. The reason it’s a tail end is because the practices that gave rise to bad debts stopped a year ago. We are now getting bad debts through the system, and after that, “that’s it”. We will be left with ultra conservative banks who are risk averse and trade with wider margins. Oligopolies such as HBOS/Lloyds are inevitable, and create a level of control of markets which allow them to withstand bad debts, and the power to extract returns from economies.

We are near the bottom, but people are still feeling worried, as most do not understand markets enough to make intelligent decisions on economic propositions. Emerging banks can be bought on P/E ratios of between 2-5, this is incredible, as these banks earnings are increasing 20-150% per year with sound balance sheets. In the case of India, its reserve bank imposes incredibly strict controls (high cash reserve ratios) which give very low risk. While both these countries are bothered by inflation (particularly India), in essence, they carry less risk than the west, but are considerably cheaper. Share prices in these regions have fallen more than the badly managed western banks.

Q: Do you think that increasing regulatory intervention is a positive thing for markets? And has banking failed the principle of ‘free markets’?

There are many factors at play here, but the management of monetary policy at the federal reserve (Greenspan) has played a big role. Greenspan flooded the market with cheap money (1% interest). When banks have little money to lend, they are selective who they lend to, and they want a good rate of return. When banks are awash with money, they soon exhaust “good” proposals, and engage in riskier activities, with poor credit. The more excess liquidity, the greater the bad debts. This is an inevitable consequence of bad management of money supply by central banks. Cheap money causes problems.

Banks and their actions are to blame also. Banks do not have to borrow money from central reserve but they chose to do so. In the same way, they did not have to lend this excess capital, but they chose to do so. This was a fundamental failing of bank boards, and an issue which needs to be addressed. The ultimate regulator of a market is not government (FSA/SEC) but is the bank boards. Strong management is essential, and banks need to stop hiring the “great and good” (ex PLC directors from unrelated industries who know nothing about banking, risk, and economic cycles) and instead look at bankers with track record, and an understanding of systemic risk. This has to be addressed before any rules changes are made at a policy level.

Q: Will the unwinding of risky derivatives and the absence of complex products from their activities see bank shares 'under perform' against their historic figures?

The reason for underperforming is there is no potential for earnings growth. Banking is shrouded in mystery, but a simple example is….

If you consider a country where 5% own mobile phones, and the rest are rapidly accumulating wealth and want those products, is that not a better place to be?

The same is true of banking services. In western markets, everyone has loans and too many loans, that is why everyone is defaulting. In Russia and India, there is huge growth opportunity, but much less risk. These aggregate numbers are very important. If Loans/GDP is c 7% it is like saying that a person on £100,000 has £1,000 of borrowings. In western economies if you earn £100,000 you are likely to have £200,000 in borrowings. This is, therefore, a key indicator of risk. The West will not perform too well (in general) but the ones which will are the investment banks which, as confidence returns in economies, will create more banking volume in mergers and acquisitions.

The greatest risk going forward is the unwillingness of banks to supply credit (which is much diminished as it’s simply not prudent to lend).

Q: Many analysts and traders favour 'technical analysis' as a method to deliver trading signals and trend information. Do you think in current markets, technical trading still provides a reliable strategy?

I don’t think that it [technical analysis] has ever proved reliable. If you consider the mathematical principle of VaR (In economics and finance, Value at Risk (VaR) is the maximum loss not exceeded with a given probability defined as the confidence level, over a given period of time) which, as any mathematician will tell you, is basing your risk analysis for what will happen in the future, on what has happened in the past. Ultimately, this is a flawed hypothesis. If I were to walk towards the end of a cliff, and after 98 steps I fell down a six foot hole, VaR would tell me that on average, every 98 steps I take, I will fall down a six foot hole (even though I am only two steps away from the edge of the cliff). Regulators and analysts love this kind of mathematical analysis because it looks like “good science” and gives the air of being useful. If you are a real mathematician or economist, you will know that it is fundamentally flawed, the unpredictable will always happen, that is the nature of things. VaR tells you the risk of an activity is X, and when an unpredicted event happens, that goes out of the window.

Einstein once said, “Knowledge is great, but imagination is better”. If you are backward looking number cruncher, you will never be great. The great economists are those with the vision to understand the market, demand, supply and how “this” set of things will result in “that” in twelve months time. It is the reason I enjoy being in the company of intellectual people where you can query “why do you hold that view?” without being given the response of simply “I have a feeling”.

If you look at the current downturn, it was predictable. The adjustment that is now taking place is a result of the reduced ability to borrow and spend.

So many analysts don’t think out of the box, and are simply “regurgitation machines” and they do not look at the macro position. The same is true of many economists. It is astounding that they don’t see problems, and when they occur, they are miles behind and incapable of understanding a resolution.

Q: Do you think it’s a good time to ‘buy in’ to banks?

We are much nearer the right level to buy banks in the right part of the world. If you can take a 2-5 year view, or even better, a 10 year view you will make huge returns. As Warren Buffet says, “buy good stocks and let them make the money for you”.

From this shake up will come immense opportunities, some banks and assets have been massively over-sold and when normality is returning, this will create growth. You have to have the courage to get involved at the bottom to make serious money and this courage comes from understanding what you’re doing.

A good analogy is to think of economics as an oil tanker, when in motion, its course is dealt. When banking was flooded with cheap money, this flooded the market, and created actions and consequences which were predictable. Even the development of economies is predictable, and is part of human nature, with very few new behaviours. Once the system is de-risked, people will then look rationally at individual banks asking “who is this bank?”, “what is the growth potential?”, “what is the ratio of deposits to loans?”. All of these questions along with analysis of penetration of banking services, point to emerging economies and against most western banks.


We are seeing in the media, many articles calling the “bottom of the market”. Mark Arbeter (technical strategist at Standard & Poors) was even quoted as saying, “On three straight days a third of the stocks on the New York Stock Exchange hit 52-week lows, the first time that has happened in almost 35 years. We think evidence of a climax bottom last week were overwhelming”.

Mr. Murray’s analysis shows how the current ‘downturn’ is the expected and predictable response of underlying economic forces, and shows the failings of not just policy makers, but the bank management themselves who act as the true ‘regulators’ of the market. It is these economic forces and principles which could have predicted the failures, and can provide insights into the solution and future, historical analysis and models while interesting, simply cannot take the unknown and the ‘macro’ into account.

Our economy was at the brink of correction, as our insatiable demand peaked with absolute saturation of available space.

It was Doug Horton who summarised this perfectly in his quote, “First rule of Economics 101: our desires are insatiable. Second rule: we can stomach only three Big Macs at a time.


Blue Planet in their own words, "Blue Planet Investment Management Ltd is a Maltese based investment management company which specialises in managing investments in financial companies. Our corporate philosophy is that consistent out-performance is more likely to be achieved by specialisation than it is from the generalist approach, which currently prevails across most of the fund management industry."

You can find out more about their activities online at:

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Monday, 15 September 2008

“The Price of Events”, an Inside Look Into the Minds of Energy Traders

In this article, we gain a better understanding of how energy traders put a ‘price’ on geopolitical and weather events, and get a unique and privileged insight into the mindset of energy traders and the market. This article features an in depth interview with Mr. Walter Zimmerman, Senior Energy Analyst & Economist for ICAP(one of the largest brokers in the world, with an average daily transaction volume in excess of US$1.5trillion) where we talk about energy prices, events, recession, political policy and how the market “thinks”.


September 12th 2008, Thought Economics, Vikas Shah

The global energy markets are absolutely critical to the daily lives of practically every human on the planet with trading sentiment and decisions affecting the price of our electricity, gasoline, travel, and more. In the past quarter of a century, the energy markets have grown and developed into a complex and sophisticated environment, which can affect, and are affected by, global events (such as weather, terrorism, political instability, etc). It is not, now, uncommon, to see headlines in our mainstream press such as:

Oil prices today jumped back towards $120 a barrel today as tropical storm Gustav, which experts said was likely to be upgraded again to a hurricane, appeared set on a course for US oil and gas rigs in the Gulf of Mexico. Crude oil rose $2.98 to $119.25 a barrel after adding $1.16 yesterday. Fears about the path of Gustav and a potential impact on oil production, could see oil near a three-week high of $122 over the coming days." - The Times (UK) August 27, 2008

Oil prices decline sharply following the September 11, 2001 terrorist attacks on the United States, largely on increased fears of a sharper worldwide economic downturn (and therefore sharply lower oil demand). Prices then increase on oil production cuts by OPEC and non-OPEC at the beginning of 2002, plus unrest in the Middle East and the possibility of renewed conflict with Iraq.” – International Energy Agency

"Continuing oil supply disruptions in Iraq and Nigeria, as well as strong energy demand, raise prices during the first and second quarters of 2005." – International Energy Agency

"Continued unrest in Venezuela and oil traders' anticipation of imminent military action in Iraq causes prices to rise in January and February, 2003." – International Energy Agency

The world of Energy Traders is one which is a fair distance away from ‘civilian’ life, but one which is of great importance to it.


Walter Zimmerman is the senior analyst and economist for ICAP (one of the largest brokers in the world, with an average daily transaction volume in excess of US$1.5trillion), and a renowned world expert in energy pricing and economics. His career started as an eminent student of chaos mathematics, where he developed his passion for seeing how, “…turbulent systems generate patterns and those patterns give you predictive value about the system”. You are unlikely to meet people in the world who have a more in-depth understanding of Energy economics, and when asked where his passion comes from he stated, “On one level, markets are driven by free will, but it is the collective exercise of free will that creates patterns in a market, and hence predictability and determinism. It is truly fascinating to watch these cycles repeating. It’s human nature repeating itself. With the phenomenon of complexity theory, and it is a real theory, you can predict the price of oil to several decimal points months in advance, this is a deeply satisfying phenomenon for me, and one which keeps me excited to go to work”. Walter’s clients include National/International oil companies, refineries, petroleum marketers, international banks, petrochemical firms, hedge funds, airlines, utility companies and governments.

I had the privilege of speaking to Mr. Zimmerman in the format of a Q&A to get his unique view on how the energy markets work.

Q: “Why are geopolitical events (such as political instability and, for example, military events) of such interest to energy traders?”

“From the first day of trading in energy, it has always been a tug of war between “there is enough today” and “there may not be enough tomorrow”. The focus has been “there is enough today” we get a downtrend. When fear of the future comes in, that’s when we see an uptrend. So the critical factor is the sentiment, what the market is focussing on. For the last few years, the market has been spending more time being afraid of the future rather than content with the adequacy of current supply. The explosive growth of demand in China/India has eliminated excess production capacity and as of Q1 2008 there was ZERO spare OPEC production capacity globally, no supply cushion, and so any little wrinkle in the news, or hint of geopolitical tension, caused the market to take off”. He continues, “Recently we have seen more collective attention brought to the adequacy of supply. The impending recession has re-created surplus production capacity. We saw it previously in 2000/2002 where decreasing global demand caused oil to fall from $38 to $17, and natural gas from $10 to $2. This was due to recession, not policy, and as soon as the economies surged, so did prices”

Q: “One of the big questions in recent years has been, ‘when will the USA notice the price at the pump?’ clearly this has started to happen, what is your view?”

A: The US took notice when oil hit $150. As the credit bubble and house prices collapsed, they lost ‘cash’ and lost the ability to take loans against their homes and more. All of a sudden, the supply/demand curve became elastic, helped by the implosion of real-estate. The UK is more energy efficient than the USA which has the worst energy efficiency of any country globally, and no future energy policy. The US is living in a 20th Century mindset of being the ‘biggest crude producer’ unfortunately the principle of ‘you cannot predict what you don’t want to happen’ holds true here and the country needs to realise that you cannot, as 4% of the worlds population, consume 25% of the worlds energy and not have to pay up for it.

Q: “How important are 'weather' events to the energy market? And surely is there not enough 'flex' in energies to cope with supply disruption from weather events?

A: During the early 1980’s there was a chronic oversupply of refining capacity, every year refining margins would go negative. Refiners would almost ‘root’ for a hurricane so that those refineries that weren’t shut down could make money. This was a constant situation, but now, with no excess refining capacity, we see that the slightest threat drives prices higher. In the last few months, there has been a lot of new capacity coming online, particularly in distillate (which have been the strongest commodity on the board, leading all other energy prices higher). The condition of a lack of excess refining capacity is therefore now improving, and you see the difference in the market where hurricanes Gustav and Ike hardly saw anything other than small spikes in price, nothing like previous years.

Q “Are the markets more responsive to events driven price differences during times of economic weakness?”

A: Price changes in a market are exacerbated due to the ‘mood’ of the market. THIS is the primary driver. Traders read how the market reacts to the news to gauge a pulse of the sentiment consensus of the market. There are other more direct ways (such as sentiment and consensus providers) but nevertheless the primacy is the mood of the market. If you follow this closely, it is quite fascinating.

The longer an uptrend lasts, the less traders are hedged against the lower prices, so by the time the market is peaking, very few are hedged against the downside risk. The bullish consensus is the strongest at the high - most are convinced price are still going much higher. As the market starts to sell off the hedgers become more and more bearish, and by the lows, everyone is hedged and protected against further downside and no one is protected against the upside. The market sentiment is the most bearish at the lows. This means that very few are protected from downside at the top, and virtually no one is protected against the upside from the lows.

The trend creates the news. Bullish news in a downtrend is simply ignored. The press digs out stories to explain “that’s why we’re going higher.” So the primary driver is not news events. The primary driver is the collective mood.

Q: “And how does this work in relation to spot and futures?”

A: Futures are a more leveraged version of the spot markets. So spot markets trends can be magnified in futures. Increasing leverage increasdes the emotional content of the market. And it is always the case that Fundamentals+Emotion=Price. To use an analogy from ‘Star Trek”, science officer Spock would state, “This is not logical” he would be completely out of his element in today’s markets. It is the nature of markets to over-react to the upside and to the downside. The markets are the display of human nature.

Q: “Freight derivatives have recently gained a lot of strength in the marketplace, are these particularly vulnerable to such risks?”

A: Risk is a function of leverage. Any derivative that increases leverage will increase risk. If you trade crude oil and every ‘tick’ costs you $1, you will sleep at night, but if every tick costs you $10,000, you will not sleep a wink. Due to their highly leveraged nature, certain derivatives can heighten risk and the attendant emotional intensity.

Q: “For a long time, the insurance market has been a primary example of a market which 'prices' terror/disasters/weather events, but people are now more aware of the similar process in energies. How does the trader and market go about putting a 'price' (eg: oil US$2 up on news of gustav) on these events?”

A: It depends on whether the market is in an uptrend or downtrend. To broaden out to a wider market, it is not just crude oil that has been getting ‘beat down’ so one has to start thinking whether we are in the early stages of a wider deflationary depression. If you recall in the press when Russia invaded S. Georgia, the gold price didn’t notice, there are so many people caught long, that the market simply cannot respond to threats. You can see therefore that to answer “What is an incident worth?” – Nothing in a downtrend, and everything in an uptrend, again, a bi-product of market mood.

Q: “Many countries such as the US carry a 'strategic reserve' of fossil fuels such as Oil. Do these reserves go a long way to affect pricing? (especially during times of 'events' such as political/weather events)”

A: The US government, since the initiation of the SPR (Strategic Petroleum Reserve) seems to have been much more intent on buying at the ‘top’. They have been uninterested in adding when prices are low, and nobody wants the oil. Governments are the ultimate trend follower, they do everything last. By the time the governments get around to blaming speculators, you know the peak has come and gone. The actual role of the SPR is a function of political agendas and ideologies.

Q: “We have already seen an emerging market for carbon credits, and many markets trading 'weather derivatives' etc. Alongside trading the raw commodities themselves? Where is the future for energies trading? Are we going to see more complex derivatives as we move towards renewable and other energy sources?

A: Part of the answer, and a MAJOR part of the answer, has to do with the collapse of the credit bubble, and global re-evaluation of credit risk. There is a flight away from complex derivatives to more simple instruments. Many hedge funds and banks are now more concerned with raising and preserving capital. Many are more interested in extracting themselves complex instruments which they now understand they didn’t understand! This will put a damper on more the more complex derivatives which were never necessary in the first place. The role of a bear market is to eliminate the speculative excesses of the prior bull market. A bear market has typically been a ’return to basics time.’ This trend is now visible for all to see.


We can see; therefore, that there is a complex mix of human behaviour and fundamentals at play, giving us the pricing phenomenon we see in energy markets and, rather than the ‘news based peaks’ which most media assume, there are much larger sentiment trends in play which are controlling the overall behaviour of the energy markets.

Most would now agree that globally we are going through one of the most fiercely challenging economic climates which our civilisation has come up against for quite some time, but to state “To think that the new economy is over” (quoting Alvin Toffler, a futurist and writer) “…is like somebody in London in 1830 saying the entire industrial revolution is over because some textile manufacturers in Manchester went broke.”

The credit crisis has exposed a lot of home truths in our economy, the rebound of which has caused a greater tidal wave of sentiment in the market, shifting us from a period of buoyancy, into depression. Much of this was, perhaps, due to economic and financial short-sightedness by political and banking leaders but, “Economic depression”, as Herbert Hoover said, “…cannot be cured by legislative action or executive pronouncement. Economic wounds must be healed by the action of the cells of the economic body - the producers and consumers themselves” and as Franklin D. Roosevelt once said, and as can be applied now with great relevance, “We have always known that heedless self-interest was bad morals; we now know that it is bad economics.

Walter Zimmerman is a senior analyst and economist for United ICAP, who were founded in 1980, and are now one of the world’s leading energy brokerage firms.

ICAP in their own words….

“ICAP is the world’s premier voice and electronic interdealer broker and the source of global market information and commentary for professionals in the international financial markets. The Group is active in the wholesale markets in interest rates, credit, commodities, foreign exchange and equity derivatives. ICAP has an average daily transaction volume in excess of $1.5 trillion, more than 60% of which is electronic. We operate in both established and emerging markets and our electronic networks deliver global connectivity to customers. We believe that we can best provide the service our customers need by combining the strengths of our people together with technology - setting the standard for our industry. ICAP provides specialist intermediary broking services to trading professionals in the wholesale financial markets. An interdealer broker draws together liquidity and matches buyers and sellers so that deals can be executed by its customers, receiving a commission when a transaction is completed. With more than 3,900 staff, ICAP has a strong presence in each of the three major financial markets; London, New York and Tokyo, together with a local presence in more than 30 countries. ICAP plc's shares are listed on the London Stock Exchange (Code:IAP) and it is a FTSE 100 company”

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