Citigroup - the spiral of lost confidence

Citigroup's shares suffered during the week, as investors showed increased nervousness about the banking group's ability to weather a downturn. Vikram Pandit, Citi's chief executive, may have a point in blaming Citi's recent share price falls on false rumours and scaremongering. However, at the moment, rumours and fear can change a company's financial position overnight. If enough people think you are in danger, then you are in danger.

One day, a famous man was walking in Wall Street when a rumour spread that he had fallen over and knocked himself unconscious. Everyone rushed into the street to see what had happened. The man was knocked unconscious in the scramble to see what had happened to him. Whose fault was that?

Why is spending the answer?

At the moment, the answer to the current financial crisis proposed most frequently is to stimulate spending with financial incentives to the public.

Just yesterday the Chief Executive of JC Penney in the States called for the new U.S. administration to step in and help boost the amount consumers spend. He said that people are not spending because they are 'concerned about the lack of visibility to '09 and beyond'.

He has identified an important problem - lack of certainty, lack of visibility of the future. But the solution should match the problem. Short term financial incentives may simply add to the uncertainty by destabilising the economy once more. Perhaps we should stop trying to give short-term stimulation, and think more over a ten- or twenty-year time frame.

In a crisis, it is the constant change, constant attempts to revive in the short term, that are exhausting, and stop the wider world from functioning. To enter a period of good, extended recovery, we first need to accept that some parts of our infrastructure may not recover in the short term. Then we need to identify a long term plan to make the most of what will be left. We are spending a lot of time hanging on to what is gone, what is spent. Let's start from where we are. The beauty of crisis is its ability to create something new.

Let's stop trying to reverse autumn by sticking leaves back on the trees. Spring comes without our desperate help.

Why has Vodafone changed its strategy?

Vittorio Colao, who has been Vodafone's CEO since July, has announced a change in strategy to focus more on two key goals: cash flow generation, and operational execution. The opposite of these two is: using up cash, and failure to deliver on operational promise. In the last decade, Vodafone has been on a sometimes cash-hungry acquisition and expansion path, whilst sometimes failing to deliver on the original promise of those acquisitions, particularly in saturated parts of the European market.

The old strategy seemed appropriate in an expanding global market where market share and global presence matters. However, it always needs to be balanced against the availability of cash in the financial markets to fund that expansion. And it is here that Colao's change in strategy has its root. Global investors have stopped buying the future, and want to see performance and cash results now.

Indian suicides

Recent reports have suggested an increase in financially-related suicides in India. For example, a Mumbai couple last month killed themselves by poison after their son and daughter had hanged themselves. The family had at least 73 credit cards, and the children had a bank loan to start a new business.

Unpleasant stories, but with a very real human point. One of the worst aspects of being in financial trouble is the inability to see a way out. Those who are proud may see bankruptcy as humiliation. But equally, they may see it as impossible to earn their way out of a crisis. In the coming year, we would do well to adapt our global culture to allow a responsible, socially-acceptable path to rehabilitation for those caught in impossible situations.

I suggest that when a person or business defaults, a bank threatening action should be legally required to offer a referral of the defaulter to an independent agency which can represent them and offer them alternative courses of action. This would remove the aggressive one-sidedness of the default process, and perhaps lead to fewer emotional casualties.

Will the U.S. soon have an interest rate of zero?

In the U.S., the interest rates set by the Federal Reserve get lower and lower. They may even hit zero at some point (probably only for very short periods of lending). This means that they would be allowing banks to borrow over time, at no cost.

Apparently, the U.S. government would be willing to take the risk of lending out, without hope of any return to compensate for the risk. The theory is that the stimulation to the economy - in the medium term - outweighs the risk to the government in the short term.

Rates to businesses would remain above zero, because banks need to operate at a margin to make a profit.

The more risk the U.S. government takes on, the more it intertwines its fate with that of the economy it oversees. And the more vulnerable it becomes to anyone who wants to disempower it by financial means.

Why was VW the world's second most valuable company yesterday?

On Tuesday, VW briefly became the world's second most valuable company in terms of market capitalisation (share price x number of shares).

A number of hedge funds (risky funds) had bet on a fall in the share price. These bets took the form of an agreement to borrow VW shares, sell them immediately at the current price, and then buy them back again at a (hopefully) lower price before giving them back to the lender. This is a process known as 'short selling'.

However, when Porsche revealed it had a larger stake in VW than expected, the price of VW shares rose. The hedge funds all became desperate to buy back the shares they had borrowed before the price rose too high. The demand for the shares meant the price rose by 82% in a day.

This leaves some hedge funds having sold their borrowed VW shares low, and then having been forced to repurchase the same shares at a value up to 82% higher in order to 'close their position' (escape from the deal).

For many, it's hard to have sympathy for the loss-makers. Yet short-term investing is akin to betting: perhaps the kind thing would be to offer the fund managers (or their computers) a spell with Gamblers Anonymous to treat their addiction.

Why are the markets so volatile?

Think of how you behave when you are uncertain or under threat. It's very hard to retain a sense of perspective. If you are a family or a football team under pressure, you may well become a little paranoid about your team members, and super-touchy about each event in the outside world. Think how your heart jumps when you are anxious and your mobile phone rings. Irrational, but understandable.

There is a strong urge at the moment to do what the group is doing, to hide behind everyone else's combined opinion. But investors, as a group, are not necessarily being particularly rational. A number of companies, which provide essentials such as food, are reasonably financially healthy, and may survive quite well. Yet their shares are still lower than reason would expect, because we cannot get rid of an overall sense of fear.

Some investors may soon choose to step across the line and decide which companies have a good future after all. They may make some money by getting in early. But this is not investment advice. Make your own decision!

Why can't UK banks help small businesses?

Why do the UK banks find it so hard to help small businesses during the current crisis?

They cannot lend more than usual, because that would be a relaxation of their attitude to risk. Relaxing their attitude to risk is what got them into the current mess in the first place. If they extend unusually high credit to failing businesses, without first giving new loans to healthy businesses, then their portfolio as a whole will get more risky. Unfortunately, healthy businesses are repaying debt, not increasing it.

To stimulate healthy businesses to approach the banks, I suggest an enlightened partnership between government and banks. The government could create new schemes to incentivise capital expenditure by healthy businesses. The banks could then coordinate their lending to match the government incentives, where a business can prove a good growth plan. Increased lending to good businesses might then create room to extend facilities to businesses in difficulty.

What causes markets to panic?

Markets can show the same dysfunctional emotions as the rest of us. They can worry, they can panic, and they can get depressed.

Imagine you hear on the news that petrol is going to be in short supply. You may rush out and buy extra petrol. If everyone does the same thing, the petrol shortage will suddenly get worse, potentially crippling a community's ability to function. What is rational in small doses, becomes self-destructive in large doses. To make matters worse, we all start fighting against each other, and it seems that nothing can restore order. Rumour abounds, and the uncertainty makes everyone unsure what to believe.

Again, imagine that you hear some bad personal news. Your hormones rush out a shot of adrenaline to adjust your system. But if too much of your system joins in, you get overloaded with adrenaline, leading to excessive anxiety, and inability to function. Your system starts behaving counterproductively. Internal rumour starts - in the form of paranoia and excessive worry. The uncertainty undermines our confidence in our own perceptions.

Now look at the current world financial situation. The markets received some bad news about U.S. mortgage debts and their performance. Cash supply was interrupted, and rumours began to circulate of cash shortages in the market. Dealers started to get anxious, and then panicked, rushing out and buying cash - in other words, converting their securities into ready money. This is crippling the financial markets' ability to function. Again, what was rational in small doses (a market adjustment), becomes self-destructive in large doses (a market collapse).

When young children feel threatened, in their panic they often rush into a barrage of self-defensive tactics. They take back their toys. They hit out. They cry. None of this helps, and it is up to adults to restore order by separating everyone for a while, waiting until things calm down, and then clearly administering guidance and discipline. With this in mind, perhaps governments should have simply closed the markets for a while, and told banks that they could have their toys back if they sat down and behaved. Well, it's a thought...!

German property giant in trouble

German property lender Hypo Real Estate is one of the latest to find that banks are unwilling to keep extending its lines of credit.

The German government has been trying to avoid going the route of wholesale nationalisation of threatened financial institutions. However, a partnership approach between government and a consortium of banks appears to have collapsed.

The banks haven't given a reason. But they may have realised that Hypo Real Estate, with its 400bn Euro balance sheet, will need a lot more than the 35bn Euros they had agreed to raise.

Why are banks collapsing?

I think there are three main reasons why banks have been collapsing:

1. Gearing
Commercial companies should get at least half their funds from equity. Banks routinely operate with much, much less equity.

2. Matching
Borrowing periods should match the life of the assets they fund. Banks routinely borrow short-term to lend long-term.

3. Sensitive giants
Many large banks are too dependent on market and customer confidence for their health.

Solutions may include:
1. Increasing the minimum equity requirement
2. Monitoring average asset life to ensure it is commensurate with average borrowing period
3. Financial institutions may be forced into smaller saleable units

Item 1 is likely. Item 2 will probably be missed. Item 3 will probably not be taken up because there are too many vested interests in larger concerns. Even though small may be beautiful, large concerns are not in it to create beauty!

Lehman Brothers in difficulties

Lehman Brothers, an investment bank based in New York, is in trouble.

Over the last 14 years, chief executive Dick Fuld (nickname The Gorilla), had transformed the bank into one of the most competitive on Wall Street.

Since 2004, Lehman Brothers has expanded rapidly into mortgage lending. Now it is stuck with around £40bn of commercial-property assets in a property slump, and significant exposure to debt trading in a credit crunch.

The share price has plummeted, from $60 in January, to $30 in June, and from $15 to $4 during September.

Last week Fuld announced a bold recovery plan, hoping the market would regain faith in the bank's prospects. But the share price seems to be continuing to fall.

Prospective buyers (e.g. Barclays) have said they would like government guarantees. But the U.S. government has a lot on its plate at the moment.

If no buyer comes forward, it remains to be seen how long Lehman Brothers can survive.

XL Leisure Group goes into administration

XL Leisure Group plc, the third-largest player in the UK holiday market, has run out of funds.

Today the group went into administration, which means it applied for court protection from its creditors to see what can be saved. In all, eleven companies are listed on the Group's announcement. Four individuals have been appointed by the court to run the companies' affairs.

The first decision the administrators had to make was: should the group continue trading? Their decision was no. All aeroplanes have been grounded, and all flights cancelled. Once a business becomes unviable, total collapse is usually quite quick, because no-one wants to trade with it.

The group had grown quickly since a management buyout in 2006. Fast-growing companies need a lot of cash to grow, and so are particularly vulnerable in a downturn if their bankers decide to call it a day.

What did Nick Leeson do to topple Barings?

Barings was a British bank, which collapsed following one of the most talked-about UK financial scandals of the 1990s.

Nick Leeson, a middle-manager with only two years trading experience, was put in charge of trading derivatives on Japan's Nikkei exchange. Not only was he put in charge of trading; he was also put in charge of accounting for his own transactions. This meant that he could hide his own bad deals with false accounting.

Derivatives are risky financial instruments which can make or lose large amounts of money in a short space of time. Trading derivatives can be similar to gambling. Leeson ran up losses, and then tried to make the losses good with bigger and bigger bets. Eventually he ran up losses of over a billion dollars, enough to cause the bank's collapse.

One of the lessons from the scandal was this: Don't give an inexperienced manager control over both doing deals, and reporting deals - especially if senior management doesn't understand what he's doing. The pressure to report good news may lead to too much risk, hidden problems, and eventual bankruptcy.

Obviously all the lessons were learned immediately around the world. Hence, Enron and Northern Rock never happened. Ahem.

What will the 2012 Olympics cost?

When London won the bid in 2005, the budget stood at £2.4bn. This had been the figure when ministers put together the bid in 2003.

In November 2006 the budget rose to £3.3bn. Culture Secretary Tessa Jowell cited a doubling in the price of steel, and a decision to add inflation to transport costs.

In March 2007, the budget rose to £9.4bn, now including: a £2.7bn contingency fund; £1.7bn for regeneration and infrastructure; £0.6bn for security outside the site; and tax of £0.8bn.

In April 2008, Jack Lemley, the former 2012 chief, said it had always been clear that he was working to a budget of over £12bn. He said that, due to problems with the land in Stratford, the final figure may well exceed £20bn. Several MPs noted that the £9.4bn bill announced in 2007 excluded £2bn for actually staging the games; £0.7bn to buy land; and £millions to cover wider transport links, and the cost of government staff working on the Olympics.

What happened to Northern Rock?

Northern Rock is a UK bank. In 2007 it ran into serious trouble. In 2008 it was nationalised.

The bank focused heavily on residential mortgages, funding them through short-term borrowing on the wholesale money markets.

In 2007, there was a crisis in confidence as lenders in the U.S. realised they had pushed too much money towards sub-prime (low quality) residential borrowers. The money supply from the money markets dried up.

With nowhere to go for replacement funds, Northern Rock asked the Bank of England for an emergency loan. When everyone heard the word 'emergency', depositors and lenders became very nervous and started to pull away from the bank. To calm things, the UK Government guaranteed all deposits.

In 2008, having made huge loans and guarantees on behalf of the taxpayer, the Government decided to put the bank into public ownership.

What's a credit crunch?

Many journalists are talking about a credit crunch, but what does it mean?

A credit crunch is an economic threat where borrowing money suddenly becomes much more difficult for everyone.

A credit crunch often happens after a period where borrowing money has been too easy. The 2008 credit crunch follows a period where banks have fallen over themselves to lend as much money as possible. Suddenly, when it becomes obvious that many borrowers have overextended themselves, everyone gets worried about how many loans will fail. So everyone stops offering new money for new loans.

The cycle is one in which binges (easy credit) are followed by purges (credit crunch).

What happened to Enron?

At The Finance Academy, we are often asked what the Enron collapse was all about.

A U.S. company, Enron began by owning gas pipeline and storage facilities. Following the deregulation of energy prices in the U.S., Enron changed its main focus to buying and selling energy contracts.

In order to make its results look better, Enron found ways to disguise debt. The accountants hid debt in other organisations, pretending that it did not belong to Enron.

During 2001, journalists, and even Enron's own senior staff, began to challenge Enron's accounting methods. In October 2001, the Securities and Exchange Commission (SEC) announced an investigation. In November 2001, Enron announced that it had substantial hidden debts.

When the market found out, the value of Enron's shares plummeted. This fall in the company's value triggered repayment clauses in agreements with investors. Faced with a sudden need for cash, and nowhere to get it, Enron filed for protection.

These are the bare bones of Enron's demise, but if you need further information, do get in touch.

Do brands go on the balance sheet?

We are often asked if a company can put a brand on its balance sheet.

Under IFRS (International Financial Reporting Standards), the position is as follows:

If a company purchases a brand as part of an acquisition, and the value of that brand is separately identifiable, then it should go onto the balance sheet.

If, however, the brand is not purchased, but internally generated, then it should not. One reason for this is that, if a company can put its own self-created brands onto the balance sheet, there is potential for overestimating these brands' value, thereby overstating assets on the balance sheet.

If the directors of a company think a purchased brand has a limited life, then they should reduce that brand value every year, so that the balance sheet value is zero when the brand's life has ended. If they think the brand's value will go on for ever, they can keep it at the same value every year. Whatever the case, the directors must regularly check the brand value; if it has fallen below the value published in the balance sheet, they must lower the balance sheet value.

IFRS (International Financial Reporting Standards) must be applied by listed European companies. In other cases, other rules can apply, and you are welcome to e-mail eddie@thefinanceacademy.com for further information.

What is 'viring' in a budgetary context?

Viring is using one budget to pay costs in another.

For example, a budget-holder may be allowed to use an underspend on advertising to cover an overspend on stationery.

An advantage of allowing viring between budgets is that budget-holders have more independence to make their own decisions, as long as they hit their overall target.

A disadvantage of allowing viring is that budget-holders, if able to set overspends against underspends, can fail to take overspends seriously enough.

Why is the Exchequer called that?

Why, in the UK, do we call our Finance Minister by a different name: Chancellor of the Exchequer?

The Exchequer was a rectangular board, chequered like a chess board. It measured about 10 by 5 feet, and was used, from the 12th century, to count out payments to the Treasury. The department which collected in this way became known as the Exchequer.

So now you know!

Does the U.S. government owe too much money?

What's the balance sheet of the U.S. government like, and is it vulnerable?

As of April 2008, U.S. federal, or government, debt was around $9.5 trillion ($9,500,000,000,000).

Tax revenue is about $2.5 trillion, but government spending is about $3 trillion. This means the debt is growing by around $0.5 trillion every year.

Interest payments alone cost the government around $0.5 trillion per year.

On a per-resident basis, this means: Tax income of $8,200; spend of $9,800; a loss of $1,600; cumulative debt of $31,000.

This represents debt of 3.8 times income, and a deficit of 20% of income.

On a personal level, in the U.S. and UK, this has become relatively common. But it has also caused a recent collapse in the debt market.

On a public level, the U.S. government may suffer an equivalent collapse. For the moment, though, we are all looking the other way.

Who are Fannie Mae and Freddie Mac?

The press has been full of concern at the dramatic fall in share price of Fannie Mae and Freddie Mac.

Who are they?

Fannie Mae (created 1938) is the Federal National Mortgage Association
Freddie Mac (created 1970) is the Federal Home Loan Mortgage Corporation

Between them Fannie Mae and Freddie Mac own or guarantee over half of US mortgage debt -about $6 trillion, of a total U.S. debt of about $12 trillion. (A trillion is a million million.)

The problem at the moment? The U.S. public are defaulting on their mortgages, and in a falling property market repossessions are not covering the debt. This is causing cash flow problems for Fannie Mae and Freddie Mac. The share prices are falling because investors believe they might go bust.

The U.S. government created these two organisations. Their function is to buy mortgage debt from mortgage lenders, and then either hold it, or sell it on to other institutions. They act as a mortgage factoring company.

The advantage to mortgage lenders is that the cash released enables them to go and sell still more mortgages. The advantage to the US government is the stimulation of the economy by encouraging the promotion of borrowing. The advantage to the public is that it's easier to get a mortgage.

The big disadvantage? Creating one big mortgage market makes the whole thing very vulnerable when times get hard. Imagine if we decided to have one big river instead of lots of little rivers. If that one river got clogged, all our resource would be threatened.

Global giants are efficient and strong most of the time. Yet when their ankles are tied, having no way to spread their vulnerability, giants fall more easily.

Risk-weighted assets

'Risk weighted assets' means the assets in a bank's balance sheet, but adjusted for risk.

Banks have minimum capital requirements (mostly equity) that they have to hold in order to be safe. If you just required a bank to hold capital equal to a fixed proportion of the assets in its balance sheet, then it would take no account of the different risk levels of different assets in that balance sheet.

By weighting the assets by risk level, you can ensure that a bank which holds more risky loans is required to hold more capital to keep it safe.

Sweating your assets

What does it mean to 'sweat your assets'?

It means to work assets hard, or to maximise usage for minimum spend.

For instance, I may choose to get maximum usage out of a car by sharing it between all members of the family, and running a rota system so that it is used most of the time. Or a company might fail to replace or update buildings or equipment until it is absolutely necessary.

The effect is to maximise return or turnover for minimum spend. This results in higher asset turnover (sales/assets) and ROCE, but if done too much can eventually affect quality and company morale.

What's a joint venture?

On a course the other day we were asked to clarify what a joint venture is, whether or not it takes the form of a separate company.

Think of a joint venture as a project partnership, supported by a contract to protect each independent party's pooled capital and agreed return. Generally, each party has the right of veto over strategic decisions.

A joint venture doesn't have to be a separate legal entity, but a joint venture agreement will usually be a legal document.

Insolvency? Bankruptcy? Liquidation?

Have you ever wondered what the difference is between the above terms? I got asked this today by a curious delegate. (Curious as in inquisitive. I don't mean to imply the delegate is strange. Very sensible chap.)

Think of financial collapse in three stages:

1. Being unable to pay your debts as they fall due. You are now in a state of insolvency.

2. Being officially declared insolvent by the court, resulting in all assets being given over to a trustee, and you being relieved from all debts. You are now in a state of bankruptcy.

3. Having your assets sold and turned into ready cash, which is distributed to your creditors, with the balance coming to you, the owner, if you are lucky. You have now been liquidated.

I hope this helps, Michael.

Bears and bulls

Do you know what a 'bear market' is? We need to remind ourselves, as recent falls in stock markets have prompted commentators to use the phrase more often.

The term 'bear market' is used to describe a prolonged and significant fall in general share prices. 'Bears' are traders who expect share prices to fall. The opposite term, used for a prolonged rise in share prices, is a 'bull market'. There is no standard measure, but, to be prolonged, a fall might last two months or more. Some argue that the fall should be at least 20% from a recent high.

How do we monitor overall prices in a market? Analysts calculate an average result, called an 'index'. One popular such index is the FTSE 100 share index - a number used to track the market value of the top 100 listed UK companies. ('FTSE' stands for 'Financial Times Stock Exchange'.) The index began in 1984 at the starting value of 1000.

On Friday, the FTSE 100 share index had fallen 19.6% from its high in October 2007. This gets close to the 20% fall which, according to some, would mean we are in a 'bear market'.

Pringles aren't crisps - ask a judge

Buy a packet of Pringles. You know, they're the pleasant-shaped crisps that come in a pretty cardboard tube with a plastic top. Sit down in front of the telly. Enjoy the crunching sound as you eat them one by one, then two by two, then four by four... and finally tip the tube up to sweep the final crumbs into your mouth. That felt like eating crisps, didn't it? Think again!

A UK judge today declared that Pringles are not potato crisps. His reasoning? Potato crisps are made from potato; but, in contrast, Pringles only have 42% potato content, and are not therefore made from potato. The relevance? If they were crisps, then 17.5% VAT would be chargeable on every packet sold. As they are not crisps, but general foodstuffs, they are zero rated, and VAT need not be charged to the general public. At stake, therefore, are thousands and thousands of pounds.

Oh joy! A win against the VAT authorities! I so admire a judge prepared to set Pringles alongside fruit and veg as a staple foodstuff!