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15 мая, 07:17

Open letter to Institutional Investor Magazine

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Last night Australian time Institutional Investor published a piece on Bronte Capital's position in Herbalife.To quote the opening sentence:Australian hedge fund manager John Hempton, the co-founder of Bronte Capital, has turned out to be a true believer in Herbalife, the controversial multilevel marketing company that has been under investigation by one federal agency or another for several years. Over the past year, Hempton doubled down on Herbalife...I observed on twitter that contrary to standard journalism ethics the author (Michelle Celarier) did not seek our comment before publishing.She told me to check my email. So I did. Ms Celarier did in fact send something.Here it is:Michelle Celarier01:15 (12 hours ago)Hi John I am writing a news story for Institutional Investor about your investment in Herbalife, as you disclosed updated filings for the quarter.   I note that you've been adding to your position over the past year, according to the SEC. I also quote from your recent letter about Herbalife-- and note your performance this calendar year. Just wanted to let you know about this. I'm on deadline, so if you have further comment please respond asap. Thank you MichelleMichelle Celariermichellecelarier.com917 971 [email protected] Follow me on twitter @mcelarierYou will notice that this came at 1.15AM Australian time. It came when I was (and could reasonably be expected to be asleep). The story was published before I woke up at approximately 6AM.This is a clear breach of journalist ethics. But it is also sloppy and demonstrates what happens when you do not check your facts.There are two reasons our Herbalife position has increased.a). Our fund was closed and it re-opened. We got considerable flows. We adjusted the Herbalife position to match the flows.b). We sold a large position in the 50s (when Bill Ackman covered) and we repurchased it (and then some) at lower prices.The second one is instructive. If you sell a $1000 worth of Herbalife stock at $53 and buy it back at $27 you will wind up with more Herbalife stock. (This trade matches some of what actually happened in our book.)For these reasons our Herbalife stock position (measured in number of shares) has increased considerably.But the position measured in the percentage of the fund at cost has actually shrunk. We did not "double-down" as the article suggests - we actually took some off the table.The article is false and should be withdrawn.The statement that we doubled-down is contrary to both our risk management policy and what actually happened.That said: for the record we still think the stock is a good value at this price. We have a full-sized position now (or we would buy more). But that is not a newsworthy story. The only story Michelle Celarier has is that a fund manager is bullish about a stock they own.John Hempton

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30 марта, 09:04

Watch what the Chinese do

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I don't easily believe Chinese statistics - especially regarding something as awful as COVID-19. Believe your eyes and common sense over Chinese statistics.When China (officially) had 19 deaths they started building massive field hospitals. Believe what you see (the hospitals) but take the 19 deaths as a rather dubious estimate (as per that time).By contrast when the Chinese Government say COVID-19 is highly controlled in China you can believe them because there are Westerners and Western companies throughout China and what you can see (Shanghai and Chongqing as functional cities) comports with the statements and the actions of the Chinese Government.My general view: watch what the Chinese Government does - rather than what they say.This is a story about journalists returning to their home in Beijing before a Government crackdown on foreigners. Watch it.You can see the Chinese take COVID-19 very seriously indeed.We can conclude thata. The Chinese have seen the virus. They think they know what it can do. They are scared. Do not believe the Chinese numbers. The truth is much worse. But believe the Chinese actions. They think fear is appropriate.b. The Chinese have proven that a super-hard lockdown lasting seven weeks in affected areas 2.5 weeks in Shanghai etc can work. Their major cities are free of the virus and major Western cities are not.c. The Chinese Government are super-scared of reintroducing it.John

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19 марта, 12:51

Coronavirus – getting angry

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I am going to give you a few stylised facts about severe acute respiratory syndrome coronavirus 2 and the data.First – no matter what you say about the Chinese data – and the Chinese data was full of lies at first – China has controlled the outbreak. Shanghai, Beijing, Chongqing are all functional mega-cities with no obvious health catastrophes.The virus has been managed to very low infection rates in Singapore and Taiwan. The numbers (completely real) in Korea show a dramatic slowdown in infection.Korea has not shut restaurants and the like. The place is functioning. But it has had rigorous quarantine of the infected and very widespread testing. It has complete social buy-in.China tests your temperature when you get on a bus or a train. It tests you when you go into a classroom, it tests you when you enter a building. There is rigorous and enforced quarantine.But life goes on – and only a few are dying.In Singapore nobody has died (yet) though I expect a handful to do so before this over. This is sad (especially for the affected families) but it is not a mega-catastrophe.There is a story in the Financial Times about a town in the middle of the hot-zone in Italy where they have enforced quarantine and tested everyone in the town twice. They have no cases.The second stylized fact – mortality differs by availability of hospital bedsA.    Coronavirus provided you do not run out of hospital beds probably has a mortality of about 1 percent. In a population that is very old (such as some areas in Italy) the mortality will be higher. In a population that is very young base mortality should be lower. Also co-morbidities such as smoking matter.B.    If you run out of ICU beds (ventilators/forced oxygen) every incremental person who needs a ventilator dies. This probably takes your mortality to two percent.C.     Beyond that a lot of people get a pneumonia that would benefit from supplemental oxygen. If you run out of hospital beds many of these people also die. Your mortality edges higher - but the only working case we have is Iran and you can't trust their data. That said a lot of young people require supplementary oxygen and will die. If you are 40 and you think this does not apply to you then you are wrong. Mass infection may kill you. Iran has said that 15 percent of their dead are below 40. I will put this in an American perspective with a 70 percent strike rate by the end.Option A: 2 million deadOption B: 4 million deadOption C: maybe 6 million dead.By contrast, Singapore: a handful of dead.China has demonstrated this virus can be controlled. The town in Italy has demonstrated it can be controlled even where it is rife.Life goes on in Singapore. Schools are open. Restaurants are open in Korea.The right policy is not “herd immunity” or even “flattening the curve”. The right policy is to try to eliminate as many cases as possible and to strictly control and test to keep cases to a bare minimum for maybe 18 months while a vaccine is produced.The alternative is literally millions of people dying completely unnecessarily.What is required is a very sharp lockdown to get Ro well below one – and put the virus into exponential decay.When the numbers are low enough – say six weeks – you let the quarantine off – but with Asian style monitoring. Everyone has their temperature measured regularly. Quarantine is rigid and enforced. You hand your phone over if you are infected and your travel routes and your contacts are bureaucratically reconstructed (as is done in Singapore). And we get through.And in a while the scientists save us with a vaccine.The economic costs will be much lower. Indeed life in three months will be approximately normal.The social costs will be much lower.Every crisis has its underlying source. And you want to throw as much resources (and then some) close to the source. Everything else is peripheral.The last crisis was a monetary crisis and it had a monetary solution.This is a virus crisis and it has a virology solution.Asian Governments are not inherently superior to ours – but they have done a much better job of it than ours. The end death toll in China (probably much higher than stated) will wind up much smaller than the Western death tolls. I do not understand our idiocy.JohnPS. Longtime followers of this blog will know that I have rarely publicly agreed with Bill Ackman. I do here. This minimises economic and social cost of the virus. I am not sure the stock market bounces hard with a rational policy, only that it minimises the damage.I regard the current course of English speaking democracies (other than New Zealand) as mass murder by the political elite. I think history will regard it that way too.

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02 марта, 14:50

Coronavirus is more popular than sex (except in South Africa)

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I was wanting a way of judging just how serious the coronavirus outbreak is in Iran. Alas government figures are not to be trusted. And figures from other sources - mostly anti-government blogs and the like - are also not to be trusted (as they have an agenda).I went for the old fall-back. Google Trends.Here is the google trends for coronavirus in Iran. It is clearly skyrocketing.Okay - but this does not help me. I needed something to judge it against.I figured that it would need to be something that was searched for a lot. So I went for the staple: sex.Here is coronavirus vs sex in Iran.I am beginning to conclude that coronavirus is more popular than sex (at least as a search topic).It sounds pretty serious.So I thought I should benchmark it.I figured the British are likely to be big searchers of sex. Maybe I am mistaken - but there seems something desperately English-schoolboy about googling "sex".Yep - coronavirus is more popular than sex in the UK too.And so it was with almost every jurisdiction I tried.Except South Africa.Sex is more popular than coronavirus in South Africa.Is that because the South Africans are really into sex or that they are not scared of coronavirus?I have no idea.Not all research is productive.John

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13 февраля, 04:56

Pretium Resources: short memory

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This post requires correction/clarification.There are at dozens of press reports that state the mining accident happened at the Brucejack Mine. See here for example. However some reports (and some supporters of the company) state the accident happened to a mine worker at the mining camp.This is supported by the production statistics - which did not show a major interruption at the time.The company has never met it grade requirements - or at least the grade as outlined in the original mining plan. But it has usually (if not always) met the tonnage plan (as in tonnes mined).There was no large interruption.Further correction. The 2018 first conference call explicitly says the accident happened at camp and not at the mine.The old postI am not going to comment about the results of Pretium Resources. But the first few sentences of the conference call made me sick. To quote:Joseph J. Ovsenek CEO, President & Director Good morning, everyone. Welcome to our 2019 results and 2020 outlook call. Participating on the call with me today is our CFO, Tom Yip. First and foremost, I again want to thank everyone at Brucejack, Smithers and here in Vancouver for their hard work that contributed to another profitable quarter. Our Brucejack Mine has proven itself to be a safe and a consistently profitable mine ever since achieving commercial production 2.5 years ago. Now mining accidents happen. Mining is a dangerous profession.But Pretium had a death at the mine less than two years ago. Which of course proves the mine is "safe".https://www.bclocalnews.com/news/smithers-man-dies-at-brucejack-mine/Maybe this is a definition of "safe" that I was not previously familiar with.If you die working for these guys they will soon forget it and forget you. And of course declare your workplace to be "safe and consistently profitable".John

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23 октября 2019, 07:31

A MiFID solution that works

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We had troubles getting brokers to organise us meetings with management and/or past staff or customers. This is a core to the research process at Bronte (and should be core to your process too). MiFID made this harder as the brokers in Europe wanted to get paid for their (inferior) introduction services.We found a solution. Kate Pike.Kate used to work at Morgan Stanley in London and whilst there she was the best corporate access person we ever used. Then - for perfectly understandable reasons - she moved back to Australia. So we decided to give her a day and a half a week doing our corporate relations (and other stuff).Fabulous does not begin to describe it.To give an example: we were interested in a company that sold trace ingredients in fish feed for salmon farms. Without any fuss (though probably with huge hidden effort) Kate got us a phone meeting with the purchasing manager of Biomar. Biomar is the largest fish-feed maker in the world. The Biomar guy knew the prices and competitive landscape in every trace ingredient. This is the sort of meeting you pay an expert network tens of thousands dollars for.And Kate does it for us on a relatively modest salary a day a half a week. And she is so cheerful about it too.Not only is Kate fabulous - but she accepts pay in Australian dollars. These Pacific Peso expenses should be just fine for a New York based fund.I am putting this advert out with vested self-interest in mind. If Kate finds enough work to fill the rest of her week (and pay for private school fees) then we reduce the risk that she goes elsewhere.So please somebody - hire her. This is a global offer. Time zones work very well for an American based hedge fund for instance.And did I mention Kate is wonderful.JohnPS - contact her at [email protected]

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30 августа 2019, 20:29

Blue Sky - some notes and an agenda for ASIC

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Blue Sky Alternative Investments Limited collapsed after a short-sellers report from Glaucus - a now-disbanded two person short-selling research shop.Blue Sky managed many funds - a macro-futures fund, a big fund trading water rights, a venture capital fund - and the funds were sold to investors (mostly retail, some institutional).Blue Sky claimed to have $3 billion under management on which they collected base and performance fees. They only had about 100 staff at peak.And they went bust.The official story - promoted by several members of Blue Sky Management - is that Blue Sky was a fine institution - but reliant on public trust - and it collapsed because of a misleading short-seller report. They think that the collapse of Blue Sky was akin to a run on a bank. Lies were sufficient to cause the demise of an otherwise sound institution.This is not obvious from the accounts. And it assigns magical powers to short-sellers that I did not know I had. (I am a short-seller.)I do not know what went on at Blue Sky beyond what is in the accounts - but just the accounts are fascinating enough.Here is a quick run through them:The Blue Sky 2014 Annual ReportBlue Sky was on its way to being a successful asset manager in 2014.Here is the key section from the shareholder letter:Assets under management had doubled from $350 million to $700 million. They bought “Investment Science” – an award winning fund manager.They raised $60 million for a listed (and closed end) fund called Blue Sky Alternatives Access Fund. Those are wonderful for an asset manager because they produce fees that do not disappear. You do not “redeem” a listed fund, you simply sell it on the stock market.Finally – and most importantly – they raised $35 million from the public which they were going to use for co-investment in their funds.The profit and loss account is repeated below.This P&L surprises me a little. The main expense of both asset managers I have worked for is staff. Asset management largely consists of desks and computers and lots of people. Analysts, compliance etc. But in this case employee benefit expense is only $8.5 million – and the biggest expense is “other expenses” detailed in Note 8. So it is worth thinking what they might be:Some of these expenses I am familiar with. Fund establishment expenses for instance are ones that I have borne but never in that sort of quantity. That said Blue Sky ran many funds – so they are plausible. Blue Sky also managed investment property – but I have never seen the manager (rather than the funds) bear the costs associated with sales of that property. But I have personally borne expenses that would normally go in small funds as part of the cost of getting funds running. So I am happy to accept it.That said – in 2014 Blue Sky is a fast-growing and profitable asset management firm that had raised $35 million in cash at parent company level which it invested in the funds it managed.The 2015 Annual ReportHere is the core extract from the shareholder letter in the 2015 annual report. Funds under management had increased to $1.35 billion – roughly doubling. And profitability grew nicely. The underlying funds were performing well with approximately 15 percent annualised performance since inception.The P&L account made progress too. Operating revenue is $58 million. For a fund manager this is an a very large revenue pile offset (again) by sundry other expenses.Remember the core expense of a fund manager is people and the desks to put them in. $58 million in revenue should leave an awful lot of fat after that expense.There wasn’t a huge cash raise this year – so the amount of co-investment in the Blue Sky managed funds was not large.The 2016 annual report2016 was very like 2014. The company raised money again to co-invest in funds. Here is an extract from the shareholders’ letter.Note the critical detail here – the company raised $66.8 million in cash at the parent company. That cash was mostly left on the balance sheet that year though some was used for co-investment in the funds that Blue Sky managed (see discussion below).The Chief Executive also noted that funds under management had grown to more than $2 billion and they were targeting $10 billion. Returns were of course good.At the end of the year they held $35 million in investments in their own funds. These are itemised.Note that a net $11 million dollars was invested in the funds during the year (16.5 million in additions, $5.1 million in disposals). Operating cash flows in the year were $13 million so the bulk of operating cash flows were invested in Blue Sky funds. Their past investments did well too.But the core observation here is an organisation in rude health., It has $35 million in investments, and a cash balance over $60 million mostly raised in the secondary market. Revenue was about $60 million and staff expenses still modest.The 2017 annual reportIn 2017 Blue Sky went from strength to strength. Here is the key extract of the annual letter.Things grew about 50 percent across the board – with fee earning assets now about $50 million. Here is the key part of the shareholder letter.Revenue was over $70 million after share of operating profits from their investments and just shy of $70 million prior. As per usual much of the cash balance got poured into their funds as co-managed investments.You can see this on the asset side of their balance sheet. Investments in retirement villages (which they operate) is $54 million. Investments in associates and joint ventures is another $51 million.The retirement villages are the Aura village – but even that was doing well as they booked an increase in fair value.We know these funds were eventually returned as Blue Sky sold the Aura projects. This was after the final 2018 annual report as per this press article.https://www.theweeklysource.com.au/blue-sky-returns-686-5m-in-funds-including-for-three-aura-projects-to-investors/The other investments were also moving along nicely. Here is the reconciliation:You will note that this lists the specific investments. They are quite profitable (with $8 million of appreciation). Net additions were about $9 million (25 additions, 15.9 disposals). They were continuing to pour money into their investments. As their investments were profitable this seems a good thing.The 2018 annual report (also the final annual report)The 2018 annual report was written after the short-seller report – and the results had begun to fall apart. Here is the core part of the shareholder letter:The Chairman described the year as Blue Sky's annus horribilis.That said the financial position is pretty good because they raised $100 million in cash from shareholders just before the Glaucus short-seller report came out. This extract makes this clear:There was no debt. They also state clearly they expect cash from the balance sheet to be “recycled”, that is they expect to cash some of their existing investments and to invest more.The asset side of the balance sheet shows the deployment of all this cash (notably the cash they raised).Note that the investment in retirement villages is now $112 million and the investment in associates is $46 million.The retirement village reconciliation is below:As of the 2018 annual report this investment was still doing well – they booked almost $5 million in unrealized gains. But they did pour in and capitalize $47 million of cash. That said this is $112 million invested in Aura – and as noted in the above press article this was largely returned to investors.The investment in associates is also reconciled in the annual.This time they made modest losses, booking 6 million in losses and partially reversing the prior year gains. They did however make net additions absorbing some more of the cash they raised.The actual investments are listed too:Presumably these investments were there at the end too.What happened next?There are no more annual reports from Blue Sky.Blue Sky ran out of money and they took a further $50 million in cash from Oaktree.They couldn’t meet the terms of the Oaktree loan and they were put in liquidation.On their numbers they had a couple of billion of funds under management which presumably come with management fees of 1 percent or so. They had collectively raised almost $200 million in cash at the holding company (with equity offerings in 2014, 2016 and 2018) and they had $50 million in cash raised from Oaktree. And they had invested that money into funds that they said performed well.And then they could not repay the money to Oaktree.Three hypothesesI have only three hypotheses to explain this situation.Eithera)     The cash raised was invested in funds that remained there when Oaktree put the firm into liquidation – and Oaktree wound up for $50 million with investments that had about $200 million in cost. Oaktree made out like bandits.b)    The cash raised and the accumulated profits were invested in Blue Sky funds – but that Blue Sky is such an atrocious investor that $200 million in investments at cost were not enough to repay Oaktree on liquidation orc)     The investments were never made – and were fictional from inception. The cash raised wasn’t invested. It was diverted for purposes unknown. And likely the profits that Blue Sky booked along the way were fictional.The second explanation - the one that management lost all that money - is the most innocent of these. Loosing money is a pity, but it is not a crime. [That explanation is also difficult for Blue Sky management who wish to stay in the asset management business without a tarnished reputation.]I do not have any access to Blue Sky's liquidation reports or internal accounts. But ASIC has been made aware of this analysis - and if by this time next year we have not seen an answer to where the $200 million raised went to then I will be disappointed.I wrote this all out because I am a little off-put by the negative press that short-sellers have received here - even though - on the face of it it looks like a cool couple of hundred million (a quarter of a billion including the Oaktree loan) have just gone missing.But at this point Blue Sky has gone to zero. It is not up to short-sellers to explain what really happened. That is up to Australia's corporate regulators.This is a really important case for them.John

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20 августа 2019, 08:45

Thinking aloud about bank margins - Part 2

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Part 1 of this series laid out a bleak future for monetary policy and/or banks. As interest rates go down so do bank margins and there are limits on how far interest rates can be cut because eventually they take bank margins below levels adequate to cover losses or even below levels adequate to covering operating costs.If this is right ultra-low interest rates are non-stimulative because they stress the bank sector causing the bank sector to tighten (not loosen) lending. Monetary policy hits a wall of non-effectiveness and ultimately bank bail-outs.This is essentially the Raoul Pal view of the world. He sees no policy way out of the next recession -particularly in Europe - because if you don't cut rates you are stuffed and if you do cut rates you blow up the banks and you are stuffed anyway.--As I said at the end of the last post I am not sure it is always so simple and/or so bleak. That is because ultimately there are two drivers of margins a weak one (Central Bank policy) and a strong one (the competitive landscape the banks face).In Europe both of these are driving bank margins down for most but not all banks. But it doesn't need to be that way and more deft policy-makers have different options.But to see why need to run you through a stylised history of banking margins.Lloyds bank as the best bank in the worldJust over twenty one years ago The Economist wrote a glowing article about what was then a roll-up of British High Street banks. It was Lloyds TSB.A glowing article about Lloyds seems peculiar now as the bank was bailed out in the crisis and has lurched from disaster to disaster ever since. But under the title of The Lloyds Money Machine the economist wrote the following:... Lloyds TSB runs head-on into a problem that most other banks would envy: it simply earns too much money. By some estimates the bank is sitting on £3 billion more than it needs. It would gladly use this for acquisitions. But short of buying another big British bank and closing down hundreds of branches, which would almost certainly be blocked on competition grounds, it is difficult to imagine an acquisition that would be as profitable as Lloyds TSB's current business.The bank had fat margins and was busy cutting costs. The article goes on:Peter Ellwood, former boss of TSB and now group chief executive, believes that even without further acquisitions the bank can continue its impressive run by cutting more flab and by persuading its existing customers to buy more of its products. Costs have already been brought down to 52% of income, a low figure for such a large bank. Once Lloyds and TSB are allowed to merge, analysts at Dresdner Kleinwort Benson reckon, the bank could shut more than 800 branches without weakening its high-street coverage, thus saving up to £300m a year. Along with these savings will come proceeds from the sale of businesses that underperform. The bank is seeking to sell Black Horse, its estate-agency arm. Its small Latin American banking and consumer-finance network may follow.*At the time Lloyds was the thirty-fifth biggest bank in the world by assets but the biggest by market capitalisation. It was hyper-profitable and traded at a svelte seven times book.And then it all went horribly wrong. The bank took only a decade to be nationalised.What went wrong was competition. At the time Lloyds revenue to risk weighted assets was 8 percent. This was the highest number I have ever seen on a major bank anywhere.These fat margins attracted competition mostly in the form of Northern Rock and Fred Goodwin's Royal Bank of Scotland behemoth. These guys never saw a loan they didn't want to undercut. Revenue to risk weighted assets in British banks went down by 75 percent. If you do it as a percentage of assets revenue as a percentage of assets fell from over 5 to about 2.The point of this is that this happened in a non-zero interest rate environment. Competition killed margins and excessive willingness to write loans meant that margins were destroyed just as credit losses ticked up. You can find a full set of Lloyds accounts from CapitalIQ downloaded here.German (and Italian and Japanese) banking margins have been terrible as long as I have looked at banks. In both markets there was strong competition and a shortage of borrowers (at least relatively). Also in Germany there were aggressive Landesbanken who fulfilled the margin compressing role of RBS. It is kinda-nice when you fund yourself with a quasi German government guarantee. It is not nice to compete against someone who has a German government guarantee.By contrast the oligopoly banks of Australia and Canada have made lots of money with a good economy despite being breathtakingly stupid. In banking - as in other industries - you make money out of market structure as much as anything.Before everyone stuffed around with the definition of risk-weighted assets I used to compare revenue to risk-weighted assets by country. These are still roughly right in terms of profitability,The thinnest margin banks in the world were Japanese with revenue to risk weighted assets of about 1 percent.Then were the Germans and the Italians at about 2 percentThe Americans were in the middle - between 4.5 and 5.5 percent with a single outlier - the most effective major bank at screwing their customers in America - and that was Wells Fargo. Wells Fargo was about 6 percent.Then there were the highly oligopolistic Canadians at 6-6.5 percent.Finally - the fattest margin banks in the world were Australians. And that was at 8 percent. Our friends at Lloyds went from 8 percent at the time of the article to something in the mid 2s now. The world wasn't quite turning Japanese - but maybe turning German.But there are outliers - and some of them are surprising. The Irish Banks look in Ireland pretty darn profitable. The Scandinavian banks are alright too - despite (say) Swedish interest rates going negative before everyone else.Even some French regional banks are okay.And these banks are profitable even in a negative interest rate world.Swedish banks faced negative rate early - and they came out kind of well.If central bank policy is going to work the central bankers are going to need to learn from the banks that have maintained reasonable profitability in the face of negative rates. This may be the single most important lesson for central bankers in the next decade.If I knew all the lessons I would tell you. I don't. I know several of the outlier banks but nailing down quite why they are outliers is hard. But I will look for you.Till next time when I will have a look at the outlier-banks.JohnPS. Whilst for years I used revenue to risk weighted assets as a measure of profitability it doesn't work that well anymore because of changes in the definition of a risk weighted asset. For the next post I just intend on using revenue to total assets. It tells the story well enough.*For the record the (retrospective) silliness of that Peter Ellwood quote didn't seem to hurt him later in his career. He got his knighthood somewhat later.

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19 августа 2019, 13:21

Thinking aloud about bank margins - Part 1

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Pre-warning: this series of posts is called "thinking aloud about..." because I do not know where it ends. I am genuinely exploring things that I do not understand very well - but are central to how the economic world and how markets will turn out over the next year or two and maybe the next decade. I do not know the answers and maybe this blog series will not end or will fizzle out....Also I will be on the road for six weeks. Expect the posts to be sporadic at best.---The most interesting thing I have seen in the past three months was an interview on Real Vision by Shannon McConaghy of Horseman Capital entitled "Prepare for a Japanese Banking Meltdown?".The title on the interview has a question mark. I am not sure that Shannon would include the question mark.But the argument is pretty simple really. Japanese regional banks have - for decades - had excess funds. They have found it extremely hard to lend at adequate rates as excess funds is the Japanese condition. Rates the banks can achieve on loans are very low.The result is that Japanese banks (especially regional banks) have very low returns on equity and generally trade below book.As an extreme example about fifteen years ago I asked Bank of Kagoshima why they could not achieve their four percent ROE target and they said that it would "put too much strain on the local community." That bank is gone now - but the problem remains right across Japanese banking.Shannon McConaghy's thesis is that "Abenomics" has made the problem much worse. He states that the average interest rate achieved on a loan by a Japanese regional bank in the first half of this year was about 79 basis points. The rate was 62 basis points in May but there may be some seasonality.* He thinks it costs about a percent to run the bank. There are staff and systems to pay and the like. So he thinks that Japanese regional banks will be loss making before they have any credit losses. Then of course they have been rolling credit losses in zombie businesses for decades and so after the credit losses settle there won't be any equity left to earn any return on anyway.Shannon thinks the problem has been masked because the banks have typically invested their excess funds in Japanese Government Bonds (JGBs) and the yield on JGBs has gone pretty sharply negative. The banks this decade have sold significant amounts of these JGBs and reflected the gains on these sales as one-off income. They then shifted much of their securities holdings into a unique type of investment trust, largely invested in domestic equities, which under unusual accounting conventions allowed the banks to report capital gains as interest income. This means they are still showing positive ROEs but earnings are highly reliant on a constantly rising domestic equity market to generate gains, which is problematic as the Japanese equity market is still down by more than 10% from its peak last year. The situation is unlikely to improve as the underlying margins are already near zero and incremental loans actually lose money after costs.[Shannon runs a Japan fund. This talk was so interesting I wrote to Shannon and got on his mailing list. I recommend readers do the same. There is plenty there that is interesting.]Anyway all this accords a little with my view of bank margins and crises. The determining factor of how well your banks recovered from the financial crisis by-and-large wasn't how many or few losses your banks took (Iceland excepted), rather it was what was the underlying pre-tax, pre-provision profitability of your banking sector.The US banking sector has pretty decent margins - and pre-tax, pre-provision profits were about $300 billion per year. In three and a bit years they had covered a trillion dollars in losses. The banks are mostly okay now.German banks have very thin margins and whilst they had less credit losses they had considerably less income to offset them. The German banks (notably Deutsche and Commerzbank) look deeply problematic. Italian banks are also very low margin and slightly higher credit losses and they have been catastrophic investments.Bank margins are really importantBank margins were once a concern to bank investors and not really to the general public. After all low margins generally meant cheaper finance. High margin banks (like Australian banks) leave you with the uneasy feeling you are being ripped off.But the world has changed. Abenomics - which includes the deliberate pushing of interest rates to very low or negative levels may suppress bank margins. And if you suppress bank margins enough your banks go bust. And if your banks are stressed they stop lending and your economy slows down.In this view of the world monetary policy (cutting rates when you need a stimulus) not only stops working but becomes counter-productive. It blows up your bank and causes an economic crisis.The Raoul Pal view of the worldRaul Pal runs real vision and has a twitter account that is absolutely worth following. He has been harping on about a single chart - the Eurostoxx Bank Index going back for thirty years.This index is bouncing along its thirty year low. [No dear Americans, stocks do not always go up over a generation.]Raoul rather grandly says that "this level in the Eurostoxx Banks Index is probably THE most important level of ANY chart pattern in the history of equity markets". [Emphasis is in the original.]And to some extend I think he is right. What the Bank of Japan is doing to Japanese regional banks the European Central Bank is doing to European banks. The possibilities are that:1. The ECB cuts rates further, blowing up the banking sector and causing the mother of all recessions starting with the weakest banks outwards (ie starting in Germany) or2. At some point they can't cut rates and you get a recession anyway and as the banks have almost no margin left the credit losses leave them pretty darn impaired.And the stakes couldn't be higher. A generalised collapse of the European banks would be a pretty big risk to the European experiment. It won't have been caused by Europe per-se, the English banks look pretty dire too, but it will be blamed on Europe, and the resultant unemployment will have large political consequences. When Raoul suggests that "this level in the Eurostoxx Banks Index is probably the most important level of any chart pattern in the history of equity markets" he is being appropriately alarmist - at least if the Eurocrats do not act accordingly.Whatever - the Raoul Pal view of the world is unremittingly bearish. The usual central banks will bail us out narrative gets exposed as impossible. It gets ugly from here.My viewI am not sure it is that simple always - but the reason Shannon McConaghy thinks that Japanese regional banks are uninvestable is the same reason European mega-banks and the Eurostoxx Bank Index is uninvestable. The European banks are deeply problematic.But it doesn't have to be that way and it isn't irrevocably that way for the whole sector. And the ECB isn't totally trapped either.But those are really the subject of the next few blog posts.JohnPS. I have mostly equity market readers. For this series I probably should have a few readers in the central banks too. Pass it on if you can.J*I asked Shannon for the source of this data - he sent me this link.Also for avoidance of doubt I am long some European banks and currently short only one. The banks look super-cheap. But Japanese regionals looked super-cheap for decades and got cheaper and cheaper and cheaper.If I entirely believed the Raoul Pal view of the world I would not hold any European banking stocks. My doubts about th Raoul Pal view are explored in the next few posts.

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16 августа 2019, 17:20

One more brief comment on the Markopolis GE paper

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The absolute core of the Harry Markopolis paper is that GE is dramatically under-reserved for long term care insurance.And it clearly has been. It took a charge (ie recognised future losses) in 2017 and 2018. In accounting parlance they RECOGNISED huge losses in 2017 and 2018 for payments they will have to make in the future.And Markopolis points to these charges as the evidence that GE has the worst long term care business in insurance.Here is a slide that had my jaw dropping:GE's Employer Re subsidiary (one of the two places it has long term care policies) it seems has a 527 percent loss ratio.Yes, it does, in the year they take the huge reserve hit.Markopolis is arguing the provisions they have already taken is proof that the book is bad. And he doesn't recognise current payments are way way below these provisions.The Employers Re cash flow statementSo here is another way of looking at it. This is the operating part of the cash flow statement of Employers Re taken from the statutory statements. You can find the original here.Yes, you see this right. The company had 500 million of premiums collected and 597 million of investment income. It paid out 893 million in benefit loss related payments. After all the sundry expenses Employers Re was still operating cash flow positive by more than 80 million.The main source of the massive cash draw central to the Markopolis thesis is still cash flow positive. The 527 percent loss reserve above isn't a current payment by Employers Re - it is an estimate of their future payments. Current payments are completely manageable.Union Fidelity Life - the other GE insurance company - the one with a mere 280 percent combined ratio - is actually cash flow negative. And the combined is marginally cash flow negative.But that is not the point. Current cash flows are not the issue. And the combined ratio that Markopolis trumpets are not indicative of current cash flow. They are the provisions that GE is making for future cash flows.Future cash flows at the insurance companiesAlas the Employers Re will not stay cash flow positive. Not close. Several things are going to happen to make it worse. These things will also happen at Union Life and both companies will become deeply cash flow negative.First investment income is going to go down. This is inevitable. These policies were written 15 years ago or more and some of the bonds that back these policies were also purchased 15 years ago. As investment income goes down the cash-flow of the book will deteriorate.Further as time goes on the insured get older. And as they pass through their 80s they will be more likely to wind up in nursing homes. Claims will increase.Finally, for better or for worse some of the insured will stop making payments. The main reason this happens is that they die. The average age of insured here is in the late 70s.When everyone has stopped making payments of course the business has run-off. Any cash left in the holding company can finally be distributed to the holding company (that is ultimately the GE parent company).So how did this impact GE holding company cash flow so negatively?GE has an agreement with the insurance commissioner to maintain a 300 percent risk based capital ratio at these subsidiaries. When the subsidiaries take additional provisions for future claims it can cause a cash draw on the parent company even if the actual insurance companies are cash flow positive.At year end last year the two companies had a capital adequacy ratio of 365 and 426 percent. They can take small hits from here without any cash charge to the parent company. But that is only after they took accounts of massive capital contributions by the GE parent company.How does this run off?After the capital contributions there are tens of billions of excess at the insurance companies. Alas this cannot be accessed for decades because of the promise to maintain 300 percent capital adequacy ratios. My guess - and at this point it is only an educated guess - that the company will still be under-reserved and further losses will be booked. But those losses will be insufficient to absorb the excess capital at the insurance companies. Over the next thirty years these insurance companies will be both a source of losses (provisioning) and a source of parent company cash (as the excess reserves get released).This is so far from the Markopolis view as to be comical.Scoping itThe average cost of a month in a nursing home is about $7000.There are about 270 thousand policies outstanding. That number falls all the time because there are a lot of ninety year olds in the book and they die.The statutory reserves per policy outstanding is about $75000. [You can multiply this out. It is a lot.]In other words give-or-take there is about 11 months in a nursing home provisioned per policy holder.The average length of stay in a nursing home seems to be about 29 months as per this.According to this a senior citizen has about a one in four chance of winding up in a nursing home at some point.So this looks fine. If the claim rate winds up being one in four and there is 11 months provisioned per policy holder it looks like there is 44 months provisioned per claimant. And the average claim is only 29 months.But it is not so simple. People who are insured are more likely to wind up in a nursing home because either it is already paid for or at least it is already partially paid for.If you know the claims rate (by age and sex) on their book and the age and sex distribution of insured you could work out whether the book was under-reserved for or not.I suspect the provisioning is line-ball accurate here now. They haven't written a new policy in over a decade so the way the book runs off should be utterly obvious to GE now.But I do not have the claim curves.I guess this was the sort of information I was hoping for from Harry.But I didn't get it.John

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15 августа 2019, 16:01

The flat-out silly Markopolos GE report

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GE is a deeply problematic company. It might not make it. And Harry Markopolos - the Madoff whistleblower - has put out a report on GE.This report focuses on the Long Term Care business.That business isa) both having reserving problems and b) is for good reason the best performed Long Term Care business in the world.Long Term Care - the business of insuring people against the need to go into a nursing home - has hurt everyone who touched it.GE used to own Genworth - and when they spun it out they reinsured Genworth's policies. Those reinsurance contracts have bitten GE pretty hard. But they were - by the standard of Long Term Care policies really well underwritten.I wrote a blog post a few years ago about how those policies were written. Read it and the ask yourself how valid is Markopolos's comparison with other companies.http://brontecapital.blogspot.com/2012/05/thoughts-on-berkshire-meeting-and.htmlStrangely and just to prove poor Harry's incompetence one of the companies he compares GE's business to is Genworth. This is bizarre. GE reinsured Genworth. They are the same policies.--But outside Long Term Care is where the report gets really silly. Here is a slide comparing GE's industrial margins to Madoff returns:He states GE Industrial Margin of 14.7 percent is "too good to be true".Let's give him some comparisons:

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02 августа 2019, 11:38

The latest Ken Henry blow-up

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Warren Buffett - quite regularly at his annual meetings - observes that almost 400 thousand people work at Berkshire - in other words a medium sized city.In those 400 thousand people (as in any medium sized city) there are almost certainly people doing things that they should not and things that you would not want to see on the front page of the local paper. They are selling products that rip off customers, they are doing things that threaten the reputation of Berkshire.It is unreasonable in any large company to expect that there is no corporate mischief, no customers that are being misled, no staff doing things that are wrong.But you can expect the management to monitor staff behaviour and to create incentives to do the right thing and to appropriately deal with staff that do the wrong thing. You should also expect them to compensate customers who fall victim and that compensation should be expensive.Warren Buffett will also endlessly talk about the things he is doing to ensure that integrity is what is rewarded at Berkshire.The Sydney Morning Herald today led with a headline that in leaked letters to consultants Dr Ken Henry (then Chair of National Australia Bank) had said that bad things were being done - even as they spoke - at National Australia Bank. To quote:[Dr Henry is] confident that there are products currently being sold now that they will need to remediate in the future ([and he] highlighted an example of SMSF borrowing to invest in managed funds).This looks pretty like the thing that Warren Buffett said about Berkshire. And it was said - as the context makes clear - to have the consultants who were hired to help in remediating the matter. In other words the admission is what is required to fix the problem.A while ago I went to look at the lending practices of the Australian banks and I am confident that all four big banks had bad processes, and ripped off customers. As I have stated elsewhere I think that National Australia was the least bad of a bad lot. But it clearly had things to fix.I still think NAB has things to fix. So does Westpac, CBA and ANZ [in that order I believe]. Stating it and acting on it is a necessary part of the process.That Ken Henry actually stated it and presumably to a consultant he had hired to help reflects well, not poorly on him. JohnPS. I also think alas that Dr Henry is right. The mis-selling scandals cost British banks billions of pounds. PPI mis-selling alone was above 20 billion pounds. There has been so much mischief at Australian banks that this issue is certain to bite them in the future. Dr Henry clearly identified the issue and wanted to do something about it. He should be applauded.