Sovereign Wealth Funds: Norway's Example

Larry Elliot of the Guardian writes in his blog  decrying Britain's squandering of its North Sea oil resource.  This once vast and rich production area reached peak output in 1999 and continues its decline.  The offshore oil industry really honed its technological, logistical and geophysical capabilities in this hostile exploration and production environment.  It has been a remarkable testament to the industry's ability to extract oil safely in such large quantities from such a nonconventional source.

When I teach my MBA Investments class, I like to break up the dry but necessary mathematical development of the capital asset pricing model and the efficient frontier, by using incorporating some practical material. For this, I incorporated a lecture Professor Robert Shiller gave to his financial economics class at Yale as additional reading material. The link above is to a YouTube video of the class and to a transcript of the lecture.

The subject of the lecture is portfolio diversification, the introduction of the riskless asset, and the optimum portfolio's location at the tangency point to the efficient frontier.  Shiller and his colleague Ronit Walny went to the Norwegian government in 2006 to encourage them to change their portfolio mix dramatically.  Shiller notes that the State pension fund was about 2 trillion Krone at that time, and the national endowment of North Sea oil was worth about 3.5 trillion krone, so 64% of the wealth that could be used to support the State pension fund was "black gold," or depleting oil.  Shiller's argument for changing the portfolio mix was heard by the State pension fund, by the government and the central bank.  Although they moved slowly, the Norwegian achievement has been remarkable, especially when compared to the British experience. 

Professor Shiller's introduction of the CAPM paradigm, the adoption of a different political approach to national involvement in oil production, together with a significant portfolio realignment has led to a $550 billion State pension fund, one of the largest in the world to support a small population of 5 million Norwegians.  In USD, the State pension fund grew from about $300 billion in 2006 to the current level of $550 billion. On top of this, the diversification has served to extend the life of Norway's North Sea oil resources to an additional 60 years, despite intensive production for the past forty years.

Shiller tells this story in a low key manner, but it's a dramatic example of how a fresh application of a rational, financial economics theory can really benefit all citizens.  Were our government only so politically and economically astute.  Alas...

EPA Acts on Coal Fired Power Plants

The EPA has proposed regulations mandating new coal-fired power plants to use carbon capture technology, and only this option, to meet stringent new air quality guidelines.  This should hopefully move the industry towards gas fired plant construction, as we advocated in a recent post.  Carbon capture has been studied and prototyped by MIT and other high powered academic engineering groups, but it is unproven on an industrial scale and costs will probably exceed early estimates. 

It is a good thing that the Administration has finally put something on the table for public comment.

Germany Blinks on a Bigger Bailout

Ambrose Evans-Pritchard in the Telegraph reports, "China is unlikely to come to the rescue. Jin Liqun, head of China Investment Corporation, told an Economist forum that Beijing is worried about the "unravelling of the situation" in Europe. "China cannot be expected to buy into high risk in the eurozone without a clear picture of debt workouts. Sorry if I have ruffled feathers," he said.


Stefan Homburg, head of Germany's Institute for Public Finance, said the EMU crisis had already gone beyond the point of no return. "The euro is nearing its ugly end. A collapse of monetary union now appears unavoidable. The Chancellor should have no illusions about this," he said. "

We've posted about the untenable position created for German Chancellor Merkel.  Today, she has deftly taken the postion that she hasn't authorized a bigger ESM facility, but merely accepted the need for keeping the EFSF to run longer so that the ESM can borrow to its full capacity.  No additional German cash has been committed.  Nicely done, but it would seem that investors like Jin Liqun and others will see through this and not like it. 

We have to acknowledge from our previous posting that Stefan Homburg might be a sharp,hedge fund-like investor when he said this, "I myself have invested a considerable sum in Greek bonds. They will mature in one year's time and, if all goes well, produce a 25 percent return on investment. I sleep very soundly at night because I believe in the boundless stupidity of the German government. They will pay up."

Natural Gas versus Coal for Power Generation

Here's information, somewhat dated, on the subject from an EPA website:
"At the power plant, the burning of natural gas produces nitrogen oxides and carbon dioxide, but in lower quantities than burning coal or oil. Methane, a primary component of natural gas and a greenhouse gas, can also be emitted into the air when natural gas is not burned completely. Similarly, methane can be emitted as the result of leaks and losses during transportation. Emissions of sulfur dioxide and mercury compounds from burning natural gas are negligible.

The average emissions rates in the United States from natural gas-fired generation are: 1135 lbs/MWh of carbon dioxide, 0.1 lbs/MWh of sulfur dioxide, and 1.7 lbs/MWh of nitrogen oxides.1 Compared to the average air emissions from coal-fired generation, natural gas produces half as much carbon dioxide, less than a third as much nitrogen oxides, and one percent as much sulfur oxides at the power plant."

With interest rates at historical lows, construction costs cyclically lower and generationally low gas prices, one wonders why the power generation industry doesn't convert significant portion of its fleet of older, coal fired electricity plants into gas fired capacity.  While there has been progress made in burning coal differently and better, this switchover isn't progressing quickly either. According to the Union of Concerned Scientists, we still have 600 coal-fired plants producing 54% of our electricity.  If hydraulic fracturing raises environmental concerns, carbon capture/sequestration is probably even more complex. 

Since electric utilities are so heavily regulated, I'd argue that we have a regulatory failure here.  What kind of regulatory regime do we need to incentivize utilities to rapidly switch more power generation capacity to widely available, cheaper and more environmentally friendly fuels?  Lack of clarity in  the government's regulatory stance may be what's holding back  investment in conversion.

And, while we're at that, what about a Marshall Plan for building the next generation power grid? 

Bond Outperformance May Be History

In USA Today, John Waggoner reports, "...for the last 30 years, bonds have beaten stocks, according to Ibbotson Associates, a highly respected Chicago research company. "It's hard to say that something that happens over 30 years is a fluke," says Francisco Torralba, economist at Morningstar Investment Management."  It is probably reasonable to say that the strong bond outperformance won't repeat itself over the next 30 year period.

Bond investing is going to get more challenging in the years ahead, particularly for those investors and institutions who favor Investment Grade Corporates.  Post-global meltdown, the supply of investment grade issues is smaller than in the past.  According to Moody's, bonds rated single 'A' or lower accounted for 58% of the corporate market in September 1990, whereas this below investment grade sector accounted for 73% of the corporate market in September 2010. 

Put the other way, investment grade corporates accounted for 42% of the market in September 1990, declining to 27% of the market in September 2010.  As Moody's points out, the cumulative defaults in the investment grade sector for the twenty year period ending September 2010 compared to cumulative defaults in the twenty year period ending September 1990 increased by 156 times. 

So, in the early stages of future market up cycles, investors can get equity-like returns in a larger below investment grade sector, recognizing that the sector has expanded because of the influx of fallen angels.

 It's also logical to expect that when the fire alarms go off in the equity casino and there are "flights to quality," that U.S. Treasuries will continue to benefit due to the immense size size, depth and liquidity of the market, especially compared to investment grade corporates. 

Those issuers remaining in the investment grade category today generally have the strongest balance sheets in recent corporate history, which is why intermediate bond funds have tilted their allocations to this sector beginning last year or before.

Fed Goes Oops on Stress Tests

The New York Times reports this morning that the Fed's stress test contained errors in the classification of losses in  Table 4, on page 32  of the report.  This is the table that I discussed in the previous post, and it's certainly disappointing that a high-powered organization like the Fed can't get these calculations right the first time.

It's also interesting to note that JP Morgan jumped on its positive stress tests to front-run the Fed by issuing its own press release.  This made sense, since JPM looked proactive and focused in defending its reputation.  By contrast, I looked around on the Citi website a few minutes ago, expecting to find prominent, flashing red lights pointing to a press release.  This release would have affirmed management's view that the initial test results were below expectations of the management and those of it its expert consultants.  It turns out Citi  had a point, but I couldn't find a press release. Disappointing.

There's another interesting line in  the table which purports to quantify the "Trading and Counterparty Losses" to the 19 bank holding companies from the use of derivatives for hedging risks.  In the original bailout, one of the justifications was that total global losses from a cascade of counterparty claims were incalculable and would bring the system down.  Now, in the case of a somewhat drastic economic scenario, these losses seem to be quite measurable, and they definitely do not bring down a system driven by these 19 systemically important financial institutions.  The Trading and Counterparty Losses shown range from $21 billion to $27 billion, affecting Bank of America, JP Morgan Chase, Goldman Sachs, and to a lesser extent Morgan Stanley.  I wonder what has changed in the world of derivatives that the formerly unknown has become known and manageable.

Fed Stress Tests 19 Banks: A Quick Road Test

The Fed's announcement of stress test results for 19 bank holding companies has provided balm for equity and debt holders, with the exception of four banks, which failed to maintain their core Tier 1 capital ratios at five percent of risk weighted assets at the end of the projection period, Q4 2013.  Although Met Life, Ally Financial, and Sun Trust failed the core Tier I test, the big news was that Citgroup also failed. 

There's no doubt that the economic scenario painted in the Fed's required simulation was extremely dire, and so the exercise is conservative in this respect.  Looking at the footnotes for Table 4 in the company projections, I suspect that the actual magnitudes for projected losses, revenue and net income could come in higher, lower and lower than projected, which would balance out the conservatism on the scenario choice.

Taking a quick look at a company like Keycorp which is included in the 19 company sample for the stress test, one still wonders how National City Bank was the only bank holding company in the Top 25 which failed to get Federal aid.  It got pushed into the arms of PNC for a song, further punishing shareholders.  It's still not clear to me how that happened, but enough on that aside.

Many of the ratios on the tables are rounded, so keep that in mind if some things don't add up.  Remember that the horizon we're looking at is 4Q 2011-4Q 2013. Beginning with Pre-Provision Net Revenue (PPNR), the format adds other revenue and subtracts Provisions, Realized Gains and Losses on Securities, Trading and Counterparty Losses, Other Losses and comes to Net Income Before Taxes.  A quick number that gives the flavor is to take the total swing PPNR to NIBT. In one sense, this is the total magnitude of the scenario's impact over the forecast period for a number that matters to investors.  For all 19 companies, this swing amount is $520.5 billion.  Here's the leader board for the swing from net revenue to loss:

1. Bank of America: $91.4 billion (17.6% of the sample total)
2. Citigroup: $91.4 billion (17.6% of the sample total)
3. JP Morgan Chase: $82.2 billion (15.8% of the sample total)
4. Wells Fargo: $72.9 billion (14.0% of the sample total)

These four bank holding companies, which are universally regarded as TBTF ("too big to fail") or Systemically Important, account for 65% of the total holding company sample's swing from PPNR to NIBT, which is negative in most cases, except for American Express, Bank of New York Mellon, and State Street which all would show positve NIBT in 4Q 2013. 

For the four leaders above, Bank of America, Citigroup and JP Morgan Chase all show significant Trading and Counterparty Losses during the simulation period: $21.1 billion, $20.9 billion, and $27.7 billion respectively.  It would be nice to understand how confident the Fed is in the computation of these losses.

If one goes back to a data set I like, the V-Lab from NYU's Stern School, it shows the top companies in "systemic risk %" being Bank of America, JP Morgan Chase, and Citigroup.  So, with different models and different simulations, we've identified the same characters, which is probably a good thing.  Let's focus the rest of the commentary on these Four Horsemen.

For the simulation period, the Total Loan Loss Table reads:

1. Bank of America--$70.1 billion
2. Citigroup--$67 billion
3. Wells Fargo--$58.3 billion
4. JP Morgan Chase--$55.8 billion

The Fed presentation shows loan losses by loan categories: First Lien Mortgages, Junior Mortgages and HELOC, C&I Loans, Commercial Real Estate Loans, Credit Cards, Other Consumer Loans, and Other Loans. 

Looking at Loan Losses as a Percent of Average Balances, Citigroup shows the highest aggregate percentage loan losses among the Four Horsemen above at 11.2%.  It shows the highest loss rates for First Lien, Junior and HELOC, and C&I Loans, the bread and butter of bank lending.

A reader can back into the average balances in each loan category, and in terms of dollars, Bank of America is the leader in aggregate loans with average balances of $845 billion, with $264 billion in first lien mortgages, $107 billion in junior mortgages and HELOC, and $160 billion in C&I loans. 

The largest card portfolio in terms of average balances is Citigroup at $146 billion, on which it is projected to generate $27 billion in losses under the simulation scenario.  JP Morgan Chase shows a credit card portfolio of $118 billion, which generates losses of $21 billion.  In the kind of severe economic and market downturn in the simulation, unsecured credit card lending bites back at bad underwriting and balance management. 

The group of four bifurcates into Wells and JPMC which passed their Tier 1 core capital tests and which have a a balance of businesses, the associated revenues and the ability to raise capital.  Bank of America, for all its good work in limiting liability for the mortgage debacle, still has challenges in the traditional product portfolio, and revenue growth will be a challenge; Merrill Lynch will probably be sold at some point, since its performance was relatively flat in 2011 compared to 2010, even though markets were heady.  Citigroup still seems like a directionless story, despite the successful financial engineering work to keep the ship from sinking. Revenue growth and value creation remain a mystery for the Citi That Never Sleeps.