The British Government borrows money by selling bonds, the bonds are known as ‘gilts’. Approximately £120 billion a year, the UK Government is borrowing to meet the short fall in tax revenue and government expenditure. (the budget deficit)
These GILTS are sold at regular auctions held by the UK Debt Management Office (DMO), to raise money for the UK Government, HM Treasury. These bonds are then traded on the bond market.

[www.dmo.gov.uk]

The DMO publishes a quarterly report that shows who currently owns the UK’s debt, summarized below.

39.8% Insurance Companies and Pension Funds
35.1% Overseas Investors
17.8% Other Financial Institutions
2.9% Households
2.9% Banks
1.5% Others.

Although the majority of gilts are held by British institutions, as you can see from the table above, 35% of our creditors are overseas investors. Thus effectively we are depending on the confidence of foreign investors to lend the UK money, and for the creditors to get their money back. The risk going forward is that once the UK gets into even more debt, confidence in the ability of the government to repay the outstanding debts falls.

The best analogy is in day to day life, would one like to lend money to a heavily indebted person ? The risk of getting one’s money back always increases when carrying a lot of existing debt.

Legal and General PLC is one of the UK largest insurers and money managers.

The Chief Executive, Dr. Nigel Wilson was interviewed on BBC Radio’s 4 The Bottom Line [http://www.bbc.co.uk/podcasts/series/bottomline/all]

The Podcast for the interview is [http://downloads.bbc.co.uk/podcasts/radio4/bottomline/bottomline_20130725-2100a.mp3]

Looking at the 256 page Annual Report of 2012, one soon realises the importance of Legal & General PLC

http://reports.legalandgeneralgroup.com/2012/ara/changestothereport.html
page 4: £406,000 million under management = £406 Billion

page 4: One of the largest investors in the UK stock market with responsibility for approximately 4% of all London-listed equities [yes, owns 4% of most UK listed companies]

page 8: 705,000 pensioners depend on Legal & General for pension income

page 9: Fiscal austerity – the UK Government has debt of over £1 Trillion, and an unsustainable deficit of £120bn
Page 11 is the most worrying set of data for society:

The ageing of most western populations poses considerable challenges for governments. in the UK, by 2030, over-60s will have grown from 22.6% of the population to 27.8% in just 20 years and the average 60-year-old woman will live until 88. Longevity and an ageing population are impacting UK government policy in three significant ways:

• The reduced ratio of the working population to the retired population makes it difficult to raise sufficient revenue from income-related taxes to finance central spending. This has been partially remedied by raising the retirement age.
• The state finds it difficult to finance retirement pensions. Solutions for this problem include the encouragement of private pension saving and changes in the retirement age and state pensions.
• Central government and local authorities are already finding it difficult to finance the costs of social care for elderly people. While the current generation is potentially able to contribute towards the costs through releasing housing equity, future generations may find this more difficult.

page 102: Largest 3 shareholders:

Schroders Plc  5.0%
BlackRock 4.9%
AXA S.A. 4.3%

page 151: Cash and cash equivalents include cash in hand, deposits held at call with banks, treasury bills and other short term highly liquid investments with original maturities of three months or less: £2,057 million = £2.057 Billion.

A well-oiled, efficent and highly liquid company, and the major investor in UK PLC.

HSBC, “the world’s local bank” has its annual report at [http://www.hsbcnet.com/gbm/rich_media/hsbc-com/annual-report-2012/index.html] is only 544 pages.

Trading has had a lot of negative publicity post the global financial crash. This is where bank’s use their own money to work the money markets and take positions (risks) on the price of commodities, currencies, shares, bonds, other financial instruments. etc etc. This is known as Proprietary Trading. The reason for this “prop trading” to be seen as controversial is, that is the bank gets into trouble and makes huge losses on bad risk decisions, the tax payer is on the hook to bail out the bank.

Page 374 onwards is the Balance Sheet of HSBC and what is interesting to see, is the trading exposure of the bank.

Trading assets of £408,811 million = £408 Billion
Trading liabilities of £304,563 million = £304 Billion

These assets are broken down on page 436.

They are the assets the bank trades with each day, of which Debt securities made up £144,677 million (£144 Billion), these are fixed income instruments.

Good to know, that the bank has a very strong position with more trading assets than liabilities, thus it is able to meet all liabilities.

The history of city of Detroit could be explained in earlier years with words like Motown Records or the power of the US Auto Industry. Today one thinks of Detroit as the film setting for Robocop (…please put down your weapon, you have 20 seconds to comply…) and the decline of a great city. Now today in a mess, it has declared bankruptcy. In the bankruptcy petition, it states 100,000 creditors make up the £12 Billion (US$18 Billion).

But who are the creditors who are owed £12 Billion ?

They are all the names of all of the city’s active employees & its retirees, a list of properties that have tax claims with the city, numerous bondholders such as municipal bonds issues by the city of Detroit, business creditors and companies that also insured Detroit debt. The single largest creditor is the city’s general pension scheme, which is owed $2 billion.

The facts will be resolved in the law courts, as the bond holders (creditors) will be offered some level of compensation for their losses (non payment of interest and principal capital), that will result in some sort of agreement, where the creditor is given something like 25 cents on the $1 owed, or something like that.

So what theoretically means, is that someone who lends Detroit money by buying bonds from Detroit (Detroit issues bonds to raise cash), now faces the prospect of losing (in my example) 75% of their capital. The risk going forward with that, is it takes a brave lender to lend to Detroit in the future, based on non-payment and bankruptcy of the past. This is best explained with the bankruptcy of Argentina in 2002. Defaulted on its debts, offered its creditors 10 cents on the Dollar, and has never been able to borrow on the international bond market. Frozen out of the capital markets.

The tax that the UK government hopes to collect in tax year is roughly as follows:

Income Tax of £155 Billion
National Insurance of £106 Billion
VAT of £102 Billion
Others Revenue £84 Billion (Radio Spectrum Auctions, Oil Leases, Petroleum Tax, Road Tax, Stamp Duties, Capital Gains Tax etc…)
Excise Duties £48 Billion (Tobacco, Alcohol)
Corporation Tax £45 Billion
Business Rates £26 Billion
Council Tax £26 Billion

∑ (£155 + £106 + £102 + £84 + £48 + £45 + £26 + 26) billion

Equates to about £592 Billion.

Yet this is not enough, spending commitments (Pensions, NHS, Defence, etc etc) of over £700 Billion means, the UK Government need to borrow on the Bond Market via Gilt Auctions, a further £120 Billion a year.

The UK Universities run a pension scheme called, The Universities Superannuation Scheme (USS).
[http://www.uss.co.uk/]. After the BT pension fund, this is the 2nd largest pension fund in the UK.

It has £34 Billion in assets, £34,000,000,000. It is very interesting to see the top 100 holdings.

[http://www.uss.co.uk/UssInvestments/InvestmentsTypes/Equities/Pages/USStop100investments.aspx]

The top 5 investments are

1 HSBC HOLDINGS £466.20m
2 ROYAL DUTCH SHELL £458.80m
3 VODAFONE GROUP £343.70m
4 GLAXOSMITHKLINE £259.40m
5 BP £235.90m

Why ?

These 5 firms are generous dividend payers.

1. HSBC yields 4% = £18,648,000 dividend income for USSC 
2. ROYAL DUTCH SHELL yields 5.1% yield = £23,398,800 dividend income for USSC
3. VODAFONE GROUP yields 5.3%. yield = £18,216,100 dividend income for USSC
4. GLAXOSMITHKLINE yields 4.3% yield = £11,154,200 dividend income for USSC
5. BP yields 4.7% yield = £11,087,300 dividend income for USSC

Good dividends to pay the pensions to the deserving retired academics.

Interesting fact that if you add up the top 5 investments:
∑ (£466,200,000 + £458,800,000 + £343,700,000 + £259,400,000 + £235,900,000)

= £1,764,000,000 (£1.764 Billion)= 5.18% of USSC Assets.

The 2012 Lloyds Banking Group Annual Report makes good reading.

[http://2012.lloydsbankinggroup-annualreport.com/downloads/lbg-2012-annual-report.pdf]

Only 372 page, but some salient points can be found, if you dig deep

Page 2: Total wholesale funding reduced by £81.6 billion to £169.6 billion;[money it needs to bridge the gap from deposits to loans]

Page 6&8: Brands: LloydsTSB, Halifax, Bank of Scotland, Cheltenham & Gloucester, Birmingham Midshires, Intelligent Finance, Scottish Widows, Lex Autolease.

Page 14: Targeting further reduction in total costs to around £9.8 billion in 2013 [more automation /job cuts and perhaps asking strategic vendors to do more for less…]

Page 29: Lloyds Banking Group has retained our position in the FTSE4Good socially responsible investment index

Page 44: the core loan to deposit ratio of 101 per cent at the end of 2012 now very close to our long-term target of 100 per cent.[today for every £100 on deposit, £101 is on loan, thus the need for £169.6 billion for wholesale funding]

Page 50: Customer deposits £422.5 billion (£422,500,000,000)

Page 63: Funds under management increased by £7.1 billion to £189.1 billion primarily driven by improved investment markets. Inflows have increased in the year primarily in St James’s Place. However this was largely offset by a reduced level of inflows in Scottish Widows

Page 124: HM Treasury currently holds 39.2% of the Group’s ordinary share capital. (UK tax payer owns 39.2% of Lloyds Banking Group)

Page 158: During the year, the Group drew €13.5 billion (£11.2 billion) under the European Central Bank’s Long-Term Refinancing Operation facility for an initial term of three years, to part fund a pool of non-core euro denominated assets. (borrowing from the ECB)

Page 170: Trading portfolios: The Group’s trading activity is small relative to its peers and the Group does not have a programme of proprietary trading activities

Page 208: Balance Sheet: Total assets £924,552 million = £924 Billion = £0.954 Trillion
Page 208: Balance Sheet: Loans to Customer £517,225 million = £517 Billion = £0.517 Trillion

The UK 2012 GDP was £1,541,465 Million = £1,541 Billion = £1.541 Trillion

Thus Lloyds Banking Groups assets = 60% of the UK 2012 GDP. The bank is vast.

A way to value an organisation, is to examine the cash generated in a 12 month period. This then shows the annual revenues.

Based on this methodology, here are the top 10 corporations in the world based on annual revenue at the end of 2012:

The world’s largest companies based on £ revenues.

1  Royal Dutch Shell £315 Billion [OIL] (UK & Netherlands)
2  Wal-Mart £307 Billion [RETAIL] (US)
3  Exxon Mobil £294 Billion [OIL] (US)
4  Sinopec £280 Billion [OIL] (China)
5  China National Petroleum £267 Billion [OIL] (China)
6  BP £254 Billion [OIL] (UK)
7  State Grid £195 Billion [POWER] (China)
8  Toyota Motor £173 Billion [CAR & TRUCK] (Japan)
9  Volkswagen £162 Billion [CAR & TRUCK] (Germany)
10 Total £153 Billion [OIL] (France)

Interesting to see how energy companies dominate the top 10, also note, that no banks are in the top 10.

One way to look at the size of an organisation, is to value the size of the business based on its market capitalisation (shareholder value) which is the number of shares in the company multiplied by the share price, this gives the overall market valuation.

Another way to size the enterprise, is to base the valuation on the size of the balance sheet. Based on this methodology, here are the top 10 banks in the world based assets at the end of 2012:

1. Industrial & Commercial Bank of China (ICBC) £1853 billion. [China]
2. HSBC Holdings £1774 billion [United Kingdom]
3. Deutsche Bank £1756 billion [Germany]
4. Crédit Agricole Group £1753 billion [France] 
5. Mitsubishi UFJ Financial Group Japan £1710 billion [Japan]
6. BNP Paribas £1665 billion [France]
7. Credit Agricole £1609 billion [France]
8. Barclays PLC £1582 billion [United Kingdom]
9. JPMorgan Chase £1555 billion [USA] 
10. Japan Post Bank £1510 billion [Japan]

When you added these numbers together:
∑(£1,853bn + £1,774bn + £1,756bn + £1,753bn + £1,710 + £1,665bn + £1,609bn + £1,582 + £1,555bn + £1,510bn)

= £16,767 billion = £16.7 Trillion.

The top 10 banks in the world hold £16.7 Trillion worth of assets.

In 2009-10 the Government spent £671.4 billion of our money, despite tax revenues of only £496.1 billion. [Thus a deficit of £671bn – 496bn = £175 bn, that £175bn short fall comes from borrowings]

This issue of spending more (government expenditure) than comes in (taxation) has been going on for years.

In 2011-11 the UK Government had to borrow £120.9bn (a budget deficit of £120.9bn)
In 2012-13 the UK Government had to borrow £119.5bn (a budget deficit of £119.5bn)
Project In 2013-14 the UK Government had to borrow £120bn (a budget deficit of £120bn)

As you can see, run up a deficit each each of £120bn each year for a few year years (borrow £120bn each year from the Bond Market) and the debts run up…..

When you add up all the borrowings, you get to about £1.2 Trillion

Yes, total debt is about £1,200,000,000,000 (£1,200 Bn = £1.2 Trillion)

In 2013-14, interest payments on the total national debt will be about £48 billion (£48,000,000 Million

It was Jim O’Neill of Goldman Sachs Asset Management who coined the term BRICS, when we was referring to the growth in the emerging market countries of Brazil, Russia, India, China and South Africa. In recent weeks one has seen an up rising in Brazil. Street demonstrations that hit Brazil last month began as opposition to transportation fare hikes, but have spread to include protests against a wide range of grievances, including the high cost of the World Cup and Olympics with the spiralling cost of living. The middle class are clearly feeling squeezed.

Latin America has seen a huge expansion in economic growth, with China buying raw materials from Brazil. Today Brazil boasts some of the largest companies, the banking giant Itau, Vale [http://en.wikipedia.org/wiki/Vale_(mining_company)] a top four miner in the world and Petrobas [http://en.wikipedia.org/wiki/Petrobras] one of the world’s largest oil companies. Also Brazil has a mature aerospace industry too, with Embraer [http://www.embraer.com/en-US/Pages/Home.aspx]

Latin America has a growing middle class that are now becoming consumers, just like India and China. The issue in Latin America as in other emerging markets is the gap between rich and poor that is causing social problems and the need for efficient transport systems that are dependent on a more robust infrastructure.

Retail investors can get access to investment opportunities in Latin America with funds like this from Invesco Perpetual:
[http://www.invescoperpetual.co.uk/site/ip/pdf/3302770_EN_GB-ip-latin-amer-fnd-fctsht.pdf]

When a company’s shares are listed on more than one stock exchange for the purpose of adding liquidity to the shares and allowing investors greater choice in where they can buy or trade their shares.

HSBC has its shares listed on the London Stock Exchange (LSE), The Hong Kong Stock Exchange, The Paris Stock Exchange and the New York Stock Exchange.
Standard Chartered has its shares listed on the London Stock Exchange (LSE), the Hong Kong Stock Exchange and The Bombay Stock Exchange.
BHP Biliton is listed on the London Stock Exchange (LSE) and the Australian Securities Exchange (ASX)
Shell has its shares listed on the London Stock Exchange (LSE) and the Amsterdam Euronext and the New York Stock Exchange (NYSE)
Unilever has its shares listed on the London Stock Exchange (LSE) and the Amsterdam Euronext.
Shell as a more complex capital structure, with Shell being made up of 2 classes of shares Shell A (class A) and Shell B (class B). Class A shares and Class B ordinary shares have identical rights, except related to the dividend access mechanism, which applies only to the Class B ordinary shares. This is due to different tax mechanisms on dividends in the UK, USA and The Netherlands.

UK Crude Oil has played a major role in the UK economy during the 1970s and 1980s for two reasons:

[1] The price of oil has fluctuated dramatically.

[2] Due to higher oil prices, there has been large-scale expansion in investment in North Sea oil production, resulting in the UK becoming a major oil-exporting nation.

The first North Sea oil came ashore in June 1975 and is thought to have peaked in 1999, with more than 40 billion barrels extracted so far. Brent Crude is $108 a barrel. So a very “crude” calculation of this value (ignoring inflation and the historical oil price):

$108 x 40,000,000,000 =  $4,320,000,000,000 = £2,853,220,000,000
£2,853,220,000,000 =  £2.853 Trillion = £2,853 Billion = £2,853,200 Millon

Oil production was negligible before 1975 but by 1980 it had risen to 603 million barrels per annum, 2.6 per cent of world production. Output from 12 crude oil fields  average 2 million barrels per day. So with Brent Crude at $108 a barrel:

$108 x 2,000,000 = $ 216,000,000 = £142,661,000 a day
£142,661,000 = £142.611 million

The 4 major North Sea oil fields are Brent, Forties, Oseberg and Ekofisk (BFOE). They are set to pump around 1,000,000 (1 million)  barrels per day.
A “crude” way to value the North Sea to the UK is to look at the value of Shell and BP
BP
[http://www.shareshop.hsbc.co.uk/shareshop/security.cgi?username=&ac=&csi=10022&record_search=1&search_phrase=bp]
£ 87,828m

Shell A
[http://www.shareshop.hsbc.co.uk/shareshop/security.cgi?username=&ac=&csi=133655&record_search=1&search_phrase=shell]
£ 84,419m

Shell B

[http://www.shareshop.hsbc.co.uk/shareshop/security.cgi?username=&ac=&csi=133755&record_search=1&search_phrase=shell]

£ 58,364m

 ∑(£ 87,828m + £ 84,419m +  £ 58,364m) = £230,611 million = £230.611 billion
The “crude value” of BP & Shell  to the UK = £230.611 billion

Systemic risk is the risk inherent to the entire market or entire market segment brought on by a major failure of a financial institution. Thus if a major bank or financial institution fails, it could being other all the others down, like a row on dominos and break the whole financial system and wipe out confidence. Or putting in bluntly, the risk that the failure of one financial institution such as a bank could cause other interconnected institutions to fail and harm the economy as a whole.

The US Treasury Department on Mon 8th July made an announcement.

[http://www.treasury.gov/initiatives/fsoc/designations/Pages/default.aspx]

It now has included AIG and GE Capital to the list of companies that need extra supervision by the US Federal Reserve. Remember back in September 2008, when AIG got into trouble, The Federal Reserve Bank of New York lent $182 Billion (1.21% of the US National debt = $182 Billion) to prevent it from failing, in Oct 2008, in the UK, The Bank of England had to lend £36.6 Billion to RBS and £25.4 Billion to HBOS. Examples of institutions that are too important to fail, thus the term Systemic Risk.

The Barclays 356 page annual report, a good read if you have time, some important nuggets can be found if you dig deep.
[http://group.barclays.com/about-barclays/investor-relations/annual-reports]

page 8: Paid £3.2 Billion (£3,200,000 million) in tax.

page 66: UK’s Legal & General Group plc own 480,805,132 shares = 3.99% of Barclays

page 66: His Highness Sheikh Mansour Bin Zayed Al Nahyanb of Abu Dhabi owns 858,546,492 shares = 7.02% of Barclays
[http://en.wikipedia.org/wiki/Mansour_bin_Zayed_Al_Nahyan]

Page 98: 373 people earned between £1,000,001 to £2,500,000 (nice work when you find it)

Page 206: Balance Sheet:

Total assets £1,490,321 million = £1,490 Billion = £1.490 Trillion
Trading portfolio assets £145,030 million = £145 Billion (effectively BarCap Trading Activities)
Customer Deposits £385,707 million = £385 Billion
Loans and advances to customers £425,729 million = £425 Billion

The UK 2012 GDP was £1,541,465 Million = £1,541 Billion = £1.541 Trillion
Assets of Barclays = £1,490,321 Million = £1,490 Billion = £1.490 Trillion

Thus Barclays’s assets = 96% of the UK 2012 GDP. The bank is HUGE.

The flagship financial index for the UK’s largest corporates (the blue chips) is the FTSE-100 share index. This index represents the UK PLC’s largest 100 companies.
Taking a closer look at the largest 10 companies that are in the FTSE-100 and seeing their representative percentage weight in the index gives even more insight:

HSBC Holdings = 7.69%
Vodafone = 5.59%
BP = 5.25%
GlaxoSmithKline = 4.77%
British American Tobacco = 4.12%
Royal Dutch Shell (A) = 4.01%
Royal Dutch Shell (B) = 3.56%
Diaego = 2.90%
AstraZeneca = 2.43%
BHP Biliton = 2.27%

[% weightings from Legal & General FTSE-100 Index Fund Managers Report]

Add up the percentages and you get 42.59%.

Yes, UK’s top 10 companies out of the 100 largest account for 42.59% of the FTSE-100.

The ‘remaining‘ 90 companies in the FTSE-100 such as BT, Barclays, Legal & General, Centrica, LloydsBankingGroup, Aviva, Prudential, British Land, Tesco, BG Group, Standard Chartered, National Grid, Arm Holdings, Marks & Spencer, Sainsburys, Severn Trent, Unilever, Burberry, Rio Tinto, GlencoreXstrata, The Royal Bank of Scotland, Land Securities, WPP, Standard Life, United Utilities, Anglo American, Rolls Royce,BAE Systems, Scottish & Southern Energy, RSA Insurance Group, Fresnillo, WM Morrison…. only account for 57.41% of the index.

Thus by investing into a FTSE-100 Index Tracker, over 13% of your investment is held in HSBC and Vodafone alone. The FTSE-100 is distorted by the UK’s  largest top 10 companies.

One can find the RBS annual report at the link below:-[http://www.investors.rbs.com/report_subsidiary_results]

Some very salient information can be found in the 543 page annual report.

page 2: RBS has £42 billion Short-term wholesale funding 

page 24: We now hold £100 of deposits for every £103 we lend (thus more loans than deposits, and thus the need for the short term wholesale funding)

page 40: At 31 December 2012, HM Treasury’s holding in the company’s ordinary shares was 65.3% and its economic interest was 81.1%.

page 97: The Balance sheet is £1,312,295 million (£1.312 Trillion = £1,312 Billion)

Page 97: Loans and advances to customers £500,135 million (£500 Billion = £0.5 Trillion)

Page 97: Customers deposits £433,239 million (£433 Billion = £0.433 Trillion)

The UK 2012 GDP was £1,541,465 Million = £1,541 Billion = £1.541 Trillion

Thus The Royal Bank of Scotland’s assets = 85% of the UK 2012 GDP. The bank is massive.

Lord Robert May [http://en.wikipedia.org/wiki/Robert_May,_Baron_May_of_Oxford], a fellow of The Royal Society, and a former President of the Royal Society, a highly respected Australian born academic, a man of great intellect in the scientific world especially in the area of biology and complex systems, has used his work and knowledge to look at the complexities in finance and financial products & instruments. This work is very much related to the global financial crisis as the work of Lord Robert May has shown that nature is based on simple mathematical models with very complicated dynamics, it is exactly these principles too, that have also resulted in the grotesque chaos of our financial markets.

A 2012 working paper from The Bank of England, co-authored by Lord May [http://www.bankofengland.co.uk/publications/Pages/workingpapers/2012/wp465.aspx] discusses the relationship of the size and complexity in financial systems.

What this work is effectively saying, is that while banks get bigger (balance sheets grow), they follow nature and become more complicated in structure, and this then results in massive risk. Due to the size of the bank and thus its overall complexity, a problem in the investment arm, this could spill over into say the retail operation, and bring the whole bank down. Thus one bad trade (like a rotten piece of fruit) could cause cross-contamination.

Thus we see the debate about banks being too big to fail.  Alan Greenspan, the former chairman of the US Federal Reserve has said that large organisations should be deliberately broken up: “If they’re too big to fail, they’re too big”. The former Governor of the Bank of England, Mervyn King, is quoted to have said that “If some banks are thought to be too big to fail, then, they are too big.”

Yesterday UK£ Sterling fell against the US Dollar$ when the Bank of England announced that UK interest rates would not be rising from the historical low of 0.5%. The markets had assumed a rise in the near future, but this was clearly an error, thus sterling has come under pressure, depreciating against the US Dollar. UK and US Equity Markets surged.

Reading the Bank of England press release [http://www.bankofengland.co.uk/publications/Pages/news/2013/007.aspx], it’s clear in the wording:

“At its meeting today, the Committee noted that the incoming data over the past couple of months had been broadly consistent with the central outlook for output growth and inflation contained in the May Report.  The significant upward movement in market interest rates would, however, weigh on that outlook; in the Committee’s view, the implied rise in the expected future path of Bank Rate was not warranted by the recent developments in the domestic economy.”

This is no different in the USA, Ben Bernanke the Chairman of the US Federal Reserve has made similar comments on low interest rates, and has stated that rates will remain low for the considerable future. His comments from a meeting in San Francisco explains why long term rates are slow low

[http://www.federalreserve.gov/newsevents/speech/bernanke20130301a.htm]

“I will begin my remarks by posing a question: Why are long-term interest rates so low in the United States and in other major industrial countries?  At first blush, the answer seems obvious: Central banks in those countries are pursuing accommodative monetary policies to boost growth and reduce slack in their economies. However, while central banks certainly play a key role in determining the behavior of long-term interest rates, theirs is only a proximate influence”

What happened on the equity markets ?

The UK’s FTSE-100 soared by over 190 points, a 3% gain, closing at 6421 adding nearly £50 Billion to corporate valuations as investors moved into equities, to get a decent return (juicy dividends) as cash on deposit yields next to nothing, and also clearly looking on the horizon the prospect of continued cheap money. By keeping rates low, it deters savers, in the hope they will spend in the wider economy and this consumption fuels some level of growth, but also reduces the cost of capital to businesses, in the hope they will invest and grow and fuel employment growth.

It was last week (late June) that HM Government announced major infrastructure investment in the region of £100 Billion

[https://www.gov.uk/government/organisations/infrastructure-uk]

It effectively is a Keynesian view to spend our way out of recession and kick start growth.

[https://www.gov.uk/government/publications/investing-in-britains-future]

The reality is like in the USA and continental Europe, infrastructure investment has been a low government priority, and we see aging bridges, old train lines that lack passenger capacity, so there is a real need to build new infrastructure, reduce overcrowding, replace ailing infrastructure and create prosperity too.

Already in the UK, there are FTSE listed companies specialising in infrastructure:

John Laing Infrastructure:[http://www.shareshop.hsbc.co.uk/shareshop/security.cgi?csi=2510086&action=]
Gives a 5% yield from its juicy dividend.

GCP Infrastructure: [http://www.shareshop.hsbc.co.uk/shareshop/security.cgi?csi=2484512&action=
Gives a 6% yield from its delicious dividend.

Also there are funds that invest in Infrastructure:
First State Global Listed Infrastructure [http://www.firststate.co.uk/uk/private/Funds/Global_Listed_Infrastructure/] that invests in companies like National Grid, Crown Castle International, Scottish and Southern Energy as just three names in the fund.

Also there are now specialist investment managers specialing in Infrastructure, like Infracapital.
[http://www.infracapital.co.uk/]
They are a part of M&G Investments [wwww.mandg.co.uk] who are a owned by Prudential [www.pru.co.uk] the UK insurance giant.

The facts are simple, about 65% of the UK’s infrastructure is already privately financed and with Government spending under massive pressure, HM Government has to ask the private sector to undertake infrastructure investment, and funding will come from companies and funds to undertake this investment.

The UK government, borrowed some “loose change” in June.

Their were four UK Gilt auctions in June, raising money for HM Treasury. The UK Debt Management Office is responsible for Gilt (UK Government Bonds) Issuance, that raises money for No 11 Downing Street.

[http://www.dmo.gov.uk/index.aspx?page=Gilts/Operations_Results]

[1]          04-Jun-2013 0 1/8% Index-linked Treasury Gilt 2024: Raised  £1,600,000 million
[2]          11-Jun-2013 2¼% Treasury Gilt 2023: Raised  £3,750.0000 million
[3]          13-Jun-2013 4¼% Treasury Stock 2032: Raised £2,250.0000 million
[4]          20-Jun-2013 1¼% Treasury Gilt 2018: Raised  £4,750.0000 million

Look at the maturities, 2018, 2023, 2024 and 2032. UK is borrowing with major debt repayments years away. We are mortgaging our futures.

In June, HM Government borrowed 

∑(£1,600,000 million + £3,750.0000 million + £2,250.0000 million + £4,750.0000 million)

=(£12,350,000,000)= £12,350 million = £12.350 Billion.

Why ?

Well clearly to meet all outgoings for HM government, (The public sector) there was not enough revenue from taxation, to bridge that gap, HM government borrowed via these 4 Gilt auctions, £12,350 Million (or £411 Million a day).

The finances of banks are highly counter intuitive. Customer savings (bank deposits) are a liability to the bank, NOT an asset (as one may mistakenly think) to the bank as they have to be repaid at any time (customer withdrawal); the assets of a bank consist largely of loans made to individuals or companies, since they too will be repaid with interest over the period of the loan. However those debtors (borrowers of the banks, such as companies or individual) may not have the liquid cash to repay the bank loans (100% loan repayment on a mortgage is not always practical, so if the bank demand the loan or mortgage to be repaid immediately, that is a tall order), thus any run on the bank (customer withdrawals) will create a huge potential problem for the debtors of the bank (individuals or companies who have borrowed money). The run on the bank will result is the bank demanding immediate repayment of the loans or mortgage to be repaid, refusal to refinance loans when they become due, or simply charge a higher rate of interest and impose more stringent conditions when the loan is renewed.

This explains why problems for the banks ripple throughout the wider economy.

Late in June, the stockmarket listing of Macau Legend in Hong Kong was suspended. This share floatation was worth approx £500million.

The reason for the abortion of this floatation was due to the market turmoil in China and the potential pending credit crisis in China. According to financial markets inter-banking lending in China is ceasing up. Last week the Shanghai index fell and has been very volatile and overnight borrowing costs jumped to 13.9% on Fri 21st June. (This is more than double the normal rate).

In 2012 the People’s Bank of China (PBoC), the central bank forced commercial banks to hold more cash in an attempt to create a buffer for banks to weather bad loans and also was an attempt to cool the inflated real estate market.

The result of all this, had rattled global markets, with the UK and US addicted to QE and when the US Federal Reserve hinted at winding down the bond buying programme (QE), the global markets too fright.

This is an age of unprecidented risk, Stagflation in Europe, High Youth Unemployment, Emerging Markets with structual issues, such as Chinese domestic real estate inflation and a potential banking problem, India with poor infrastructure, and the US gripped by an economy that is stuck in 2nd gear, and a huge budget deficit.

A somewhat abstract term, random walk in finance is commonly used to describe the movement of share prices. Share prices are said to follow a random walk which can be represented by what is called Brownian motion, a scientific term commonly referred to when describing atomic movements.

[https://en.wikipedia.org/wiki/Brownian_motion]

In short, random walk says that shares take a random and unpredictable path. The chance of a shares future price going up is the same as it going down

Share prices take on similar movements in that they are ‘random’, and this essentially forms the foundation of option pricing models through the modeling of share price movements. Options are derivative contracts that give the holder the right, but not the obligation, to buy or sell the underlying financial instrument at a specified price on or before a specified future date.

A new market of investment is Frontiers Markets.

Investing in these territories means greater risks, but potentially higher rewards. These markets are Nigeria, Saudi Arabia, the UAE, Sri Lanka, Ukraine, Kazakhstan, Mexico and Vietnam.

The MSCI Frontier Market index has gained 13.3 per cent in the first five months of the year.

To access to these markets are easy. This fund, The BlackRock Frontier Markets Fund and The Franklin Templeton Frontier Markets Fund:-

[http://www.blackrock.co.uk/individual/products/investment-trust/blackrock-frontiers-investment-trust]

[http://www.franklintempleton.co.uk/en_GB/adviser/funds/fund-detail.page?FundID=12904]

All give exposure to these exciting markets that of course offer that higher reward with the added excitement of risk.

The 2012 Annual report that was published in March 2013.

[http://www.hsbc.com/investor-relations/financial-results]

Looking at the figures, one can see the strong position that the bank is in, good news for UK plc, good news for worried depositors and good news for borrowers.

Total assets US$ 2,692,538 million [US$ 2.692 Trillion] = UK£ 1.745 Trillion = UK £1,745 Billion
Total liabilities 2,509,409 million [US$ 2.509 Trillion] = UK£ 1.626 Trillion = UK £1,626 Billion
Total equity 183,129

Customer deposits US$ 1,340,014 million [US$ 1.340 Trillion] = UK£ 0.686 Trillion = UK £868 Billion
Loans and advances to customers US$ 997,623 million = UK£ 626,724 Million = UK £626 Billion

In short the bank has more cash on deposit (UK£ 868 Billion) than loans advanced (UK £626 Billion)

A bank with more cash than loans. A strong capital position.

How big is HSBC ?
Well, it is massive.

UK HMRC (Her Majesty’s Revenue and Customs) collected UK £469 Billion in taxes in 2012-13.
UK Government spent UK £694.89 Billion in 2012.

The Japanese prime minister is called Shinzo Abe. He has created a new form of Economic Policy in Japan since coming to power that is is now known as Abenomics. It is brutal strategy to kick start Japan’s stagant economy, that has delivered next to zero growth for 20 years.

In essence, Abenomics is a policy designed to deflate the yen to boost exports. The policy is based on simply unprecedented monetary stimulus by the Bank of Japan undertaking huge bond purchases (Quantative Easing), extra budget spending by government borrowing and pro-growth policies such as an offer of tax breaks to companies investing in new equipment and facilities. What this has done, is to force down the value of its currency to give its domestic exporters a competitive advantage.

Thus it should be no suprise, that the Japanese Stock Market Index of the Nikkei 225 has done incredibly well in the past few weeks.

Others could think, Japan is embarking on a currency war, to drive down the value of the Yen to make its Japanese exports cheap. The debate will rage, but one question that is very hard to answer, with the Bank of Japan owning all these JGB’s (Japanese Government Bond’s) how will the BoJ sell these bonds (unwind / exit) ?

Near St. Paul’s in the City of London, literally, a one minute walk is Gresham Street
[http://www.streetmap.co.uk/newmap.srf?x=532454&y=181322&z=1&sv=gresham+street&st=6&tl=Gresham+Street,+London,+EC2v&searchp=newsearch.srf&mapp=newmap.srf]

It is named after Thomas Gresham was a financial agent and representative of the English Crown during the 16th Century. King Henry VIII had replaced 40% of the silver content in the English shilling with lower value base metals, effectively devaluing the shilling by 40%. Thus what happened was that business folk and merchants were hoarding the old shillings and using the new devalued shillings for trade. “Bad money crowds out good money.” The old shilling had far more value than the new shilling and the masses began to hoard the old ones.

Gresham’s law is an economic principle that states, “when a government overvalues one type of money and undervalues another, the undervalued money will leave the country or disappear from circulation into hoards, while the overvalued money will flood into circulation.” It is commonly stated as: “Bad money drives out good” – Gresham’s Law.

Modern examples are seen in the post financial crisis.

1. In Zimbabwe, shop keepers would sells items in shops, accept South African Rand or US dollers during the days of hyperinflation, and give change back to the customers in Zimbabwe Dollars.

2. In Iceland, shop keepers would sells items in shops, accept Euros during the Icelandic bankruptcy, and give change back to the customers in Icelandic Krona.

What you see in both cases, is the effective hoarding of what is perceived the more valuable asset, the South African Rand or the Euro.

With the levels of Quantative Easing, one has to think about whether governments are effectively trying to de-base the currency.

The US Fed Balance Sheet, shows the assets and liabilities of the US Central Bank.
Do you want to see a large number ?

Checkout the US Federal Reserve website :-

[http://www.federalreserve.gov/releases/h41/current/h41.htm#h41tab9]

This is the balance sheet of the US Federal Reserve (The Fed).

Total Assets = Total Liabilities (The famous account equation).

United States Federal Reserve Total Assets: $3,410,842 million.
YES, that is a large number, what I will explain that number.
$3.410842 Million Million dollar$
or
$3410.842 Billion dollar$
or
$3.410 Trillion dollar$.

To keep things in perspective, US GDP is about $15 Trillion dollars. However, that balance sheet is huge.

Thank goodness “In Fed We Trust“

The Co-Operative Bank The restructuring of Co-Op Bank shows how exposed the bank had become. A classic example of excessive borrowing during good times, but when the economic times got tough, the debt burden was simply too much. (over leverage)

[http://www.cooperativebank.co.uk/customerservices/announcements/recentannouncements/outcome-of-review-june-2013]

When one looks at the all bonds that are being re-structured:-

*9.25% Non-Cumulative Irredeemable Preference Shares GB0002224516  £60,000,000  Tier 1
 
13% Perpetual Subordinated Bonds  GB00B3VH4201  £110,000,000  Upper Tier 2
 
5.5555% Perpetual Subordinated Bonds  GB00B3VMBW45  £200,000,000  Upper Tier 2
 
Floating Rate Callable Step-up Dated Subordinated Notes due 2016  XS0254625998  €34,980,000  Lower Tier 2
 
5.875% Subordinated Callable Notes due 2019  XS0189539942  £37,775,000  Lower Tier 2 
 
9.25% Subordinated Notes due 28 April 2021  XS0620315902  £275,000,000  Lower Tier 2
 
Fixed/Floating Rate Subordinated Notes due November 2021  XS0274155984  £8,747,000  Lower Tier 2
 
7.875% Subordinated Notes due 19 December 2022  XS0864253868  £235,402,000  Lower Tier 2
 
5.75% Dated Callable Step-up Subordinated Notes due 2024  XS0188218183  £200,000,000  Lower Tier 2
 
5.875% Subordinated Notes due 2033  XS0145065602  £150,000,000  Lower Tier 2

[* – Tier 1 is the most junior ranking of Target Securities. Lower Tier 2 is the most senior ranking of Target Securities]

Count these numbers and guess what you get :- £1,306,782,200 (£1.306 Billion) of debt that is crippling the bank. The interest rate on some of these bonds is 9.25% and thus the interest repayments are effectively breaking the bank.

There is term that global banking regulators have been talking about, since the Federal Reserve Bank of New York in 2008 “generously lent” AIG $182 Billion, the term is known as The Shadow Banking System.
[It was Tim Geithner the former US Treasury Secretary who was the head of the New York FED in 2008 that approved the AIG rescue].
Princeton academic Paul Krugman is the economist who coined the term, The Shadow Banks.
[http://www.amazon.com/Return-Depression-Economics-Crisis-2008/dp/B0051BNVIG/ref=sr_1_1?ie=UTF8&qid=1318576098&sr=8-1]
Within the market-based financial system, “shadow banks” are particularly important institutions. Shadow banks are financial intermediaries that conduct maturity, credit, and liquidity transformation without access to central bank liquidity or public sector credit guarantees. Examples of shadow banks include finance companies, asset-backed commercial paper (ABCP) vehicles, limited-purpose finance companies, structured investment vehicles, money market unit trusts, securities lenders, and even supermarkets, UK has Tesco Bank and Sainsbury’s Bank for example. All are able to take deposits and enter the financial market and trade.
Shadow banks are interconnected along a vertically integrated, long intermediation chain, which intermediates credit through a wide range of securitisation and secured funding techniques such as ABCP, asset-backed securities, collateralised debt obligations, and repo.

This intermediation chain binds shadow banks into a network, which is the shadow banking system. The shadow banking system rivals the traditional banking system in the intermediation of credit to households and businesses. Over the past decade, the shadow banking system provided sources of inexpensive funding for credit by converting opaque, risky, long-term assets into money-like and seemingly riskless short-term liabilities. Maturity and credit transformation in the shadow banking system thus contributed significantly to asset bubbles in residential and commercial real estate markets prior to the financial crisis of 2008.
In essence, a failure in a Shadow Bank like AIG would have hadmassive effects, such as contagian, or US savers with 401k plans loosing life savings, so regulating these institutions is a key issue that governments and regulators are trying to address.

In these historically low interest rate times, looking for a better interest rate is hard. Also when credit is constrained, and banks are unwilling to lend, their is new source of credit. That is Peer to Peer lenders.

A new innovation is Peer to Peer lending, where people pool deposit money together with effectively a broker, who then credit assesses potentials lenders, and then lends the money out for a small management fee.

In the UK, Zopa and The Funding Circle are making great inroads into this market place.

What is now interesting, that this ability to create a new pool of lenders from new creditors, is a force that is actually being seen as a force for change in the banking world.

Andrew Haldane at the Bank of England, is quoted as saying “innovations in commercial peer-to-peer lending, again using the web as a conduit, could make some bank functions surplus to requirements”

A good article from the Bank of England:-

[http://www.bankofengland.co.uk/publications/Pages/news/2012/029.aspx]

and a paper:-

[http://www.bankofengland.co.uk/publications/Documents/speeches/2012/speech552.pdf]

In the low interest climate, a peer to peer lender can get 5%.

In 2008, the term MBS was common when referring to the banking crisis that gripped the western world, when Lehman Brothers collapsed. They held a portfolio of Mortgage Backed Securities that turned out to be of much lower value, and were also highly illiquid. These Mortgage Backed Securities, are effectively collections of mortgages, and thus are ‘debt instruments’.

With the growth in the sophistication of mortgage finance, a home owner today, that has financed the home purchase by a mortgage, that debt (the mortgage loaned against the house)could be backing up a publicly traded security. Yes a mortgage could form a part of a Mortgage Back Security traded on the stock market. Today a high percentage of individual mortgages originated by banks and other lenders are ultimately pooled and used as collateral to issue mortgage-backed securities (MBS), which are then sold to investors, like investment banks, pension funds, insurance companies who then derive an income.

The mechanism to create a Mortgage Backed Security is a process called Securitisation of an asset. That was covered in an earlier article I published.

A mortgage-backed security are bonds that are backed by pools of mortgage loans. In the most basic type of MBS, homeowners’ mortgage payments are passed through to the bondholder, meaning the bondholder receives monthly payments that include both capital and interest. This is a key difference between mortgage backed security and other bonds such as UK Gilts, which pay interest every six months or annually and return the whole capital principal at maturity.
In the USA, the mortgage backed security market is the largest component of the U.S. Bond Market, with about £ 5.6 Trillion [$8.9 Trillion] in mortgage-related debt outstanding. (interesting comment that £5.6 Trillion is 4 times the UK GDP !!) As I said, mortgages are the largest segment of the U.S. bond market, accounting for 26% of all bond market debt outstanding.
However the trading of these securities, that then were passed from bank to bank, all turned sour, when the deck of cards collapsed. What do I mean by that ?
Simple, as soon as the mortgage holder stops paying the mortgage, the whole stack collapses, and the holder of the mortgage backed security, is effectively holding a worthless asset (or a lot less in value) as in the US, where this started, the actual underlying asset, the property that the loan is secured against, had sharply fallen in price, so the loan is larger than the property (bricks and mortar) thus negative equity.

These mortgage backed security then become a lot less valuable, and the media has referred to them as Toxic Assets.

A benchmark serves a crucial role in investing. Often a market index, a benchmark provides a starting point for a portfolio manager to construct a portfolio and directs how that portfolio should be managed on an ongoing basis from the perspectives of both risk and return. It also allows investors to gauge the relative performance of their portfolios; an annual return of 6% on a diversified bond portfolio may seem strong, but if the portfolio’s benchmark returns 7% over the same time period, the bond portfolio has fallen short of its goal. The number of benchmarks is virtually endless, and selecting the right one is not always easy. To try to simplify the selection process, we examine in this blog what a benchmark is, how it is calculated, and why portfolio performance may differ from that of the benchmark. Benchmarks should be investable, but it is possible that a universe of shares and bonds (securities) in a benchmark may be so broad that it would not be practical to purchase all of them. In other cases, a benchmark may contain securities that are difficult to purchase.
In most cases, investors choose a market index, or combination of indexes, to serve as the portfolio benchmark. An index tracks the performance of a broad asset class, such as all listed stocks, or a narrower slice of the market, such as technology company shares. Because indexes track returns on a buy-and-hold basis and make no attempt to determine which securities are the most attractive, they represent a “passive” investment approach and can provide a good benchmark against which to compare the performance of a portfolio that is actively managed. Using an index, it is possible to see how much value an active manager adds and from where, or through what investments, that value comes.
These are among the most widely followed stock indexes, or benchmarks:

FTSE100: U.K. Market capitalisation-weighted index of the 100 largest U.K. companies traded on the London Stock Exchange (e.g. BT Group PLC, GlaxoSmithKline PLC, Rolls Royce PLC, BP PLC, Vodafone PLC, AstraZeneca PLC)

DJIA : U.S. Price-weighted average of 30 large publicly traded U.S. “blue chip” stocks (e.g. Intel, Alcoa, IBM)

Hang Seng Index: Hong Kong. Free float-adjusted market capitalisation-weighted index of the 45 largest companies on the Hong Kong stock market. (e.g. Cathy Pacific, FoxConn)

MSCI World Index: Global Equities. Free float-adjusted market capitalisation index consist of 24 developed market country indexes, 6000 companies.

NASDAQ Composite: U.S. More than 3,000 technology and growth domestic and international based companies on the NASDAQ stock market (e.g. Oracle Corporation, Cisco Systems, Yahoo, Google, Sybase)

Nikkei 225: Japan. 225 leading stocks traded on the Tokyo Stock Exchange (e.g. Sony, NTT, Toshiba, NEC)

S&P 500: U.S. 500 leading companies in the Large-Cap segment of the U.S. equities market. (e.g. AT&T, JP Morgan Chase, ExxonMobil)

Numerous other equity indexes have been designed to track the performance of various market sectors and segments. Because stocks trade on open exchanges and prices are public, the major indexes are maintained by publishing companies like Dow Jones and the Financial Times, or the stock exchanges. Fixed income securities do not trade on open exchanges, and bond prices are therefore less transparent. As a result, the most commonly used indexes are those created by large broker-dealers that buy and sell bonds, including Barclays Capital (which now also manages the indexes originally created by Lehman Brothers), Citigroup, J.P. Morgan, and BofA Merrill Lynch. Widely known indexes include the Barclays U.S. Aggregate Bond Index, tracking the largest bond issuers in the U.S., and the Barclays Global Aggregate Bond Index of the largest bond issuers globally. Actually, bond firms have created dozens of indexes, providing a benchmark for virtually any bond market exposure an investor might want. Barclays Capital alone publishes more than 30 different bond indexes. New indexes are often created as investor interest grows in different types of portfolios. For example, as investor demand for emerging market debt grew, J.P. Morgan created its Emerging Markets Bond Index in 1992 to provide a benchmark for emerging market portfolios.
Indexes also exist for other asset classes, including property (real estate) and commodities

In the bond market (fixed interest market or debt market as it is sometimes referred too), there is methodology to turn an asset into a debt instrument, that pays a yield (income or coupon) like a bond. This is called securitisation.

Securitisation is a well-established methodology used in the global debt markets. It was introduced initially as a means of funding for mortgage banks. Iike HBOS or Building Societies. Subsequently, the technique was applied to other assets such as credit card payments. Barclaycard do this with their creditcard portfolio. It has also been employed as part of asset/liability management, as a means of managing balance sheet risk. The excellent book that explains Securitisation is by Somsekhar Sundaresan:

http://www.amazon.co.uk/Markets-Derivatives-Academic-Advanced-Finance/dp/0123704715/ref=sr_1_fkmr0_3?s=books&ie=UTF8&qid=1318102497&sr=1-3-fkmr0

The process of securitisation creates asset-backed bonds. These are debt instruments that have been created from a package of loan assets on which interest is payable, usually on a floating basis. The asset-backed market was developed in the United States and is a large, diverse market containing a wide range of instruments. Techniques employed by investment banks today enable an entity to create a bond structure from any type of cash flow; assets that have been securitised include loans such as residential mortgages, small business loans, commercial property mortgages, car loans, and credit card loans. The loans form assets on a bank or finance house balance sheet, which are packaged together and used as backing for an issue of bonds. The interest payments on the original loans form the cash flows used to service the new bond issue. Traditionally mortgage-backed bonds are grouped in their own right as mortgage-backed securities (MBS) while all other securitisation issues are known as asset-backed bonds or ABS. Let me give you an example ‘closer to home’.

Take the hypothetical company, Asad Karim Telecoms PLC. This business has a retail operation, called AK Retail, and delivers a broadband service to its 1000 customer base, and charges a monthly fee of £100, and the service is 0.5Mb. (A high quality operation as you can see…) Asad Karim Telecoms PLC, decides to securitise the AK Retail broadband business to raise cash, get the business off the balance sheet, so creates an special purpose investment vehicle called AK Retail Broadband PLC, that pays a monthly income to investors based on those 1000 customers each of which pay £100. Thus Asad Karim Telecoms PLC has “unlocked” the cash flows of the AK Retail business, and investors of course get access to the cash flows on the broadband business. Simples….
The securitisation process involves a number of participants. In the first instance is the originator, the firm whose assets are being securitised. The most common process involves an issuer acquiring the assets from the originator. The issuer is usually a company that has been specially set up for the purpose of the securitisation and is known as a special purpose vehicle or SPV and is usually domiciled offshore. In the UK for example, Northern Rock had an SPV for its mortgage book called Granite that was based in the UK Channel Islands, and Halifax Bank of Scotland (HBOS) had a similar vehicle that was called Grampian Mortgages. All clever accounting mechanisms for off balance sheet reporting. The creation of an SPV ensures that the underlying asset pool is held separate from the other assets of the originator. This is done so that in the event that the originator is declared bankrupt or insolvent (or rescued my HM Government…), the assets that have been transferred to the SPV will not be affected.

A credit default swap (CDS) is the most highly utilised type of credit derivative. In its most basic terms, a credit default swap is similar to an insurance contract, providing the buyer with protection against specific risks. Most often, corporate bond investors buy credit default swaps for protection against a default by the issuer of the corporate bond, but these flexible instruments can be used in many ways to customise exposure to corporate credit. CDS contracts can mitigate risks in bond investing by transferring a given risk from one party to another without transferring the underlying bond or other credit asset. Prior to credit default swaps, there was no vehicle or instrument to transfer the risk of a default or other credit event, such as a downgrade, from one investor to another.

In a CDS, one party “sells” risk and the counterparty “buys” that risk. The “seller” of credit risk-who also tends to own the underlying credit asset-pays a periodic fee to the risk “buyer.” In return, the risk “buyer” agrees to pay the “seller” a set amount if there is a default (technically, a credit event). CDS are designed to cover many risks, including: defaults, bankruptcies and credit rating downgrades. The characteristics of Credit Default Swaps: The credit default swap market is generally divided into three sectors:

[1] Corporates

[2] Bank credits

[3] Emerging market sovereigns.

CDS can reference a single credit or multiple credits. Multi-credit CDS can reference a custom portfolio of credits agreed upon by the buyer and seller, or a CDS index. The credits referenced in a CDS are known as “reference entities.” CDS range in maturity from one to 10 years although the five-year CDS is the most frequently traded.

Unlike total return swaps that provide protection against the loss of credit value irrespective of the cause, credit default swaps provide protection only against previously agreed upon credit events. Below are the most common credit events that trigger a payment from the risk “buyer” to the risk “seller” in a CDS. The settlement terms of a CDS are determined when the CDS contract is written. The most common type of CDS involves exchanging bonds for their par value, although the settlement can also be in the form of a cash payment equal to the difference between the bonds’ market value and par value.

The CDS market was originally formed to provide banks with the means to transfer credit exposure and free up regulatory capital. As the credit default swaps market became more standardised and gained credibility, particularly following smooth credit event settlements in high profile cases such as WorldCom and Enron, more investors entered the market. While banks-through broker-dealers and reinsurance companies-are still both the largest buyers and sellers of credit default swaps, investment management firms are following closely.

Today, CDS have become the engine that drives the credit derivatives market. According to the British Bankers’ Association, the credit default swaps market currently represents over one-half of the global credit derivative market. The growth of the CDS market is due largely to CDS’ flexibility as an active portfolio management tool with the ability to customise exposure to corporate credit. In addition to hedging event risk, the potential benefits of CDS include:

[1] A short positioning vehicle that does not require an initial cash outlay

[2] Access to maturity exposures not available in the cash market

[3] Access to credit risk not available in the cash market due to a limited supply of the underlying bonds

[4] Investments in foreign credits without currency risk

[5] The ability to effectively ‘exit’ credit positions in periods of low liquidity

The performance of credit default swaps, like that of corporate bonds, is closely related to changes in credit spreads. This sensitivity makes them an effective hedging tool that can assume exposure to changes in credit spreads as well as default risk.

The event risk embedded in bonds and other credit assets was very difficult to reduce prior to the evolution of credit default swaps. In the brief decade since their inception, credit default swaps have become not only a tool that effectively hedges event risk but also a flexible portfolio management tool that far exceeds that single benefit.

The question has to be asked, from a moral perspective, the ability to trade such instruments. So perhaps it is the interest of the CDS owner that the bond that is being insured actually goes into default, so the CDS owner can claim on the insurance. Hmmmmm, one is not allowed to take out life insurance on someone else, otherwise wise their is an incentive that the person owning the insurance policy (paying the premiums) would like the person to “snuff it” (die), and then claim (thus get the benefit) on the insurance policy.

To me, these are the fundamental questions that needed to be asked, when we look at our financial industry, we need insurance, but do we need to be able to make profits from someone elses distress ?

There has been a lot of talk about bonds in the media. Bank bonds, Government bonds, Junk Bonds, Greek Bonds, Bond Default.

[Junk Bonds are sometimes called High Yielding Bonds, as the risk is the issuer, is a risky government, or new company or an un-creditworthy institution, so certain investors like pension funds are unable to hold such risky assets, and perhaps some cynical or risk adverse investors look at the Junk Bond see the relatively high interest rate, but look at the issuer and then simply draw the conclusion that the Junk Bond is just ‘Mutton Dressed As Lamb’]

I thought it was a good opportunity to explain these financial instruments. Sometimes known as fixed income securities or debentures, or debt securities or debt instruments or income bearing securities. Yes, lots of explanations for the same thing. A financial product that promises to pay a return to the holder of the product. It is an “I Owe You”

The bond market is by far the largest securities market in the world, providing investors with virtually limitless investment options. Many investors are familiar with aspects of the market, but as the number of new products grows, even a bond expert is challenged to keep pace. While we spend a great deal of time discussing economic forecasts and how those forecasts may affect unique sectors of the bond market. So to be clear, the Bond Market (Debt Market) is many many times larger than the Stockmarket. Yes, the value of companies listed (Market Capitalisation) is dwarfed by the Bond Market.

I will now explain the fundamentals of the bond market. (sometimes known as the debt market)
First and foremost, a bond is a loan that the bond purchaser, or bondholder, makes to the bond issuer. Governments and companies issue bonds when they need capital. If you buy a government bond, you’re lending the government money. If you buy a corporate bond, you’re lending the corporation money. Like a loan, a bond pays interest periodically and repays the principal at a stated time.

Suppose a hypothetical world class company (Asad Karim PLC) that wants to build a new global telecommunications network for £1 million and decides to issue a bond to help pay for the network. Asad Karim PLC might decide to sell 1,000 bonds to investors for £1,000 each. In this case, the “face value” of each bond is £1,000. Asad Karim PLC—now referred to as the bond “issuer”—determines an annual interest rate, known as the “coupon,” and a timeframe within which it will repay the principal, or the £1 million. To set the coupon, the issuer takes into account the prevailing interest-rate environment to ensure that the coupon is competitive with those on comparable bonds and attractive to investors. Our hypothetical company (a world class operation of course…..) may decide to sell five-year bonds with an annual coupon (the yield or interest rate payable) of 5%. At the end of five years, the bond reaches “maturity” and Asad Karim PLC repays the £1,000 face value to each bondholder. (Asad Karim PLC honours its debts of course)

Vodafone has issued bonds:

[http://www.vodafone.com/content/index/investors/debt_investors/bonds.html]

You will see that Vodafone have 3 programmes of Bond Issuance (Debt Issuance) in the form of a European, US and Commercial Paper programme. The European programme has raised €30 Billion. Quoting Vodafone the reason for the Bond programme:

‘Our financing strategy is to provide timely, cost efficient and secure financial resources to the Group and to manage Vodafone’s capital structure in line with its targeted low single A credit rating. The Group’s policy is to borrow centrally using a mixture of long-term and short-term capital market issues and borrowing facilities to meet anticipated funding requirements. In respect of certain emerging markets we may elect to borrow on a non-recourse basis. Risk management is at the core of our financing policies. We use derivative instruments to manage our currency and interest rate risk and collateral support agreements to mitigate the credit risk of banking counterparts. Liquidity risk on long term borrowings is managed by maintaining a disciplined maturity profile. Our mid to long-term debt is primarily financed via corporate bonds programmes. Our short-term funding requirements are met through our commercial paper programme’

In essence, buyers of Vodafone bonds, are lenders to Vodafone, (Vodafone creditors) and lend cash to Vodafone, and and have to trust Vodafone to repay them. That is the risk.

How long it takes for a bond to reach maturity can play an important role in the amount of risk as well as the potential return an investor can expect. A £1 million bond repaid in five years is typically regarded as less risky than the same bond repaid over 30 years because many factors can have a negative impact on the issuer’s ability to pay bondholders over a 30-year period. The additional risk incurred by a longer maturity bond has a direct relation to the interest rate, or coupon, the issuer must pay on the bond. In other words, an issuer will pay a higher interest rate for a long-term bond. An investor therefore will potentially earn greater returns on longer-term bonds, but in exchange for that return, the investor incurs additional risk.

Every bond also carries some risk that the issuer will “default,” or fail to fully repay the loan. Independent credit rating services assess the default risk of most bond issuers and publish credit ratings in major financial newspapers. These ratings not only help investors evaluate risk but also help determine the interest rates on individual bonds. An issuer with a high credit rating will pay a lower interest rate than one with a low credit rating. Again, investors who purchase bonds with low credit ratings can potentially earn higher returns, but they must bear the additional risk of default by the bond issuer.

It is an bond investor today, with a large appetite for risk who today buys Greek Government Bonds or Spanish Bonds for example.

There has been a lot of talk in the past 12 months, about the level of U$ National Debt.
Question: But how large is it ?
Answer: 100% of GDP.
The debt ceiling, the amount the US is legally allowed to borrow is 100% of GDP (a self imposed limit)

The numbers…..

The current limit (debt ceiling) is $14.294 Trillion.
That is $14,294,000,000,000 dollars to be mathematically elegant.

Or in Engli$h: Fourteen Million Million Dollar$. In UK Sterling that is only £8.737 Trillion of course.

To be global, I will try and be equitable to all….

[$14.294 Trillion = EU€ 9.88 Trillion = AUD$ 12.96 Trillion = Chinese Yuan CNY = 91.87 Trillion = Singapore $SGD 17.17 Trillion = Hong Kong $HKD 111.35 Trillion]

Useful to quantify the $14.294 Trillion figure with some good comparisions.

The assets of Bank of New York Mellon under custody are $26.3 Trillion. So the US ‘only’ owes 54% of the assets under custody at Bank of New York Mellon.

The assets at State Street under custody are  $22.8 Trilllion . So the US ‘only’ owes 62% of the assets under custody at State Street.

The assets of Blackrock are $3.66 Trillion. Thus the assets of Blackrock are 25% of the US National Debt.

The assets of HSBC (UK largest bank based on assets) are $2.597 Trillion. Thus the assets of HSBC are 18% of the US National Debt.

The assets of the world’s largest pension fund (The Government Pension Investment Fund of Japan) are $1.315 Trillion. Thus the assets of The Government Pension Investment Fund of Japan are 9.1% of the US National Debt.

BT’s Pension Fund according to Towers Watson, is the largest pension in the UK, and is the world’s 40th largest pension fund with assets on March 31st 2011 of $57.211 Billion (£34.97 Billion)
The BT Pension Fund (assets $57.211 Billion / £34.97 Billion) equates to 0.4% of the US National Debt.

Big numbers.

I saw on the UK Debt Management Office [http://www.dmo.gov.uk] that the UK HM Government are going to borrow using Gilt Issuance. (A bond issue)

Nothing new with this, but what is interesting, is the fact, that this Gilt Auction is for long term gilts. The Gilts to be issued will mature in 2068. Yes, a 55 year maturity.

[http://www.dmo.gov.uk/documentview.aspx?docName=/gilts/press/pr070613.pdf]

So the UK government are able to borrow at very low interest rates, and the maturity is way in the future, 22nd July 2068 to be precise. By reading the press release, this very long-dated bond, that expires in 2068, is actually going to being issued through a syndicate of banks rather than a normal auction process, thus meaning there is no set amount to be raised, it will be interesting to see how much cash will be raised, and what the coupon rate is (interest rate).

Quantative Easing (creating new credit by the Central Bank) is having major effects on Pension Funds.

Let me give you a real example.

In June 2013, BT (a FTSE-100) giant, published the 2012-13 Annual Report
[http://www.btplc.com/Sharesandperformance/Annualreportandreview/index.cfm]

Look at page 25 of the annual report.

“Government bond yields have fallen since the valuation at 30 June 2011, with real yields being negative at times. This has been caused by a number of factors, including the Bank of England’s Quantitative Easing programme. If the fall in yields is maintained and reflected in the next funding valuation, due as at 30 June 2014, this would increase the value of the BTPS
liabilities”

What this is telling us, in very clear terms, as the Bank of England creates new money in the form of new credit, it is thus forcing down the cost of borrowing for HM Treasury, by reducing the yield on UK Gilts (UK Soverign Bonds), and the effect of this, is that BT’s Pension Fund run by Hermes Investment Management for example [www.hermes.co.uk] that holds UK Gilts, is getting a reduce return on its holding (investment) in UK Gilts, and this now means, the effective gives the pension fund a headache, as the investment returns are reducing, and thus increasing the overall liability.

This pressure on bond yields is resulting in pension funds globally to look for new sources of investment, which is why we are seeing pension funds and insurance companies looking to other forms of investments in alternative assets classes, such as infrastructure, long term university accomodation or raw materials like commodities. Of course QE is only one pressure, people living longer is another demand and pressure in pension funds, QE just makes the situation worse.

I saw the Bank of England released the 2013 Annual Report

[http://www.bankofengland.co.uk/publications/Pages/annualreport/default.aspx]

Makes interesting reading, see page 44. This shows the massive growth in the BoE balance sheet.

The reason for this growth is down to the BoE increasing the Quantitative Easing programme, (BEAPFF = Bank of England Asset Purchase Facility Fund).

What this means is that Bank of England has been buying UK government bonds (Gilts) with new money, thus growing the monetary base. A consequence of this, is that yields on Gilts are falling, and thus investors have been forced to look for other yielding assets (equities & corporate bonds), so reducing the price of the long-term cost of capital for businesses. Thus we see booming stock markets and real estate assets increasing in value, as investors move out of cash and government bonds. Thus creating a wealth effect to investors fortunate enough to hold financial assets, and thus their wealth rises, as share prices and property prices are rising.

The truth be known, it is about reducing the value of savers cash on deposit. That is the told story.

If you get a chance, it is worth listening to Radio 4’s Desert Island Discs, as it features this week, Sir Mervyn King, the outgoing Govenor of The Bank of England.

[http://www.bbc.co.uk/programmes/b02116z9]

In the UK, the central bank is the Bank of England. In the US, the central bank is The US Federal Reserve. In the Euro Zone, the central bank is the ECB, The European Central Bank. The distinctive feature of a central bank derives from its role as the monopoly supplier of outside money, comprising notes and coin and commercial banks’ reserve deposits.
These constitute the ultimate settlement asset for an economy and mean that a central bank has a unique ability to create or destroy liquidity through the use of its balance sheet. Setting the interest rate in the country and the primary objective is to ensure that the supply of that liquidity is consistent with the smooth functioning of the real economy. From this follows the two core tasks of a central bank: the maintenance of broad stability in the price level, nowadays often enshrined in a formal numerical target for inflation; and supporting the process of financial intermediation during times of stress, including acting as Lender of Last Resort to solvent, though temporarily illiquid, financial institutions. The best example of this was when in 2007, the lender Northern Rock suffered a run, where savers (depositors) formed queues to get their money out. To plug the gap, when wholesale funding / money markets / credits markets froze for Northern Rock. The Bank of England, lent £30bn to The Northern Rock. Later it was disclosed after the collapse of Lehman Brothers, The Royal Bank of Scotland and Halifax Bank of Scotland got £62bn in secret emergency loans in the October 2008, showing the Bank of England was the lender of last resort (and HM Government = The UK Tax Payer being the investor of last resort in the merged LloydsTSB & HBOS (Lloyds Banking Group) and RBS with the £37bn in equity stakes in RBS and Lloyds Banking Group owned by UK Financial Investments (UKFI) the government institution charged with running and managing the UK Tax Payer stakes in RBS and LBG)

The secret support began for HBOS on October 1st 2008, two weeks after the collapse of America’s Lehman Brothers and when financial markets were at their most panicky, and peaked at £25.4 billion on November 13 2008. The money was eventually repaid on January 16 2009. RBS began tapping the Bank for liquidity on October 7 2008 and at its peak borrowed £36.6 billion. It paid back all the money by December 16 2008. Both banks eventually provided the Bank with collateral with a value in excess of £100 billion. They were also charged fees by the Bank of England. It was clear, the emergency loans from The Bank of England were to ensure smooth functioning of the UK economy as if RBS or Lloyds Banking Group failed, perhaps a depression would have occurred.

Of course, central banks sometimes carry out other tasks too. The Bank of England, for instance, manages the government’s foreign exchange reserves and used to manage our national debt. And in some countries, central banks are responsible for banking supervision, such as the MAS, The Monetary Authority of Singapore, but such tasks do not by their nature have to be carried out by the central bank. In the UK currently banking supervision is undertaken by the FCA, the Financial Conduct Authority.

In these crazy times of extra-ordinary low interest rates, where does one look to find an investment that gives a decent rate of return ?

For pension funds or retired people, looking for a regular rate of return, these times are very hard to secure a reliable source of income. However one can find investments that do yield 5%, so there are ways to make your hard earned savings pay a decent yield with a level of risk, as it is not possible to get 5% on a deposit account, but I can show you some investments that do yield 5% provided you have an appetite for risk.

HICL Infrastructure PLC [http://www.shareshop.hsbc.co.uk/shareshop/security.cgi?csi=185903&action=]

John Laing Infrastructure PLC
[http://www.shareshop.hsbc.co.uk/shareshop/security.cgi?csi=2510086&action=]

Individual stocks that give exposure to hard assets that give a return of 5%.
There are investment funds that pay monthly and are yielding 4%.

The Legal & General Monthly Income Fund:
[http://i.legalandgeneral.com/consumer/investments/products-and-funds/actively-managed/income/investments-productsandfunds-activelymanaged-income-fund-managedmonthlyincome.jsp]

One has to look hard, but as you see, one can get an income if one is willing to take a risk.

Today the stockmarket is dominated by High Frequency Trading and Algorithmic Trading operations. Both these types of trading have made the global stock markets very volatile, but also investors trying to buy or sell securities (shares or bonds) such as long term investors like pension funds, can have their trade distorted by high frequency or algorithmic trading computers, which means the investor trying to buy or sell, may not get best pricing.

Thus, as global stock markets gyrate wildly in these volatile times, institutional investors like pension funds or unit trust managers, have had to shift trading from public stock exchanges to private networks that are called dark pools. These “Dark Pools” are specialist communities that are known in the industry as “electronic crossing networks ” that offer the institutional investors many of the same benefits associated with making buy or sell trades on the public stock exchange but all done in a private environment, so the price is never publicly disclosed, as when one trades publicly on a stock exchange, as this tells the whole public market the buy or sell price, thus potentially tips platforms like an Algorithmic platform, that could negatively affect the trading price. So these Dark Pools are effectively a private market, thus meaning publicly quoted prices aren’t affected. This is the capital markets’ version of a godsend – especially for traders who desire to move large blocks of shares without the public investors ever knowing and getting an agreed price that can not be affected by other players in the market like a high frequency trading platform.

Some examples of Dark Pools are Liquidnet Inc and the SIGMA X unit of Goldman Sachs.
In simple terms, Dark Pools bring buyers and sellers together in a private environment, to trade and only the two parties know the price.

The UK Goverment borrows money on the open market, the agency responsible for raising money for HM Government is The UK Debt Management Office.

[http://www.dmo.gov.uk]

The DMO can issue Gilts or Treasury Bills to raise cash. These are effectively “I Owe You’s” that mature in the future.

Looking at May 2013, we had 4 Gilt auctions:

Wednesday 8-May-2013: 0 1/8% Index-linked Treasury Gilt 2044: Raised: £1,335.4556 Million
Tuesday 14-May-2013: 1¼% Treasury Gilt 2018:  Raised: £5,297.7305  Million
Thursday 16-May-2013: 3¼% Treasury Gilt 2044: Raised: £2,727.0145 Million
Wednesday 29-May-2013: 4¾% Treasury Stock 2015: Raised: £1,922.4556 Million

This equates to £11.282 Billion for May 2013 on issuing gilts only

Or to put it simply, The UK Goverment borrowed (using Gilts) £363 million a day to bridge the gap of its income (tax collection) and government spending.

The financial world has so many terms for these complex instruments, like the CDO, CDS, BCMH, MBS, LBO and of course FX.
Foreign exchange or as it is commonly known, “forex” or “FX” is where you buy one currency while simultaneously selling another – that is, very simple, you’re exchanging the sold currency for the one you’re buying. The foreign exchange market is an over-the-counter market. (OTC)
Currencies trade in pairs, like the Euro-US Dollar (EUR/USD) or US Dollar / Japanese Yen (USD/JPY). Unlike stocks or futures, there’s no centralised exchange for forex. All transactions happen via phone or electronic network. The electronic network like BT Radianz.
Daily turnover in the world’s currencies comes from two sources: The statistics are a real eye opener:-

Foreign trade (5%).

Companies buy and sell products in foreign countries, plus convert profits from foreign sales into domestic currency. Or travelers changing cash or tourists spending overseas on credit or debit cards.

Speculation for profit (95%).

Traders trying to make a profit. Yes, professional gamblers account for 95% of the market. Naked Speculation. Most traders focus on the biggest, most liquid currency pairs. “The Majors” include US Dollar, Japanese Yen, Euro, British Pound, Swiss Franc, Canadian Dollar and Australian Dollar. In fact, more than 85% of daily forex trading happens in the major currency pairs. The world’s most traded market, trading 24 hours a day, with average daily turnover of US$3.2 trillion, forex is the most traded market in the world.

Yes, Trillon. A large number. Let’s try and quantify the Trillion figure…..

US$3.2 Trillion = UK£2.0 Trillion. The UK GDP, the UK ANNUAL output is £1.4 Trillion, so forex turnover a DAY is larger that the UK GDP.
A true 24-hour market from Sunday 12 Noon UK / 5 PM US Eastern Time to Friday 12 Noon UK / 5 PM US Eastern Time, forex trading begins in Sydney, and moves around the globe as the business day begins, first to Tokyo, London, and New York. Unlike other financial markets, investors can respond immediately to currency fluctuations, whenever they occur – day or night. Banks located in the United Kingdom accounted for 37% of all foreign exchange market turnover, followed by the United States with 18% market share.

University fees in the USA have increased at a rate 6% higher than the general rate of inflation in the US for the past 25 years, making it four times as expensive relative to other goods and services as it was in 1985.

[1985 was the year when Duran Duran released the James Bond title song, A View To A Kill, and Madonna was Crazy For You….]

The logical explanation is that University finance departments have a talent for increasing top line fees via tuition. However the number of science and engineering graduates are falling in a lot of Universities. This is a trend in the mature economies in The West. We have focused on arts instead of more practical subjects such as mathematics, science and engineering.
The shocking statistics, are that the average US college graduate now leaves University with $24,000 of debt and total student loans now exceed the US credit card debt of $1 Trillion, (yes, I did say Trillion) and counting (7% of the US national debt). Yes, I said 7%, do the numbers, the US total national debt is about $14.2 Trillion. The US Economy is has an output (GDP) of $14.2 Trillion. Yes, you are reading my numbers correctly, the US National Debt is now approaching 100% of GDP.

Don’t be surprised, this is becoming the accepted state of affairs in Western Economies. Greece is worse of course, it is about 142% of Debt to GDP, and the UK is 76% of GDP with the UK total national debt outstanding is about £1105.8 billion, plus or minus a few billion, which I am sure you will forgive me for. Back to the US Universities. They are run for the benefit of the adult establishment, both politically and financially, not students. To radically change the system and to question the sanctity of a University education would be to jeopardise trillions of misdirected investment dollars and financial obligations.

The numbers are huge when it comes to our economies, debt, student tuition fees, healthcare, pensions etc etc. Also when it comes to government debt, of course the debt is issued in the form of debentures (the posh word), commonly known as bonds. Pension funds buy these bonds to pay pensioners. We can’t default on our debts, a lot of people rely on these bonds.

The death of Steve Jobs was a tragic loss to the world, but also to the technology sector. Much has been written about this brilliant man, a clever business man with vision, passion and drive, partnering with a smart engineer like Steve Wozniak to create brilliant technology that was user friendly, but also sophisticated.

[http://www.independent.co.uk/news/obituaries/steve-jobs-apple-cofounder-hailed-as-one-of-the-most-important-pioneers-of-the-modern-computing-age-2366680.html]

What is just incredible is the share price growth of Apple. Between 1997 and 2011, the stock as grown by 9000%. In that same period, the share price of the rival Hewlett Packard has shrunk by 48%. Thus technology investment has risks and rewards.
Thus investing £100 in 1997 in Hewlett Packard would have been pretty tough to swallow, with that £100 being worth £52 today. Hmmmmm, a grim investment return. Thus diversification into a technology funds is a good way to get exposure into the technology sector, some great funds with great holdings are easily accessible to retail investors.

(http://i.legalandgeneral.com/consumer/investments/products-and-funds/index-tracker/investments-productsandfunds-indextracker-fund-globaltech.jsp)The Legal & General Technology Index Fund, 13% of this £20m fund is in Apple !!!

[http://www.polarcapitaltechnologytrust.co.uk/]
Polar Capital Technology Investment Trust, 10.2% of this £413m fund in Apple and 4.2% in Google.

[http://www.rcm.com/investmenttrusts/investment_rcm.php]
RCM Technology Trust 4% of this £80m fund is in Apple.

[http://www.henderson.com/sites/henderson/uk_pi/FundCentre/ProductDetail.aspx?xfid=8]The Henderson Global Technology fund, 9.8% of this £340m fund is in Apple.

As you can see, Apple features very high in technology funds, as today when one thinks of a technology pioneer and the bell weather of the sector, Apple is that company.

I was reading an article about final salary pensions for council workers, and the research has brought to light some incredible costs. Investment fees in the Local Government Pension Scheme average around 0.2 per cent of assets which compares favourably with the OECD average of 0.5 per cent.

In all £347million was paid out by the council pension funds to investment managers last year, up nearly 9 per cent on the £319million paid out in 2011. The overall cost of the fees would be the equivalent of adding £15 to every council tax bill in England and Wales. The increase is more than double the increase in the value of the council pension funds, which went up by nearly 4 per cent to £158.6 billion, raising fundamental questions about whether the taxpayer is getting value for money.

The figures were obtained by analysis by The Daily Telegraph of the annual reports and accounts of 89 local pension funds in England and Wales. It shows big disparities between different council funds, with some cutting fees and others seeing big increases.

For example fees paid by Lewisham jumped by 85 per cent to £3million and by 41 per cent to £8.7million in Durham. Pension fund charges fell in other parts of the country, 39 per cent in Cambridgeshire to £2.8million and down 37 per cent in Richmond-upon-Thames to £675,000. There was also a big disparity between funds, with Kent paying out nearly £4million in fees to fund managers more than Lancashire, despite having a smaller fund.

A breakdown shows taxpayers in some of the country’s poorest boroughs supporting payments to some of the City’s biggest fund managers.

Camden paid out £2.8million fund managers including £1.1million to Aberdeen Asset Management and £667,000 to Fidelity while Barking and Dagenham paid £2.2million to fund managers including Aberdeen Asset Management, Goldman Sachs, Prudential and Schroders. Somerset paid £2million to a group of fund managers including Jupiter Asset Management, Aviva Investors and JP Morgan.

The Chinese Yuan (Renminbi) is becoming like a reserve currency.

[UK £10 = 103 Chinese RMB/Yuan = US$16 = Euro €11 = Singapore$19 = Hong Kong$124 = Australia$15 = Japanese Yen 1297]

The Central Bank of Sri Lanka has given approval for the Renminbi to be used in cross-border banking transactions, in a move that underscores the growing internationalisation of the Chinese currency as well as the close ties between the two countries. The central bank said its monetary board had agreed to allow the use of the Renminbi in international banking deals because it would significantly facilitate the growing volume of trade and investments between Sri Lanka and China.

China is today as the world’s second-largest economy, while also being a leading player in international trade, investments and foreign reserves. It also enjoys extensive economic connections with many countries; as a result the Renminbi has been gradually evolving as a globally accepted currency. The Renminbi is allowed in international transactions by several countries, including the US and the UK. However, Sri Lanka’s decision to allow the currency highlights its strengthening relationship with China.

Beijing has forged closer political ties with Sri Lanka and has been the biggest source of foreign funding to the country in recent years. China is also playing a big part in helping Sri Lanka with reconstruction following the end of the country’s 25-year civil war two years ago.

Beijing has been encouraging the use of the Renminbi as an international alternative to the US dollar. Over the past two years renminbi cross-border trades deals have surged.

Much of the activity around the currency has focused on Hong Kong, initially chosen by the Beijing to act as a launch pad for the currency’s expansion beyond mainland China.

The New Silk Road of Emerging Markets.

Stephen King is a very well respected Economist at HSBC. He wrote a paper called the Silk Road that is stating the emerging nations will increasingly be trading with each other in the future, thereby leaving the western economies more and more isolated. This is why BT is investing so heavily in Asia with Project Prosperity. Stephen King wrote in The Independent re-iterating this view.
[http://www.independent.co.uk/news/business/comment/stephen-king/stephen-king-western-nations-may-be-forced-to-sell-off-some-of-their-prized-assets-2300034.html]

The issue is as the UK, Germany, France and the USA all emerge from recession, investors are wondering where the growth is going to come from. Take Marcopolo. Brazil’s biggest bus maker. It’s having a fantastic year, with revenue up 47 percent so far. However, we don’t see Marcopolo buses on the streets of Europe or North America though. They’re cruising the roads, highways and city streets of Argentina, Colombia, Mexico, Egypt, India, China, and South Africa. Maybe the Brazilians have a better relationship with these customers than the traditional big multinationals. Interesting point, Marcopolo sold 460 buses to South Africa for the World Cup last year. Stephen King, chief economist of HSBC, has dubbed “the new Silk Road”—a 21st-century version of the trade routes that criss-crossed Asia almost 2,000 years ago, linking merchants in China to their counterparts in India, Arabia, and the Roman Empire. The new Silk Road spans the globe, connecting companies and consumers in Latin America, the Mideast, Asia, and Africa, and generating some $2.8 trillion in trade, according to the World Trade Organisation.

[an interesting side comment, US$2.8 Trillion = GBP £1.72 Trillion, in Oct 2008 at the height of the global financial crisis was the size of the Royal Bank of Scotland balance sheet was over £1.7 Trillion, yes RBS had assets of GBP £2.2 Trillon, remember the UK GDP is about GBP £1.4 Trillion….]

King is quoted to have said that emerging markets will grow about three times faster than rich nations this year and next. There are now massive trade connections within the emerging markets. It means in one sense the emerging world is protected from the worst ravages of the developed world. The WTO estimates intra-emerging-market trade rose, on average, by 18 percent per year from 2000 to 2008, faster than commerce grew between emerging and advanced nations.
The developed world will increasingly compete with these fast-rising countries for resources like oil and iron ore. The established multinationals will also encounter new pressure from emerging-market rivals, many of them state-supported. Yet for Western and Japanese companies that are the best in their industries, the opportunities are great. One example: Caterpillar, the world’s largest maker of construction equipment, raised its full-year earnings forecast last month on higher demand in developing countries for mining, energy, and rail equipment. Note that demand was not from mature markets. While the USA, Europe (not Greece….) and other developed countries hope to find their place on the Silk Road, the central player is China. Chinese exports to the emerging world accounted for about 9.5 percent of its gross domestic product in 2008, compared with 2 percent in 1985. Last month the Saudi Railways Organization awarded a contract to China South Locomotive & Rolling Stock to supply 10 locomotives. The Mecca-Medina rail contract went to Beijing-based China Railway Group. Shenzhen-based Huawei Technologies, China’s top maker of phone equipment, is investing $500 million in its research centre in Bangalore. China Mobile, the world’s biggest phone carrier, may soon invest in Africa. India and Brazil are stepping up their efforts, too. India’s Tata Group was one of the largest investors in sub-Saharan Africa in the six years through 2009, according to the Organisation for Economic Cooperation & Development. Many Silk Road companies are becoming aggressive acquirers. We are seeing the same phenomenon with European and American companies as they went global over the past 100 years, eg Vodafone, BP, HSBC, Nestle, Ericsson, Unilever, Cisco, Shell, Coca-Cola, UPS, Toyota, Oracle, Boeing, Pfizer, Ford, Siemens, Proctor and Gamble, ExxonMobil, McDonalds blah, blah, blah….
Today, Brazilian mining company Vale has invested in three copper projects in Zambia and the Democratic Republic of the Congo. In April the company agreed to pay $2.5 billion for iron ore deposits in Guinea, and another example is Australia’s mining giant, BHP-Biliton who bought Chesapeake Energy Corp for $4.75bn, note that the balance sheet of BHPBiliton shows they have assets of $98.2bn.
Such trade used to be conducted in Dollars, Pounds, and Euros, even when the deals did not involve U.S. or European companies. Today companies in emerging markets are more willing to take Reals, Rupees, and, above all, Yuan as the Silk Road economies prosper. If emerging-market fundamentals continue to be superior there is the potential for serious currency appreciation against old-guard currencies, (the mature markets).
With trade comes competition. About a third of the order book of Brazilian plane maker Empresa Brasileira de Aeronáutica, or Embraer, comes from emerging-market customers, up from 1 percent in 2005. Yet Embraer doesn’t have the field to itself. The Brazilians are bracing for a fight from Russia’s Sukhoi and Commercial Aircraft Corporation of China, which are both developing airliners.
Traffic on the Silk Road is getting pretty heavy. Names like ZTE, Petrobas, Huawei, Tata, China Life, America Movil,  ICBC, Levono, Bank of China, Ping Insurance, BHPBiliton, Bank of Baroda, SingTel, China Telecom, Haier, Reliance, Hutchison Whampoa, Shanghai Automotive, Astra International, China Mobile, Dr.Reddy, Mahindra & Mahindra, AirAsia, RioTinto, PT Indosat, Vale, Sinopec, Infosys, Cemex, Bumi Resources, State Bank of India, Petronas, ICICI Bank, Wipro, Mittal Steel, Bajaj, Godrej….blah, blah, blah will be household names in the very near future.

Finally, trading ties among developing nations are intensifying fast and may eclipse emerging-market ties with the West.

In the FT recently, there was an article on how rare earth metals have doubled in just three weeks amid heavy stockpiling in China.

A trend in the market place has been the movement of investment funds out of traditional financial instruments such as shares and bonds, into other asset classes such as commodities like metals and natural resources. Today Legal and General the UK’s largest institutional investor owning about 5% of the UK Stock Market

[http://www.lgim.com/about-us/]

They have launched a new fund, that is focussed on Environmental Enterprises:

[http://i.legalandgeneral.com/consumer/investments/products-and-funds/specialist/investments-productsandfunds-activelymanaged-other-fund-globalenvironmentalenterprises.jsp]

Another fund is the JP Morgan Natural Resources Fund:
[http://www.morningstar.co.uk/uk/funds/snapshot/snapshot.aspx?id=F0GBR04S4X]

Also M&G (the Fund Management company of Prudential) have a fund called Global Basics:[http://www.mandg.co.uk/Consumer/FundInfo/FundsAtoZ/OEICFunds/GlobalBasicsFund/]

Perhaps when interest rates are near zero, then investors are looking at more sophisticated assets to find a better return, such as natural resources to diversify the asset base, or if you are pension fund manager, that has monthly obligations, getting an income from having investments in natural resources, or getting the generous dividend from BHP Biliton are really vital.

An investment fund = Unit Trust = Mutual Fund = Open End Investment Company (OEIC) = Individual Company with Variable Capital (ICVC)

Think of a fund as a collection of stocks or bonds (securities) with something in common.

By investing in a fund, you’re essentially pooling your money with other investors to access a broader range of stocks or bonds than most people could own by themselves.

Every fund reflects a particular investment objective and style, such as growth or value, which affects the stocks, bonds, and/or other securities that it buys. Knowing this can help you to determine whether a fund would be a good fit for your overall portfolio.

Funds have some advantages over individual stocks or bonds, including:

Diversification. For a minimum investment, you gain exposure across broad market segments at a fraction of the cost of owning representative individual securities on your own.

Professional management. You don’t have to keep track of the individual securities that make up the fund. An expert fund manager (like Asad Karim) takes care of that by buying and selling as needed to help the fund meet its objectives.

Convenience/liquidity. You can buy and sell funds daily during market hours by phone or online, so you can always access your money.

When you invest in a fund, you purchase shares along with many other investors. The cost of a fund share is called the net asset value (NAV). For example, if you invest £1,000 in a fund with an NAV of £50, you will own 20 shares.

Active and Index

There are two main types of funds: actively managed and index. With an actively managed fund, a fund manager attempts to exceed the average returns of the market. There is the risk that the fund manager’s selection may underperform, but there is also a chance to beat the market.

Index funds try to track the return of a benchmark index such as the FTSE-100 Index by owning shares (securities) that make up the index or a representative sample. They won’t beat the market, but they shouldn’t substantially underperform it either. They usually have lower costs than actively managed funds. Active and index funds can complement each other in a well-diversified portfolio.

Index Tracking Funds

Index-tracking funds closely follow the performance of a particular stock market or sector – tracking the index. They’re also known as passively managed funds. There are various ways the fund providers do this. Index-tracking doesn’t involve the extensive research used in an actively managed fund to select particular companies. Also, an index-tracking fund will only buy and sell shares to match the index: typically, these transactions are less frequent than those made by an actively managed fund. Index-tracking funds will typically have a lower management charge than an actively managed fund, as one is not paying for a fund manager, the index fund is just a computer trading buying and selling as the index moves.

The Fibonacci sequence first appeared as the solution to a problem in the Liber Abaci, a book written by Leonardo Fibonacci in 1202 to introduce the Hindu-Arabic numerals used today to a Europe still using Roman numerals. That in itself is one of the greatest innovations the world has ever seen.

Fibonacci was an Italian mathematician and he’s finest remembered by his globe popular Fibonacci sequence, the definition of this sequence is always that it is formed by a series of numbers in which each amount may be the sum from the two preceding numbers; 1, 1, two, 3, 5, 8, 13….

What is incredible that mathematics from 800 years ago, today is used in Financial Markets. [and no, Asad Karim does not use an abacus to calculate his ‘low net worth’ !!!]

The case of foreign exchange dealing, Fibonacci mathematics is essential for that foreign exchange market, as the Fibonacci ratios derived from this sequence of numbers, that i. e.. 236,. 50,. 382,. 618, etc etc, are related to the direction of foreign currency exchange market movements. The Fibonacci retracements is a method of technical analysis for determining support and resistance levels in foreign exchange markets. Fibonacci retracement is based on the idea that markets will retrace a predictable portion of a move, after which they will continue to move in the original direction. Hedge funds and foreign exchange trading use Leonardo Fibonacci’s genius.

The original problem in the Liber Abaci posed the question: How many pairs of cute fluffy rabbits can be generated from a single pair, if each month each mature pair brings forth a new pair, which, from the second month, becomes productive. [when I was 17 I had a grey pet rabbit called Norman who sadly died the night before I left home for The University of Liverpool to read Applied Mathematics & Theoretical Physics.]

These ratios are mathematical proportions prevalent in several areas and structures in nature, as properly as in several man made creations like financial markets.

After the first few numbers in the Fibonacci sequence, the ratio of any number to the next higher number is approximately .618, and the lower number is 1.618. These two figures are the golden mean or the golden ratio. Its proportions are pleasing to the human senses and it appears throughout biology, art, music, and architecture. A few examples of natural shapes based on the Golden Ratio include DNA molecules, sunflowers, snail shells, pineapples, galaxies, and hurricanes.

In the back pages of The FT you will see lots of different interest rate terms. Always confused me what all these terms and rates actually meant.

A term that is oftern reported in the press and media is the Repo Rate. When a bank or financial institution is short on funds they are able to borrow money from the central bank, eg The Bank of England. The repo rate is the rate at which banks or financial institutions borrow short term money. The repo rate is also referred to as the repurchase rate. A repo rate can be described as an interest rate on loans from the central bank. If the Bank of England desires to make it more costly for high street banks to borrow money then it will increase the repo rate, if they want to make it cheaper for money to be borrowed then the central bank reduces the repo rate.

Repo stands for “repurchase”.  A good explanation is below, that I took from Wiki.

” A Repurchase agreement, also known as a Repo, or Sale and Repurchase Agreement, is the sale of securities together with an agreement for the seller to buy back the securities at a later date. The repurchase price will be greater than the original sale price, the difference effectively representing interest, sometimes called the repo rate. The party who originally buys the securities effectively acts as a lender. The original seller is effectively acting as a borrower, using their security as collateral for a secured cash loan at a fixed rate of interest. ”

To put it simply, the security that is the subject of the agreement to sell now and buy back later remains the asset of the bank. The bank, on the other hand, gets money which can be added to its cash reserve. The “fixed rate of interest” being charged in this transaction is the Repo Rate.

To summarise this, the bank enters into an agreement with the central bank, based on which it gets a security on loan from the central bank. It then promptly sells that security in the open market, raises cash and adds that to its cash reserves.Thus we see that Repo Rate are the means by which the central bank lends cash reserves to banks. When the central bank lends cash to a bank by accepting a government security as collateral (Repo), it is essentially augmenting the bank’s cash reserves.

In September of 2008, when the financial crisis was at its peak, after Lehman Brothers failed,  European banks we running out of US Dollar$, infact that was a major problem at RBS, it was running out of US Dollar$ fortunately, UK HM Government came to the rescue, we saw a co-ordinated approach for the global central banks and use of the Repo Rate, when the US Federal Reserve lent US$ Dollars to the Bank of England, than then in turn lent those dollar$ to the UK banks, all via the Repo process

Sometimes it feels as if we are slaves to Outloook & Calendar, meetings, appointments, BT Meet Me audio conferences, webinars, livemeetings, knowledge calls, Telepresence requests, 1-2-1’s, sales deadlines, blah, blah, blah.
I was thinking about the fact of how important the calendar is when it comes to our daily routine but also other key days like the annual performance review, the payment of annual subscriptions, closer to retirement age, etc etc, and I started to think about the mechanics of the annual calendar.

It is incredible to think, it was nearly 1000 years ago, that Persia’s greatest mathematician, astronomer and poet, Omar Khayyam [1048-1131] worked out the solar year. In 1074 AD Omar Khayyam built an observatory in Persia at a location called Ray, as he was asked to develop an accurate solar calendar to be used for tax collection and various local administrative matters. This calendar was way ahead of its time, it is today accurate to within one day in 3770 years. Specifically, Omar Khayyam measured the length of the year as 365.24219858156 days. It shows that he recognised the importance of accuracy by giving his result to eleven decimal places. In telecoms, the accuracy of data is essential. We take it for granted, our network time (Network Synchronisation) is essential for basically the integrity of all telecommunications.
Omar Khayyam’s work, was done effectively in a time of very limited mathematical knowledge, to put things into context, Sir Issac Newtons “Principia” was published in 1671, the corner stone to modern mathematics, and yet Omar Khayyam was laying the foundations to our calendar 597 years BEFORE our Newton. Next time you are sending out a calendar appointment remember it is based on mathematics from 937 years ago. (approx….)

Complex financial instruments have been an innovation in the market efficiency in capital markets. They can help reduce risk, limit exposure to changing prices, but also can be highly lethal, when it comes to bringing down financial empires. eg. CDO’s from the USA, were traded, and they turned into toxic assets.
Warren Buffet the legendary investor, the Sage of Omaha, the CEO of Berkshire Hathaway, and one of the world’s richest men, is quoted to refer to derivatives as financial weapons of mass destruction.

So what are derivatives ?

To put is simply, they come from agriculture, when farmers hundreds of years ago want to secure the price of their harvest crop (rice, corn, wheat etc etc) in the future, to protect them against market changes, such as over production or perhaps another unforeseen problem like a drought. In the financial world, they are exactly the same, derivatives are contracts whose value is “derived” from the price of something else, typically a share (stock), and a share is an equity instrument, so an equity derivative, for example, might give you the right to buy BT Shares (BT plc) at a stated price up to a given date. And in these circumstances the value of that right will be directly related to the price of the “underlying” BT Share: if the share price of BT moves up (which can only be a good thing…especially if you are in sharesave…..) then the right to buy BT shares at a fixed price becomes more valuable; if it BT shares then moves down (which upsets me and fellow shareholders), the right to buy BT shares at a fixed price becomes less valuable.

A good example from the FT, as explaining them which a physical asset, shoes !! Here is the example.

Say you believe the price of Gucci shoes is going to rise in 30 days’ time. You want exposure to that price rise. To speculate, you buy those Gucci shoes on Ebay at today’s price for delivery in 30 days. No matter what happens to the price of Gucci shoes in the interim, you are scheduled to receive your shoes in 30 days’ time for the price you paid today. If the price of the shoes shoots up in the interim, there is nothing stopping you from selling them on to someone else for a higher price. On delivery date, you would simply sign over the right to the delivery to the person you sold the shoes to.
In some cases, the seller of the Gucci shoes (if she believes the price is going to fall) might even be inclined to sell the right to those shoes in 30 days’ time, before actually obtaining them first herself. That is because she believes they may become cheaper closer to delivery time. No matter how many times the contract exchanges hands, in 30 days one pair of Gucci shoes has to be delivered by the seller to the ultimate recipient. Not a pair of Clarks loafers. Not a pair of Nike trainers. Only a pair of Gucci shoes of a certain specification will do. On delivery day, then, the price of the futures contract has to converge with the underlying supply and demand fundamentals of Gucci shoes.

To put it very crudely, it is like a piece of insurance, to protect against price movement.

Our ‘Crude Oil Addiction’ is best described by our shear volume of consumption of this black gold. A co$tly addiction, l£t m£ £xplain…..

Using BP’s Statistical Review of World Energy, the world uses 80m barrels a day. Production approximately meets this demand.
[1 barrel of crude oil costs about $110]

The numbers are staggering:

80,000,000 barrels at $110 = $8,800,000,000 = $8.8 bn [£5.5 bn]

So the world each day spends £5.5bn or $8.8bn Per Day on Crude Oil.
A little side fact, the US is the largest consumer at about 19m barrels a day = $2,090,000,000 = $2.09 bn per day.

(about 20% of world production is used by the USA)

China use 4m barrels a day, which equates to $440,000,000 = $440m a day spent by the Chinese on Crude Oil. The largest producer is Saudi Arabia with 8m barrels a day produced = $880,000,000 a day ($880m) in revenue to Saudi Arabia.
The numbers just show our desire for crude oil.

Ethical Investment funds are designed to only invest in companies, that avoid questionable activities, such tobacco production, arms and weapons manufacturing or processes that pollute the environment.They are tailored for investors who have principals or questions on how there money in tied up and invested. In the UK the Co-Operative Bank have for a long time, refused business customers who pollute the environment.

[http://www.goodwithmoney.co.uk/why-do-we-need-ethical-policies/]

The idea originated in the US, where church investment groups who controlled billions of dollars and often did not want the money used to prop up repressive regimes in the developing world. It became very popular in the 1970s when the Vietnam War led to some investors questioning what their money was funding. Friends Provident the life insurance firm founded by Quakers – set up the first so-called ‘ethical fund’, called The Stewardship Unit Trust, back in 1983.
A good site that recommends other ethical investment funds is :- [http://www.ethicalinvestment.co.uk/Socially_Responsible_Investment.htm]
Here is a good example of a fund that has an ethical investment policy.

[http://i.legalandgeneral.com/consumer/investments/products-and-funds/specialist/investments-productsandfunds-activelymanaged-other-fund-ethical.jsp]

The Legal and General Ethical Trust.
Interesting to see the names that this fund holds:- BT Group PLC, Vodafone PLC, Prudential PLC,
The FTSE has an index known as the FTSE 4 Good Index which of course BT is a member of:- [http://www.ftse.com/Indices/FTSE4Good_Index_Series/index.jsp]
In general, an ethical fund manager will run checks on the company to find out if it has interests in a number of positive and negative criteria.

Positive criteria includes:

• Specific environmental protection practices.
  Extensive involvement in conservation and recycling measures.
  Pollution control.
  Ethical employment practices, such as recognising trade unions and treating workers fairly and an emphasis on health and safety

Negative criteria includes:

• Involvement in weapons manufacture.
  Pornography
  Animal exploitation and testing.
  Gambling.
  Poor employer relations like a non-union workforce
  Involvement in supporting oppressive regimes.
  Alcohol and tobacco promotion.
  Environmentally damaging product practices.

However, this is not a complete list, and it is hard to determine, on what is ethical or not ethical, it is am imprecise science, but also who determines what is ethical or moral?

Th€ $hear size of the global capital markets is incredible, and when hears the size of the US National debt ($14 Trillion), getting ones head around the size of an economy can prove hard.
The power and control of the Bond Mark£t is what I find more thought provoking. Governments can be brought down by the bond market.

However a good way to understand numbers, is to compare, so I thought I would undertake some research (Asad Karim style) into the size of the Stock Market (equity market) and then Bond Market (debt market).

The world’s Stock and Bond markets in total have a market value in U.S. dollar terms of more than $125 Trillion, [£77 Trillion] or approximately two times the value of the world’s total economic output (GDP), estimated at approximately $61 Trillion. [£38 Trillion]

Total value of the Stock(equity) & Bond markets (debt)
$126,449 Billion or $126.449 Trillion. [£77.601 Trillion]
That is made up of  $44,223 Billion in Stock (Shares) [£27,139 Billion or £27.139 Trillion]
So you would need to have £27,139 Billion to buy all the shares in all the companies listed around the world.

[Apple has a very large market capitalisation of £352 Billion, (352/44223 x 100) equates to 0.79% of the Global Stock Market]

[BT has a market capitalisation of £13.759 Billion which equates to 0.05% of the Global Stock Market]

[HSBC has a market capitalisation of £99.558 Billion which equates to 0.36% of the Global Stock Market]
$82,226 Billion is Bonds. [£50,461 Billion]
So today there is £50,461 Billion (£50.461 Trillion) in debt that is outstanding. A note to remember is that this debt is gathering interest too. It is the fact that the global bond market nearly exceeds the world stock market in size by a factor of nearly 2 to 1 really puts things into perspective for me.
Yes, the debt market is nearly twice as large as the stock market. So that is why when you see such a major financial crisis in banking, the credit markets and governments in danger of not paying there obligations, you see this massive turmoil.
When one looks at the mechanics of banking, apart from raising cash from deposits, banks raise cash from the bond market, by bond issuance, and then use the cash to fund themselves like creating mortgages or loans from the cash raised from the bonds issued.
Governments are the same, raising funds from the international money markets, and pension funds. So when these bonds are at risk of not being paid, that is when you have such horrific market turmoil and lack of confidence. Remember if you borrow, you have to pay back, thus the term bond. My word is my bond, or in global terms a £50.461 Trillion Pound Bond or $82,226 Billion Dollar Bond !!
(and it is paper after all…..as Paul Krugman has said)

The serious issue is these bonds must be honoured, as who buys them ? Pension funds. Pensioners deserve good pensions.
……but then as Pink Floyd said in ‘Money’ from Dark Side of the Moon from the wonderful year 1973 (a critical year for Asad Karim….), in the 3rd verse “Money, It’s a crime, Share it fairly, But don’t take a slice of my pie, Money, So they say, Is the root of all evil today”…..

In this highly volatile times, how can you secure your capital and where is it safe to invest our hard earned money ?
Infrastructure is something that professional funds like pension funds are moving their money into, and I am showing some specific funds that invest in essential infrastructure and public-private finance deals to provide an income too.
The return (yield) can be between 4 and 6% easily beat returns on most deposit accounts. The rent, tolls or usage fees for the infrastructure asset are often linked to inflation, which boost income
With governments unable to pay for new roads, hospitals, bridges, tunnels, schools, public sector facilities etc etc, the governing authorities are looking for private partners to help pay to replace ageing infrastructure.
Thus infrastructure funds could “bridge” that public sector funding gap.
These funds give predictable cash flows, often in highly regulated markets, and this provides a good, inflation-linked income stream. While infrastructure investment funds are a new source of income they are also investing in hard assets rather than paper financial assets.
Have a look at 3i Infrastructure, HICL Infrastructure, John Laing Infrastructure, Macquarie Infrastructure and First State Infrastructure.
[http://www.3i-infrastructure.com/]
[http://www.hicl.com/]
[http://www.jlif.com]
[http://www.macquarie.com/uk/infra/index.htm]
[http://www.firststate.co.uk/ListedInfrastructureEnGB.aspx]

They all offer a healthy dividend in these low interest rate times, and hold their investments in hard assets like bridges, roads, hospitals etc.  An asset class that is physical.
An interesting little snippet, when one looks at 3i Infrastructure:
Question: Guess who is one of the largest shareholders, with 3.48% of all the shares?
Answer: The BT Pension Fund (Hermes Invesment Management)
[http://tools.morningstar.co.uk/t92wz0sj7c/stockreport/default.aspx?tab=6&SecurityToken=0P0000ATL8%5D3%5D0%5DE0EXG$XLON&Id=0P0000ATL8&ClientFund=0&CurrencyId=GBP]

The Mechanics of the Banking System

Today marks a turning point in UK banking, with the long awaited report from Independent Commission on Banking, chaired by Sir John Vickers.
[http://bankingcommission.independent.gov.uk/]

Effectively this is recommending that the retail banking business is ring fenced from the risking investment banking arm, to avoid a banking collapse, and protect the UK taxpayer from a bailout.
The banking system on the high street works on a process called The Fractional Reserve Banking. This refers to a banking system which requires the high street banks to keep only portion (a fraction) of the money deposited with them as reserves. The bank pays interest on all deposits made by its customers and uses the deposited money to make new loans. In order to understand how fractional reserve banking works, in this blog let’s look at the following example.
[I read a book on finance by Liaquat Ahamed that gives a worked example]
Somebody (not Asad Karim, he’s not that flush…) deposits £10,000 with HSBC. HSBC is obligated by law to keep 10% of the deposited money as a reserve, that’s why the bank keeps £1000 and lends out £9000. Somewhere down the road the £9000 loan is deposited in another bank account (RBS for example, or it could be with the same bank HSBC but let’s keep things simple). Now RBS (our second bank 83% owned by us, the UK Taxpayer…) also wants to make money by giving out loans, that’s why it keeps the required £900 and lends £8100. Fast forward to a deposit with a LloydsTSB (fourth bank, 41% owned by us, the UK Taxpayer…) and you’ll get the following:
Bank             Deposit           Reserve           Loan
HSBC             £10000            £1000                £9000
RBS                £9000             £900                  £8100
Barclays         £8100             £810                  £7290
LloydsTSB     £7290              £7290                £0
Total              £34390            £10000              £24390
As you can see from the table above, the banks created £24,390 in loans based on the first £10,000 deposited. Yes, you guessed it a licence to print money. This is sometimes known as the ‘Money Multiplier’ where money gets re-lent out, some commentators call the banking system a hugh Ponzi Scheme. The fractional reserve banking works for now, because the total amount of withdrawals is offset by deposits made at the same time. While the depositors are confident at the fractional-reserve banking system, a very small part of all deposits is withdrawn at the same time allowing the banks to handle the withdrawals through their minuscule reserves. However when people’s confidence in the banks is shaken, bank runs are possible, (2007 UK Northern Rock) and the entire banking and financial system can collapse.
However, what I don’t understand from the Sir John Vickers report, is that even if the report is put into law, and retail deposits are secured, that would not saved HBOS, Northern Rock, Bradford and Bingley, London Scottish Bank, all of which, were Retail banks, with NO risking investment arms, and were brought to their knees, by simply lending too much (from retail deposits) to the property (real estate sector) !!
In otherwords, poor credit management was to blame.

A few weeks ago, I watched the TV drama ‘Too Big Too Fail’ on Sky Atlantic, based on Andrew Ross Sorkin’s book called Too Big To Fail.

[https://www.amazon.co.uk/Too-Big-Fail-Inside-ebook/dp/B002VNFNZ6/ref=sr_1_2?ie=UTF8&qid=1316416338&sr=8-2]

Andrew Ross Sorkin is the business editor of The New York Times. The drama was about the 2008 Wall Street Crisis, and throughout the drama, the term Moral Hazard is mentioned.
Economics and finance are complex subjects as they are governed by forces such human behaviour. The banking crisis that begun in 2007 in the UK with the run on the bank, Northern Rock, again the term coined in the media (Robert Peston & Co) was again Moral Hazard.
In this blog, I will explain what it means in the context of global banking and financial markets. The phrase “moral hazard” originally comes from the world of insurance. It refers to the future situation that insurance will distort peoples behaviour. For example when a holder of fire insurance take less precaution with respect to avoiding fire.
In the banking context, what this means, is that ‘bad beaviour’ or ‘reckless actions’ will be rewarded with a bailout. So let explain in more human terms. If a child (not Asad Karim) is being naughty, and chocolate (candy) is given to the child, then the chances of the child being naughty again are high, as they know they could be rewarded with more chocolate.

Central bank chiefs, economists and government officials have warning about moral hazard, especially with regard to the sub-prime crisis from 2007. In the context that if a high street retail bank lends in a reckless fashion to the property sector that ultimately leads of insolvency, (Northern Rock as an example) then the Bank of England will step in and  provide emergency loans (£30 billion) to Northern Rock, then perhaps in the future, the high street retail bank will continue to be careless and irresponsible with its lending decisions, as ultimately it knows it will be rescued by the state / central bank.
One argument about allowing Lehman Brothers to fail, was a government decision, to send a a clear message out to the market, that bad behaviour has its very serious consequences, and reckless actions will NOT be rewarded, and a rescue will not come from government / tax payers.
Final comment, perhaps today when commentators talk about banks unwilling to lend, it could be the simple fact that perhaps their will not be a government organised rescue, or perhaps it could be the honest fact, that government has no more money, and a rescue is not possible, so to to avoid any risk, banks are not lending as they can’t take the chance of a loan going bad as their is no lender or investor of last resort.
Moral Hazard at work.

The UK Bank of England injected into the UK Economy a sum of £375 Billion. This process of injecting money is called Quantitative Easing. The Japanese did this in the 1990’s to rescue their banking sector, and the UK Federal Reserve has done the same, to help the US economy after the financial crisis. Only last week the Bank of England are talking about more Quantitative Easing, and also the US decided to do more by buying short term US Government Bonds to lower long term interest rates, by more Quantitative Easing.

But what really is Quantitative Easing ?

To put it simply the Central Bank (eg The Bank of England) creates money and uses it to buy assets such as government bnods and high quality debt from private companies, (like BT)

[http://www.btplc.com/Sharesandperformance/Fixedincome/index.htm]

BT’s bonds.

This created money feeds into the wider economy as high street banks that hold government bonds and corporate debt (high quality debt from private companies) sell the gilts and corporate bonds to The Bank of England, and get the newly created cash. The Bank of England for example, in March 2009, they decided to buy two types of asset – UK government bonds (known as gilts) and high-quality corporate bonds. Making the majority of purchases in gilts allows the Bank to increase the quantity of money in the economy rapidly. Targeted purchases of private sector assets has make it easier and cheaper for companies to raise finance by improving conditions in corporate credit markets.
[http://www.federalreserve.gov/boarddocs/speeches/2004/200401033/default.htm]
The above link from a speech in 2004 that makes interesting reading on monetary policy from the US Federal Reserve, and now quantitative easing.  So really it is not printing money as the media often say, but really it creating new credit

Hi.

I am Asad Karim, welcome to my new site. A few of my friends often ask me for advice & comment and my informed opinion on economics and financial planning. So I have decided to write the odd article here.

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