Revelations of Folly in the Russian Federation
It’s only when the tide goes out that you learn who’s been swimming naked. — Warren Buffett
Warren Buffett’s ominous quote sprang to mind when it was revealed that the Bank of Moscow received an unprecedented $14 billion state rescue package on Friday. For now at least, this fiasco seems to be regarded as a compartmentalized instance of fraud — in contrast, we suspect that this could be just the tip of the iceberg.
As will be shown below, it’s not impossible to correctly anticipate such events — a sharp understanding of Austrian economics and a devotion to contrarian opportunities are two things that can get one on the right track.
Russia’s fifth largest bank, Bank of Moscow, has been given the biggest bail-out in Russian history.
The $14bn rescue came after another bank, VTB, gained control through a hostile bid, only to uncover bad loans valued at $9bn – a third of the bank’s assets.
Bank of Moscow’s former head, Andrei Borodin, has fled the country, and a warrant has been issued for his arrest.
The bank was used by ex-Moscow Mayor Yuri Luzhkov to fund property projects…
Mr Luzhkov was sacked by Russian President Dmitry Medvedev last year.
In a statement issued in London, Mr Borodin said he was shocked at the size of the bail-out, and claimed that VTB’s takeover of the bank was politically motivated.
VTB, for its part, accused Bank of Moscow of committing “fraudulent lending” under Mr Borodin’s control, while Russian Finance Minister Alexei Kudrin has called for a criminal investigation.
Under the rescue deal, the Russian central bank will provide a 295bn rouble ($10.6bn) 10-year loan at a negligible interest rate to Bank of Moscow.
Meanwhile, VTB will invest a further 100bn roubles to recapitalise the bank – taking its ownership share from 46% to 75%, enough to qualify for state aid.
VTB, Russia’s second-biggest lender, had itself to be rescued by the Russian state to the tune of $6.4bn during the financial crisis.
Adopting an ‘Austrian Lens’:
The Austrian Business Cycle Theory eloquently describes how the entrepreneurial class is drawn to endeavors that are unsuitable for their customers. In essence, a large proportion of aggregate resources get caught up in projects that are not as keenly desired as other potential projects. The manner in which entrepreneurs get caught up in such inappropriate projects relates to time, or more specifically, consumers preferences relating to time. Essentially, the structure of the fractional-reserve banking system sends signals to entrepreneurs that suggest that consumers are wealthier and/or more abstinent than they actually are.
The really great thing about this theory and the Austrian School in general, is that the intellectual insights involved really do correspond to the objects to which they refer — in short; they are by and large true! I’m sure that many would disagree with me, but a significant proportion of economic thinkers seem to be quite indifferent as to whether or not they are engaging in a process that corresponds to reality. Instead, they blithely make their assumptions, create the subsequent economic models (etc.), and arrive at conclusions. Only after such conclusions have been arrived at do they consider the validity of their work (if at all)! Moreover, the conspiratorial voice in my head even suggests that they only really care about the conclusion if it corroborates the proposed statist ‘solution’ that they already had in mind!
A testament to the philosophical rigor of the Austrian School is that the great treatises (Human Action; Man, Economy & State; The Theory of Money & Credit; Money, Bank Credit & Economic Cycles etc.) all contain chapters that address questions such as; Do I really know what I am saying? Is what I’m saying really valid? What can I say? and so on…
Since the Austrian cycle theory at least attempts to correspond to reality, it gets the ‘green light’ — so to speak — from investors like us. Moreover, given that most other investors so often claim to be the most practical of practical men, we think that it should get the green light from them too…
Enmeshing Austrian Thought Within an Investment Framework:
It’s clear that a theory that relates to reality, and helps anticipate large changes the economy’s entrepreneurial framework would be rather useful for anyone interested in allocating capital in the financial markets. However, there is one important problem that one has to overcome before one can truly enmesh the Austrian thought process with one’s investment strategy: — namely, the qualifier that says; ‘Sure we know that the structure of production is unsustainable, but we don’t exactly know how that will come to be widely realized (i.e. we don’t know exactly when the crisis will hit).‘
For the investor, who inevitably has to deal with price and time, this is a seemingly insurmountable problem. And, perhaps inevitably, we at greshams-law.com certainly do not have a watertight answer to this problem. Instead, we simply seek to balance risk and potential reward to yield asymmetric opportunities. The Austrian insights of capital misallocation lend us the conviction that imbalances require painful realignment processes (i.e. crises), which are ever-greater with ever-greater excessive credit growth. So, our task then proceeds onto the optimal timing of entry positions.
Our thoughts on this are simple; we seek opportunities where there is significant evidence of profound increases in credit, significant evidence of excessively one-sided sentiment, and – finally – evidence that the momentum of such credit creation is waning. Of course, there is never any guarantee that one is capable of timing the faltering of the credit creation process, however one can be confident that a probability is put in one’s favor. We can seek to figure this out by looking at money supply figures, credit figures, real rates, and — of course — prices (in particular, relative prices). If we can see that there has been excessive credit growth, that there has been emotional favoritism towards an asset class and that the reversal process has subtly begun to take hold, then we can seek to execute positions with the presumption that we are risking fairly little for a fairly large potential gain.
The Case of the Russian Federation:
As mentioned in the June 2011 (sample) newsletter, we have seen this in the case of Russia for several months now. Given the extreme nature of the money supply dynamics, we were not surprised (at all!) by the revelation of significant folly in the Russian banking system. In fact, we were quite frankly relieved that we have been on the right track (even if the price-action is yet to corroborate our view in a sweeping and drastic fashion). The following charts are some examples of the mounting evidence that we came across (and — indeed — continue to come across).
Something that we’ve noticed for several months is that Russia has been subject to negative monetary momentum. Although the chart below is only updated until the end of 2010 (more up-to-date data is yet to come), it demonstrates that the real money supply of the Russian Federation has been losing upward momentum for some months.
Moreover, combine that with the fact that real short-term interest rates are negative and headed downwards (see chart below).
With a keen eye, a passion for truth and a solid understanding Austrian-style economics, one can really execute favorable trades with asymmetric risk/reward profiles. Given our understanding of monetary trends in the Russian Federation, we believe that the revelation that the Bank of Moscow was harboring — well — a load of junk could be just the beginning of longer period of the unraveling of Russian follies.
Recommended: Charting the Federal Reserve's Assets - 1915 to 2012