The madness of markets. Nothing better illustrates the occasional madness of markets than the story this morning that for a brief moment last night, Australian time, the German car manufacturer Volkswagen overtook Exxon as the world’s biggest company by market value. VW shares peaked at €1,005 in early trading not because that in any way reflects the intrinsic worth of the company but because of what can best be described as a game of financial musical chairs where, as one trader described it, “there are too few chairs for the players.”

The song being played by that group of investors called hedge funds when this VW game got started had lyrics suggesting that the price of the stock in Europe’s largest car manufacturer would fall as people woke up to the devastation that the world financial crisis would cause to car sales as Germany entered a recession. The hedgers sold short believing they soon could cleverly buy in at lower prices and land a healthy profit.

Then Porsche came along and sang a different tune even louder. It announced on Sunday it had increased its direct stake in VW to 42.6% and that its combined stock and options totalled 74 percent. With the German State Government of Lower Saxony owning just over 20 percent, this left a shrinking pool of stock available for the hedge funds to acquire to meet their obligations in repaying the 12 to 15% of the company they had sold without owning.

Panic set in on Monday and VW’s share price, which had started the year at around €150, closed up more than 146% at €520 on Monday. It doubled again on Tuesday, vaulting over the €1,000 mark. The current valuation of Volkswagen is greater than all its European and American car making competitors combined!

As if this is not bizarre enough in itself, consider that there are institutions, perhaps even those handling your superannuation money, who use the DAX index of German Stock Exchange prices as a performance benchmark and buy and sell shares in parallel with its movements. Because of the influence of VW on the index, it rose 10% on Tuesday whereas it would have fallen without the VW share price increase. Those institutions linking their investments to the DAX thus had to in in the scramble to buy VW shares as well.

So just remember that when you deal with investment bankers and their wonderfully automated computer programs that your money is in the very best of hands. Just don’t expect all of it to end up in yours.

Putting our banks to the test. Two years ago as part of its review of the Australian financial system the International Monetary Fund performed what it calls “a macroeconomic stress scenario” on the five major Australian banks. In the cheerful way of economic inquisitors it envisaged a recession with an initial large drop in housing price (-30% drop in the first year), a substantial increase in the rate of unemployment (from 5% to a peak of 9%), exchange rate shocks (a 40% depreciation of the Australian dollar vis a vis the trade weighted index), and increased funding costs for the banks. What it found was that “the large Australian banks exhibited considerable resilience.” While their financial performance deteriorated in response to shocks to their mortgage portfolios and funding costs, the banks withstood the adverse macroeconomic scenario relatively well.

The main results were:

  • Under the macroeconomic stress scenario, the banks continue to be profitable, although their profitability decreases significantly compared to the baseline scenario.
  • These reductions stem mostly from an increase in provisions for bad debts and from volume and margin effects on net interest income.
  • Net interest income decreases by an average 1% of capital (ranging from 0.5 to 3% across the banks).
  • On the funding side the banks experience a significant cost increase when they do not alter their funding mix

The quote of the day:

Everything is very expensive”

An Australian tourist as quoted by the Japan Times on the recent unfavourable movement in exchange rates.

Peter Fray

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