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Buying Facebook - March 5th, 2011

The London Brief Buying Facebook March 5th, 2011 There was a spoof news item posted on the Internet from LOL News. The item said King Abdullah was offering $150 billion in cash to buy out Facebook "in order to end the Arab revolt". Sadly, it had enough basis that the Saudi government had to issue an official denial. On February 27th, after Friday prayers, Saudi officials detained a Shi'ite cleric in the Eastern Province after he called for a Constitutional monarchy and an end to discrimination. In 2009, he was arrested for inciting people against the regime. In 2008 he recited the call to prayer in a Shi'ite way and was arrested. In 2005 he was arrested for sponsoring events and religious gatherings banned by the Saudi authorities. Thousands of Saudi Shi'ites crossed into Bahrain and protested against his imprisonment. Other protests in Saudi Arabia involve the economy. A Facebook campaign titled "We Are Also Saudis" urged the government to release the money paid to the General Organization for Social Insurance, which is 9% of a monthly salary. The campaign also urged private companies to hire more Saudis over foreign workers. A particular grievance is that the state increased government worker salaries by 30% this year, whereas the private sector had little increase. One Saudi said: “We feel depressed when we hear about royal gestures increasing the salary of government employees as we in the private sector are excluded from such benefits without any reason.” A schoolteacher said: “I am receiving a monthly salary of SR1,500. My counterparts in the government schools receive higher salaries although we have the same certificates.” The unemployment rate among Saudis in the age bracket of 20-24 has risen to 43.2% in 2009. Massive amounts are spent on education, yet Saudi Arabia scores one of the lowest in eighth grade science and math. Teaching school-children that Shi'ites are apostates rather than concentrating on hard science is one part of the problem. Oil Prices Continue to Rise On March 11th, Saudi Arabia faces a Day of Rage. However, it's stock market had a tremendous rally on Saturday on the back of local buying. It appears that last week's local sell-off may have just been reactive and not predictive as some commentators have worried about. We'll all be watching that day closely. Yet hopefully it may prove as anti-climatic as the Day of Rage in February. But besides the risks in Saudi Arabia and the civil war in Libya, other factors are likely to keep oil prices high. Nigeria is having elections in April. The last election cycle they had saw a number of terrorist activities on oil infrastructure. Iran seems to be beating back and imprisoning a higher number of people than usual. In democratic Iraq, protests have been taking place for weeks because of anger over unemployment, corruption and poor basic services. 13 people died in protests on Friday. There were protests in Kuwait by "non-nationals" citing discrimination. Kuwait has 2.7 million people, but 1.3 million are registered as "non-nationals". The protests only numbered 200-400 people though. Substantively none affects immediate supply, but with Libya out, there is no spare capacity so we are quite vulnerable to an oil shock. Higher oil prices are creeping into inflation and slowing economies. The first quarter should show a slow-down in growth now. At prices of $120 WTI, we will start to see demand destruction and negative growth similar to what we saw in 2008. This is why it's pretty important that Western forces take out Qaddafi or impose a 'no-fly' zone to help stabilize Libya. Property Bubbles In light of Northern Rock offering 90% mortgages again, the Economist's survey on property prices was quite timely. Here are some of the dangers: 1. It is the single largest asset class for households. Property in rich world countries is estimated at $52 trillion for residential property. That is 126% of rich countries' combined GDP. When credit is loose, property absorbs the liquidity. When credit tightens, there is not enough liquidity to hold up the prices. The sheer size ends up causing highly positive and negative feedback loops. 2. Most people do not borrow to buy shares and bonds. When they do, the leverage is about 50% of the value of the investment. When assets decline, investors are liquid enough to bring their loan to value levels into balance. With property, buyers take on loans worth 90% or more of the value of the property. As property values decline, there is no way to bring loan-to-value levels down by selling a kitchen or a living room. 3. There is double leverage in property in that the banks that give the home-owners the loans are also highly leveraged. As borrowers default, banks thin layer of capital diminishes. 4. There is an emotional issue that makes house buyers pay high prices. Like art, people fall in love with a home and buy it. People buy homes to protect themselves from price rises in the future, to have more control of their living space and to have a safe place to raise children. As a result, the financial reasoning involved with buying the home is decoupled from the actual financials underlying the purchase. So during good times, things become a bit too good and prices push up above fair value. For these reasons, government policies designed to encourage people to buy homes seems like a sure way to create financial crises. First, the size of the property market ends up being valued extremely high because of the high amounts of leverage. That leverage then creates systemic risk in the banking system and general economy. Increasing Inflation Mervyn King said, “I don’t believe we’ve yet seen significant evidence of a pickup of medium-term inflation expectations,”. Yet the markets are factoring in interest rate hikes in the UK as three members of the Monetary Policy Committee (out of 9) are calling for interest rate hikes. The ECB changed its stance to use the words "strong vigilance" indicating a potential interest rate hike in April. This raised the euro toward the $1.40 level and helped it appreciate against the pound. But do Ireland, Greece and Spain need a higher currency right now? JP Morgan's private bank is calling for the end of "free money" in 2011 except in the U.S.. If free money ends, markets will become more volatile because governments are still running budget deficits and debt levels are at high percentages of GDP. While the ECB talks tough, I don't see how they can be conservative on monetary policy and not have a sovereign default in the periphery. Also China's monetary policy is tightly interwoven with the Fed's. Until the U.S. tightening cycle begins, a hard landing in China is unlikely. This makes me feel a tightening cycle is more lip service than reality. End Note In Italy, what's a great way to improve your capital ratios? You revalue your Bank of Italy holdings of course. Several Italian banks are asking the Bank of Italy to write up its gold holdings so they can report their stake in the BOI at a higher level and reduce their capital requirements. However, if you can't really sell a Bank of Italy stake, does it make sense to apply it to capital which supposedly should be a bit liquid? Just a thought. Enjoy your week and let's hope for a Day of Apathy rather than a Day of Rage in Riyadh. Omar Sayed London, March 5th, 2011 Hide message history

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