CLEM SUNTER, Light versus darkness: the moment of truth - by Clem Sunter. Clem Sunter - articles by Clem Sunter.
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Light versus darkness: the moment of truth

Author: Clem Sunter

By Clem Sunter

I have just finished reading a book called The Big Short by Michael Lewis. It brilliantly explains the reasons for the great financial crash in America in 2007/8. As Reuters states on the back cover, it is "probably the single best piece of financial journalism ever written".

The explanation is as follows. Prior to the crash, a whole bunch of sub-prime mortgages were given to people around the US who really could not afford to service the interest and capital repayments on them. These individual mortgages were bundled up into security-backed mortgage bonds and then the bonds were further bundled up into CDOs or collateralised debt obligations.

A total of around $300bn dollars-worth of CDOs were then traded on Wall Street among the banking community as top quality, triple-A rated instruments with the full approval of the major ratings agencies. Investment in these instruments then expanded into other countries like Germany and Japan.

The arrogance of intelligence

How, you may ask, can a bunch of dodgy, triple-B rated mortgages end up being collectively classified as CDOs with the equivalent status of US treasury bonds? The answer is that because a CDO was a geographically diversified portfolio of mortgages taken out in Florida, California, Texas and all the other states in America, there appeared to be an infinitesimally small chance of all of the mortgages going bad at the same time.

The circumstances of each individual mortgage holder were not correlated in any way. Hence it was assumed that the good mortgages with up-to-date payments on them would always outweigh the ones going bad because of non-payment by at least 20 to 1. Randomness would not allow the kind of singularity of circumstances which could lead to catastrophe for the entire CDO system.

However, when US interest rates started rising in 2007 and house prices started falling, this assumption was proved devastatingly wrong as many of the mortgages were variable-rate and became more expensive to pay off just as the underlying security of the house against the mortgage started declining in value. The combination of these two trends, influencing as they did the whole American mortgage market, meant that correlation between the individual sub-prime mortgages in different states approached unity. Simultaneously, they lost much of their value.

Thus, the complete foundation of CDOs crumbled in one massive event and the holders of CDOs suffered gigantic losses on what they thought was a totally safe investment. Overnight, the CDOs became untradeable junk bonds and caused the bankruptcy and takeover of several famous names on Wall Street. The smartest brains that ran these firms did not have a clue as to what their traders were up to in making the bets they did. They even acted dumb in public when asked for an idea of what had transpired.

By contrast, the mavericks who were pessimistic about CDOs took out credit default swaps against them before the apocalypse. According to Michael Lewis, these swaps are similar in nature to insurance policies that pay out when the house burns down. While the mavericks did not own the destroyed house, they had paid the premiums on the policy covering the value of the building and as such were the beneficiaries after its destruction. They made a fortune when the policy paid out.

The relevance for Eskom

Eskom is considered a hugely diversified energy source in South Africa with coal-burning, oil-burning and nuclear power plants in different provinces. The strategy has assumed a low degree of correlation between the different plants and therefore it is presumed that if one plant goes offline in any way, the others can make up for the shortfall. Moreover, the chances of a spectacular grid collapse have until recently been reduced further by keeping spare capacity of 20% over and above national electricity demand.

Things have changed. Firstly, there is no surplus capacity due to the delays in commissioning the Medupi power station. Last year, South Africa experienced a small drop in electricity demand which put off the moment of truth. Now we are in the thick of it with stage two and stage three load shedding. Lots of households and businesses are being disrupted by it because demand can never be allowed to exceed supply. At least, we have schedules of planned outages for each area even if Eskom does not always strictly adhere to them.

Nevertheless, that is not where the real risk lies if you believe in the kind of reasoning Michael Lewis presented in his book. The threat is around the commonality of adverse factors facing all of our power stations at one and the same time, signifying an alignment between them like passengers and crew on a descending aeroplane. The factors are as follows:

  1. All the existing plants are getting old as we have not constructed a new power station for a long time. Eskom also admits that it has fallen behind in the maintenance of these stations.
  2. There is a critical shortage of technical skills in this country, particularly at the level of foreman and artisan. Eskom must be suffering on this front like all other industries, which makes it harder to keep up standards and avoid costly operational errors.
  3. Eskom faces an ever increasing cash crunch as its revenue is diminished by lower sales of electricity, people making alternative plans to satisfy their energy needs and municipalities defaulting on their payments to Eskom. Less money is forthcoming for maintenance at exactly the time when more funds are necessary.
  4. Of course, if the economy goes into reverse, a vicious circle of declining revenue will be created not only for Eskom but also for the government as lender of last resort. Nothing increases risk more than a problem that creates another problem that makes the first problem worse.
  5. The turnover of directors on the board of the company has been far too high for an operation that is in dire need of consistent and capable leadership.


Hence, the probability of a catastrophic scenario has risen as a result of the more intertwined destiny between the major sources of electrical power available to Eskom in South Africa. Nobody has offered a detailed scenario if we have an unplanned shutdown of the whole grid. Is it weeks or months that the shutdown could last, given that a restoration of power requires synchronicity between the plants in the start-up phase as well as an external source of power to fire up the system -as happened in California a few years ago?

More transparency and diversity of power sources

I do believe we need more transparency from Eskom on this complex issue to avoid panic and social unrest in the event that the worst happens. We certainly need more accurate information than the cream of American financial institutions offered on CDOs prior to the crisis of 2007/8.

We also need to become more energy-efficient as a nation and develop alternative sources of power which are independent of one another and independent of Eskom. Perhaps each power station should be separately privatised rather than kept under one corporate umbrella. That will lower the risk of accidental or deliberate load shedding in the long run by reducing the correlation between the functioning units. They will be managed by different entities.

We also need to become more energy-efficient as a nation and develop alternative sources of power which are independent of one another and independent of Eskom. Perhaps each power station should be separately privatised rather than kept under one corporate umbrella. That will lower the risk of accidental or deliberate load shedding in the long run by reducing the correlation between the functioning units. They will be managed by different entities.

This is the moment of truth and for the truth. How close to the edge of disaster are we? What is the plan of the 'war cabinet' in its totality to avoid it? For once, be honest with the people who are bearing the brunt of the disruptions. Electricity is now central to our way of life.

By Clem Sunter

 
     
   

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